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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): April 16, 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
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Item 5. Other Events.
On April 16, Destia Communications, Inc. (the "Company") filed a second
amendment to a registration statement on Form S-1 (the "Registration
Statement"), initially filed with the Securities and Exchange Commission (the
"Commission") on January 29, 1999 and amended on February 17, 1999, for an
initial Public offering of its common stock.
Included below are the "Selected First Quarter 1999 Results" that
appeared in the prospectus summary of the Registration Statement and selected
portions of the "Risk Factors" section of the Registration Statement, 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 or distributor 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.
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SELECTED FIRST QUARTER 1999 RESULTS
Based on internal preliminary reports, our total revenues during the
first quarter of 1999 were approximately $62.5 million, representing an
increase of approximately 18% over our fourth quarter 1998 revenues, which
were $52.8 million, and an increase of approximately 50% over our first
quarter 1998 revenues, which were $41.7 million. The primary source of this
growth was a substantial increase in retail revenues in North America, the
United Kingdom and continental Europe. In North America, the increase was
primarily attributable to higher direct dial and prepaid calling card
revenues and, to a lesser extent, wholesale revenues. In Europe, we
experienced a substantial percentage increase in our presubscribed and
"1xxx" long distance services, particularly in Belgium and Switzerland,
where we completed interconnection in late 1998. Furthermore, we realized
substantial growth in our prepaid card sales, particularly in the United
Kingdom and Germany. We expect our gross profit margins for the first quarter
of 1999 to be similar to the approximately 29% gross profit margins that we
reported for the fourth quarter of 1998. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Overview" for a
discussion of how gross margins are calculated.
The foregoing information concerning our total revenues for the first
quarter of 1999 is preliminary in nature, has not been reviewed or audited by
our independent accountants and is therefore subject to completion and/or
modification. In addition, complete financial information for the first
quarter of 1999 is unavailable at this time. Accordingly, the preliminary
information contained above concerning our total revenues for the first
quarter of 1999 should be read in conjunction with that additional financial
information when made available.
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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
1996 or later. 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.
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.
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 a dominant carrier (a "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 would be materially adversely affected.
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.
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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 to continue to expand and enhance our customer
support, billing, order provisioning and other information processing
capabilities. These initiatives will be costly and will affect our operating
results.
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 continued 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 intend to pursue selected acquisitions and strategic alliances, some
of which may be material. We continuously engage in discussions with
potential acquisition candidates. 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 network and operations of acquired businesses into
our own;
- 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 could be adversely affected.
SUBSTANTIAL INDEBTEDNESS, FUTURE LOSSES AND NEGATIVE EBITDA
As of December 31, 1998, we had total consolidated indebtedness of
$397.4 million and a stockholders' deficit of $102.5 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
January 1, 1999 to February 15, 2003 will accrete in value (i.e.,
effectively increase in principal amount), by approximately $107.1 million.
Thereafter, interest on the 1998 Notes must be paid in cash. For 1998, we had
a net loss of $68.9 million, we had negative EBITDA of $27.6 million
and net cash used in operating activities was $26.4 million. We expect to
have operating losses and negative EBITDA and negative cash flow from
operations through at least 2000. We cannot be 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.
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We expect that the net proceeds of our initial public offering, together
with equipment loans 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.
The indentures pertaining to 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 liberalization. Competition results in customer "churn" or
"turnover" as well as downward price pressure. 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 British Telecom's alliance with AT&T (which
recently announced that their alliance will include Japan 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.
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 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 currently have
no plan to offer local service in the United States.
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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. On April 13, 1999, Bell Atlantic filed its application
with the New York Public Service Commission. 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. For long distance
calls, Bell Atlantic will have a substantial cost advantage because it will
not have to pay "access fees" to a local carrier to originate the call.
Access fees constitute a large portion of a long distance carrier's cost of
services, including ours. Moreover, should Bell Atlantic's proposed
acquisition of GTE be consummated, Bell Atlantic will have even greater
resources to compete in its service markets.
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 PTTs with certain inherent competitive advantages
over other providers, including:
- 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;
- extensive, and in many cases exclusive, ownership of facilities;
- the 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 (otherwise, the call will be carried by a
competitor). In Germany, Deutsche Telekom was granted the approval to charge
one-time fees to any customer that changes its preselected long distance
service provider. During 1998, this fee was 20 Deutsche Marks ("DM") and is
currently DM10. In Greece, regulatory restrictions prohibit us from offering
long distance services other than value-added services, such as prepaid
cards, 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 PTTs 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 or PCS 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."
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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.
Our larger competitors generally 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.
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. We believe that European PTTs are reacting
to competition more aggressively than AT&T did in the U.S. following the
break-up of its monopoly in the 1980s.
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 recently announced
that it will reduce its prices on average by 10% on international services
and by 12% on domestic long distance services. 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 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. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Overview--Cost of
Services." As retail prices continue to fall, we will be subject to
increasing pressure, which could have a material adverse effect on our
business.
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. Because
these rates were set by national monopolies, they were traditionally set at
arbitrary, artificially high levels that enabled many carriers to enjoy high
gross margins on international calls. With the introduction of competition in
many countries, international settlement rates have been declining for
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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 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.
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, MCI WorldCom and ICG Communications
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. Access fees constitute a
large portion of a long distance carrier's cost of services, including ours.
This cost advantage in favor of Internet telephony providers could have a
material adverse effect on our business.
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 multilevel 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. 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.
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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--1997 Compared to 1996--SG&A."
IMPORTANCE OF CARRIER AND OTHER WHOLESALE CUSTOMERS
Carrier customers generally are extremely price sensitive, generate very
low margin business and 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.
During 1997 and 1998, our sales of transmission capacity to carrier
customers ranged from 9% 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,
which could have a material adverse effect on our business.
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, which
could have a material adverse effect on our business.
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 these
jurisdictions. 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:
- restrictions on our use of leased lines;
- universal service fund contribution requirements;
- access charges that we are required to pay to local exchange carriers
("LECs");
- payphone access charges that we are required to pay;
- regulations and penalties relating to "slamming" (i.e., switching a
customer's service without its permission); and
- regulations concerning use of customer proprietary network information
in cross marketing efforts.
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In Europe, regulatory considerations that affect or limit our business
include:
- 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" and "Business--Regulation"
for a discussion of these and certain other regulatory risks and
considerations relevant to our business.
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.
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. 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 agreement in Germany granting us
access to Deutsche Telekom's network expired at the end of February 1999,
although we have initiated legal action to maintain continued interconnection
with Deutsche Telekom's network. In the interim, we are currently still
interconnected to Deutsche Telekom's network. If Deutsche Telekom were
permitted to restrict our interconnection, our transmission costs in Germany
would increase and the services we could offer might be limited. We expect
our temporary interconnections in Belgium and Germany to be extended until
relevant national rules or interconnection decisions are adopted, although
there can be no assurance that either of them will be extended. See
"Business--Regulation--Belgium" and "Business--Regulation--Germany."
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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. We are also
dependent upon LECs to implement the transfer of customers from other long
distance carriers to us in a timely and accurate manner. 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 price
disadvantage compared to the LECs.
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 (i.e., an IRU) the
facilities of another carrier or consortium of carriers 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
U.S.-bound foreign traffic and our desire to provide services in more U.S.
markets, we recently acquired a 20-year IRU from Frontier to use
portions of 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, and we expect this network to be completed and
substantially operational by the end of 1999. We expect to begin using a
portion of Frontier's network by July 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. In addition, as a
result of the pending acquisition of Frontier by Global Crossing, there may
be potential operational and management integration issues that affect us.
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.
12
<PAGE>
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."
When we negotiate our 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 business. 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.
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.
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<PAGE>
Levy, our ability to successfully implement our ambitious business plan 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 for the 1997 Notes (the "1997 Indenture") and the
indenture for the 1998 Notes (the "1998 Indenture") and could require
prepayment of all amounts outstanding on the $155.0 million principal amount
of 13 1/2% Senior Notes due 2007 (the "1997 Notes") and the 1998 Notes. That
would have a material adverse effect on our business.
YEAR 2000 TECHNOLOGY RISKS
We face certain risks arising from Year 2000 issues which could have a
material adverse effect on our business. 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.
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 approximately 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 (1)
the number of minutes of telecommunications traffic carried and (2) generally, a
fixed per minute rate. The following table shows the total revenue and billable
minutes of use attributable to the Company's operations by region for 1996, 1997
and 1998. Over time, the Company expects its European markets to contribute a
larger percentage of its revenues.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------------
<S> <C> <C> <C>
1996 1997 1998
---------- ---------- ----------
<CAPTION>
(IN THOUSANDS)
<S> <C> <C> <C>
REVENUE
North America................................................................ $ 18,185 $ 48,899 $ 116,645
United Kingdom............................................................... 15,477 18,363 55,991
Continental Europe........................................................... 11,441 15,741 21,101
---------- ---------- ----------
Total.................................................................... $ 45,103 $ 83,003 $ 193,737
---------- ---------- ----------
---------- ---------- ----------
BILLABLE MINUTES OF USE
North America................................................................ 68,247 244,095 549,654
United Kingdom............................................................... 27,968 68,810 288,892
Continental Europe........................................................... 8,351 17,239 45,085
---------- ---------- ----------
Total.................................................................... 104,566 330,144 883,631
---------- ---------- ----------
---------- ---------- ----------
</TABLE>
The Company generally prices its services at a discount to the dominant
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, particularly European 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
15
<PAGE>
innovation and the availability of substantial 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 are recorded based upon usage rather than at the time of
initial sale.
Revenues also include amounts billed to customers which are, in turn,
remitted to third parties, including universal service fund fees, fixed rate
access charges paid to LECs and payphone owner compensation fees. These
charges are expensed in cost of services in amounts similar to corresponding
amounts billed to customers and included in revenue.
COST OF SERVICES
The major components of the Company's cost of services are the cost of
origination, transmission and termination of traffic. Virtually all calls
carried by Destia must be originated or terminated on another carrier's local
facilities, for which the Company pays a per minute charge. These charges are
known as "access" or "termination" charges. 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 for specific point-to-point routes on a fixed cost basis, which involve
monthly payments regardless of usage levels. Leased lines have a shorter
duration than IRUs. Because the cost of leased lines is typically 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 transmit calls to 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 termination
charges. As the Company's minutes of traffic carried have grown, the Company
has obtained better pricing on switched minute 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, increased leverage with suppliers and the increasing availability
of substantial third-party transmission capacity.
A substantial and increasing 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. To the extent the Company's increased use of IRUs reduces its
utilization of leased lines and switched minutes, the increase in
depreciation expense of the IRUs will be offset by a decrease in the cost of
services of leased lines and switched minutes. As a result, although the
Company's gross margins and EBITDA are expected to improve, the Company's net
income (loss) will not necessarily improve to the same extent.
Cost of services also includes certain fees imposed by regulators and third
parties that are typically billed to customers together with an administrative
fee. See "--Revenues."
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES ("SG&A")
To date, the Company has sold its services primarily through independent
sales channels. Selling expenses have, therefore, primarily consisted of
commissions paid to agents. To a lesser extent, selling expenses have also
included advertising and promotion costs, sales by the Company's internal sales
force and expenses related to its customer service department. Since completing
the acquisition of VoiceNet
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<PAGE>
during the first quarter of 1998, the Company's commissions paid to and retained
by VoiceNet (i.e., commissions not subsequently paid by 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 intends to increase its
advertising expenses. The Company expects all of these costs to eventually
decline as a percentage of its revenues. General and administrative expenses
have increased primarily as a result of the Company's expansion of its customer
service, billing, financial reporting and other management information systems.
These expenses have also increased as a result of implementing more extensive
network management systems and organizational expenses related to entering
additional markets.
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
amortization of goodwill from the purchases of VoiceNet and the minority
interest in its subsidiary, Telco Global Communications ("Telco").
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. Transmission over IRUs involves only fixed
costs, with no per minute charges, and is 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 Destia with fiber
optic transmission capacity in the United States. The Company 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 of the IRUs will be offset by a
decrease in the cost of services of leased lines and switched minutes. As a
result, although the Company's gross margins and EBITDA are expected to improve,
the Company's net income (loss) will not necessarily improve to the same extent.
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. Until that date, interest expense on the 1998 Notes will increase in
each period. Thereafter, interest on the 1998 Notes will accrue and be required
to be paid in cash semi-annually.
RESULTS OF OPERATIONS
The following table presents certain data concerning Destia's results of
operations for 1996, 1997 and 1998.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
---------------------------------
<S> <C> <C> <C>
1996 1997 1998
--------- ---------- ----------
<CAPTION>
(IN THOUSANDS)
<S> <C> <C> <C>
Revenues....................................................................... $ 45,103 $ 83,003 $ 193,737
Cost of services............................................................... 35,369 63,707 140,548
Selling, general and administrative expenses................................... 16,834 37,898 80,092
Depreciation and amortization.................................................. 1,049 3,615 11,866
Net income (loss).............................................................. (8,312) (30,128) (68,944)
</TABLE>
17
<PAGE>
1998 COMPARED TO 1997
REVENUES. Total revenues for 1998 increased by 133% to $193.7 million
from $83.0 million for 1997. Billable minutes of use increased 168% to 883.6
million in 1998 from 330.1 million in 1997. The increases in revenues and
billable minutes were primarily attributable to strong customer growth in
both the U.S. and U.K. markets. Revenues for all services 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. This competition was a primary factor in
the decrease in average revenue per minute from $.25 per minute during 1997
to $.22 per minute in 1998.
In North America, revenues grew by 139% to $116.6 million from $48.9
million. This increase was due principally to prepaid and calling card
revenues. The remainder of the increase resulted from increases in long
distance revenues. Average North American revenue per minute increased to
$.21 per minute during 1998 from $.20 per minute during 1997. This increase
was due principally to the substantial growth of prepaid card sales, which
typically carry a higher per minute rate than long distance service, offset
in part by rate decreases for long distance services.
In the United Kingdom, revenues increased 205% to $56.0 million in 1998
from $18.4 million in 1997, while the average revenue per minute decreased
from $.27 per minute during 1997 to $.19 per minute during 1998. This
reduction was due principally to increased price competition.
In continental Europe, revenues increased by 34% to $21.1 million from
$15.7 million. A portion of this revenue growth was attributable to a full
year of revenue reported for certain country operations that commenced during
1997. Average continental European revenue per minute decreased from $.91 per
minute during 1997 to $.47 per minute during 1998, as a result of increased
competition brought about by deregulation of the Company's continental
European markets.
GROSS MARGIN. The Company's gross margin for 1998 increased to 27.5%
from 23.2% for 1997. This increase was attributable to (1) expansion of the
Destia Network (which shifted some expenses from cost of services to
depreciation expense), (2) migration of additional switched traffic onto the
Destia Network, (3) "least-cost" routing, (4) leveraging the Company's
traffic volumes to negotiate lower usage-based costs from domestic and
foreign providers of transmission capacity and (5) the Company's ability to
obtain more cost effective interconnect agreements. An improvement in gross
margin does not necessarily result in an equal improvement in net income
(loss). See "--Overview--Cost of Services."
SG&A. SG&A increased to $80.1 million for 1998 from $37.9 million for
1997, and, as a percentage of revenues was 41% for 1998 and 46% for 1997. The
decrease in SG&A as a percentage of revenue during 1998 was primarily
attributable to the significant increase in revenues. The increase of $42.2
million in SG&A from 1997 was attributable to the expansion of the sales,
operations and back office infrastructure to support the significant retail
sales growth the Company experienced in 1998. During 1998 the Company
expanded its management team and significantly increased staffing levels in
its customer service, network management, management information systems and
finance organizations. In addition, substantial expenses were incurred in
connection with entering new markets and further developing existing
marketing and sales channels. The Company recorded bad debt expense of $7.4
million, or 3.8% of revenue, for 1998, compared to bad debt expense of $3.9
million, or 4.7% of revenue, for 1997. This decline in bad debt expense as a
percent of revenue was primarily the result of improved credit and collection
procedures and controls.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expenses
increased to $11.9 million for 1998 from $3.6 million for 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, amortization of
costs associated with the Company's issuance of the 1997 Notes and the 1998
Notes and amortization of goodwill from the purchases of VoiceNet and the
minority interest in Telco.
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<PAGE>
INTEREST EXPENSE AND INTEREST INCOME. Interest expense increased to
$41.0 million in 1998 from $11.4 million in 1997. This increase was
attributable to the issuance of the 1997 Notes and the 1998 Notes. Interest
income increased to $11.5 million in 1998 from $3.7 million in 1997. This
increase was primarily due to interest income earned on the investment of the
net proceeds received from the 1998 Notes.
NET LOSS. The Company reported a net loss of $68.9 million for 1998,
compared to a net loss of $30.1 million for 1997. The increase in net loss is
primarily due to the higher level of SG&A expenses and higher interest
expense. Net loss is expected to increase substantially over the near term,
primarily due to interest expense incurred on the 1998 Notes and the 1997
Notes.
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 by 19% 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. 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 Destia Network Services, Ltd. ("DNS"), 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.
In North America, 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 of the period divided by the average monthly number of customers
for the period. Customers that have ceased using the Company's services
during any
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<PAGE>
given month are those customers who used the Company's services during the prior
month but not during any subsequent month of the applicable period.
GROSS MARGIN. The Company's gross margin for 1997 increased to 23.2% from
21.6% for 1996. This increase was attributable to the Company's increased use of
owned and leased line transmission capacity and its ability to obtain lower
prices on switched transmission capacity because of increased traffic volumes
and a greater availability of capacity generally. An improvement in gross margin
does not necessarily result in an equal improvement in net income (loss). See
"--Overview--Cost of Services."
SG&A. SG&A increased to $37.9 million for 1997 from $16.8 million for
1996, and, as a percentage of revenues, was 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 was charged to bad debt
expense. 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.
The Company recorded bad debt expense of $3.9 million, or 4.7% of
revenue, for 1997, compared to bad debt expense of $2.0 million, or 4.4% of
revenue, for 1996. The charge in 1996 was related to EI.
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
$57.4 million of the net proceeds from the Company's 1997 offering of units
(the "1997 Unit Offering").
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.
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.
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 continue to 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 and a $14.0 million
equity investment (less fees and expenses) by Princes Gate Investors.
As of December 31, 1998, the Company had $139.6 million of cash, cash
equivalents and marketable securities, as well as $40.5 million of restricted
cash and securities (which will be used to pay interest expense on the 1997
Notes through July 15, 2000). The Company believes that the net proceeds of
its initial public offering,
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<PAGE>
as well as 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 the success of its business, its gross margins, and its SG&A
expenses, as well as other factors, many of which are not within its control,
including competitive conditions and regulatory developments. 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 financings. There can be no assurance that additional financing
arrangements will be available on acceptable terms.
The Company's capital expenditures during 1998 were approximately $76.7
million. These were made principally to support the continued expansion of
the Destia Network, including the purchase of telecommunications equipment
and the purchase of additional transatlantic IRUs. In addition, the Company
made capital expenditures related to the continued development of its back
office capabilities, including management information and network management
systems.
In 1999, the Company plans to spend approximately $100 million for
capital expenditures on network equipment, back-office systems, the continued
build-out of its network operations center in St. Louis, Missouri,
transatlantic IRUs 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 $26.4 million for
1998 and was primarily attributable to a net loss of $68.9 million and an
increase in accounts receivable of $22.1 million partially offset by an
increase in accounts payable, accrued expenses and other current liabilities
of $34.7 million and non-cash interest expense of $17.7 million. Net cash
used in investing activities of $119.1 million for 1998 was attributable to
the purchase of marketable securities, investments made primarily in
switching and other telecommunications equipment and IRUs and the VoiceNet
Corporation ("VoiceNet") acquisition. Net cash provided by financing
activities in 1998 of $177.6 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.
At the end of 1998, the Company completed two small acquisitions. In
November 1998, the Company acquired a controlling interest in America First
Ltd. ("America First"), a prepaid card distributor in the United Kingdom for
approximately $5.5 million. The majority of the purchase price was recorded
as goodwill and will be amortized over 20 years. In December 1998, the
Company also acquired the customer list of a long distance reseller, also
located in the United Kingdom. The purchase price was allocated to the
customer base and will be amortized over 5 years.
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 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
21
<PAGE>
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.
During 1998, the Company incurred certain other non-operating cash
commitments which, as of December 31, 1998, included approximately $42.3
million in the aggregate for a 20-year IRU from Frontier to use portions of
its U.S. fiber optic network and for the purchase of a transatlantic IRU. As
of December 31, 1998, the Company is required to pay 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 from Frontier,
see "Business--The Destia Network--North American Network."
The Company continually evaluates business opportunities, including
potential acquisitions, and engages in discussions with potential acquisition
candidates. The Company may use funds to consummate suitable strategic
acquisitions. The Company will seek to acquire or align itself 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 wireless or Internet
services).
MARKET RISK
The carrying value of cash and cash equivalents approximates fair value
due to the short-term, highly liquid nature of the cash equivalents, which
have maturities of three months or less. Interest rate fluctuations would not
have a significant effect on the fair value of cash equivalents held by the
Company.
At December 31, 1998 the Company had debt in the amount of $396.8 million
of which $375.7 million is fixed interest debt. The remaining $21.1 million
carries adjustable interest rates equal to the 90-day commercial paper rate
plus 395 basis points. A one percent change in the interest rate would change
interest payments by approximately $18,000 per month.
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 Notes and 1998 Notes is in U.S. dollars. For each of 1998 and
1997, approximately 40% 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 on the Company's revenues
for 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 December 31, 1998 and 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.
Since that date, the euro has traded on currency exchanges, although 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.
22
<PAGE>
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 be
reduced as the legacy currencies now trade at a fixed exchange rate against
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 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 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.
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 $0.9 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 during the second quarter of 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
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<PAGE>
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 possible worst case Year 2000
scenario is disruption of its ability to route traffic over portions of its
own network or an inability to terminate calls to certain destinations, 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 the Company, alternate
carriers and other third parties (or third parties on whom they depend) would
have a material adverse effect on the Company's business.
The Company estimates the total cost for resolving its Year 2000 issues
to be approximately $2.0 million, of which approximately $1.0 million has
been spent through the end of the first quarter of 1999, with the majority of
expenditures expected to be incurred in the first two quarters of 1999 in
connection with upgrades of its Northern Telecom switches and the retention
of an outside consulting firm. This estimate includes the accelerated cost of
replacing systems that are not Year 2000 compliant. Actual costs 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, and we believe that we are well
positioned to capitalize on the continued growth in these markets. In 1997,
worldwide international long distance traffic totaled 81.8 billion minutes
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 approximately
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, 1997 and 1998, our revenues were $45.1 million, $83.0 million
and $193.7 million, respectively. In addition, for 1996, 1997 and 1998, we
carried 104.6 million, 330.1 million and 883.6 million minutes of traffic,
respectively. Substantially all of our growth has been generated internally,
although we have made several minor 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 operational carrier-grade switches with seven in North America and
seven in Europe;
- an IRU from Frontier on portions of its U.S. fiber optic network;
- transatlantic IRUs;
- leased capacity and IRUs in Europe; and
- leased capacity in Canada.
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In addition, we have completed direct interconnections with the PTTs in five
of our major European markets (the United Kingdom, Belgium, Germany, France and
Switzerland) and have signed an interconnection agreement with the PTT in The
Netherlands. Interconnection allows us to offer services to customers as a
domestic carrier through a direct connection to 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 cross-market many of our services. For example, we recently started
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 59% of Destia and following the offering will own
approximately 48%.
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.
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<PAGE>
SOPHISTICATED OPERATIONAL CONTROL SYSTEMS
We have internally developed sophisticated 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 every day 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 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;
- higher barriers to entry because of the significant investments required
to develop sales, 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, 1997, 1998
and the fourth quarter of 1998, our gross margins were 21.6%, 23.2%, 27.5%
and 29.0%, respectively. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Overview--Cost of Services"
and "--Depreciation and Amortization" for a description of how gross margins
are calculated. 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 for
1996 to $56.0 million for 1998, and our U.K. customer accounts have increased
from approximately 1,000 at the end of 1996 to approximately 107,000 at the
end of 1998. We believe we can continue to replicate this strategic focus and
further improve our revenue growth and gross 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 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
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<PAGE>
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.
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. On the other hand, 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. 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 so we can generate revenues from otherwise unused
portions of the Destia Network.
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 presence ("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. However, we have very limited
experience with IP technology and many of our competitors are making
substantial IP investments. There can be no assurance that we will be
successful with IP technology.
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 and we continuously
engage in discussions with potential acquisition candidates. 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 wireless or Internet services). We believe that our
geographic reach and management expertise create access to acquisition
opportunities.
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
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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.
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 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 X
<CAPTION>
<S> <C>
E-COMMERCE
AND INTERNET
SERVICES
-----------------
Continental Europe
Belgium.......................... --
France........................... --
Germany.......................... --
Switzerland...................... X
United Kingdom..................... X
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, France 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-TM- 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
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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 Telco Prepaid-TM- service to residential
customers in the United Kingdom. Telco Prepaid 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 from the customer's prepaid account balance. Telco Prepaid
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! Card-TM- in the United States. During March 1999, we introduced presto
phone-TM- in the United Kingdom. Presto! Card and presto phone are our first
e-commerce services and the first services offered through what we intend to
develop as an Internet-based portal for telecommunications services. Presto!
Card and presto phone allow users to establish a virtual prepaid account that is
purchased and recharged exclusively over the Internet at www.prestocard.com and
www.prestophone.com, respectively. These services enable users to make
international and domestic long distance calls at competitive rates and to view
their call records on a real-time basis. We believe that Presto! Card and presto
phone are currently the only prepaid services that can be purchased and
recharged instantly over the Internet. We intend to offer these services in
Canada and our continental 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! Card and presto phone, like our other prepaid cards, do not require any
billing support and do 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. In February 1999 we began offering Internet access to
retail customers in Switzerland, and we expect to offer Internet access to
retail customers in Belgium by the end of the third quarter of 1999. We believe
offering Internet access will increase 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.
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- 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 in certain area codes, 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.
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.
During 1997 and 1998, sales of transmission capacity to carrier customers
ranged from 9% to 30% of our consolidated revenues on a quarterly basis,
comprising 9% of our consolidated revenues for the fourth quarter of 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 operational carrier-grade Northern Telecom switches with seven in North
America and seven in Europe;
- ten POPs in North America and seven POPs in Europe, in addition to our
switch locations;
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- over 100 interconnections to LEC tandems and LEC end-offices in the United
States, which provide us with direct interconnections to LECs;
- 20 points of interconnection to PTTs in the United Kingdom and continental
Europe;
- a U.S. fiber optic transmission network backbone that we currently lease
from Qwest;
- 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 attractive origination and termination
rates in 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 Europe and leased capacity in Canada;
- 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 switches 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
typically of up to 20 or 25 years (which is usually the entire 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
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- 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
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 we have 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 in some cases utilize
carrier grade compression or multiplexing equipment.
As part of our expansion strategy, and as a result of increasingly
attractive pricing, we intend to acquire additional IRUs, including in
continental Europe. Although our IRUs are currently operated and maintained by
third parties, we have the right to transmit our telecommunications traffic
through the fiber. To the extent cost efficient, we may acquire additional IRUs
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 operational costs and 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 for the build-out of the network operations
center. 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.
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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 recently implemented an interactive voice
response system that will permit customers to obtain up-to-date information
concerning their account and their most recent invoice by telephone.
During 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 every day 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 2Q99
London, United Kingdom................... 2Q97 2Q97
Frankfurt, Germany....................... 3Q98 4Q98
Zurich, Switzerland...................... 3Q98 4Q98
Amsterdam, The Netherlands............... 4Q98 3Q99E
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
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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.
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 are currently in the final stage of testing our
interconnection with the PTT in France, and we expect to implement
interconnection with the PTT in The Netherlands during the third quarter of
1999. 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 ten POPs in the United States and Canada. Our
North American switches, which are all interconnected and operational, 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 portions of 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 in 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
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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, and we expect this network to be completed and substantially operational by
the end of 1999. We expect to begin using a portion of Frontier's network by
July 1999.
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 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
(such as the PTT) in the terminating country. We currently have gateway switches
in New York and London. During 1999 and early 2000, we intend to upgrade our
switches in Miami and Los Angeles to have international gateway capabilities,
which will allow them to 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 the fourth quarter of 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 our
company as its long distance carrier and the LEC's or PTT's 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,
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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
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 better 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.
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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.
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 "packets") 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 less
transmission capacity, thus increasing the amount of information we can transmit
over a given line and our network 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, we have very limited experience with IP technology and many of our
competitors are making substantial IP investments. There can be no assurance
that we will be successful with IP technology.
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 Denmark, Greece, Ireland, Israel, Italy, Poland, Romania,
Russia, Slovenia, Sweden and the Ukraine. 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. We note, however, that the international settlement regime is collapsing.
See "Risk Factors--Increasing Price Pressure--Collapse of the International
Settlement Regime." 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 otherwise have to pay if we had a direct operating
agreement with the terminating PTT. See "--Regulation" for additional
information concerning these types of agreements.
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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 in
all our geographic markets 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 began marketing 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 began providing Internet services in Switzerland
in February 1999 and introduced a promotional program that offers one year of
free Internet access to customers who purchase our long distance services.
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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 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 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 full 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 market and distribute
our presto phone virtual prepaid service, which is currently available only to
our long distance customers, directly to customers over the Internet.
We also 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.
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
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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 "DESTIADVISOR" 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 market and distribute our Presto! Card virtual prepaid service to
customers over the Internet and through an affinity program with the New
Jersey Devils professional hockey team.
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 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 have implemented an
interactive voice response system that will permit customers to obtain
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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
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 international 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. We began offering domestic long distance services in selected markets
in France in April 1999. 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 are currently in the final stage of
testing our interconnection with France Telecom. However, there may still be
delays in completing our interconnection. See "Risk Factors--Need for
Interconnection" and "-- Regulation."
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GERMANY. Germany is the largest market for telecommunications services
in continental Europe. Our current 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 began marketing domestic
long distance services in the third quarter of 1998 because we completed
interconnection in the fourth quarter 1998. We also began marketing long
distance services to residential accounts. 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
third 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. Our interconnection agreement in
Germany granting us access to Deutsche Telekom's network expired at the end of
February 1999, although we have initiated legal action to maintain continued
interconnection with Deutsche Telekom's network. In the interim, we are
currently still interconnected to Deutsche Telekom's network. If Deutsche
Telekom were permitted to restrict our interconnection, our transmission costs
in Germany would increase and the services we could offer might be limited. We
expect to be able to maintain our interconnection to Deutsche Telekom's network
although there can be no assurance that this will be the case. See "Risk
Factors--Need for Interconnection--Considerations Affecting Interconnection in
Europe." 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. See
"Risk Factors--Competition."
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. In February 1999, we began providing Internet services in
Switzerland and introduced a promotional program that offers one year of free
Internet access to customers who purchase 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 one of the first telecommunications carriers 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 quadrupled and as of April 1, 1999 we had
approximately 20,000 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.
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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 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.
In March 1999, we launched the presto phone virtual prepaid service.
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 its
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 DNS, one
of our wholly-owned subsidiaries, in London and by Destia through 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 16 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!
Card virtual prepaid service in the United States over the Internet. We also
intend to test (and cross market) additional e-commerce services to Presto! Card
customers due to their predisposition to making purchases on-line.
As of March 31, 1999, we had six switches and ten 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 portions of 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 that we will use, and we
expect this network to be completed and substantially operational by the end of
1999. We expect to begin using a portion of Frontier's network by July 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 the fourth quarter of 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. We began providing services in Canada late in the fourth
quarter of 1998 and intend to further expand our internal sales force in Canada
in 1999.
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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 can now enter the local telephone service markets, and cable
television companies and utilities can now 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.
As a result of the 1996 Telecommunications Act, the RBOCs can compete
with us 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 Federal Communications Commission ("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 services. On April 13, 1999,
Bell Atlantic filed its application with the New York PSC. 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. For long distance calls, Bell Atlantic will have a substantial
cost advantage, because it will not have to pay access fees to a local
carrier to originate the call.
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Access fees constitute a large portion of a long distance carrier's cost of
services, including ours. Moreover, should Bell Atlantic's proposed
acquisition of GTE be consummated, Bell Atlantic will have even greater
resources to compete in its service markets.
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 Frontier (the primary
provider of our U.S. transmission capacity beginning later in 1999) by Global
Crossing and of GTE by Bell Atlantic, the proposed acquisition of Ameritech
by SBC, the merger of WorldCom and MCI, AT&T's acquisitions of
Telecommunications, Inc. and 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"), that has already resulted 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. On April 5, 1999, US
West filed a petition with the FCC asking the FCC to find that Internet
telephony services are telecommunications services, not enhanced services or
information services, and therefore should be subject to access charge and
universal service obligations. We cannot predict how the FCC will rule on US
West's petition. Should the FCC rule adversely to U.S. West, however, 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, 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.
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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 both British
Telecom and Japan Telecom (the members of which have 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.'s 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.
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.
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 Public Service
Commissions ("PSCs"). The recent trend in the United States for both federal
and state regulation of 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
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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 from RBOCs. We cannot be certain whether future
regulatory, judicial and legislative changes in the United States will
materially affect our business.
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.
The FCC and certain 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.
In a recently released order, the FCC announced it will forebear from
reviewing PRO FORMA assignments and transfers of control of international
Section 214 authorizations. Instead, only post-consummation notifications
will be required and then only in the case of PRO FORMA assignments, not PRO
FORMA transfers of control. The rules implementing these determinations are
not, however, yet in effect. Although we believe that no material penalties
would result from our failure to notify the FCC and certain PSCs of a change
of control or from our failure to seek prior approval or take certain actions
where required, we cannot be certain whether this will be the case.
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 fashion. For example, the FCC's private line resale policy
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 will allow ISR between the U.S. and
a WTO member country for which it has not previously authorized such service
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 FCC has authorized ISR
to the following countries: Australia, Austria, Belgium, Canada, Denmark,
France, Germany, Hong Kong, Ireland, Italy, Japan, Luxembourg, New Zealand,
The 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. The policy
may materially limit the best 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 note, however, that on
March 23, 1999, the FCC released an order simplifying the procedures for
obtaining authorization to provide ISR to previously unauthorized countries.
Specifically, the rules, which are not yet effective, will reduce both the
amount of information required of a carrier seeking authority to provide ISR
to a particular country and the FCC's decision making time. Additionally, the
FCC is expected to in the near future adopt rules removing competitive routes
from the ISR. While this should afford us additional flexibility, it may also
increase our competition on these routes.
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We are also subject to the FCC's International Settlements Policy ("ISP")
which governs the exchange of traffic and settlement between U.S. carriers
and their foreign correspondents of the cost of terminating traffic over each
other's network. The FCC could find that, absent a waiver, certain terms of
our foreign carrier agreements or our actions do not meet the requirements of
the ISP. 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 ISP, and it could take other action against a carrier violating
the ISP, including issuing a cease and desist order or imposing fines. If the
FCC were to impose such fines or other penalties on our company, we do not
believe that it would have a material adverse effect on our business.
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.
In late 1996, the FCC ruled that interexchange carriers are no longer
required to file their tariffs for domestic interstate interexchange
services. In August 1997, the FCC affirmed its decision to end tariff filing
requirements for domestic interstate long distance services provided by
non-dominant carriers. The FCC also eliminated the requirement that
non-dominant long distance carriers disclose information on rates and terms
of their products. These detariffing orders have been stayed by the U.S.
Court of Appeals for the District of Columbia. Most recently, on March 18,
1999, the FCC adopted an order that would permit the alternative of posting
rates on a carrier's web site. This order will not become effective until the
Court affirms the FCC's mandatory detariffing scheme.
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 showing that
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. We expect that Bell Atlantic will have a cost
advantage over our company because it will not need to pay access charges,
which constitute a substantial portion of our cost of services. See "Risk
Factors--Competition."
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
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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 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 its 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.).
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. Such affiliates would continue to be prohibited from
completing interLATA calls but would not be required to unbundle network
elements under Section 251(c).
On March 31, 1999, the FCC released its Collocation Order. The
Collocation Order strengthened collocation requirements applicable to
incumbent local exchange carriers ("ILECs") requiring ILECs to permit CLECs
to collocate any equipment used for interconnection or access to unbundled
network elements even if that equipment includes switching or enhanced
service functions.
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 revenues. Our
revenues that are subject to the high cost and low income fund are our
interstate and international gross end-user telecommunications revenues. Our
revenues for the schools and libraries and rural health care fund are our
intrastate, interstate and international gross end-user telecommunications
revenues. Contribution factors vary quarterly and we and other carriers are
billed monthly. 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. Contribution factors for second quarter 1999 are: (i)
3.05% for the high cost, insular 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 annual 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 LECs for origination and
termination of calls over local facilities. The FCC has significantly revised
its access charge rules in recent years to permit ILECs greater pricing
flexibility and relaxed
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regulation of new switched access services in those markets where there are
other providers of access services. 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 are scheduled to
increase in July 1999 and then yearly thereafter until they reach certain
caps.
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 or that doing so will not result in a loss
of customers. Additionally, we currently have 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 our
company's costs or could disrupt our company's ability to terminate,
originate or exchange traffic and, therefore, have a material adverse effect
on our company.
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. Most recently, the FCC issued an order that
clearly established the definition of a "primary line." The FCC defines a
primary residential line to be "one residential line provided by a price cap
LEC per service location." The FCC retained its price cap rule definition of
a single line business subscriber line as a line for which the subscriber
pays a rate that is not described as a residential rate in the local exchange
service tariff and does not obtain more than one such line from a particular
telephone company.
The 1996 Telecommunications Act also requires interexchange carriers to
compensate payphone owners when a payphone is used to originate a telephone
call using a 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 payphone calls. 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. On February
4, 1999 the FCC released an order which lowered the payphone compensation
rate on a going forward basis to $.240. For amounts already due, the FCC
determined that the payphone owners should be compensated at a rate of $.238.
As a result of many factors, including a complex and shifting regulatory
scheme, many long distance carriers have been the subject of compensation
claims by payphone service providers. Several lawsuits have been filed
against the Company by payphone service providers alleging that the Company
owes such payphone service providers compensation for completed access code
and toll free calls that had been carried over the Company's network during
the 12 months prior to any claim being made. The Company has paid all
payphone compensation that it believes is due under the most recent payphone
compensation scheme and believes that the aggregate liability to the Company
of all such claims, if concluded in a manner adverse to the Company, would
not have a material adverse effect on the Company. However, there can be no
assurance that the Company will prevail in these lawsuits.
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." Under an order recently issued by the
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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 transferred the
authorizations to our wholly-owned subsidiary, Econophone Services, Inc.,
which recently changed its name to Destia Communications Services, Inc. We
are in the process of notifying the various state PSCs and, where necessary,
seeking approval in connection with the name change. We cannot be certain
that we will obtain all necessary regulatory approvals in connection with the
name change.
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.
States generally retain the right to sanction a carrier or to condition,
modify, cancel, terminate or revoke authorization to provide
telecommunications services within the state for failure to comply with state
law and/or rules, regulations and policies of the state regulatory
authorities.
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
that 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. On April 5, 1999, US West filed a
petition with the FCC asking the FCC to find that IP telephony services are
telecommunications services, not enhanced services or information services,
and therefore should be subject to access charge and universal service
obligations. We cannot predict how the FCC will rule on US West's petition.
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.
EUROPEAN UNION
In Europe, the regulation of the telecommunications industry is governed
at a supra-national level by legislation passed by the European Commission,
the Council and the Parliament of the European Union ("EU"), (formerly the
European Communities), consisting of the EU member states: Austria, Belgium,
Denmark, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, The
Netherlands, Portugal, Spain, Sweden and the United Kingdom. The EU has
adopted pan-European policies through legislation and developed a regulatory
framework to ensure an open and competitive telecommunications market.
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As of January 1, 1998 the EU required all special or exclusive rights
that restrict the provision of telecommunications services to be abolished.
Specific directives have been adopted, which include the Open Network
Provision ("ONP") Framework Directive, the Leased Lines Directive, the
Revised Voice Telephony Directive, the ONP Adaptation of Full Competition
Amending Directive and the Interconnection Directive, the latter of which has
been amended to provide for carrier preselection and number portability on or
before January 1, 2000. Carrier preselection would enable a customer to
access our network over the fixed public telephone network of operators with
significant market power without dialing an access code, by "preselecting"
our company as its long distance carrier. However, Oftel, the U.K. regulatory
authority, already has indicated that it will seek to defer the
implementation of carrier preselection in the United Kingdom. Number
portability would enable customers to retain their existing telephone numbers
when switching to alternative carriers and is already available (although not
universally) in the United Kingdom. Some EU member states have been granted
temporary waivers from implementing certain EU liberalization requirements
and have only fully liberalized recently. Ireland and Portugal have
derogations until January 1, 2000 and Greece until January 1, 2001.
National governments must pass legislation within their countries to give
effect to EU directives. Each EU member state in which we currently conduct
business has implemented the EU directives differently and we will therefore
continue to operate under different national regulatory regimes. The
requirements for us to obtain necessary approvals vary between member states
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 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 U.K. subsidiary DNS, 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 DNS 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, the
national regulatory authority is seeking to defer the implementation of
carrier preselection 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.
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Providers of voice telephony services must apply for a voice telephony
license. We were recently granted a permanent license, which expires in 2014,
by the Belgium Minister for Telecommunications.
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 are
not a facilities-based carrier within the meaning of Belgian regulations, 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 could increase our
transmission costs in Belgium.
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. Because we lease, rather than own, our transmission
lines in France, we are not required to have an infrastructure license.
France Telecom's standard interconnection offer provides the 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. Through our interconnection with Deutsche Telekom
and on the basis of our carrier identification code, our customers are able
to preselect us as their carrier for certain services. 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, over a privately owned telecommunications network,
requires a Class 4 license under the German Telecommunications Act. We
received a Class 4 license during the second quarter of 1998, which enables
us to provide voice telephony services throughout 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, which expired at the
end of February 1999. We initiated a legal action with the German regulatory
authorities on February 25, 1999 that challenged the terms of interconnection
being offered by Deutsche Telekom and requested the German regulatory
authorities to issue a
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preliminary order and a final order requiring Deutsche Telekom to offer
reasonable interconnection terms to maintain continued interconnection of our
German network with Deutsche Telekom's network.
A large number of other competitive carriers, government authorities and
industry associations are now participating in this legal action, since the
determination on these issues is likely to have industry-wide consequences
for all competitive carriers that interconnect with Deutsche Telekom in
Germany. Deutsche Telekom, as a market-dominating operator, is obligated to
grant us access to its network. In addition, certain conditions of such
network access may be determined by the regulatory authorities. Nevertheless,
it is uncertain if the regulatory authorities will grant us access on
desirable terms and conditions. If Deutsche Telekom were permitted to
restrict our interconnection, our transmission costs in Germany would
increase and the services we could offer might be limited.
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 GmbH, 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.
AUSTRIA. We recently obtained a license from the Austrian regulator,
Telekom-Control-Commission, to provide public telephone service in Austria
for an unlimited time period. We are one of 13 telecommunications services
providers in Austria. We plan to file an application for interconnection in
Austria.
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 were not permitted to 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 Canada-overseas transmission facilities effective on October 1,
1998. We received a license early in the first quarter of 1999 which
authorizes us to provide to offer international 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. As a reseller of long distance services, 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
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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:
- Amsterdam, The Netherlands
- Antwerp, Belgium
- Athens, Greece
- Berlin, Germany
- Brussels, Belgium
- Frankfurt, Germany
- Hamburg, Germany
- London, England
- Lyon, France
- Marseilles, France
- Paris, France
- Vienna, Austria
- Zurich, Switzerland
56
<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: April 20, 1999
57
