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ECONOPHONE, INC.
F O R M 8 - K
CURRENT REPORT
Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
Date of Report (Date of earliest event reported): February 17, 1998
ECONOPHONE, INC.
(Exact name of each registrant as specified in its charter)
Delaware
(State or other jurisdiction of incorporation)
333-33117 11-3132722
(Commission File Number) (IRS Employer Identification No.)
45 Broadway, 30th Floor
New York, New York 10006
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (212) 444-6991
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Item 5. Other Events.
On February 12, 1998, Econophone, Inc. ("Econophone") issued a final
offering memorandum (the "Memorandum") in connection with the offering and
sale of $300,000,000 in aggregate principal amount at maturity of 11% Senior
Discount Notes due 2008 (the "Notes").
Included below are selected portions of the "Risk Factors" section of
the Memorandum and the "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and "Business" sections of the
Memorandum. The Consolidated Financial Statements as of December 31, 1996 and
1997 and for the three years ended December 31, 1997 and the related
footnotes thereto contained in the Memorandum are also included below. The
inclusion of such information is for disclosure purposes only and does not
constitute an offer to sell or a solicitation of an offer to purchase the
Notes or any other securities of Econophone.
Statements contained herein regarding Econophone's expectations with
respect to future operations and other matters, which can be identified
by use of forward-looking terminology, such as "may," "will," "expect,"
"anticipate," "estimate" or "continue" or the negative thereof or variations
thereon or comparable terminology, are forward-looking statements within
the meaning of Section 21E of the Securities Exchange Act of 1934, as amended.
See "Risk Factors" for cautionary statements identifying important factors
with respect to such forward-looking statements, including important risks
and uncertainties, that could cause actual results to differ materially from
results referred to in the forward-looking statements.
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RISK FACTORS
LIMITED OPERATING HISTORY
Econophone commenced operations in 1989, and prior to 1994 engaged only
in limited operations, and, therefore, has a limited operating history upon
which potential investors may base an evaluation of its performance.
Econophone's principal operations have been in the United Kingdom
(principally in the London area), the United States (principally in the New
York area) and Belgium (principally in the Antwerp area). Econophone began
providing services in its other continental European and U.S. markets only in
1996 and 1997 and, to date, its business activities in most of such markets
have been limited. In addition, the liberalization of the European regulatory
environment is substantially changing the nature of European
telecommunications markets. See "Business--Services," "Business--Competition"
and "Business--Regulation."
Econophone is in the process of significantly expanding its operations in
its current markets and intends to enter into a number of markets where it
currently does not have operations. In many of its existing and future
markets, Econophone also plans to offer services that have been provided in
the past to a large extent only by the continental European state-owned
telecommunications organizations (the "PTOs"). Furthermore, in certain of such
markets, Econophone also intends to utilize access and transmission methods
with respect to which it has limited operating experience. Econophone's
prospects must, therefore, be considered in light of the risks, expenses,
problems and delays inherent in substantially expanding a business and in
establishing a new business in additional markets in an evolving industry.
Any of these factors could have a material adverse effect on Econophone's
business, financial condition, results of operations and its ability to pay
principal of and interest on the Notes. See "--Implementation of Expansion
Plans," "--Competition," "--Dependence on Third Party Sales Organizations,"
"--Risks Associated with Rapidly Changing Industry; Significant Price
Declines," "--Risks Associated with Rapid Growth," "--Need for Local
Connectivity," "--Dependence on Effective Information Systems," "--Dependence
Upon Key Personnel; Integration of Management," "--Dependence on Equipment
Supplier" and "Business--Services."
IMPLEMENTATION OF EXPANSION PLANS
Econophone's successful implementation of its strategy will require the
continued expansion and development of its network in Europe and the United
States, as well as the continued expansion and development of related
back-office capacity, including billing systems, and the hiring and retention
of highly productive internal sales personnel and independent sales agents.
Execution of Econophone's expansion plans is subject to a variety of risks,
including, but not limited to, operating and technical problems, regulatory
uncertainties and competition, and there can be no assurance that Econophone
will be able to successfully implement such plans.
As Econophone continues to expand its network, it will incur significant
fixed costs, relating principally to switching equipment costs, indefeasible
rights of use ("IRUs") and leased lines and network management costs. The
installation and expansion of Econophone's network has entailed and will
continue to entail considerable expenses in advance of anticipated revenues
and may cause substantial fluctuations in Econophone's operating results.
Econophone presently uses its network primarily to originate, but not
terminate, calls. Therefore, the economic benefits of Econophone's network
are primarily limited to originating calls where Econophone has a switch,
node or point of presence. There can be no assurance that Econophone will be
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able to continue to expand its network successfully or that Econophone will
generate traffic volumes sufficient to enjoy significant economies of scale,
which Econophone believes are critical to the overall success of its
strategy. Failure by Econophone to implement its expansion plans would have a
material adverse effect on Econophone's business, financial condition,
results of operations and on its ability to pay principal of and interest on
the Notes.
HIGH LEVERAGE, FUTURE LOSSES, DEFICIENCY OF EARNINGS TO FIXED CHARGES AND
NEGATIVE CASH FLOW
At December 31, 1997, on a pro forma as adjusted basis after giving
effect to the offering of the Notes (the "Offering"), Econophone would have
had total consolidated indebtedness of approximately $333.7 million and a
stockholders' deficit of approximately $33.7 million. The notes issued by
Econophone in 1997 (the "1997 Notes") have a principal amount at maturity of
$155.0 million and mature prior to the Notes offered hereby. As of December
31, 1997, the 1997 Notes were secured by $59.0 million of restricted cash.
Econophone anticipates that it will incur substantial additional
indebtedness. Econophone had a net loss of $30.1 million for the year ended
December 31, 1997. On an as adjusted basis, assuming that the Offering and
the 1997 sale of units (the "1997 Unit Offering") consisting of the 1997
Notes and warrants (the "Warrants") to purchase 1,265,885 shares of voting
common stock ("Common Stock") of Econophone had been consummated on January
1, 1997, Econophone would have had a net loss of $61.1 million for 1997.
Econophone also had negative EBITDA of $18.8 million for the year ended
December 31, 1997. Furthermore, Econophone's net cash used in operating
activities was $12.2 million for the year ended December 31, 1997. Econophone
expects to have operating losses and net losses for at least the next several
years and negative EBITDA and negative cash flow from operations until at
least 2000. There can be no assurance that Econophone will ever operate at
profitable levels, have positive EBITDA or be able to service its
indebtedness.
The ability of Econophone to meet its debt service obligations will
depend upon its future performance, which, in turn, is subject to
Econophone's successful implementation of its strategy, as well as to
financial, competitive, business, regulatory, technical and other factors,
substantially all of which are beyond Econophone's control. There can be no
assurance that Econophone will ever operate at profitable levels, have
positive EBITDA or eliminate its deficiency of earnings to fixed charges. If
Econophone is unable to generate cash flow from operations that, together
with its restricted cash, is sufficient to meet its debt service
requirements, it may be required to refinance all or a portion of its
indebtedness. There can be no assurance that any such refinancing would be
possible on terms that would be acceptable to Econophone, if at all. If such
refinancing were not possible or if additional financing were not available,
Econophone could be forced to default on its obligations with respect to the
Notes.
The Indenture under which the Notes will be issued (the "Indenture") and
the Indenture pertaining to the 1997 Notes (the "1997 Indenture") contain
certain restrictive covenants. Such restrictions will affect, and in many
respects will significantly limit, among other things, the ability of
Econophone to incur indebtedness, make prepayments of subordinated
indebtedness, pay dividends, make investments, engage in transactions with
stockholders and affiliates, issue capital stock of restricted subsidiaries,
create liens, sell assets and engage in mergers and consolidations. The terms
of Econophone's Series A Preferred Stock (the "Series A Preferred Stock") and
the Secured Amended and Restated Equipment Loan and Security Agreement (as
amended, the "NTFC Agreement") between Econophone and NTFC Capital
Corporation ("NTFC") also place restrictions on the ability of Econophone to
incur indebtedness and to engage in certain other transactions. These
restrictions, in combination with Econophone's high leverage, could limit the
ability of Econophone to effect financings or other corporate activities.
Furthermore, the high level of Econophone's indebtedness could restrict its
flexibility in responding to changing business and economic conditions, its
ability to take advantage of business opportunities and its ability to pay
principal and interest on the Notes.
The level of Econophone's indebtedness could have important consequences
to holders of the Notes, including the following: (i) the debt service
requirements of other indebtedness could make it more difficult for
Econophone to make payments on the Notes; (ii) the ability of Econophone to
obtain any
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necessary financing in the future for working capital, capital expenditures,
debt service requirements or other purposes may be limited; (iii) a
substantial portion of Econophone's future cash flow from operations, if any,
may be dedicated to the payment of principal and interest on its indebtedness
and other obligations and might not be available for Econophone's business;
(iv) Econophone's level of indebtedness could limit its flexibility in
planning for, or reacting to changes in, its business; (v) Econophone will be
more highly leveraged than certain of its competitors, which may place it at
a competitive disadvantage; and (vi) Econophone's high degree of indebtedness
could make it more vulnerable in the event of a downturn in its business.
Econophone's high level of indebtedness may have a material adverse effect on
its ability to pay principal and interest on the Notes. See "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Liquidity and Capital Resources."
COMPETITION
The provision of telecommunications services is extremely competitive and
will become increasingly so due to the reduction or elimination of regulatory
barriers to entry into telecommunications markets. Econophone believes that
its non-U.S. markets will experience increased competition and will begin to
resemble the competitive landscape in the United States, in part as a result
of regulatory initiatives. It appears that continental European
telecommunications markets will experience price competition more rapidly and
more extensively than was experienced when deregulation occured in the United
States and the United Kingdom. Econophone's success will depend upon its
ability to compete with a variety of other telecommunications providers in
each of its markets.
Competition for customers is primarily on the basis of price and, to a
lesser extent, on the type and quality of services offered and customer
service. Econophone has no control over the prices set by its competitors.
Econophone has a large number of competitors which may use their substantial
financial resources to cause severe price competition in the markets in which
Econophone operates, which would require Econophone to reduce its prices in
order to remain competitive. For example, Sprint has implemented a program
offering $.10 per minute rates on certain calls to the United Kingdom and
free U.S. domestic long distance calls on Friday and MCI has priced certain
domestic off-peak calls at $.05 per minute. In the United Kingdom, the Office
of Telecommunications ("Oftel"), the U.K. telecommunications regulatory
authority, is expected to require British Telecom to reduce its retail prices
by continuing to impose a price cap on its residential retail prices,
although, since October 1997, it has allowed British Telecom far more freedom
in respect of its pricing of its retail business services. In continental
Europe, France Telecom and Deutsche Telekom have recently taken steps to
substantially reduce prices in an effort to protect their market share and
deter competitors, such as Econophone. France Telecom has obtained approval
to reduce retail prices on domestic and international long distance services
by an average of 9% during each of 1997 and 1998 and 4.5% during each of 1999
and 2000. Deutsche Telekom will reduce retail prices on domestic and
international long distance service by up to 40% beginning March 1, 1998.
Neither France Telecom nor Deutsche Telekom have reduced wholesale prices to
the same extent as retail prices. Price reductions by France Telecom and
Deutsche Telekom may over time create substantial pressure on Econophone's
gross margins in those countries. In the United States, the Federal
Communications Commission (the "FCC"), the U.S. telecommunications regulatory
authority, also has adopted rules which are designed to bring downward
pressure on international telephone rates. The FCC is requiring U.S.
international facilities-based carriers to negotiate lower settlement rates
with correspondent foreign carriers that deliver calls in foreign
jurisdictions. The FCC expects such lower settlement rates to become
effective on a transitional basis, commencing January 1, 1999 for major
countries, with lower settlement rates in effect for substantially all
countries by January 1, 2003. Any resulting savings to the U.S.
facilities-based carriers might be passed along to their customers in the
form of reduced rates for international calls. Corresponding price reductions
by Econophone could reduce Econophone's revenue and margins, which could have
a material adverse effect on Econophone's business, financial condition,
results of operations and its ability to pay principal of and interest on the
Notes.
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Econophone has experienced, and expects to continue to experience, declining
revenue per billable minute in all of its markets, including France and Germany,
in part as a result of increasing worldwide competition within the
telecommunications industry. Econophone also experiences customer attrition, or
"churn," as a result of the highly competitive nature of its markets and expects
current levels of churn to continue or increase. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations-- Results of
Operations."
Competition is strong for all of Econophone's services. Competition for
U.S. calling card services is particularly intense. Larger service providers
such as AT&T, MCI and Sprint have substantial brand recognition and market
penetration for their calling cards, while a large number of smaller calling
card providers compete fiercely based almost entirely on price. In addition,
the Regional Bell Operating Companies ("RBOCs") are eligible, subject to FCC
approval, to offer domestic long distance and international
telecommunications services in their "in region" service areas, as well as
outside of their service areas, and have applied for FCC approval for "in
region" market entry. To date, the FCC has denied each of those applications.
However, the FCC has been meeting with the RBOCs to explain FCC requirements.
This may lead to one or more successful RBOC "in region" applications in the
future. Recently, a lower court decision that is currently being appealed
invalidated the FCC's statutory authority for prior approval of market entry
by several RBOCs into certain "in region" long distance markets.
Because all of Econophone's current and intended European markets (other
than the United Kingdom) have only recently liberalized or still are in the
process of liberalizing the provision of telephone services, customers in
most of these markets are not accustomed to obtaining services from
competitors to PTOs and may be reluctant to use new providers, such as
Econophone. In particular, Econophone's target European customers, small- and
medium-sized businesses and residential users with significant international
calling needs, may be reluctant to entrust their telecommunications needs to
new operators that are believed to be unproven. In addition, in continental
Europe, certain of Econophone's competitors (including the PTOs) provide
potential customers with a broader range of services than Econophone
currently offers or can offer due to regulatory restrictions. PTOs also
generally have certain competitive advantages over Econophone and other
providers due to their control of local connectivity, their extensive
ownership of facilities, their ability to delay or prevent equal access to
lines and the reluctance of some regulators to adopt policies and grant
regulatory approvals that will result in increased competition for the local
PTO. For example, Deutsche Telekom recently proposed, subject to regulatory
approval, a fee of approximately 50 Deutsche Marks ("DM") for any customer
changing long distance service providers. In addition, in France, only seven
carriers will be able to provide long distance service using a single digit
prefix. Econophone does not expect to be one of these carriers. If the PTO in
any jurisdiction uses its competitive advantages to their fullest extent,
Econophone's operations in such jurisdiction would be adversely affected.
Further, if European PTOs persist in substantial retail price reductions, it
would have a material adverse effect on Econophone's ability to generate
positive gross margins in Europe, which will have a material adverse effect
on Econophone's ability to pay principal of and interest on the Notes.
In addition, there are pending major consolidations in the
telecommunications industry which could result in even more powerful
competitors to Econophone in its major markets. For example, the creation of
a new company with the international facilities of the AT&T Unisource
partners could result in downward pressure on prices without a corresponding
reduction in transmission costs. In addition, the recent merger between Bell
Atlantic and NYNEX, the pending acquisition of MCI by WorldCom, Inc. and the
proposed acquisition of Teleport Communications by AT&T may result in
increased price competition for retail services, but reduced competition for
wholesale services used by Econophone.
Econophone also may experience competition in one or more of its markets
from competitors utilizing new or alternative technologies and/or
transmission methods, including cable television companies, wireless
telephone companies, satellite owners and resellers, electric and other
utilities, railways, microwave carriers and large end users that have private
networks. In addition, existing
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telecommunications companies, including AT&T, are implementing plans to offer
voice telecommunications services over the Internet at substantially reduced
prices.
Many of Econophone's competitors are significantly larger, have
substantially greater financial, technical and marketing resources and larger
networks than Econophone, control transmission lines and have long-standing
relationships with Econophone's target customers. If any of Econophone's
competitors were to devote additional resources to the provision of
international and/or domestic long distance voice telecommunication services
to Econophone's target customer base, there could be a material adverse
effect on Econophone's business, financial condition, results of operations
and its ability to pay principal of and interest on the Notes. Many of
Econophone's larger competitors have lower incremental transmission costs
than Econophone due to, among other things, greater use of owned transmission
capacity, more favorable interconnection rates and volume discounts on
transmission. Furthermore, in certain European countries (including in France
and Belgium), telecommunications companies that make substantial investments
in network infrastructure will receive a substantial discount on
interconnection rates. Econophone does not expect to qualify for such a
discount. In addition, certain of Econophone's competitors offer customers an
integrated full service telecommunications package consisting of local and
long distance voice, data and Internet transmission. Econophone does not
offer all of these types of service, and presently does not intend to do so,
which could have a material adverse effect on Econophone's competitiveness
and its ability to pay principal of and interest on the Notes.
Each of the markets in which Econophone offers or intends to offer its
services will present unique competitive factors. There can be no assurance
that Econophone will be able to effectively compete in any given market and
the success of Econophone's strategy in any one market is not necessarily
indicative of its ability to succeed in any other market. See
"Business--Competition."
DEPENDENCE ON THIRD PARTY SALES ORGANIZATIONS
Econophone historically has sold substantially all, and intends to
continue selling a substantial percentage of, its services through indirect
channels of distribution, consisting of independent sales agents and
resellers. For the year ended December 31, 1997, 52% of Econophone's revenues
were attributable to independent sales agents and 20% were attributable to
resellers. Although Econophone believes that it offers its independent sales
agents and resellers sufficient incentives to market and sell its services,
Econophone does not have direct control over such persons and there can be no
assurance that they will perform in a satisfactory manner. Econophone has, in
the past, experienced disputes with certain of its independent sales agents.
In connection with its change in distribution strategy, in the United
Kingdom, in late 1996, Econophone entered into a settlement agreement with
Europhone International ("EI"), its former partner in its U.K. sales and
marketing joint venture. Pursuant to the terms of the settlement, among other
things, EI retained all of the rights in the customer list of the joint
venture, which included approximately 21,700 names, and Econophone agreed not
to solicit sales from such customers, subject to certain exceptions. For
1996, Econophone's joint venture with EI and sales of carrier services to EI
contributed 32% of Econophone's consolidated revenues and 92% of its U.K.
originated revenues. See "-- Dependence on Carrier Customers," "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
"Business--Sales and Marketing."
Econophone believes that its relationships with its current independent
sales agents and resellers are good. However, there can be no assurance that
Econophone will not in the future experience material disputes with any such
person or that Econophone and/or any such person will not decide to terminate
their business relationship. In addition, regulations pertaining to
commercial agents introduced by the European Union ("EU") have given sales
agents far greater protection than before, resulting in the potential for
increased termination payments in the event of a dispute. Such disputes or
terminations could adversely affect the number of customers obtained and/or
retained by Econophone, which could have a material adverse effect on
Econophone's business, financial condition, results of operations and its
ability to pay principal of and interest on the Notes.
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DEPENDENCE ON CARRIER CUSTOMERS
Revenues derived from carrier customers accounted for 20% of Econophone's
revenues during 1997. Such revenues are produced by a limited number of
carrier customers. Accordingly, the loss of revenue from one or more carrier
customers could have a material adverse effect upon Econophone's business,
financial condition, results of operations and its ability to pay principal
of and interest on the Notes.
From June through November 1996, following the changing of its U.K.
distribution strategy, Econophone provided carrier services to EI. This
relationship was terminated as a result of disputes between Econophone and EI
following payment delinquencies by EI. In connection with the termination,
Econophone extended the payment period for receivables from EI and agreed not
to solicit sales from former customers of Econophone's joint venture with EI,
subject to certain exceptions. EI accounted for 12% of Econophone's revenues
during the time it was a carrier customer and such carrier sales and revenues
attributable to the U.K. sales and marketing joint venture between EI and
Econophone accounted for 92% of U.K. and 32% of consolidated revenues for
1996. In the United States, Econophone's five largest carrier customers
accounted in the aggregate for 13% of U.S. revenues and 8% of consolidated
revenues in 1997. See "--Dependence on Third Party Sales Organizations"
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Business--Sales and Marketing."
Carrier customers are extremely price sensitive, generate very low margin
business and frequently choose to move their business based solely on small
price changes. In addition, smaller carrier customers generally are perceived
in the telecommunications industry as presenting a higher risk of payment
delinquency or non-payment than other customers. While Econophone believes
that its credit criteria enables it to reduce its exposure to the higher
payment risks generally associated with carrier customers, no assurance can
be given that such criteria will afford adequate protection against such
risks.
RISKS ASSOCIATED WITH RAPIDLY CHANGING INDUSTRY; SIGNIFICANT PRICE DECLINES
The international telecommunications industry is changing rapidly due to,
among other things, regulatory liberalization, privatization of PTOs, the
expansion of telecommunications infrastructure and the globalization of the
world's economies. The telecommunications industry also is in a period of
rapid technological evolution, marked by the introduction of new product and
service offerings and increased satellite and fiber optic cable transmission
capacity for services similar to those provided by Econophone, including
utilization of the Internet for voice and data communications. See
"--Competition."
There can be no assurance that one or more of the foregoing factors will
not vary unpredictably, which could have a material adverse effect on
Econophone's business financial condition, results of operations and its
ability to pay principal of and interest on the Notes. There also can be no
assurance, even if such factors turn out as anticipated by Econophone, that
Econophone will be able to implement its strategy or that its strategy will
be successful in the rapidly evolving telecommunications market. In addition,
there can be no assurance that Econophone will be able to compete effectively
or adjust its contemplated plan of development to meet changing market
conditions. Furthermore, Econophone is unable to predict which of the many
possible future service offerings will be important to establish and maintain
a competitive position or what expenditures will be required to develop and
provide such services. Econophone's profitability will depend, in part, on
its ability to anticipate and adapt to rapid technological changes occurring
in the telecommunications industry and on its ability to offer, on a timely
basis, services that satisfy evolving industry standards. The failure by
Econophone to respond to new technologies on a timely basis, penetrate new
markets in a timely manner in response to changing market conditions or
customer requirements or achieve a significant degree of market acceptance of
new or enhanced services could have a material adverse effect on Econophone's
business, financial condition, results of operations and its ability to pay
principal of and interest on the Notes.
Prices for international long distance calls historically have been
determined by international settlement rates. Because these rates
historically have been negotiated between national telephone
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monopolies, they have been artificially high and have allowed carriers to
enjoy artificially high gross margins on international calls. However, many
observers believe that, given the negligible marginal cost to a
facilities-based carrier of carrying an international call and given the
emergence of competition in many countries, the international settlement rate
system is in the process of collapsing. In addition, EC Directive 97\33\EC
(the "Interconnection Directive"), which became effective January 1, 1998,
requires EU operators with significant market power to have charges for call
termination for cross border traffic that are cost-based and
non-discriminatory, which will have an effect on settlement rates with
countries and territories outside the EU and may also contribute to the
collapse of the accounting rate system. For the foregoing reasons, price
reductions have begun to be reflected in international rates, particularly
the rates charged for calls between countries where competition exists. For
example, Sprint has reduced its rates on certain calls between the United
States and the United Kingdom to $.10 per minute. This represents a steep
decline from rates charged for such calls as recently as several years ago
and Econophone expects rates on international calls, particularly between the
United States and the United Kingdom, to continue to decline significantly.
Furthermore, the FCC has adopted rules designed to bring downward pressure on
international telephone rates that would require U.S. international
facilities-based carriers to pay lower settlement rates to their
correspondent foreign carriers. Industry observers predict that telephone
charges will be less affected by the distance a call is carried, particularly
with the possible increased use of voice services over the Internet. As a
consequence, Econophone would experience a substantial reduction in its gross
margins on international calls, which, absent a substantial increase in
billable minutes of traffic carried or charges for additional services, would
have a material adverse effect on Econophone's business, financial condition,
results of operations and its ability to pay principal of and interest on the
Notes. In addition, France Telecom and Deutsche Telekom have recently taken
steps to substantially reduce retail prices, in excess of reductions in
wholesale prices, in an effort to protect their market share and deter
competitors, such as Econophone. See "--Competition."
RISKS ASSOCIATED WITH RAPID GROWTH
Econophone has experienced rapid growth. Econophone's revenues were $3.5
million for 1993, increasing to $83.0 million for 1997.
Econophone's strategy contemplates continued growth primarily through
further expansion of its existing operations and the establishment of new
operations. Econophone's ability to manage its anticipated future growth will
depend on its ability to evaluate new markets, secure, retain and motivate
independent sales agents and its internal sales forces, monitor operations,
control costs, maintain effective quality controls, provide customer service,
obtain satisfactory and cost-effective lease rights from, and interconnection
with, competitors that own transmission lines (in many cases, intra-national
transmission lines may be available only from the PTO), and significantly
expand its internal management, technical, accounting and customer billing
systems. Econophone's rapid growth has placed, and its planned future growth
will continue to place, a significant and increasing strain on its financial,
management and operational resources. There can be no assurance that
Econophone's financial, management and operational systems and infrastructure
will be adequate to maintain and effectively monitor future growth or that
Econophone will be able to successfully attract, train and manage additional
employees and/or independent sales agents. The failure to continue to upgrade
Econophone's financial, management and operational control systems and
infrastructure or the occurrence of unexpected expansion difficulties could
have a material adverse effect on Econophone's business, financial condition,
results of operations and its ability to pay principal of and interest on the
Notes. See "--Dependence on Effective Information Systems" and "--Dependence
on Key Personnel; Integration of Management."
RISKS ASSOCIATED WITH IMPOSITION OF VAT
Value added tax ("VAT") is a tax charged on goods and services that is
designed to be borne by the ultimate end user of the goods or services. The
rate of VAT varies among EU member states but typically
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is between 15% and 21% of the cost of the goods or services. Prior to January
1, 1997, pursuant to the Sixth VAT Directive adopted in 1977 (the "VAT
Directive"), providers of telecommunications services in the EU were liable
for VAT in the EU member state where the provider of the services was
"established" or where the provider had a "fixed establishment" from where
the services were provided. The provider charged VAT to its customers at the
rate prevailing in the provider's state of establishment. Under VAT rules,
most businesses are permitted to offset the VAT charged to them with the VAT
that they charge to their customers. Residential customers and certain
categories of businesses cannot offset VAT and, therefore, bear the cost of
the tax. With respect to the provision of services by Econophone to EU
customers, other than in the United Kingdom, where it had a fixed
establishment, Econophone until recently had a competitive price advantage
over its competitors, including the PTOs. Because services to these customers
were provided by a company based in the United States, Econophone was not
required to charge VAT to them.
In March 1997, the Council of the European Union issued derogations to
the VAT Directive (the "VAT Derogation") that, as of January 1, 1997,
permitted individual EU member states to amend their laws so as to treat
telecommunications services as being provided where the customer is located
rather than where the telecommunications provider is established. In the case
of sales by a telecommunications provider to residential customers, the VAT
Derogation permits EU member states to require all providers to collect and
remit VAT. With effect from between January 1, 1997 and July 1, 1997, EU
member states adopted rules that subject all telecommunications services
provided to residential customers in such states to VAT.
There can be no assurance that, in order to remain competitive,
Econophone will not need to reduce prices in the future in one or more EU
markets in order to offset VAT that it is now required to charge. Any such
reduction could have a material adverse effect on Econophone's business,
financial condition, results of operations and its ability to pay principal
of and interest on the Notes.
DEVALUATION AND CURRENCY RISKS
A substantial portion of Econophone's revenues and expenses are
denominated in non-U.S. currencies, consisting principally of the British
pound, Belgian franc and French franc. Furthermore, Econophone's business
strategy contemplates that, although an increasing portion of its revenues
and expenses will be denominated in non-U.S. currencies, a disproportionate
portion of Econophone's expenses, including interest and principal on the
Notes and the 1997 Notes, will be denominated in dollars. Econophone from
time to time uses foreign exchange contracts relating to its trade accounts
receivables to hedge foreign currency exposure and to control risks relating
to currency fluctuations. In addition, as part of its efforts to mitigate the
exposure to changes in foreign exchange rates, to the extent practicable,
Econophone varies the portion of its transmission purchased in U.S. dollars
and other currencies. Because of the number of currencies involved,
Econophone's constantly changing currency exposure and the fact that all
foreign currencies do not fluctuate in the same manner against the dollar,
Econophone cannot quantify the effect of exchange rate fluctuations on its
future financial condition or results of operations. Since the first quarter
of 1997, the U.S. dollar has appreciated relative to the principal European
currencies in which Econophone bills its European customers. A sustained
increase in the value of the U.S. dollar relative to such currencies would
reduce Econophone's gross margins on European calls and could have a material
adverse effect on Econophone's ability to pay principal of and interest on
the Notes. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Overview."
REGULATORY RESTRICTIONS
National and local laws and regulations governing the provision of
telecommunications services differ significantly among the countries in which
Econophone currently operates and intends to operate. The interpretation and
enforcement of such laws and regulations varies and could limit Econophone's
ability to provide certain telecommunications services in certain markets.
There can be no assurance that future
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<PAGE>
regulatory, judicial and legislative changes will not have a material adverse
effect on Econophone, that domestic or international regulators or third
parties will not raise material issues with regard to Econophone's compliance
or noncompliance with applicable laws and regulations or that other
regulatory activities will not have a material adverse effect on Econophone's
business, financial condition, results of operations and its ability to pay
principal of and interest on the Notes. See "Business--Regulation."
A substantial portion of Econophone's strategy is based upon the
regulatory liberalization of certain EU markets that occurred on January 1,
1998. In anticipation of such liberalization, Econophone established
operations and made capital expenditures in certain EU countries and intends
to continue to do so. Although liberalization is a legal obligation required
by EC directives, a substantial portion of the more detailed EU regulatory
framework to apply in the new liberalized environment is not yet in place. In
addition, certain EU member states have been granted a derogation from
liberalizing their telecommunication markets. Ireland and Portugal have been
granted a derogation until January 1, 2000. Spain has been granted a
derogation entitling it to delay liberalization until November 30, 1998.
Luxembourg and Greece have been granted a derogation entitling them to delay
full liberalization until July 1, 1998 and January 1, 2001, respectively.
There can be no assurance that each EU member state will proceed with the
expected liberalization on schedule or to the extent required (although
failure to do so would be a breach of EU law) or that the trend towards
liberalization will not be stopped or reversed. Accordingly, Econophone faces
the risk that it will establish operations and make capital expenditures in a
given country in anticipation of regulatory liberalization which either does
not subsequently occur or is delayed.
The national governments of EU member states must pass legislation to
liberalize the markets within their countries to give effect to EC
directives. This applies not only to the liberalization requirements set out
in EC directives that already have been adopted, but will also apply to
requirements to be contained in those directives which still remain to be
adopted by the Council of the European Communities. Econophone's provision of
services in Europe may be materially adversely affected if any EU member
state imposes greater restrictions on non-EU international services than on
international services within the EU, although EU members have signed the
World Trade Organization agreement which allows access to their markets by
other signatories. In addition, some EU member states have inconsistently
and, in some instances, unclearly implemented EC telecommunications
directives, which could limit, constrain or otherwise adversely affect
Econophone's ability to provide certain services. Furthermore, national
governments may not necessarily pass legislation enacting an EC directive in
the form required, if at all, or may pass such regulations only after a
significant delay. In November 1997, the European Commission commenced
proceedings against seven EU member states, including Belgium, for failure to
implement certain EU telecommunications directives fully. Even if a national
government enacts appropriate regulations within the time frame established
by the European Union, there may be significant resistance to the
implementation of such legislation from PTOs, regulators, trade unions and
other sources. For example, in France, the telecommunications union has
stated its objection to the current move towards liberalization. In Germany,
competitors of Deutsche Telekom have had to resort to court proceedings to
attempt to obtain unbundled access to the local loop and the interconnection
prices set by the relevant ministry have been challenged. These and other
potential obstacles to liberalization could have a material adverse effect on
Econophone's operations by preventing Econophone from expanding its
operations as currently intended, as well as a material adverse effect on
Econophone's business, financial condition, results of operations and its
ability to pay principal of and interest on the Notes.
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<PAGE>
In the United States, Econophone's authority to engage in the resale of
international private lines to provide international telephone service is
pursuant to an authorization (the "Section 214 Private Line Authorization")
granted under Section 214 of the 1934 Act. Certain rules of the FCC prohibit
Econophone from (i) transmitting calls routed over leased lines between New
York and London onward over a leased line to continental Europe (other than
to a country which the FCC deems to be "equivalent," which currently is only
Sweden) or (ii) transmitting calls from continental European countries (other
than those deemed to be equivalent) over leased lines to London and then
onward over a leased line between London and New York. FCC restrictions thus
may materially limit the optimal and most profitable use of Econophone's
leased lines between New York and London and result in increased transmission
costs on certain calls, which Econophone may not be able to pass on to its
customers.
In the United States, the FCC and relevant state public service
commissions ("PSCs") have the authority to regulate interstate and intrastate
telephone rates, respectively, ownership of transmission facilities and the
terms and conditions under which certain of Econophone's services are
provided. Federal and state regulations and regulatory trends have had, and
in the future are likely to have, both positive and negative effects on
Econophone and its ability to compete. The recent trend in both Federal and
state regulation of telecommunications service providers has been in the
direction of reduced regulation. In general, neither the FCC nor the relevant
state PSCs currently regulate Econophone's domestic long distance rates or
profit levels, although either or both may do so in the future. There can be
no assurance that changes in current or future Federal or state regulations
or future judicial changes would not have a material adverse effect on
Econophone's business, financial condition, results of operations and its
ability to pay principal of and interest on the Notes. See
"Business--Regulation."
In order to provide their services, inter-exchange carriers, including
Econophone, must generally purchase "access" from local exchange carriers
("LECs") to originate calls from and terminate calls in the local exchange
telephone networks. In the United States, access charges generally are
regulated by the FCC and the relevant state PSCs. Under the terms of the AT&T
Divestiture Decree, a court order entered in 1982 (the "AT&T Divestiture
Decree"), the RBOCs were required to price the "local transport" portion of
such access charges on an "equal price per unit of traffic" basis. The FCC
has adopted, subject to reconsideration, a change in the access charge
structure, which reduces per minute access charges, but applies additional
per line charges for business users. This change in access charge structure
may disproportionately disadvantage smaller carriers such as Econophone.
Under alternative access charge rate structures proposed to the FCC, LECs
would be permitted to allow volume discounts in the pricing of access
charges. If these rate structures are adopted, access charges for AT&T and
other large inter-exchange carriers would decrease and access charges for
small inter-exchange carriers would increase. While the outcome of these
proceedings is uncertain, should the FCC adopt permanent access charge rules
along the lines of the proposed structures, Econophone would be at a cost
disadvantage with regard to access charges in comparison to AT&T and other
large inter-exchange carrier competitors.
Beginning January 1, 1998, Econophone, as well as its U.S. competitors,
became obligated to make FCC-mandated contributions to universal service
funds. These funds subsidize the provision of telecommunications services in
high cost areas and to low-income customers, as well as the provision of
telecommunications and certain other services to eligible schools, libraries
and rural health care providers. The contributions are billed monthly and are
assessed based on intrastate, interstate and international "end-user" gross
telecommunications revenues. However, revenues from international calls that
both originate and terminate in foreign points are excluded from assessment.
On December 16, 1997, the FCC approved the following contribution factors for
carriers' first quarter 1998 contributions: (i) 3.19% for the high cost and
low income funds (interstate and international revenues); and (ii) 0.72% for
the schools, libraries and rural health care funds (intrastate, interstate
and international revenues). Econophone currently is evaluating which
categories of its revenues are subject to assessment and, as a result, has
not filed a universal service fund worksheet. Because the contribution
factors are likely to vary quarterly, the annualized impact on Econophone
cannot be estimated at this time.
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<PAGE>
Additionally, effective January 1, 1998, Econophone is required to pay to
LECs specified presubscribed interexchange carrier charges ("PICCs") in order
to compensate such LECs for their investment in the telephone lines
Econophone uses to access its customers. The costs of these charges vary in
amount depending upon the type of presubscribed lines that are serviced by
Econophone and the individual LEC's revenue requirements. While Econophone
currently intends to pass through the costs of both the PICC and its
universal service fund contributions to its customers, there can be no
assurance that Econophone will be able to fully pass on such costs or that
doing so will not result in a loss of customers. In addition, the FCC orders
implementing the universal service contribution obligation and the PICC are
both subject to petitions seeking reconsideration by the FCC and to certain
appeals. Until such petitions or appeals are decided, there can be no
assurance as to how the orders will be implemented or enforced or what effect
the orders generally will have on competition within the telecommunications
industry or specifically on the competitive position of Econophone.
The FCC requires long distance carriers to pay access charges to payphone
providers for calls made from payphones to toll free numbers administered by
long distance carriers. The FCC had required the immediate payment of such
access charges by long distance carriers with toll revenues of $100 million
or more per annum. The FCC had also required, after October 7, 1997, all long
distance carriers, irrespective of their annual toll revenues, to pay to each
payphone operator $0.35 for each access or toll free call made from the
operator's payphones unless the payphone operator and the long distance
carrier agree upon a different rate of compensation. The FCC payphone order
was reversed by an appellate court and remanded to the FCC by the court for
further consideration. The FCC subsequently adopted a rate of $0.284 per call
in lieu of the $0.35 rate, effective October 7, 1997, and issued further
clarifications of its initial order. This decision is also before an
appellate court and some aspects of its implementation remain unclear.
Econophone's card-based services in the United States are accessed by
customers through a toll free number, often from payphones. Econophone has
marketed its services at a discount to prices charged by larger carriers
which recently have begun charging this $0.284 access charge. Econophone
recently began charging the $0.284 access charge. There can be no assurance
that, over time, Econophone will be able to fully pass the cost of this
charge on to its customers or that doing so will not result in a loss of
customers. Furthermore, larger carriers are likely to be able to negotiate
lower payphone access charges than Econophone, which could result in such
carriers offering lower pricing on card-based services in the United States
accessed from payphones than that offered by Econophone.
If Econophone is unable to provide the services it is presently providing
or intends to provide or to use its existing or contemplated access or
transmission methods due to its inability to receive or retain formal or
informal approvals for such services or access or transmission methods, or
for any other reason related to regulatory compliance or the lack thereof,
Econophone's business, financial condition, results of operations and its
ability to pay principal of and interest on the Notes would be materially and
adversely affected. See "Business--Regulation."
NEED FOR LOCAL CONNECTIVITY
To originate and terminate calls, Econophone requires "local
connectivity," which is connection to the public switched telephone network
("PSTN"). Local connectivity can be obtained through third parties or through
interconnection agreements negotiated directly with PTOs. Interconnection
agreements may provide for more favorable carrier rates based on volume and
other benefits such as the ability to offer customers abbreviated dialing. In
Europe, although Econophone has been successful to date in obtaining local
connectivity in each of its existing network cities, there can be no
assurance that Econophone will be able to maintain local connectivity, obtain
additional local connectivity in such cities to the extent necessary or
desirable or obtain local connectivity in additional cities, in each case
either on acceptable terms or at all. Furthermore, where local connectivity
is obtained through third parties, there can be no assurance that Econophone
will be able to enter into interconnection agreements with PTOs on acceptable
terms.
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<PAGE>
Econophone obtains its local connectivity in the United Kingdom from
British Telecom, the PTO in the United Kingdom and a principal competitor of
Econophone in the United Kingdom. In continental Europe, Econophone obtains
its local connectivity from PTOs which are, and are expected to continue to
be, among Econophone's primary competitors in continental Europe. In the
United States, Econophone obtains local connectivity from LECs, which also
are competitors of Econophone. Furthermore, in the United States, access and
termination costs charged by LECs to long distance providers constitute a
significant portion of the total cost of domestic long distance calls. There
can be no assurance that any of the foregoing competitors will make local
connectivity available to Econophone at commercially reasonable rates or on a
timely basis.
The availability and rates of local connectivity are, and will continue
to be, determined on a country-by-country basis. The failure to obtain local
connectivity on commercially acceptable terms could have a material adverse
effect on Econophone's business, financial condition, results of operations
and its ability to pay principal of and interest on the Notes.
DEPENDENCE ON LEASED LINES
Econophone does not own most of the telecommunications transmission lines
that it uses. The telephone calls made by Econophone's customers are and will
continue to be connected, at least in part, through transmission lines that
Econophone leases. Many of the lessors of such lines are competitors of
Econophone. In many countries, the only provider of transmission facilities
is the PTO. Accordingly, there may be only one source of intra-national
transmission lines in these countries and Econophone may be required to lease
transmission capacity at artificially high rates from a provider that
occupies a monopoly or near monopoly position on the portion of a call
transmitted in that provider's country. In several European countries,
including France and Germany, this currently is the case. Such rates may be
too high to allow Econophone to generate gross profit. In addition, PTOs will
not necessarily be required by law to allow Econophone to lease transmission
lines. Even where applicable law requires PTOs to lease transmission lines to
other carriers, delays are nevertheless being encountered with respect to the
commencement of operations and extensive delays are occurring with respect to
the negotiation of leases and interconnection agreements. In addition,
disputes are occurring with respect to pricing terms and billing.
Econophone leases capacity for point-to-point circuits on a monthly or
longer-term fixed cost basis. Econophone is vulnerable to changes in its
lease arrangements, such as price increases and service cancellations. The
negotiation of lease agreements involves estimates regarding future supply
and demand for transmission capacity as well as estimates of the calling
patterns and traffic levels of Econophone's existing and future customers.
Econophone's profitability depends, in part, on its ability to obtain and
utilize leased capacity on a cost-effective basis. Depending upon the rate,
Econophone could suffer competitive disadvantages if it entered into leases
with inappropriate durations or leases based on per-minute charges for high
volume routes (or leases with fixed monthly rates for low volume routes), or
if it failed to meet any minimum volume requirements thereunder. Econophone
also is vulnerable to service interruptions and poor transmission quality
from leased lines. The deterioration or termination of Econophone's
relationships with one or more of its carrier vendors could have a material
adverse effect upon Econophone's business, financial condition, results of
operations and its ability to pay principal of and interest on the Notes.
DEPENDENCE ON EFFECTIVE INFORMATION SYSTEMS
To complete its billing, Econophone must record and process large amounts
of data quickly and accurately. Econophone's public financial reporting
requirements also require it to process large amounts of information. While
Econophone believes its management information systems currently are
adequate, substantial investment will continue to be required to satisfy
anticipated billing and public financial reporting needs. Econophone believes
that the successful implementation and integration of enhanced and
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<PAGE>
new information systems will be important to its continued growth and its
ability to bill customers, monitor costs and other financial data and achieve
operating efficiencies, but there can be no assurance that Econophone will
not encounter delays or cost-overruns or suffer adverse consequences in
implementing such systems. In addition, as Econophone's information systems
suppliers revise and upgrade their hardware, software and equipment
technology, there can be no assurance that Econophone will not encounter
difficulties in integrating such new technology into its business or that the
new systems will be appropriate for Econophone's business. If Econophone's
information systems prove to be inadequate, it could have a material adverse
effect on Econophone's business, financial condition, results of operations
and its ability to pay principal of and interst on the Notes. See
"Business--Information Technology."
DEPENDENCE ON KEY PERSONNEL; INTEGRATION OF MANAGEMENT
The success of Econophone is dependent, in large part, upon its key
management. The loss of services of any of the members of Econophone's senior
management team, particularly Alfred West, the Chief Executive Officer and
Chairman of the Board of Directors of Econophone and Alan L. Levy, the
President and Chief Operating Officer and a Director of Econophone, could
have a material adverse effect on Econophone, its ability to successfully
implement its business plan (including, without limitation, the continued
roll-out of its network infrastructure, its sales and marketing initiatives
and the continued expansion of its back-office capabilities) and its ability
to pay principal of and interest on the Notes. Messrs. West and Levy are
parties to employment agreements with Econophone, expiring on December 31,
1999 and July 31, 1999, respectively. Other than Messrs. West and Levy,
Econophone has not entered into employment agreements with members of
management, although it intends to do so with certain new senior employees.
Econophone maintains "key man" life insurance policies on Mr. West that
provide for payment of $10.0 million to Econophone in the event of the death
or long-term disability of Mr. West.
Pursuant to the NTFC Agreement, Econophone may not cease to employ Alfred
West (other than by reason of his death or disability) or suffer to exist any
material competition by Mr. West with the business now or hereafter conducted
by Econophone. Failure to comply with the foregoing requirement would
constitute a default under the NTFC Agreement, which, if not cured, could
require the prepayment of all amounts outstanding thereunder.
Econophone has significantly increased the size of its management team
since the second half of 1997. Econophone's management team has limited
experience in working together and any delays in the integration of new
members of Econophone's management team could result in delays in the
implementation of Econophone's strategy.
Econophone's success also will depend on its ability to attract, retain
and motivate additional qualified management, marketing, technical and sales
executives and other personnel who are in high demand and are often subject
to competing employment opportunities, including qualified independent sales
agents. In addition, the labor market for software engineers has been
extremely competitive recently and Econophone may lose key employees or be
forced to increase their compensation as a result. The loss of the services
of key personnel, or the inability to attract additional qualified personnel,
could have a material adverse effect on Econophone's business, financial
condition, results of operations and its ability to pay principal of and
interest on the Notes. There can be no assurance that Econophone will be
successful in attracting, retaining and motivating such personnel. Although
members of management participate in Econophone's incentive plan, other than
Mr. Levy and Mr. Alward, their options do not provide the right to acquire a
significant portion of the equity of Econophone.
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<PAGE>
INTEGRATION OF VOICENET AND OTHER ACQUISITIONS
Although Econophone and VoiceNet Corporation ("VoiceNet") have had an
extensive business relationship since VoiceNet's inception, VoiceNet will
need to be integrated with Econophone's existing operations. In particular,
Econophone must maintain and develop the numerous distributor relationships
that have been critical to VoiceNet's operations to date. The integration of
VoiceNet also will entail, among other things, the integration of management
and other personnel and of accounting and other record-keeping systems.
Econophone has had limited experience with the integration of acquired
businesses and there can be no assurance that it will be able to successfully
integrate VoiceNet's operations. Other acquisitions, if any, would pose even
greater integration challenges.
DEPENDENCE ON EQUIPMENT SUPPLIER
Econophone purchases a significant portion of its switching equipment
from Northern Telecom. There can be no assurance that Econophone will be able
to acquire the switches that it will require as it continues to expand its
network from Northern Telecom or from another manufacturer of compatible
equipment. Any inability of Econophone to acquire such switches on a timely
basis or at a similar price, or any failure by Econophone to successfully
integrate such switches into its network, could result in delays, operational
problems or increased expenses, which could have a material adverse effect on
Econophone's business, financial condition, results of operations and its
ability to pay principal of and interest on the Notes. See "Business--Network
Infrastructure."
CONTROL BY PRINCIPAL STOCKHOLDERS
Alfred West, the Chief Executive Officer of Econophone and Chairman of
its Board of Directors, Steven West, the brother of Alfred West and a member
of the Board of Directors of Econophone, and Gary Bondi, a member of the
Board of Directors of Econophone, beneficially own, in the aggregate,
approximately 85.5% of the outstanding shares of Common Stock (assuming
conversion of the Series A Preferred Stock, but not giving effect to the
issuance or exercise of any warrants or options issued by Econophone). To the
extent such stockholders exercise their voting rights in concert, such
stockholders will have the ability to control the election of all members of
Econophone's Board of Directors, the outcome of all matters submitted to a
vote of the holders of Common Stock and generally will be able to direct the
affairs of Econophone. In addition, the affirmative vote of such stockholders
will be required to effect a change of control of Econophone. The exercise of
these powers may present conflicts of interest between these individuals and
the holders of the Notes.
POTENTIAL INABILITY TO REPAY NOTES AND OTHER INDEBTEDNESS UPON A CHANGE OF
CONTROL
The Indenture and the 1997 Indenture provide that, upon the occurrence of
a Change of Control thereunder, Econophone must make an offer to purchase all
of the Notes and 1997 Notes issued and then outstanding at a purchase price
equal to 101% of the then accreted value or principal amount thereof plus
accrued interest (if any) thereon to the payment date. Under the NTFC
Agreement, a change of control (as such term is used in such agreement)
occurring without the prior written consent of NTFC would constitute a
default thereunder, which would permit NTFC to accelerate repayment of all
amounts outstanding under the NTFC Agreement. In addition, pursuant to the
Certificate of Incorporation of Econophone, a change of control (as such term
is used therein) would permit holders of the Series A Preferred, at their
option, to require Econophone to redeem all shares of Series A Preferred held
by them. If an event were to occur that would constitute a "change of
control" pursuant to the NTFC Agreement, the Certificate of Incorporation
and/or the 1997 Indenture, prior to, or simultaneously with any payment to
the holders of the Notes in connection with a repurchase offer resulting from
a Change of Control pursuant to the Indenture, NTFC would be entitled to
receive payment of all outstanding obligations under the NTFC Agreement and
the holders of the Series A Preferred Stock and the 1997 Notes would be
entitled to redemption of such securities. If a Change of Control were to
occur, there can be no assurance
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that Econophone would be able to satisfy its obligations under the NTFC
Agreement, the Certificate of Incorporation, the 1997 Notes and the Notes.
Such a failure would constitute an Event of Default under the 1997 Indenture
and the Indenture and the NTFC Agreement.
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
REVENUES; PRICE DECLINES
Econophone derives its revenues from the provision of long distance
telecommunications services in certain major western European and U.S.
markets. In the United States and the United Kingdom, Econophone provides
principally international and domestic long distance, calling card, prepaid
and carrier services. In continental Europe, Econophone provides principally
international long distance, calling card and prepaid services. Econophone's
services utilize various access methods, including "1xxx," "1+," local
dial-up, national toll free and international toll free access. See
"Business--Services" and "Business--Network Infrastructure--Access Methods."
Econophone's revenues are derived from minutes of telecommunications traffic
carried. The following table shows the total revenue and billable minutes of use
attributable to Econophone's U.S., U.K. and continental European operations for
the years ended December 31, 1995, 1996 and 1997. Over time, Econophone expects
its European markets to contribute an increasingly larger percentage of its
revenues.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
--------------------------------
<S> <C> <C> <C>
1995 1996 1997
--------- --------- ----------
(IN THOUSANDS)
<S> <C> <C> <C>
REVENUE
United States............................................... $ 8,292 $ 18,185 $ 48,899
United Kingdom.............................................. 14,173 15,477 18,363
Continental Europe.......................................... 5,025 11,441 15,741
BILLABLE MINUTES OF USE
United States............................................... 23,411 68,247 244,095
United Kingdom.............................................. 20,592 27,968 68,810
Continental Europe.......................................... 3,856 8,351 17,239
</TABLE>
Econophone generally prices its services at a discount to the primary
carrier (or carriers) in each of its markets. Econophone has experienced and
expects to continue to experience declining revenue per minute in all of its
markets as a result of increased competition worldwide, although, due to
technological innovation and substantial available transmission capacity,
transmission costs in the telecommunications industry historically have
declined at a more rapid rate than prices. There can be no assurance that
this cost trend will continue. Industry observers predict that, early in the
next decade, telephone charges will no longer be based on the distance a call
is carried. As a consequence, Econophone would experience a substantial
reduction in its margins on international calls which, absent a significant
increase in billable minutes of traffic carried or charges for additional
services, would have a material adverse effect on Econophone's business,
financial condition, results of operations and its ability to pay principal
of and interest on the Notes. See "Risk Factors--Risks Associated with
Rapidly Changing Industry; Significant Price Declines" and
"Business--Industry Overview."
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For prepaid cards, Econophone's revenues are reported net of selling
discounts and commissions and upon usage rather than sale.
Econophone's U.K. revenues were limited in 1996 due to a restructuring of
Econophone's U.K. sales and marketing arrangements resulting from a change in
its distribution strategy. In September 1994, Econophone entered into a sales
and marketing joint venture with EI in the United Kingdom. EI engaged in
sales and marketing, while Econophone provided network support, billing and
transmission services. Revenues attributable to sales by the joint venture
were included in Econophone's consolidated revenues and customers of the
joint venture were included as customers of Econophone. After deducting
transmission expenses and direct selling expenses incurred by EI, Econophone
was entitled to 50% of the net profits on sales by EI. In connection with
Econophone's change in U.K. distribution strategy, Econophone's joint
marketing arrangement with EI was modified on June 1, 1996, at which time EI
effectively became a carrier customer. This arrangement subsequently was
terminated during December 1996. Econophone's services (excluding carrier
services) now are sold in the United Kingdom primarily through Telco Global
Communications ("Telco"), a majority-owned subsidiary of Econophone. Telco
began marketing efforts during the first quarter of 1997. During 1997,
Econophone's U.K. revenues were $18.4 million, $10.6 million of which was
generated by Telco. See "Business--Sales and Marketing."
Until recently, Econophone was not required to charge VAT to its
customers based in the European Union, other than in the United Kingdom,
where it was required to charge VAT. This resulted in a competitive price
advantage for Econophone over competitors, including the PTOs, who were
required to charge VAT to such customers. There can be no assurance that, in
order to remain competitive, Econophone will not need to reduce prices in the
future in one or more EU markets in order to offset VAT that it is now
required to charge. See "Risk Factors--Risks Associated With Imposition of
VAT."
In continental Europe, France Telecom and Deutsche Telekom have recently
taken steps to substantially reduce prices in an effort to protect their
market share and deter competitors, such as Econophone. France Telecom has
obtained approval to reduce retail prices on domestic and international long
distance services by an average of 9% during each of 1997 and 1998 and 4.5%
during each of 1999 and 2000. Deutsche Telekom will reduce retail prices on
domestic and international long distance service by up to 40% beginning
March 1, 1998. Neither France Telecom nor Deutsche Telekom have reduced or
proposed reducing wholesale prices to the same extent as retail prices. Price
reductions by France Telecom and Deutsche Telekom, may over time, create
substantial pressure on Econophone's gross margins in France and Germany. See
"Risk Factors--Competition."
COST OF SERVICES
Econophone's cost of services is composed of the costs associated with
acquiring switched transmission and leased line capacity. Switched
transmission capacity is acquired on a per-minute basis (with volume
discounts) and is, therefore, a variable cost. Virtually all calls carried by
Econophone must be originated or terminated over another carrier's
facilities. Termination and origination charges on calls generally are paid
by Econophone, although in continental Europe origination charges on calls
utilizing local dial-up access are paid by Econophone's customers and do not
constitute costs of Econophone. Leased transmission capacity is acquired on a
fixed cost basis, generally involving monthly payments regardless of usage
levels. Accordingly, once certain volume levels are reached, leased line
capacity is more cost effective than switched transmission capacity. As
Econophone's minutes of traffic carried have grown, Econophone has obtained
better pricing on switched transmission capacity. The marginal cost of
services also has decreased, independent of volume discounts, due to greater
usage of owned transmission capacity, technological innovation and
substantial available third-party transmission capacity.
The cost of calls transmitted between Econophone's London and New York
switches consist of IRU costs. IRU costs are included in depreciation and
amortization, involve only fixed costs and no per minute charges and are,
therefore, a more cost-effective means of transmitting traffic once certain
volume levels
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are reached. Econophone has, over time, reduced the average costs of
transmitting the London to New York portion of its calls by increasing its
customer traffic. Econophone recently completed the purchase of five
half-circuits on PTAT-1 and one on Cantat-3, which were previously leased.
Econophone also recently purchased IRUs on the AC-1 transatlantic cable,
which are expected to become operational during the second quarter of 1998.
See "Business--Network Infrastructure--Transmission Capacity."
As Econophone expands its customer base, it will require additional
transmission capacity. Its actual infrastructure requirements will depend
upon the capacity of the switches, nodes and points of presence installed by
Econophone and the extent to which it utilizes compression technology to
transmit calls. Based on current and anticipated availability of switching
and compression equipment and owned and leased transmission capacity,
Econophone believes that it will be able to meet its capacity requirements
for the foreseeable future, although there can be no assurance that this will
be the case.
The FCC adopted, effective October 7, 1997, a $0.284 access charge for
each call made using toll free access from a payphone in the United States.
The FCC's decision is before an appellate court. Econophone recently began to
charge the $0.284 access charge to its customers. If this charge is upheld,
there can be no assurance that Econophone will over time be able to fully
pass this cost on to its U.S. calling card and prepaid card customers or that
doing so will not result in a loss of customers. Furthermore, larger carriers
are likely to be able to negotiate lower payphone access charges than
Econophone, which could result in lower pricing on card-based services in the
United States accessed from payphones than that offered by Econophone. Had
such access charge been in effect during all of 1997, the aggregate payphone
access charge paid by Econophone would have been approximately $3.3 million.
Beginning January 1, 1998, Econophone, as well as its U.S. competitors,
became obligated to make FCC-mandated contributions to universal service
funds. These funds subsidize the provision of telecommunications services in
high cost areas and to low-income customers, as well as the provisions of
telecommunications and certain other services to eligible schools, libraries
and rural health care providers. The contributions are billed monthly and are
assessed based on intrastate, interstate and international "end-user" gross
telecommunications revenues. However, revenues from international calls that
both originate and terminate in foreign points are excluded from assessment.
On December 16, 1997, the FCC approved the following contribution factors for
carriers' first quarter 1998 contributions: (i) 3.19% for the high cost and
low income funds (interstate and international revenues); and (ii) 0.72% for
the schools, libraries and rural health care funds (intrastate, interstate
and international revenues). Econophone currently is evaluating which
categories of its revenues are subject to assessment and, as a result, has
not filed a universal service fund worksheet. Because the contribution
factors are likely to vary quarterly, the annualized impact on Econophone
cannot be estimated at this time.
Additionally, effective January 1, 1998, Econophone is required to pay to
LECs specified PICCs in order to compensate such LECs for their investment in
the telephone lines Econophone uses to access its customers. The costs of
these charges vary in amount depending upon the type of presubscribed lines
that are serviced by Econophone and the individual LEC's revenue
requirements. While Econophone currently intends to pass through the costs of
both the PICC and its universal service fund contributions to its customers,
there can be no assurance that Econophone will be able to fully pass on such
costs or that doing so will not result in a loss of customers. In addition,
the FCC orders implementing the universal service contribution obligation and
the PICC are both subject to petitions seeking reconsideration by the FCC and
to certain appeals. Until such petitions or appeals are decided, there can be
no assurance as to how the orders will be implemented or enforced or what
effect the orders generally will have on competition within the
telecommunications industry or specifically on the competitive position of
Econophone. See "Risk Factors -- Regulatory Restrictions."
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SELLING EXPENSES
Econophone has historically sold its services primarily through
independent sales channels in both Europe and the United States. Selling
expenses have, therefore, primarily consisted of commissions paid to agents
and resellers. To a lesser extent, Econophone also has incurred selling
expenses arising out of advertising and promotion costs and sales by
Econophone employees and expenses related to its customer service department.
For the year ended December 31, 1997, commissions earned by VoiceNet
accounted for $5.7 million, or 43%, of selling expenses. Commissions were
based on calling card usage by VoiceNet customers and consisted of two
components: (i) commissions received by VoiceNet that it retained; and (ii)
commissions received by VoiceNet that it subsequently paid to its independent
sales agents. As of the date of consummation of the acquisition of VoiceNet,
that portion of commissions paid to and retained by VoiceNet has been
eliminated. For the year ended December 31, 1997, $2.3 million of the
commissions paid to VoiceNet were retained by VoiceNet.
In the fourth quarter of 1996, Econophone began to establish its internal
sales forces in Hamburg, London and Paris, and, in the first quarter of 1997,
Econophone began to establish its internal sales force in Brussels. Beginning
in the fourth quarter of 1996, Econophone also hired senior sales personnel
in continental Europe. The establishment and expansion by Econophone of its
internal sales forces and the hiring of senior sales personnel has and will
continue to increase significantly its selling expenses due to costs
associated with operating and staffing sales offices. Econophone expects
these costs to decline as a percentage of its continental European revenues
over time. Econophone will continue to utilize indirect channels of
distribution in its European network cities, although these channels will be
managed by its internal sales forces. See "Business--Sales and Marketing."
Deutsche Telekom recently proposed, subject to regulatory approval, a fee
of approximately DM50 for a customer to change long distance service
providers. If Econophone were required to bear this cost in order to remain
competitive, its selling expenses in Germany would be increased. See "Risk
Factors--Competition."
GENERAL AND ADMINISTRATIVE EXPENSES
Since the fourth quarter of 1996, Econophone has significantly increased
the size of its management team and established new sales offices in London,
Paris, Berlin, Brussels, Hamburg, Marseilles and Zurich, all of which
resulted in an increase in general and administrative expenses. Since the
fourth quarter of 1996, general and administrative expenses have primarily
consisted of expanding Econophone's customer service, billing, financial
reporting and other management information systems and network management
systems and organizational expenses related to entering additional markets.
Such expenses have been and will continue to be incurred in advance of
anticipated related revenues and are expected to decline as a percentage of
revenues over time. Econophone intends to establish sales offices in
additional network cities, which will further increase general and
administrative expenses.
INTEREST EXPENSE
Prior to July 1, 1997, interest expense principally consisted of interest
payable in connection with equipment financing loans and short-term
indebtedness. The 1997 Notes were issued on July 1, 1997 and currently
constitute most of Econophone's interest expense. Annual interest expense on
the 1997 Notes is $20.9 million. Econophone used $57.4 million of the net
proceeds from the 1997 Unit Offering to purchase 1,265,885 shares of Common
Stock, to purchase a portfolio of U.S. government securities (the "Pledged
Securities"). Proceeds from the Pledged Securities will be used by Econphone
to make the first six scheduled interest payments on the 1997 Notes.
Thereafter, interest on the 1997 Notes will be paid out of other cash
sources. Interest expense will increase substantially as a result of the
Offering.
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<PAGE>
FOREIGN CURRENCY EXPOSURE
Econophone is exposed to fluctuations in foreign currencies relative to
the U.S. dollar because Econophone bills in local currency, while
transmission costs are largely incurred in U.S. dollars. For the years ended
1995, 1996 and 1997, approximately 60%, 40% and 40%, respectively, of
Econophone's revenues were billed in currencies other than the U.S. dollar,
consisting primarily of British pounds, Belgian francs and French francs. The
effect of these fluctuations on Econophone's margins for the year ended
December 31, 1997 was a reduction of $2.7 million or 3% of gross margin. As
Econophone expands its operations, a higher percentage of revenues is
expected to be billed in currencies other than the U.S. dollar. Econophone
from time to time uses foreign exchange contracts relating to its receivables
to hedge foreign currency exposure and to control risks relating to currency
fluctuations. Econophone does not use derivative financial instruments for
speculative purposes and, at December 31, 1997, Econophone had $0.3 million
in open foreign currency hedging positions. As Econophone's operations in
Europe expand, it intends to utilize hedging contracts to control risks
relating to currency fluctuations. As part of its efforts to mitigate
exposure to changes in foreign exchange rates, to the extent practicable,
Econophone also varies the portion of its transmission capacity purchased in
U.S. dollars and other currencies. Since the first quarter of 1997, the U.S.
dollar has appreciated relative to the principal European currencies in which
Econophone bills its European customers. A sustained increase in the value of
the U.S. dollar relative to such currencies would reduce Econophone's gross
margins on European calls and could have a material adverse effect on
Econophone's ability to pay principal of and interest on the Notes. See "Risk
Factors-- Devaluation and Currency Risks."
THE VOICENET ACQUISITION
On February 12, 1998, Econophone acquired VoiceNet, a major reseller of
Econophone's calling card products. The initial purchase price for VoiceNet
was $21.0 million. which was paid out of cash on hand. The sellers of
VoiceNet also are entitled to receive an earn-out based upon the revenue
growth of the VoiceNet business for a period of up to one year following the
closing of the acquisition if certain performance criteria are met. See "Risk
Factors--Integration of VoiceNet."
VoiceNet provides travellers and other callers with calling card
services, which are advertised primarily in in-flight magazines. Econophone
has provided substantially all of VoiceNet's transmission, billing and
customer service functions since April 1996. The acquisition of VoiceNet by
Econophone ensures the continuity of Econophone's sales to VoiceNet, provides
Econophone with an established U.S. calling card business and enables
Econophone to cross-market its other services to VoiceNet's customer base,
which during December 1997 consisted of approximately 110,000 calling card
holders. The acquisition of VoiceNet also will reduce Econophone's selling
expenses in respect of services provided to VoiceNet customers. See
"--Selling Expenses."
The acquisition of VoiceNet will be accounted for under the purchase
method of accounting. Goodwill is recorded to the extent the purchase price
exceeds the fair value of the net assets purchased. Based on Econophone's
preliminary analysis, approximately $1.0 million of the initial purchase
price will reflect the underlying value of the assets acquired and $20.0
million will reflect goodwill. Goodwill will be amortized over 15 years.
ACQUISITION OF TELCO MINORITY INTEREST
In the United Kingdom, most of Econophone's sales are made through Telco,
its majority owned subsidiary that was established during the fourth quarter
of 1996, although sales to carriers continue to be made directly by
Econophone through its wholly-owned subsidiary, ATL. On January 29, 1998,
Econophone received notice from Goldvalley Limited ("Goldvalley"), the
minority partner in Telco, that pursuant to existing arrangements between
Econophone and Goldvalley, Goldvalley has elected to exercise an option to
cause Econophone to acquire Goldvalley's interest in Telco. The parties
recently commenced
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negotiations with respect to the terms of such acquisition, including the
form and amount of the consideration. There can be no assurance whether such
acquisition ultimately will be consummated, and if consummated, whether it
will be on terms favorable to Econophone.
NEW ACCOUNTING PRONOUNCEMENTS
During 1997, the Financial Accounting Standards Board (the "FASB") issued
SFAS No. 128, "Earnings Per Share." This statement established standards for
computing and presenting earnings per share ("EPS"), replacing the
presentation of currently required primary EPS with a presentation of Basic
EPS. For entities with complex capital structures, the statement requires the
dual presentation of Basic EPS and Diluted EPS on the face of the statement
of operations. Under this new standard, Basic EPS is computed based on
weighted average shares outstanding and excludes any potential dilution.
Diluted EPS reflects potential dilution from the exercise or conversion of
securities into common stock or from other contracts to issue common stock
and is similar to the currently-required fully diluted EPS. Econophone has
adopted the provisions of SFAS No. 128 as of December 31, 1997.
In June 1997, Statement of Financial Accounting Standards (SFAS) No.
130--"Reporting Comprehensive Income" and SFAS No. 131--"Disclosures about
Segments of an Enterprise and Related Information" were issued and are
effective for periods beginning after December 15, 1997. SFAS No. 130
establishes standards for reporting comprehensive income and its components.
SFAS No. 131 establishes standards for reporting financial and descriptive
information regarding an enterprise's operating segments. These standards
increase disclosure only and will have no impact on the Company's financial
position or results of operations.
RESULTS OF OPERATIONS
The following table presents certain data concerning Econophone's results
of operations for the years ended December 31, 1995, 1996 and 1997.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
-------------------------------
<S> <C> <C> <C>
1995 1996 1997
--------- --------- ---------
(IN THOUSANDS)
Revenues..................................................................... $ 27,490 $ 45,103 $ 83,003
Cost of services............................................................. 19,735 35,369 63,707
Selling expenses............................................................. 3,934 7,821 13,357
General and administrative expenses.......................................... 3,153 9,013 24,541
Depreciation and amortization................................................ 389 1,049 3,615
Net income (loss)............................................................ 121 (8,312) (30,128)
</TABLE>
1997 COMPARED TO 1996
REVENUES. Total revenues for 1997 increased by 84% to $83.0 million on
330.1 million billable minutes of use from $45.1 million on 104.6 million
billable minutes of use for 1996. Billable minutes of use increased by 216%
for 1997 from 1996. Growth in revenues during 1997 primarily was attributable
to additional minutes of use, particularly in the United States, offset in
part by a substantial decline in prices, as a result of increased
competition. This competition was a primary factor for the average revenue
per minute decrease from $.43 during 1996 to $.25 during 1997. An additional
factor in the decrease in revenues per minute was a larger portion of
national, as opposed to international, minutes of use. The increase in
revenues was primarily attributable to sales by VoiceNet of $23.6 million for
1997, compared to $1.9 million for 1996.
In the United Kingdom, revenues increased to $18.4 million from $15.5
million, primarily due to sales by Telco which increased to $10.6 million in
1997 from $1.3 million in 1996. Increases in U.K. revenue were
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<PAGE>
partially offset by the termination of Econophone's business relationship
with EI, which accounted for $14.2 million in revenues in 1996. During the
fourth quarter of 1996, Econophone began marketing efforts in the U.K.
through Telco, its majority owned subsidiary. During 1997, U.K. revenues
consisted principally of $10.6 million from international and domestic long
distance and prepaid card services attributable to Telco, as well as $7.2
million from carrier services sold through American Telemedia Limited
("ATL"), a wholly-owned subsidiary of Econophone. Average U.K. revenue per
minute decreased from $.55 per minute during 1996 to $.27 per minute during
1997. This reduction was due principally to sales of a larger percentage of
domestic long distance minutes, which are sold at lower rates than
international minutes, and to increased price competition.
In continental Europe, revenues increased by 38% to $15.7 million from
$11.4 million. This increase was attributable to an increase in prepaid card
services, primarily in France and Germany. Average continental European
revenue per minute decreased from $1.37 per minute during 1996 to $.91 per
minute during 1997. This decrease was due to lower rates in France and
Germany.
In the United States, revenues grew by 169% to $48.9 million from $18.2
million. This increase was due principally to calling card revenues
attributable to sales by VoiceNet, which were $23.6 million during 1997,
compared to $1.9 million during 1996. VoiceNet began reselling Econophone's
calling card services to end users during the second quarter of 1996. The
remainder of the increase resulted from increases in sales of carrier
services, and, to a lesser extent, international and domestic long distance
and prepaid card services. Average U.S. revenue per minute decreased to $.20
per minute during 1997 from $.27 per minute during 1996. This reduction was
due principally to sales of a larger percentage of domestic long distance
minutes, which are sold at lower rates than international minutes, and to
increased price competition.
During 1997, Econophone experienced an average customer turnover or
"churn" rate of approximately 5% relating to U.S., U.K. and continental
European "1+", "1xxx" and calling card services. To date, Econophone's
revenues and margins have not been materially impacted by its "churn" rate.
Econophone's "churn" rate with respect to any given period consists of the
average number of customers that ceased using Econophone's services during
any month during the period divided by the average monthly number of
customers for the period. Customers that have ceased using Econophone's
services during any given month are those customers who used Econophone's
services during the prior month but not during any subsequent month during
the applicable period.
COST OF SERVICES. Cost of services increased to $63.7 million for 1997
from $35.4 million for 1996. As a percentage of revenues, cost of services
decreased slightly to approximately 77% for 1997 from approximately 78% for
1996. Average cost per minute for 1997 decreased to $.19 from $.34 for 1996.
This was a result of increased use of owned and leased line transmission
capacity acquired by Econophone during the period, as well as obtaining
better prices on switched transmission capacity because of the growth of
Econophone's minutes of traffic and more available capacity.
SELLING EXPENSES. Selling expenses increased to $13.4 million for 1997
from $7.8 million for 1996, and, as a percentage of revenues, were 16% for
1997 and 17% for 1996. The increase in selling expenses primarily consisted
of commissions paid to resellers (principally VoiceNet) and independent
agents, expenses associated with Econophone's sales offices in London,
Brussels, Hamburg and Paris and expenses attributable to Econophone's
customer service department, which has been substantially enlarged since June
of 1996. For 1996, selling expenses primarily consisted of expenses related
to EI and commissions paid to independent sales agents.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased to $24.5 million for 1997 from $9.0 million for 1996, and, as a
percentage of revenues, increased to 30% for 1997 from 20% for 1996. The
increase in general and administrative expenses was primarily attributable to
an increase in payroll costs related to additional management and staff in
the areas of finance, network management and
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<PAGE>
information systems at Econophone's Manhattan, New York, Brooklyn, New York
and College Station, Texas facilities, as well as the London, Brussels,
Hamburg and Paris offices.
In connection with the termination of Econophone's joint venture with EI
during June 1996, EI granted Econophone the right to compete with EI in the
United Kingdom in exchange for forgiveness of a net receivable due to
Econophone of $2.0 million. The forgiveness of the receivable has been
reclassified as an expense of the joint venture and has been charged to
operations. Econophone previously had capitalized the U.K. territorial rights
granted to it by EI on its consolidated balance sheet and was amortizing the
rights over a 15 year life. Econophone subsequently decided to write off this
asset, resulting in an additional $1.9 million charge in 1996.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expenses
increased to $3.6 million for 1997 from $1.0 million for 1996. This increase
was substantially due to the depreciation associated with upgrades in
Econophone's switch in New York and installation of multiplexing equipment in
New York and London, as well as amortization of costs associated with the
1997 Unit Offering.
BAD DEBT EXPENSE. Econophone had bad debt expense of $3.9 million for
1997, compared to bad debt expense of $2.0 million for 1996, which was due to
the $2.0 million charge relating to EI during 1996.
INTEREST EXPENSE. Econophone had $11.4 million of interest expense
during 1997, as compared to interest expense of $0.4 million during 1996.
Interest expense has increased substantially as a result of the 1997 Unit
Offering, with $10.5 million of 1997 expense attributable to the 1997 Unit
Offering. Interest expense will increase substantially as a result of the
Offering.
NET LOSS. Econophone had a net loss of $30.1 million during 1997, compared
to a net loss of $8.3 million during 1996. The increase is primarily due to
costs associated with increasing the internal infrastructure, building the
network, marketing, commissions paid to resellers and interest expense related
to the 1997 Notes. Net loss is expected to increase substantially over the near
term, primarily due to interest expense incurred on the Notes and the 1997
Notes.
1996 COMPARED TO 1995
REVENUES. Total revenues for 1996 increased by 64% to $45.1 million on
104.6 million billable minutes of use from $27.5 million on 47.9 million
billable minutes of use for 1995. Growth in revenues during 1996 was generated
primarily from an increase in minutes of traffic in existing markets, offset in
part by declining prices. At December 31, 1996, Econophone had approximately
24,700 customer accounts, compared to approximately 26,400 customer accounts at
December 31, 1995. The reduction in the number of customer accounts was
attributable to the termination of Econophone's relationship with EI discussed
below.
In the United Kingdom, revenues grew 9% to $15.5 million. Econophone's
U.K. revenues were limited in 1996 due to a restructuring of Econophone's
U.K. sales and marketing arrangements resulting from a change in its
distribution strategy. For the first five months of 1996, U.K. revenues
increased substantially over the corresponding period in 1995. On June 1,
1996, Econophone effectively terminated its joint venture with EI, pursuant
to which EI had the exclusive right to sell Econophone's services in the
United Kingdom. In exchange for Econophone being granted the right to compete
in the United Kingdom, Econophone forgave a net receivable of $2.0 million
and agreed to sell transmission to EI at lower rates than transmission was
sold to the joint venture, thereby substantially reducing revenues from U.K.
sales during the second half of 1996 as compared to the corresponding period
in 1995. Econophone ceased providing transmission services to EI during
November 1996 due to payment delinquencies by EI and terminated its
relationship with EI during December 1996. In connection with the
termination, EI agreed to pay Econophone $2.2 million on an agreed upon
payment schedule, substantially all of which has been paid. In addition,
Econophone agreed not to solicit sales from customers of the joint venture,
subject to
25
<PAGE>
certain permitted exceptions. See "Risk Factors--Dependence on Carrier
Customers," and "Business-- Sales and Marketing."
During 1996, average U.K. revenue per minute was $.55, down from $.69 in
1995. This reduction was attributable to price decreases resulting from
increased price competition, as well as the modification of Econophone's
relationship with EI on June 1, 1996, which included a reduction in prices
charged to EI as compared to the prices charged to Econophone's joint venture
with EI.
In continental Europe, revenues increased by 128% to $11.4 million. This
increase was attributable primarily to growth in prepaid card services of
$7.2 million due to full year sales and increased marketing and, to a lesser
extent, growth in calling card services of $4.2 million. Average continental
European revenue per minute was $1.37, up from $1.30 in 1995. This increase
was principally due to an increase in higher priced prepaid card traffic.
In the United States, Econophone's revenues grew 119% to $18.2 million,
primarily as a result of substantial increases in sales of international and
domestic long distance services of $7.8 million, prepaid card services of
$2.6 million (which were introduced during the second half of 1995 and
generated minimal revenue during such year) and carrier services of $5.9
million, as well as the introduction of calling card services of $1.9
million, which were sold primarily through VoiceNet. Average U.S. revenue per
minute was $.27 in 1996, down from $.35 in 1995. This decrease was due
principally to a reduction in rates resulting from increased price
competition attributable to pricing reductions by larger carriers and sales
of a larger percentage of domestic long distance minutes, which are sold at
lower rates than international minutes.
COST OF SERVICES. Cost of services increased to $35.4 million for 1996
from $19.7 million for 1995 and, as a percentage of revenues, increased to
78% for 1996 from 72% for 1995. The increase as a percentage of revenues was
primarily due to the modification of Econophone's relationship with EI on
June 1, 1996, pursuant to which Econophone agreed to charge a lower
transmission rate to EI, thereby reducing margins on sales to EI. Average
costs per minute for 1996 decreased to $.34 from $.41 for 1995. This decrease
was attributable to volume discounts resulting from the higher volume of
traffic carried and general price reductions on transmission capacity.
SELLING EXPENSES. Selling expenses increased to $7.8 million for 1996
from $3.9 million for 1995, and, as a percentage of revenues, increased to
17% in 1996 from 14% in 1995. These expenses consisted primarily of expenses
related to EI and commissions paid to independent sales agents.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased to $9.0 million for 1996 from $3.2 million for 1995, and, as
percentage of revenues, increased to 20% in 1996 from 11% in 1995,
respectively. This increase was primarily due to increases in the size of
Econophone's customer service department and, starting in August 1996, a
substantial increase in Econophone's management and staff in the areas of
finance, network management and information systems at its New York, New
York, Brooklyn, New York and College Station, Texas facilities, and the
establishment of sales offices in London during the second quarter of 1996
and in Paris, Brussels and Hamburg during the third quarter of 1996.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expenses
increased to $1.0 million for 1996 from $.4 million for 1995. This increase
was substantially due to the depreciation expense associated with upgrades in
Econophone's switch in New York and installation of multiplexing equipment in
New York and London.
BAD DEBT EXPENSE. Econophone had bad debt expense of $2.0 million during
1996, compared to bad debt expense of $.2 million during 1995. For bad debt
expense in 1996, $2.0 million was attributable to the charge relating to EI
during 1996.
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<PAGE>
LIQUIDITY AND CAPITAL RESOURCES
At December 31, 1997, Econophone had approximately $67.2 million in cash
and cash equivalents, excluding the Pledged Securities, but including other
unused net proceeds of the 1997 Unit Offering, which are invested in short
term, interest-bearing, investment grade securities, as compared to cash and
cash equivalents of $6.3 million at December 31, 1996. Econophone's net cash
used by operating activities was $12.2 million for 1997, primarily due to a
net loss of $30.1 million, an increase in accounts receivable of $10.7
million, and an increase in other assets of $1.7 million, offset by an
increase in accounts payable of $15.9 million, an increase in accrued
interest on the 1997 Notes of $10.5 million and depreciation and amortization
of $2.6 million. Cash used for investing in property and equipment of $13.3
million for 1997 was primarily attributable to the implementation and
expansion of Econophone's network in Europe. Cash provided by financing
activities of $145.8 million was primarily related to cash received from the
sale of the 1997 Notes and Warrants of $155.0 million.
Econophone's net cash used by operating activities was $6.0 million for
1996 and net cash provided by operating activities was $2.0 million for 1995.
Negative cash flow from operating activities in 1996 primarily was
attributable to an operating loss of $6.4 million for such year. Cash used
for investing in property and equipment was $4.2 million and $1.2 million for
1996 and 1995, respectively. Such property and equipment was primarily
utilized in connection with the implementation and expansion of Econophone's
network. Cash provided by financing activities was $16.4 million in 1996,
primarily reflecting net cash proceeds of $13.1 million from the sale of
Series A Preferred Stock to Princes Gate Investors II, L.P. ("Princes Gate"),
an affiliate of Morgan Stanley, net borrowings of $3.6 million less
shareholder distributions, in order to pay income taxes with respect to the
period in which Econophone was a sub-Chapter S corporation, of $.2 million.
Cash used in financing activities was $.8 million in 1995, reflecting net
debt repayments of $.3 million and shareholder distributions, in order to pay
income taxes with respect to the period in which Econophone was a sub-Chapter
S corporation, of $.5 million.
Capital expenditures during 1997 were $19.0 million. Capital expenditures
for 1997 related primarily to the further implementation and expansion of
Econophone's network, including the upgrade of Econophone's New York switch
and the purchase of switches or nodes for Antwerp, Berlin, Brussels, Hamburg,
London, Los Angeles, Marseilles, Paris and Zurich, the purchase of additional
transatlantic IRUs and the expansion of Econophone's back office
capabilities, including its management information and network management
systems. Capital expenditures for 1998 are budgeted at $58.0 million and are
expected to consist of the purchase of telecommunications equipment and IRUs,
network management systems and management information systems.
Econophone expects to continue to make further significant capital
expenditures as it continues to expand the geographic scope of its services
in Europe, the United Kingdom, the United States and Canada, and as it
continues to increase its network capabilities and network infrastructure.
Econophone's actual capital expenditures and cash requirements will depend on
numerous factors, including the nature of future expansion, economic
conditions, competition, regulatory developments and the ability to incur
debt and make capital expenditures under the Indenture, the 1997 Indenture
and the NTFC Agreement.
The initial purchase price for VoiceNet was $21.0 million, which was paid
out of cash on hand. The sellers of VoiceNet also are entitled to an earn-out
based upon the revenue growth of the VoiceNet business for a period of up to
one year following the closing of the acquisition if certain performance
criteria are met.
The net proceeds from the Offering, together with the remaining proceeds
from the 1997 Unit Offering, and, to the extent available on favorable terms,
vendor financing, will be used to fund Econophone's continued expansion and
operating losses until it generates positive cash flow; however, this is a
forward-looking statement and there can be no assurance in this regard. The
ability of Econophone to generate more than insignificant positive cash flow,
which is not expected to occur prior to 2000, and to
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meet its debt service obligations will be subject to Econophone's successful
implementation of its operating strategy, as well as to financial,
competitive, business, regulatory and other factors beyond Econophone's
control. If Econophone is unable to generate cash flow from operations that,
together with its restricted cash, is sufficient to meet its debt service
requirements, it may be required to refinance all or a portion of its
indebtedness or raise additional capital. There can be no assurance that any
such refinancing would be possible on terms that would be acceptable to
Econophone or that any additional financing could be obtained. See "Risk
Factors--High Leverage; Future Losses and Negative Cash Flow."
PRIOR FINANCINGS. From its inception until November 1996, Econophone
relied primarily on founders' capital, equipment financing and internally
generated funds to finance its operations and growth. From November 1996
until the consummation of the Offering, Econophone had four primary sources
of funding: (i) Princes Gate; (ii) NTFC; (iii) the sale of Bridge Notes to
Morgan Stanley Group, an affiliate of the Placement Agent and Princes Gate,
and (iv) the 1997 Unit Offering.
On November 1, 1996, Princes Gate purchased 140,000 shares of Series A
Preferred Stock for $14.0 million, less certain fees, resulting in net proceeds
to Econophone of $13.1 million. The proceeds of the issuance to Princes Gate
were used to fund the expansion of Econophone's network, the implementation of
its marketing strategy and operations generally, including operating losses.
On May 28, 1996, Econophone entered into a credit facility with NTFC,
which has been amended and increased as to amount on several occasions. On
January 28, 1998, the NTFC credit facility was amended and restated in its
entirety in order to effect various amendments and increase the amount of
NTFC's commitment thereunder (as amended and restated, the "NTFC Facility").
The NTFC Facility provides for borrowings by Econophone and its subsidiaries
to fund certain equipment acquisition costs and related expenses. The NTFC
Facility provides for an aggregate commitment of NTFC of $24.0 million
pursuant to three tranches of $2.0 million, $3.0 million and $19.0 million.
Loans borrowed under each tranche of the NTFC Facility amortize in equal
monthly installments over a five year period ending on July 1, 2001, April 1,
2002 and January 1, 2003, respectively. As of December 31, 1997, the
aggregate amount outstanding under all tranches of the NTFC Facility was $7.1
million. Loans under the NTFC Facility accrue interest at an interest rate
equal to the 90-day commercial paper rate plus 395 basis points, subject to
certain quarterly adjustments depending upon financial performance. All of
the equipment purchased with the proceeds of the NTFC Facility has been
pledged to NTFC.
On April 24, 1997, Econophone entered into a Note Purchase Agreement (the
"Note Purchase Agreement") with Morgan Stanley Group, pursuant to which
Morgan Stanley Group agreed to purchase from Econophone up to $15.0 million
of Bridge Notes. At such time, Econophone paid to Morgan Stanley Group a
commitment fee of $225,000 and agreed to pay a further fee of 2.0% of the
principal amount of each issuance after the aggregate principal amount of
Bridge Notes issued exceeded $5.0 million. A total of $7.0 million of Bridge
Notes were issued under the Note Purchase Agreement. The net proceeds from
the Bridge Notes sold by Econophone were $6.6 million and were used to fund
equipment and other capital expenditures and operations. Immediately
following the consummation of the 1997 Unit Offering, all of the outstanding
Bridge Notes were redeemed and all accrued interest thereon was paid.
Econophone is not entitled to place any additional Bridge Notes under the
Note Purchase Agreement and the facility represented by the Note Purchase
Agreement has terminated.
On July 1, 1997, Econophone consummated the 1997 Unit Offering. In
connection with the 1997 Unit Offering, Econophone issued $155.0 million in
aggregate principal amount of 1997 Notes and Warrants to purchase 1,265,885
shares of Common Stock. The net proceeds of the 1997 Unit Offering were
approximately $148.1 million. Of this amount, approximately $57.4 million was
used to purchase the Pledged Securities, the proceeds of which will be used to
make the first six scheduled interest payments on the 1997 Notes.
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BUSINESS
Econophone is a rapidly growing switch-based provider of long distance
telecommunications services in selected major U.S. and western European
markets. Econophone's customer base consists primarily of residential
customers, small-and medium-sized businesses and other telecommunications
carriers. In the United States and the United Kingdom, Econophone provides
principally international and domestic long distance, calling card, prepaid
and carrier services. In continental Europe, Econophone provides principally
international long distance, calling card and prepaid services.
Econophone was incorporated in the State of New York under the name
"Switchtel Communications Corp." on July 10, 1992. During 1996, the name of
the Company was changed to "Econophone, Inc." A wholly-owned subsidiary named
"Econophone, Inc." was subsequently incorporated in the State of Delaware for
the sole purpose of changing the state of incorporation of the Company, and
the New York parent corporation was merged into the Delaware subsidiary on
February 11, 1998, with the Delaware corporation being the surviving entity.
Econophone's principal executive offices are located at 45 Broadway, New
York, New York 10006. Its main telephone number is (212) 444-6991.
INDUSTRY OVERVIEW
International telecommunications is one of the fastest growing segments
of the long distance industry, having experienced a compounded growth in
total minutes of 14% per annum from 1989 to 1996. Forecasts by the
International Telecommunications Union (the "ITU"), a worldwide
telecommunications organization under the auspices of the United Nations,
project this growth to continue at approximately 13% per annum through the
year 2000. Based on this estimate, worldwide international long distance
traffic is projected to increase from approximately 70 billion minutes in
1996 to over 114 billion minutes by the year 2000. The market for these
services is highly concentrated in more developed countries, with
approximately 40% and 27% of 1996 worldwide international long distance
traffic originating in Europe and the United States, respectively.
The international telecommunications industry has been undergoing
regulatory liberalization generally, which has resulted in increased
competition, lower prices and increased demand for telecommunications
services worldwide. Liberalization has coincided with the construction of
additional infrastructure and technological innovation in the
telecommunications industry. Fiber optic cable, which has widely replaced
wire lines for the transmission of the long distance portion of calls,
improvements in computer software and digital compression technology have
dramatically increased the capacity, speed and flexibility of telephone lines
and have substantially eliminated capacity constraints as a technical barrier
to entry for new international telephone companies. Liberalization of the
regulation of telecommunications services and technological developments have
also resulted in the broadening of service offerings, including advanced and
enhanced services such as voicemail, faxmail and electronic mail, itemized
and multicurrency billing, calling cards and intranet and Internet services.
Also as a result of these trends, the marginal transmission costs per minute
of an international call have decreased substantially and at a more rapid
rate than the decline in prices to customers.
CONTINENTAL EUROPEAN INTERNATIONAL LONG DISTANCE MARKET
The continental European international long distance market is the
largest in the world, generating approximately 24 billion minutes of outgoing
calls or 34% of international calling volume in 1996. In most EU member
states, the ability to provide telecommunications services was liberalized on
January 1, 1998. Until such time, most continental European PTOs had
monopolies on providing telephone services from their respective countries,
making the price of international telephone calls from continental Europe
much higher than comparable calls initiated from the United States or the
United Kingdom. Furthermore, customers in many continental European markets
until recently have generally not been able to obtain value-added features
that are readily available in the United States, such as touch tone dialing,
voice mail
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and other enhanced services. Regulatory liberalization, together with
significant advances in technology that have decreased the cost of providing
services and allowed the provision of sophisticated value-added features, is
facilitating competition with European PTOs by emerging telecommunications
service providers.
Econophone believes that regulatory liberalization in many countries in
continental Europe will lead to market developments similar to those that
occurred in the United States and the United Kingdom upon regulatory
liberalization of long distance telecommunications services in those
countries, although certain European PTOs appear to be responding more
rapidly to competition than the former PTOs in the United States and the
United Kingdom. Regulatory liberalization in the United States and the United
Kingdom has resulted in an increase in call traffic and the emergence of
multiple new telecommunications service providers of varying sizes. In
addition, significant reductions in prices, particularly for domestic long
distance calls, as well as improvements in both the services offered and the
level of overall responsiveness to customers, have occurred. Although pricing
has become competitive in both the United States and the United Kingdom,
marginal costs have declined significantly. There can be no assurance,
however, that the continental European experience will mirror those in the
United States or the United Kingdom or that competitive and other factors
will not adversely impact profitability of companies in the industry.
UNITED KINGDOM LONG DISTANCE MARKET
Since 1991, the U.K. government has sought to encourage increased
competition in telecommunications services, including international
telecommunications services. The price of international calls made from the
United Kingdom has decreased significantly since 1991 due to increased
competition and the downward pressure exerted on British Telecom's prices by
Oftel. As a consequence of these actions, the United Kingdom now has a
dynamic telecommunications market, with over 200 public telecommunications
operators licensed to operate in the U.K. market.
According to Oftel, during the period April 1996 to March 1997, the
amount of international calls originating from the United Kingdom was
approximately 4.5 billion minutes, consisting of 47% of the calling minutes
from residential users and 53% from business users. Over that period, there
were 39.7 billion minutes of U.K. domestic long distance calls, 55% from
residential users and 45% from business users.
The interconnection regime in the United Kingdom provides operators with
the ability to obtain cost based, non-discriminatory charges for
interconnection services. Oftel regulates the interconnection charges charged
to other operators by British Telecom and other PTOs. Since October 1997,
British Telecom has set its own prices for services that are competitive,
with an overall price cap on the basket of non-competitive services. Oftel
does, however, have the power to intervene and determine charges and other
terms if an operator believes that it is not being offered fair pricing.
Oftel has stated that the category of companies that qualify for
interconnection services consist of those network operators that are making a
significant contribution to infrastructure competition by installing
transmission capacity or any international simple resale operator making a
significant contribution to competition in the international market.
Econophone believes it qualifies as one of the latter.
In December 1996, the U.K. government issued the first licenses for the
provision of international facilities-based services, which until then only
British Telecom and Mercury had been authorized to provide. ATL, a
wholly-owned subsidiary of Econophone was awarded an international facilities
based license (an "IFL") during the second quarter of 1997, which enables
Econophone to provide international services over its own international
facilities. As a result of acquiring an IFL, Econophone has been able to
acquire international circuits originating in the United Kingdom. See
"--Network Infrastructure--Transmission Capacity."
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The United Kingdom is the favored hub for international traffic
originating in continental Europe due to the availability of relatively
inexpensive transmission capacity to and from the United Kingdom. This
preference is expected to continue as rates for international services are
further reduced as a result of additional competition.
UNITED STATES LONG DISTANCE MARKET
Approximately 19 billion minutes or 27% of global international calling
volume originated in the United States in 1996. According to estimates by the
FCC, the industry is large and has grown consistently, with aggregate
U.S.-originated international long distance telephone traffic rising from
approximately 7 billion minutes in 1989 to approximately 19 billion minutes
in 1996, a compound annual growth rate of approximately 16%. The growth of
the U.S.-originated international long distance market was initially
attributable to regulatory liberalization and the decrease in prices that
accompanied the onset of competition. Regulatory liberalization and the
resulting competition also have led to improvements in service offerings and
customer service.
The profitability of the U.S.-originated international long distance
market is principally driven by the difference between billed revenues and
settlement rates (i.e., the rates paid to other carriers to terminate an
international call). Increased competition arising from regulatory
liberalization and pressure arising from increased global trade have brought
about reductions in settlement rates and end-user prices, reducing
termination costs for U.S. based carriers. Based on FCC data for the period
1989 through 1996, per minute settlement payments by U.S. based carriers to
foreign PTOs fell 39%, from $.70 per minute to $.43 per minute. However, over
this same period, per minute international billed revenues fell only 27%,
from $1.02 in 1989 to $.74 in 1996. As a result, gross profit margin for
outbound international calls (before local access charges) grew from 31% in
1989 to 42% in 1996. The FCC has recently issued benchmark levels for
settlement rates, of between $.15 and $.23 per minute, in an effort to reduce
the settlement rates charged and paid by U.S. based carriers. Such benchmark
rates are substantially lower than the current settlement rates. The FCC has
encouraged carriers to use alternative measures to terminate international
traffic other than through operating agreements and the international
settlement process. Econophone believes that international long distance will
continue to provide substantial gross profit per minute, although there can
be no assurance in this regard and some industry observers have predicted
otherwise. See "Risk Factors--Risks Associated with Rapidly Changing
Industry; Significant Price Declines."
Econophone also provides domestic long distance services to a substantial
portion of its U.S. customers and, as part of its strategy, is increasing its
U.S. domestic long distance business, including through its acquisition of
VoiceNet. According to the FCC, the U.S. domestic long distance market grew
in total minutes at an annual compound rate of approximately 7.8% from 1989
to 1996. Although the domestic market is much larger than the U.S.-originated
international long distance market, the profit per minute of use for
international traffic has generally been higher than for domestic traffic.
STRATEGY
Econophone's strategy is to (i) expand into additional geographic markets
in continental Europe, the United Kingdom, the United States and Canada, with
a focus on large markets that generate substantial long distance and
international calling traffic, (ii) add customers in its existing markets,
(iii) migrate additional switched traffic on to its expanding network and
(iv) deliver an expanded portfolio of features and services to its customers.
Econophone intends to implement its strategy by continuing to expand its
network, broadening its sales and marketing efforts and developing and
introducing innovative services and features. Over time, Econophone expects
its European markets to contribute an increasing percentage of its revenues.
- EXPAND INTO NEW MARKETS. During 1997, Econophone installed switches in
Brussels, London and Paris, nodes in Antwerp, Berlin, Marseilles, Nice
and Zurich and points of presence serving a
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number of major cities in the northeastern United States. During 1998,
Econophone's network expansion will be focused on North America and
continental Europe. During 1998, Econophone intends to install switches
in Chicago, Dallas, Frankfurt, Los Angeles and Miami and a node in
Geneva. This expansion is largely driven by existing customer calling
patterns. Econophone also intends to expand its network into Canada,
with the installation of a switch in Toronto and a point of presence in
Montreal. In addition, Econophone intends to upgrade its node in Berlin
and point of presence in Washington, D.C. to switches. Econophone's
network expansion will enable it to route calls from each of its new
network cities, providing for more cost-efficient transmission from
these cities. The switches in Chicago, Dallas, Los Angeles and Miami
and the point of presence in Montreal also will enable Econophone to
provide international and domestic long distance service originating in
those cities through "1+" access. Econophone intends to enter
additional markets in western Europe, the United States and Canada as
market and regulatory conditions warrant. See "--The Econophone
Network--European Expansion," "--The Econophone Network--U.S. Expansion"
and "--Regulation."
Econophone also is in the process of seeking to enter into
interconnection agreements in Belgium, France and Germany.
Interconnection agreements would provide Econophone with a direct
connection to the PSTN in such countries, which would enable it to
provide network access through abbreviated dialing, originate calls in
a greater number of cities and terminate calls in such countries more
cheaply. In particular, in Germany, interconnection to the PSTN would
enable Econophone to offer domestic long distance service through "1+"
access in its German network cities. Econophone expects the foregoing
interconnection agreements to be obtained by the end of the first half
of 1998.
- ADD CUSTOMERS IN EXISTING MARKETS. By adding customers in its existing
markets, Econophone is able to increase network utilization, which reduces
transmission costs per minute. Econophone markets its services through
various channels, each of which is designed to serve a particular
geographic market, customer group and product. Econophone sells to
non-business customers primarily through independent sales representatives
retained directly by Econophone or by master distributors and to business
customers and other telecommunications carriers primarily through its
internal sales forces. Depending upon the service, sales are made either
directly to end-users (e.g., residential and business long distance) or to
retail establishments for resale (e.g., prepaid cards). Econophone
believes that its multi-channel marketing strategy enhances its growth
prospects and reduces the risks associated with dependence on a smaller
number of distribution channels. See "-- Sales and Marketing."
As of December 31, 1997, Econophone had (i) 122, (ii) 28,180 and (iii)
305 independent sales representatives, and 23, 19 and 9 internal sales
representatives, in continental Europe, the United Kingdom and the
United States, respectively.
Econophone intends to continue to advertise VoiceNet's calling card
services primarily through in-flight magazines and through
advertisements placed in high traffic locations such as restaurants.
Econophone also intends to cross-market many of its other services to
VoiceNet's customer base, which consisted of approximately 110,000
calling card holders for December 1997, and to use VoiceNet's expertise
to market its calling card services in Europe.
- MIGRATE ADDITIONAL TRAFFIC ON TO ECONOPHONE NETWORK. By transmitting a
greater portion of its calls over its network, Econophone reduces its
transmission costs. Transmission costs are reduced because, once certain
volume levels are met, it is cheaper to transmit calls over lines that are
owned or leased on a fixed cost basis than lines leased on a per-minute
basis. In addition, local access (which can be used in Econophone's
network cities), is less expensive for Econophone than national or
international toll-free access. Econophone is increasing the percentage of
traffic carried on its network by installing additional switches, nodes
and points of presence, which increases
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Econophone's addressable market, and by increasing the transmission
capacity that it owns or obtains on a fixed-cost lease basis. See "--The
Econophone Network."
- CONTINUE TO DEVELOP AND INTRODUCE INNOVATIVE SERVICES AND FEATURES.
Econophone strives to differentiate itself from its competitors by
designing value-added features and integrating these features into its
services and network. Features under development include voice mail and
conference calling, both of which Econophone plans to introduce during the
first half of 1998. See "--Services--Value-added Features."
SERVICES
The following table summarizes Econophone's current service offerings by
principal geographic market:
<TABLE>
<CAPTION>
GEOGRAPHIC MARKET
-------------------------------------------------
<S> <C> <C> <C>
UNITED CONTINENTAL UNITED
KINGDOM EUROPE(1) STATES
--------------- ----------------- ------
International Long Distance........................ x x x
Domestic Long Distance............................. x x
Calling Card Services.............................. x x x
Prepaid Services................................... x x x
Carrier Services................................... x x
</TABLE>
- ------------------------
(1) Consists of selected cities in Belgium, France, Germany, Greece,
Switzerland and The Netherlands. Not all services listed are
provided in all continental European markets.
INTERNATIONAL AND DOMESTIC LONG DISTANCE SERVICE
"International and domestic long distance service" is service that is
accessed from the customer's billing location using "1xxx" access in the
United Kingdom, "1+" access in the United States or local dial-up access in
continental Europe. Econophone's international and domestic long distance
service generally enables customers to call to any destination. International
and long distance service accounted for $17.7 million or 21% of total
revenues during 1997, and $8.0 million (44%) and $9.6 million (20%) of U.K.,
and U.S. revenues, respectively. See "--Network Infrastructure--Access
Methods."
UNITED KINGDOM. Econophone has provided international and domestic long
distance service in the London area since the third quarter of 1996. Since
April 1997, Econophone has provided this service throughout England. For the
year ended December 31, 1997, approximately 70% of Econophone's U.K. revenues
from international and domestic long distance service were derived from the
London area, with the remainder derived principally from Manchester and
Leeds. Econophone's services are at present principally used by its U.K.
customers to make domestic long distance calls. See "--The Econophone
Network--European Expansion" and "--Network Infrastructure."
CONTINENTAL EUROPE. Econophone has offered international long distance
service to customers in Hamburg since February 1997, to customers in Antwerp,
Brussels and Paris since March 1997 and to customers in Berlin, Marseilles,
Nice and Zurich since the fourth quarter of 1997. During the second quarter
of 1998, Econophone intends to add a node in Geneva and, during the third
quarter of 1998, Econophone intends to add a switch in Frankfurt, both of
which will enable Econophone to offer international long distance service to
customers in those cities. At present, Econophone cannot offer intra-European
international long distance service other than from its network cities on a
cost-efficient basis.
Econophone is in the process of seeking to enter into interconnection
agreements in Belgium, France and Germany, which would provide it with a
direct connection to the PSTN in such countries, enabling it to provide
international long distance service through abbreviated dialing and originate
calls in a greater
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number of cities. In Germany, interconnection to the PSTN would enable
Econophone to provide domestic long distance service through "1+" access in
its German network cities. Econophone expects the foregoing interconnection
agreements to be obtained by the end of the first half of 1998. See
"--Strategy."
UNITED STATES. Econophone has offered international and domestic long
distance service in the New York metropolitan area since March 1994 and in
Baltimore, Connecticut, northern New Jersey, Philadelphia and Washington,
D.C. since the first quarter of 1997. During 1998, Econophone intends to
install switches in Chicago, Dallas, Los Angeles and Miami, which will enable
it to offer international and domestic long distance in those markets. See
"--The Econophone Network--U.S. Expansion."
CANADA. During the first half of 1998, Econophone intends to expand its
network into Canada by installing a switch in Toronto and a point of presence
in Montreal. This will enable Econophone to offer international and domestic
long distance service in both cities.
CALLING CARD SERVICES
In continental Europe, Econophone believes that a substantial portion of
its calling card customers use Econophone's service from their home or office
as an alternative to the PTO for international calls. In contrast, in the
United Kingdom and the United States, Econophone's calling cards, including
those that are marketed through VoiceNet, are sold to customers who use its
calling card service primarily for convenience when traveling. Over time, in
each of its continental European network cities, Econophone intends to
migrate its home- and office-based calling card customers to its
international and domestic long distance service. Its calling card service
will continue to be offered in continental Europe as a premium travel service.
Econophone's calling card customers are issued an identification or "PIN"
number that permits them to access Econophone's network. Econophone's calling
card services are sold in both Europe and the United States and can be used
in over 40 countries.
In the United Kingdom and the United States, Econophone's calling card
service is accessed by dialing a national toll free number. From other
countries, calling card customers access Econophone's services by dialing an
international toll free number.
Econophone offers calling card customers in the United Kingdom and the
United States competitive rates on calls to domestic and international
locations. In continental Europe, Econophone offers calling card customers
competitive rates on intercontinental card-based calls. Due to the high costs
resulting from international toll free access, which involves the
transmission of calls to Econophone's New York or London switch, and
subsequent transmission of calls back to continental Europe, Econophone does
not presently offer competitive rates on intra-European calls made by calling
card customers. See "--The Econophone Network."
In 1997, calling card service in the United Kingdom, continental Europe
and the United States accounted for $0.5 million, $4.2 million and $23.6
million, or 1%, 5% and 28%, of Econophone's revenues, respectively.
Substantially all of Econophone's U.S. calling card sales are attributable to
VoiceNet. A definitive agreement to acquire VoiceNet was entered into on
January 28, 1998. On February 12, 1998, Econophone acquired VoiceNet, which
ensures the continuity of Econophone's sales to VoiceNet and provides
Econophone with an established U.S. calling card business.
PREPAID SERVICES
Econophone's prepaid card service is a pre-paid version of its calling
card. Econophone's prepaid card has similar features and is used in the same
manner as its calling card. Econophone's prepaid card generally can be used
from the United Kingdom, the United States, Belgium, Canada, Germany, France,
Israel, The Netherlands, and Switzerland, although it also sells prepaid
cards that can be used only from the country in which they are sold.
Econophone is an early entrant into the market for prepaid services in
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continental Europe. In 1997, prepaid card services in the United Kingdom,
continental Europe and the United States accounted for $2.6 million, $11.5
million and $6.0 million, or 3%, 14% and 7%, of Econophone's revenues,
respectively.
Econophone's software development group has developed a new prepaid
service called "Debit Phone." Debit Phone was introduced in the United
Kingdom during the first quarter of 1998 and is expected to be introduced in
the United States by the end of the second quarter of 1998. Debit Phone
allows customers to access Econophone's services from their homes on a
prepaid basis utilizing "1xxx" or "1+" access. When the customer makes a
domestic or international long distance call, Econophone's switch
automatically recognizes the customer's telephone number and deducts the cost
of the call from the customer's prepaid account balance. Debit Phone
customers are able to replenish their balances on line by credit card or by
purchasing vouchers. Customers also can access their balance by phone using
voice prompts. Econophone believes that this service will enable it to
broaden its addressable market by appealing to cost-conscious callers.
CARRIER SERVICES
In both the United Kingdom and the United States, Econophone resells
transmission capacity to carrier customers who use the transmission capacity
to service their end-user customers. U.S. carrier customers buy transmission
from Econophone in bulk almost exclusively based on price. In the United
Kingdom, Econophone believes that many of its carrier customers instead
choose Econophone for access to its software platform, which, among other
things, allows them to utilize Econophone's software technology to sell
calling cards and prepaid cards and perform specialized billing functions.
However, Econophone's U.K. carrier customers are also price sensitive.
Carrier services are sold at substantially lower margins than
Econophone's other services. However, because carrier customers purchase
transmission capacity in bulk, these services allow Econophone to increase
the amount of transmission capacity that it purchases, enabling it to obtain
volume discounts on transmission capacity from its vendors and, therefore,
generate higher margins and/or offer better pricing on its other services. In
addition, the sale of transmission capacity on Econophone's IRUs and leased
lines allows Econophone to generate additional revenues on transmission lines
operating at less than full capacity without incurring significant marginal
costs.
Carrier customers, especially those in the United States, frequently
change vendors based on small differences in price and certain carrier
customers have subjected and could in the future subject Econophone to credit
risks. In 1997, sales of transmission capacity to carrier customers in the
United Kingdom and the United States accounted for $7.2 million and $9.7
million respectively, or 20% of Econophone's total revenues. See "Risk
Factors--Dependence on Carrier Customers" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations."
OTHER SERVICES
TOLL FREE SERVICE. Econophone provides domestic toll free service (i.e.,
"800" or "888" service) to customers in the United States and the United
Kingdom. This service is targeted at customers who have a substantial number
of incoming domestic long distance calls, such as mail order companies.
Customers of Econophone's toll free service are assigned a toll free number.
Calls to the toll free number are routed to an Econophone switch. From there,
the call is transmitted to the customer's location in the same manner as
other calls routed through the switch.
DEDICATED ACCESS SERVICE. Customers using this service lease a
transmission line that connects the customer's business directly to an
Econophone switch or node. By leasing a direct line, the customer avoids
local access charges and can reduce its cost of services. This service is
marketed to high volume customers. Econophone presently offers dedicated
access service in the United States and the United Kingdom.
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<PAGE>
Econophone intends to introduce dedicated access service in its continental
European network cities during 1998.
During 1997, sales of toll free and dedicated access service accounted
for an insignificant amount of Econophone's revenues. Econophone expects that
revenues from these services will continue to represent a relatively small
portion of its revenues.
VALUE-ADDED FEATURES
Econophone strives to differentiate itself from its competitors by
designing value-added features and integrating these features into its
services and network and believes that its emphasis on technological
innovation and quality is one of its competitive strengths. Econophone
provides customers with value-added features such as speed dialing, redial
and multi-lingual voice prompts. In addition, Econophone's customers can
obtain detailed billing information, which is particularly important for
business users, including breakdowns of usage by account code and department.
Callers in many European markets are not able to obtain these value-added
features from their PTO.
Econophone intends to continue to introduce new value-added features. For
example, during the first quarter of 1998, Econophone intends to introduce
voicemail and conference calling capability. Econophone believes that its
emphasis on technological innovation and quality is one of its principal
competitive strengths.
THE ECONOPHONE NETWORK
Econophone's network consists of (i) carrier grade Northern Telecom
switches in New York, London, Brussels and Paris, (ii) nodes in Antwerp,
Berlin, Hamburg, Marseilles, Nice and Zurich, (iii) points of presence in
Baltimore, Connecticut, northern New Jersey, Philadelphia and Washington,
D.C., (iv) IRUs and leased trans-Atlantic telecommunications lines and (v)
leased lines in Europe and the United States. A key element in Econophone's
growth strategy is the continued build-out of its network in Europe and the
United States and the introduction of its network in Canada. As Econophone
expands its network, it expects to be able to provide service on an
increasingly cost effective basis to a greater number of customers. See "Risk
Factors--Implementation of Expansion Plans" and "Business--Strategy."
Econophone's network is designed to enable it to provide competitively
priced service from its network cities by reducing its total transmission
costs (i.e., the sum of its variable and fixed transmission costs) on calls
originating from these cities. Econophone's network enables it to reduce its
variable transmission costs because, among other things, (i) Econophone does
not incur any significant marginal costs for calls carried over its IRUs or
leased lines, (ii) calls routed by Econophone's switches can be delivered on
a "least cost" basis and (iii) in markets with switches, nodes or points of
presence, customers use local access instead of more expensive toll free
access.
The fixed costs associated with Econophone's network relate principally
to switching equipment, leased lines and IRUs, rental charges, local
connectivity and facility/network management. Once sufficient traffic levels
are attained, Econophone's total costs of carrying calls are expected to
decline as a percentage of revenue, although there can be no assurance in
this regard, particularly given continuing signficant price reductions. See
"Risk Factors--Implementation of Expansion Plans," "Risk
Factors--Competition" and "Risk Factors--Risks Associated with Rapidly
Changing Industry; Significant Price Declines."
EUROPEAN EXPANSION
During 1997, Econophone significantly expanded its network in continental
Europe. During the first quarter of 1997, Econophone installed switches in
Brussels and Paris that are connected to its New York and London switches by
leased lines. Econophone also installed nodes in Antwerp and Hamburg that are
connected to the Brussels and London switches by leased lines. In addition,
during the first quarter of
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1997, Econophone installed its own switch in London. Prior to that time,
Econophone had leased a portion of Colt's London switch. Nodes in Berlin,
Marseilles, Nice and Zurich were installed during the fourth quarter of 1997.
The Berlin, Marseilles, Nice and Zurich nodes are connected to Econophone's
Hamburg, Paris and London node and switches, respectively, by leased line.
The Geneva node will be connected to the Zurich node by leased line.
During the second and third quarters of 1998, Econophone intends to
install a switch in Frankfurt and a node in Geneva and to upgrade its node in
Berlin to a switch. These switches will enable Econophone to route calls from
these cities, rather than transmitting them to another network city with a
switch for routing, which will result in more cost-efficient transmission.
Econophone also is in the process of seeking to enter into
interconnection agreements in Belgium, France and Germany, which would
provide it with a direct connection to the PSTN in such countries, enabling
it to provide network access through abbreviated dialing, originate calls in
a greater number of cities and terminate calls in such countries more
cheaply. In Germany, interconnection to the PSTN would enable Econophone to
offer domestic long distance service through "1+" access in its German
network cities. Econophone expects the foregoing interconnection agreements
to be obtained by the end of the first half of 1998. See "--Strategy."
In addition to increasing its addressable market, the expansion of
Econophone's network in continental Europe enables it to provide
intra-European international long distance service from more continental
European cities on a cost-competitive basis. Prior to establishing its
network in continental Europe, Econophone was not able to transmit
intra-European international long distance calls on a cost-competitive basis
because of the high cost of transmitting those calls to its New York or
London switch using international toll free access and routing the calls back
to continental Europe over the PSTN. Calls that originate in cities with a
switch or node can use less expensive local dial-up access instead of
international toll free access.
U.S. AND CANADIAN EXPANSION
During 1998, Econophone intends to substantially expand its network in
North America, particularly in the United States. This expansion is largely
driven by existing customer calling patterns. During the first half of 1998,
Econophone intends to install switches in Los Angeles and Miami. During the
third quarter of 1998, Econophone also intends to install switches in Chicago
and Dallas. These switches will enable Econophone to offer international and
domestic long distance service through "1+" access and carrier services from
those cities. In those cities in which Econophone has a switch, it is able to
route traffic, which provides for more cost-efficient transmission.
Econophone also intends to upgrade its point of presence in Washington,
D.C. to a switch during the second quarter of 1998. This upgrade will allow
for more cost-efficient transmission by enabling Econophone to route calls
from Washington D.C.
Econophone intends to establish additional switches in other selected
U.S. markets that generate substantial long distance calling traffic.
During the second quarter of 1998, Econophone also intends to install a
switch in Toronto and a point of presence in Montreal. In both cities,
Econophone intends to target customers with significant international calling
needs.
OPERATING AGREEMENTS
Econophone has entered into operating agreements with OTE, the Greek PTO,
Golden Lines International Telecommunications Services, an Israeli carrier,
and Utel in the Ukraine. Econophone's operating agreements provide it with a
direct interconnection to the foregoing carriers. By entering into operating
agreements, Econophone is able to obtain more favorable termination rates.
Operating
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agreements also enable Econophone to better control the quality of the
terminating segment of a call and can provide for favorable transit rates to
third countries (such as between Greece and Turkey). In addition, pursuant to
its operating agreements, Econophone's correspondent carriers are required to
send to Econophone a specified portion of their traffic. The revenues for
terminating this traffic are substantially in excess of Econophone's actual
termination costs, which increases Econophone's overall gross margins or
enables it to price its services more competitively. As part of its strategy,
as market and regulatory conditions warrant, Econophone intends to enter into
additional operating agreements with foreign carriers.
NETWORK INFRASTRUCTURE
NETWORK HARDWARE
Econophone's network employs Northern Telecom carrier grade switches.
Carrier grade switch technology is primarily employed by large carriers and
not by smaller competitors. Certain advantages of Econophone's carrier grade
network are described below.
QUALITY AND RELIABILITY. Econophone believes that carrier grade
switching enables it to provide higher transmission quality and greater call
completion rates to its customers than are offered by carriers that use
smaller, less powerful switches.
CARRIER GRADE SWITCHES. Carrier grade switches enable Econophone's
network to interconnect directly with the networks of PTOs and LECs, subject
to applicable regulatory requirements and an inter-connection agreement
having been entered into.
In Europe, carrier grade switches enable Econophone to provide
international and domestic long distance service utilizing abbreviated
dialing. Carrier grade switches also enable Econophone to originate calls in
a greater number of cities in countries in which it is connected to the PTO's
network and terminate calls in such countries more cheaply. In addition,
Econophone is able to provide domestic long distance service to the extent
permitted by law. Many of Econophone's competitors in continental Europe do
not utilize carrier grade switches and, therefore, cannot provide service on
the same basis as Econophone, which Econophone believes provides it with a
competitive advantage over those competitors. See "-- Strategy,"
"--Services--International and Domestic Long Distance Service--United
Kingdom," "-- Services--International and Domestic Long Distance
Service--Continental Europe" and "--The Econophone Network--European
Expansion."
In the United States, Econophone's carrier grade switches enable it to
interconnect with LECs. This interconnection reduces Econophone's
transmission costs.
TRANSMISSION SPEED AND EFFICIENCY. Econophone's switches have call
completion capabilities that reduce the time needed to connect calls, reduce
waiting times and allow for more efficient use of transmission capacity. In
addition, for calls transmitted over Econophone's IRUs between London and New
York (including calls originating in continental Europe) and leased lines
between Brussels and New York, Econophone's network utilizes "fast signaling"
(also known as "SS7", "CCS7" or "EUROISDN"). Before a call is completed,
"fast signaling" notifies the originating switch if the number being called
is busy, in which case a busy signal will be sent back to the caller without
routing the call, freeing up transmission capacity for calls that can be
completed.
ABILITY TO PROVIDE ENHANCED SERVICES. The carrier grade switching
platforms used by Econophone, in conjunction with other hardware and
software, are capable of supporting the enhanced services that Econophone
currently offers, such as prepaid card services, as well as other enhanced
services that Econophone intends to introduce, such as voicemail and
conference calling. Econophone's network primarily employs switch
architecture that allows for integration of voice and data onto a single
platform.
HARDWARE INTEGRATION. Econophone believes that, by principally utilizing
the equipment of a single supplier, it is able to minimize difficulties
associated with integrating equipment from various sources and with differing
specifications, although this entails certain risks. See "Risk
Factors--Dependence on Equipment Supplier."
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TRANSMISSION CAPACITY
Econophone utilizes IRUs and leased lines to transmit the on-network
portion of its calls. If the initial point of network access is a node or
point of presence, the call is then transmitted over a leased line to an
Econophone switch for routing to its destination. Once certain traffic levels
are attained, local dial-up access to the node or point of presence and
transmission over a leased line is a less expensive means of transmitting a
call to an Econophone switch than toll free access. The reduced transmission
costs result because there is no significant marginal cost to Econophone for
carrying a call over facilities it owns or leases on a fixed cost basis. In
order to increase the capacity of its transmission lines, Econophone utilizes
carrier grade compression, or multiplexing, equipment.
Econophone owns five IRUs on the PTAT-1 transatlantic cable, one IRU on
the Cantat-3 transatlantic cable and one IRU on the TAT 12/13 transatlantic
cable. Econophone also recently acquired 63 IRUs on the AC-1 transatlantic
cable, which will enable it to transmit 1,890 non-compressed simultaneous
calls (or 7,560 calls that are compressed). Econophone's IRUs on the AC-1
transatlantic cable are expected to become operational during the second
quarter of 1998. As part of its expansion strategy, Econophone intends to
acquire additional IRUs, including half-circuits originating in the United
Kingdom running between the United Kingdom and selected continental European
cities.
In addition to utilizing IRUs to carry traffic, Econophone utilizes
leased lines. Econophone's aggregate cost for its leased lines for the month
ended December 31, 1997 was approximately $.3 million. Leased line costs will
substantially increase as Econophone expands its network to the extent that
Econophone leases additional lines instead of purchasing them.
Listed below are Econophone's currently operational IRUs and principal
leased lines and the maximum number of calls that can be carried at one time
over each circuit. Other than Econophone's circuits from New York to London,
which are owned, all of the lines listed below are leased lines.
<TABLE>
<CAPTION>
SIMULTANEOUS
TRANSMISSION LINES CALLS(1)
------------------ -----------------
<S> <C>
Los Angeles -- New York......................................................... 696
London -- New York.............................................................. 680
New Brunswick, New Jersey -- New York........................................... 336
Paris -- London................................................................. 240
Newark -- New York.............................................................. 192
Washington, D.C. -- New York.................................................... 168
Brussels -- Antwerp............................................................. 120
Brussels -- London.............................................................. 120
Brussels -- New York............................................................ 120
Hamburg -- Berlin............................................................... 120
Philadelphia -- New York........................................................ 96
Baltimore -- New York........................................................... 72
New Haven, Connecticut -- New York.............................................. 72
Brussels -- Paris............................................................... 60
Hamburg -- London............................................................... 60
Paris -- Nice .................................................................. 60
Paris -- Marseilles............................................................. 60
London -- Zurich................................................................ 60
</TABLE>
--------------------------------------------
(1) Reflects transmission capacity after taking into account
compression or multiplexing equipment utilized by Econophone on
its intra-European lines and its lines between London and New
York.
Econophone also purchases switched minutes from carriers on a per minute
basis. Such purchases are made on an as-needed basis and do not involve
significant minimum purchase requirements.
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In addition, during November, 1997, Econophone entered into a Service
Agreement with Intelsat. Pursuant to this Agreement, Econophone has a direct
link to Intelsat's satellite, which reduces Econophone's transmission costs
on certain calls. Econophone's Intelsat link also enables it to more
efficiently carry traffic to certain countries that do not have direct fiber
links to the country in which Econophone's originating switch is located.
As Econophone expands its customer base, it will require additional
transmission capacity. Its actual infrastructure requirements will depend
upon the capacity of the switches, nodes and points of presence installed by
Econophone and the extent to which it utilizes compression technology to
transmit calls. Based on current and anticipated availability of switching
and compression equipment and owned and leased transmission capacity,
Econophone believes that it will be able to meet its capacity requirements
for the foreseeable future, although there can be no assurance that this will
be the case.
NETWORK MANAGEMENT
Econophone's network is controlled from its New York and London switching
centers and its College Station, Texas facility. Centralized network
management enables Econophone to perform network monitoring and selected
network maintenance from these centers, rather than on-site. Econophone
devoted approximately $2.0 million to enhancing and developing its network
management systems during 1997 and has budgeted $7.0 million in 1998 to
further enhancing and developing its network management systems.
ACCESS METHODS
Econophone's services are accessed through a variety of methods, as
described below, depending upon the particular service and the location from
which the customer is calling.
"1XXX" ACCESS. "1xxx" access, or prefix dialing, enables a long distance
customer in the United Kingdom to access Econophone's network from the
customer's home or office by dialing "1" and Econophone's three digit access
code and then the number the customer is calling.
"1+" ACCESS. In the United States, "1+" access enables a long distance
customer to access Econophone's network from the customer's home or office by
dialing "1" and then the number that the customer is calling. The customer
does not need to dial a special access number or code. This access method is
available where Econophone has a U.S. switch or point of presence and is
expected to be available in Germany in the future.
LOCAL DIAL-UP ACCESS. In cities in continental Europe where Econophone
has installed a switch or node, customers can access Econophone's
international long distance service by dialing a local telephone number.
Local dial-up access reduces transmission costs for Econophone on these calls
because it reduces the cost of accessing an Econophone switch. The reduction
in transmission costs enables Econophone to increase its margins and/or
reduce its prices on these calls, as well as to provide competitively-priced
intra-European long distance service. See "--The Econophone Network."
Econophone is in the process of seeking to enter into interconnection
agreements in Belgium, France and Germany that would enable it to provide
network access in those countries through abbreviated dialing (the equivalent
of "1xxx" or "1+"). Econophone expects these interconnection agreements to be
obtained by the end of the first half of 1998.
INTERNATIONAL TOLL FREE ACCESS. This access method is used to access
Econophone's card-based services outside of the United States and the United
Kingdom. Econophone's calling card customers in its continental European
network cities that use its calling card service for home- and office-based
calls will over time be provided with a local access number to use, subject
to applicable regulatory limitations,
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<PAGE>
because local dial-up access allows Econophone to provide its services at a
substantially lower rate than international toll free access. See
"--Services--Calling Card Services."
NATIONAL TOLL FREE ACCESS. Customers who access Econophone's services in
this manner do so by dialing a national toll free number. This access method
is available to U.S. and U.K. customers who use Econophone's calling card and
prepaid card services.
DEDICATED ACCESS. Carrier customers and high volume end-users in the
United States are connected to Econophone's switch by dedicated leased line.
During 1997, Econophone introduced dedicated access service in the United
Kingdom. In continental Europe, Econophone intends to introduce dedicated
access during 1998. The advantages of dedicated access are simplified
dialing, faster call set-up times and potentially lower access costs
(assuming a sufficient volume of calls is transmitted over the leased line to
generate economies of scale).
CALL ROUTING
Calls are routed to their destination through one or more Econophone
switches. If the call originates in an Econophone network city with a switch,
the call generally will access the network using "1xxx," "1+" or local
dial-up access. A call originating in a city with a node or point of presence
generally will access the network in the same manner and then be routed to an
Econophone switch over leased line. If the call originates in a city where
Econophone does not have a switch, node or point of presence, the call
generally accesses the network using toll free access, which is substantially
less cost efficient for Econophone than "1xxx," "1+" or local dial-up access.
From an Econophone switch, "least cost routing" techniques are used to
determine whether the call should be transferred directly to the PSTN or
routed to another Econophone switch and then transferred to the PSTN for
termination.
SALES AND MARKETING
Econophone's services are marketed primarily to residential customers and
small- and medium-sized businesses, with a focus on customers with
significant long distance calling needs. Econophone also sells transmission
capacity to carriers in the United States and the United Kingdom. As of
December 31, 1997, Econophone had 37,751, 3,769 and 125,705 customer accounts
in the United Kingdom, continental Europe and the United States,
respectively, generating approximately 69 million, 17 million and 244 million
minutes of calling traffic, respectively, for the year then ended. Econophone
markets its services through various channels, each of which is tailored to
the particular geographic market, customer group and product. Econophone
believes that its multi-channel marketing strategy enhances its growth
prospects and reduces the risks associated with dependence on a smaller
number of distribution channels. See "--Strategy."
In the United Kingdom, most of Econophone's sales are made through Telco,
its majority owned subsidiary that was established during the fourth quarter
of 1996, although sales to carriers continue to be made directly by
Econophone through its wholly-owned subsidiary, ATL. On January 29, 1998,
Econophone received notice from Goldvalley, the minority partner in Telco,
that pursuant to existing arrangements between Econophone and Goldvalley,
Goldvalley has elected to exercise an option to cause Econophone to acquire
Goldvalley's interest in Telco. The parties recently commenced negotiations
with respect to the terms of such acquisition, including the form and amount
of the consideration. There can be no assurance whether such acquisition
ultimately will be consummated, and if consummated, on terms favorable to
Econophone.
As of December 31, 1997, Telco had retained 28,180 independent sales
representatives in the United Kingdom, primarily through master agents. A
substantial number of these sales representatives also sell products and
services other than long distance telephone service of other companies. As of
December 31, 1997, Telco also had 8 internal sales representatives, which
sell Econophone's services primarily to business users. Prior to April 1997,
Econophone's services were marketed only in the London area. Since that time,
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<PAGE>
Econophone has been able to provide services on a U.K.-wide basis and its
services have been marketed by Telco and ATL in additional U.K. markets,
consisting principally of Manchester and Leeds. Prior to the establishment of
Telco, Econophone's services in the United Kingdom primarily were marketed
under a joint venture between Econophone and EI. See "Risk
Factors--Dependence on Third Party Sales Organizations," "Risk
Factors--Dependence on Carrier Customers" and "Management's Discussion of
Financial Condition and Results of Operations."
As of December 31, 1997, Econophone had 23 internal sales representatives
and 122 independent sales representatives in continental Europe. Econophone's
internal sales representatives are based in Antwerp, Berlin, Brussels,
Hamburg and Paris. In all five of these cities, Econophone is expanding its
internal sales forces and recruiting additional independent sales
representatives. In addition to the foregoing cities, Econophone also has
independent sales representatives in Amsterdam and Zurich. Econophone's
strategy to date in its continental European markets generally has been
initially to concentrate on sales of prepaid card services since prepaid
operations limit credit risk and do not require substantial amounts of
start-up capital. Thereafter, after establishing its local sales and
marketing infrastructure and gaining market acceptance, Econophone has
introduced calling card and other services. Econophone also typically has
initially concentrated on sales in ethnic communities and to expatriates
since these market segments can be effectively targeted with limited
resources, enabling Econophone to rapidly generate revenues and create brand
awareness.
During December 1997, Econophone, through Telco, implemented a sales and
marketing strategy in Germany similar to that utilized in the United Kingdom,
retaining master agents who then retain individual independent sales
representatives. As of December 31, 1997, Telco had approximately 150 direct
and indirect independent sales representatives in Germany and intends to
significantly expand this distribution channel. Telco's German sales force
will concentrate on sales to residential customers. Econophone's internal
sales force in Hamburg will continue to concentrate on prepaid card sales and
sales to business customers.
In the United States, Econophone's services have been sold primarily in
the New York metropolitan area. Econophone has begun to focus its marketing
efforts on its other U.S. network cities and, as of December 31, 1997,
Econophone had 9 internal sales representatives and 305 independent sales
representatives in the United States.
VoiceNet's calling card services are marketed primarily through in-flight
magazines and through advertising materials placed in high traffic locations,
such as restaurants. Econophone intends to cross-market many of its other
services to VoiceNet's customer base, which for December 1997, consisted of
approximately 110,000 calling card holders, and to use VoiceNet's marketing
expertise to market its calling card services in Europe.
In Canada, Econophone intends to market its services primarily through
independent sales representatives. Initially, Econophone intends to market
its services in Canada primarily to ethnic communities that generate
substantial international calling volume.
Econophone's internal sales forces concentrate primarily on sales to
small-and medium-sized businesses and to other carriers, while independent
sales representatives concentrate primarily on residential sales. Econophone
believes that local internal sales forces substantially enhance market
acceptance of the Econophone brand and improve the performance of its
independent sales representatives. Econophone's internal sales forces make
local advertising decisions and provide support for its independent sales
representatives. Internal sales forces also enable Econophone to more
effectively focus marketing efforts on target customer groups. In addition,
Econophone believes that internal sales forces have a higher sales completion
rate to business users than independent sales representatives due to the
higher degree of technical knowledge required to close sales to business
users.
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<PAGE>
As Econophone expands into new network cities, it intends to establish
internal sales forces and recruit independent sales representatives in those
cities.
The terms on which Econophone retains independent sales representatives
are determined on a case-by-case basis and depend on a variety of factors,
including the geographic market, the services being sold by the
representative and the anticipated sales levels of the representative.
Econophone's independent sales representatives are retained on a
commission-only basis, with commissions generally ranging from 6% to 16% of
sales. Relationships with independent sales representatives generally are
terminable at will by either party. In certain cases, Econophone has engaged
master sales representatives, who have then engaged sub-representatives. In
other cases, Econophone has engaged individual independent sales
representatives directly.
INFORMATION TECHNOLOGY
Econophone believes that advanced, effective and flexible billing, public
financial reporting and customer service information systems are vital for
its operations and continued growth. Econophone engages in design and
integration of billing, public financial reporting and customer service
information systems at its College Station, Texas and Brooklyn, New York
facilities, where it employs 26 systems engineers. Econophone's systems
engineers have designed direct debit, multi-currency and multi-language
billing, as well as other billing features. By developing systems internally,
Econophone believes that it is able to reduce development costs, improve
quality control and expedite systems development and integration. While
Econophone believes that its current information systems are adequate,
substantial investment will be required to maintain the adequacy of these
systems as Econophone expands its operations. Econophone currently is in the
process of upgrading its billing systems to a format that will provide for
greater expandability and that will accommodate greater customer volumes.
Econophone expended approximately $1.4 million during 1997 to enhance current
and develop new customer service, billing, financial reporting and other
management information systems and has budgeted $3.4 million for such
expenditures during 1998. See "Risk Factors--Dependence on Effective
Information Systems" and "Management--Directors, Executive Officers and Other
Senior Management."
COMPETITION
The provision of telecommunications services is extremely competitive and
will become increasingly so as the regulatory barriers to entry into
telecommunications markets are increasingly reduced or eliminated.
Competition for customers is primarily on the basis of price and, to a lesser
extent, on the type and quality of services offered and customer service. The
telecommunications industry has relatively insignificant economic and
technological barriers to entry and numerous entities competing for the same
customer. Econophone has experienced, and expects to continue to experience,
declining revenue per billable minute in all of its markets in part as a
result of increasing worldwide competition within the telecommunications
industry. Econophone also experiences customer attrition, or "churn," as a
result of the highly competitive nature of its markets and expects current
levels of churn to continue or increase. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Results of
Operations."
In Europe, Econophone's competitors include (i) PTOs, (ii) alliances such
as AT&T's alliance with Unisource (itself a joint venture among Telecom
Netherlands, Telia AB and Swiss Telecom PTT), known as "AT&T Unisource," and
the corresponding alliance with WorldPartners, Sprint's alliance with
Deutsche Telekom and France Telecom, known as "Global One," (iii) companies
offering resold international telecommunications services, such as Esprit
Telecom, Viatel and RSL Communications, and (iv) other companies with
business plans similar in varying degrees to Econophone's, including emerging
public telephone operators who are constructing their own networks. Unisource
has recently announced that its venture partners would contribute their
international facilities and personnel to a newly formed company, and some
commentators have speculated that AT&T might do the same. The resulting
company is likely to
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be a substantially more formidable competitor. Econophone believes that its
non-U.S. markets will experience increased competition and begin to resemble
the competitive landscape in the United States. In addition, Econophone
anticipates that numerous new competitors will enter the European
telecommunications market. See "Risk Factors--Competition."
In the United States, Econophone's competitors include AT&T, MCI, Sprint
and numerous other carriers and providers, including calling card providers,
for domestic and international long distance calls. Competition is strong for
all of Econophone's services. Competition for U.S. calling card services is
particularly intense. Larger service providers such as AT&T, MCI and Sprint
have substantial brand recognition and market penetration for their calling
cards, while a large number of smaller calling card providers compete
fiercely based almost entirely on price.
As a result of the Communications Act of 1996 (the "1996 Act"), RBOCs are
eligible, subject to FCC approval, to offer domestic long distance and
international telecommunications services in their "in region" service areas,
as well as outside of their service areas, and have applied for FCC approval
for "in region" market entry. To date, the FCC has denied each of these
applications. However, the FCC has been meeting with the RBOCs to explain FCC
requirements. This may lead to one or more successful RBOC "in region"
applications in the future. Recently, a lower court decision, which is
currently being appealed, invalidated the FCC's statutory authority for prior
approval of market entry by several RBOCs into certain "in region" long
distance markets. In addition, the FCC is now also permitting foreign
telecommunications entities to enter the U.S. international
telecommunications market, including dominant foreign entities whose home
markets are conducive to competition. The FCC also has substantially reduced
the regulatory constraints on AT&T, Econophone's largest competitor, by
declaring AT&T to be "non-dominant," first, in the domestic long distance
market, and more recently in the international market; thus, granting AT&T
more pricing and service flexibility and permitting AT&T to compete more
effectively with smaller inter-exchange carriers, such as Econophone.
The World Trade Organization (the "WTO") recently concluded an agreement,
known as the WTO Basic Telecommunications Service Agreement (the "WTO
Agreement"), which will open the telecommunications markets of the 70
signatory countries to foreign carriers on varying dates. The WTO Agreement
became effective February 5, 1998. Pursuant to the WTO Agreement, U.S.
companies would have foreign market access for local, long distance and
international services, either on a facilities basis or through resale of
existing network on a reasonable and non-discriminatory basis. The WTO
Agreement affords no private right of action, however, so a company would
have to pursue any complaint at the national government level. Although the
WTO Agreement may open additional markets to Econophone or broaden the
permissible services that Econophone can provide in certain markets, the WTO
Agreement also may subject Econophone to greater competitive pressures in its
markets, with the risk of losing customers to other carriers and reductions
in Econophone's rates.
In addition, recently consummated and currently pending major
consolidations in the telecommunications industry could result in even more
powerful competitors to Econophone in its major markets. For example, the
merger between Bell Atlantic and NYNEX, the pending acquisition of MCI by
Worldcom, Inc., the proposed acquisition of Teleport Communications by AT&T
and the creation of a new company with the national and/or international
facilities of the Unisource partners could result in downward pressure on
prices without a corresponding reduction in transmission costs.
Econophone also may experience competition in one or more of its markets
from competitors utilizing new or alternative technologies and/or
transmission methods including cable television companies, wireless telephone
companies, satellite owners and resellers, Internet service providers
providing national and/or international long distance voice transmission
(including AT&T), electric and other utilities, railways, microwave carriers
and large end users that have private networks.
As Econophone expands its geographic coverage, it will encounter
additional regional competitors and increased competition. Many of
Econophone's competitors are significantly larger, have substantially
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<PAGE>
greater financial, technical and marketing resources and larger networks than
Econophone, control transmission lines and have long-standing relationships
with Econophone's target customers. If any of Econophone's competitors were
to devote additional resources to the provision of international and/or
domestic long distance voice telecommunication services to Econophone's
target customer base, there could be a material adverse effect on
Econophone's, business, financial condition, results of operations and its
ability to pay principal of and interest on the Notes. Many of Econophone's
larger competitors have lower incremental transmission costs than Econophone
due to, among other things, greater use of owned transmission capacity, more
favorable interconnection rates and volume discounts on transmission.
Furthermore, in certain European countries (including in France and Belgium),
telecommunications companies that make substantial investments in network
infrastructure will receive a substantial discount on interconnection rates.
Econophone does not expect to qualify for such a discount. In addition,
certain of Econophone's competitors offer customers an integrated full
service telecommunications package consisting of local and long distance
voice, data and Internet transmission. Econophone does not offer all of these
types of service, and presently does not intend to do so, which could have a
material adverse effect on Econophone's competitiveness and its ability to
make payments of principal of and interest on the Notes.
Each of the markets in which Econophone offers or intends to offer its
services will present unique competitive factors. There can be no assurance
that Econophone will be able to effectively compete in any given market and
the success of Econophone's strategy in any one market is not necessarily
indicative of its ability to succeed in any other market. See "Risk
Factors--Competition."
REGULATION
A summary discussion of the regulatory frameworks in certain geographic
regions in which Econophone operates or has targeted for penetration is set
forth below. This discussion is intended to provide a general outline of the
more relevant regulations and current regulatory posture of the various
jurisdictions and is not intended as a comprehensive discussion of such
regulations or regulatory posture. There can be no assurance that future
regulatory, judicial and legislative changes will not have a material adverse
effect on Econophone, that domestic or international regulators or third
parties will not raise material issues with regard to Econophone's compliance
or noncompliance with applicable laws and regulations or that other
regulatory activities will not have a material adverse effect on Econophone.
See "Risk Factors--Regulatory Restrictions."
EUROPEAN UNION
Over the last decade, the telecommunications market in the EU has been
subject to gradual liberalization. Some EU member states (including the
United Kingdom, Sweden and Finland) have opened up their markets on their own
initiative and are already substantially liberalized. In other member states,
liberalization has come about through the implementation of EU legislation
and in most of these member states the liberalization process and the
establishment of a liberalized regulatory framework are still in their
initial stages. National governments must pass legislation within their
countries to give effect to EC directives. Each EU member state in which
Econophone currently conducts its business will continue to, in part, have a
different regulatory regime. The requirements for Econophone to obtain
necessary approvals vary considerably from country to country and are
expected to continue to so vary. See "Risk Factors--Regulatory Restrictions."
As a first step towards removing PTOs' monopolies in each member state
and enabling competition both within each member state and between them, in
1990, the European Commission issued a Directive on Competition in the
Markets for Telecommunications Services (the "Services Directive"). The
effect of the Services Directive was to direct EU member states to permit the
competitive provision of all services other than voice telephony, including
value-added services and voice services within closed user groups.
45
<PAGE>
The Service Directive was amended by later directives concerned with
liberalizing various sections of the telecommunications market. Finally, in
March 1996, the Services Directive was amended by the adoption of the Full
Competition Directive, which required all EU member states, with the
exception of Greece, Ireland, Luxembourg, Portugal and Spain, to fully
liberalize the supply of all telecommunications services and the provision of
telecommunications infrastructure by January 1, 1998. Ireland and Portugal
have obtained a derogation from compliance with the Services Directive, as
amended by the Full Competition Directive, until January 1, 2000. Spain has
been granted a derogation entitling it to delay compliance with the Services
Directive, as amended, until November 30, 1998 and Luxembourg and Greece have
been granted a derogation entitling them to delay compliance until June 30,
1998 and January 1, 2001, respectively.
The Full Competition Directive abolished, as of January 1, 1998 (subject
to permitted derogations by EU member states described above), all special or
exclusive rights that restrict the provision of telecommunications services
by companies established in the European Union without regard to the
destination or origin of the communications involved. However, neither that
directive nor the original Services Directive prevent EU member states from
maintaining restrictions on companies which are not established in the
European Union in order to ensure that EU companies are afforded comparable
and effective treatment in third countries. Thus, the United Kingdom has in
the past limited the provision of certain international services on routes to
countries that do not have open markets comparable to the U.K.'s liberalized
market. However, in 1994, the United Kingdom ruled that the United States (in
addition to certain other countries) provided an equivalent open market and
since that date has had no restrictions (subject to operators obtaining the
necessary license) on services provided over leased lines between the United
States and the United Kingdom. During 1996, the United Kingdom liberalized
all international facilities-based services and international simple resale
services between the United Kingdom and other countries, subject to operators
meeting certain proportionate return conditions on routes that were not
considered to be competitive. From January 1997, these remaining restrictions
on international simple resale have been removed, although the United Kingdom
has reserved the right to reimpose proportionate return conditions in the
event that market distortions occur. However, the ability of EU member states
to in the future enact restrictions on the provision of telecommunications
services is limited due to the WTO Agreement. See "--World Trade Organization
Initiatives."
In addition to the abolition of special and exclusive rights, the Council
of the European Communities has adopted regulatory measures in order to
harmonize the rules applying in the liberalized EU telecommunications
environment. In this respect, an Open Network Provision ("ONP") Framework
Directive was adopted in 1990. Further more specific directives, which
include the ONP Leased Lines Directive, the ONP Voice Telephony Directive,
the ONP (Adaptation of the Framework and Leased Lines to a Competitive
Environment) Directive and the Interconnection Directive, as well as
directives concerned with licensing and satellite PCS services have been
adopted. In addition an amendment to the Interconnection Directive, which
would provide for equal access and number portability has been proposed.
Equal access would enable a customer to access Econophone's network over
another operator's network, without dialing an access code, by notifying the
network operator that it wishes all long distance calls to be carried by
Econophone. Oftel has already indicated that it will seek to defer the
implementation of equal access in the United Kingdom. Number portability
would enable customers to retain their existing telephone numbers when
switching to alternative carriers and is already available (although not
universally) in the United Kingdom. Additional directives, in addition to
those described above, remain to be adopted by the Council of the European
Communities, although their final content and timing of implementation cannot
be predicted at this time.
UNITED KINGDOM
The telecommunications services provided by Econophone in the United
Kingdom are subject to and affected by legislation and the terms of its
licenses. Licenses are granted by the Secretary of State for Trade
46
<PAGE>
and Industry but enforced by Oftel under powers granted by the
Telecommunications Act 1984. Since the break-up of the U.K.
telecommunications duopoly consisting of British Telecom and Mercury in 1991,
it has been the stated goal of Oftel to create a competitive marketplace from
which detailed regulation could eventually be withdrawn.
In 1991, a "multi-operator" policy was established to introduce increased
competition in the market for telecommunication services and infrastructure.
Under the multi-operator policy, the U.K. Department of Trade and Industry
(the "DTI") will recommend the grant of a license to operate a
telecommunications network to any applicant that the DTI believes has a
reasonable business plan and where there are no other overriding
considerations not to grant such license. All public telecommunications
operators operate under individual licenses granted by the Secretary of State
for Trade and Industry pursuant to the Telecommunications Act 1984.
International simple resellers operate under registrable class licenses.
Currently, most telecommunications systems with compatible equipment that are
authorized to be run under an individual license granted under this Act are
permitted to interconnect to British Telecom's network. Under the terms of
British Telecom's license, it is required to allow any such licensed operator
to interconnect its system to British Telecom's system, unless it is not
reasonably practicable to do so (e.g., due to incompatible equipment). The
statutory instrument implementing the Interconnection Directive extends this
requirement to operators with "relevant connectable system status." Oftel has
stated that the categories of companies that qualify for relevant connectable
system status are those network operators that are making significant
contributions to infrastructure competition by installing transmission
capacity or international simple resale operators making significant
contributions to competition in their respective international market.
Econophone believes it qualifies as one of the latter.
Since 1992, the U.K. government has permitted competition in the
provision of "any to any" international services over leased lines where
calls originate and terminate on the PSTN. Econophone, through its subsidiary
ATL, held an International Simple Resale ("ISR") license in the United
Kingdom, which entitled it to resell international message, telephone and
private line services. All ISRs were revoked on December 31, 1997 and all
holders were required to reapply to the Secretary of State for Trade and
Industry to be registered under the new International Simple Voice Resale
Class License (the "ISVR"), which authorizes the same activities as the old
ISR. ATL, a subsidiary of Econophone, has registered itself under the ISVR.
The ISVR license enables ATL to interconnect with, and lease capacity at
wholesale rates from, British Telecom, Mercury and other public
telecommunications operators.
In the United Kingdom, there was until recently a duopoly on ownership of
international facilities vested with British Telecom and Mercury. All other
operators were required to buy leased capacity from British Telecom or
Mercury, rather than installing their own facilities or acquiring IRUs on
existing cable routes. This constraint was removed in December 1996 when the
U.K. government began to issue IFLs. An IFL authorizes its holder to provide
international telecommunication services over its own international
infrastructure. There is no limit on the number of these licenses that may be
issued. ATL was awarded an IFL during the second quarter of 1997.
WORLD TRADE ORGANIZATION INITIATIVES
The WTO recently concluded the WTO Agreement, which would open the
telecommunications markets of the signatory countries to entry by foreign
carriers on varying dates. The WTO Agreement becomes effective on February 5,
1998. Pursuant to the WTO Agreement, U.S. companies would have foreign market
access for local, long distance and international services, either on a
facilities basis or through resale of existing network capacity on a
reasonable and non-discriminatory basis. The WTO Agreement affords no private
right of action, however, so a company would have to pursue any complaint at
the national government level. Although the WTO Agreement may open additional
markets to Econophone or broaden the permissible services that Econophone can
provide in certain markets, the WTO Agreement also may subject Econophone to
greater competitive pressures in its markets, with the risk of losing
customers to other carriers and reductions in Econophone's rates.
47
<PAGE>
BELGIUM
Until January 1, 1998, the provision of "telephone services" was reserved
for the Belgian PTO. "Telephone services" consist of real-time voice
telephony involving switching in Belgium. Services that did not constitute
"telephone services" could be provided by private service providers that are
duly licensed. Prior to January 1, 1998, a subsidiary of Econophone was
granted a license to provide certain non-reserved services. Pursuant to the
license, the subsidiary may, among other things, provide international
service utilizing international toll free access and local access, as well as
card-based services. Pursuant to the terms of its license, the subsidiary can
transmit both voice and data, and, thus, is able to offer voicemail, e-mail
and facsimile service. Econophone currently has pending an application for a
license to provide "telephone services" in Belgium.
FRANCE
Beginning on January 1, 1998, licensed private service providers were
able to offer domestic and international long distance voice telephony
services to the general public in France. These services are permitted to
utilize local dial-up access and may involve switching in France or routing
of calls over leased lines that are part of an authorized network to a second
country for switching. Econophone intends to file an application for a
license to provide international and long distance voice telephony services
to the general public utilizing local dial-up access.
GERMANY
In Germany, Econophone's activities are governed by the
Telecommunications Act of July 25, 1996 (the "German Telecommunications
Act"). Under the German Telecommunications Act, the provision of "voice
telephone service" requires a license. "Voice telephone service" is defined
in the German Telecommunications Act, in part, as "the commercial provision
for the public of the direct transport and switching of voice in real-time to
and from the network termination points of the public switched network." The
provision of telecommunications services that do not constitute "voice
telephone services" does not require a license. Under current regulatory
practice, the provision by Econophone of international long distance, calling
card and prepaid card services in Germany do not constitute "voice telephone
services," and therefore do not require a license, because Econophone does
not switch the calls in Germany, although Econophone was required to file a
notification of the commencement of services. The provision by Econophone of
domestic long distance service in Germany under the presently planned
technical setup would involve switching and would, therefore, require a
license. Econophone currently has pending an application for a license to be
able to provide such service.
UNITED STATES
Econophone's U.S. operations are subject to extensive federal and state
regulation. Federal laws and FCC regulations apply to interstate
telecommunications (including international telecommunications that originate
or terminate in the United States), while particular state regulatory
authorities have jurisdiction over telecommunications originating and
terminating within the state.
FEDERAL. The FCC currently regulates Econophone as a non-dominant
carrier with respect to both its international and domestic long distance
services. In the domestic, as distinguished from the international sector,
the FCC abstains from closely regulating the services and charges of
non-dominant carriers. Nevertheless, the FCC acts upon complaints against
such carriers for failure to comply with statutory obligations or with the
FCC's rules, regulations and policies. The FCC also has the power to impose
more stringent regulatory requirements on Econophone and to change its
regulatory classification. In the current regulatory atmosphere, Econophone
believes that the FCC is unlikely to do so with respect to Econophone's
international or domestic service offerings.
48
<PAGE>
FCC policy and rules authorize (without the need to obtain specific
service authorizations) a non-dominant carrier to provide domestic interstate
telecommunications services, and generally to resell international private
leased lines connected to the PSTN in Canada, Sweden, the United Kingdom, New
Zealand and Australia. In the international sector, specific FCC
authorizations, which Econophone has acquired, are required for the resale of
switched and private line services of U.S. facilities-based carriers, and to
provide telecommunications services, both switched and private line, as a
facilities-based carrier by acquiring circuits or various undersea cables or
leasing satellite facilities. The FCC reserves the right to condition, modify
or revoke such domestic and international authority for violations of the
1934 Act or the FCC's regulations, rules or policies promulgated thereunder.
Although Econophone believes the probability to be remote, a rescission by
the FCC of Econophone's domestic or international authority or a refusal by
the FCC to grant additional international authority would have a material
adverse effect on Econophone.
Econophone, as a non-dominant carrier, is required to file with the FCC
domestic and international tariffs containing charges and related practices,
regulations and classifications. The FCC presumes the tariffs of non-dominant
carriers to be lawful. Therefore, the FCC does not carefully review such
tariffs. The FCC could, however, investigate Econophone's tariffs, upon its
own motion or upon complaint by a member of the public. As a result of any
such investigation, the FCC could order Econophone to revise its tariffs, or
the FCC could prescribe revised tariffs.
Generally, authorizations held under Section 214 of the 1934 Act (such as
those held by Econophone) for international services are limited to providing
services or using facilities between the United States and countries
specified in the authorizations. Econophone holds all necessary Section 214
authorizations for conducting its present business but may need additional
authority in the future. Additionally, carriers may not lease private lines
between the United States and an international point for the purpose of
offering switched services unless the FCC has first determined that the
foreign country affords resale opportunities to U.S. carriers equivalent to
those available under United States law. The FCC has made such a
determination with respect to Canada, Sweden, the United Kingdom, New Zealand
and Australia, and Econophone is authorized to resell international private
lines to these points interconnected to the PSTN for the provision of voice
and data services.
The FCC requires long distance carriers to pay access charges to payphone
providers for calls made from payphones to toll free numbers administered by
long distance carriers. The FCC had required the immediate payment of such
access charges by long distance carriers with toll revenues of $100 million
or more per annum. The FCC had also required, after October 7, 1997, all long
distance carriers, irrespective of their annual toll revenues, to pay each
payphone operator $0.35 for each access or toll free call made from the
operator's payphones unless the payphone operator and the long distance
carrier agree upon a different rate of compensation. The FCC payphone order
was reversed by an appellate court and was remanded to the FCC by the court
for further consideration. The FCC subsequently adopted a rate of $0.284, in
lieu of the $0.35 rate, effective October 7, 1997 and made further
clarifications of its initial order. This decision is also before an
appellate court and some aspects of its implementation remain unclear. There
can be no assurance that Econophone will be able to fully pass the cost of
this charge, if applied to Econophone, on to its customers or that doing so
will not result in a loss of customers.
The FCC has issued an order designed to bring downward pressure on
international telephone rates. This order directs the U.S. international
facilities-based carriers to negotiate lower settlement rates paid to their
correspondent foreign carriers for international telephone calls. A
transition period is provided for these lower settlement rates of between one
and five years depending upon the country involved. Any resulting savings to
the U.S. facilities-based carriers might be passed along to their customers
in the form of reduced rates for international calls.
Beginning January 1, 1998, Econophone, as well as its U.S. competitors,
became obligated to make FCC-mandated contributions to universal service
funds. These funds subsidize the provision of
49
<PAGE>
telecommunications services in high cost areas and to low-income customers,
as well as the provisions of telecommunications and certain other services to
eligible schools, libraries and rural health care providers. The
contributions are billed monthly and are assessed based on intrastate,
interstate and international "end-user" gross telecommunications revenues.
However, revenues from international calls that both originate and terminate
in foreign points are excluded from assessment. On December 16, 1997, the FCC
approved the following contribution factors for carriers' first quarter 1998
contributions: (i) 3.19% for the high cost and low income funds (interstate
and international revenues); and (ii) 0.72% for the schools, libraries and
rural health care funds (intrastate, interstate and international revenues).
Because the contribution factors are likely to vary quarterly, the annualized
impact on Econophone cannot be estimated at this time. Econophone currently
is evaluating which categories of its revenues are subject to assessment and,
as a result, has not filed a universal service fund worksheet.
Additionally, effective January 1, 1998, Econophone is required to pay to
LECs specified PICCs in order to compensate such LECs for their investment in
the telephone lines Econophone uses to access its customers. The costs of
these charges vary in amount depending upon the type of presubscribed lines
that are serviced by Econophone and the individual LEC's revenue
requirements. While Econophone currently intends to pass through the costs of
both the PICC and its universal service fund contributions to its customers,
there can be no assurance that Econophone will be able to fully pass on such
costs or that doing so will not result in a loss of customers. In addition,
the FCC orders implementing the universal service contribution obligation and
the PICC are both subject to petitions seeking reconsideration by the FCC and
to certain appeals. Until such petitions or appeals are decided, there can be
no assurance as to how the orders will be implemented or enforced or what
effect the orders generally will have on competition within the
telecommunications industry or specifically on the competitive position of
Econophone. See "Risk Factors--Regulatory Restrictions."
STATE. The intrastate long distance operations of Econophone are subject
to various state laws and regulations. Most states require Econophone to
apply for certification to provide intrastate telecommunications services, or
to register or be found exempt from regulation, before commencing intrastate
services. Most states also require Econophone to file and maintain detailed
tariffs listing their rates for intrastate service. Many states also impose
various reporting requirements and/or require prior approval for transfers of
control of certified carriers, assignment of carrier assets, including
customer bases, carrier stock offerings, incurrence by carriers of
significant debt obligations and acquisitions of telecommunications
operations. Certificates of authority can generally be conditioned, modified,
cancelled, terminated or revoked by state regulatory authorities for failure
to comply with state law and/or rules, regulations and policies of the state
regulatory authorities. Fines and other penalties also may be imposed for
such violations.
Econophone provides interstate and international long distance service in
all or some portions of 50 states, for which Econophone has filed a tariff
with FCC. Econophone, Inc., a New York corporation, the predecessor to
Econophone ("Econophone NY"), has received authority, pursuant to state
regulation, certification, tariffs, notifications, or on an unregulated
basis, to provide intrastate long distance service in 49 states. Econophone
and Econophone NY are in the process of transferring such authorities from
Econophone NY to Econophone, or notifying or obtaining the approval of the
state regulatory authorities of the merger of Econophone NY into Econophone,
where required. Econophone anticipates that it will obtain all required state
regulatory approvals.
EMPLOYEES
As of December 31, 1997, Econophone had 408 employees worldwide. Of this
total, 248 were based in the United States and 160 were based in Europe.
Econophone's U.S. employees are based principally in its offices in New York,
New York and Brooklyn, New York and in College Station, Texas. In Europe,
Econophone's employees are based principally in its offices in Antwerp,
Brussels, Hamburg, Marseilles, London, Paris and Zurich.
50
<PAGE>
Econophone has never experienced a work stoppage and its employees are
not represented by a labor union or a collective bargaining agreement.
Econophone considers its employee relations to be good.
LITIGATION
Econophone is from time to time a party to litigation that arises in the
ordinary course of its business operations or otherwise. Econophone is not
presently a party to any litigation that it believes would have a material
adverse effect on its business or operations.
PROPERTIES
Econophone's executive offices and main operations center are located in
New York City, where Econophone leases approximately 18,000 square feet of
space at two facilities. Econophone also leases approximately 16,000 square
feet of office space in College Station, Texas, 10,500 square feet of office
space in Brooklyn, New York, approximately 2,400 square feet of office space
in Los Angeles, approximately 12,800 square feet in London, approximately
2,400 square feet in Brussels and approximately 3,150 square feet in Paris,
where it maintains its European sales and marketing headquarters. Econophone
maintains smaller sales offices in Antwerp, Athens, Berlin, Hamburg,
Marseilles and Zurich.
51
<PAGE>
ECONOPHONE, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
-----------
<S> <C>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS................................................................... F-2
CONSOLIDATED BALANCE SHEETS AS OF DECEMBER 31, 1996 AND 1997............................................... F-3
CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997................. F-4
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND
1997..................................................................................................... F-5
CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997................. F-6
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS................................................................. F-7
</TABLE>
F-1
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Stockholders of
Econophone, Inc.:
We have audited the accompanying consolidated balance sheets of
Econophone, Inc. (a Delaware corporation) and subsidiaries as of December 31,
1996 and 1997, and the related consolidated statements of operations,
stockholders' equity (deficit) and cash flows for each of the three years
ended December 31, 1997. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of
Econophone, Inc. and subsidiaries as of December 31, 1996 and 1997, and the
results of their operations and their cash flows for each of the three years
ended December 31, 1997, in conformity with generally accepted accounting
principles.
Arthur Andersen LLP
New York, New York
February 12, 1998
F-2
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, 1996 AND 1997
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------
1996 1997
---------- -----------
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents............................................................. $6,271,641 $67,201,901
Accounts receivable, net of allowance for doubtful accounts of $761,372 and
$1,593,531, respectively............................................................ 7,946,042 16,796,253
Prepaid expenses and other current assets............................................. 863,735 1,867,941
Restricted cash and securities........................................................ -- 10,462,500
---------- -----------
Total current assets.............................................................. 15,081,418 96,328,595
PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS net of accumulated depreciation and
amortization of $1,643,151 and $3,689,550, respectively (Note 4)...................... 6,242,472 23,216,765
Debt issuance costs..................................................................... -- 6,355,491
Other assets (Note 6)................................................................... 1,431,446 3,139,117
Restricted cash and securities.......................................................... -- 48,964,970
---------- -----------
Total assets...................................................................... $22,755,336 $178,004,938
---------- -----------
---------- -----------
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES:
Accounts payable...................................................................... $5,190,086 $21,100,675
Accrued expenses and other current liabilities........................................ 6,188,847 5,355,975
Interest accrued on Senior Notes...................................................... -- 10,462,500
Short-term borrowings (Note 8)........................................................ 2,127,726 --
Current maturities of long-term debt (Note 8)......................................... 753,881 1,828,962
Current maturities of obligations under capital lease (Note 14)....................... 130,867 156,067
Current maturities of notes payable--related party (Note 12).......................... 7,884 315,493
Deferred revenue...................................................................... 859,803 2,567,606
---------- -----------
Total current liabilities......................................................... 15,259,094 41,787,278
LONG-TERM DEBT (Note 8)................................................................. 1,707,941 5,657,042
OBLIGATIONS UNDER CAPITAL LEASE (Note 14)............................................... 235,074 278,667
NOTES PAYABLE--RELATED PARTY (Note 12).................................................. 319,531 --
SENIOR NOTES............................................................................ -- 149,680,000
SERIES A REDEEMABLE CONVERTIBLE PREFERRED STOCK (Note 11)............................... 13,357,940 14,327,588
COMMITMENTS AND CONTINGENCIES (Note 14)
STOCKHOLDERS' EQUITY (DEFICIT) (Note 10):
Common stock--voting, par value $.0001; authorized 29,250,000 shares; 20,000,000
shares issued and outstanding in 1995 and 1996...................................... 2,000 2,000
Non-Voting Common stock, par value $.0001; authorized 500,000 shares; no shares issued
and outstanding..................................................................... -- --
Additional paid-in capital............................................................ 481,870 6,081,870
Cumulative translation adjustment..................................................... -- (103,880)
Retained earnings (deficit)........................................................... (8,608,114) (39,705,627)
---------- -----------
Total stockholders' equity (deficit).............................................. (8,124,244) (33,725,637)
---------- -----------
Total liabilities and stockholders' equity (deficit).............................. $22,755,336 $178,004,938
---------- -----------
---------- -----------
</TABLE>
The accompanying notes are an integral part of these consolidated
balance sheets.
F-3
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED DECEMBER 31,
-----------------------------------
1995 1996 1997
---------- ---------- -----------
<S> <C> <C> <C>
REVENUES...................................................................... $27,490,490 $45,102,882 $83,002,625
COST OF SERVICES.............................................................. 19,735,530 35,368,603 63,707,453
---------- ---------- -----------
Gross profit............................................................ 7,754,960 9,734,279 19,295,172
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES.................................. 7,087,735 16,833,779 37,897,940
DEPRECIATION AND AMORTIZATION................................................. 388,508 1,049,651 3,615,283
---------- ---------- -----------
Income (loss) from operations........................................... 278,717 (8,149,151) (22,218,051)
OTHER INCOME.................................................................. 31,425 106,580 101,926
FOREIGN CURRENCY EXCHANGE GAIN (LOSS), net.................................... (41,097) 26,649 (264,521)
INTEREST EXPENSE, net......................................................... (147,826) (295,677) (7,747,219)
---------- ---------- -----------
Net income (loss)....................................................... $ 121,219 $(8,311,599) $(30,127,865)
---------- ---------- -----------
---------- ---------- -----------
BASIC EARNINGS (LOSS) PER SHARE (Note 2)...................................... $ .01 $ (0.43) $ (1.55)
---------- ---------- -----------
---------- ---------- -----------
PRO FORMA INFORMATION (Note 2):
Income before pro forma provision for income taxes.......................... $ 121,219
Pro forma provision for income taxes........................................ 41,214
----------
Pro forma net income.................................................... $ 80,005
----------
----------
PRO FORMA NET INCOME PER SHARE................................................ $ .00
----------
----------
WEIGHTED AVERAGE NUMBER OF BASIC COMMON SHARES OUTSTANDING (Note 2)........... 20,000,000 20,000,000 20,000,000
---------- ---------- -----------
---------- ---------- -----------
</TABLE>
The accompanying notes are an integral part of these consolidated statements.
F-4
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
<TABLE>
<CAPTION>
RETAINED
COMMON STOCK ADDITIONAL EARNINGS CUMULATIVE
----------------------- PAID-IN (ACCUMULATED TRANSLATION
SHARES AMOUNT CAPITAL DEFICIT) ADJUSTMENT TOTAL
---------- ----------- ---------- ------------ ----------- ------------
<S> <C> <C> <C> <C> <C> <C>
BALANCE, December 31, 1994................... 20,000,000 $ 2,000 $ 391,883 $ 694,217 $ -- $ 1,088,100
Net income................................... -- -- -- 121,219 -- 121,219
Distribution of S Corporation Earnings....... -- -- -- (499,301) -- (499,301)
---------- ----------- ---------- ------------ ----------- ------------
BALANCE, December 31, 1995................... 20,000,000 2,000 391,883 316,135 -- 710,018
Distribution of S corporation earnings....... -- -- -- (316,135) -- (316,135)
Contribution of capital to C corporation..... -- -- 89,987 -- -- 89,987
Net loss..................................... -- -- -- (8,311,599) -- (8,311,599)
Accretion of preferred stock................. -- -- -- (15,115) -- (15,115)
Dividends on preferred stock................. -- -- -- (281,400) -- (281,400)
---------- ----------- ---------- ------------ ----------- ------------
BALANCE, December 31, 1996................... 20,000,000 2,000 481,870 (8,608,114) -- (8,124,244)
Net loss..................................... -- -- -- (30,127,865) -- (30,127,865)
Warrants..................................... -- -- 5,600,000 -- -- 5,600,000
Accretion of preferred stock................. -- -- -- (91,054) -- (91,054)
Dividends on preferred stock................. -- -- -- (878,594) -- (878,594)
Cumulative translation adjustment............ -- -- -- -- (103,880) (103,880)
---------- ----------- ---------- ------------ ----------- ------------
BALANCE, December 31, 1997................... 20,000,000 $ 2,000 $6,081,870 ($39,705,627) $(103,880) ($33,725,637)
---------- ----------- ---------- ------------ ----------- ------------
---------- ----------- ---------- ------------ ----------- ------------
</TABLE>
The accompanying notes are an integral part of these consolidated statements.
F-5
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
FOR THE YEARS ENDED
DECEMBER 31,
-----------------------------------
1995 1996 1997
---------- ---------- -----------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)........................................................... $ 121,219 $(8,311,599) $(30,127,865)
Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities:
Depreciation and amortization............................................. 388,508 1,049,651 3,615,283
Provision for doubtful accounts........................................... 721,215 290,762 832,159
Accreted interest expense................................................. -- -- 280,000
Changes in assets and liabilities:
Increase in accounts receivable........................................... (5,694,774) (887,670) (9,682,370)
Increase in prepaid expenses and other current assets..................... (189,879) (350,500) (1,004,206)
Increase in other assets.................................................. -- (1,514,284) (3,276,550)
Increase in accounts payable, accrued expenses and other current
liabilities............................................................. 6,196,439 3,351,953 14,973,832
Increase in interest accrued on senior notes.............................. -- -- 10,462,500
Increase in deferred revenue.............................................. 494,409 365,394 1,707,803
---------- ---------- -----------
Net cash provided by (used in) operating activities..................... 2,037,137 (6,006,293) (12,219,414)
---------- ---------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment......................................... (1,206,077) (4,246,997) (13,266,837)
---------- ---------- -----------
Net cash used in investing activities................................... (1,206,077) (4,246,997) (13,266,837)
---------- ---------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Net proceeds from sale of preferred stock................................... -- 13,061,425 --
Proceeds from line of credit................................................ 1,760,000 800,000 --
Repayment of line of credit................................................. (1,860,000) (1,000,000) --
Proceeds from short term borrowing.......................................... -- 5,436,582 --
Repayments of short-term borrowings......................................... -- (3,308,855) (2,127,726)
Proceeds from long-term debt................................................ -- 2,232,195 --
Repayments of long-term debt................................................ (116,400) (447,910) (428,268)
Repayments of notes payable--related party.................................. (9,383) (10,636) (11,922)
Repayments of capital leases................................................ (85,379) (117,844) (232,612)
Dividends paid.............................................................. (499,301) (226,148) --
Proceeds from senior notes.................................................. -- -- 149,400,000
Proceeds from warrants...................................................... -- -- 5,600,000
Payment of debt issuance cost............................................... -- -- (6,355,491)
Proceeds from bridge loan................................................... -- -- 7,000,000
Repayments of bridge loan................................................... -- -- (7,000,000)
---------- ---------- -----------
Net cash provided by (used in) financing activities..................... (810,463) 16,418,809 145,843,981
---------- ---------- -----------
Increase in cash and cash equivalents, (including restricted cash and
securities)............................................................... 20,597 6,165,519 120,357,730
Cash and cash equivalents, beginning of period.............................. 85,525 106,122 6,271,641
---------- ---------- -----------
Cash and cash equivalents, end of period (including restricted cash and
securities)............................................................... $ 106,122 $6,271,641 $126,629,371
---------- ---------- -----------
---------- ---------- -----------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid during the period for:
Interest.................................................................. $ 193,455 $ 210,280 $ 504,981
Income Taxes.............................................................. 193,554 -- --
SUPPLEMENTAL DISCLOSURE OF NONCASH ACTIVITIES:
Accretion of preferred stock................................................ $ -- $ 15,115 $ 91,054
Accrued dividends on preferred stock........................................ -- 281,400 878,594
Capital leases entered into................................................. 471,000 423,000 5,753,855
</TABLE>
The accompanying notes are an integral part of these consolidated statements.
F-6
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1996 AND 1997
1. NATURE OF BUSINESS
Econophone, Inc. ("Econophone") is a rapidly growing switch-based
provider of long-distance telecommunications services in selected major U.S.
and western European markets. Econophone's customer base consists primarily
of residential customers, small- and medium-sized businesses and other
telecommunications carriers. In the United States and the United Kingdom,
Econophone provides principally international and domestic long distance,
calling card, prepaid and carrier services. In continental Europe, Econophone
provides principally international long distance, calling card and prepaid
services.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Econophone
and its wholly owned subsidiaries, its 70% owned subsidiary, Telco Global
Communications Ltd. (England) and its 72% owned subsidiary, Econophone
Services GmbH (Switzerland) (collectively, the "Company"). The full amount of
the net loss for the year ended December 31, 1997 for Telco Global
Communications Ltd. and Econophone Services GmbH have been recorded in the
consolidated financial statements of the Company. All significant
intercompany balances and transactions have been eliminated in consolidation.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
REVENUE RECOGNITION
The Company records revenue based on minutes of service provided.
Deferred revenue consists of unused minutes on prepaid calling cards.
CASH AND CASH EQUIVALENTS
Cash equivalents consist of highly liquid investments with a maturity of
less than three months when purchased.
PROPERTY AND EQUIPMENT
Depreciation of property and equipment is computed using the
straight-line method over the estimated useful lives of the respective
assets, which range from three to fifteen years. Beginning July 1996, the
Company adjusted the useful lives of equipment to be more reflective of their
actual usefulness. The change in estimate was accounted for on a going
forward basis. The impact to the 1996 results of operations was not material.
Amortization of leasehold improvements is computed using the straight-line
method over the lesser of the lease term or estimated useful lives of the
improvements.
INTERNAL-USE SOFTWARE
The Company capitalizes certain software development costs for internal
use. For the year ended December 31, 1997, the Company incurred approximately
$897,000 of such costs and has included them in Other Assets. The capitalized
software development costs are reported at the lower of unamortized cost or
net realizable value. These costs are amortized on a straight-line basis over
the estimated useful life, generally two years. Such costs were immaterial,
prior to 1997.
F-7
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996 AND 1997
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
LONG-LIVED ASSETS
The Company's policy is to record long-lived assets at cost. In
accordance with Statement of Financial Accounting Standards No. 121 ("SFAS
121"), "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to be Disposed Of," these assets are reviewed for impairment whenever
events or changes in circumstances indicate that the carrying amounts of the
assets may not be recoverable. Furthermore, the assets are evaluated for
continuing value and proper useful lives by comparison to expected future
cash projections. At December 31, 1996, the adoption of SFAS 121 did not have
a material effect on the Company. The Company amortizes these costs over the
expected useful life of the related asset.
INCOME TAXES
Prior to 1996, the Company was an S Corporation for federal and state
income tax purposes and, as a result, the earnings of the Company were
taxable directly to the shareholders. During 1996, the Company changed its
tax status to a C Corporation.
In the accompanying financial statements, pro forma income taxes have
been provided for at the expected effective rate as if the Company was a C
Corporation for the year ended December 31, 1995.
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between financial statement carrying
amounts of existing assets and liabilities and their respective tax bases.
Deferred tax assets and liabilities are measured using enacted tax rates
expected to be applied to taxable income in the year in which those temporary
differences are expected to be recovered or settled. Deferred income taxes
are not provided on undistributed earnings of foreign subsidiaries since such
earnings are currently expected to be permanently reinvested outside the
United States.
STOCK-BASED COMPENSATION
Statement of Financial Accounting Standards No. 123 ("SFAS 123"),
"Accounting for Stock-Based Compensation," encourages, but does not require
companies to record compensation cost for stock-based employee compensation
plans at fair value. The Company has chosen to continue to account for
stock-based compensation awards to employees and directors using the
intrinsic value method prescribed in Accounting Principles Board Opinion
("APB") No. 25, "Accounting for Stock Issued to Employees," and related
interpretations. Accordingly, compensation cost for stock options awarded to
employees and directors is measured as the excess, if any, of the fair value
of the Company's stock at the date of grant over the amount an employee or
director must pay to acquire the stock.
The Company accounts for stock-based compensation awards to outside
consultants and affiliates based on the fair value of such awards.
Accordingly, compensation costs for stock option awards to outside
consultants and affiliates is measured at the date of grant based on the fair
value of the award using The Black-Scholes option pricing model (See Note 13).
NEW ACCOUNTING PRONOUNCEMENTS
In June 1997, Statement of Financial Accounting Standards (SFAS) No.
130--"Reporting Comprehensive Income" and SFAS No. 131--"Disclosures about
Segments of an Enterprise and Related Information" were issued and are
effective for periods beginning after December 15, 1997. SFAS No. 130
establishes standards for reporting comprehensive income and its components.
SFAS No. 131 establishes standards for reporting financial and descriptive
information regarding an enterprise's operating segments.
F-8
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996 AND 1997
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
These standards increase disclosure only and will have no impact on the
Company's financial position or results of operations, upon adoption.
FOREIGN CURRENCY EXCHANGE
The financial statements of all foreign subsidiaries were prepared in
their respective local currencies and translated into U.S. dollars based on
the current exchange rate at the end of the period for the balance sheet and
a weighted-average rate for the period on the statement of operations.
Translation adjustments generally are reflected as foreign currency
translation adjustments in the Statement of Stockholders' Equity and,
accordingly, have no effect on net income. Foreign currency transaction
adjustments are reflected in the Statements of Operations.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform with the
current year's presentation.
PER SHARE DATA
During 1997, SFAS No. 128 "Earnings per Share" was issued and became
effective for the Company's December 31, 1997 financial statements. SFAS No.
128 establishes new standards for computing and presenting earnings per share
(EPS). The new standard requires the presentation of basic EPS and diluted
EPS. Basic EPS is calculated by dividing income available to common
shareholders by the weighted average number of shares of common stock
outstanding during the period. Diluted EPS is calculated by dividing income
available to common shareholders by the weighted average number of common
shares outstanding adjusted to reflect potentially dilutive securities.
Diluted EPS has not been presented since the inclusion of outstanding options
would be antidilutive.
The following is the reconciliation of net income (loss) per share as of
December 31,
<TABLE>
<CAPTION>
1995 1996 1997
---------- ------------- --------------
<S> <C> <C> <C>
Net income (loss)................................. $ 121,219 ($ 8,311,599) ($ 30,127,865)
Less Dividends on Preferred Stock................. 0 (281,400) (878,594)
---------- ------------- --------------
Income (loss) available to common shareholders.... $ 121,219 $ (8,592,999) $ (31,006,459)
---------- ------------- --------------
---------- ------------- --------------
</TABLE>
3. FAIR VALUE OF FINANCIAL INSTRUMENTS
The Financial Accounting Standards Board has issued Statement of
Financial Accounting Standards No. 107 ("SFAS No. 107") entitled "Disclosures
About Fair Value of Financial Instruments," which requires entities to
disclose information about the fair values of their financial instruments.
The following methods and assumptions were used to estimate the fair
value of each class of financial instruments for which it is practicable to
estimate that value.
LONG AND SHORT-TERM DEBT
The carrying amount of the Company's short-term borrowings approximates
fair value. The fair value of the Company's long-term debt, including current
portions, is determined based on market prices for similar debt instruments
or on the current rates offered to the Company for debt with similar
maturities.
As of December 31, 1997, the fair value based upon quotes from securities
dealers and carrying value of the Company's Senior Notes were $168,175,000
and $149,680,000 respectively.
F-9
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996 AND 1997
3. FAIR VALUE OF FINANCIAL INSTRUMENTS (CONTINUED)
FOREIGN EXCHANGE CONTRACTS
The Company from time to time uses foreign exchange contracts relating to
its receivables to hedge foreign currency exposure and to control risks
relating to currency fluctuations in British Pounds, Belgian Francs and
French Francs. The Company does not use derivative financial instruments for
speculative purposes and, at December 31, 1996, the Company had no open
foreign currency hedging positions. At December 31, 1997, the Company had
$300,000 of open foreign currency hedging positions.
4. PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS
Property, equipment and leasehold improvements consist of the following:
<TABLE>
<CAPTION>
DECEMBER 31
---------------------------
1996 1997
------------ -------------
<S> <C> <C>
Equipment........................................................ $ 7,189,102 $ 23,403,236
Computer software................................................ 182,963 1,365,820
Furniture and fixture............................................ 136,399 634,269
Leasehold improvements........................................... 377,159 1,502,990
------------ -------------
7,885,623 26,906,315
Less-Accumulated depreciation and amortization................... (1,643,151) (3,689,550)
------------ -------------
Property, equipment and leasehold improvements, net........ $ 6,242,472 $ 23,216,765
------------ -------------
------------ -------------
</TABLE>
Depreciation expense for the years ended December 31, 1996 and 1997, was
$1,008,402 and $2,296,855, respectively.
5. TERRITORIAL RIGHTS
In September 1994, the Company entered into a joint venture with
Europhone International Ltd. ("EI") to jointly market Econophone's services
in the United Kingdom. EI engaged in sales and marketing, while Econophone
provided network support, billing and transmission services.
In connection with the modification of the joint marketing arrangement
which occured in June 1996, EI granted the Company the right to compete with
them in exchange for forgiveness of the net receivable due to the Company of
$2,000,000. The Company charged this to operations in 1996 as an expense of
the joint venture.
6. OTHER ASSETS
Other assets consist primarily of security deposits and software
development costs.
7. FOREIGN OPERATIONS AND CONCENTRATIONS
FOREIGN OPERATIONS
The Company's trade accounts receivable are subject to credit risk.
Although diversified due to the large number of customers comprising the
geographically dispersed customer base, the Company does not require
collateral or other security to support its receivables. The Company's total
sales, operating income
F-10
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996 AND 1997
7. FOREIGN OPERATIONS AND CONCENTRATIONS (CONTINUED)
(before interest, foreign currency exchange and other income) and
identifiable assets by geographical area for the years ended and as of
December 31, 1995, 1996 and 1997 are as follows:
<TABLE>
<CAPTION>
UNITED OTHER
ENGLAND STATES BELGIUM EUROPE CONSOLIDATED
------------- -------------- ------------ ------------ --------------
<S> <C> <C> <C> <C> <C>
1995
Revenues............................. $ 14,172,747 $ 8,292,415 $ 4,235,155 $ 790,173 $ 27,490,490
------------- -------------- ------------ ------------ --------------
------------- -------------- ------------ ------------ --------------
Operating income..................... $ 143,693 $ 84,074 $ 42,939 $ 8,011 $ 278,717
Corporate expenses................... (157,498)
--------------
$ 121,219
--------------
--------------
Account receivable................... $ 4,343,590 $ 900,883 $ 1,331,276 $ 773,385 $ 7,349,134
Other identifiable assets............ -- 2,183,642 397,675 -- 2,581,317
Corporate assets..................... 577,770
--------------
$ 10,508,221
--------------
--------------
1996
Revenues............................. $ 15,477,308 $ 18,185,110 $ 9,037,967 $ 2,402,497 $ 45,102,882
------------- -------------- ------------ ------------ --------------
------------- -------------- ------------ ------------ --------------
Operating loss....................... ($ 2,472,933) ($3,855,148) (1,472,157) (348,913) ($8,149,151)
Corporate expenses................... (162,448)
--------------
($8,311,599)
--------------
--------------
Accounts receivable.................. $ 2,282,951 $ 3,718,158 $ 1,487,965 $ 456,968 $ 7,946,042
Other identifiable assets............ 1,423,097 4,001,405 847,181 200,789 6,472,472
Corporate assets..................... 8,336,822
--------------
$ 22,755,336
--------------
--------------
1997
Revenues............................. $ 18,362,999 $ 48,898,882 $ 7,980,848 $ 7,759,896 $ 83,002,625
------------- -------------- ------------ ------------ --------------
------------- -------------- ------------ ------------ --------------
Operating loss....................... ($ 2,966,508) ($ 17,213,062) ($374,446) ($664,033) ($ 21,218,049)
Corporate expenses................... (7,909,816)
--------------
($ 29,127,865)
--------------
--------------
Accounts receivable.................. $ 5,252,202 $ 9,034,226 $ 1,250,317 $ 1,259,508 $ 16,796,253
Other identifiable assets............ 6,731,185 16,514,567 462,682 405,331 24,113,765
Corporate assets..................... 137,094,920
--------------
$ 178,004,938
--------------
--------------
</TABLE>
Management does not anticipate incurring losses on its trade receivables in
excess of established allowances based on factors surrounding the credit risk of
specific customers and historical trends.
The revenues of Europhone International accounted for $13.2 million or 48%
in 1995 and $14.2 million or 32% in 1996. The relationship was terminated in
December 1996.
F-11
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996 AND 1997
7. FOREIGN OPERATIONS AND CONCENTRATIONS (CONTINUED)
SUPPLIERS
Sprint Communication, Inc. ("Sprint"), one of the Company's principal
suppliers of telephone lines, has a recorded lien on all accounts receivable
of the Company. This lien is subordinated to the debt owed to Israel Discount
Bank of New York (Note 8). For the years ended December 31, 1996 and 1997,
Sprint supplied approximately $9.4 million and $6.0 million respectively, of
telephone line usage to the Company. In addition, Switch Services, Inc.
('SSI") supplied approximately $6.9 million of telephone line usage to the
Company in 1997. These amounts have been included in cost of services.
8. BORROWINGS
At December 31, 1997, the Company was obligated under the following debt
agreements:
<TABLE>
<CAPTION>
CURRENT LONG-TERM TOTAL
------------ -------------- --------------
<S> <C> <C> <C>
Long-term debt:
NTFC note (a)................................ $ 1,633,136 $ 5,521,792 $ 7,154,928
Cable lines (b).............................. 195,826 135,250 331,076
Senior notes (c)............................. 149,680,000 149,680,000
------------ -------------- --------------
$ 1,828,962 $ 155,337,042 $ 157,166,004
------------ -------------- --------------
------------ -------------- --------------
</TABLE>
- ------------------------
(a) On May 28, 1996, Econophone entered into a credit facility with NTFC, which
has been amended and increased as to amount on several occasions. On January
28, 1998, the NTFC credit facility was amended and restated in its entirety
in order to effect various amendments and increase the amount of NTFC's
commitment thereunder (such credit facility, as amended and restated, is
referred to herein as the "NTFC Facility"). The NTFC Facility provides for
borrowings by Econophone and its subsidiaries to fund certain equipment
acquisition costs and related expenses. The NTFC Facility provides for an
aggregate commitment of NTFC of $24.0 million pursuant to three tranches of
$2.0 million, $3.0 million and $19.0 million. Loans borrowed under each
tranche of the NTFC Facility amortize in equal monthly installments over a
five year period ending on July 1, 2001, April 1, 2002 and January 1, 2003,
respectively. As of December 31, 1997, the aggregate amount outstanding
under all tranches of the NTFC Facility was $7,154,928. Loans under the NTFC
Facility accrue interest at an interest rate equal to the 90-day commercial
paper rate plus 395 basis points, subject to certain quarterly adjustments
depending upon financial performance. All of the equipment purchased with
the proceeds of the NTFC Facility has been pledged to NTFC.
The NTFC Facility requires Econophone to maintain a Debt Service Coverage
Ratio for each quarter through December 31, 1999 of not less than 1.10 to
1.00 and for each fiscal quarter thereafter of not less than 1.25 to 1.00.
In addition, Econophone must maintain specified minimum cash balances
(certain related business investments and acquisitions qualify as cash for
the foregoing purposes). Econophone also must have EBITDA (as defined in the
NTFC Facility) of not less than: negative $5,500,000 for the fiscal year
ending December 31, 1998; $3,000,000 for the fiscal year ending December 31,
1999; $10,000,000 for the fiscal year ending December 31, 2000; and
$10,000,000 for the
F-12
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996 AND 1997
8. BORROWINGS (CONTINUED)
fiscal year ending December 31, 2001. Econophone was in compliance with
these covenants at December 31, 1997.
(b) The Company has six notes payable related to the purchase of cable lines.
Three of these notes bear interest at 12%, and mature through September
1998. The remaining three notes bear interest at LIBOR plus 5%, and mature
on June 30, 2001. These notes have quarterly principal and interest payments
ranging from $5,849 to $30,291.
(c) The 1997 Unit Offering
Econophone completed on July 1, 1997 the Offering of 155,000 units (each a
"Unit"), each Unit consisting of one 13 1/2% Senior Note due 2007 of
Econophone and one warrant (each a "Warrant") to purchase 8.167 shares of
common stock of Econophone (the "Common Stock"). The Units were sold for an
aggregate purchase price of $155.0 million. On December 5, 1997, the Company
consummated an offer to exchange the notes issued in the 1997 Unit Offering
for $155.0 million of notes that had been registered under the Securities
Act.
The 1997 Notes are unsecured unsubordinated obligations of Econophone,
limited to $155.0 million aggregate principal amount at maturity, and mature
on July 15, 2007. Interest on the 1997 Notes accrues at the rate of 13 1/2%
per annum from the most recent interest payment date on which interest has
been paid or provided for, payable semiannually (to holders of record at the
close of business on the January 1 or July 1 immediately preceding the
interest payment date) on January 15 and July 15 of each year, commencing
January 15, 1998. At the closing of the 1997 Unit Offering, Econophone used
$57.4 of the net proceeds of the 1997 Unit Offering to purchase the Pledged
Securities, which were pledged as security for the payment of interest on
the principal of the 1997 Notes. Proceeds from the Pledged Securities are
being used by Econophone to make interest payments on the 1997 Notes through
July 15, 2000. The Pledged Securities are being held by a trustee pending
disbursement.
Maturities of other long-term debt over the next five years are as follows:
<TABLE>
<S> <C>
1998............................................................ $2,144,455
1999............................................................ 1,689,280
2000............................................................ 1,688,848
2001............................................................ 1,499,620
2002............................................................ 779,294
---------
Total........................................................... $7,801,497
---------
---------
</TABLE>
9. TAXES
As a telephone carrier and reseller doing business in New York State, the
Company is required to file annual telephone and transmission tax returns in
accordance with New York State tax laws. These returns include taxes on net
worth, gross sales and gross profit. In addition, each type of tax requires
an additional tax surcharge. The Company also remits federal and state excise
taxes and other state and local sales taxes. All of these taxes are included
in general and administrative expenses.
F-13
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996 AND 1997
9. TAXES (CONTINUED)
As of December 31, 1997, the Company had a net operating loss
carryforward of approximately $36,000,000 which is available to reduce its
future taxable income and expires at various dates through 2012. A valuation
allowance of approximately $14,000,000 has been established against this
amount due to the uncertainties surrounding the utilization of the
carryforward.
A value added tax "VAT" is a tax charged on goods and services that is
designed to be borne by the ultimate end user of the goods and services.
Pursuant to the Sixth European Commission (the "EC") VAT Directive adopted in
1977 (the "VAT Directive"), providers of telecommunications services in the
European Union are liable for VAT in the EU member state where the provider
of the services is established. The provider, in turn, charges VAT to its
customers at the rate prevailing in the provider's country of establishment.
To date, the collection of VAT by Econophone does not appear to have a
material adverse effect on its ability to attract or retain customers and the
collection of VAT has not required Econophone to reduce its prices to remain
competitive.
Econophone's foreign subsidiaries file separate tax returns and provide
for taxes accordingly.
10. STOCKHOLDERS' EQUITY (DEFICIT)
On November 1, 1996, the Company's Articles of Incorporation were amended
to change all of the authorized shares of Common Stock and Non-Voting Common
Stock from no par value per share to $.0001 per value per share, to increase
the number of shares of authorized Common Stock from 400 shares to 29,250,000
shares, to increase the number of authorized shares of Non-Voting Common
Stock from 19,600 shares to 500,000 shares and to authorize the issuance of
250,000 shares of Preferred Stock (Note 11). Additionally, the Company
effected a recapitalization whereby the outstanding shares of Common Stock
were converted on a 73,125:1 basis.
All information contained in the accompanying financial statements and
footnotes has been retroactively restated to give effect to these
transactions.
Included within additional paid in capital, is $5.6 million attributable
to the Warrants, which represents the portion of the issue price for the
Units attributable to the fair value of the Warrants. Such amount has been
recognized as a discount on the 1997 Notes and will be amortized over the
term of the 1997 Notes. Each Warrant may be exercised for 8.167 shares of
Common Stock at an exercise price of $.01 per share. The Warrants are
exercisable for 1,265,885 shares of Common Stock, in the aggregate. The fair
value of the shares issuable upon exercise of the Warrants was determined to
be $4.43 per share based on an agreement between Econophone and the Placement
Agent in connection with the 1997 Unit Offering. Among the factors considered
in making such determinations were the history of the prospects for the
industry in which Econophone competes, an assessment of Econophone's
management, the present operations of Econophone, the historical results of
operations of Econophone and the trend of its revenues and earnings, the
prospects for future earnings of Econophone, the general condition of the
securities markets at the time of the 1997 Unit Offering and the prices of
similar securities of generally comparable companies. The Warrants expire on
June 30, 2007.
F-14
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996 AND 1997
11. SERIES A REDEEMABLE CONVERTIBLE PREFERRED STOCK
On November 1, 1996, the Company entered into a Securities Purchase
Agreement (the "Agreement") with Princes Gate Investors II, L.P., an
affiliate of Morgan Stanley & Co., Incorporated, whereby it authorized and
issued 140,000 shares of $.01 par value Redeemable Convertible Preferred
Stock (the "Series A Preferred") for a purchase price of approximately
$13,061,000, net of issuance costs. The stated redemption value on the
preferred stock is $14,000,000 (or $100 per share). The Series A Preferred is
senior to all other capital stock of the Company.
The Series A Preferred accrued monthly cumulative dividends on each
outstanding share at a rate of $1.00 per month. The accrued and unpaid
dividends compound monthly at a rate of 12% per year. The dividends began to
accrue and compound interest from the issuance date of the preferred stock
and ceased to accrue on July 1, 1997, when the Senior Notes were issued.
The mandatory redemption of the Series A Preferred is October 31, 2006.
The redemption shall be in cash.
Each holder of the Series A Preferred shall have the right, at the option
of the holder, to convert any of its shares of Series A Preferred, into a
number of fully paid and nonassessable whole shares of common stock. At any
time, any holder of Series A Preferred Stock may convert all or any portion
thereof into Common Stock of Econophone. As of December 31, 1997, the shares
of Series A Preferred Stock outstanding were convertible into 3,420,701
shares of Common Stock. The number of shares of Common Stock that each share
of Series A Preferred Stock is convertible into is equal to the number of
shares of Common Stock outstanding on November 1, 1996 (on a fully diluted
basis), which was 22,564,000, multiplied by a fraction (i) the numerator of
which is equal to the stated value with respect to the shares of Series A
Preferred Stock being so converted, plus any dividends accrued thereon, and
(ii) the denominator of which is equal to $100.0 million plus the number of
dollars received by Econophone since November 1, 1996 from the exercise of
specified options or warrants.
12. RELATED PARTY TRANSACTIONS
The Company has notes payable at December 31, 1996 and 1997 due to
various related parties. These notes are unsecured, and accrue interest at
annual rates ranging from 9% to 18%. One note is a demand obligation while
the others have maturities which range through November 15, 1998.
The Company has a non-interest bearing note receivable at December 31,
1997 for approximately $215,000 from a related party.
The brother-in-law of Alfred West owns a 28% interest in Econophone's
Swiss subsidiary, Econophone Services GmbH.
13. STOCK-BASED COMPENSATION PLANS
On October 31, 1996, the Board of Directors adopted the Econophone, Inc.
1996 Flexible Incentive Plan (the "1996 Plan") and an Incentive Stock Option
Agreement with the Chief Operating and Financial Officer of the Company. The
Company accounts for awards granted to employees and directors under APB No.
25, under which no compensation cost has been recognized for stock options
granted. Had
F-15
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996 AND 1997
13. STOCK-BASED COMPENSATION PLANS (CONTINUED)
compensation cost for these stock options been determined consistent with
SFAS No. 123, the Company's net income and earnings per share would have been
reduced to the following pro forma amounts:
<TABLE>
<CAPTION>
1996 1997
------------- ---------------
<S> <C> <C>
Net Loss:
Available to $ (8,592,999) $ (31,006,459)
Common
Shareholders
Pro Forma (9,088,001) (31,797,731)
Basic EPS:
As Reported $ (.43) $ (1.55)
Pro Forma (.45) (1.59)
</TABLE>
The effects of applying SFAS 123 in this pro forma disclosure are not
indicative of future amounts as additional awards in future years are
anticipated.
During 1996, under the 1996 Plan, the Company granted 10,000 options to
outside consultants. All transactions with individuals other than those
considered employees, as set forth within the scope of APB No. 25, must be
accounted for under the provisions of SFAS No. 123. Under SFAS No. 123, the
fair value of the options granted to the consultants as of the date of grant
using the Black-Scholes pricing model is $8,936. The NQSOs (as hereinafter
defined) were granted to the consultants for terms of up to ten years, at an
exercise price of $2.50 and are exercisable in whole or in part at stated
times from the date of grant up to three years from the date of grant. As of
December 31, 1996 and 1997, 0 and 1,667 of the options granted to the
consultants were exercisable, respectively, and the expense recognized in
1996 and 1997 relating to these options was $496 and $2,976, respectively.
The 1996 Plan authorizes the granting of awards, the exercise of which
would allow up to an aggregate of 3,000,000 shares of the Company's common
stock to be acquired by the holders of said awards. The awards can take the
form of Incentive Stock Options ("ISOs"), Non-qualified Stock Options
(NQSOs), Stock Appreciation Rights ("SARs"), Restricted Stock and
Unrestricted Stock. The SARs may be awarded either in tandem with options or
on a stand-alone basis. Awards may be granted to key employees, directors and
consultants. ISOs and NQSOs are granted in terms not to exceed ten years and
become exercisable as set forth when the award is granted. Options may be
exercised in whole or in part. The exercise price of the ISOs is the market
price of the Company's common stock on the date of grant. The exercise price
of NQSOs shall never be less than the par value of the Company's common
stock. Any plan participant who is granted ISOs and possesses more than 10%
of the voting rights of the Company's outstanding common stock must be
granted an option price with at least 110% of the fair market value on the
date of grant and the option must be exercised within five years from the
date of grant. Under the Company's 1996 Plan, ISOs and have been granted to
key employees and directors for terms of up to ten years, at an exercise
price of $2.50, and are exercisable in whole or in part at stated times from
the date of grant up to three years from the date of grant. At December 31,
1996 and 1997, 226,527 and 1,109,250 options respectively, were exercisable
under the Company's 1996 Plan.
F-16
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996 AND 1997
13. STOCK-BASED COMPENSATION PLANS (CONTINUED)
Option activity during 1996 and 1997 is as follows:
<TABLE>
<CAPTION>
1996 1997
--------------------------- ---------------------------
<S> <C> <C> <C> <C>
WEIGHTED WEIGHTED
AVERAGE AVERAGE
SHARES EXERCISE PRICE SHARES EXERCISE PRICE
---------- --------------- ---------- ---------------
Outstanding at beginning of year...... -- -- 2,606,500 $ 2.50
Granted............................... 2,606,500 $ 2.50 294,945 5.00
Outstanding at end of year............ 2,606,500 2.50 2,901,445 2.74
---------- ---------- -----
---------- ---------- -----
Exercisable at end of year............ 226,527 2.50 1,109,250 2.50
Weighted average fair value of options
granted............................. .89 1.91
</TABLE>
The fair value of each option grant is estimated on the date of grant
using the Black-Scholes option pricing model with the following
weighted-average assumptions used for grants in 1996 and 1997: risk-free
interest rate of 6.23 percent for 1996 and 1997; expected life of three years
for 1996 and 1997; expected volatility of 43 percent for 1996 and 47% for
1997 and expected dividend yield of zero percent for 1996 and 1997.
The following table summarizes information with respect to stock options
outstanding at December 31, 1997:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------------------ --------------------------------
NUMBER WEIGHTED AVERAGE NUMBER
EXERCISE OUTSTANDING AT REMAINING WEIGHTED AVERAGE EXERCISABLE WEIGHTED AVERAGE
PRICE 12/31/97 CONTRACTUAL LIFE EXERCISE PRICE AT 12/31/97 EXERCISE PRICE
- ------------- -------------- ------------------- ----------------- ------------- -----------------
<S> <C> <C> <C> <C> <C>
$2.50-$5.00 2,901,445 8.97 $ 2.74 1,109,250 $ 2.50
</TABLE>
14. COMMITMENTS AND CONTINGENCIES
The Company has various lease agreements for offices, automobiles and
other property. Future minimum annual lease payments under the Company's
operating and capital leases with initial or remaining terms of one year or
more at December 31, 1997 are as follows:
<TABLE>
<CAPTION>
OPERATING CAPITAL
LEASES LEASE
------------ ----------
<S> <C> <C>
1998................................................................ $ 1,500,451 $ 156,067
1999................................................................ 1,535,221 159,311
2000................................................................ 1,593,025 97,105
2001................................................................ 1,629,640 21,481
2002................................................................ 1,450,602 770
------------ ----------
Total minimum lease payments........................................ $ 7,708,939 $ 434,734
------------ ----------
------------ ----------
</TABLE>
The rent expense for the year ended December 31, 1996 and 1997 was
approximately $394,000 and 1,378,000, respectively.
F-17
<PAGE>
ECONOPHONE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
DECEMBER 31, 1996 AND 1997
14. COMMITMENTS AND CONTINGENCIES (CONTINUED)
In January, 1998, the Company obtained a line of credit from European
American Bank ("EAB") in the amount of $2,000,000 and a foreign exchange line
in the amount of $5,000,000, which are collateralized by $2,300,000 in time
deposits. Interest is charged at the prime rate in effect, and is payable
monthly from the date of advance of the line.
The Company has entered into employment agreements with certain officers
which expire by December 31, 1999. The aggregate commitment for future
compensation under these agreements is approximately $990,000. These officers
are also eligible for annual bonuses based on performance.
On January 29, 1998, the Company received notice from the minority
partner in Telco, that pursuant to existing arrangements between them, it has
elected to exercise an option to cause the Company to acquire its interest in
Telco. The parties recently commenced negotiations with respect to the terms
of such acquisition, including the form and amount of the consideration.
There can be no assurance whether such acquisition ultimately will be
consummated, and if consummated, on terms favorable to the Company.
15. SUBSEQUENT EVENTS
VOICENET ACQUISITION. A definitive agreement to acquire VoiceNet was
entered into on January 28, 1998. The closing of the VoiceNet Acquisition
occurred on February 12, 1998. The initial purchase price for VoiceNet was
$21.0 million and was paid out of cash on hand. The sellers of VoiceNet also
are entitled to receive an earn-out based upon the revenue growth of the
VoiceNet business for a period of up to one year following the closing of the
acquisition.
VoiceNet provides travellers and other callers with calling card
services, which are advertised primarily in in-flight magazines. Econophone
has provided substantially all of VoiceNet's transmission, billing and
customer service functions since April 1996.
SENIOR DISCOUNT NOTES. During February 1998, the Company authorized the
issue and sale of Senior Discount Notes. The Notes will be unsecured
unsubordinated obligations of the Company, initially limited to $300 million
aggregate principal amount at maturity, and will mature on February 15, 2008,
Although for federal income tax purposes a significant amount of original
issue discount, taxable as ordinary income, will be recognized by the Holder
as such discount accrues from the Closing Date, no interest will be payable
on the Notes prior to February 15, 2003. From and after February 15, 2003,
interest on the Notes will accrue at 11.0% from February 15, 2003 or from the
most recent Interest Payment Date to which interest has been paid or provided
for, payable semiannually (to Holders of record at the close of business on
the February 1 or August 1 immediately preceding the Interest Payment Date)
on February 15 and August 15 of each year, commencing August 15, 2003.
Interest will be computed on the basis of a 360-day year of twelve 30-day
months.
F-18
<PAGE>
Item 7. Financial Statements, Pro Forma Financial Information and Exhibits.
c. Exhibits
23.1 Consent of Arthur Andersen LLP
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
ECONOPHONE, INC.
By: /s/ RICHARD L. SHORTEN, JR.
---------------------------
Name: Richard L. Shorten, Jr.
Title: Senior Vice President
and General Counsel
Dated: February 17, 1998
<PAGE>
EXHIBIT INDEX
23.1 Consent of Arthur Andersen LLP
<PAGE>
Exhibit 23.1
[Letterhead of Arthur Anderson LLP]
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
-----------------------------------------
As independent public accountants we hereby consent to the incorporation in
the Form 8-K of our report dated February 12, 1998. It should be noted that
we have not audited any financial statements of the company subsequent to
December 31, 1997 or performed any audit procedures subsequent to the date of
our report.
/s/ ARTHUR ANDERSEN LLP
- -------------------------
Arthur Andersen LLP
New York, New York
February 13, 1998
