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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-KSB
(Mark One)
[ X ] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
Commission File No. 0-230 17
CHOICETEL COMMUNICATIONS, INC.
(Name of small business issuer in its charter)
MINNESOTA 41-1649949
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
9724 10TH AVENUE NORTH, PLYMOUTH, MN 55441
(Address of principal executive offices)
Issuer's telephone number: (612) 544-1260
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
Title of each class: Name of each exchange on which registered:
COMMON STOCK, $.01 PAR VALUE THE NASDAQ SMALLCAP MARKET
REDEEMABLE WARRANT THE NASDAQ SMALLCAP MARKET
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Securities Exchange Act of 1934 during the past 12
months (or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days. Yes [X] No [ ]
Check if there is no disclosure of delinquent filers in response to Item
405 of Regulation S-B is not contained in this form, and no disclosure will be
contained, to the best of registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-KSB
or any amendment to this Form 10-KSB. [X]
The revenues for ChoiceTel Communications, Inc. for the fiscal year ended
December 31, 1997 were $7,081,000.
The aggregate market value of the voting and non-voting common equity
held by non-affiliates as of March 24, 1998, based on the closing sale price
of the Common Stock on such date as reported on the Nasdaq SmallCap Market,
was $3,405,188.
On March 1, 1998, the Company had outstanding 2,915,006 shares of Common Stock,
par value $.01 per share.
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DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Prospectus filed November 12, 1997 pursuant
to Rule 424(b)(1), File Number 333-29969, are incorporated by reference into
Part II of this Form 10-KSB.
Portions of the Registrant's Proxy Statement for its 1998 Annual Meeting of
Shareholders are incorporated by reference into Part III of this Form 10-KSB.
Transitional Small Business Disclosure Format (Check one): Yes ; No X
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TABLE OF CONTENTS
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PART I
ITEM 1. DESCRIPTION OF BUSINESS. . . . . . . . . . . . . . . . . . . . . . 1
ITEM 2. DESCRIPTION OF PROPERTY. . . . . . . . . . . . . . . . . . . . . . 10
ITEM 3. LEGAL PROCEEDINGS. . . . . . . . . . . . . . . . . . . . . . . . . 10
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. . . . . . . . 11
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS . . . . . 12
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATION. . . . . 12
ITEM 7. FINANCIAL STATEMENTS . . . . . . . . . . . . . . . . . . . . . . . 18
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE. . . . . . . . . . . . . . . . 37
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL
PERSONS; COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT . . . . 38
ITEM 10. EXECUTIVE COMPENSATION . . . . . . . . . . . . . . . . . . . . . . 38
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT . . . . . . . . . . . . . . . . . . . . . . . . . . 38
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS . . . . . . . . . . 38
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K . . . . . . . . . . . . . . . . . 39
SIGNATURES . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
INDEX TO EXHIBITS. . . . . . . . . . . . . . . . . . . . . . . . . F-1
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PART I
ITEM 1. DESCRIPTION OF BUSINESS
GENERAL
ChoiceTel Communications, Inc. (the "Company") was formed as a Minnesota
corporation in 1989. The Company is the largest independent payphone service
provider ("PSP") in Minnesota. The Company installed its first payphones in
early 1990 and as of December 31, 1997, had an installed phone base of
approximately 3,200 payphones in 10 states. The Company has grown its business
through the installation of pay telephones in new areas and through strategic
asset acquisitions of payphone routes and related assets, including 270
payphones located in Minnesota acquired from American Amusement Arcade in 1993;
85 payphones acquired in Nevada from Telco West in 1995; an additional 1,020
payphones acquired from Telco West in 1997 in Oregon, Idaho, Colorado,
Washington and Wyoming; and, also in 1997, 586 payphones located in Minnesota
and Wisconsin acquired from Computer Assisted Technologies, Inc.,
together with site contracts only for the installation of an additional 98
payphones.
INDUSTRY OVERVIEW
In 1996, calls made from pay telephones were estimated at $7 billion in
annual revenues to the United States telecommunications industry. Pay telephones
may be "public," meaning they are owned by local exchange carriers ("LECs"), or
"independent," meaning they are owned and operated by companies independent of
the LECs, such as the Company. Of the approximately 2 million pay telephones
operating in the United States in 1996, it is estimated that approximately
350,000 were independent.
Today's telecommunications marketplace was principally shaped by the 1985
AT&T divestiture of the 22 regional Bell operating companies ("RBOCs"), which
provided local telephone services within their areas of operation. The AT&T
divestiture and the many regulatory changes adopted by the FCC and state
regulatory authorities in response to the AT&T divestiture have resulted in the
creation of new business segments in the telecommunications industry. As a
result of the AT&T divestiture, pay telephones may now be owned and operated
independently.
As part of the AT&T divestiture, the United States was divided into
geographic areas known as local access transport areas or "LATAs." Telephone
service that both originates and terminates within the same LATA ("intraLATA")
is priced based on tariffs filed with and approved by state regulatory
authorities. LECs provide intraLATA telephone service to, among others,
independent pay telephone companies. LECs are generally prohibited from offering
or deriving revenues or income from services between LATAs ("interLATA"). In
addition, most state regulatory authorities require LECs to provide local access
line service to independent pay telephone companies. See "Government
Regulation" below.
Long-distance carriers provide interLATA service and, in some
circumstances, may also provide long-distance service within LATAs. An interLATA
long-distance pay telephone call begins with an originating LEC transmitting the
call from the pay telephone that originates the call to a point of connection
with a long-distance carrier. The long-distance carrier, through its owned or
leased switching and transmission facilities, transmits the call across its
long-distance network to the LEC serving the local area in which the recipient
of the call is located. This terminating LEC then delivers the call to the
recipient. Independent PSPs contract with one or more long-distance carriers to
provide long-distance service to their pay telephones.
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BUSINESS STRATEGY
The Company has focused on identifying payphone sites that have the
potential to achieve a high return on investment ("ROI") after depreciating the
equipment over the life of the phone lease. Although others in the industry have
used shorter leases, the Company's analysis indicated that a long-term lease was
necessary in order to achieve the Company's ROI objective and to offer a
competitive commission to location owners ("Site Providers"). Therefore, most of
the Company's pay telephones are placed with Site Providers under leases having
terms of five years or more.
The Company's objective is to grow through additional acquisitions and
internally, thereby achieving economies of scale. There are approximately
1,500 independent PSPs nationally. The Company believes that there is a
significant opportunity to consolidate the highly fragmented independent
segment of the payphone industry. Further, independent PSPs, as compared to
the RBOCs, generally have a larger percentage of computer-based, or "smart,"
phones in their inventory of pay telephones and their payphones are placed in
locations that generate higher revenue per phone. The Company intends to
become an active consolidator of the independent payphone market. Management
believes that the Company's experience in completing acquisitions will be
instrumental in identifying, negotiating and ultimately integrating
additional acquisitions.
The Company also intends to expand through internal growth. The Company
actively seeks to contract and install additional payphones to increase its
sales in existing markets. The installation of new payphone locations is
generally less expensive, though less predictable, than acquiring existing PSPs.
ACQUISITION AND EXPANSION STRATEGY
The Company believes that the existence of many small independent PSPs
presents acquisition opportunities for the Company. The Company further believes
that management's experience in identifying and negotiating potential
acquisitions and integrating acquired companies into the Company's ongoing
operations will enable it to grow and benefit from the associated economies of
scale.
In reviewing potential acquisition candidates, the Company considers
various factors, including:
1. HISTORICAL AND PRO FORMA FINANCIAL PERFORMANCE
The Company reviews the historical revenues, mix between coin and
non-coin revenue and cash flows of the telephones to be acquired and
analyzes their prospective profitability based upon pro forma
considerations such as lower service and collection expenses, lower general
and administrative expenses, and the more favorable terms and conditions
which the Company may be able to obtain from long-distance service
providers.
2. LOCATION AGREEMENTS
The Company seeks to acquire payphone contracts that are long-term
(five or more years) with automatic renewals at the end of the term, that
are assignable to another company, and which cannot be canceled by the Site
Provider but give the Company the right to remove the phone if the revenues
are insufficient.
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3. EQUIPMENT IN SERVICE
There are three primary suppliers of smart phones to PSPs. To date,
the Company has installed only "INTELLICALL" brand payphones and has
acquired only companies using INTELLICALL payphones. This has allowed the
Company to quickly integrate acquired phones into daily operations. The
Company could acquire routes using another brand's smart phones but it
would have to factor in the additional costs associated with adapting
proprietary software, stocking additional spare parts and training
personnel for proficiency on new equipment.
4. LOCATION AND ECONOMIES OF SCALE
The Company considers the geographic proximity of the payphones to be
acquired to the Company's existing service areas, and the extent to which the
acquisition would provide the Company with economies of scale through more
efficient utilization of coin collection and service personnel. The Company
seeks to enter new geographic areas that will result in similar economies of
scale through one or more acquisitions.
Installations at new locations are an important part of the Company's
expansion strategy in that pay telephones placed directly with Site Providers,
rather than through acquisition, have historically provided the Company with its
highest returns. The Company has generally been able to add pay telephones at
the rate of 100 phones per year in Minnesota, and anticipates that this rate of
expansion will increase as the Company enters additional markets. Because the
Company's Site Provider base is primarily businesses, the Company regularly
obtains additional pay telephone locations as the Site Providers' respective
businesses grow.
OPERATIONS
The Company operates, services and maintains a system of approximately
3,200 pay telephones in the midwestern and western United States, with
approximately 60% of its payphones located in Minnesota. All of the Company's
pay telephones accept coins as payment for local or long-distance calls and can
also be used to place local or long-distance cashless calls.
COIN CALLS
The Company's pay telephones generate coin revenue primarily from local
calls. In all of the states in which the Company's pay telephones are
located other than Minnesota, the Company charges the same rates for local
coin calls as does the relevant LEC; in most states that charge is $0.25.
Until October 1997, local coin calls were regulated by the public utilities
commissions of the states in which the Company operated. On October 7, 1997
the FCC ended the authority of states to regulate local coin call rates at
pay telephones and allowed the market to set the rates. In anticipation of
this change, the Company notified its Minneapolis and St. Paul site providers
explaining the change in regulation and outlining its plans to increase the
cost of local calls in Minneapolis and St. Paul to $0.35. Site providers
were encouraged to call and discuss the change with the Company, and for
those who still felt uncomfortable, the cost of a local call was not changed.
On October 7 the Company started increasing the cost of local calls at
approximately 1,500 of its Minnesota payphones. Although US West did not
increase the cost of a local call at their payphones, the Company feels it
was able to generate a modest increase in revenues from the change.
Long-distance coin calls are carried by long-distance carriers that have
agreed to provide long-distance service to the Company's telephones. The
majority of the Company's phones sell coin long-distance for a rate of $0.25
per minute, with a two minute minimum. This rate is well below U.S. West's
rates for coin long-distance
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and is significantly less expensive than credit card or collect long-distance
rates. For example, U.S. West charges approximately $3.10 for the first three
minutes of a coin long-distance call made in Minnesota, and AT&T charges
$3.30 and $3.50 for the first three minutes of credit card and collect
long-distance calls, respectively, made from public payphones. The Company
offers lower rates to create a better value for price sensitive consumers and
to discourage Dial-Around calling from its phones (as the Company receives no
incremental revenue from users who place long-distance calls through such
services as "1-800-COLLECT" and the many other long-distance providers that
can be accessed through the Company's payphones). However, in October 1997,
the Company began to recognize incremental revenue from Dial-Around calling.
See "Government Regulation" and "Dial-Around Compensation" below. Management
believes that its $0.25 per minute long-distance rate results in considerable
goodwill and is a point of differentiation between its phones and its LEC
competitors.
NON-COIN CALLS
The Company also receives revenue from non-coin, or cashless, calls made
from its pay telephones, including credit card calls, calling card calls,
collect calls and third-party billed calls. These calls are processed by the
payphone's computer using store and forward technology, or, if a live operator
is requested, then the call is transferred to the Company's designated operator
service provider ("OSP").
DIAL-AROUND CALLS
A Dial-Around call originates from a payphone when the user dials a
non-billable access number such as, for example, 1-800-Collect, 1-800-CallATT or
10ATT, and thereby dials around the Company's long-distance carrier in order to
reach another long-distance carrier. The user deposits no money for the call
and, prior to 1992, the long-distance provider carrying the call paid no
commission to the payphone owner. Since 1992, payphone owners have been
compensated by long-distance carriers for Dial-Around calls. See "Government
Regulation - Dial-Around Compensation."
COMPUTER NETWORK AND EQUIPMENT. The Company focused its early efforts on
building a computer processing network that automated many of the operations of
managing a pay telephone enterprise. Specialized software was designed and
written when it was not available from industry suppliers. The Company's smart
phones are part of a centralized network that links all of the Company's phones
in the field with central processors. The system allows the Company to monitor
phone call volume, identify malfunctioning equipment, dispatch repair service,
schedule efficient coin collections, calculate commissions, print checks to Site
Providers, rate and process long-distance calls using store and forward
technology, and generate necessary reports that analyze and monitor
profitability of the phones. Management believes that as the Company grows, this
network can be expanded easily with little additional investment in
infrastructure.
The Company installs pay telephones which it believes incorporate the
latest technology. The equipment makes use of microprocessors to provide voice
synthesized calling instructions, detect and count coins deposited during each
call, inform the caller at certain intervals of the time remaining on each call,
and identify the need for and the amount of an additional deposit. The pay
telephones can be programmed and reprogrammed from the Company's central
computer facilities to update rate information or to direct different kinds of
calls to particular carriers. The Company's pay telephones can distinguish coins
by size and weight, report to a remote location the total coinage in the coin
box, perform self-diagnosis and automatically report problems to a
pre-programmed service number, and immediately report attempts of vandalism or
theft. Some of the telephones also operate on power available from the telephone
lines, thereby avoiding the need for and reliance upon an additional power
source at the installation location. The telephones are designed to have a
user-friendly appearance and manner of operation similar to LEC-owned pay
telephones.
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The Company's smart phones utilize store and forward technology which
enables the Company to sell credit card, calling card and collect calls
through its own OSP. The store and forward software program provides callers
with instructions communicated by a digitized human voice for entering
billing information, such as a calling card number or a terminating phone
number for a collect call, prior to connecting a call. For example, for a
collect call, a synthesized voice directs the caller to speak his or her name
into the payphone handset, the caller's response is digitally recorded and
played back when the call is answered at its destination, and the called
party is instructed to press "1" on his or her telephone to accept the call.
The software program also minimizes fraudulent charges for calling card or
credit card calls by automatically communicating with a credit bureau to
verify that the card has not been identified as a lost, stolen or delinquent
card. For a collect call, the software program can also verify that the
number being called is not delinquent. After verifying the call, the payphone
will complete the connection using a long-distance carrier. When the call is
concluded, the software program directs the billing information, including
the date, time and length of the call, the billed-to-number and the charges
for the call, to the Company's computer. Later, the billing records are sent
to a processing agent that bills and collects the charges. The processing
agent keeps a percentage of the billed amount as its processing fee and
remits the balance to the Company. The Company books the net amount received
as non-coin revenue. The Company is billed by the long-distance carrier for
long-distance charges, which charges are only a small percentage of the
amount billed to the customer.
Some of the Company's payphones, primarily those placed in locations that
are not high generators of long-distance calls, do not have store and forward
capability. In addition, customers occasionally request a live operator even
with phones that have the store and forward technology. Examples of calls
requiring live operator assistance include person-to-person calls and calls
billed to a third party. In these situations, the calls are transferred to an
OSP which completes and bills the calls and pays the Company a commission based
on the amount billed. The Company contracts with several OSPs for this 24-hour a
day service. The Company routes all of these calls to a single OSP to maximize
the commission revenue it receives. There are numerous OSPs available to the
Company and the terms offered by them are highly competitive. In selecting an
OSP, the Company considers numerous factors including the commission offered,
the quality of service and the pricing of calls to customers.
PLACEMENT OF PAY TELEPHONES. As of December 31, 1997, the Company's pay
telephone system consisted of approximately 3,200 telephones located in 10
states. The following table sets forth certain information as of the dates
indicated concerning the number and location of pay telephones operated by the
Company:
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NUMBER OF PAY TELEPHONES
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DECEMBER 31,
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STATE 1994 1995 1996 1997
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Minnesota . . . . . . . . . . . . . . . . . . . . . . 792 910 1,074 1,849
Oregon . . . . . . . . . . . . . . . . . . . . . . . - - 10 714
Idaho . . . . . . . . . . . . . . . . . . . . . . . . - - - 318
Nevada . . . . . . . . . . . . . . . . . . . . . . . - 84 112 115
Washington . . . . . . . . . . . . . . . . . . . . . - - - 50
Wisconsin . . . . . . . . . . . . . . . . . . . . . . 7 7 32 70
New York . . . . . . . . . . . . . . . . . . . . . . - - 12 40
Wyoming . . . . . . . . . . . . . . . . . . . . . . . - - - 33
Colorado . . . . . . . . . . . . . . . . . . . . . . - - - 19
North Dakota . . . . . . . . . . . . . . . . . . . . - - 5 5
Total 2,793 1,013(1) 1,245 3,213
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(1) Includes 12 phones located in Indiana and removed from service in
1996.
The Company's ROI focus has enabled it to profile locations based on the
likely profitability of a location. While this methodology is proprietary, as
are the specific locations under contract, the Company's locations include a
wide variety of establishments, such as restaurants, shopping malls, convenience
stores, grocery stores, gas stations and schools. The Company's pay telephone
lease mix includes indoor phones, walk-up outdoor phones and drive-up payphones.
While the Company had a single Site Provider that accounted for more than 5% of
its pay telephones and revenue in the years ended December 31, 1995 and 1996, no
single Site Provider accounted for more than 5% of its pay telephones and
revenues in the year ended December 31, 1997.
Agreements with Site Providers to install the Company's pay telephones (the
"Site Agreements") provide for revenue sharing with Site Providers, typically a
commission based on a negotiated percentage of revenue from the pay telephone.
The Site Agreements give the Company the exclusive right to install pay
telephones at that location and are generally of a five-year or greater term
with automatic renewal provisions. The Company's Site Agreements normally give
the Company the right to remove poor performing phones. Further, the Company can
typically terminate a Site Agreement on 30 days' notice to the Site Provider.
The Site Provider generally does not have the right to terminate a Site
Agreement.
PHONE LINE RATES. The Company pays local line charges for each of its
installed payphones. These line charges cover basic service to the telephone
as well as the transport of local calls. The Company's business model has
always been based on ROI and thus is highly influenced by the line rate
charged by LECs, primarily U.S. West. Pay telephone line rates are regulated
by state public utilities commissions ("PUCs")and generally can be connected
only to a Public Access Line ("PAL"). When the Company commenced operations,
the PAL rate in effect resulted in an average phone bill of about $130 per
month per phone. In order to achieve its ROI objective, the Company targeted
high volume phones. In 1992, the Minnesota Public Utilities Commission
("MNPUC") reduced the tariff for PALs, which resulted in an average cost
reduction of about $20 per phone per month, allowing the Company to include
slightly lower volume phones in its network and still achieve its ROI
objective. In April 1996, the Company's wholly-owned subsidiary, ChoiceTel,
Inc. ("CI"), was approved to purchase business lines which U.S. West sells at
a monthly rate of $52 per phone including tax. CI resells those lines to the
Company as PAL lines at this lower rate which has allowed the Company to
increase the profitability of its existing phones and to reduce the minimum
call volume it needs from new phones to achieve its ROI objective. In May
1997, CI entered into an agreement with U.S. West that provides CI with a
21.5% reseller discount on the pre-tax cost of business lines in Minnesota,
which results in a monthly rate for the Company of $42.50 per phone in such
state.
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On March 9, 1998, the FCC issued an order which requires payphone
providers to use PALs in order to continue to receive dial-around
compensation from long-distance carriers. This may require CI to purchase PAL
lines. If the MNPUC approves U.S. West's tariff filed on March 25, 1998 to be
effective on April 17, 1998 reducing the cost of PAL lines to the business
line rate, the effective cost of the lines to the Company will increase to
$52.00 per phone in that CI has no agreement for a reseller's discount on PAL
lines at this time.
MARKETING. At December 31, 1997, four of the Company's employees
devoted substantially all of their time to locating and contracting with new
Site Providers in Minnesota. In addition, the Company has engaged one
independent contractor in Oregon to locate new sites for payphone
installations. A successful contracting program requires identifying good
locations, selling Site Providers on the benefits of the Company's payphones,
and negotiating favorable Site Agreement terms.
Identifying good locations for payphones is the most important aspect of
the Company's marketing program, which includes an evaluation of population
density, calling patterns and neighborhood socio-economic factors. The Company
concentrates its efforts towards high traffic locations, lower income
neighborhoods, and venues where people expect to find payphones.
The Company promotes its payphone program to Site Providers by emphasizing
service and maintenance. Site Providers generally view the payphone as a
customer service rather than a profit center. Providing repair and collection
services during evenings and on weekends and providing 24-hour a day live call
placement assistance sometimes is more important in securing the Site Agreement
than the amount of commission paid to the Site Provider.
SERVICE AND MAINTENANCE. The Company believes it offers many of its Site
Providers a higher level of service than is provided by the LEC competitors, who
typically offer lower commissions and do not monitor payphone performance. The
Company monitors its payphones electronically and offers evening and weekend
repair service for its Minnesota payphones. The Company uses 29 full- and
part-time field service technicians, each of whom collects money, cleans phones
and responds to trouble calls made by either a consumer or by the telephone
itself as part of its internal diagnostic procedures. Many technicians are also
responsible for the installation of new telephones. Due to the ability of the
field service technicians to perform multiple service and maintenance functions,
the Company is able to limit the frequency of trips to each pay telephone as
well as the number of employees needed to service the pay telephones.
COMPETITION
The Company competes for pay telephone locations with LECs and other
independent pay telephone operators. The Company also competes indirectly with
long-distance carriers, which can offer Site Providers commissions on
long-distance calls made from LEC-owned payphones. Most LECs and long-distance
carriers against which the Company competes and some independent pay telephone
companies have substantially greater financial, marketing and other resources
than the Company. In addition, many LECs, faced with competition from the
Company and other independent pay telephone companies, have increased their
compensation arrangements with Site Providers to offer more favorable commission
schedules.
The Company believes the principal competitive factors in the pay telephone
business are (i) responsiveness to customer service needs, (ii) the amount of
commission payments to a Site Provider and the opportunity for a Site Provider
to obtain commissions on both local and long-distance calls from the same
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company, (iii) the quality of service and the availability of specialized
services provided to a Site Provider and telephone users, and (iv) the ability
to serve accounts with locations in several LATAs or states. The Company
believes that independent pay telephone operators have an advantage over LECs in
that they can offer Site Providers commissions on coin and cashless local and
long-distance calls. Most LECs are prohibited from obtaining revenues or
commissions on interLATA long-distance telephone calls and, consequently,
generally only pay commissions to Site Providers for local and intraLATA calls.
Under the Telecom Act, this prohibition will be removed at such time as
sufficient competition for local telephone service has been established.
Opening the local telephone markets to competition will likely reduce
telephone line charges, the Company's largest operating expense. In most of the
areas where the Company operates, it must purchase local telephone service from
a single regulated monopoly (primarily, U.S. West). As AT&T, MCI, Sprint and
others compete to offer local telephone service, telephone line charges are
expected to decline. In addition, the Company expects that its high number of
telephone lines will give it the ability to negotiate additional volume
discounts.
Technological advances and cost efficiencies underlie a continuing increase
in the transmission of voice messages. More telephone calls are being made
because the manner, means and cost of completing a call have improved. With the
advent of call waiting and caller I.D., and as the number of answering machines,
voice mail systems, pagers and cellular phones increases, the likelihood of a
telephone call being made also increases due to the perceived certainty that a
message can be communicated even if the intended recipient may not be reached
directly. Accordingly, as the means and desire to communicate by telephone
increase, the Company anticipates that its payphones will experience increased
usage.
GOVERNMENT REGULATION
In 1995, the State of Minnesota passed comprehensive legislation for the
telecommunications industry (the "MN Act"). One provision of the legislation
created the ability for companies to compete with U.S. West in providing local
telephone service. The effect of the legislation for the Minnesota payphone
industry was to immediately decrease the cost of telephone lines. The Company
believes that the increased competition to provide local telephone service may
further reduce the cost of telephone lines.
In January 1996, Congress passed the Telecommunications Act of 1996 (the
"Telecom Act"), a comprehensive telecommunications bill that, in part, dealt
with several concerns of the independent pay telephone industry. Congress
stated that its intent was to create a "pro-competitive, de-regulatory
national policy framework designed to accelerate rapidly private sector
deployment of advanced telecommunications and information technologies and
services to all Americans by opening all telecommunications markets to
competition." The Telecom Act, among other things, requires local telephone
companies to eliminate subsidies of their pay telephone services and to treat
their own and independent payphones in a nondiscriminatory manner. Of
particular importance to the Company, the Telecom Act addressed the
inherently unfair disadvantage independent pay telephone companies have in
competing with regulated monopolies, the compensation of independent pay
telephone companies for calls made from their equipment that previously
offered no compensation, and the issue of price regulation of local calls by
the various state PUCs.
COMPETITION WITH RBOCS. Under the Telecom Act, the RBOCs must operate their
payphone divisions with separate profit and loss statements. The Company
believes that this will likely result in the Company's RBOC competitors
(primarily, U.S. West) being less aggressive in bidding for locations. It also
may result in the RBOCs removing many low volume pay telephones that
collectively compete with the Company's pay telephones and, ultimately, may
result in the RBOCs raising prices for pay telephone calls. See "Deregulation
of Local Pay Telephone Rates" below.
8
<PAGE>
DIAL-AROUND COMPENSATION. Pay telephones are required by the FCC to
provide equal Dial-Around access to all long-distance carriers, either by
access code (such as "10ATT") or by 800 service. Prior to November 1996, the
Company received $6 per payphone per month from long-distance carriers for
providing this Dial-Around service. The Telecom Act recognized that it is a
burden to payphone companies to provide such access and that the compensation
paid to payphone companies for this access should be greater. Because the
infrastructure to track and compensate for these calls did not then exist,
the FCC's 1996 order raised the flat rate of compensation for the Dial-Around
service to approximately $45 per payphone per month, based on $0.35 per call
(the per call rate for a local coin call in deregulated states) times the
national average of 131 monthly Dial-Around calls placed per payphone. In
October 1997, the method of compensating payphone companies was scheduled to
switch to a per call charge of $0.35 to be tracked and paid by the
long-distance carriers and, in November 1998, the per call charge was
scheduled to equal the cost of a local pay telephone call. While the Company
is unable to estimate the number of Dial-Around calls made from its
payphones, management believes that there will not be a material change in
the total amount of Dial-Around compensation it receives when the basis for
compensation is switched to a per call rate.
The FCC's 1996 order implementing the increased Dial-Around compensation
was appealed, with the intent, in part, of decreasing the amount of
Dial-Around compensation mandated by the order. In July 1997, the Court
remanded the matter to the FCC for reconsideration of the rate of Dial-Around
compensation. The Court found that the per call charge of $0.35 (which was
multiplied by 131 calls to determine the rate of monthly Dial-Around
compensation per payphone) was inappropriate because the FCC did not consider
evidence of the differences in the cost of coin calls and Dial-Around calls.
The long-distance carriers then petitioned the Court to clarify the effect of
the Court's July decision and to vacate the portion of the FCC's 1996 order
setting the rate of Dial-Around compensation pending the FCC's re-examination
of the Dial-Around rate. Further, in a letter to the FCC dated August 15,
1997, AT&T challenged the FCC's authority to order the long-distance carriers
to make any payments during the pendency of the rate determination and stated
its intention to make Dial-Around payments voluntarily based on its imputed
rate of $0.12 per call, subject to retroactive adjustments, up or down, after
the FCC's final order on remand. The Court agreed with the long-distance
carriers. In a decision dated September 16, 1997, the Court vacated the
portion of the FCC's 1996 order setting the rate of Dial-Around compensation
pending a new FCC order on remand. Accordingly, the long-distance carriers
were not required to make Dial-Around payments to payphone service providers
until the FCC issued a new order setting the Dial-Around rate. On October 9,
1997, the FCC issued an order establishing the Dial-Around rate as of October
7, 1997 at $0.284 per call ($0.35 minus an offset of $0.066 for expenses
unique to coin calls) for the two years beginning October 7, 1997. The FCC
indicated that it planned to address Dial-Around compensation for the period
from November 6, 1996 through October 6, 1997 in a subsequent order and
tentatively concluded that the $0.284 per call rate adopted on a going
forward basis should also govern compensation during the period from November
6, 1996 through October 6, 1997. This would be approximately $37 per payphone
per month. Because the Company cannot be certain what the rate of Dial-Around
compensation will be for the period from November 7, 1996 through October 6,
1997, it has determined the amount of its revenue from Dial-Around
compensation for the six months ended June 30, 1997 and going forward through
October 6, 1997 based upon the previous rate of $6.00 per payphone per month,
and it has established an $80,000 liability for revenue accrued in excess of
the previous rate during the period from November 6, 1996 through December
31, 1996. Beginning October 7, 1997, the Company began recognizing revenue
from Dial-Around compensation based upon the Dial-Around rate of $0.284 per
call. However, there can be no assurance that Dial-Around compensation will
not be based on a rate that is less than $6.00 per payphone per month for the
period from November 6, 1996 through October 6, 1997 or that is less than
$0.284 per call for the period beginning October 7, 1997. The setting of a
rate of Dial-Around compensation that is to be paid to the Company that is
less than the Company's estimate of such rate could have an adverse effect on
the results of operations and financial condition of the Company, which could
be material.
9
<PAGE>
DEREGULATION OF LOCAL PAY TELEPHONE RATES. The FCC also adopted rules
pursuant to the Telecom Act which on October 7, 1997, repealed all rules
regulating the cost of a local call placed at a payphone and allowed the market
to set the rate for local coin calls, unless the state can demonstrate to the
satisfaction of the FCC that there are market failures within the state that
would not allow market-based rates. Management anticipates that this
deregulation will result in the per call price of pay telephone service rising
to $0.35 or more. Management bases its belief on the experience in Iowa in 1989
when the price of pay telephone calls was deregulated and U.S. West raised its
price to $0.35. U.S. West has announced it has no plans to increase the amount
it charges for local calls; however, the prohibitions on the RBOCs subsidizing
their pay telephone business, and given the large number of low volume RBOC pay
telephones in the marketplace, management believes the RBOCs will have a strong
desire to eventually raise pay telephone rates. As of October 15, 1997, the
Company had increased the amount it charges for local calls to $0.35 at 1,150 of
its phones in Minnesota.
EMPLOYEES
As of December 31, 1997, the Company had 32 employees, 26 of whom were
full-time. No employees are covered by a collective bargaining agreement. The
Company believes that its relationships with employees are good.
ITEM 2. DESCRIPTION OF PROPERTY
The Company's corporate offices are located in approximately 5,000 square
feet of leased space in Plymouth, Minnesota. The lease for this property expires
in May 2000 and the Company has two successive options to extend the lease for
additional one-year periods. The Company also leases approximately 2,250 square
feet of warehouse and office space in Lake Oswego, Oregon, pursuant to a lease
which expires in July 1998, subject to the exercise by the Company of two
successive options to extend the lease for additional one-year periods. The
Company believes that its current facilities are sufficient for its needs for
the foreseeable future.
ITEM 3. LEGAL PROCEEDINGS
MINNESOTA SALES TAX. The Company, based on an analysis of the published
regulations of the Minnesota Department of Revenue, has not remitted any sales
tax payments to the State of Minnesota. In 1996, the Company learned that the
opinion of the Department was that coin-operated payphone receipts were subject
to state sales tax. Despite the Department's position, management is still of
the view that the Company is not subject to sales tax, and the Company is
challenging the imposition of the tax. The Company retained special tax counsel
to contest the Department's position that coin-operated payphone receipts are
subject to sales tax. Nonetheless, the Company has established a reserve of
$1,100,000 as of December 31, 1997, to provide for the potential sales tax
liability and will continue to reserve on a monthly basis until a definitive
ruling is obtained.
CLAIM FOR REFUND OF OVERPAYMENT. Prior to enactment of the MN Act which
facilitated increased competition in the telecommunications industry, U.S. West
had required, with MNPUC approval, that PSPs purchase PALs at approximately
twice the cost of business lines even though business lines and PALs were
essentially the same. Beginning in August 1995, LECs could no longer restrict
the resale of its products, and the Company, along with other Minnesota
independent PSPs, requested to purchase for resale from U.S. West regular
business lines for its payphones. U.S. West refused the request on the grounds
that its requirement that PSPs use PALs had, prior to the enactment of the law,
been approved by the MNPUC. In November 1996, the MNPUC concluded that the law
did entitle PSPs to use business lines in place of PALs and ordered U.S. West to
convert the lines to business lines within 60 days. The MNPUC, however, did not
require U.S. West to refund the
10
<PAGE>
difference in costs collected during the period from August 1995 until
October 1996. Even though the Company was able to purchase business lines
through CI starting in the summer of 1996, it estimates that it has overpaid
U.S. West approximately $450,000. In April 1997, the Company, together with
other Minnesota independent PSPs, initiated an action in the Minnesota Court
of Appeals requesting such court to order the MNPUC to order U.S. West to
refund the overpayment. On December 30, 1997, the Court denied request for
the refund, and the Company has determined not to pursue the matter further.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders during the
quarter ended December 31, 1997.
11
<PAGE>
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock and Redeemable Warrants have been quoted on the
Nasdaq SmallCap Market under the symbol "PHON" and "PHONW", respectively, since
November 10, 1997. The following table sets forth, for the period indicated,
the range of high and low prices for the Company's Common Stock and Redeemable
Warrants as reported on the Nasdaq SmallCap Market.
<TABLE>
<CAPTION>
COMMON REDEEMABLE
STOCK WARRANTS
------------- ------------
HIGH LOW HIGH LOW
------ ------ ------ -----
<S> <C> <C> <C> <C>
1997:
Fourth Quarter . . . . . . . . . . . . $6.250 $4.625 $1.375 $.750
</TABLE>
As of March 1, 1998, there were 22 shareholders of record and
approximately 200 beneficial owners of the Company's Common Stock.
The information concerning the sale of the Company's unregistered
securities is set forth in Part II, Item 26, of the Form SB-2, Registration
Number 333-29969, which information is incorporated herein by reference.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS
Except for historical information contained in this report, information
contained in this Form 10-KSB contains "forward-looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995, which
can be identified by the use of forward-looking terminology such as "may",
"will", "expect", "plan", "anticipate", "estimate", or "continue" or the
negative thereof or other variations thereon or comparable terminology. There
are certain important factors that could cause results to differ materially
from those anticipated by some of these forward-looking statements, including
without limitation, the effects of changes in economic conditions and the
"Risk Factors" entitled "Risks Associated with Expansion Strategy,"
"Competition," "Pending Determination of Dial-Around Compensation Rate,"
"Other Regulatory Factors," "Technological Change and New Services,"
"Dependence Upon Third-Party Providers," "Service Interruptions; Equipment
Failures," "Reliance on Single Brand of Payphones," "Seasonality" and
"Reliance on Key Personnel" contained in the Company's Prospectus dated
November 10, 1997 included in the Registration Statement on Form SB-2 filed
with the Securities and Exchange Commission (Registration No. 333-29969).
Such "Risk Factors" are incorporated herein by reference. Investors are
cautioned that all forward-looking statements involve risks and uncertainty.
GENERAL
The Company derives revenue from three principal sources: coin calls, non-
coin calls and Dial-around calls. Coin calls represent calls paid for with
coins deposited in the telephone. The Company recognizes coin revenue in the
amount deposited. Non-coin calls are calls charged to a customer credit card or
billed to the called party (collect calls). These calls are processed by the
payphone's computer using "store and forward" technology or, if a live operator
is requested, the call is processed by an operator service provider ("OSP") such
as, for example, AT&T, MCI or Sprint. Compensation for Dial-Around calls is
paid by long-distance carriers when consumers access a long-distance carrier
directly by dialing an access number or an 800 number or by using a non-billable
calling card.
The principal costs related to ongoing operation of the Company's payphones
include telephone line charges, consisting of payments made by the Company to
telephone companies and long-distance carriers for access charges and use of
their networks; commission payments to Site Providers; and collection, repair
and maintenance costs.
12
<PAGE>
RESULTS OF OPERATIONS
The following table presents certain items in the combined statements of
operations as a percentage of revenue for the years ended December 31, 1996 and
1997.
<TABLE>
<CAPTION>
STATEMENT OF OPERATIONS DATA: 1996 1997
---- ----
<S> <C> <C>
REVENUE:
Coin revenue . . . . . . . . . 78.9% 77.0%
Non-coin revenue . . . . . . . 14.1 14.7
Dial-around revenue . . . . . . 5.5 6.5
CLEC revenue . . . . . . . . . 1.4 1.8
Total Revenue . . . . . . . . . 100% 100%
SERVICE COSTS AND EXPENSES:
Telephone line charges . . . . 36.2% 30.8%
Commissions . . . . . . . . . . 16.3 18.0
Collection, repair and
maintenance (1) . . . . . . . . 8.5 12.0
Total cost of service . . . . . 61.0 60.8
Gross margin . . . . . . . . . 39.0 39.2
Selling, general and admin.(1). 18.1 16.8
Interest . . . . . . . . . . . 3.4 9.9
Depreciation and amortization . 10.2 13.1
Sales tax contingency . . . . . 24.3 3.4
Net income (loss) before
income tax provision. . . . . . (17.0%) (4.0%)
Average phones in service . . . 1,123 2,980
</TABLE>
(1) A portion of the expenses classified as "Collection, repair and
maintenance" are classified as "Selling, general and administrative
expenses" in the Combined Financial Statements of the Company and notes
thereto.
YEAR ENDED DECEMBER 31, 1997 COMPARED WITH YEAR ENDED DECEMBER 31, 1996
For the year ended December 31, 1997, total revenue increased approximately
$3,519,000, or 98.8%,
13
<PAGE>
compared to the year ended December 31, 1996. This growth was primarily
attributable to the increase in the average number of pay telephones in
service from 1,125 during 1996 to 2,980 during 1997. Coin revenues during
the period increased by $2,728,000 or 97.0% and non-coin revenues increased
by $556,500 or 110.8%.
Telephone charges increased in 1997 by $935,000 or 72.5% above the previous
year's period. The growth in telephone charges was kept below the rate of
growth in payphones primarily due to the Company's subsidiary, CI, receiving
authorization to act as a reseller of telephone service in April 1996, which
ultimately reduced the Company's line charges in Minnesota to $52 per line.
Commissions paid to Site Providers increased $714,000 or 123.2% above
the previous year's period, primarily as the result of the growth of phones
in service. Collection, repair and maintenance increased $578,500 or 190.1%
above the previous year period. In the 1997 period, selling, general and
administrative expenses increased approximately $566,000, or 88.1%, from the
prior year's period. Interest expense increased $581,000 or 485.9% compared
to the prior year period due to increased borrowing to finance the
acquisition of routes from Telco West and Computer Assisted Technologies,
Inc. Depreciation and amortization increased in 1997 by $562,800, an increase
of 154.2% over the prior year's period, attributable to amortization
associated with the acquired phones and contracts.
YEAR ENDED DECEMBER 31, 1996 COMPARED WITH YEAR ENDED DECEMBER 31, 1995
For the year ended December 31, 1996, total revenue increased approximately
$745,000, or 26.4%, compared to the year ended December 31, 1995. This growth
was primarily attributable to the increase in the average number of pay
telephones in service from 865 during 1995 to 1,123 during 1996, the increase in
Dial-Around compensation and the initiation of operations as a competitive LEC.
Of the increase in revenue, $147,000, or 19.7%, of the increase, was
attributable to the increase in the Dial-Around compensation rate on November 6,
1996, and $50,700, or 6.8%, of the increase in revenue was attributable to sales
of telephone service to non-affiliated companies.
Telephone and long-distance charges decreased in 1996 to 36.2% of total
revenue, compared to 42.5% of total revenue the prior year. The decrease was
primarily attributable to CI receiving authorization to act as a reseller of
telephone service in April 1996, which ultimately reduced the Company's line
charges in Minnesota to $52 per line.
Commissions paid to Site Providers decreased to 16.3% of total revenue in
1996, compared to 18.0% in the prior year. This was attributable to increased
Dial-Around compensation revenue (which is not included in commission
calculations for Site Providers) and to the phones added in 1996 which generated
less revenue and, therefore, lower Site Provider commissions than the phones
placed into service in prior years. As part of its growth strategy and in order
to take advantage of lower line rates, the Company was able to install pay
telephones that previously had insufficient revenue to meet the Company's ROI
objectives.
Service, collection, repair and maintenance costs increased in 1996 over
the prior year by approximately $94,000, or 44.4%, due to the start-up costs
associated with adding phones in new geographic areas, as well as the increased
number of phones in service.
In 1996, selling, general and administrative expenses increased
approximately $200,000, or 45.1%, from the prior year. This was attributable, in
part, to higher marketing costs associated with the Company's growth strategy.
Interest expense increased to 3.4% of revenue compared to 3.2% of revenue in the
prior year due to increased borrowing to finance an acquisition of 85 phones in
December 1995. Depreciation and amortization
14
<PAGE>
increased in 1996 to 10.2% of revenue from 8.8% of revenue in the prior year,
attributable to amortization associated with the acquired contracts.
SALES TAX CONTINGENCY
The Company, based on its analysis of the published regulations of the
Minnesota Department of Revenue, has not remitted any sales tax payments to
the State of Minnesota. In 1996, the Company learned that the opinion of the
Department was that calls from payphones were subject to state sales tax.
Management is of the view that the payphone service it provides is not
subject to sales tax and the Company is challenging the imposition of the
tax. Nonetheless, on December 31, 1996, the Company established a reserve of
$865,000 for the years prior thereto and has reserved an additional $242,760
for the year ended December 31, 1997.
LIQUIDITY AND CAPITAL RESOURCES
For the year ended December 31, 1997, the Company's operating activities
provided $1,262,000 and the sale of shares of Common Stock and the collection
of subscription receivables provided $4,520,200. The Company invested
$4,985,000 in acquisitions, new installations and short-term investments,
and reduced debt by $1,406,000, resulting in a $608,800 reduction in cash
balance.
In January 1997, the Company entered into an Amended and Restated Loan
Agreement with the National City Bank (the "Bank") pursuant to which the Company
can borrow up to $3,000,000. The Company granted the Bank a first lien on all of
its assets to secure its obligations to the Bank. The agreement provided for the
payment of interest on the amount outstanding from time to time at an annual
rate equal to 2.0% over the "reference" rate announced from time to time by the
Bank and expired in January 1998. In November 1997, the Company used a portion
of the proceeds from its public offering to repay the remaining balance on its
$3,000,000 Amended and Restated Loan Agreement with the Bank.
Operating activities for the year ended December 31, 1996 provided
$677,800 and sales of shares of Common Stock and collection of subscription
receivables during such year provided $920,000. During 1996, the Company
invested $462,200 in new installations, reduced debt by $68,500 and paid
$143,700 in dividends. The overall impact was an $923,400 increase in cash
balances.
For the year ended December 31, 1995, the Company's operating activities
provided $161,000 and long-term financing provided $778,000. During the year,
$623,000 was invested in acquisitions and new installations, $320,000 of
short-term debt was retired and $33,000 was paid as dividends, resulting in a
$37,000 decrease in cash balances for the year.
RECENT ACQUISITIONS
In January 1997, the Company completed its acquisition from Telco West
of site contracts for 1,020 payphones located in Colorado, Idaho, Oregon,
Washington and Wyoming, equipment located at the respective sites, as well as
the trade name "Telco Northwest" (collectively, the "Acquired Assets"). The
purchase price for the Acquired Assets was $3,374,745, $2,173,245 of which
was paid in cash (financed with a short-term loan from the Bank) and the
balance of which was paid by delivery of two 10% secured subordinated notes,
the first in the principal amount of $365,000, with the principal due on
April 1, 1998, and the second in the principal amount of $841,500, which
amortizes over a 54-month period (collectively, the "Telco West Notes"). The
Telco West Notes are collateralized by a security interest granted in
substantially all of the Company's pay telephone assets, which security
interest is subordinate to the senior secured position of the Bank as the
Company's primary lender.
15
<PAGE>
In connection with the acquisition, Telco West and its principal shareholder
entered into a five-year non-compete agreement covering the states of
Colorado, Idaho, Oregon, Washington and Wyoming. In 1996, Telco West's
payphone division earned $248,650 on revenues of $2,663,994. The Company
expects results to improve due to increased Dial-Around compensation.
In January 1997, the Company entered into an agreement to acquire from
Computer Assisted Technologies, Inc. ("CAT") 586 pay telephone site contracts
and related assets, as well as site contracts only for the installation of an
additional 98 pay telephones, all located in Minnesota and Wisconsin.
Pending approval of the acquisition by the MNPUC and the satisfaction of
other conditions of closing, the parties entered into a Route Service
Agreement effective as of February 1, 1997, pursuant to which the Company
managed and serviced the CAT payphones in Minnesota and Wisconsin for a
monthly fee equal to the operating revenue therefrom less equipment leasing
costs and certain other expenses payable by CAT to third parties. The MNPUC
entered an order on June 27, 1997, approving the Company's acquisition of
CAT's assets and the transaction was consummated as of August 14, 1997. The
purchase price for the assets was approximately $2,400,000, consisting of
$100,000 payable in cash, $350,000 pursuant to a convertible note payable to
CAT, the Company's assumption of $1,115,500 of debt to two equipment leasing
companies, and the balance of $838,000 by delivery to CAT unregistered Common
Stock. In connection with the transaction, CAT and its principal shareholder
entered into a two-year non-compete agreement with the Company covering the
states of Minnesota and Wisconsin. The president of CAT, Dustin Elder, now a
Vice President of the Company, also entered into employment, non-compete and
stock option agreements with the Company. In 1996, CAT had a net loss of
$246,266 on revenues of $1,479,337. The Company expects results to improve
due to lower line rates in Minnesota and the increase in Dial-Around
compensation.
16
<PAGE>
USE OF PROCEEDS FROM INITIAL PUBLIC OFFERING
In November 1997, the Company completed an initial public offering of
800,000 Units at an offering price of $7 per Unit. Each Unit consists of one
share of common stock and one redeemable warrant. The Company realized
proceeds of approximately $4.5 million, net of offering expenses and
underwriting fees. During the period from November 15, 1997 through December
31, 1997, the Company used approximately $3.2 million to pay down short-term
and acquisition-related debt and approximately $165,000 for the purchase of
equipment.
ACCOUNTING STATEMENTS
In 1997, the Financial Accounting Standards Board (FASB) issued Statement
No. 128, EARNINGS PER SHARE. Statement 128 replaced the calculation of primary
and fully diluted earnings per share with basic and diluted earnings per share.
Unlike primary earnings per share, basic earnings per share excludes any
dilutive effects of options, warrants and convertible securities. Diluted
earnings per share is very similar to the previously reported fully diluted
earnings per share. All earnings per share amounts for all periods have been
presented, and where appropriate, restated to conform to Statement 128
requirements.
In 1997, the FASB issued Statements No. 130, REPORTING COMPREHENSIVE
INCOME, and No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED
INFORMATION, effective for fiscal years beginning after December 15, 1997. The
adoption by the Company of these Statements in January 1998 is not expected to
have a material impact on the Company's financial statements.
YEAR 2000 ISSUES
Many existing computer programs use only two digits to identify a year in
the date field, with the result that data referring to the year 2000 and
subsequent years may be misinterpreted by these programs. If present in the
computer applications of the Company and not corrected, this problem could cause
computer applications to fail or to create erroneous results and could cause a
disruption in operations and have a short-term adverse effect on the Company's
business and results of operations. The Company has evaluated its principal
computer systems and has determined that they are substantially Year 2000
compliant. The Company has initiated discussions with its key suppliers and
customers to determine whether they have any Year 2000 issues. The Company has
not incurred any material expenses to date in connection with this evaluation
and does not
17
<PAGE>
anticipate material expenses in the future, depending on the status of its
suppliers and customers with respect to this issue.
ITEM 7. FINANCIAL STATEMENTS
The following financial information of the Company is included as follows:
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Independent Auditors . . . . . . . . . . . . . . . . . . . 20
Consolidated Financial Statements:
Consolidated Balance Sheets for Years Ended December 31, 1997
and 1996. . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Consolidated Statements of Operations for Years Ended
December 31, 1997 and 1996 . . . . . . . . . . . . . . . . . . 22
Consolidated Satements of Shareholders' Equity for Years Ended
December 31, 1997 and 1996. . . . . . . . . . . . . . . . . . . 23
Consolidated Statements of Cash Flows for Years Ended
December 31, 1997 and 1996. . . . . . . . . . . . . . . . . . . 24
Notes to Consolidated Financial Statements. . . . . . . . . . . 26
</TABLE>
18
<PAGE>
CONSOLIDATED FINANCIAL STATEMENTS FOR:
CHOICETEL COMMUNICATIONS,
INC. AND SUBSIDIARY
(FORMERLY INTELLIPHONE, INC.)
Years ended
December 31, 1997 and 1996
19
<PAGE>
INDEPENDENT AUDITORS' REPORT
Board of Directors
ChoiceTel Communications, Inc.
Minneapolis, Minnesota
We have audited the accompanying consolidated balance sheets of ChoiceTel
Communications, Inc. (formerly Intelliphone, Inc.) and Subsidiary as of
December 31, 1997 and 1996, and the related consolidated statements of
operations, shareholders' equity, and cash flows for the years 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 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 consolidated financial position of ChoiceTel
Communications, Inc. and Subsidiary as of December 31, 1997 and 1996, and the
consolidated results of its operations and cash flows for the years then
ended, in conformity with generally accepted accounting principles.
Minneapolis, Minnesota
March 13, 1998
20
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS - DECEMBER 31, 1997 AND 1996
ASSETS
<TABLE>
<CAPTION>
1997 1996
------------ ------------
<S> <C> <C>
Current assets:
Cash $ 343,705 $ 952,481
Short-term investments 1,151,215
Accounts receivable 575,313 172,934
Prepaid:
Rent 93,357 78,732
Other 458,509 66,656
Deferred taxes 601,000
----------- ----------
Total current assets 3,223,099 1,270,803
----------- ----------
Property and equipment, net 4,521,017 1,558,332
----------- ----------
Other assets:
Prepaid rents 92,179 134,443
Rental contracts, net of accumulated
amortization of $355,412 in 1997 and
$111,073 in 1996 3,212,450 65,632
Deferred financing, net of accumulated
amortization of $35,252 in 1997 and
$33,870 in 1996 1,382
----------- ----------
3,304,629 201,457
----------- ----------
$11,048,745 $3,030,592
----------- ----------
----------- ----------
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Checks outstanding in excess of bank
balance $139,239 $77,331
Notes payable 350,000 360,000
Current portion of long-term debt 843,301 265,931
Accounts payable 48,000
Accrued expenses 2,116,142 1,093,540
----------- ----------
Total current liabilities 3,496,682 1,796,802
Long-term liabilities:
Deferred taxes 449,000
Long-term debt, net of current portion 1,269,985 569,702
----------- ----------
1,718,985 569,702
----------- ----------
Shareholders' equity 5,833,078 664,088
----------- ----------
$11,048,745 $3,030,592
----------- ----------
----------- ----------
</TABLE>
See notes to consolidated financial statements.
21
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1997 AND 1996
<TABLE>
<CAPTION>
1997 1996
----------- -----------
<S> <C> <C>
Service revenue $7,081,227 $3,561,902
Cost of service 3,725,204 1,986,985
----------- -----------
Gross margin 3,356,023 1,574,917
----------- -----------
Selling, general and administrative
expenses:
Salary and benefits 1,260,863 559,494
Travel and related 128,115 58,351
Office and overhead 379,711 212,506
----------- -----------
1,768,689 830,351
Depreciation and amortization 927,697 364,849
Interest 701,048 119,649
Sales tax contingency 242,760 865,000
----------- -----------
3,640,194 2,179,849
----------- -----------
Loss before income taxes (284,171) (604,932)
Provision for income taxes (benefit) (150,000)
----------- -----------
Net loss $ (134,171) $ (604,932)
----------- -----------
----------- -----------
Basic net loss per share $ (.06) $ (.31)
----------- -----------
----------- -----------
Shares outstanding weighted average 2,114,922 1,948,489
----------- -----------
----------- -----------
</TABLE>
See notes to consolidated financial statements.
22
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 1997 AND 1996
<TABLE>
<CAPTION>
Common stock
----------------------------------------------
ChoiceTel
Choicetel, Inc. Communications, Inc.
---------------------- ----------------------
10,000,000 shares 15,000,000 shares
authorized, no par authorized, $.01 par Additional
---------------------- ---------------------- paid-in Accumulated Subscriptions
Shares Amount Shares Amount capital deficit receivable Total
--------- ----------- ----------- ---------- ---------- ----------- ------------- ----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, January 1, 1996 1,657,016 $ 524,473 -- $ (3,172) $(28,571) $ 492,730
Collection of subscription
receivable 10,000 10,000
Issuance of stock for:
Cash 256,000 910,000 910,000
Subscription receivable 846,508 $ 1,000 6,250 25,000 (26,000)
Dividends (143,710) (143,710)
Net loss (604,932) (604,932)
-------- ------- --------- ---------- --------- -------- ----------
Balance, December 31, 1996 846,508 1,000 1,919,266 1,459,473 (751,814) (44,571) 664,088
Contributions of subsidiary
stock to parent (846,508) (1,000) $ 1,000
Reclassification of S-Corp
accumulated deficit (751,814) 751,814
Collection of subscription
receivable 25,990 25,990
Conversion to $.01 par value
stock (1,440,280) 1,440,280
Issuance of stock as compensation 9,500 95 37,905 38,000
Issuance of stock in acquisition 186,240 1,862 743,098 744,960
Issuance of 800,000 common
shares in public offering 800,000 8,000 4,486,211 4,494,211
Net loss (134,171) (134,171)
-------- ------- --------- ---------- ---------- --------- -------- ----------
Balance, December 31, 1997 -0- $ -0- 2,915,006 $ 29,150 $5,956,680 $(134,171) $(18,581) $5,833,078
-------- ------- --------- ---------- ---------- --------- -------- ----------
-------- ------- --------- ---------- ---------- --------- -------- ----------
</TABLE>
See notes to consolidated financial statements.
23
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 1997 AND 1996
<TABLE>
<CAPTION>
1997 1996
------------ -----------
<S> <C> <C>
Cash flows from operating activities:
Net loss $ (134,171) $(604,932)
Adjustments to reconcile net loss to net
cash provided by operating activities:
Deferred taxes (152,000)
Depreciation 681,983 300,600
Amortization 245,714 64,249
Stock issued as compensation 38,000
Changes in operating assets and
liabilities:
(Increase) decrease in:
Accounts receivable (402,379) (137,645)
Prepaid expenses (54,737) 70,537
Increase (decrease) in:
Checks outstanding in excess of bank
balance 61,908 77,331
Accounts payable 48,000
Accrued expenses 929,481 907,613
----------- ---------
Net cash provided by operating
activities 1,261,799 677,753
----------- ---------
Cash flows used in investing activities:
Purchase of:
Equipment (1,223,657) (462,239)
Short-term investments (1,151,215)
Payments for acquisitions (2,300,224)
Advances in connection with acquisition (309,479)
----------- ---------
Net cash used in investing activities (4,984,575) (462,239)
----------- ---------
Cash flows from financing activities:
Proceeds from:
Issuance of:
Long-term debt 7,103
Common stock 4,494,211 910,000
Payments of subscription receivable 25,990 10,000
Principal payments on long-term debt (1,046,201) (100,572)
Dividends paid (143,710)
Increase in notes payable 25,000
Payments on notes payable (360,000)
----------- ---------
Net cash provided by financing
activities 3,114,000 707,821
----------- ---------
</TABLE>
See notes to consolidated financial statements.
24
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
<TABLE>
<CAPTION>
1997 1996
----------- ----------
<S> <C> <C>
Net(decrease) increase in cash $ (608,776) $923,335
Cash, beginning balance 952,481 29,146
---------- --------
Cash, ending balance $343,705 $952,481
---------- --------
---------- --------
Supplemental disclosure of cash flow
information:
Cash paid for interest $714,381 $121,530
---------- --------
---------- --------
Supplemental schedule of noncash investing
and financing activities:
In connection with acquisition:
Details of acquisition:
Fair value of assets $5,810,350
Liabilities assumed (includes
$1,556,500 of seller financing) $2,765,166
Issuance of stock $ 744,960
----------
Cash paid for assets $2,300,224
----------
----------
Issuance of stock in lieu
of compensation $ 38,000
----------
----------
Issuance of common shares in exchange
for subscription receivable $ 26,000
--------
--------
</TABLE>
See notes to consolidated financial statements.
25
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 1997 AND 1996
1. Nature of business and summary of significant accounting policies:
Principles of consolidation:
The consolidated financial statements for 1997 include the accounts of
ChoiceTel Communications, Inc. (formerly Intelliphone, Inc.) and its
wholly owned subsidiary Choicetel, Inc. The 1996 statements represent
the combined financial statements of ChoiceTel Communications, Inc. and
Choicetel, Inc., companies that were commonly owned through February 24,
1997 at which time the shareholders of Choicetel, Inc. contributed their
shares to ChoiceTel Communications, Inc. All material intercompany
balances have been eliminated.
Nature of business:
Intelliphone, Inc. was incorporated in October 1989 and changed its name
to ChoiceTel Communications, Inc. in April 1997. The Company provides
coin operated pay telephone service in ten states, however, revenue is
generated predominantly in Minnesota and Oregon.
Choicetel, Inc. was incorporated in 1995 and was dormant until June 1996
when operations began. Choicetel, Inc. is a reseller of telephone service
to pay telephone owners in Minnesota.
Short-term investments:
The Company classifies all of its marketable securities, consisting of
U.S. Treasury Bills, as available-for-sale. Available-for-sale
securities are carried at fair value, with the unrealized gains and
losses, net of income taxes, reported as a component of shareholders'
equity.
Property and equipment and depreciation methods:
Property and equipment, consisting principally of coin operated
telephones, are stated at cost. Depreciation is being provided by the
straight-line method over the estimated useful lives, principally, seven
years, of the related assets. Phone locations including rental
contracts are evaluated by management to determine if their carrying
amounts have been impaired. No reduction for impaired assets has
occurred.
Prepaid rents:
Prepaid rents represent incentives paid to phone location merchants and
property owners to secure long-term contracts at such sites and are
being amortized as consumed per the rental agreement.
26
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
1. Nature of business and summary of significant accounting policies
(continued):
Rental contracts:
Rental contracts consist of the purchase price paid for phone location
agreements in excess of the purchase price of the related equipment on
site and are amortized on a straight-line basis over the estimated
remaining life of the rental agreements, currently ranging from five to
twelve years.
Deferred financing:
Deferred financing costs are being amortized over the life of the
related note on a straight-line basis.
Income taxes:
Prior to 1997, ChoiceTel Communications, Inc. and Choicetel, Inc., were
"S" corporations under the Internal Revenue Code. Instead of paying
corporate income taxes, the shareholders of an "S" corporation are taxed
individually on their proportionate share of the Company's taxable
income or loss. No tax credits are provided for in 1996 due to
management's belief that some credits would not be realized.
Effective January 1997, ChoiceTel Communications, Inc.'s "S" corporation
status terminated and it became subject to federal and state income
taxes.
27
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
1. Nature of business and summary of significant accounting policies
(continued):
Stock-based compensation:
Prior to January 1, 1996, the Company accounted for its stock options in
accordance with the provisions of Accounting Principles Board Opinion
No. 25 (APB No. 25), ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, and
related interpretations. As such, compensation expense was recorded on
the date of grant only if the current market price of the underlying
stock exceeded the exercise price. On January 1, 1996, the Company
adopted SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION (SFAS No.
123), 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 allows entities to continue to apply the
provisions of APB No. 25 and provide pro forma net income disclosures
for employee stock option grants as if the fair-value based method
defined in SFAS No. 123 had been applied. The Company has elected to
continue to apply the provisions of APB No. 25 and provide the pro forma
disclosure provisions of SFAS No. 123.
Net loss per share:
Basic net loss per share is computed on the basis of the number of
shares of common stock outstanding during the year. Diluted net loss per
share which would include the effect of options, warrants, and a
convertible note is not presented because it is antidilutive.
Pursuant to Securities and Exchange Commission Staff Accounting Bulletin
No. 83, stock issued by the Company at prices less than the initial
offering price during the twelve months immediately preceding the
initial public offering have been included in the determination of
shares used in the calculation of historical earnings (loss) per share
as if they were outstanding for all periods.
Use of estimates:
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect certain reported amounts of certain assets and
liabilities and disclosures. Accordingly, the actual amounts could
differ from those estimates. Any adjustments applied to estimated
amounts are recognized in the year in which such adjustments are
determined. Estimates that are susceptible to significant change are
disclosed in notes 3 and 7.
28
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
2. Shareholders' equity:
In February, 1997 the shareholders of Choicetel, Inc. contributed all
outstanding shares of Choicetel, Inc. to the Company. The contribution was
recorded as an adjustment to additional paid-in capital.
In April, 1997 the shareholders approved an increase in the number of
authorized shares of common stock from 2,000,000 with no par value to
15,000,000 with $.01 par value. The shareholders also approved the
authorization of 5,000,000 shares of preferred stock with $.01 par value.
The change in par value did not affect any existing rights of shareholders
and has been recorded as an adjustment to additional paid-in capital and
common stock. No shares of preferred stock were issued as of December 31,
1997.
In November 1997, the Company completed the issuance of an additional
800,000 shares of common stock through a public offering, resulting in net
proceeds (after deducting issuance costs) of $4,494,211. A portion of the
proceeds were used to retire existing debt and debt acquired in the
acquisition of Telco West, Inc.
3. Acquisitions:
Telco West, Inc.:
On January 2, 1997 the Company purchased a route of pay telephones in
the Northwestern United States from Telco West, Inc. (Telco). The
purchase price was approximately $3,400,000 and was financed primarily
with bank and seller financing. The Company accounted for the
acquisition using the purchase method and accordingly the results of
operations of the Telco route are included in the consolidated financial
statements since the date of acquisition.
29
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
3. Acquisitions (continued):
Computer Assisted Technologies Inc.:
On August 14, 1997 the Company purchased a route of pay telephones in
Minnesota and Wisconsin from Computer Assisted Technologies, Inc. (CAT).
The purchase price was approximately $2,400,000, subject to contingent
compensation and adjustment, and was financed principally through the
assumption of notes and leases in the aggregate of $1,115,545, issuance
of stock in the amount of $744,960, and convertible seller financing in
the amount of $350,000. The purchase agreement included contingent
compensation in the form of additional stock should the Initial Public
Offering price of the Company's common stock be less than $8.00 per
share. The Company's opening price on November 21, 1997 was $7.00 per
unit and accordingly the Company has recorded the equivalent of the
additional compensation of $93,121 in accrued expenses.
Prior to the closing of the purchase in August 1997, the Company entered
into a Route Service Agreement (Agreement) with CAT on February 1, 1997
until such time CAT received approval of the sale from the Minnesota and
Wisconsin Public Utilities Commissions. The Agreement provided for the
servicing of the CAT pay phone route during the period up to closing. In
exchange for a monthly lease fee the Company received all revenues
derived from the route. The Company accounted for the CAT acquisition
using the purchase method. The results of operations of the CAT route is
included in the consolidated financial statements since the inception date
of the Route Service Agreement through the date of acquisition. This
constitutes substantially all of CAT's activity for 1997.
Subsequent to the closing of the sale in August 1997, the Company
determined that certain location agreements acquired in the sale may not
be valid and therefore certain adjustments to the original purchase
price are necessary. Additionally, the Company advanced monies to, and
paid certain expenses of CAT during 1997 in excess of the required lease
payments of the Route Service Agreement. Total amounts paid of $309,479
are included in the consolidated financial statements as other prepaid
expenses. These potential adjustments have not been netted against the
seller financing by the Company although management believes the
adjustment to the purchase price and advances made substantially satisfy
the $350,000 note payable.
30
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
3. Acquisitions (continued):
The following summarized unaudited proforma information assumes the
acquisition had occurred on January 1, 1996. Proforma information for the
year ended December 31, 1997 has not been provided as the acquisitions
occurred at or near the beginning of the period:
Proforma information for year ended
December 31, 1996:
<TABLE>
<CAPTION>
Telco Pro Forma
Company West CAT adjustments Combined
-------- -------- -------- ----------- ----------
(Dollars in 000s)
<S> <C> <C> <C> <C> <C>
Service revenue $3,562 $2,664 $1,479 $7,705
Cost of service 1,987 1,486 825 4,298
------ ------ ------ ------
Gross margin 1,575 1,178 654 3,407
------ ------ ------ ------
Selling, general and
administrative
expenses 830 393 487 1,710
Depreciation and
amortization 365 307 158 $ 209 1,039
Interest expense 120 95 180 256 651
Sales tax contingency 865 84 949
------ ------ ------ ----- ------
Income (loss) before
income taxes (605) 383 (255) (465) (942)
Provision for income
taxes -- -- -- -- --
Pro forma provision
for income taxes
(credit) 134 (9) 125
------ ------ ------ ----- ------
Pro forma net income
(loss) $ (605) $249 $ (246) $(465) $(1,067)
------ ------ ------ ----- ------
------ ------ ------ ----- ------
Pro forma net income
(loss) per share $ (.31) $.13 $ (.13) $(.24) $ (.55)
------ ------ ------ ----- ------
------ ------ ------ ----- ------
</TABLE>
The proforma amounts reflect the results of operations for the Company, the
acquired businesses, and the following purchase acquisition adjustments for
the period presented:
- - Depreciation on fixed assets and amortization of contracts is based on the
purchase price allocation.
- - Elimination of historical interest expense on the acquired businesses as
well as the addition of the incremental interest expense on additional debt
that would have been incurred to finance the acquisition.
31
<PAGE>
CHOICETEL COMMUNICATIONS INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
4. Property and equipment:
<TABLE>
<CAPTION>
1997 1996
------------ -----------
<S> <C> <C>
Phones and related equipment $ 5,937,547 $2,373,199
Accumulated depreciation (1,469,906) (845,176)
----------- ----------
4,467,641 1,528,023
----------- ----------
Office equipment and improvements 96,860 66,548
Accumulated depreciation (43,484) (36,239)
----------- ----------
53,376 30,309
----------- ----------
$ 4,521,017 $1,558,332
----------- ----------
----------- ----------
</TABLE>
5. Notes payable:
<TABLE>
<CAPTION>
1997 1996
------------ -----------
<S> <C> <C>
Note payable, shareholder, interest
only at 8.5% through February 7, 1998,
at which time the principal is due.
Convertible to shares of common stock
at $6.75 plus adjustment based on
IPO price of stock. $350,000
Line of credit, bank, $300,000,
interest at 1.0% above the bank's
prime rate (9.25% at December 31,
1996) guaranteed by shareholders
and secured by equipment. $275,000
Note payable, interest only payable
monthly at 8.75%. Due on demand. 50,000
Note payable, interest only payable
monthly at 12%. Due on demand. 35,000
----------- ----------
$350,000 $360,000
----------- ----------
----------- ----------
</TABLE>
32
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
6. Long-term debt:
<TABLE>
<CAPTION>
1997 1996
------------ -----------
<S> <C> <C>
Note payable, Telco, due in monthly
installments of $21,342 including
interest at 10% through July 2001,
secured by equipment. $ 753,452
Note payable, Telco, due in monthly
installments of $3,042 including
interest at 10% through April 1998,
at which time the remaining principal
is due, secured by equipment. 364,884
Note payable, Telecapital, due in
monthly installments of $4,452
including interest at 14.5% through
April 2002, secured by equipment. 169,069
Capital leases, interest at 9.5% 825,881
Note payable, interest only payable
monthly at 12% through April 1997.
Thereafter due in monthly installments
of $2,354 including interest. $ 50,000
Notes payable, interest only payable
monthly at 12% with various maturing
dates from March 1997 through December
1997. 150,000
Note payable, interest at 12% compounded
quarterly. Interest due on demand. 67,926
Note payable, bank, due in monthly
installments of $6,000 plus interest
at 1.25% above bank's prime rate (9.5%
at December 31, 1996). 396,279
Note payable, bank, due in monthly
installments of $2,381 plus interest
at 1.25% above prime rate (9.5% at
December 31, 1996). 171,428
------------ -----------
2,113,286 835,633
Less current portion 843,301 265,931
------------ -----------
$1,269,985 $569,702
------------ -----------
------------ -----------
</TABLE>
33
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
6. Long-term debt (continued):
At December 31, 1996, notes with shareholders and shareholder family members
included in long-term debt and notes payable amounted to $135,000. Interest
expense on these notes was approximately $15,000 and $10,000 in 1997 and
1996, respectively.
Included in interest expense for 1997 is approximately $200,000 of interest
paid to Computer Assisted Technologies, Inc. during the Route Service
Agreement period.
Future maturities of long-term debt are as follows:
<TABLE>
<CAPTION>
Year ending December 31, Amount
------------------------- ----------
<S> <C>
1998 $ 843,301
1999 559,112
2000 505,455
2001 191,828
2002 13,590
----------
$2,113,286
----------
----------
</TABLE>
7. Commitments and contingency:
Phone locations:
The Company rents phone locations from merchants and property owners
under varying lease terms, usually seven years, generally cancelable by
the Company upon 15 days notice.
Consulting agreement:
The Company paid a director/shareholder $24,000 and $18,000 for certain
consulting services in 1997 and 1996, respectively.
Leases:
Operating leases:
The Company leases its offices in Minnesota and Oregon under operating
leases expiring through May 2000. The leases have renewal options and
require the Company to pay certain common area costs and real estate
taxes. Rent expense under the leases was $39,831 and $18,821 for the
years ended December 31, 1997 and 1996, respectively.
34
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
7. Commitments and contingency (continued):
Future minimum lease payments are as follows:
<TABLE>
<CAPTION>
Year ending December 31, Amount
------------------------ ----------
<S> <C>
1998 $ 43,345
1999 45,388
2000 19,295
----------
$108,028
----------
----------
Capital leases:
The cost of equipment, included in property and equipment, acquired
under capital leases and the related accumulated depreciation at
December 31, 1997, is as follows:
Cost $934,856
Less accumulated depreciation 55,646
----------
$879,210
----------
----------
The future minimum lease payments under capital leases and their net
present value are as follows:
<CAPTION>
Amount
----------
<C>
Total future minimum lease
payments, payable in:
1998 $341,426
1999 355,158
2000 241,970
----------
938,554
Less amounts representing interest 112,673
----------
Present value of future minimum
lease payments $825,881
----------
----------
</TABLE>
35
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
7. Commitments and contingency (continued):
Dial-around compensation:
The Company has recognized revenue for dial-around compensation based
upon rates for such compensation set by the Federal Communication
Commission (FCC). In July, 1997 the U.S. Court of Appeals ruled that
the rate set by the FCC was inappropriate and needed to be reexamined.
The FCC solicited comments on this matter on August 5, 1997 and on
October 9, 1997 issued an order establishing a dial-around rate for the
two year period commencing October 6, 1997. The FCC indicated that it
planned to address dial-around compensation for the period from November
6, 1996 through October 6, 1997 in a subsequent order and tentatively
concluded that the $0.284 per call rate adopted on a going forward basis
should also govern compensation during the period from November 6, 1996
through October 6, 1997. This would be approximately $37 per phone per
month. There can be no assurance when the FCC will issue another order
regarding the rate of dial-around compensation, what that order will
determine, whether such order will be appealed, and what the
determination would be upon any appeal. Accordingly, the Company has
reduced its rate for recognizing revenue to the previous rate of $6.00
per phone per month effective January 1, 1997 through October 6, 1997.
The change in estimate resulted in an accrual of a $351,000 liability at
December 31, 1997 to reflect an estimated liability for the period from
November 6, 1996 to October 6, 1997. Effective October 7, 1997, the
Company began recognizing dial-around revenue at approximately $37 per
phone per month. The setting of lower dial-around rates could have a
material effect on the Company's results of operations.
Sales tax contingency:
After an original contact by ChoiceTel Communications, Inc., the
Minnesota Department of Revenue conducted an audit of the Company's
revenues for calculation of sales taxes the department asserts are due
on telephone receipts. While the Company does not believe its coin
receipts are subject to sales tax and has notified the Minnesota
Department of Revenue of its position, it may have to assert its
position in the Minnesota courts in order to prevail. The financial
statements include an accrual management believes is sufficient to cover
this contingency.
36
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
8. Stock options and warrants:
On April 11, 1997, the Company's Board of Directors adopted the 1997
Long-Term Incentive and Stock Option Plan (the "Plan"). The Plan provides
for the issuance of incentive stock options and non-qualified stock
options to key employees and directors of the Company. The total number
of shares of common stock authorized and reserved for issuance under the
Plan is 100,000 shares. The exercise price for each incentive stock
option granted under the Plan may not be less than the fair market value
of the common stock on the date of the grant, unless, in the case of
incentive stock options, the optionee owns greater than 10% of the total
combined voting power of all classes of capital stock of the Company, in
which case the exercise price may not be less than 110% of the fair market
value of the common stock on the date of the grant. The exercise price
for each non-qualified option may not be less than 85% of the fair market
value of the common stock on the date of grant. Unless otherwise
determined by the Board, incentive options granted under the Plan have a
maximum duration of 10 years, non-qualified options and awards have a
maximum duration of 15 years. Vesting is based on such terms and
conditions as the Board shall determine. As of December 31, 1997, no
options have been granted under the plan.
During 1997 the Company granted to certain employees options to purchase
60,000 shares and to non-employees options to purchase 12,500 shares of
the Company's common stock. Utilizing the Black Scholes option pricing
model the Company determined that the fair value of options granted during
1997 would not have effected net loss or loss per share as reported, and
accordingly, the Company has not provided proforma income and earnings per
share information.
37
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
8. Stock options and warrants (continued):
Information with respect to options outstanding as of December 31, 1997, is
summarized as follows:
<TABLE>
<CAPTION>
1997 1996
------------------------ ----------------------
Weighted- Weighted-
average average
exercise exercise
Shares price Shares price
---------- ----------- ---------- -----------
<S> <C> <C> <C> <C>
Outstanding at
beginning of year 50,000 $1.50 50,000 $1.50
Granted 72,500 5.90
Exercised
Forfeited
---------- ----------
Outstanding at
end of year 122,500 $4.10 50,000 $1.50
---------- ----------- ---------- -----------
---------- ----------- ---------- -----------
Options exercisable
at year end 92,500 50,000
Weighted average
remaining life 2 years 1.8 years
</TABLE>
In connection with the public offering of its stock the Company has
outstanding the following warrants:
<TABLE>
<CAPTION>
Weighted average
1997 exercise price
----------- -----------------
<S> <C> <C>
Issued as part of units in
offering 800,000 $9.50
Granted to Underwriter 160,000 8.95
---------
Outstanding at end of year 960,000 $9.40
--------- -----
--------- -----
Warrants exercisable at year
end 800,000
Weighted average remaining
life 4.9 years
</TABLE>
38
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
8. Stock options and warrants (continued):
The warrants granted to the Underwriter consist of one warrant for 80,000
units at $8.40 per unit and is not exercisable until one year after the date
the registration statement is declared effective. Each unit contains a
warrant that entitles the holder to purchase at any time one share of common
stock at an exercise price of $9.50. The warrants expire November 2002.
Additionally, the Underwriter was granted an option to purchase 120,000 units
as an over allotment that expired 45 days after the initial public offering
in November, 1997. The option was outstanding as of December 31, 1997.
9. Income taxes:
On January 1, 1997 the Company terminated its status to be treated as an "S"
corporation. The provision for income taxes is as follows:
<TABLE>
<CAPTION>
1997
-----------
<S> <C>
Current, state $ 2,000
Deferred:
Federal (90,000)
State (16,000)
Effect of change in tax status (46,000)
---------
$(150,000)
---------
---------
</TABLE>
A reconciliation between the statutory federal income tax rates to the
Company's effective tax rate is as follows:
<TABLE>
<CAPTION>
1997
----------
<S> <C>
Statutory federal tax rate 33.0%
State taxes (net of federal
tax benefit) 3.6%
Effect of change in tax status 16.2%
-------
Effective tax rate 52.8%
-------
-------
</TABLE>
A reconciliation for 1996 has not been presented as there was no provision
for income taxes.
39
<PAGE>
CHOICETEL COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
YEARS ENDED DECEMBER 31, 1997 AND 1996
9. Income taxes (continued):
The deferred tax asset and deferred tax liability consists of the following
at December 31, 1997:
<TABLE>
<S> <C>
Deferred tax asset:
Sales tax contingency $444,000
Employee benefits 17,000
Accrued dial-around compensation 140,000
--------
$601,000
--------
--------
Deferred tax liability:
Depreciation $448,000
Amortization 1,000
--------
$449,000
--------
--------
</TABLE>
Utilization of the deferred tax asset of $601,000 disclosed above is
dependent on future taxable profits in excess of profits arising from
existing taxable temporary differences. Although there was a reported loss
for the year ended December 31, 1997 the assets have been recognized based
on management's estimate of future taxable income.
10. Financial instruments:
The Company's financial instruments recorded on the balance sheet include
cash and short-term investments, accounts receivable, notes and accounts
payable and debt. Because of their short maturity, the carrying amount of
cash, short-term investments, accounts receivable and notes and accounts
payable approximates fair value. Fair value of long-term debt approximates
recorded value based on rates available to the Company for similar terms and
maturities.
11. Reclassification:
Certain reclassifications have been made to the 1996 financial statements in
order to conform with the 1997 presentation.
40
<PAGE>
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
41
<PAGE>
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT
The information concerning the Directors, Executive Officers,
Promoters and Control Persons is set forth in the Company's definitive Proxy
Statement to be delivered to stockholders in connection with the Company's
Annual meeting of Stockholders to be held on May 27, 1998 (the "Proxy
Statement") under the headings "Election of Directors" and "Executive
Officers", which information is incorporated herein by reference to the Proxy
Statement which the Company intends to file with the Securities and Exchange
Commission by April 30, 1998. The information regarding compliance with
Section 16(a) of the Securities Exchange Act of 1934 is set forth in the
Proxy Statement under the heading "Section 16(a) Beneficial Ownership
Reporting Compliance", which information is incorporated herein by reference.
ITEM 10. EXECUTIVE COMPENSATION
The information concerning executive compensation is set forth in
the Proxy Statement under the heading "Executive Compensation", which
information is incorporated herein by reference.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information concerning security ownership of certain
beneficial owners and management is set forth in the Proxy Statement under the
heading "Beneficial Ownership of Common Stock", which information is
incorporated herein by reference.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information concerning certain relationships and related
transaction is set forth in the Proxy Statement under the heading "Certain
Transactions", which information is incorporated herein by reference.
42
<PAGE>
PART IV
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS. SEE "EXHIBIT INDEX" ON PAGE FOLLOWING SIGNATURES.
(b) REPORTS ON FORM 8-K
The Company filed reports on Form 8-K on December 19, 1997
announcing the execution of a letter of intent to acquire Sine Communications,
Inc. and on December 29, 1997 reporting the Company's financial results for the
third quarter ended September 30, 1997.
43
<PAGE>
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the
registrant caused this report to be signed on its behalf by the undersigned,
thereunto duly authorized.
CHOICETEL COMMUNICATIONS, INC.
Date: March 27, 1998
By /s/ Gary S. Kohler
-------------------------------
Gary S. Kohler
Chairman of the Board of Directors
In accordance with the Exchange Act, this report has been signed below
by the following persons on behalf of the registrant and in the capacities
and on the dates indicated.
Power of Attorney
Each person whose signature appears below constitutes and appoints
JEFFREY R. PALETZ and JACK S. KOHLER as his true and lawful attorneys-in-fact
and agents, each acting alone, with full power of substitution and
resubstitution, for him and in his name, place and stead, in any and all
capacities, to sign any and all amendments to this Annual Report on Form
10-KSB and to file the same, with all exhibits thereto, and other documents
in connection therewith, with the Securities and Exchange Commission,
granting unto said attorneys-in-fact and agents, each acting alone, full
power and authority to do and perform each and every act and thing requisite
and necessary to be done in and about the premises, as fully to all intents
and purposes as he might or could do in person, hereby ratifying and
confirming all said attorneys-in-fact and agents, each acting alone, or his
substitute or substitutes, may lawfully do or cause to be done by virtue
thereof.
SIGNATURE TITLE DATE
/s/ Gary S. Kohler
- ----------------------------------- Director March 27, 1998
Gary S. Kohler
/s/ Jeffrey R. Paletz
- ----------------------------------- President and Director March 27, 1998
Jeffrey R. Paletz
/s/ Melvin Graf
- ----------------------------------- Executive Vice President March 27, 1998
Melvin Graf and Director
/s/ Jack S. Kohler
- ----------------------------------- Financial Officer March 27, 1998
Jack S. Kohler
/s/ Dustin Elder
- ----------------------------------- Vice President March 27, 1998
Dustin Elder
/s/ Robert A. Hegstrom
- ----------------------------------- Director March 27, 1998
Robert A. Hegstrom
/s/ Michael Wigley
- ----------------------------------- Director March 27, 1998S
Michael Wigley
44
<PAGE>
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON D.C.
EXHIBIT INDEX TO FORM 10-KSB
OF
CHOICETEL COMMUNICATIONS, INC.
For the Fiscal Year Ended December 31, 1998
Commission File Number: 0-230 17
<TABLE>
<CAPTION>
EXHIBIT
NO. DESCRIPTION
- -------- -----------
<S> <C>
3.1 Amended and Restated Articles of Incorporation
(incorporated by reference to Exhibit 3.1 of the
Registrant's Registration Statement on Form SB-2;
Registration No. 333-29969)
3.2 Bylaws (incorporated by reference to Exhibit 3.2 of the
Registrant's Registration Statement on Form SB-2;
Registration No. 333-29969)
4.1 Specimen Certificate representing the Common Stock
(incorporated by reference to Exhibit 4.1 of the
Registrant's Registration Statement on Form SB-2;
Registration No. 333-29969)
4.2 Form of Redeemable Warrant Agreement with Norwest Bank
Minnesota, National Association, including certificate
representing the Redeemable Warrants (incorporated by
reference to Exhibit 4.2 of the Registrant's
Registration Statement on Form SB-2; Registration
No. 333-29969)
10.1* 1997 Long-Term Incentive and Stock Option Plan
(incorporated by reference to Exhibit 10.1 of the
Registrant's Registration Statement on Form SB-2;
Registration No. 333-29969)
10.2 Lease Agreement (incorporated by reference to Exhibit
10.2 of the Registrant's Registration Statement on Form
SB-2; Registration No. 333-29969)
10.3* Bonus Program (incorporated by reference to Exhibit
10.3 of the Registrant's Registration Statement on Form
SB-2; Registration No. 333-29969)
10.4 Amended and Restated Loan Agreement with National City
Bank, dated as of January 2, 1997 (incorporated by
reference to Exhibit 10.4 of the Registrant's
Registration Statement on Form SB-2; Registration
No. 333-29969)
10.5 Promissory Note payable to Serence Paletz, dated April
10, 1995 (incorporated by reference to Exhibit 10.5 of
the Registrant's Registration Statement on Form SB-2;
Registration No. 333-29969)
10.6 Promissory Note payable to William Opsahl, dated April 18,
1995 (incorporated by reference to Exhibit 10.6 of
the Registrant's Registration Statement on Form SB-2;
Registration No. 333-29969)
</TABLE>
F-1
<PAGE>
<TABLE>
<S> <C>
10.7 Promissory Note payable to Miriam Graf, dated November 3,
1995 (incorporated by reference to Exhibit 10.7 of
the Registrant's Registration Statement on Form SB-2;
Registration No. 333-29969)
10.8 Promissory Note payable to William Opsahl, dated
December 2, 1995 (incorporated by reference to Exhibit 10.8
of the Registrant's Registration Statement on Form SB-2;
Registration No. 333-29969)
10.9 Promissory Note payable to Ronald M. Gross and Elaine
Weitzman, dated December 7, 1995 (incorporated by
reference to Exhibit 10.9 of the Registrant's
Registration Statement on Form SB-2; Registration
No. 333-29969)
10.10 Promissory Note payable to William B. Topp and Norma
Topp, dated July 7, 1996 (incorporated by reference to
Exhibit 10.10 of the Registrant's Registration
Statement on Form SB-2; Registration No. 333-29969)
10.11 Promissory Note payable to The Topp Family Trust, dated
July 27, 1996 (incorporated by reference to Exhibit
10.11 of the Registrant's Registration Statement on
Form SB-2; Registration No. 333-29969)
10.12 Agreement for Sale and Purchase of Business Assets with
Telco West, Inc. ("Telco"), dated January 2, 1997
(incorporated by reference to Exhibit 10.12 of the
Registrant's Registration Statement on Form SB-2;
Registration No. 333-29969)
10.13 Installment Collateral Note payable to Telco, dated
January 2, 1997 (incorporated by reference to Exhibit
10.13 of the Registrant's Registration Statement on
Form SB-2; Registration No. 333-29969)
10.14 Installment Collateral Note payable to Telco, dated
January 2, 1997 (incorporated by reference to Exhibit
10.14 of the Registrant's Registration Statement on
Form SB-2; Registration No. 333-29969)
10.15 Agreement for Sale and Purchase of Assets with Computer
Assisted Technologies, Inc. ("CAT"), dated as of March
14, 1997 (incorporated by reference to Exhibit 10.15 of
the Registrant's Registration Statement on Form SB-2;
Registration No. 333-29969)
10.16 Route Service Agreement with CAT, dated as of February
1, 1997 (incorporated by reference to Exhibit 10.16 of
the Registrant's Registration Statement on Form SB-2;
Registration No. 333-29969)
10.17* Employment Agreement with Jeffrey R. Paletz, dated as
of April 15, 1997 (incorporated by reference to Exhibit
10.17 of the Registrant's Registration Statement on
Form SB-2; Registration No. 333-29969)
10.18* Employment Agreement with Melvin Graf, dated as of
April 15, 1997 (incorporated by reference to Exhibit
10.18 of the Registrant's Registration Statement on
Form SB-2; Registration No. 333-29969)
10.19* Employment Agreement with Jack S. Kohler, dated as of
April 15, 1997 (incorporated by reference to Exhibit
10.19 of the Registrant's Registration Statement on
Form SB-2; Registration No. 333-29969)
</TABLE>
F-2
<PAGE>
<TABLE>
<S> <C>
10.21 Agreement for Service Resale with U.S. West
Communications, Inc., undated (incorporated by
reference to Exhibit 10.21 of the Registrant's
Registration Statement on Form SB-2; Registration
No. 333-29969)
21 Subsidiary of ChoiceTel Communications, Inc. (incorporated by
reference to Exhibit 21 of the Registrant's Registration
Statement on Form SB-2; Registration No. 333-29969)
24 Power of Attorney (included on the signature page of this Form 10-KSB)
27 Financial Data Schedule (filed with electronic version
only)
</TABLE>
_____________
* Management contract or compensatory plan or arrangement.
F-3
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM CHOICETEL
COMMUNICATIONS, INC AND SUBSIDIARY CONSOLIDATED BALANCE SHEET AND CONSOLIDATED
STATEMENT OF OPERATION AND CONSOLIDATED STATEMENT OF SHAREHOLDERS EQUITY AND IS
QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 244
<SECURITIES> 1,151
<RECEIVABLES> 575
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 3,223
<PP&E> 5,937
<DEPRECIATION> (1,470)
<TOTAL-ASSETS> 11,049
<CURRENT-LIABILITIES> 3,497
<BONDS> 0
0
0
<COMMON> 29
<OTHER-SE> 5804
<TOTAL-LIABILITY-AND-EQUITY> 11,049
<SALES> 7,081
<TOTAL-REVENUES> 7,081
<CGS> 3,725
<TOTAL-COSTS> 3,725
<OTHER-EXPENSES> 3,640
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 702
<INCOME-PRETAX> (284)
<INCOME-TAX> (150)
<INCOME-CONTINUING> (134)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (134)
<EPS-PRIMARY> (.06)
<EPS-DILUTED> (.06)
</TABLE>
