<PAGE>
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): January 29, 1999
DESTIA COMMUNICATIONS, INC.
(Formerly Econophone, Inc.)
(Exact name of each registrant as specified in its charter)
Delaware
(State or other jurisdiction of incorporation)
33-33117 11-3132722
(Commission File Number) (IRS Employer Identification No.)
95 Rte. 17 South
Paramus, NJ 07652
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (201) 226-4500
<PAGE>
Item 5. Other Events.
On January 29, 1999, Destia Communications, Inc. (the "Company") issued
a press release announcing the change of its corporate name from "Econophone,
Inc." to "Destia Communications, Inc."
In addition, on January 29, 1999, the Company filed a registration
statement on Form S-1 (the "Registration Statement") for an initial public
offering of its common stock.
Included below are selected portions of the "Risk Factors" section of
the Registration Statement and the "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and "Business" sections of the
Registration Statement. 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 shares of the Company's common stock or any other
securities of the Company.
Some of the statements contained herein that are not historical facts,
including some statements made in the sections entitled
"Risk Factors," "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and "Business" are statements of future
expectations and other forward-looking statements pursuant to Section 21E of
the Securities Exchange Act of 1934, as amended. These statements are based
on management's current views and assumptions and involve known and unknown
risks and uncertainties that could cause actual results, performance or
events to differ materially from those expressed or implied in those
statements, including:
- the rate of expansion of the Company's network and/or customer base;
- inaccuracies in the Company's forecasts of telecommunications traffic
or customers;
- loss of a customer which provides Destia with significant revenues;
- concentration of credit risk;
- highly competitive market conditions;
- changes in or developments under laws, regulations, licensing
requirements or telecommunications standards;
- changes in the availability of transmission facilities;
- currency fluctuations;
- changes in retail or wholesale telecommunications rates;
- changes in international settlement rates;
- loss of the services of key officers, such as Alfred West, the
Chairman and Chief Executive Officer, or Alan L. Levy, the President
and Chief Operating Officer; and
- general economic conditions.
The foregoing important factors should not be construed as exhaustive.
The Company undertakes no obligations to update or revise any forward-looking
statements, whether as a result of new information, future events or
otherwise. See also "Risk Factors" for additional cautionary statements
identifying important factors with respect to forward-looking statements
contained herein that could cause actual results to differ materially from
results or expectations referred to in the forward-looking statements.
2
<PAGE>
RISK FACTORS
LIMITED OPERATING HISTORY
We have a limited operating history. We were founded in 1992 and before 1994
only conducted minimal business. In addition, we have only begun providing most
of our current services in most of our current markets since late 1996 or after
that time. See "Business--Products and Services."
We have had limited experience in most of the markets we currently serve and
intend to significantly expand the scale and scope of our operations in our
markets. As part of this expansion, we intend to introduce new services and
features including enhanced services such as voicemail, "follow me," data and
Internet access services that we have not historically offered to any
significant extent. We also intend to enter into new geographic markets where we
currently do not have operations. In 1999, the new geographic markets that we
intend to enter include Austria, Ireland, Italy and The Netherlands. These
expansion plans are subject to our obtaining any necessary authorizations,
including any governmental licenses, registrations or notifications that may be
required.
Our prospects must therefore be considered in light of the foreseeable and
unforeseeable risks, expenses, problems and delays inherent in an early stage
company substantially expanding its business in a rapidly evolving industry and
in new markets. Any of these factors could have a material adverse effect on our
business or the price of our common stock.
IMPLEMENTATION OF OUR EXPANSION PLANS
Our company is highly leveraged, which we hope will enhance the return to
our stockholders. However, our leverage makes our success, and the return to our
stockholders, extremely dependent on our ability to grow. To successfully
implement our goal of expanding and enhancing our business operations, we will
need to:
- successfully implement our marketing strategies;
- continue the development, expansion and integration of our network;
- obtain satisfactory and cost-effective ownership interests and lease
rights from, and establish interconnection arrangements with, competitors
that own transmission lines (in certain cases, intra-national transmission
lines may be available only from the dominant carrier in a particular
market (the "PTT");
- hire, retain and motivate highly productive sales personnel and
independent sales agents, particularly in Europe, where such individuals
are particularly difficult to identify and retain;
- continue to expand and develop our billing systems, order provisioning
processes, technical support, customer service and other back-office
capacity;
- enhance and expand our service features and offerings; and
- continue to attract and hire experienced corporate professionals.
If we fail to successfully implement these plans, it is likely that our
business and the price of our common stock would be materially adversely
affected.
3
<PAGE>
EXPANSION COSTS AND RISKS WILL BE SIGNIFICANT
We will incur significant costs as we attempt to expand. These costs
generally will be incurred in advance of anticipated related revenues, and may
cause substantial and unanticipated fluctuations in our operating results.
To increase our customer base and enhance our support of our customers, we
intend to substantially increase our sales and marketing and customer care
expenses, especially in our newer geographic markets and over the Internet. We
plan to conduct new sales and marketing campaigns. We also plan to hire
additional internal sales personnel. In addition, we intend to make significant
investments in our customer support, billing, order provisioning and other
information processing capabilities. These initiatives will be costly.
We also will make substantial capital expenditures. For 1999, we plan to
spend approximately $100 million for capital expenditures on network
equipment, back-office systems, the build-out of our network operations
center in St. Louis, Missouri, a transatlantic indefeasible right of use (an
"IRU") and other fiber optic transmission capacity. Actual capital
expenditures may be significantly different than our current plans, in part
because we intend to be opportunistic in acquiring transmission capacity in a
dynamic market. We also expect to have substantial capital expenditures after
1999. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Liquidity and Capital Resources."
We may seek to finance our capital expenditures by issuing additional debt
or equity securities. The issuance of debt would increase risk to our
stockholders. See "--Substantial Indebtedness, Future Losses and Negative
EBITDA." The issuance of equity would dilute our stockholders' ownership
interests in our company.
RISKS OF POTENTIAL ACQUISITIONS
We are not engaged in any negotiations regarding any material acquisitions,
but intend to pursue selected acquisitions and strategic alliances. Our ability
to engage in acquisitions will be dependent upon our ability to identify
attractive acquisition candidates and, if necessary, obtain financing on
satisfactory terms. The challenges of acquisitions include:
- potential distraction to management;
- integrating the acquired business's financial, computer, payroll and other
systems into our own;
- implementing additional controls and information systems appropriate to a
growing company;
- unanticipated liabilities or contingencies from the acquired company; and
- reduced earnings due to increased goodwill amortization, increased
interest costs and costs related to integration.
It is possible that we will pay for acquisitions using our common stock,
which would dilute our stockholders' ownership interests in our company. If we
are unsuccessful in meeting the challenges arising out of our growth, our
business and the price of our common stock could be adversely affected.
SUBSTANTIAL INDEBTEDNESS, FUTURE LOSSES AND NEGATIVE EBITDA
As of September 30, 1998 we had total consolidated indebtedness of
approximately $374.0 million and a stockholders' deficit of approximately $81.1
million. Furthermore, the 11% Senior Discount Notes due 2008 that we issued
during 1998 (the "1998 Notes") currently do not pay interest in cash, and from
September 30, 1998 to February 15, 2003 will accrete in value (i.e., effectively
increase in principal amount), by approximately $112.2 million. Thereafter,
interest on the 1998 Notes must be paid in cash. For the nine months ended
September 30, 1998, we had a net loss of $47.2 million, we had negative EBITDA
of $19.7 million and net cash used in operating activities was $28.8 million. We
expect to have operating losses and negative EBITDA and negative cash flow from
operations through at least 2000. We cannot be
4
<PAGE>
certain that we will ever operate at profitable levels or have positive EBITDA
or be able to repay principal and interest on money that we have borrowed. Our
failure to achieve any of these results would materially adversely affect our
business and the price of our common stock.
We expect that the proceeds of the offering of our common stock, together
with an equipment loan that we expect to obtain and our other cash resources,
will be sufficient to fund our budgeted capital expenditures and operations
until we generate positive cash flow from operations. However, if we make any
significant acquisitions of businesses or assets, or our business plans or
assumptions prove to be inaccurate, we may need to borrow more money, which
would increase our overall indebtedness.
If we are unable to generate sufficient cash flows from operations to pay
principal and interest on our indebtedness, we may be required to refinance some
or all of it. If we are not able to refinance our indebtedness on acceptable
terms or to borrow additional money, we could be forced to default on our
indebtedness obligations. This would have a material adverse effect on our
business and the price of our common stock.
The indentures pertaining to the $155.0 million in total principal amount
of 13 1/2% Senior Notes due 2007 (the "1997 Notes") and the 1998 Notes that
we have issued contain various restrictive covenants. All of these
restrictions, in combination with our highly leveraged financial situation,
could:
- limit our ability to react to changing market conditions, changes in our
industry or economic downturns;
- place us at a competitive disadvantage if we are not able to borrow money
on acceptable terms for future acquisitions, capital expenditures or other
purposes;
- increase the losses we will need to fund and require us to dedicate a
substantial portion of the cash flow from our operations, if any, to pay
our interest expense, which would make it more difficult to fund our
company's needs or plans; and
- make it more difficult for us to satisfy our debt obligations.
See "Management's Discussion and Analysis of Financial Condition and Results
of Operations--Liquidity and Capital Resources."
COMPETITION
The markets for all of our services are extremely competitive and we expect
competition to continue to intensify, particularly in continental Europe, where
many regulatory barriers have recently been reduced as part of an ongoing
regulatory liberalization. Competition results in customer "churn" or
"turnover." We believe that competition in many of our markets in Europe will
eventually become as strong as competition in the United States. For a
discussion of price competition, see the Risk Factor entitled "--Increasing
Pricing Pressures."
Many of our competitors are well-known, have substantially greater
financial, technical and marketing resources and larger networks than we do,
control a greater portion of their transmission lines and have long-standing
relationships with our target customers and the regulators in local markets.
Many of our larger competitors, such as AT&T, MCI WorldCom, Sprint, British
Telecom, Deutsche Telekom, France Telecom, Belgacom and SwissCom already have
universal name recognition. We also compete with alliances such as AT&T's
alliance with British Telecom. We believe that many of these competitors will
continue to increase the resources that they devote to marketing and selling
international and/or domestic long distance services in each of the markets
where we operate. As a result, we will face increasing pressure upon our ability
to acquire customers. These competitive pressures could materially adversely
affect our business and the price of our common stock.
Many of our larger competitors, particularly in the United States, also
offer customers an integrated full service telecommunications package consisting
of local and long distance voice, data and Internet
5
<PAGE>
transmission. We do not currently offer all of these types of services and only
intend to add some or all of such offerings over time. In particular, we have no
plan to offer local service in the United States.
In the United States, we expect that, in the near future, the Regional Bell
Operating Companies ("RBOCs"), which are the principal U.S. local telephone
companies, also may compete with us for long distance customers in their "in
region" service areas. RBOCs have to satisfy a list of competitive requirements
before they are authorized to offer long distance service to their local
customers. No RBOC is authorized to do so yet, but they are expected to be
authorized soon. When they are authorized, they will be very formidable
competitors. In particular, Bell Atlantic, which serves the New York
metropolitan and mid-Atlantic regions, is considered by industry observers to be
the RBOC most likely to be the first permitted to offer long distance services.
Because a substantial portion of our customer base and traffic originates in the
New York metropolitan area, Bell Atlantic will be a particularly formidable
competitor.
In many foreign markets where we do business, our principal competitor is
the government-owned or quasi-governmental PTT, which has a long history of
influence and control over the telecommunications market in its country. This
history provides the PTT with certain inherent competitive advantages over other
providers, including:
- their control of "interconnection," which is the direct connection at one
or more switches between a competing carrier (such as our company) and the
PTT, which owns the lines to virtually every telephone in the country;
- their extensive, and in many cases exclusive, 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
approval that will result in increased competition for the local PTT.
For example, in England a caller must dial a four-digit prefix before every
call in order to select our long distance service. If a customer does not dial a
prefix, the call is automatically carried by British Telecom. In France, only
seven carriers have been granted regulatory approval to provide long distance
service using a single digit prefix. We are not one of these carriers. Thus, a
caller in France must dial a four-digit prefix in order to select our long
distance service. In Germany, Deutsche Telekom recently proposed, subject to
regulatory approval, levying a fee of approximately 50 Deutsche Marks ("DM") on
any customer that desires to change long distance service providers. In Greece,
regulatory restrictions prohibit us from offering long distance services other
than value-added services or services to closed user groups (i.e., we cannot
offer services to the general public). Furthermore, because competition has only
recently been allowed in most of our European markets, the customers of PTT's
may be reluctant to entrust their telecommunications needs to new providers,
such as Destia.
We also may experience competition from competitors that use new or
different technologies and/or transmission methods, including Internet service
providers, 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. While few of these types of
competitors have been able to gain any material market share for our principal
services to date, technological advances may enable one or more of them to
provide attractive alternative services. For example, we expect flat-rate
nationwide cellular phone plans to offer increasingly formidable competition to
our calling card services. In the United Kingdom, cable companies have been very
successful in entering the telecommunications market. See "Business-- Products
and Services."
INCREASING PRICING PRESSURES
We compete for customers based primarily on price. Price competition for all
of our services is intensive, but it is particularly acute for our U.S. prepaid
card and calling card services.
6
<PAGE>
Many of our larger competitors have lower per call transmission costs than
we have. They own more transmission capacity, have more favorable
interconnection rates and obtain larger volume discounts from suppliers. We have
no control over the prices set by our competitors, and when our competitors
reduce their prices, we must reduce our prices.
Industry observers predict that prices will continue to drop. This trend
will in part be due to the increase in the number of carriers with international
transmission networks. By having their own international networks, carriers are
able to substantially reduce their variable transmission costs, which enables
them to offer lower retail and wholesale prices. If this trend continues, we
expect to experience a substantial reduction in our gross margins for
international calls, which, absent a substantial increase in traffic carried or
charges for additional services, would have a material adverse effect on our
business and the price of our common stock.
We expect that retail telecommunications rates in all of our principal
markets, particularly in continental Europe and Canada, will continue to
decrease rapidly. Some of the factors that will affect price competition for our
services are discussed below.
PRICE COMPETITION IN EUROPE
We anticipate that continuing deregulation will cause significant retail
price declines, similar to the price declines experienced in the United States
and being experienced in the United Kingdom as a result of deregulation in those
countries.
For example, each of our PTT competitors in Europe has taken steps to
substantially reduce retail prices in an effort to protect its market share and
deter competitors. In this regard, France Telecom has obtained approval to
reduce retail prices on domestic and international long distance services by an
average of 4.5% during each of 1999 and 2000. In the United Kingdom, the
national regulatory authority has put downward pressure on British Telecom's
retail prices by imposing a price cap on its retail prices for residential
services. In Germany, Deutsche Telekom has recently announced that it will
reduce its retail long distance rates by as much as 60%.
In certain European countries, carriers that make significant investments in
infrastructure have cost advantages over other carriers. For example, in France
and Belgium, "facilities-based" carriers that make investments in infrastructure
receive lower interconnection rates than non-facilities-based providers. We are
not a "facilities-based" provider within the meaning of French and Belgian
regulations.
The rapid reduction of retail prices by PTTs in continental Europe places
increasing pressure on us to reduce our costs in order to preserve and improve
our gross margins. Because of the expansion of the Destia Network and reductions
in wholesale transmission costs, we have been able to avoid substantial declines
in gross margins. As retail prices continue to fall, we will be subject to
increasing pressure, which could have a material adverse effect on our business
and the price of our common stock.
COLLAPSE OF THE INTERNATIONAL SETTLEMENT REGIME
Prices for international long distance calls are determined in part by
international settlement rates, which are the rates that a carrier (often a PTT)
charges to terminate an international call in its home country. These rates were
traditionally set at arbitrary, artificially high levels that enabled many
carriers to enjoy high gross margins on international calls. International
settlement rates have been declining for the last several years and an
increasing number of calls are being placed outside the international settlement
rate system, resulting in drastically lower prices. Industry observers believe
that the combined effects of deregulation, excess transmission capacity,
advances in technology and the negligible marginal cost to a carrier that owns
its own switches and transmission facilities of carrying an international call,
are gradually causing the collapse of the international settlement rate system.
Practices such as "refile" (where traffic originating from a particular country
is rerouted through another country with a lower settlement rate), off
settlement rate terminations (where a local carrier agrees to terminate an
international call at rates below
7
<PAGE>
the settlement rates) and transit (where a carrier agrees to terminate another
carrier's traffic to a particular country at a negotiated price other than the
settlement rate) are becoming increasingly common.
Settlement rates also are being reduced as a result of regulatory
initiatives. Lower settlement rates are scheduled to be in effect for
substantially all countries over the next several years. Lower settlement rates
will reduce our per call revenue, which could have a material adverse effect on
our business and the price of our common stock.
PRICE COMPETITION FROM INTERNET TELEPHONY
The increased use of voice services over the Internet also is expected to
result in a further reduction in prices. Competition from Internet telephony is
expected to come from both Internet service providers and telephone companies.
For example, AT&T and MCI WorldCom have begun to offer voice telecommunications
services over the Internet at substantially reduced prices. While the provision
of voice telephony over the Internet historically has been characterized by
lower standards of quality, technological improvements may result in
Internet-based voice telephony becoming a strong competitor to voice services
that are typically offered by carriers today.
In the United States, providers of Internet telephony also benefit from an
inherent cost advantage because their traffic is considered data, rather than
voice telephony. This allows them to avoid paying access fees to RBOCs and other
local telephone companies, while providers of traditional long distance services
are required to pay such fees.
DEPENDENCE ON THIRD PARTY SALES ORGANIZATIONS
We sell a substantial portion of our services through indirect channels of
distribution, which consist of independent sales agents, distributors and, to a
lesser extent, resellers ("Third Party Agents").
We believe that our relationships with our Third Party Agents are good.
However, we do not have control over Third Party Agents or their agents and
employees. We therefore cannot be certain that they will perform in a
satisfactory manner or that their interests will be aligned with ours. In
addition, Third Party Agents also may terminate their business relationships
with us at any time, with little or no prior notice. They could do this if our
competitors offer them increased sales incentives. This risk is especially
pronounced in our multi level marketing program in the United Kingdom, where a
master agent could determine to terminate its business relationship (and that of
its sub-agents) with us and conduct business with a competitor, although the
agent would be contractually obligated to leave its customers with us.
Unsatisfactory performance by Third Party Agents, or the termination by them of
their business relationship with us, would hinder our ability to continue to
grow and could have a material adverse effect on our business and the price of
our common stock.
Recent European Union ("EU") regulations pertaining to commercial agents
provide sales agents with far greater protection than that provided by prior
legislation, and could result in increased termination payments in the event of
a dispute with a Third Party Agent.
We previously experienced disputes with some of our independent sales
agents. In connection with a change in our distribution strategy in the United
Kingdom, in late 1996, we entered into a settlement agreement with Europhone
International ("EI"), our former partner in a U.K. sales and marketing joint
venture. Under the terms of the settlement, among other things, EI retained all
of the rights in the customer list of the joint venture. For 1996, our joint
venture with EI and sales of carrier services to EI contributed 32% of our
consolidated revenues and 92% of our U.K. originated revenues. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."
8
<PAGE>
IMPORTANCE OF CARRIER AND OTHER WHOLESALE CUSTOMERS
Carrier customers generally are extremely price sensitive, generate very low
margin business and frequently move their traffic from carrier to carrier based
solely on small price changes. These changes occur as frequently as daily.
Furthermore, there are numerous examples of small carriers obtaining service and
credit terms from other carriers, reselling this service to customers at a loss
in order to quickly build revenue and then refusing to pay the carrier bills
when they come due. In the deregulating markets in Europe, these risks are
particularly acute. Therefore, we could be exposed to a material credit risk
over a very short period of time. We maintain a reserve for doubtful accounts
receivable and periodically write off specific accounts receivable. We believe
that our credit criteria enable us to reduce our exposure to these risks.
However, we cannot be certain that our criteria will afford adequate protection
against these risks.
From January 1, 1997 through September 30, 1998, our sales of transmission
capacity to carrier customers ranged from 13% to 30% of our consolidated
revenues on a quarterly basis. During 1999, we intend to increase our carrier
revenues, although our business will continue to be predominantly focused on
retail sales. This may make us more susceptible to the risks associated with
carrier customers. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
REGULATORY RESTRICTIONS
Regulation of the telecommunications industry is changing rapidly, both
domestically and internationally. Although we believe that deregulation efforts
will create opportunities for us, they also present risks.
As an international telecommunications company, we are subject to varying
degrees of regulation in each of the jurisdictions in which we provide our
services. Laws and regulations differ significantly among the jurisdictions in
which we operate. There can be no assurance that future regulatory, judicial and
legislative changes will not have a material adverse effect on our company or
that domestic or international regulators or third parties will not raise
material issues with regard to our compliance with applicable regulations.
In the United States, regulatory considerations that affect or limit our
business include, but are not limited to:
- restrictions on our use of leased lines;
- universal service fund contribution requirements;
- local access charges that we are required to pay to local exchange
carriers ("LECs");
- payphone access charges that we are required to pay;
- regulations relating to "slamming" and related penalties, which recently
have been severe; and
- regulations concerning use of customer proprietary information in cross
marketing efforts.
In Europe, regulatory considerations that affect or limit our business
include, but are not limited to:
- EU directives pertaining to equal access and number portability;
- implementation of national legislation giving effect to EU directives;
- EU directives relating to data protection and customer privacy; and
- temporary license and/or interconnection regimes.
In addition to the regulatory considerations indicated in this Risk Factor,
see also "--Need for Interconnection." Also see "Business--Regulation" for a
discussion of these and certain other regulatory risks and considerations
relevant to our business.
9
<PAGE>
NEED FOR INTERCONNECTION
In each jurisdiction in which we operate, a monopoly or former monopoly owns
the only line to an overwhelming majority of the telephones. Therefore, we need
to interconnect with these monopolies or former monopolies.
In the United States, LECs are required to provide interconnection at
regulated rates. Outside the United States, interconnection can be obtained
through interconnection agreements negotiated directly with the PTTs (such as
our PTT interconnection agreements in the United Kingdom, Belgium, Germany,
France, The Netherlands and Switzerland), or indirectly through other parties
that have direct interconnection with the PTT. Interconnection agreements with
PTTs typically provide for substantially more favorable access and termination
rates and other benefits, such as the ability to offer customers abbreviated
dialing. As a practical matter, interconnection with the PTT is a prerequisite
to offering cost-effective services to customers in local markets. The
availability and rates of interconnection are determined on a country-by-country
basis. The failure to obtain interconnection on commercially acceptable terms,
particularly in key markets, could have a material adverse effect on our
business and the price of our common stock.
CONSIDERATIONS AFFECTING INTERCONNECTION IN EUROPE
Regulations governing interconnection are not as developed and favorable to
us in most of continental Europe as in the United States and the United Kingdom.
We have been successful to date in obtaining interconnection in most of our
major network cities in continental Europe. However, we have experienced delays
in obtaining interconnection from some PTTs. However, we cannot be certain that
we will be able to maintain all of our interconnections, obtain additional
interconnection in current network cities (which would increase our ability to
handle larger traffic volumes) or obtain interconnection in additional cities,
in each case on acceptable terms, on a timely basis or at all. In addition, in
continental European cities where we have interconnection through private
parties, we cannot be certain that we will be able to satisfactorily migrate to
interconnection agreements with PTTs.
In continental Europe, we generally must obtain our local connectivity
directly from the PTTs, which are our primary competitors in that region. The
PTTs have only recently begun the process of providing interconnection to other
carriers and in many cases have delayed doing so.
Our interconnection to the PTT in Belgium has been granted on a temporary
basis pending the adoption of certain new telecommunications legislation in
Belgium. Our interconnection in Germany to Deutsche Telekom's network expires on
February 28, 1999. We expect our temporary interconnections in Belgium and
Germany to be extended until relevant national legislation or regulations,
respectively, pertaining to permanent interconnection are adopted, although
there can be no assurance that either of them will be extended. If we were to
lose either interconnection, we would need to obtain interconnection from
another carrier, which would increase our transmission costs in that country.
See "Business-- Regulation--Belgium" and "Business--Regulation--Germany."
CONSIDERATIONS AFFECTING INTERCONNECTION IN THE UNITED STATES
In the United States, we obtain interconnection from LECs. Because per
minute retail rates on U.S. domestic long distance calls are low, the access and
termination costs charged by LECs to long distance providers make up a
significant portion of the total cost of these calls. If a LEC increases its
access and termination charges, our margins on domestic long distance calls to
that LEC's home region would be materially adversely affected. In addition, when
LECs are able to offer long distance services to their local customers, they
will not have to pay these access charges. This will put us at a competitive
disadvantage to the LECs.
10
<PAGE>
DEPENDENCE ON TRANSMISSION LINE PROVIDERS
Transmission lines are the connections that carry substantially all of our
voice and data communications. We have not constructed our own fixed
transmission lines and we do not have any plans to do so. Instead, we either
acquire ownership or a long-term right to use the facilities of another carrier
or consortium of carriers (I.E., an IRU) or we lease our transmission capacity
on a short-term basis.
RISKS RELATING TO U.S. TRANSMISSION ARRANGEMENTS
In the United States, we currently have a lease arrangement with Qwest that
provides us with most of our U.S. transmission capacity. By primarily using one
transmission provider in the United States, we are able to obtain more favorable
leased line charges, although it increases our dependence on a single
transmission provider.
Because of the substantial increase in our domestic traffic and our desire
to provide services in more U.S. markets, we recently acquired a 20-year IRU
from Frontier to use its U.S. fiber optic network. This will replace our use of
the Qwest network. Frontier is in the process of building the fiber optic
network that we will use. The buildout of Frontier's planned network is
approximately 60% completed and we expect it to be fully operational by the end
of 1999, although there can be no assurance in this regard. If the Frontier U.S.
fiber optic network is not completed within this time frame, we will need to
obtain more expensive transmission capacity from other network providers, which
will reduce our gross margins on substantially all of our U.S. calls. See
"Business--The Destia Network--North American Network."
Because we will obtain most of our U.S. transmission capacity from Frontier,
network failures or quality problems experienced by Frontier will affect us.
Furthermore, because the network will be managed by Frontier and not by our own
personnel, we will not have the ability to directly remedy network problems. If
Frontier is not able to adequately manage and maintain the network or our
interconnection, we could experience quality and reliability problems, which
would require us to secure more expensive transmission capacity. In the past,
Frontier has experienced problems with its existing network, which utilizes
technology different from that of its new network. We cannot be certain that
similar problems will not arise with Frontier's new network or with the
technology utilized in the network. This could have a material adverse effect on
our business and the price of our common stock.
RISKS RELATING TO ACQUIRING LINES FROM PTTS
In several European countries, including France and Germany, the only
large-scale providers of transmission facilities are the PTTs. In these
countries, we may be required to acquire or lease transmission capacity at
artificially high rates from a provider that occupies a monopoly or near
monopoly position. In some areas, PTTs may not be required by law to provide us
with the transmission capacity that may be required to implement our anticipated
growth plans.
Even when PTTs are required by law to provide transmission capacity to other
carriers, we and other private carriers have experienced recurring and
substantial delays in the negotiation of leases and interconnection agreements
and in the commencement of operations.
RISKS RELATING TO CAPACITY PURCHASE AND LEASE TERMS
Under our short-term lease arrangements, we typically acquire transmission
capacity on a fixed cost basis for a term of one month, one year or, in the case
of our current arrangement with Qwest, three years. Our long-term capacity
arrangements are for periods of up to 20 or 25 years. Our IRU from Frontier for
our domestic network and our IRU agreements providing us with capacity on
various transatlantic crossings are long-term capacity arrangements. See
"Business--The Destia Network--Network Economics."
11
<PAGE>
When we negotiate purchase and lease agreements and make a determination to
acquire a long-term lease or ownership of transmission capacity rather than a
short-term lease, we must estimate the future supply and demand for transmission
capacity, as well as our customer calling patterns and traffic levels. Our
profitability depends, in part, on our ability to obtain capacity on a
cost-effective basis and determine when it is appropriate to buy transmission
capacity or lease it on a long-term basis, rather than to lease it on a
short-term basis. We could suffer competitive disadvantages if we base our
acquisitions of transmission capacity on inaccurate projections.
DEPENDENCE ON EFFECTIVE INFORMATION SYSTEMS
In order to bill our customers, we must record and process large amounts of
data quickly and accurately. While we believe our management information systems
currently are adequate, if our customer base continues to increase, we will need
to continue to make substantial investments in new and enhanced information
systems. If we encounter delays or cost-overruns or suffer adverse consequences
in implementing these systems, there could be a material adverse effect on our
ability to grow our business, which could have a material adverse effect on our
business and the price of our common stock. See "Business--The Destia
Network--Network Operations."
As our information systems suppliers revise and upgrade their hardware,
software and equipment technology, we may encounter difficulties in integrating
these new technologies into our business; in addition, these new revisions and
upgrades may not be appropriate for our business.
DEVALUATION AND CURRENCY RISKS
A substantial portion of our revenues and expenses are denominated in
non-U.S. currencies, consisting principally of the British pound and the
currencies represented by the euro. Although our business strategy contemplates
that an increasing portion of our revenues and expenses will be denominated in
non-U.S. currencies, a disproportionate portion of our expenses, including
interest and principal on our indebtedness, will nevertheless continue to be
denominated in U.S. dollars. This exposes us to fluctuations in the rate of
exchange between foreign currencies and the U.S. dollar. Significant exchange
rate fluctuations could have a material adverse effect on our business and the
price of our common stock.
At times, we use foreign exchange contracts to hedge foreign currency
exposure resulting from our non-U.S. trade accounts receivables. Because of the
number of currencies involved, our constantly changing currency exposure and the
fact that all foreign currencies do not fluctuate in the same manner against the
U.S. dollar, we cannot quantify the effect of exchange rate fluctuations on our
future financial condition or results of operations.
DEPENDENCE ON KEY PERSONNEL; INTEGRATION OF MANAGEMENT AND OTHER PERSONNEL
Our success depends largely on the skills, experience and performance of key
members of our senior management team. If we lose one or more of these key
employees, particularly Alfred West or Alan L. Levy, our ability to successfully
implement our ambitious business plan and the price of our common stock could be
materially adversely affected. We have employment agreements with certain senior
employees, but we cannot prohibit our employees from leaving.
Under our equipment financing agreement (the "NTFC Agreement"), we may not
cease to employ Mr. West (other than by reason of his death or disability) or
let Mr. West compete with us. If we were to breach our equipment financing
agreement, we would be in default, which would require us to prepay all
borrowings outstanding thereunder, which would cause a default under the
indenture in connection with the 1997 Notes (the "1997 Indenture") and the
indenture in connection with the 1998 Notes (the "1998
12
<PAGE>
Indenture") and could require prepayment of all amounts outstanding on the 1997
Notes and the 1998 Notes. That would have a material adverse effect on our
business and the price of our common stock.
YEAR 2000 TECHNOLOGY RISKS
We face certain risks arising from Year 2000 issues. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--Year
2000 Compliance" for a discussion of certain risks relating to Year 2000 issues.
DEPENDENCE ON OUR PRINCIPAL EQUIPMENT SUPPLIER
We purchase a significant portion of our switching equipment from Northern
Telecom. We also rely on Northern Telecom for a substantial portion of our
technical support for this equipment. From time to time, Northern Telecom also
introduces software and hardware upgrades, which increase the efficiency and/or
features of our switching equipment. These upgrades frequently can be purchased
only directly from Northern Telecom. Northern Telecom is aware of our reliance
on them for our network hardware and we believe that this may put us at a
disadvantage in our negotiations with them to acquire network hardware at
reasonable prices. See "Business--The Destia Network--Network Hardware and
Software."
As we continue to expand our network (the "Destia Network"), we cannot be
certain that we will be able to acquire all of the compatible equipment that
we require. Our inability to acquire network hardware on a timely basis or at
a reasonable price could result in delays, operational problems or increased
expenses, any of which could have a material adverse effect on our business
and the price of our common stock.
13
<PAGE>
In addition, we intend to adopt a shareholder rights plan prior to the
completion of this offering. Our shareholder rights plan would cause substantial
dilution to any person or group that attempts to acquire our company on terms
not approved in advance by our Board of Directors.
Section 203 of the Delaware General Corporation Law (the "DGCL") also
imposes certain restrictions on mergers and other business combinations
between us and any holder of 15% or more of our common stock. By its terms,
the prohibitions of Section 203 of the DGCL are not applicable to Messrs.
Alfred West, Steven West and Gary Bondi. In addition, certain of our
employment agreements provide for payments to be made to the employees
thereunder if their employment is terminated in connection with a change of
control.
Certain provisions of the DGCL, our shareholder rights plan and some of our
employment agreements may delay, deter or prevent someone from acquiring or
merging with us, including in a transaction that results in stockholders
receiving a premium over the market price for the shares of common stock held by
them.
In addition to the foregoing, under the 1997 Indenture and the 1998
Indenture, we must commence, within 30 days of the occurrence of a change of
control, an offer to purchase all the 1997 Notes and 1998 Notes then
outstanding, at a purchase price equal to 101% of the principal amount or
accreted value (as applicable) of such notes on the relevant payment date,
plus accrued interest (if any) to the payment date. We cannot be certain
whether we will have sufficient funds available at the time of any change of
control to make any payment required by the foregoing covenant (as well as
any payment that may be required pursuant to any other outstanding
indebtedness at the time, including our indebtedness to our equipment
financing lender). The foregoing covenants may also deter third parties from
entering into a change of control transaction with us.
14
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
OVERVIEW
The Company is a rapidly growing, facilities-based provider of domestic and
international long distance telecommunications services in North America and
Europe. Its extensive international telecommunications network allows it to
provide services primarily to retail customers in many of the largest
metropolitan markets in the United States, Canada, the United Kingdom, Belgium,
France, Germany and Switzerland.
The Company provides its customers with a variety of retail
telecommunications services, including international and domestic long distance,
calling card and prepaid services, and wholesale transmission services. The
Company's 350,000 customer accounts are diverse and include residential
customers, commercial customers, ethnic groups and telecommunications carriers.
In each of the Company's geographic markets, it utilizes a multichannel
distribution strategy to market its services to its target customer groups.
REVENUES
The Company's revenues are primarily based on usage and are derived from the
number of minutes of telecommunications traffic carried at a fixed per minute
charge. The following table shows the total revenue and billable minutes of use
attributable to the Company's operations by region for the nine months ended
September 30, 1997 and 1998. Over time, the Company expects its European markets
to contribute an increasingly larger percentage of its revenues.
<TABLE>
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30,
------------------------------------
<S> <C> <C> <C>
1997 1998 % CHANGE
--------- ---------- -------------
<CAPTION>
(IN THOUSANDS)
<S> <C> <C> <C>
REVENUE
United States.............................................. $ 32,492 $ 80,354 147%
United Kingdom............................................. 9,330 45,555 388%
Continental Europe......................................... 11,316 15,047 33%
--------- ---------- ---
Total...................................................... $ 53,138 $ 140,956 165%
--------- ---------- ---
--------- ---------- ---
BILLABLE MINUTES OF USE
United States.............................................. 156,835 366,655 134%
United Kingdom............................................. 29,951 211,478 606%
Continental Europe......................................... 11,241 29,181 160%
--------- ---------- ---
Total...................................................... 198,027 607,314 207%
--------- ---------- ---
--------- ---------- ---
</TABLE>
The Company generally prices its services at a discount to the primary
carrier (or carriers) in each of its markets. The Company has experienced and
expects to continue to experience declining revenue per minute in all of its
markets as a result of increased competition. However, the Company believes such
declines in revenue per minute will be offset in part by an increased demand for
long distance services and declining costs of transmission. Historically,
transmission costs in the telecommunications industry have declined at a more
rapid rate than prices due to technological innovation and the availability of
substantial
15
<PAGE>
transmission capacity. There can be no assurance that this cost trend will
continue. See "Risk Factors-- Increasing Pricing Pressures."
The Company's revenues are recorded upon completion of calls. For prepaid
services, the Company's revenues are reported net of selling discounts and
commissions and upon usage rather than sale.
COST OF SERVICES
The major components of the Company's cost of services include the cost of
origination, transmission and termination of traffic. In general, the Company
pays a per minute charge to originate and terminate calls. However, in
continental Europe, origination charges on calls utilizing local dial-up access
are paid by the Company's customers. In countries where the Company has
interconnection, it is able to originate and terminate calls more
cost-effectively, either pursuant to fixed price contractual arrangements with
PTTs or LECs or pursuant to a tariff.
The Company's transmission cost of services consists of expenses related to
leased lines and switched minutes. The Company typically acquires leased lines
on a fixed cost basis, which involves monthly payments regardless of usage
levels. Leased lines are used for specific point-to-point routes and have a
shorter duration than IRUs. Because the cost of leased lines involve a fixed
monthly payment, transmitting an increased portion of the Company's calls over
leased lines reduces its incremental transmission costs. Accordingly, once
certain traffic volume levels are reached, leased line capacity is more cost
effective than capacity acquired on a variable cost basis, such as switched
minutes.
To terminate calls in locations not covered by its network, the Company
acquires switched minutes from other carriers. Switched minutes are acquired on
a per minute basis (with volume discounts) and, accordingly, are a variable
cost. The cost of switched minutes also includes origination and termination
charges. As the Company's minutes of traffic carried have grown, the Company has
obtained better pricing on switched minutes transmission capacity. In general,
the Company expects its marginal cost of services will decline over time due to
greater usage of owned transmission capacity, technological innovation and the
availability of substantial third-party transmission capacity.
A substantial portion of the Company's calls are also transmitted over its
IRUs. The cost of IRUs is expensed in depreciation and amortization and is,
therefore, not accounted for as part of cost of services.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
To date, the Company has sold its services primarily through independent
sales channels. Selling expenses have, therefore, primarily consisted of
commissions paid to agents and resellers. To a lesser extent, the Company
also has incurred selling expenses arising out of advertising and promotion
costs, sales by the Company's internal sales force and expenses related to
its customer service department. Since the consummation of the acquisition of
VoiceNet during the first quarter of 1998, commissions paid to and retained
by VoiceNet (i.e., commissions not subsequently paid by VoiceNet Corporation
("VoiceNet") to its independent sales agents) have been eliminated.
The Company is continuing to increase its internal sales force and this
expansion will significantly increase the selling expenses associated with
operating and staffing sales offices. In addition, as the Company expands its
customer base in new and existing markets, it also intends to increase its
advertising expenses. The Company expects all of these costs to eventually
decline as a percentage of its revenues over time. General and administrative
expenses have increased primarily as a result of expanding the Company's
customer service, billing, financial reporting and other management information
systems and network management systems and organizational expenses related to
entering additional markets.
16
<PAGE>
DEPRECIATION AND AMORTIZATION EXPENSE
The Company's depreciation and amortization expense is primarily related to
depreciation on the Company's IRUs and switching equipment, amortization of
costs associated with the issuance of the 1997 Notes and 1998 Notes and the
amortization of goodwill from the purchase of VoiceNet and of the 30% interest
in Telco Global Communications ("Telco") that the Company did not already own.
As the Company expands the Destia Network, it will continue to add new
switching equipment and acquire additional IRUs, both of which will increase the
Company's depreciation expense. IRUs involve only fixed costs, with no per
minute charges, and are a more cost-effective means of transmitting traffic once
certain volume levels are reached. The Company recently acquired a 20-year IRU
from Frontier which provides it with fiber optic transmission capacity in the
United States and also intends to acquire additional IRUs, particularly in
Europe. To the extent the Company's increased use of IRUs reduces its
utilization of leased lines and switched minutes, the increase in depreciation
expense will be offset, in part, by a decrease in its cost of services. As a
result, the Company's gross margins will improve, although the Company's net
income will not necessarily improve.
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 and 1998 Notes currently constitute most of the
Company's interest expense. Annual interest expense for the 1997 Notes and
1998 Notes will aggregate $43.3 million in 1999. The 1998 Notes were issued
at a discount and accrete to their aggregate principal amount at maturity on
February 15, 2003. Thereafter, interest on the 1998 Notes will be required to
be paid in cash.
RESULTS OF OPERATIONS
NINE MONTHS ENDED SEPTEMBER 30, 1998 COMPARED TO NINE MONTHS ENDED SEPTEMBER
30, 1997
REVENUES. Revenues for the nine months ended September 30, 1998 increased
165% to $141.0 million from $53.1 million for the nine months ended September
30, 1997. Billable minutes of use increased 207% to 607.3 million in the first
nine months of 1998 from 198.0 million in the comparable prior year nine-month
period. The year-to-year revenue increase was primarily attributable to strong
customer growth in both the U.S. and U.K. markets.
Revenues for all products increased substantially from 1997 to 1998. The
increase in revenues resulting from the growth in billable minutes was partially
offset by per-minute price reductions caused by increased competition, most
significantly in the U.K. and continental European markets.
GROSS PROFIT. The gross profit margin of 26.9% reported for the nine-month
period ended September 30, 1998 increased 4.2% from the 22.7% achieved in the
nine-month period ended September 30, 1997. This increase was attributable to
network expansion and increased utilization of transmission capacity which
contributed to lower per-minute costs.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses in 1998 were $57.1 million, representing 40.5% of
revenue, compared to $22.5 million in 1997, or 42.4% of revenue. The decrease in
selling, general and administrative expenses as a percentage of revenues during
1998 was primarily attributable to the significant increase in revenues from the
nine-month period of the prior year.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expenses
increased to $7.1 million for the nine-month period ended September 30, 1998
from $2.2 million for the nine-month period ended September 30, 1997. This
increase was substantially due to the continuing build-out of the Company's
network in the United States, the United Kingdom and continental Europe and
amortization of costs
17
<PAGE>
associated with the Company's issuance of 1997 Notes and the 1998 Notes and the
amortization of goodwill from the purchase of VoiceNet and Telco.
INTEREST EXPENSE AND INTEREST INCOME. Interest expense increased to $29.4
million in 1998 from $5.8 million in the prior year comparable period. This
increase was attributable to the issuance of the 1997 Notes and the 1998 Notes.
Interest income increased to $9.0 million in 1998 from $1.8 million in the
comparable period of 1997. This increase was primarily due to interest income
earned on the investment of the net proceeds received in connection with these
offerings.
NET LOSS. The Company reported a net loss of $47.2 million for the
nine-month period ended September 30, 1998 compared to a net loss of $16.5
million for the comparable period of 1997. The increase is primarily due to the
higher level of selling, general and administrative expenses and higher debt
service costs.
The following table presents certain data concerning the Company's results
of operations for 1995, 1996 and 1997.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31
-------------------------------
<S> <C> <C> <C>
1995 1996 1997
--------- --------- ---------
<CAPTION>
(IN THOUSANDS)
<S> <C> <C> <C>
Revenues..................................................... $ 27,490 $ 45,103 $ 83,003
Cost of services............................................. 19,735 35,369 63,707
Selling expenses, general and administrative expenses........ 7,087 16,834 37,898
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 partially
offset by the termination of the Company's business relationship with EI,
which accounted for $14.2 million in revenues in 1996. During the fourth
quarter of 1996, the Company 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 America Telemedia, Limited ("ATL"), a
wholly-owned subsidiary of the Company. 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.
18
<PAGE>
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 the Company'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, the Company 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, the Company's revenues and margins
have not been materially impacted by its "churn" rate. The Company's "churn"
rate with respect to any given period consists of the average number of
customers that ceased using the Company's services during any month during the
period divided by the average monthly number of customers for the period.
Customers that have ceased using the Company's services during any given month
are those customers who used the Company'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 the
Company during the period, as well as obtaining better prices on switched
transmission capacity because of the growth of the Company's minutes of traffic
and more available capacity.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased to $37.9 million for 1997 from $16.8 million
for 1996, and, as a percentage of revenues, were 46% for 1997 and 37% for 1996.
The increase primarily consisted of commissions paid to resellers (principally
VoiceNet) and independent agents, an increase in payroll costs related to
additional management and staff in the areas of finance, sales, customer service
network management and information systems at the Company's Manhattan, New York,
Brooklyn, New York and College Station, Texas facilities, as well as the London,
Brussels, Hamburg and Paris offices. For 1996, a majority of the expenses
consisted of expenses related to EI and commissions paid to independent sales
agents.
In connection with the termination of the Company's joint venture with EI
during June 1996, EI granted the Company the right to compete with EI in the
United Kingdom in exchange for forgiveness of a net receivable due to the
Company 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. The
Company 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. The Company 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 the Company'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. The Company 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. The Company 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.
19
<PAGE>
NET LOSS. The Company 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.
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, the Company 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 the Company's relationship with EI discussed
below.
In the United Kingdom, revenues grew 9% to $15.5 million. The Company's U.K.
revenues were limited in 1996 due to a restructuring of the Company'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, the Company effectively
terminated its joint venture with EI, pursuant to which EI had the exclusive
right to sell the Company's services in the United Kingdom. In exchange for the
Company being granted the right to compete in the United Kingdom, the Company
forgave a net receivable of $2.0 million and agreed to sell transmission to EI
at lower rates than that charged 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. The Company 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 the Company $2.2 million on an agreed upon payment
schedule, substantially all of which has been paid. In addition, the Company
agreed not to solicit sales from customers of the joint venture, subject to
certain permitted exceptions.
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 the Company's
relationship with EI on June 1, 1996, which included a reduction in prices
charged to EI as compared to the prices charged to the Company'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, the Company'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 the Company's relationship with EI on June 1, 1996,
pursuant to which the Company agreed to charge a lower transmission rate to EI,
thereby reducing
20
<PAGE>
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, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and
administrative expenses increased to $16.8 million for 1996 from $7.1 million
for 1995, and, as a percentage of revenues, increased to 37% in 1996 from 26% in
1995. This increase was primarily due to increases in the size of the Company's
customer service department and, starting in August 1996, a substantial increase
in the Company'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 as well as expenses related to EI and
commissions paid to independent sales agents.
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 the
Company's switch in New York and installation of multiplexing equipment in New
York and London.
BAD DEBT EXPENSE. The Company 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.
LIQUIDITY AND CAPITAL RESOURCES
The Company has incurred significant operating and net losses and made
substantial capital expenditures, due in large part to the start-up and
development of the Company's operations and the Destia Network. The Company will
incur additional losses and have substantial additional capital expenditures.
The Company has utilized cash provided from financing activities to fund losses
and capital expenditures. The sources of this cash have primarily been the
proceeds from the sale of the 1997 Notes and the 1998 Notes and, to a lesser
extent, equipment-based financing.
As of September 30, 1998, the Company had $153.5 million of cash, cash
equivalents and marketable securities. The Company believes that the net
proceeds of this offering, equipment loans it expects to obtain and cash on hand
will provide sufficient funds for the foreseeable future. However the amount of
the Company's future capital requirements will depend on a number of factors,
including success of its business, its gross margins, and its selling, general
and administrative expenses, as well as other factors, many of which are not
within its control, including competitive conditions, regulatory developments
and capital costs. In the event that the Company's plans or assumptions change
or prove to be inaccurate, it may be required to delay or abandon some or all of
its development and expansion plans or the Company may be required to seek
additional sources of capital. Future sources may include public debt or equity
offerings or equipment financing. There can be no assurance that additional
financing arrangements will be available on acceptable terms.
In 1999, the Company plans to spend approximately $100 million for capital
expenditures on network equipment, back-office systems, the build-out of its
network operations center in St. Louis, Missouri, a transatlantic IRU and other
fiber optic transmission capacity. Actual capital expenditures may be
significantly different from the Company's current plans, in part because the
Company intends to be opportunistic in acquiring transmission capacity in a
dynamic market. The Company also expects to have substantial capital
expenditures after 1999.
The Company's net cash used in operating activities was $28.8 million for
the nine months ended September 30, 1998, and was primarily attributable to a
net loss of $47.2 million and an increase in accounts receivable of $24.3
million, partially offset by an increase in accounts payable, accrued expenses
and other current liabilities of $18.5 million, and non-cash interest expense of
$12.6 million. Net cash used
21
<PAGE>
in investing activities of $136.8 million for the nine months ended September
30, 1998 was attributable to the purchase of marketable securities, investments
made primarily in switching and other telecommunications equipment and IRUs and
the VoiceNet acquisition. Net cash provided by financing activities of $174.4
million was primarily related to the issuance of the 1998 Notes.
On February 12, 1998, the Company acquired VoiceNet, a major distribution
channel for the Company's calling card products. The initial purchase price was
$21.0 million, which was paid in cash. The sellers of VoiceNet also are entitled
to receive an earn-out based upon the revenue growth of the VoiceNet business.
The earn-out bonus will not have a material impact on the Company's liquidity.
The acquisition was accounted for under the purchase method of accounting.
Goodwill was recorded to the extent the purchase price exceeded the fair value
of the net assets purchased. 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. The goodwill is being amortized over 20 years.
During November 1998, the Company completed two small acquisitions. It
acquired a controlling interest in America First Ltd. ("America First"), a
prepaid card distributor in the United Kingdom, and it acquired the customer
accounts of a long distance reseller, also located in the United Kingdom. The
Company is in the process of determining appropriate allocations of the purchase
prices and related amortization periods of the intangible assets.
In the United Kingdom, the majority of the Company's sales are made through
Telco, its majority owned subsidiary. On July 17, 1998, the Company acquired the
30% minority interest in Telco that it did not already own in exchange for a
note in the principal amount of approximately $14.0 million, payable by the
Company in quarterly installments, together with interest at a rate of 8.0% per
annum, over approximately three years. The entire purchase price is classified
as goodwill, which will be amortized over 20 years. In connection with such
acquisition, (1) Telco obtained ownership rights with respect to certain
proprietary software used in Telco's business and (2) the Company converted
options to acquire Telco shares held by Telco employees into grants of
non-voting restricted shares of the Company's common stock.
Subsequent to September 30, 1998, the Company incurred certain other
non-operating cash commitments, including approximately $42.3 million in the
aggregate for a 20-year IRU from Frontier to use its U.S. fiber optic network
and for the purchase of a transatlantic IRU. As of December 31, 1998, the
Company pays approximately $1.2 million per quarter as installments of principal
on its equipment facility. In addition, the Company pays $20.9 million per annum
as interest expense on the 1997 Notes. The Company has put funds in escrow to
cover this expense through July 15, 2000. For a discussion of the Company's IRU
on the Frontier network, see "Business--The Destia Network--North American
Network."
The Company continually evaluates business opportunities, including
potential acquisitions. In addition, although the Company is not currently
engaged in negotiations regarding any material acquisitions, the Company may use
net proceeds of the offering to fund suitable strategic acquisitions. The
Company will seek to acquire or align itself with complimentary companies that
(1) offer attractive opportunities in new geographic markets (with an emphasis
on continental Europe), (2) have an established customer base or (3) have
innovative telecommunications services or technologies (such as data
transmission and Internet Services).
FOREIGN CURRENCY EXPOSURE
The Company is exposed to fluctuations in foreign currencies relative to the
U.S. dollar because the Company bills in local currency, while transmission
costs are largely incurred in U.S. dollars and interest expense on the 1997 and
1998 Notes is in U.S. dollars. For the first nine months of 1998 and 1997,
approximately 43% and 38%, respectively, of the Company's revenues were billed
in currencies other than the U.S. dollar, consisting primarily of British pounds
and Belgian francs. The effect of these fluctuations
22
<PAGE>
on the Company's revenues for the nine months ended September 30, 1998 and 1997
was immaterial. As the Company expands its operations, a higher percentage of
revenues is expected to be billed in currencies other than the U.S. dollar. The
Company, 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. The Company does not use derivative
financial instruments for speculative purposes. At September 30, 1998 and
December 31, 1997, the Company had $0 and $.3 million open foreign currency
hedging positions, respectively.
EURO CONVERSION
On January 1, 1999, several member countries of the EU established fixed
conversion rates, and adopted the euro as their new common legal currency.
Beginning on such date, the euro traded on currency exchanges. The legacy
currencies will remain legal tender in the participating countries for a
transition period between January 1, 1999 and January 1, 2002. During the
transition period, parties can elect to pay for goods and services and
transact business using either the euro or a legacy currency. Between
January 1, 2002 and July 1, 2002, the participating countries will introduce
euro currency coins and withdraw all legacy currencies.
The euro conversion may affect cross-border competition by creating
cross-border price transparency. The Company is assessing its pricing and
marketing strategy in order to insure that it remains competitive in a broader
European market. In addition, the Company is reviewing whether certain existing
contracts will need to be modified. The Company's currency risks and risk
management for operations in participating countries may, in fact, be reduced as
the legacy currencies are converted to the euro. The Company will continue to
evaluate issues involving introduction of the euro. However, based on current
information and assessments, the Company does not expect that the euro
conversion will have a material adverse effect on its results of operations or
financial condition.
NEW ACCOUNTING PRONOUNCEMENTS
In June 1997, 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 requires that all items recognized as comprehensive income be reported in
the financial statements. The components of other comprehensive income consist
primarily of foreign currency translation adjustments. SFAS No. 131 establishes
standards for reporting financial and descriptive information regarding an
enterprise's operating segments. Generally, financial information is required to
be reported on the basis that it is used internally for evaluation of segment
performance and deciding how to allocate resources to segments. This standard
increases disclosure only and has no impact on the Company's financial position
or results of operations. These standards have been adopted in 1998 and have
been reflected in the financial statements for the year ended December 31, 1998.
In March 1998, the American Institute of Certified Public Accountants (the
"AICPA") issued Statement of Position ("SOP") 98-1, "Accounting for Costs of
Computer Software Developed or Obtained for Internal Use." SOP 98-1 provides
guidance on accounting for the costs of computer software developed or obtained
for internal use software, dividing the development into three stages: (1) the
preliminary project stage, during which conceptual formulation and evaluation of
alternatives takes place, (2) the application development stage, during which
design, coding, installation and testing takes place and (3) the operations
stage during which training and maintenance takes place. Cost incurred during
the application development stage are capitalized, all other costs are expensed
as incurred. SOP 98-1 is effective for financial statements for fiscal years
beginning after December 15, 1998. The Company is currently evaluating the
impact of adopting SOP 98-1.
In April 1998, the AICPA issued SOP 98-5, "Reporting on the Costs of
Start-up Activities." SOP 98-5 requires that all non-governmental entities
expense the costs of start-up activities, including organization
23
<PAGE>
costs, as those costs are incurred. SOP 98-5 is effective for financial
statements for fiscal years beginning after December 15, 1998. The Company has
reviewed the provisions of SOP 98-5 and does not believe adoption of this
standard will have a material effect on its results of operations, financial
position or cash flows.
YEAR 2000 COMPLIANCE
The Company is engaged in an ongoing process of assessing its exposure to
the Year 2000 issue--the potential problems arising from computer systems that
were designed to use two digits, rather than four, to specify the year. The
Company has formed a project team (consisting of representatives from its
information technology, finance, business development, product development,
sales, marketing and legal departments) to address internal and external Year
2000 issues. By December 31, 1998, the Company had completed its internal review
of its financial and other computer systems (which include switching, billing
and other platforms) to assess Year 2000 issues. Based on this review, the
Company believes that the amount of work and expense required to address Year
2000 issues relating to its internal systems will not be material. The Company
is upgrading certain of its Northern Telecom switches to make them and their
related software Year 2000 compliant. The Company expects this upgrade to be
completed by June 30, 1999 at a cost of approximately $1.3 million. In addition,
the Company may be required to modify some of its other existing software. The
Company estimates that it will have updated all of its significant internal
systems to make them Year 2000 compliant and will be able to begin testing by
June 30, 1999.
In addition to assessing its own systems, the Company plans to retain a
consulting firm by the end of February 1999 to assist it in conducting an
external review of its significant customers, suppliers and other third parties
with which it does business, including significant equipment and system
providers and telecommunications service providers, to determine their
vulnerability to Year 2000 problems and any potential impact on the Company. In
particular, the Company may experience problems to the extent that other
telecommunications carriers are not Year 2000 compliant. The Company anticipates
that this external review and related third party review will be substantially
completed by September 30, 1999. The Company's ability to determine the status
of these third parties ability to address issues relating to the Year 2000
issues is limited and there is no assurance that these third parties will
achieve full Year 2000 compliance before the end of 1999.
The Company believes that its reasonably likely worst case Year 2000
scenario is disruption of its ability to route traffic over portions of its own
network, which would require the Company to utilize other transmission capacity
at greater cost. To the extent that a limited number of carriers experience
disruption in service due to the Year 2000 issue, the Company's contingency plan
is to obtain service from alternate carriers. However, there is no assurance
that alternate carriers will be available or, if available, that the Company can
purchase transmission capacity at a reasonable cost. In addition, in many
continental European countries there are no alternative carriers to use.
Significant Year 2000 failures in the systems of carriers and other third
parties (or third parties on whom they depend) would have a material adverse
effect on the Company's business and the price of its common stock.
The Company estimates the total cost for resolving its Year 2000 issues to
be approximately $2.0 million, of which approximately $.1 million has been spent
through January, 1999, with the majority of expenditures expected to be incurred
in February, 1999. This estimate includes the accelerated cost of replacing
systems that are not Year 2000 compliant. Actual costs and may, however, differ
materially.
24
<PAGE>
BUSINESS
We are a rapidly growing, facilities-based provider of domestic and
international long distance telecommunications services in North America and
Europe. Our extensive international telecommunications network allows us to
provide services primarily to retail customers in many of the largest
metropolitan markets in the United States, Canada, the United Kingdom, Belgium,
France, Germany and Switzerland. In 1997, there were 81.8 billion minutes of
international long distance traffic with the majority originating in the United
States and Europe. This volume is expected to grow at a compound annual growth
rate of 12% to 18% from 1997 to 2001.
We provide our customers with a variety of retail telecommunications
services, including international and domestic long distance, calling card and
prepaid services, and wholesale transmission services. Our 350,000 customer
accounts are diverse and include residential customers, commercial customers,
ethnic groups and telecommunications carriers. In each of our geographic
markets, we utilize a multichannel distribution strategy to market our services
to our target customer groups. We believe this strategy greatly enhances our
growth prospects and reduces our dependence on any one service, customer group
or channel of distribution.
We entered the U.S. market during 1993 and the U.K. market during 1995. In
continental Europe, we commenced offering our services before the January 1,
1998 full liberalization of telecommunications services in those markets. We
established operations in Belgium, France and Germany in the first quarter of
1997 and Switzerland in the fourth quarter of 1997. Given our early entry into
many of our continental European markets, as well as our established network,
sales and marketing and customer support infrastructure, we believe we are well
positioned to further grow our business in continental Europe.
COMPETITIVE STRENGTHS
The European and North American telecommunications industry is rapidly
evolving following the reduction of regulatory barriers, investment in new
transmission capacity and the development of new services and technologies. In
this dynamic environment, we believe we have successfully distinguished
ourselves from many of our competitors and enjoy several competitive strengths:
PROVEN TRACK RECORD OF STRONG INTERNAL GROWTH
For 1996 and 1997 and the nine months ended September 30, 1998, our revenues
were $45.1 million, $83.0 million and $141.0 million, respectively. In addition,
for 1996 and 1997 and the nine months ended September 30, 1998, we carried 104.6
million, 330.1 million and 607.3 million minutes of traffic, respectively.
Substantially all of our growth has been generated internally, rather than
through acquisitions. Our only significant acquisition to date, the purchase of
VoiceNet, solidified a key distribution channel, but had no direct effect on our
revenues or customer base. As we have grown our business, we have focused on
managing our growth in a manner that has enabled us to increase our customer
base and maintain our high standards of service quality and customer support. We
believe that our demonstrated ability to grow organically and manage rapid
growth provides us with a solid foundation to continue to grow our business.
ESTABLISHED INTERNATIONAL TELECOMMUNICATIONS NETWORK
Since 1996, we have made substantial investments in expanding the Destia
Network. The Destia Network is comprised of:
- 14 carrier-grade switches in operation, with seven in North America and
seven in Europe;
- an IRU from Frontier on its U.S. fiber optic network;
- transatlantic IRUs;
- leased capacity and IRUs in Europe; and
- leased capacity in Canada.
25
<PAGE>
Additionally, as of the end of 1998, we have completed direct
interconnections with the PTTs in four of our major European markets (the
United Kingdom, Belgium, Germany and Switzerland) and have signed
interconnection agreements with the PTTs in France and The Netherlands.
Interconnection allows us to offer services to customers as a domestic
carrier through a direct connection to the public switched telephone network
(the "PSTN") and with lower access costs. In expanding our network, we have
used "carrier-grade" equipment, which allows us to offer high quality
services and expand our service offerings on a cost-efficient basis. As a
result of our network build-out program, we believe that we are
well-positioned to aggressively grow our revenues.
COST-EFFECTIVE MULTICHANNEL MARKETING
We reach a broad range of customer groups by using a variety of marketing
channels, including a direct sales force, independent sales agents, multilevel
marketing, customer incentive programs, advertising and the Internet. Our
multichannel approach allows us to tailor our marketing to specific geographic
markets and services. We believe this is an especially cost-effective means of
marketing to our target customers. For example, to sell our residential long
distance, calling card and prepaid services in the United Kingdom, we use a
multilevel marketing program. To market our VoiceNet-TM- calling card to U.S.
business travelers, we use advertisements in in-flight magazines and selected
well-known U.S. newspapers and magazines. For marketing our international and
domestic long distance and prepaid card services to metropolitan-area ethnic
communities, we use independent sales representatives who are part of the
targeted community, and we advertise in local, ethnic-oriented publications and
co-sponsor ethnic events. We also intend to begin cross-marketing many of our
services, including marketing our "1+" services to our VoiceNet customer base.
We expect that our multichannel marketing approach will facilitate our continued
rapid growth while reducing the risks associated with dependence on a limited
number of distribution channels.
EXPERIENCED MANAGEMENT TEAM WITH SIGNIFICANT OWNERSHIP
We believe we have an experienced and motivated management team that is
well-suited to continue leading the growth of our company. Our management team
includes a broad base of seasoned professionals from the domestic and
international telecommunications sector with expertise in management,
multinational sales and marketing, network operations and engineering, finance
and regulatory issues. Furthermore, in each of our geographic markets, we employ
local staffs in management, operations, sales and marketing and customer
service. These staffs are familiar with local technical issues, market dynamics,
customer preferences and cultural norms. On a fully diluted basis, our senior
management and other employees currently own approximately % of Destia and
following the offering will own approximately %.
COMMITMENT TO SUPERIOR CUSTOMER SERVICE
We are committed to providing our customers with superior customer service
and believe we have developed the infrastructure to deliver high levels of
customer satisfaction. For example, in all of our markets, we provide customers
with local customer service and billing support and, in the United States and
the United Kingdom, we provide this support 24 hours a day. In addition, for our
ethnic customers, we provide customer service in their native language. As of
December 31, 1998, we had 242 full-time equivalent customer service
representatives company-wide. We have also developed our own proprietary
software systems to better serve our customers. For example, in each of our
network countries, our monthly bills are in the customer's native language and
local currency (and we have the ability to bill in euros). We also provide
detailed billing information for commercial customers that includes itemized
breakdowns of usage by telephone number or by account code and department. We
believe that our customer support infrastructure, together with our
customer-oriented philosophy, differentiates us from many of our competitors.
26
<PAGE>
SOPHISTICATED OPERATIONAL CONTROL SYSTEMS
We have internally developed sophisticated proprietary software and intranet
systems that enable us to better manage our business and appropriately price our
services in each of our markets on a real-time basis. For example, we have
developed an interface with our network switches that allows us to compile
network information on a real-time basis, including the number of minutes being
routed through our switch (and corresponding revenue), points of origination and
termination, sources of traffic (by area code, city and carrier) and other
traffic information. We use this information everyday in connection with "least
cost" routing, pricing, cost and margin analysis, identifying market
opportunities and developing our sales and marketing and network expansion
strategies. We believe these analytical tools allow us to quickly identify new
market growth and cost saving opportunities as well as control our business in
an environment of rapid growth.
COMPANY STRATEGY
Our objective is to become a leading facilities-based provider of
telecommunications services in the largest metropolitan markets in Europe and
North America that generate significant domestic and international call traffic.
The key elements of our growth strategy are as follows:
FOCUS ON HIGH MARGIN RETAIL BUSINESS
Since our inception, the primary focus of our business has been to provide
services to retail customers. We believe that the advantages of focusing on
retail, instead of wholesale, customers include:
- higher margins;
- substantial barriers to entry because of the significant investments
required to develop sales and marketing and customer support;
- more opportunities to bundle value-added services;
- more opportunities to build brand loyalty; and
- reduced credit and cancellation risk (compared to wholesale customers who
buy transmission services almost entirely based on price).
We believe that our retail focused strategy has been highly successful to
date and has allowed us to build strong gross margins. For 1996 and 1997 and the
nine months ended September 30, 1998, our gross margins were 21.6%, 23.2% and
26.9%, respectively. In addition, we have also achieved strong growth,
particularly in the largely deregulated U.S. and U.K. telecommunications
markets. For example, our U.K. revenues have increased from $15.5 million during
1996 to $45.6 million for the nine months ended September 30, 1998, and our U.K.
customer accounts have increased from 1,029 at December 31, 1996 to 79,500 at
September 30, 1998. We believe we can continue to replicate this strategic focus
and further improve our growth and margin performance as we expand our retail
presence in our European and North American markets.
LEVERAGE OUR EXISTING NETWORK AND CUSTOMER SUPPORT INFRASTRUCTURE
We believe that our switching infrastructure and our sales and marketing and
customer support infrastructure in our core European and North American markets
will enable us to expand our retail customer base in these markets. We will seek
to add to our customer base by increasing the size of our direct sales force,
targeting additional ethnic markets, expanding our global carrier services
group, introducing multilevel marketing in additional markets, increasing
advertising, co-branding our services, participating in affinity programs and
cross-marketing our services. Because our existing infrastructure was designed
with the retail customer in mind, we believe that we can add customers rapidly
without sacrificing transmission quality or our established level of customer
service.
27
<PAGE>
In addition to expanding our customer base, we will also seek to increase
our utilization of the Destia Network and thereby reduce our per minute costs
and increase our gross margins. In general, the incremental cost to us of
carrying calls on the Destia Network is much less than the incremental cost of
carrying calls over other carriers' networks. This is because the cost of our
IRUs and certain leased lines is fixed, regardless of how many calls we carry.
Alternatively, when we transmit calls over another carrier's network, we pay a
per minute charge. As a result, by increasing our amount of "on-net" traffic, we
can reduce our per minute costs and increase our gross margins. In addition, we
also can better control call quality. We intend to increase the utilization of
our network by (1) migrating a greater percentage of our overall traffic on to
the Destia Network, (2) increasing those sales and marketing initiatives that
promote customer usage of services that are provided in a Destia Network city,
such as "1+" and "1xxx" services, and (3) targeting carrier and other wholesale
customers.
ENHANCE THE DESTIA NETWORK AND OPPORTUNISTICALLY ENTER NEW MARKETS
As we continue to complete the build-out of our network, we intend to do
so in a cost-effective manner that provides us with the flexibility to
introduce new services, employ new technologies and reach new customers. For
example, in the United States our recent agreement with Frontier provides us
with fiber optic transmission capacity connecting 43 U.S. markets. In
addition, the Frontier arrangement gives us favorable origination and
termination rates throughout the continental United States. We also intend to
continue to explore opportunities to extend our network into additional
markets which complement our existing regional presences, or otherwise offer
significant growth opportunities for our company. For example, during 1999,
we intend to install points of prensence ("POPs" and begin marketing our
services in selected cities in Ireland and Italy, to begin marketing our
services in Austria and The Netherlands and to expand our service offerings
in Greece.
EXPAND OUR IP TELEPHONY CAPABILITIES
We are currently deploying an Internet protocol ("IP") network overlay on
selected transatlantic and European routes. This network overlay enables us to
carry voice and data traffic using IP technology over portions of the Destia
Network. During 1999, we plan to expand our IP network overlay and explore new
IP-based service offerings for Destia customers. We will be able to offer
customers direct access to our network for both voice and data services using
cost-effective, off-the-shelf equipment located at the customer's premises. In
addition, this overlay will allow us to more efficiently use transmission
capacity.
PURSUE STRATEGIC ACQUISITIONS AND ALLIANCES
To date, a substantial majority of our growth has been internally generated.
While we will continue to focus on internal growth, we also intend to pursue
selected acquisitions and strategic alliances. In particular, we will seek to
acquire or align ourselves with complementary companies that (1) offer
attractive opportunities in new geographic markets (with an emphasis on
continental Europe), (2) have an established customer base or (3) have
innovative telecommunications services or technologies (such as data
transmission and Internet services). We believe that our geographic reach and
management expertise create access to acquisition opportunities. Although we
from time to time engage in discussions concerning potential acquisitions, we
are not currently engaged in negotiations regarding any material acquisitions,
other than discussions related to the long-term lease or acquisition of fiber
optic transmission capacity in Europe.
PRODUCTS AND SERVICES
We provide our customers with a variety of retail telecommunications
services, including international and domestic long distance, calling card and
prepaid services. Our retail customer base is diverse and includes residential
customers, commercial customers and ethnic groups. In addition, we also provide
wholesale transmission services to carriers and other wholesale customers. Our
services are discussed below.
28
<PAGE>
RETAIL SERVICES
The following table summarizes our principal retail services in our
principal geographic markets.
<TABLE>
<CAPTION>
RETAIL SERVICES
------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
INTERNATIONAL LONG DOMESTIC LONG CALLING CARD PREPAID
DISTANCE DISTANCE SERVICES SERVICES
----------------------- ------------------- ----------------- -------------------
Continental Europe
Belgium........................... X X X X
France............................ X -- X X
Germany........................... X X X X
Switzerland....................... X X X X
United Kingdom...................... X X X X
North America
United States..................... X X X X
Canada............................ X -- X X
<CAPTION>
<S> <C>
E-COMMERCE
SERVICES
---------------
Continental Europe
Belgium........................... --
France............................ --
Germany........................... --
Switzerland....................... --
United Kingdom...................... --
North America
United States..................... X
Canada............................ --
</TABLE>
INTERNATIONAL AND DOMESTIC LONG DISTANCE SERVICE. International and
domestic long distance service is service that is accessed from a customer's
billing location (I.E., their home or office) using "1xxx" access in the United
Kingdom, France and Belgium or "1+" access in the United States and Canada. In
Germany and Switzerland, long distance service is accessed by using either "1+"
or "1xxxx" access. Our international and domestic long distance service
generally enables customers to call to any destination.
CALLING CARD SERVICES. Our calling card services are sold in all of our
principal markets and can be used in over 50 countries. In the United States, we
principally market our calling cards under the VoiceNet brand name.
In continental Europe, we believe that a substantial portion of our calling
card customers use this service from their home or office as an alternative to
the PTT for international calls. In contrast, in the United Kingdom and the
United States, our calling cards are sold to customers primarily for convenience
when traveling. As we complete interconnection in continental Europe and are
able to provide both international and domestic long distance service to our
customers on a cost-efficient basis, we intend to migrate our home- and
office-based calling card customers to our international and domestic long
distance service. Our calling card service will then be offered in continental
Europe as a premium travel service.
In Europe and North America, our calling card service is accessed by dialing
a national toll free number or a local access number. Calling card customers can
access our services from outside their home country by dialing an international
toll free number, a national toll free number or a local access number,
depending on the country from which the customer is calling. We can offer
customers competitive domestic and international long distance rates for calls
from places where customers can use national toll-free and local access numbers.
For calls from places where customers can only use international toll-free
numbers, we can offer customers competitive rates only on international long
distance calls.
We also intend to introduce an enhanced service, using our calling card
platform, which will allow a user's calls to "follow" him or her from the home,
to the office, to the mobile phone, while also enabling the user to screen
calls. This service is currently being developed for us by an outside firm
specializing in enhanced services. We expect to have this service ready for our
customers by the third quarter of 1999.
PREPAID SERVICES. Our prepaid card service is a prepaid version of our
calling card, with similar features and the same manner of use as our calling
card. Our prepaid cards generally can be used from the United Kingdom, the
United States, Belgium, Canada, Germany, France, Israel, Greece, The Netherlands
and Switzerland. We also sell prepaid cards that can be used only from the
country in which they are sold.
In 1998, we introduced our Debit Phone-TM- prepaid service to residential
customers in the United Kingdom. Debit Phone allows customers to access our
services from their homes on a prepaid basis utilizing "1xxx" and toll-free
access. When the customer makes a domestic or international long distance call,
our switch automatically recognizes the customer's telephone number and deducts
the cost of the call
29
<PAGE>
from the customer's prepaid account balance. Debit Phone customers are able to
replenish their balances by purchasing vouchers or by phone with a credit card.
Customers also can access their account balance by phone using voice prompts.
E-COMMERCE SERVICES. As part of our strategy, we seek to introduce services
that capitalize on the growing popularity of the Internet for everyday
commercial transactions. During the fourth quarter of 1998, we introduced
Presto!-TM- in the United States. Presto! is our first e-commerce service and
the first service offered through what we intend to develop as an Internet-based
portal for telecommunications services. Presto! is a virtual prepaid account
that is purchased and recharged exclusively over the Internet at
www.prestocard.com. This service enables users to make international and
domestic long distance calls at competitive rates and to view their Presto! call
records on a real-time basis. We believe that Presto! is currently the only
prepaid service that can be purchased and recharged instantly over the Internet.
We intend to offer Presto! in Canada and our European markets and to develop
additional e-commerce services that take advantage of the growing use of the
Internet.
We believe that e-commerce services offer us significant opportunities for
growth. In particular, we believe these services will appeal to a highly
desirable segment of the population that is technologically proficient, makes a
significant number of long distance calls and represents a broad geographic
base. In addition, e-commerce services offer a number of other advantages.
Presto!, like our prepaid cards, does not require any billing support and does
not expose us to any credit risk. Also, e-commerce services have lower
associated sales and marketing and customer service costs. We believe that
e-commerce may, over time, become an important distribution channel for certain
other services.
INTERNET SERVICES. By July of 1999, we plan to offer Internet access to
retail customers in Switzerland and Belgium, which we believe will increase
their usage of our services, provide us with additional revenue and further
enhance our ability to attract and retain customers. We intend to offer Internet
access during 1999 in selected additional European countries in which we have
interconnection, such as the United Kingdom and Germany. The legal regime
concerning Internet access services in Europe is under development. This also is
a new service that we have not provided before which may present implementation
risks.
OTHER RETAIL SERVICES. We also provide the other retail services described
below. These services currently represent a relatively small portion of our
revenues. We expect most of these services to continue as ancillary service
offerings.
- DEDICATED ACCESS SERVICE. Customers using this service lease a
transmission line that connects the customer's business directly to one of
our switches or POPs. This service is marketed to high-volume customers in
the United States and can be used for voice, data, video and the Internet.
We intend to increase our sales and marketing efforts for this service.
- TOLL-FREE SERVICE. We provide domestic toll-free service (I.E., "800",
"888" or "877" service) to customers in the United States, the United
Kingdom, Belgium, Germany and Switzerland. We also provide international
toll-free services ("ITFS") for our customers in Europe.
- DIRECTORY ASSISTANCE. In the United States, we provide nationwide
directory assistance service for our long distance customers 24 hours a
day.
- LONG DISTANCE WIRELESS SERVICE. We offer domestic and international long
distance services to cellular telephone users in the New York metropolitan
area. Users access this service by dialing a local access number or, in
the case of Bell Atlantic Mobile customers, by selecting Destia as their
long distance provider. We intend to market domestic and international
long distance services to cellular telephone users in selected
metropolitan U.S. markets.
30
<PAGE>
WHOLESALE SERVICES
CARRIER SERVICES. In the United Kingdom, Belgium, France, Germany and the
United States, we sell wholesale transmission capacity to carrier customers who
use the transmission capacity to service their end-user customers. Carrier
customers generally are extremely price sensitive, generate very low margins and
frequently move their traffic from carrier to carrier based solely on small
price changes in termination costs to particular destinations. Larger carrier
customers sometimes change providers on a daily basis. Furthermore, smaller
carrier customers are generally perceived in the telecommunications industry as
presenting a higher risk of payment delinquency or nonpayment than other
customers. In the deregulating markets in Europe, these risks are particularly
acute.
When we sell transmission capacity to carrier customers where all or a
portion of the traffic is transmitted on our IRUs or fixed-cost leased lines
that have unused capacity, we can generate additional revenues without incurring
significant marginal costs. When we sell carrier customers transmission capacity
which we purchase from third-party vendors, providing these services allows us
to increase the amount of transmission capacity that we purchase overall. As a
result, we are able to obtain even greater volume discounts on our purchases of
transmission capacity from these third-party vendors and therefore generate
higher margins and/or offer better pricing on our retail services.
From January 1, 1997 through September 30, 1998, sales of transmission
capacity to carrier customers ranged from 13% to 30% of our consolidated
revenues on a quarterly basis, comprising 13% of our consolidated revenues for
the quarter ending September 30, 1998. During 1999, we intend to increase our
carrier revenues, although our business will continue to be predominantly
focused on retail sales. In order to increase our carrier revenues, we have
increased our carrier services group to 12 people, located in the United States,
the United Kingdom and Germany, who are responsible for sales to carriers in
each of the cities the Destia Network serves. In addition to increasing carrier
revenues, we also seek to diversify our carrier customer base to include more
higher margin continental European traffic. See "Risk Factors--Importance of
Carrier and Other Wholesale Customers."
OTHER WHOLESALE SERVICES. We sell transmission capacity to third parties
that offer their own branded products and services such as private label calling
cards. We believe that many of these customers buy transmission from us not only
for our prices, but also for access to our software platform, which, among other
things, allows them to utilize our software technology to process calls made
with calling cards and prepaid cards and perform specialized billing functions.
In addition, we also sell transmission capacity to resellers who in turn sell
our long distance services to their customers. In 1999, we intend to grow the
reselling portion of our business, since this channel typically has higher
margins than wholesale carrier sales. See "Risk Factors--Importance of Carrier
and Other Wholesale Customers."
THE DESTIA NETWORK
As of December 31, 1998, the Destia Network was comprised of:
- 14 carrier-grade Northern Telecom switches in operation, with seven in
North America and seven in Europe;
- nine POPs in North America and seven POPs in Europe, in addition to our
switch locations;
- over 100 interconnections to LEC tandems and LEC end-offices in the United
States, which provide us with direct interconnections to LECs;
- 20 interconnections to PTT networks in the United Kingdom and continental
Europe;
- a U.S. fiber optic transmission network backbone that we currently lease
from Qwest;
31
<PAGE>
- a U.S. fiber optic transmission network that will consist of IRUs covering
more than 27 million DS-0 miles of fiber optic cable connecting 43 U.S.
markets. This transmission network will be leased from Frontier on a
long-term basis and will replace our existing Qwest network. In addition,
the Frontier arrangement gives us favorable origination and termination
rates throughout the continental United States;
- a transcontinental transmission network consisting of IRUs and other
ownership interests, including rights on the AC-1, PTAT, TAT 12/13 and
CANTAT-3 transatlantic cables;
- leased capacity and IRUs in Canada and Europe;
- 32 network-based servers located in nine cities in continental Europe, the
United Kingdom and North America controlled by a centralized enhanced
services platform; and
- an Internet protocol network overlay that permits point-to-point
transmission using packet-switched voice and data transmission technology.
This network overlay is currently deployed between certain of our European
switches and between those locations and our switch in New York.
See the inside cover of this prospectus for a graphic depiction of the
Destia Network. We intend to continue to make significant investments in network
infrastructure, particularly investments that will provide us with long-term
access to high-bandwidth capacity in European markets where we are seeking to
expand our customer base. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources."
NETWORK ECONOMICS
The major components of our costs include the cost of origination,
transmission and termination. To the extent we can manage these costs
appropriately we believe that we can significantly improve our gross margins.
ORIGINATION AND TERMINATION. In general, we pay a per minute fee to
originate and terminate calls. In the United States, we can reduce these costs
by having direct interconnection to LECs through LEC tandems and end-offices,
which allows us to carry a larger portion of each call on our network. In
Europe, we can reduce these costs through implementing direct interconnection
with the local PTTs. In addition, by having these interconnections, we are able
to provide network access through abbreviated dialing and to originate calls on
our network in a greater number of cities. Direct interconnection also provides
better transmission quality and greater reliability. However, there are often
delays in executing and implementing interconnection. See "Risk
Factors--Competition" and "--Regulation".
TRANSMISSION CAPACITY. At present, our transmission capacity consists
primarily of:
- IRUs, which are long-term capital leases of fiber optic cable for periods
of up to 20 or 25 years (which is typically the entire economically useful
life of the transmission facility);
- leased lines, which as the term is generally used in the
telecommunications industry, represent transmission capacity leased for a
shorter duration under an operating lease. Our leased lines generally are
leased for 12 to 36 months; and
- switched minutes, which are purchased from carriers on a per minute basis.
Switched minutes are used principally to carry traffic to destinations not
covered by the Destia Network. These purchases are made on an as-needed
basis and do not involve significant minimum purchase requirements.
In order to effectively manage our transmission costs, we utilize a mix of
IRUs, leased lines and switched minutes. We typically seek to acquire IRUs that
connect network cities which have significant calling traffic between them.
However, in regions where transmission capacity costs have been rapidly
32
<PAGE>
declining, such as in continental Europe, we have instead utilized leased lines
and intend to obtain IRUs when we believe prices for IRUs have sufficiently
declined. Leased lines also permit us to operate on a fixed-cost basis for
certain routes where the Company has experienced increased traffic, but do not
require a significant investment of infrastructure, human resources or
technology and have a shorter duration than IRUs. Because the cost of IRUs and
leased lines involve an initial capital outlay or a fixed monthly payment,
transmitting an increased portion of calls over these IRUs and leased lines
reduces our incremental transmission costs and thereby enables us to offer
services on a competitive basis and/or increase our gross margins. Once we have
generated enough traffic to cover the costs of IRUs and leased lines, there is
no significant marginal cost to us for carrying additional calls over these IRUs
and leased lines. In order to further increase the capacity of our IRUs, we
utilize carrier grade compression, or multiplexing, equipment where doing so
will not diminish the quality of the transmission.
As part of our expansion strategy, and as a result of increasingly
attractive pricing, we intend to acquire additional IRUs, including in
continental Europe. At present, all of our existing IRUs are operated and
maintained by third parties, while we lease the right to run calling traffic
through the fiber. To the extent cost efficient, we may acquire additional IRUs,
for which we will either control or install the network optronics, including
IRUs in "dark fiber". Under certain circumstances, acquiring these types of IRUs
may be more cost advantageous than acquiring IRUs in transmission capacity that
is operated and maintained by third parties, although it also involves certain
additional risks and, in some countries, additional regulatory compliance
requirements. See "Risk Factors--Dependence on Transmission Line Providers."
In addition, we can further reduce our transmission costs for traffic on our
network by increasing the amount of traffic routed by our switches. Because our
switches are programmed to route traffic over the lowest cost network service,
depending upon cost and bandwidth availability, traffic routed by our switches
can be delivered on a "least cost" basis.
OTHER. In addition to the cost of origination, transmission and
termination, the other costs of our network relate primarily to switching
equipment, compression equipment, our Internet protocol overlay and
facility/network management and related software.
NETWORK OPERATIONS
NETWORK OPERATIONS CENTER. During the fourth quarter of 1998, we
established a network operations center in St. Louis, Missouri, which operates
on a 24-hour-a-day, 7-day-per-week basis. From this facility, we monitor our
operations in the United Kingdom, continental Europe and North America.
Performing these tasks from a centralized location enables us to monitor the
network more effectively and on a more cost-efficient basis. In addition, we
also have the capability to monitor our European network from our network
operations center in London.
During 1998, we began rolling out our St. Louis network operations center
and developing and enhancing our network control systems. We expect to invest a
total of approximately $3.0 million in this build-out and for further
development and enhancement of our network control systems. Among the most
significant of the improvements we are undertaking is the installation of
digital cross-connect systems ("DACs") equipment at each of our switch
locations, which will enable us to monitor, test and re-configure network
facilities from a central location to maintain transmission quality on our
network.
INTEGRATED INFORMATION SYSTEMS. The development and integration of the
information systems that interface with the Destia Network are performed at our
College Station, Texas, and Brooklyn, New York, facilities. One of the principal
development projects during 1998 was the development of a proprietary integrated
customer service database and billing system, called Service One-TM-, which is
currently in use for all of our U.S. services. Service One will afford greater
flexibility as we increase service offerings and will accommodate greater
customer volume. In addition, we are currently implementing an interactive voice
33
<PAGE>
response system that will permit customers to obtain up-to-date information
concerning their account and their most recent invoice by telephone.
For the first nine months of 1998, we spent approximately $2.3 million to
enhance current, and develop new, network information systems. We expect to
invest approximately $2.4 million for these purposes during 1999. While we
believe that our current information systems are adequate for our near term
growth, additional investment will be required as we expand our operations. See
"Risk Factors--Dependence on Effective Information Systems."
SOPHISTICATED OPERATIONAL CONTROL SYSTEMS. Our systems development group
has internally developed sophisticated proprietary software and intranet systems
to better manage our business and appropriately price our services in each of
our markets on a real-time basis. For example, we have developed an interface
with our network switches that allows us to compile network information on a
real-time basis, including the number of minutes being routed through our switch
(and corresponding revenue), points of origination and termination, sources of
traffic (by area code, city and carrier) and other traffic information. We use
this information everyday in connection with "least cost" routing, pricing, cost
and margin analysis, identifying market opportunities and developing of our
sales and marketing and network expansion strategies, among other things. We
believe that these analytical tools allow our management team to quickly
identify new market growth and cost saving opportunities as well as control our
business in an environment of rapid growth. We believe that we are one of the
few competitive telecommunications companies that have these types of analytical
tools and to have integrated them into our daily operations.
EUROPEAN NETWORK
We have seven switches and seven POPs in continental Europe and the United
Kingdom. The location of our European switches and the date of completed
interconnection of each are as follows:
<TABLE>
<CAPTION>
DATE OF DATE OF
CITY OPERATION INTERCONNECTION
- ----------------------------------------- --------------- ---------------
<S> <C> <C>
Brussels, Belgium........................ 1Q97 4Q98
Paris, France............................ 1Q97 2Q99E
London, England.......................... 2Q97 2Q97
Frankfurt, Germany....................... 3Q98 4Q98
Zurich, Switzerland...................... 3Q98 4Q98
Amsterdam, The Netherlands............... 4Q98 2Q99E
Berlin, Germany.......................... 4Q98 4Q98
</TABLE>
We also own IRUs on the PTAT-1, CANTAT-3, TAT 12/13 and AC-1 transatlantic
cables. As part of our expansion strategy, we intend to acquire additional IRUs,
including in continental Europe. See "--Network Economics--Transmission
Capacity."
The Destia Network's European hub is located in London. A large portion of
our transatlantic calls between continental Europe and the United States are
routed through London because it is the most cost-effective routing due to the
low per minute marginal costs associated with our transatlantic IRUs. We also
route a substantial portion of our international intra-European calls (E.G.,
Berlin to Paris) through our London hub to take advantage of favorable
transmission rates to and from London. These rates are often lower than the
costs of transmitting the call by a more direct "off-net" route where the Destia
Network does not have a transmission line between the originating and
terminating switch.
As a result of deregulation and geography, Frankfurt is emerging as a
popular European hub for telecommunications carriers, especially for calls to
and from Eastern Europe. We believe that we are well positioned to take
advantage of these market developments due to our Frankfurt switch and intend to
market our carrier services to carriers that route calls through Frankfurt.
34
<PAGE>
In addition to adding new switches in continental Europe during 1998, we
further enhanced the Destia Network in continental Europe by entering into and
implementing direct interconnection agreements with the PTTs in Belgium, Germany
and Switzerland. We also expect to implement interconnection during the second
quarter of 1999 in France and The Netherlands, where we already have signed
interconnection agreements with the PTTs. These agreements add to the
interconnection that we have had in place with British Telecom in the United
Kingdom since the second quarter of 1997. Our interconnection arrangements
provide us with a direct connection to the PSTN. By having a direct connection
to the PSTN, we are able to offer domestic long distance service, provide
network access through abbreviated dialing and originate and terminate calls in
a greater number of cities and at a substantially reduced cost.
In addition, in 1999, we intend to upgrade our POPs in Hamburg, Germany and
Vienna, Austria to switches and install POPs in Dublin, Ireland and Milan,
Italy.
NORTH AMERICAN NETWORK
We have seven switches and nine POPs in the United States and Canada. Our
North American switches, which are all interconnected, are located in the
following cities:
<TABLE>
<CAPTION>
DATE OF
CITY OPERATION
- --------------------------------------------------------------- -----------
<S> <C>
New York....................................................... 3Q93
Los Angeles.................................................... 1Q98
Miami.......................................................... 3Q98
Washington, D.C................................................ 3Q98
Toronto........................................................ 3Q98
Chicago........................................................ 4Q98
Dallas......................................................... 4Q98
</TABLE>
U.S. NETWORK EXPANSION. In 1998, we substantially expanded our U.S. network
infrastructure by adding switches in Chicago, Dallas, Los Angeles, Miami and
Washington, D.C. We also added a number of POPs connecting various cities to our
network. All of the foregoing reduce our transmission costs.
During 1999, we intend to upgrade our POP in Atlanta, Georgia to a switch.
In addition, during 1999, we intend to add additional connections to LEC tandem
switches and LEC end-offices.
We currently obtain most of our U.S. fiber optic transmission capacity from
Qwest. Because of the substantial increase in our domestic traffic and our
desire to provide services in more U.S. markets, we recently acquired a 20-year
IRU from Frontier to use its U.S. fiber optic network. This network will consist
of more than 27 million DS-0 miles of fiber optic cable connecting 43 markets
and will replace our Qwest network. In addition, the Frontier arrangement also
gives us favorable origination and termination rates throughout the continental
United States. This will provide us with the cost benefits of having additional
network access and drop-off points in areas where we have not invested in our
own switches or POPs. We believe that the extensive reach of the Destia Network
in the United States following the addition of transmission capacity from
Frontier will provide us with a significant cost advantage over many of our
competitors, although relying primarily on one network provider for U.S.
transmission capacity also results in additional risks. See "Risk
Factors--Dependence on Transmission Line Providers."
Frontier is in the process of building the fiber optic network that we will
use. We believe that approximately 60% of Frontier's planned network is
completed. We expect the Frontier U.S. fiber optic network to be fully
operational by the end of 1999, although there can be no assurance in this
regard. See "Risk Factors--Dependence on Transmission Line Providers."
GATEWAY SWITCH UPGRADES. Gateway switches permit us to convert
international protocols to U.S-based protocols. This ability to convert
protocols enables us to terminate inbound international traffic
35
<PAGE>
in the United States for overseas carriers and to carry outbound international
traffic closer to its destination and at a lower cost before handing it off to
another carrier or to the PTT in the terminating country. At present, our only
gateway switch is in New York, although our London switch also has international
conversion capabilities. During 1999 and early 2000, we intend to upgrade our
switches in Miami and Los Angeles to have international gateway capabilities,
allowing them to also interface directly with protocols used by non-U.S.
carriers. The Miami gateway switch will interface primarily with carriers from
Latin America and the Caribbean and the Los Angeles gateway switch will
interface primarily with carriers from Asia.
CANADIAN EXPANSION. During the third quarter of 1998, we expanded the
Destia Network to Canada by installing a switch in Toronto. We plan to install a
POP in Montreal by July 1999. This switch and POP will enable us to originate
calls in two of the largest long distance markets in Canada.
NETWORK ACCESS AND CALL ROUTING
NETWORK ACCESS. The Destia Network can be accessed through a variety of
methods, depending upon the service and the location from which the customer is
calling. These methods are as follows:
- "1+" ACCESS. "1+" access, also known as preselection or equal access,
enables a long distance customer to access the Destia Network from the
customer's premises by dialing "1" and then the number that the customer
is calling. "1+" access is currently available to our customers in the
United States, Canada, Germany and Switzerland where the Destia Network
has a switch or POP. Using this access method, a customer does not need to
dial a special prefix access code because the customer has preselected the
Company as its long distance carrier and the LEC's or PTTs' switching
system already is programmed to direct long distance calls from the
customer's telephone to the nearest Destia Network switch.
- "1XXX" ACCESS. "1xxx" access, or prefix dialing, enables a long distance
customer in our European countries (as well as the United States) to
access the Destia Network from the customer's premises by dialing "1" and
a code number and then the number the customer is calling.
- LOCAL DIAL-UP ACCESS. In continental European cities where we have
installed a switch or POP, customers can access our international and
domestic long distance service and, in some cases, prepaid card service,
by dialing a local telephone number. Local dial-up access reduces our
transmission costs for these calls because it shifts the cost of accessing
our switch to the customer. The reduction in transmission costs enables us
to increase our margins and/or reduce our retail prices on these calls, as
well as to provide competitively priced intra-European long distance
service.
- INTERNATIONAL TOLL-FREE ACCESS. This access method allows customers to
access our card-based services in selected continental European markets by
dialing an international toll-free number. This access method is
predominantly used by business travelers.
- NATIONAL TOLL-FREE ACCESS. Customers who access our services in this
manner do so by dialing a national toll-free number. This access method is
available to customers who use our calling card and prepaid card services
in the United States, the United Kingdom and Germany.
- DEDICATED ACCESS. Carrier customers and high volume end-users can be
connected to our switch by a dedicated leased line. The advantages to the
customer of dedicated access are simplified dialing, faster call setup
times and lower access costs if a sufficient volume of calls is
transmitted over the leased line. This service can be used for voice,
data, video and the Internet over a single leased line.
CALL ROUTING. Calls are routed to their destination through one or more of
our switches. If the call originates in a network city with a switch, the caller
generally will dial into the network over local lines. These calls will then be
routed by the local service provider (a LEC in the U.S. and typically a PTT in
36
<PAGE>
Europe) to our switch. A call originating in a city with a POP, which acts
solely as a collection point for calls, generally will be originated using one
of the foregoing access methods and will be sent to the POP. The call will then
be transmitted from the POP to one of our switches on an owned or leased line
comprising part of the Destia Network. If the call originates in a city where we
do not have a switch or POP, the caller generally dials into the network using
national or international toll-free access, which is substantially less
cost-efficient for us than "1xxx," "1+" or local dial-up access. From our
switch, "least cost" routing techniques are used to determine whether the call
should be transferred directly to the PSTN or routed to another one of our
switches over an owned or leased line and then transferred to the PSTN for
termination. See "--Network Hardware and Software--Least Cost Routing."
NETWORK HARDWARE AND SOFTWARE
CARRIER GRADE SWITCHES AND TECHNOLOGY. We use Northern Telecom carrier
grade switches throughout the Destia Network. The principal benefits of carrier
grade switches are their ability to (1) handle large, simultaneous call volumes,
(2) provide better quality service to customers, and (3) seamlessly interconnect
with local operators. Each of these benefits is discussed below:
- CALL CAPACITY. Carrier grade switches generally have more port capacity
than smaller switches, which enables them to route a greater number of
simultaneous calls.
- BETTER QUALITY SERVICE. Carrier grade switches provide higher transmission
quality, faster call setup times and higher greater call completion rates
than smaller, less powerful switches. Our carrier grade switches also have
call completion capabilities that reduce the time needed to connect calls
and allow for more efficient use of transmission capacity.
- DIRECT INTERCONNECTION WITH PTT AND LEC NETWORKS. Carrier grade switches
enable our network to interconnect directly with the networks of PTTs and
LECs, subject to applicable regulatory requirements and an interconnection
arrangement being in place. The benefits of direct interconnection
generally include better quality service, lower costs, improved
reliability and the ability to rapidly increase call-handling capacity.
We believe that by utilizing the equipment of a single principal supplier we
are able to minimize the difficulties associated with integrating equipment from
various sources and with differing specifications. In addition, it also enables
us to develop a single proprietary software to compile our network information
since we do not need to accommodate switches of different manufacturers.
However, using equipment principally from one supplier does entail certain
risks. See "Risk Factors--Dependence on Our Principal Equipment Supplier."
SS7 TECHNOLOGY. Signaling System 7 technology (also known as "SS7"), which
is used primarily in the United States, performs two significant functions
within the Destia Network. SS7 facilitates faster call setup by sending messages
that precede the call and obtain information about its destination, such as
whether the destination number is available or engaged in a call. Second, SS7 is
able to look up destination numbers, such as toll-free "800" numbers, in a
central database. This allows the Destia Network to use intelligent call
routing.
We are currently migrating from SS7 services provided by third parties on a
per switch basis to using our own SS7 equipment throughout our U.S. network. We
will then use one centralized provider to enable us to make SS7 connections with
LEC offices nationwide. This will provide us with greater flexibility and will
enable us to control equipment usage, maintain network integrity and reduce
costs.
Our SS7 technology will be supported from the St. Louis network operations
center. This will provide real time information on network usage and integrity
while allowing for instantaneous call tracing, monitoring, and fraud detection.
37
<PAGE>
LEAST COST ROUTING. Through a combination of hardware and software, our
network enables us to perform "least cost" routing analysis, which enables us to
transmit a call over the most cost-efficient route during that time of day.
Prices for various destinations fluctuate on a daily basis. Our least cost
routing software enables us to continually revise our routing tables, including
accounting for fluctuations in currency exchange rates, as the cost of certain
routes change. We have a dedicated group that is responsible for monitoring the
routing of calls and seeking to minimize our transmission costs.
DIGITAL CROSS-CONNECT CAPABILITY. We are in the process of installing DACs
hardware and software at each of our switches and major POPs. DACs will enable
us to monitor, test and re-configure network facilities from a central location
to maintain transmission quality on our network.
INTERNET PROTOCOL OVERLAY. Currently, voice calls are carried by keeping a
circuit open between two (or more) parties. This is inefficient because it uses
transmission capacity even when the parties are silent. Our carrier grade
switches are capable of interfacing with TCP/IP, an Internet protocol software,
and the related hardware. TCP/IP technology would enable us to provide
simultaneous voice and data transmission over a single line, since the
technology compartmentalizes voice, data and/or video into digital pieces of
information (I.E., into a "packet") before they are transmitted. The packets can
be sent separately over one or more lines and are then reassembled at the
destination switch prior to being converted into their original format. This is
a much more efficient use of transmission capacity than keeping a circuit open.
Packet-based transmission would enable us to transmit data and video using lower
amounts of bandwidth, thus increasing the amount of information we transmit over
a given line and increasing the capacity of our network can carry overall.
We have installed TCP/IP hardware and software manufactured by third parties
on selected transatlantic and European routes, which enable us to carry traffic
using Internet protocol technology over a portion of the Destia Network. We are
currently exploring various potential service applications. For example,
packet-based transmission would allow us to offer integrated voice, fax and
video services as well as Internet access over an ordinary telephone line.
However, there can be no assurance that we will be successful in this regard.
OPERATING AGREEMENTS; TRANSIT AGREEMENTS
Through our affiliates, we have entered into operating, termination and/or
transit agreements with a number of overseas PTTs and competitive carriers,
including carriers in Greece, Israel, the Ukraine, Denmark, Sweden, Italy,
Slovenia and Ireland. As part of our strategy, and as market and regulatory
conditions warrant, we intend to enter into more of these agreements with
additional overseas carriers.
Operating and termination agreements provide us with more favorable
termination rates in the home country of the other carrier who is a party to the
agreement. We can directly interconnect with the local carrier who then locally
terminates all calls. These agreements also afford us more control over the
quality of the terminating segment of our international calls. In addition,
operating agreements also increase our overall gross margins because our
correspondent carriers are required to send us a specified portion of their
traffic that is bound for markets covered by the Destia Network. We can charge
"settlement rates" for this traffic that substantially exceed our termination
costs. Alternatively, the additional gross margins on this return traffic enable
us to price our calls to a given country more competitively while still
maintaining an acceptable average gross margin on all calls both to and from
that country. Similarly, transit agreements are advantageous to us because they
provide us with more favorable transit rates to third countries. Such agreements
and switched hubbing arrangements may allow us to pay less than the full
settlement rate we would have to pay if we had a direct operating agreement with
the terminating PTT. See "--Regulation" for additional information concerning
these types of agreements.
38
<PAGE>
SALES AND MARKETING
We reach a broad range of customer groups through a variety of marketing
channels, including a direct sales force, independent sales agents, multilevel
marketing, customer incentive programs, advertising and the Internet. As part of
our multichannel marketing approach, we tailor our marketing to our specific
geographic markets and services. We believe this is an especially cost-effective
means of marketing to our target customers. In addition, we expect that our
multichannel marketing approach will facilitate our continued rapid growth while
reducing the risks associated with dependence on a limited number of
distribution channels.
We market our services at the local level through both independent sales
agents and an internal sales force, depending upon the particular geographic
market, customer group and service. Our independent sales representatives, who
generally are retained on a commission-only basis, concentrate primarily on
residential sales and sales to commercial accounts. Our internal sales force
concentrates primarily on sales to commercial accounts, wholesale customers and
other carriers. This internal sales force includes a recently expanded carrier
services group of 12 people located in the United States, the United Kingdom and
Germany who are responsible for sales to carriers in each of the Destia Network
cities. Our local internal sales forces also typically advertise locally and
provide support for our independent sales representatives.
We recently changed our name to "Destia Communications, Inc." and also
developed a new company logo. We believe that our new name and logo better
emphasize our focus on providing innovative services. We also believe that by
establishing a widely recognized brand, we can increase brand awareness among
our target customers and facilitate cross-marketing of additional services to
our existing customers. After completing the transition to the Destia name,
which will occur after the offering, nearly all of our primary services will be
either branded or co-branded with the Destia name and logo.
CONTINENTAL EUROPE
Our sales and marketing strategy in most of our continental European markets
has been initially to concentrate on sales of prepaid services through
independent distribution channels since prepaid services operations present a
limited credit risk and independent distribution does not require substantial
initial investments. After gaining market acceptance and establishing our local
sales and marketing infrastructure, we typically have then introduced calling
card services and, once a POP or switch is installed, international long
distance services. Concurrently, we also have aggressively pursued
interconnection arrangements with the local PTTs, which allow us to provide
national origination on a cost-effective basis. Following interconnection, we
further increase our sales and marketing activities in a market in order to
promote our services. As part of our initial entry into a new market, we also
typically have concentrated on sales in ethnic communities since these market
segments can be effectively targeted with limited resources, enabling us to
rapidly generate revenues, create brand awareness and promote customer loyalty.
While our general sales and marketing strategy in continental Europe remains
consistent, we also tailor it to meet the needs of each particular market. For
example, in Belgium, we have generated significant revenues by placing our
prepaid cards (together with point of purchase displays) in many highly visible
locations such as bookstores, newsstands, kiosks and convenience stores. In
France, we concentrate on commercial accounts and employ an internal sales force
for this purpose. In Germany, we have an internal sales force in Hamburg that
primarily markets prepaid cards and commercial long distance services. We also
plan to market our "1+" long distance services in Germany during the first
quarter of 1999 through a multilevel marketing program that is similar to our
U.K. program. In Switzerland, we market our services through indirect channels,
supported by direct advertising in national media. We also cross-market our
services in Switzerland. For example, we intend to begin providing Internet
services in
39
<PAGE>
Switzerland by the second quarter of 1999 and expect to offer one year of free
Internet access to customers who sign up for our long distance services.
We also adapt successful marketing approaches from certain countries to
other continental European markets. For example, we intend to advertise in
national magazines and newspapers in Germany, which has been effective in
Switzerland. In addition, we intend to replicate the success of our multilevel
marketing program in the United Kingdom in our other European markets.
We have an internal sales force based in each city in which we have a switch
except Amsterdam. In each of these cities, we are expanding our internal sales
forces and recruiting additional independent sales representatives.
UNITED KINGDOM
In the United Kingdom, we market our services nationally. We offer
substantially all of our U.K. services through Telco, our wholly-owned U.K.
subsidiary.
Our residential domestic and international long distance service and calling
and prepaid cards are marketed primarily by independent sales representatives
through multilevel marketing. We believe that multilevel marketing is the most
cost-effective way to continue to increase our U.K. residential and card-based
customer revenues since it encourages independent sales representatives to both
sell services and recruit additional independent sales representatives. Sales
representatives are motivated to both sell and recruit because they receive a
commission based on their own sales and sales of representatives recruited by
them. A substantial number of these sales representatives operate on a part-time
basis, using the commissions from sales of services as a secondary source of
income. During December 1998, we had approximately 4,000 independent sales
representatives that received commissions. In addition, we are one of only 150
companies, and the first telecommunications company, to be accepted for
membership in the Direct Sellers Association, a nationally recognized U.K.
industry trade group for multilevel marketing.
We market domestic and international long distance services to U.K.
commercial accounts and carrier services to carrier customers through a direct
sales force. We have adopted this approach for these services since they are
more complex and usually require a longer sales cycle.
We recently increased our U.K. prepaid card distribution capabilities
through our acquisition of a controlling interest in America First, a
well-recognized prepaid card distributor, during the fourth quarter of 1998. We
intend to migrate our U.K. prepaid card distribution to America First because we
believe that America First is well positioned as an experienced and recognized
distributor of prepaid phone cards in the London area.
NORTH AMERICA
UNITED STATES. Prior to 1998, we marketed our services primarily in the New
York metropolitan area. During 1998, we significantly expanded our marketing
efforts beyond the New York metropolitan area to include other U.S. network
cities. We now have independent sales representatives in all of our network
cities and have internal sales representatives in New York, Los Angeles, Miami
and Washington, D.C.
Our international and domestic residential long distance services, which are
marketed primarily to ethnic communities, are sold primarily through independent
sales representatives. We target ethnic communities for these services because
we believe that members of these communities generate above average
international calling volumes, are not as heavily targeted by other long
distance providers as the general population and enable us to build brand
recognition in a well-defined community. We intend to expand the use of
independent sales representatives to market our residential services in the
United States beyond the ethnic market.
40
<PAGE>
Our international and domestic long distance services for commercial
accounts are sold primarily through our internal sales force, which targets
accounts with significant calling volumes to European destinations. Many
business customers also require unified or other specialized billing formats.
Members of our sales force work with customers to address their billing needs
such as providing monthly bills with breakdowns of usage by account code, area
code or department.
Our calling card services are marketed and co-branded under both the
VoiceNet and EconoCard-TM- brand names. VoiceNet calling cards are marketed
primarily through in-flight magazines, national magazines and newspapers and
through advertising materials placed in high traffic locations, such as
restaurants. We also market VoiceNet calling cards through independent sales
representatives. EconoCard calling cards are marketed to ethnic groups in
conjunction with our residential services.
Prepaid cards are sold under a variety of brand names in major metropolitan
areas and are primarily sold through wholesale distributors and other
independent sales representatives. These distinctively branded prepaid cards can
be accessed by dialing a local access number in the area in which the card was
purchased, which reduces our costs and permits us to offer lower rates than most
of our competitors. This is important because prepaid card customers are
particularly price sensitive and frequently purchase prepaid cards based on
small differences in price for calls to specific destinations.
We currently are in the process of implementing a cross-marketing program to
VoiceNet customers to offer them our "1+" long distance service in the United
States. We also have expanded our marketing of new services to existing
residential long distance customers by describing these services regularly in
the ECONOTIPS monthly insert included with each customer bill. In addition, we
have entered into affinity programs with major credit card companies, such as
First USA and GE Capital, to promote our VoiceNet calling cards. These affinity
programs include mass mailings in customers' monthly billing statements that
contain a preapproved VoiceNet calling card which, when used by the customer, is
automatically billed to the customer's credit card account.
We use an internal sales force to market to carrier customers and other
wholesale customers that purchase privately branded calling cards and prepaid
cards. We have adopted this sales approach for these services since they are
more complex and usually require a longer sales cycle.
CANADA. In Canada, we currently market our services in Toronto and Montreal
primarily to ethnic communities that generate substantial international calling
volume. Marketing is being done primarily through independent sales
representatives and our internal sales representatives in Canada. As we expand
our customer base in Toronto and Montreal, we intend to broaden our target
customer groups, introduce additional services and increase our internal sales
and marketing capabilities.
CUSTOMER SERVICE
We are committed to providing our customers with superior customer service
and believe that we have developed the infrastructure necessary to serve both
our existing customer base and accommodate substantial growth with minimal
additional investment. We have a 24-hour-a-day customer service department
located in College Station, Texas, which, at December 31, 1998, had 157
full-time equivalent customer service representatives. In the United Kingdom, we
also maintain a 24-hour-a-day customer service department that, at December 31,
1998, had 65 full-time equivalent customer service representatives located at
the Telco facility in London, England. In continental Europe, each country in
the Destia Network has a customer call center, which in the aggregate totalled
20 full-time equivalent customer service representatives at December 31, 1998.
At all of our customer service facilities, our customer service representatives
handle both service and billing inquiries. In addition, our call centers all
have representatives that are multilingual.
We also have developed our own proprietary software systems to better serve
our customers. For example, in each of our network countries, our monthly bills
are in the customer's native language and
41
<PAGE>
local currency (and we have the ability to bill in euros). We also provide
detailed billing information for commercial customers that includes itemized
breakdowns of usage by account code and department. In addition, we are
currently implementing an interactive voice response system that will permit
customers to obtain up-to-date information concerning their account and their
most recent invoice. We believe that our customer-oriented philosophy backed by
the strength of our customer support infrastructure allows us to differentiate
ourselves from our competitors.
COMPANY OPERATIONS
Currently, our extensive international telecommunications network allows us
to provide services in many of the largest metropolitan markets in the United
States, Canada, the United Kingdom, Belgium, France, Germany and Switzerland.
Our operations in each of our principal markets are briefly described below.
CONTINENTAL EUROPE
A significant component of our growth strategy is focused on the continued
development of our business in the deregulating telecommunications markets of
continental Europe. Prior to January 1, 1998, there were significant regulatory
limitations on our ability to provide services in most continental European
countries. Now, as a result of EU and national regulatory initiatives, we may
provide a range of services in many of these countries that is comparable to the
services we provide in the United States and the United Kingdom. In some cases,
however, national regulatory restrictions and technology issues (such as credit
card verification for e-commerce purchases) may limit our ability to do so.
Subject only to these limitations, in continental Europe we intend to offer the
same range of services that we offer in the United States and the United
Kingdom.
BELGIUM. Belgium was our third largest market based on revenues for the
nine months ended September 30, 1998. Sales of prepaid cards comprised the
largest portion of our Belgian revenues, followed by revenues derived from
international long distance from commercial and residential customers.
Prior to January 1, 1998, due to regulatory limitations, we only were able
to provide a limited number of services in Belgium that included international
service utilizing international toll-free access and local access for card-based
services, but did not include domestic long distance service. Since regulatory
liberalization occurred on January 1, 1998, we have expanded our services to
include both domestic and international long distance service. In addition,
during the fourth quarter of 1998, we completed our interconnection with
Belgacom, the Belgian PTT. This interconnection provides us with a total of 10
connection points with Belgacom, including our switch in Brussels, and permits
us to provide our services to customers anywhere in Belgium. This
interconnection also permits us to provide network access to our customers
through abbreviated dialing and enables us to originate and terminate calls in
Belgium on a more cost effective basis.
FRANCE. We have offered long distance service to customers in Paris since
the first quarter of 1997, in Marseilles and Nice since the fourth quarter of
1997 and in Lyon and Toulouse since the fourth quarter of 1998. Our revenues in
France are currently predominantly generated by international long distance
services. Sales of prepaid cards comprise virtually all of the other revenues.
Most of our customers have CLI (calling line identity), which allows our
switches to recognize the number that the customer is calling from, so that the
customer can access our network without the need for a personal identification
number. In addition, we provide automatic dialers free of charge to our
commercial accounts. Automatic dialers eliminate the need for a customer to dial
a prefix to use our services.
Our network includes a switch in Paris and POPs in Marseilles, Toulouse,
Nice and Lyon. During the fourth quarter of 1998, we entered into an
interconnection agreement with France Telecom that will enable our customers to
access our long distance service from their home or office through abbreviated
dialing, although certain carriers (including France Telecom) are able to
provide direct, "1xxx" access. We
42
<PAGE>
anticipate that our interconnection with France Telecom will be fully
operational during the second quarter of 1999 since France Telecom has indicated
that we will be able to complete our interconnection by February 15, 1999.
However, there are often delays in executing and implementing interconnection.
See "Risk Factors--Need for Interconnection" and "--Regulation."
GERMANY. Germany is the largest market for telecommunications services in
continental Europe. Our principal service in Germany is our prepaid card
service, which we offer predominantly to commercial accounts. We currently
provide international long distance service, which we market primarily to
commercial customers. We have offered this service in Hamburg since the first
quarter of 1997, in Berlin since the fourth quarter of 1997 and in Frankfurt
since the third quarter of 1998. We will begin marketing domestic long distance
services in the first quarter of 1999 because we completed interconnection in
the fourth quarter 1998. We also plan to begin marketing long distance services
to residential accounts in 1999. We intend to introduce our Presto! card in
Germany during the second quarter of 1999. In addition, in 1999, we intend to
roll out our successful U.K. multilevel marketing program in Germany and to
establish an internal sales force in Frankfurt. See "--Sales and
Marketing--United Kingdom."
As of December 31, 1998, we had switches in Berlin and Frankfurt and a POP
in Hamburg. We expect to upgrade our Hamburg POP to a switch during the first
quarter of 1999. We believe that our Frankfurt switch will allow us to take
advantage of the growing popularity of Frankfurt as a European hub for
telecommunication carriers, especially for calls to and from Eastern Europe, and
we intend to market our carrier services to carriers that route calls through
Frankfurt.
During the fourth quarter of 1998, we implemented our interconnection with
Deutsche Telekom, which enables us to offer customers in our German network
cities and the surrounding metropolitan areas, both domestic and international
long distance service through "1+" access. We plan to add additional
interconnection points in Germany in 1999 to meet additional traffic or
regulatory requirements, which will enable us to originate and terminate traffic
in most of the major cities in Germany.
SWITZERLAND. Switzerland has been substantially deregulated. Our principal
service in Switzerland is international long distance. Customers may preselect
our company as their long distance carrier and make long distance calls on our
network using "1+" dialing. During 1998, the majority of our customers were
commercial accounts. During the first quarter of 1999, we intend to begin
providing Internet services in Switzerland and expect to offer one year of free
Internet access to customers who sign up for our long distance services.
We established a POP in Zurich during the third quarter of 1997 and upgraded
it to a switch in the third quarter of 1998. In addition, during October 1998,
we were the fourth telecommunications carrier to be interconnected to SwissCom,
the PTT in Switzerland. This interconnection enables us to originate and
terminate traffic in Switzerland more cost effectively, which provides us with a
competitive advantage over those of our competitors who do not currently have
interconnection. Since we completed our interconnection in October 1998, our
number of customers has more than doubled and as of December 31, 1998 we had
approximately 7,000 customer accounts in Switzerland. During the same period,
our Swiss revenues also more than doubled. We intend to expand our customer base
significantly in Switzerland during 1999. We anticipate, however, that
additional competitive carriers will obtain interconnection rights from
SwissCom, which will lead to increased competition.
UNITED KINGDOM
Since 1991, the U.K. government has sought to encourage increased
competition in telecommunications services. As a result of regulatory
initiatives, the telecommunications market in the United Kingdom now resembles
the United States in terms of services and pricing.
International and domestic long distance services generated the largest
percentage of our U.K. revenues during 1998. We have provided these services in
the London area since the fourth quarter of 1996
43
<PAGE>
and nationwide in the United Kingdom since the second quarter of 1997. Our other
principal services in the United Kingdom are prepaid cards and sales to
resellers and carrier customers. We also intend to launch the Presto! card in
the United Kingdom during the second quarter of 1999.
We offer all our residential, calling card and prepaid services in the
United Kingdom primarily through Telco. We believe that Telco has been
particularly successful marketing our services in the United Kingdom through our
multilevel marketing program. Our prepaid card services, which are currently
offered by Telco, are being migrated to America First, a prepaid card
distributor that we acquired a majority interest in during the fourth quarter of
1998. See "--Sales and Marketing--United Kingdom."
We currently have five interconnection points in London that enable us to
provide our services throughout the United Kingdom. However, our U.K. customers
currently are unable to preselect any carrier except British Telecom as their
long distance carrier and thus cannot access our services without first dialing
a four-digit access code. Under EU regulations, preselection is scheduled to
become available by January 1, 2000, although the U.K. regulator is seeking a
waiver of this requirement until a later date. In order to migrate more traffic
on to our network, we are marketing automatic dialers to our residential and
commercial customers in order to compete more effectively against British
Telecom, which provides long distance service without requiring the user to dial
an access code. Customers purchase or lease the dialer, which automatically
dials our network access code for the customer.
Our European network (including the United Kingdom) is monitored by ATL,
one of our wholly-owned subsidiaries, in London and our network operations
center in St. Louis, Missouri.
NORTH AMERICA
UNITED STATES. The United States is one of our original markets. We have
been providing international and domestic long distance service in the New York
metropolitan area since 1993. We now also provide our calling card, prepaid
card, wireless access to long distance and directory assistance services
nationally and provide our other services (primarily residential and commercial
long distance) in the 15 U.S. cities in which the Destia Network has a switch or
POP. Because of the U.S. market's size and receptiveness to new services, we
typically introduce new services in the United States before our other markets.
For example, during the last quarter of 1998, we first introduced our Presto!
service in the United States over the Internet. We also intend to test (and
cross market) additional e-commerce services to Presto! customers due to their
predisposition to making purchases on-line.
As of December 31, 1998, we had six switches and nine POPs in the United
States, which enable us to originate domestic and international long distance
calls in many of the largest U.S. metropolitan areas. Because of the substantial
increase in our domestic traffic and our desire to provide services in more U.S.
markets, we recently acquired a 20-year IRU from Frontier to use its U.S. fiber
optic network. This will replace our use of the Qwest network. Frontier is in
the process of building its fiber optic network. This build-out of Frontier's
planned network is approximately 60% completed and we expect it to be fully
operational by the end of 1999, although there can be no assurance in this
regard. In addition, the Frontier arrangement will give us favorable origination
and termination rates throughout the continental United States. See "--The
Destia Network--North American Network--U.S. Network Expansion."
CANADA. We expanded our network into Canada during the third quarter of
1998 by installing a switch in Toronto. We also plan to install a POP in
Montreal by July 1999. This switch and POP will enable us to originate and
terminate calls in Toronto and Montreal, two of the largest long distance
markets in Canada. Like most of western Europe, Canada also has recently
liberalized its telecommunication laws. Since October 1, 1998, private carriers
have been able to provide international long distance service originating in
Canada. As of January 1, 1999, we were granted a license under this liberalized
regulatory regime to provide competitive telecommunications services. Additional
deregulation, which would permit us also to provide domestic long distance
service, is expected by January 1, 2000. We began providing
44
<PAGE>
services in Canada late in the fourth quarter of 1998 and intend to further
expand our internal sales force in Canada in 1999.
COMPETITION
The international telecommunications industry is highly competitive and
significantly affected by regulatory changes, marketing and pricing decisions of
the larger industry participants and the introduction of new services and
transmission methods made possible by technological advances. We believe that
long distance service providers compete principally on the basis of price,
customer service, product quality and breadth of services offered. In each
country of operation, we have numerous competitors. We believe that as the
international telecommunications markets continue to deregulate, competition in
these markets will increase, similar to the competitive environment that has
developed in the United States following the AT&T divestiture in 1984. Prices
for long distance calls in the markets in which we compete have declined
historically and are likely to continue to decrease. Many of our competitors are
significantly larger, have substantially greater financial, technical and
marketing resources and larger networks than us.
Privatization and deregulation have had, and are expected to continue to
have, significant effects on competition in the industry. For example, as a
result of legislation enacted in the United States, RBOCs will be allowed to
enter the long distance market, AT&T, MCI WorldCom and other long distance
carriers will be allowed to enter the local telephone service markets, and cable
television companies and utilities will be allowed to enter both the local and
long distance telecommunications markets. In addition, competition has begun to
increase in the EU telecommunications markets in connection with the
deregulation of the telecommunications industry in most EU countries, which
began in January 1998. This increase in competition is likely to affect revenue
per minute and gross margin as a percentage of revenue.
NORTH AMERICA
UNITED STATES. In the United States, which is among the most competitive
and deregulated long distance markets in the world, competition is based
primarily upon pricing, customer service, network quality, and the ability to
provide value added services. As such, the long distance industry is
characterized by a high level of customer attrition or "churn," with customers
frequently changing long distance providers in response to the offering of lower
rates or promotional incentives by competitors. We compete with major carriers
such as AT&T, MCI WorldCom and Sprint, as well as other national and regional
long distance carriers and resellers, many of whom are able to provide services
at costs that are lower than our current costs. Many of these competitors have
greater financial, technological and marketing resources than we do. If any of
our competitors were to devote additional resources to the provision of
international and/or domestic long distance telecommunications services to our
target customer base, there could be a material adverse effect on our business
and the price of our common stock.
As a result of the 1996 Telecommunications Act, the RBOCs are also expected
to become competitors in the long distance telecommunications industry, both
outside of their service territory and, upon satisfaction of certain conditions,
within their service territory. The Telecommunications Act prospectively
eliminated the restrictions on incumbent LECs, such as the RBOCs, from providing
long distance service. These provisions permit an RBOC to enter an
"out-of-region" long distance market immediately upon the receipt of any state
and/or federal regulatory approvals otherwise applicable in the provision of
long distance service. RBOCs must satisfy certain procedural and substantive
requirements, including obtaining FCC approval upon a showing that, in certain
instances, facilities-based competition is present in its market, that it has
entered into interconnection agreements that satisfy a 14-point checklist of
competitive requirements and that its entry into the in-region long distance
market is in the public interest before they are authorized to offer long
distance service in their regions. No RBOC is authorized to do so yet, but they
are expected to be authorized soon. When they are authorized, they will be very
formidable competitors. In particular, Bell Atlantic, which serves the New York
metropolitan and mid-Atlantic regions, is considered by industry observers to be
the most likely RBOC to be the first to be permitted to offer long distance
45
<PAGE>
services. Because a substantial portion of our customer base and traffic
originates in the New York metropolitan area, Bell Atlantic will be a
particularly formidable competitor.
The continuing trend toward business combinations and alliances in the
telecommunications is also creating significant new or more powerful competitors
to our company. The proposed acquisition of GTE by Bell Atlantic, the merger of
WorldCom and MCI, AT&T's proposed acquisition of Telecommunications, Inc. and
AT&T's acquisition of Teleport Communications Group, Teleglobe's acquisition of
Excel Communications and SBC's acquisition of SNET are examples of some of the
business combinations that are being formed. Many of these combined entities
have, or will have, resources far greater than those of our company. These
combined entities may, now or in the future, be able to provide bundled packages
of telecommunications products, including local and long distance services and
data services and prepaid services, in direct competition with the products
offered or to be offered by us, and may be capable of offering these products
sooner and at more competitive rates than us.
For example, AT&T's recently announced agreement to acquire Smartalk, which
sells prepaid cards would, if consummated, provide AT&T with access to a major
distribution network for inexpensive prepaid cards, a market where AT&T has not
historically competed on the basis of price. AT&T's significant marketing
resources and extensive network would make it a formidable competitor in the
prepaid card market.
The World Trade Organization (the "WTO") recently concluded an agreement,
known as the WTO Basic Telecommunications Service Agreement (the "WTO
Agreement") could also result in additional competitors entering the U.S.
telecommunications markets. Under the WTO Agreement, the U.S. and other members
of the WTO committed themselves to, among other things, opening their
telecommunications markets to foreign carriers. The FCC has adopted streamlined
procedures for processing market entry applications from foreign carriers,
making it easier for such carriers to compete in the U.S. There can be no
assurance that the WTO Agreement will not have a material impact on our
business.
We also expect increasing competition from Internet telephony service
providers, including Internet service providers. The use of the Internet to
provide telephone service is a recent development. To date, the FCC has
determined not to subject such services to FCC regulation as telecommunications
services. Accordingly, Internet service providers are, today, not subject to
universal service contributions, access charge requirements, or traditional
common carrier regulation. We cannot predict the impact that this continuing
lack of regulation will have on our business.
CANADA. The Canadian telecommunications market is highly competitive and is
dominated by a few established carriers whose marketing and pricing decisions
have a significant impact on the other industry participants, including our
company. We compete with facilities-based carriers, other resellers and
rebillers, primarily on the basis of price. The principal facilities-based
competitors include the former Stentor partner companies, in particular, Bell
Canada, the dominant supplier of local and long distance services in the
provinces of Ontario and Quebec, BC Tel and Telus Communications, as well as the
next largest Stentor companies which have announced a proposed merger, as well
as non-Stentor companies, such as AT&T Canada, Teleglobe Canada, and Sprint
Canada. We also compete with ACC TelEnterprises which, until its recent merger
with AT&T Canada, was one of the largest resellers in Canada. The former Stentor
partner companies discontinued their partnership on January 1, 1999 and are now
competing against one another for the first time.
46
<PAGE>
EUROPE
In continental Europe, our competitors include:
- PTTs;
- alliances such as Sprint's alliance with Deutsche Telekom and France
Telecom, known as "Global One", and AT&T's alliance with British Telecom
(that has recently announced a plan to contribute their international
facilities and personnel to a newly formed company that is likely to be a
substantially more formidable competitor);
- companies offering resold international telecommunications services; and
- other companies with business plans similar in varying degrees to us,
including emerging public telephone operators who are constructing their
own networks and wireless network operators.
We believe that our continental European markets will continue to experience
increased competition and will begin to resemble the competitive landscape in
the United States and the United Kingdom. In addition, we anticipate that
numerous new competitors will enter the continental European telecommunications
market.
Competition is strong in the liberalized U.K. telecommunications market. In
the United Kingdom our principal competitors are British Telecom, the U.K. PTT,
First Telecom and Cable & Wireless. We also face competition from emerging
licensed public telephone operators (who are constructing their own facilities-
based networks) and from resellers. We also compete with wireless service
providers and cable companies.
Furthermore, in certain European countries (including in France and Belgium)
"facilities based" carriers that make investments in infrastructure receive
lower interconnection rates than non-facilities based providers. We do not
expect to qualify for such a discount until we purchase more fiber optic
transmission capacity in Europe (particularly in France and Belgium). In
addition, certain of our competitors offer customers an integrated full service
telecommunications package consisting of local and long distance voice, data and
Internet transmission. We do not currently offer all of these types of service,
which could have a material adverse effect on our competitiveness and the price
of our common stock.
For a discussion of additional competitive factors that affect our business
in certain of our markets, see "Risk Factors--Competition" and "Risk
Factors--Increasing Pricing Pressures."
REGULATION
Regulation of the telecommunications industry is changing rapidly both
domestically and globally. As an international telecommunications company, we
are subject to varying degrees of regulation in each of the jurisdictions in
which we provide our services. Laws and regulations, and the interpretation of
such laws and regulations, differ significantly among the jurisdictions in which
we operate. There can be no assurance that future regulatory, judicial and
legislative changes will not have a material adverse effect on our company or
that domestic or international regulators or third parties will not raise
material issues with regard to our compliance or noncompliance with applicable
regulations.
See "Risk Factors--Need for Interconnection" for a discussion of certain
regulatory risks relating to our business. The regulatory framework in certain
jurisdictions in which we provide our services is described below:
UNITED STATES
In the United States, our services are subject to the provisions of the
Communications Act of 1934, as amended by the 1996 Telecommunications Act, the
FCC regulations thereunder, as well as the applicable laws and regulations of
the various states administered by the relevant state public service commissions
("PSCs"). The recent trend in the United States for both federal and state
regulation of
47
<PAGE>
telecommunications service providers has been in the direction of reduced
regulation. Although this trend facilitates market entry and competition by
multiple providers, it has also given AT&T, the largest international and
domestic long distance carrier in the United States, increased pricing and
market entry flexibility that has permitted it to compete more effectively with
smaller carriers, such as the company. In addition, the 1996 Telecommunications
Act has opened the United States market to increased competition, including for
RBOCs as well as current and former PTTs. We cannot be certain whether future
regulatory, judicial and legislative changes in the United States will not
materially affect our business and the price of our common stock.
The FCC currently regulates our company as a non-dominant carrier with
respect to both its international and domestic interstate long distance
services. Although the FCC has generally chosen not to closely regulate the
charges, practices or classifications of non-dominant carriers, the FCC has
broad authority which includes the power to impose more stringent regulatory
requirements on our company, to change our regulatory classification, to impose
monetary forfeiture, and to revoke our authority. In this increasingly
deregulated environment, however, we believe that the FCC is unlikely to do so
with respect to our international or domestic service offerings.
FCC INTERNATIONAL. In addition to the general requirement that we obtain
authority under Section 214 of the Communications Act and file a tariff
containing the rates, terms and conditions applicable to our international
services, we also are subject to the FCC's international service policies,
certain of which may affect our ability to provide our services in the most
economical and, thus, profit-maximizing fashion. For example, the FCC's private
line resale policy, part of its International Settlements Policy ("ISP"),
prohibits a carrier from reselling interconnected international private leased
circuits to provide switched services (known as "ISR") to or from a country
absent FCC authorization. The FCC recently modified its policy on private line
resale to allow such resale between the U.S. and a WTO member country for which
the FCC has not previously authorized the provision of switched services over
private lines upon a demonstration that (1) settlement rates for at least 50
percent of the settled U.S.-billed traffic between the U.S. and the country at
the foreign end of the private line are at or below the benchmark settlement
rate adopted by the FCC, or (2) where the country at the foreign end affords
resale opportunities "equivalent" to those available under U.S. law. Both
conditions must be present before the FCC will authorize private line resale
between the U.S. and a non-WTO member country for which the FCC has not
previously authorized the provision of private line resale. The following
countries have been approved by the FCC for ISR to date: Australia, Austria,
Belgium, Canada, Denmark, France, Germany, Hong Kong, Ireland, Italy, Japan,
Luxembourg, New Zealand, Netherlands, Norway, Sweden, Switzerland, United
Kingdom. The practical implication for us of this policy is that we are
restricted 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 approved for ISR); and (ii) transmitting calls from continental European
countries (other than those approved for ISR) over leased lines from London and
then onward over a leased line between London and New York, although in both
cases around hubbing via "switched hubbing" is permitted to non-ISR-approved
countries. The policy may materially limit the best and most profitable use of
our leased lines between New York and London and may result in increased
transmission costs on certain calls, which we are not able to pass through to
our customers.
We are also subject to the FCC's International Settlements Policy which
governs the settlement between U.S. carriers and their foreign correspondents of
the cost of terminating traffic over each other's network, the "benchmark"
settlement rates for such settlements, and permissible exceptions of these
policies. The FCC could find that, absent a waiver, certain terms of our foreign
carrier agreements do not meet the requirements of the International Settlements
Policy or that certain actions do not constitute permissible deviations from
this policy. Although the FCC generally has not issued penalties in this area,
it has recently issued a Notice of Apparent Liability against a U.S. company for
violating the International Settlements Policy and it could, among other things,
issue a cease and desist order or impose fines if it finds that these agreements
conflict with the International Settlements Policy. We do not believe that any
48
<PAGE>
such fine or order would have a material adverse effect on our business or the
price of our common stock. In addition, the FCC is presently reconsidering
certain aspects of its ISP, including the complete elimination of its ISP and
contract filing requirements on competitive routes, elimination of these
requirements for arrangements with non-dominant carriers in WTO member countries
and allowing greater opportunities to engage in international simple resale. The
FCC also regulates foreign carrier affiliations.
The FCC and certain State PSCs require prior approval of transfers of
control, including PRO FORMA transfers of control resulting from corporate
reorganizations, and assignments of regulatory authorizations. Such requirements
may delay, prevent or deter a change in control of our company. Additionally,
the FCC and certain State PSCs require notification of our name change from
Econophone, Inc. to Destia Communications, Inc. Although we believe that no
material penalties will result from our failure to notify the FCC and certain
State PSCs of the name change prior to its effectuation or from our failure to
seek prior approval or take certain actions, we cannot be certain whether this
will be the case.
FCC DOMESTIC INTERSTATE. We are considered a non-dominant domestic
interstate carrier subject to minimal regulation by the FCC. We are not required
to obtain FCC authority to expand our domestic interstate operations, but we are
required to maintain, and do maintain, a domestic interstate tariff on file with
the FCC. 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 our 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
us to revise our tariffs, or the FCC could prescribe revised tariffs.
The 1996 Telecommunications Act is intended to increase competition in the
U.S. telecommunications markets. Among other things, the legislation contains
special provisions that eliminate the restrictions on incumbent LECs such as the
RBOCs from providing long distance service. These provisions permit an RBOC to
enter an "out-of-region" long distance market immediately upon the receipt of
any state and/or federal regulatory approvals otherwise applicable in the
provision of long distance service. The provisions also permit an RBOC to enter
the "in-region" long distance market if it satisfies procedural and substantive
requirements, including obtaining FCC approval upon a showing that in certain
situations facilities-based competition is present in its market, that it has
entered into interconnection agreements which satisfy a 14-point "checklist" of
competitive requirements and that its entry into the "in-region" long distance
market is in the public interest.
A number of RBOCs have made initial applications for the approvals necessary
to enter their "in-region" long distance markets, although, to date, all such
applications have been denied on the basis that the RBOC has not satisfied the
list of competitive requirements. However, there have recently been extensive
discussions among the state PSCs, the FCC and RBOCs in order to develop a
definitive understanding of these requirements and the specific criteria to
measure their satisfaction. These discussions may lead to one or more successful
RBOC "in-region" applications in the future. In particular, Bell Atlantic, which
serves the New York metropolitan and mid-Atlantic regions is considered by
industry observers to be the most likely RBOC to be the first to be permitted to
offer long distance services. Because a substantial portion of our customer base
and traffic originates in the New York metropolitan area, Bell Atlantic would be
a particularly formidable competitor.
The 1996 Telecommunications Act also addresses a wide range of other
telecommunications issues that may potentially impact our operations. It is
unknown at this time precisely the nature and extent of the impact that the
legislation will have on us. On August 1, 1996, the FCC adopted an
Interconnection Order implementing the requirements that incumbent LECs make
available to new entrants interconnection and unbundled network elements, and
offer retail local services for resale at wholesale rates. Important portions of
the FCC's order were subsequently overturned by a court order. However, on
January 25, 1999, the U.S. Supreme Court upheld most of the challenged rules,
finding that the FCC has significant jurisdiction to establish rules to promote
competition for competitive local exchange services. Although
49
<PAGE>
some of the FCC's rules may be challenged in future proceedings and the Supreme
Court decision requires the FCC to conduct additional proceedings to determine
new unbundling standards, the Supreme Court decision seems likely to promote
competition for telecommunications services generally.
Section 706 of the Telecommunications Act gives the FCC the right to forbear
from regulating a market if the FCC concludes that such forbearance is necessary
to encourage the rapid deployment of advanced telecommunications capability.
Section 706 has not been used to date, but in January 1998, Bell Atlantic filed
a petition under Section 706 seeking to have the FCC deregulate entirely the
provision of packet-switched telecommunications services. Similar petitions were
filed later by the Alliance for Public Technology and US West Inc. (currently
Media One Group Inc.) and other ILECs are expected to file similar petitions in
the near future.
On August 7, 1998, the FCC released an order denying requests by the RBOCs
that it use Section 706 of the Telecommunications Act to forbear from regulating
advanced telecommunications services. Instead, the FCC determined that advanced
services are telecommunications services and that ILECs providing advanced
services are still subject to unbundling and resale obligations of Section
251(c) and the in-region interLATA restrictions of Section 271.
On the same day, the FCC released a Notice of Proposed Rulemaking ("NPRM")
proposing that ILECs be permitted to offer advanced services through separate
affiliates. Subject to certain restrictions on transfers from the ILEC to the
affiliate, structural separation rules and nondiscrimination safeguards, these
separate affiliates would not be subject to the obligations imposed on ILECs
under Section 251(c), but would remain subject to the in-region interLATA
restrictions imposed on RBOCs and RBOC affiliates by Section 271. In the order,
the FCC did not specifically authorize ILECs to provide advanced services
through a separate affiliate immediately. ILECs may, of course, immediately
provide advanced services but until the separate affiliate is properly
established pursuant to rules to be promulgated following comment on the NPRM,
such provision of advanced services will be subject to Section 251. The outcome
of this proceeding could materially adverse affect our business and the price of
our common stock.
The FCC has also significantly revised the universal service subsidy regime.
Beginning January 1, 1998, interstate carriers, such as our company, as well as
certain other entities, 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. Our share of these
federal subsidy funds will be based on our share of certain defined
telecommunications end-user revenue. Our revenues that are subject to the high
cost and low income fund are our quarterly interstate and gross end-user
telecommunications revenues. Our revenues for the schools and libraries and
rural health care fund are our estimated quarterly intrastate, interstate and
international gross end-user telecommunications revenues. Contribution factors
vary quarterly and we and other carriers are billed monthly. Contribution
factors for first quarter 1999 are: (i) 3.18% for the high cost and low income
funds (interstate and international revenues); and (ii) 0.58% for the schools,
libraries, and rural health care funds (intrastate, interstate and international
revenues). Because the contribution factors do vary quarterly, the annualized
impact on our company cannot be estimated at this time, although we do not
expect it to be material.
Our costs of providing long distance services will also be affected by
changes in the access charge rates imposed by incumbent LECs for origination and
termination of calls over local facilities. The FCC has significantly revised
its access charge rules in recent years to permit incumbent LECs greater pricing
flexibility and relaxed regulation of new switched access services in those
markets where there are other providers of access services. The Company
currently has agreements to terminate, originate or exchange traffic with a
variety of carriers who, in turn, may be subject to similar agreements with
other carriers or LECs. Any change in any of these agreements, whether by
operation of law or otherwise, may affect the company's costs or could disrupt
the company's ability to terminate, originate or exchange traffic and,
50
<PAGE>
therefore, have a material adverse effect on our company. The FCC has, for
example, created a new presubscribed interexchange carrier charge ("PICC") rate
element. The PICC is a flat-rate, per line charge that is recovered by LECs from
interexchange providers. Effective January 1, 1998, the initial maximum
permitted interstate PICC charge is $0.53 per month for primary residential
lines and single-line business lines and $1.50 per month for second and
additional residential lines. The initial maximum interstate PICC for multi-line
businesses are $2.75 per month, per line. The ceilings will be permitted to
increase over time. The FCC continues to adjust its access charge rules and has
indicated that it will promulgate additional rules sometime in 1999 that may
grant certain LECs further flexibility. While we currently intend to pass
through the costs of both the PICC and our universal service fund contributions
to our customers, there can be no assurance that we 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 are subject to petitions seeking reconsideration by the FCC and to
certain appeals. Until such petitions and appeals are decided, there can be no
assurance as to how the orders will be ultimately implemented or enforced or
what effect the orders will have on competition within the telecommunications
industry or specifically on our competitive position.
The 1996 Telecommunications Act also requires interexchange carriers to
compensate payphone owners when a payphone is used to originate a telephone call
through an access code or a toll-free number (including by means of a prepaid
calling card). In orders issued in September and October of 1996, the FCC
established a compensation scheme that required all carriers to begin
compensating payphone owners on a per-call basis beginning October 7, 1997 at a
rate $.35 per call. On July 1, 1997, the United States Court of Appeals for the
District of Columbia ("D.C. Circuit") issued an opinion reversing in part the
FCC's payphone orders. The court ruled that the rate of $.35 per call was
arbitrary and capricious and remanded the case to the FCC for further
proceedings. The FCC, thereafter, issued a further rulemaking on compensation
for payphone owners. On October 9, 1997, the FCC ruled that interexchange
carriers are required to compensate payphone owners at a rate of $.284 for all
calls using their payphone. The FCC ruled that this compensation method will be
effective from October 7, 1997 through October 7, 1999. On May 15, 1998, the
D.C. Circuit remanded the order to the FCC, ruling that the $.284 rate
established was arbitrary and capricious, but did not vacate it. We expect the
FCC to issue a further remand order establishing a revised payphone compensation
rate during the first quarter of 1999.
The FCC also imposes requirements for the marketing of telephone services
and for obtaining customer authorization for changes in a customer's primary
long distance carriers. The FCC has recently imposed severe penalties on a
number of carriers for "slamming," the unauthorized change of a customer's
presubscribed long distance carrier. Under an order recently issued by the FCC,
carriers such as our company, are required to take certain additional steps to
prevent slamming. The FCC is continuing to reexamine its slamming rules.
STATES. Our predecessor corporation, Econophone, Inc., which was
incorporated in New York, received authorization, where necessary, either
pursuant to certification, the fulfillment of tariff requirements or
notification requirements, to provide long distance services in 49 states.
Following the reorganization of Econophone, Inc. as a Delaware corporation, the
authorizations were transferred to us. We in turn have recently transferred the
authorizations to a recently created wholly-owned subsidiary, Econophone
Services, Inc. Certificates of authority can generally be conditioned, modified,
canceled, terminated or revoked by state regulatory authorities for failure to
comply with state law and/or rules, regulations and policies of the state
regulatory authorities.
Many states also impose various reporting and other requirements. A number
of state PSCs have adopted rules governing the markets of telephone services and
obtaining customer authorizations for changes of a customers' primary long
distance carrier. State commissions also regulate access charges and other
pricing for telecommunications services within each state. We may also be
required to contribute to universal service funds in some states.
51
<PAGE>
REGULATION OF THE INTERNET. The use of the Internet to provide telephone
service is a recent development. Currently, the FCC is considering whether or
not to impose surcharges or additional regulations upon certain providers of
Internet telephony. In an April 1998 report to Congress, the FCC indicated it
would examine the question of whether certain forms of "phone-to-phone" Internet
protocol telephony are information services or telecommunications services. It
noted that certain forms of phone-to-phone Internet telephony appeared to have
the same functionality as non-Internet protocol telecommunications services and
lacked the characteristics that would render them information services. If the
FCC were to determine that certain services are subject to FCC regulations as
telecommunications services, it may require these service providers to make
universal service contributions, pay access charges or be subject to traditional
common carrier regulation. State PSCs may also retain jurisdiction to regulate
the provision of intrastate Internet telephony services and could initiate
proceedings to do so.
PATENT RIGHTS RELATING TO PREPAID SERVICES. Various parties have claimed
that certain prepaid card providers are infringing upon patent rights held by
these parties relating to the provision of prepaid card services. We do not
expect that our prepaid card services will be found to infringe upon any
third-party patent rights, although there can be no assurance that we would
prevail if a claim were asserted by a third party. If we were unable to provide
our prepaid card services in the manner in which they currently are provided, it
could have a material adverse effect on our business and the price of our common
stock.
EUROPEAN UNION
In Europe, the regulation of the telecommunications industry is governed at
a supra national level by the European Commission ("EC"), consisting of the EU
member countries. The EU member countries include: Austria, Belgium, Denmark,
Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The Netherlands,
Portugal, Spain, Sweden and the United Kingdom. The EU is responsible for
creating pan-European policies and, through legislation, developing a regulatory
framework to ensure an open, competitive telecommunications markets.
As of January 1, 1998 the EU abolished all special or exclusive rights that
restrict the provision of telecommunications services. Specific directives have
been adopted, which include the Open Network Provision ("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, the latter of which would provide for equal access
and number portability on January 1, 2000. Equal access would enable a customer
to access our network over another operator's network, without dialing an access
code, by "preselecting" our company as its long distance carrier. However, Oftel
already has indicated that it will seek to defer the implementation of equal
access in the United Kingdom, and PTTs and/or regulators in certain other EU
jurisdictions also are expected to seek deferrals. 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.
Certain EU countries have temporary waivers from these EU deregulation
requirements: Greece and Portugal until January 1, 2000.
National governments also must pass legislation within their countries to
give effect to EC directives. Each EU member state in which we currently conduct
business will therefore continue to, in part, have a different regulatory
regime. The requirements for us to obtain necessary approvals vary considerably
from country to country and are expected to continue to so vary. See "Risk
Factors--Regulatory Restrictions."
WORLD TRADE ORGANIZATION INITIATIVES. The WTO recently concluded the WTO
Agreement, which opens the telecommunications markets of the signatory countries
to entry by foreign carriers on varying dates and to varying degrees. The WTO
Agreement became effective on February 5, 1998. Pursuant to the WTO Agreement,
U.S. companies would have foreign market access for local, long distance and
52
<PAGE>
international services, either on a facilities basis or through resale of
existing network capacity on a reasonable and non-discriminatory basis. Although
the WTO Agreement may open additional markets to us or broaden the permissible
services that we can provide in certain markets, the WTO Agreement also may
subject us to greater competitive pressures in our markets, with the risk of
losing customers to other carriers and reductions in our rates.
UNITED KINGDOM. Licenses are needed to provide all the international
services that we provide in the United Kingdom. Licenses are granted by the
Secretary of State for Trade and Industry but enforced by the U.K. regulatory
authority under powers granted by the Telecommunications Act, 1984. We have all
of the necessary licenses to provide our services in the United Kingdom.
International simple resellers, such as our company, operate under
registrable class licenses. Through our subsidiary ATL, we have an International
Simple Voice Resale Class License (the "ISVR"), which entitles us to resell
international message, telephone and private line services. The ISVR license
also enables ATL to interconnect with, and lease capacity at wholesale rates
from, British Telecom and other public telecommunications operators. We also
have an International Facilities License, which authorizes us to provide
international telecommunication services over our own international
infrastructure.
Our U.K. customers currently are unable to preselect us as their long
distance carrier. Equal access is scheduled to become available in the United
Kingdom on January 1, 2000 pursuant to relevant EU directives. However, British
regulators have indicated that it will seek to defer the implementation of equal
access in the United Kingdom until a later date.
BELGIUM. Since January 1, 1998, licensed operators have been able to
provide telephony services in Belgium. On July 15, 1998, the Royal Decree of
Voice Telephony removing the last remaining monopolies of Belgacom, the Belgium
PTT, was published. These permitted services include all of the services that we
currently provide in Belgium.
Providers of voice telephony services must apply for a voice telephony
license. We currently have a temporary voice telephony license and have applied
for a permanent license, although the Belgium Minister for Telecommunications
has not yet begun to grant permanent licenses. This temporary licensing regime
was recently extended to enable the Minister for Telecommunications to review
all license applications. We expect that our temporary license will continue to
be extended until the Minister for Telecommunications begins to issue permanent
licenses, although there can be no assurance that this will be the case. If our
license was not extended, we would not be able to provide services in Belgium.
In Belgium, "facilities-based" carriers that make investments in
infrastructure receive lower interconnection rates than non facilities-based
providers. These incentives provide carriers that own infrastructure with a cost
advantage over carriers that do not own infrastructure. Because we lease, rather
than own, transmission lines in Belgium, we are not eligible for these
incentives.
Preselection currently is unavailable to our customers in Belgium. The
Belgian regulatory authorities have not yet introduced the regulations setting
forth the criteria that private carriers must satisfy in order to be able to
offer preselection to their customers.
Our interconnection in Belgium has been granted on a temporary basis until
July 15, 1999 pending the adoption of certain new telecommunications legislation
in Belgium. Once this legislation has been adopted, we will need to enter into a
new interconnection agreement with Belgacom. If this new legislation has not
been adopted before July 15, 1999, we expect the term of our Belgian
interconnection to be extended. Furthermore, once the new legislation is
adopted, we expect to be able to enter into a new interconnection agreement with
Belgacom. However, there can be no assurance that this will be the case with
respect to either of the foregoing. If we were to lose our interconnection with
Belgacom in Belgium, we would need to obtain interconnection from another
carrier, which would increase our transmission costs in Belgium.
53
<PAGE>
FRANCE. Since January 1, 1998, licensed private service providers have been
able to offer domestic and international long distance voice telephony services
to the general public in France after obtaining a voice telephony license. Our
French subsidiary, Econophone SA, obtained its voice telephony license during
the third quarter of 1998. This license enables us to provide all of our current
services in France.
In order to own and control transmission infrastructure in France, a carrier
must obtain an infrastructure license from the Autorite de Regulation de
T elecommunications ("ART"). Because we lease, rather than own, our transmission
lines in France, we are not required to have an infrastructure license. The ART
provides financial incentives to certain infrastructure providers. These
incentives provide carriers that own infrastructure with a cost advantage over
carriers that do not own infrastructure and are not available to us.
Preselection currently is unavailable to our customers in France. In
addition, seven carriers that have agreed to interconnect on a national basis to
the French PSTN in a substantial number of markets have been granted single
digit access for their customers. We are not one of these carriers.
GERMANY. On January 1, 1998, the German telecommunications market was
substantially liberalized. In Germany, our 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," which includes services involving switching in Germany, requires a
license. We received a Class 4 license during the second quarter of 1998, which
enables us to provide voice telephone services within Germany.
The German Telecommunications Act and the Network Access Ordinance require
public telecommunications network operators to offer interconnection at the
request of other network interconnection operators. This requires Deutsche
Telekom to allow other providers interconnection to its telecommunications
networks. During the fourth quarter of 1998, we entered into an interconnection
agreement with Deutsche Telekom. Our current interconnection agreement with
Deutsche Telekom will expire on February 28, 1999. We expect it to be extended
before this time for a further temporary period, although there can be no
assurance in this regard. If we were to lose our interconnection with Deutsche
Telekom in Germany, we would need to obtain interconnection from another
carrier, which would increase our transmission costs in Germany. There is
currently a regulatory dispute in Germany between Deutsche Telekom and
competitive carriers. If Deutsche Telekom prevails in that dispute, it could put
us and other competitive carriers at an additional cost disadvantage versus
Deutsche Telekom.
Through our interconnection with Deutsche Telekom, our customers are able to
preselect us as their carrier.
SWITZERLAND. With the implementation of the Telecommunication Act of 1997
on January 1, 1998, Switzerland became a fully liberalized telecommunications
market. The provision of our services in Switzerland does not require a license,
although we are required to make certain notice filings.
Our Swiss subsidiary, Econophone AG, signed an interconnection agreement
with Swisscom, the Swiss PTT, during the second quarter of 1998. Our
interconnection with Swisscom enables our customers to preselect our company as
their long distance carrier in Switzerland.
CANADA
The domestic long distance market in Canada was first opened to resale
competition in 1990 and then to facilities-based competition in 1992. Although
Canada's international market was also opened to competition in 1992, most
facilities-based competitors did not enter this market due to a long-standing
monopoly held by Teleglobe Canada. As a signatory to the WTO Agreement, Canada
agreed to end Teleglobe Canada's monopoly on international transmission to and
from Canada beginning on October 1, 1998. Full liberalization of
telecommunications services is expected to occur on January 1, 2000. We received
a license early in the first quarter of 1999 which authorizes us to provide to
offer international
54
<PAGE>
long distance services to our customers in Canada. The provision of domestic
long distance services in Canada does not require a license, although we are
required to make certain notice filings. We are currently not subject to any
foreign ownership restrictions in Canada.
EMPLOYEES
As of December 31, 1998, we had 877 employees, an increase from the 408
employees that we had at December 31, 1997. The breakdown of our employees by
region as of December 31, 1998 was as follows:
<TABLE>
<CAPTION>
NUMBER
REGION OF EMPLOYEES
- ------------------------------------------------------------ ---------------
<S> <C>
Continental Europe.......................................... 108
United Kingdom.............................................. 247
North America............................................... 522
---
Total....................................................... 877
</TABLE>
Our North American employees are based principally in our offices in
Paramus, New Jersey (executive offices); New York, New York; Brooklyn, New York;
College Station, Texas; and St. Louis, Missouri. In Europe, our employees are
based principally in offices located in cities where we have a switch. We have
never experienced a work stoppage and our employees are not represented by a
labor union or a collective bargaining agreement. We consider our employee
relations to be good.
LITIGATION
We are from time to time a party to litigation that arises in the ordinary
course of our business operations or otherwise. We believe that we are not
presently a party to any litigation that, if decided in a manner adverse to us,
would have a material adverse effect on our business or operations.
PROPERTIES
All of our facilities are leased from third parties. Our principal facilities
are located in Paramus, New Jersey; College Station, Texas; Brooklyn, New York;
and London, England. Our network operations center is located in St. Louis,
Missouri. We also maintain sales offices in several cities in the United States
including in most switch locations and in the following European cities, among
others:
- Antwerp, Belgium
- Athens, Greece
- Berlin, Germany
- Brussels, Belgium
- Frankfurt, Germany
- Hamburg, Germany
- London, England
- Lyon, France
- Marseilles, France
- Paris, France
- Vienna, Austria
- Zurich, Switzerland
55
<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.
DESTIA COMMUNICATIONS, INC.
By: /s/ RICHARD L. SHORTEN, JR.
---------------------------
Name: Richard L. Shorten, Jr.
Title: Senior Vice President
and General Counsel
Dated: February 2, 1999
