-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, RIxQG/li4fP72AmKWSaUrGRf1GYCXiwxDJnHNnBGrzVBmIMe9ZTk3YbSsKh07kwh awdbr93viW1Os+2PqWz0xQ== 0000950123-98-005919.txt : 19980714 0000950123-98-005919.hdr.sgml : 19980714 ACCESSION NUMBER: 0000950123-98-005919 CONFORMED SUBMISSION TYPE: S-1/A PUBLIC DOCUMENT COUNT: 1 FILED AS OF DATE: 19980612 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: GLOBAL TELESYSTEMS GROUP INC CENTRAL INDEX KEY: 0000946392 STANDARD INDUSTRIAL CLASSIFICATION: 4813 IRS NUMBER: 943068423 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: S-1/A SEC ACT: SEC FILE NUMBER: 333-52733 FILM NUMBER: 98646860 BUSINESS ADDRESS: STREET 1: 1751 PINNACLE DRIVE NORTH TOWER CITY: MCLEAN STATE: VA ZIP: 22102 BUSINESS PHONE: 7039184500 S-1/A 1 AMENDMENT NO. 1 TO FORM S-1 1 AS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION ON JUNE 12, 1998 REGISTRATION NO. 333-52735 ================================================================================ SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 --------------------- AMENDMENT NO. 2 TO FORM S-1 REGISTRATION STATEMENT UNDER THE SECURITIES ACT OF 1933 --------------------- GLOBAL TELESYSTEMS GROUP, INC. (Exact name of registrant as specified in charter) DELAWARE 4813 94-3068423 (State or other jurisdiction of incorporation or (Primary Standard Industrial (I.R.S. Employer organization) Classification Code Number) Identification Number)
--------------------- 1751 PINNACLE DRIVE NORTH TOWER -- 12TH FLOOR MCLEAN, VA 22102 (703) 918-4500 (Address, including zip code, and telephone number, including area code, of registrant's principal executive offices) --------------------- GRIER C. RACLIN, ESQ. 1751 PINNACLE DRIVE NORTH TOWER -- 12TH FLOOR MCLEAN, VA 22102 (703) 918-4573 (Name, address, including zip code, and telephone number, including area code, of agent for service) --------------------- Copies to: DAVID J. BEVERIDGE, ESQ. JAMES J. CLARK, ESQ. SHEARMAN & STERLING CAHILL GORDON & REINDEL 199 BISHOPSGATE 80 PINE STREET LONDON EC2M 3TY, ENGLAND NEW YORK, NEW YORK 10005 (44) 171-920-9005 (212) 701-3000
--------------------- APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO PUBLIC: As soon as practicable after this Registration Statement becomes effective. If the securities being registered on this Form are being offered pursuant to dividend or interest reinvestment plans, please check the following box. [ ] If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box. [ ] If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering. [ ] - - - - ---------------------. If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier registration statement for the same offering. [ ] - - - - ---------------------. If delivery of the prospectus is expected to be made pursuant to Rule 434 under the Securities Act, please check the following box. [ ] THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(a) OF THE SECURITIES ACT OF 1933, AS AMENDED, OR UNTIL THIS REGISTRATION STATEMENT SHALL BECOME EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SUCH SECTION 8(a), MAY DETERMINE. ================================================================================ 2 EXPLANATORY NOTE This Registration Statement contains two forms of prospectus: one to be used in connection with an underwritten public offering in the United States and Canada of 6,274,800 shares (the "U.S. Prospectus"), and one to be used in a concurrent underwritten public offering outside the United States and Canada of 4,183,200 shares (the "International Prospectus"). The two prospectuses are identical except for the front and back cover pages and the section entitled "Underwriting." The form of U.S. Prospectus is included herein and is followed by the alternate pages to be used in the International Prospectus. Each of the alternate pages for the International Prospectus included herein is labeled "International Prospectus -- Alternate Page." Final forms of each Prospectus will be filed with the Securities and Exchange Commission under Rule 424(b) under the Securities Act of 1933. 3 INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF ANY SUCH STATE. SUBJECT TO COMPLETION PRELIMINARY PROSPECTUS DATED JUNE 12, 1998 PROSPECTUS 10,458,000 SHARES GLOBAL TELESYSTEMS GROUP, INC. COMMON STOCK [GLOBAL TELESYSTEMS GROUP, INC. LOGO] --------------------- Of the 10,458,000 shares of Common Stock, par value $.10 per share (the "Common Stock"), offered hereby (the "Offered Securities"), 2,614,500 shares are being offered by Global TeleSystems Group, Inc. (the "Company") and 7,843,500 shares are being offered by certain of the Company's stockholders (the "Selling Stockholders"). The Company will not receive any of the proceeds from the sale of shares by the Selling Stockholders. See "Principal and Selling Stockholders" and "Underwriting." Of the 10,458,000 shares of Common Stock offered hereby, 6,274,800 shares are being offered in the United States and Canada (the "U.S. Offering") and 4,183,200 shares are being offered outside the United States and Canada (the "International Offering" and, together with the U.S. Offering, the "Stock Offerings"). The initial offering price per share and the underwriting discount per share are identical for both Stock Offerings. See "Underwriting." The Company has also filed a registration statement with respect to the offering of $350,000,000 of its % Convertible Senior Subordinated Debentures due 2010 (the "New Convertible Bonds"), and such offering (the "New Convertible Bond Offering" and, together with the Stock Offerings, the "Offerings") is being made by a separate prospectus. The consummation of the New Convertible Bond Offering is not conditioned upon the consummation of the Stock Offerings, and there can be no assurance that the New Convertible Bond Offering will be consummated. The Common Stock is traded on the Nasdaq National Market and the European Association of Securities Dealers Automated Quotation ("EASDAQ") Market Authority under the symbol "GTSG." On June 8, 1998, the last reported sale price of the Common Stock on the Nasdaq National Market was $38.25 per share. SEE "RISK FACTORS" BEGINNING ON PAGE 11 FOR A DISCUSSION OF CERTAIN FACTORS THAT SHOULD BE CONSIDERED BY PROSPECTIVE PURCHASERS OF THE COMMON STOCK OFFERED HEREBY. --------------------- THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION, NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
===================================================================================================================== PRICE TO UNDERWRITING PROCEEDS TO PROCEEDS TO PUBLIC DISCOUNT(1) COMPANY(2) SELLING STOCKHOLDERS - - - - --------------------------------------------------------------------------------------------------------------------- Per share............ $ $ $ $ - - - - --------------------------------------------------------------------------------------------------------------------- Total(3)............. $ $ $ $ =====================================================================================================================
(1) The Company and the Selling Stockholders have agreed to indemnify the several Underwriters (as defined herein) against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the "Securities Act"). See "Underwriting." (2) Before deducting expenses payable by the Company estimated at $1,494,780. (3) The Company and the Selling Stockholders have granted to the U.S. Underwriters (as defined herein) and the International Managers (as defined herein) options, exercisable within 30 days of the date hereof, to purchase up to an additional 941,220 and 627,480 shares of Common Stock, respectively, solely to cover over-allotments, if any. If such options are exercised in full, the total Price to Public, Underwriting Discount and Proceeds to the Company and the Selling Stockholders will be $ , $ and $ , respectively. See "Underwriting." --------------------- GLOBAL COORDINATOR MERRILL LYNCH & CO. --------------------- The shares of Common Stock are offered by the several Underwriters, subject to prior sale, when, as and if issued to and accepted by them, subject to approval of certain legal matters by counsel for the Underwriters and certain other conditions. The Underwriters reserve the right to withdraw, cancel or modify such offer and to reject orders in whole or in part. It is expected that delivery of the shares of Common Stock will be made in New York, New York on or about , 1998. --------------------- MERRILL LYNCH & CO. --------------------- BEAR, STEARNS & CO. INC. DONALDSON, LUFKIN & JENRETTE SECURITIES CORPORATION --------------------- BT ALEX. BROWN LEHMAN BROTHERS PRUDENTIAL SECURITIES INCORPORATED ARNHOLD AND S. BLEICHROEDER, INC. --------------------- The date of this Prospectus is , 1998. 4 [HER MAP] CERTAIN PERSONS PARTICIPATING IN THE STOCK OFFERINGS MAY ENGAGE IN TRANSACTIONS THAT STABILIZE, MAINTAIN, OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK. SUCH TRANSACTIONS MAY INCLUDE STABILIZING AND THE PURCHASE OF COMMON STOCK TO COVER SYNDICATE SHORT POSITIONS. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING." IN CONNECTION WITH THE OFFERINGS, CERTAIN UNDERWRITERS MAY ENGAGE IN PASSIVE MARKET MAKING TRANSACTIONS IN THE COMMON STOCK ON NASDAQ IN ACCORDANCE WITH RULE 103 OF REGULATION M. SEE "UNDERWRITING." ii 5 AVAILABLE INFORMATION The Company has filed with the Securities and Exchange Commission (the "Commission") in Washington, D.C. a Registration Statement on Form S-1 (as amended, the "Registration Statement") of which this Prospectus is a part under the Securities Act with respect to the Common Stock offered hereby. This Prospectus does not contain all of the information set forth in the Registration Statement and the exhibits and schedules thereto. Statements made in this Prospectus as to the contents of any contract, agreement or other document are summaries of the material terms of such contract, agreement or other document. With respect to each such contract, agreement or other document filed as an exhibit to the Registration Statement, reference is made to the exhibit. The Registration Statement (including the exhibits and schedules thereto) may be inspected and copied at the public reference facilities maintained by the Commission at Room 1024, Judiciary Plaza, 450 Fifth Street, NW, Washington, D.C. 20549 and will also be available for inspection and copying at the regional offices of the Commission located at Seven World Trade Center, 13th Floor, New York, New York 10048 and at Citicorp Center, 500 West Madison Street (Suite 1400), Chicago, Illinois 60661. Copies of such material may also be obtained from the Public Reference Section of the Commission at 450 Fifth Street, N.W., Washington, D.C. 20549 at prescribed rates. The Commission also maintains a Web site that contains reports, proxy and information statements and other information regarding registrants that file electronically with the Commission. The address of such site is http://www.sec.gov. The Company's Common Stock is traded on the Nasdaq National Market and EASDAQ and reports, proxy statements and other information concerning the Company can also be inspected at the offices of the National Association of Securities Dealers, Inc., 1735 K Street, N.W., Washington, D.C. 20006 which supervises the Nasdaq National Market. The Company is subject to the informational requirements of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and, in accordance therewith, files reports, proxy and information statements and other information with the Commission. Such reports, proxy and information statements and other information can be inspected and copied at the addresses set forth above. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS Any statements that express, or involve discussions as to, expectations, beliefs, plans, objectives, assumptions or future events or performance (often, but not always, through the use of words or phrases such as "will likely result," "are expected to," "will continue," "is anticipated," "estimated," "intends," "plans," "projection" and "outlook") are not historical facts and may be forward-looking and, accordingly, such statements involve estimates, assumptions and uncertainties which could cause actual results to differ materially from those expressed in the forward-looking statements. Accordingly, any such statements are qualified in their entirety by reference to, and are accompanied by, the factors discussed throughout this Prospectus, and particularly in the risk factors set forth herein under "Risk Factors." Among the key factors that have a direct bearing on the Company's results of operations are the potential risk of delay in implementing the Company's business plan; the political, economic and legal aspects of the markets in which the Company operates; competition and the Company's need for additional substantial financing. These and other factors are discussed herein under "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations," "Business" and elsewhere in this Prospectus. The risk factors described herein could cause actual results or outcomes to differ materially from those expressed in any forward-looking statements of the Company made by or on behalf of the Company, and investors, therefore, should not place undue reliance on any such forward-looking statements. Further, any forward-looking statement speaks only as of the date on which such statement is made, and the Company undertakes no obligation to update any forward-looking statement or statements to reflect events or circumstances after the date on which such statement is made or to reflect the occurrence of unanticipated events. New factors emerge from time to time, and it is not possible for management to predict all of such factors. Further, management cannot assess the impact of each such factor on the Company's business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements. --------------------- Russia On Line(TM) is a trademark of the Company. iii 6 SUMMARY The following summary is qualified in its entirety by the more detailed information and financial statements appearing elsewhere in this Prospectus (this "Prospectus"). Unless otherwise indicated, (i) the term "GTS" or the "Company" refers to Global TeleSystems Group, Inc. (and, when appropriate, to its predecessor) and its subsidiaries and (ii) references to the number of shares of common stock outstanding after the Stock Offerings assume the Underwriters' over-allotment option has not been exercised. See "Exhibit A -- Glossary of Telecommunications Industry Terms" for definitions of acronyms and technical telecommunications terms used in this Prospectus. THE COMPANY GTS is a provider of a broad range of telecommunications services to businesses, other telecommunications service providers and consumers in Russia, the Commonwealth of Independent States ("CIS") and Central Europe. Through its subsidiary Hermes Europe Railtel B.V. ("HER"), GTS is developing, and operating the initial segments of, a pan-European high capacity fiber optic network that is designed to interconnect a majority of the largest Western and Central European cities and to transport international voice, data and multimedia/image traffic for other carriers throughout Western and Central Europe. GTS's strategy to develop its businesses generally has been to establish joint ventures with a strong local partner or partners while maintaining a significant degree of operational control. The Company's business activities consist of the ownership and operation of (i) international long distance businesses, which operate through international gateways that provide international switching services and transmission capacity, (ii) local access networks, which provide local telephone service, (iii) cellular networks, which provide wireless telecommunications services, (iv) a domestic long distance business, (v) data networks and (vi) carriers' carrier networks, which provide high volume transmission capacity to other carriers. In addition, the Company has recently developed a business plan to offer facilities-based telecommunications products and services to businesses and other high usage customers in certain metropolitan markets throughout Europe. See "-- Business Strategy." In Russia and the CIS, GTS's objective is to become the premier alternative telecommunications operator. To attain its objective, the Company has partnered with regional telephone companies and with Rostelecom, the national long distance carrier in Russia. The Company currently operates in 27 oblasts (regions) and the city of Moscow in Russia, as well as in 13 additional cities in the CIS, and believes it is well-positioned to become the leading independent telecommunications service provider in Russia. These businesses include: (i) EDN Sovintel ("Sovintel"), which provides Moscow, and recently St. Petersburg, with international long distance and local telephone services and access to the major domestic long distance carriers; (ii) TeleCommunications of Moscow ("TCM"), which provides local access services in Moscow; (iii) TeleRoss (as defined herein), which provides domestic long distance services in fourteen cities in Russia, including Moscow, as well as Very Small Aperture Terminal ("VSAT") service to customers outside its primary long distance satellite network; (iv) Sovam Teleport ("Sovam"), which provides data services, including high-speed data transmission, electronic mail, Internet access services, as well as Russia On Line, the first Russian language Internet service; and (v) the Company's cellular operations ("GTS Cellular"), which operate cellular networks in thirteen regions in Russia and also in Kiev, Ukraine, with licenses covering regions with an aggregate population of approximately 28 million people at the end of 1997. Whenever practical, GTS's businesses integrate and co-market their service offerings in Russia and the CIS, utilizing TeleRoss as the domestic long distance provider, Sovintel as the international gateway, TCM and GTS Cellular for local access, and Sovam as the data communications and Internet access network for business applications and on-line services. Together, GTS's Russian and CIS ventures carried approximately 442 million and 147 million minutes of traffic for the year ended December 31, 1997, and the three months ended March 31, 1998, respectively, and had approximately 38,000 customers, including approximately 27,500 cellular subscribers, as of March 31, 1998. See "Business -- Russia and the CIS." In Western Europe, GTS believes that it is well-positioned to establish itself as the leading independent carriers' carrier through the development of two ventures, HER and GTS-Monaco Access S.A.M. ("GTS-Monaco Access"). HER's objective is to become the leading pan-European carriers' carrier by 1 7 providing centrally managed cross-border telecommunications transmission capacity to telecommunications companies including traditional Public Telecommunications Operators ("PTOs") and new entrants, such as alternative carriers, global consortia of telecommunications operators, international carriers, Internet backbone networks, resellers, value-added networks and other service providers ("New Entrants") on an approximately 18,000 kilometer high capacity fiber optic network designed to interconnect a majority of the largest Western and Central European cities. As of April 30, 1998, HER's network linked Brussels, Antwerp, Rotterdam, Amsterdam, London, Paris, Frankfurt, Strasbourg, Zurich and Geneva. By the end of the second quarter of 1998, HER expects this segment of the network to deliver managed transport services over approximately 3,000 kilometers of fiber optic cable linking, in addition to the cities discussed above, the cities of Dusseldorf, Stuttgart and Munich. The full 18,000 kilometer network is expected to become fully operational during the year 2000. HER also plans to lease capacity on a transatlantic cable linking the European network to North America and is exploring various interconnectivity options to Russia and Asia. Such intercontinental interconnectivity will help HER satisfy the needs of its European customers with respect to outgoing traffic and attract additional non-European customers with traffic terminating in Europe. HER commenced commercial service over the Brussels-Amsterdam portion of the network in late 1996 and the London-Paris portion in November 1997. GTS-Monaco Access operates an international gateway in Monaco in partnership with, and utilizing the existing gateway infrastructure of, the Principality of Monaco and provides transit and routing of international calls to other telecommunications operators. Through its HER and GTS-Monaco Access ventures, GTS is building a new network for transporting voice, data and multimedia/image traffic for other carriers throughout Western and Central Europe and for worldwide international voice, data and multimedia/image traffic that either originates or terminates in, or transits through, Western and Central Europe. See "Business -- Western Europe." In Central Europe, GTS's objective is to become one of the leading alternative telecommunications providers in the region. GTS currently provides private data communications services to government and commercial customers in Hungary and the Czech Republic. In the Czech Republic, the Company provides outgoing voice services and operates an international gateway and a data services network. In Hungary, GTS operates a VSAT network, which GTS believes is the largest VSAT network in Central Europe as measured by number of VSAT sites. The Company has also signed an agreement to provide international data services in Poland, subject to the receipt of necessary governmental approvals. GTS's strategy is to expand its service offerings as the regulatory environment permits, leverage its existing VSAT and international gateway infrastructure where possible and provide a broad range of services to its target markets. See "Business -- Central Europe." GTS does not currently own or operate significant telecommunication assets in Asia. GTS's objective is to capitalize on opportunities as they arise in the telecommunications markets in China and India. See "Business -- Asia." 2 8 The following table sets forth certain information, as of March 31, 1998, for the principal ventures through which the Company conducts its business:
COUNTRY/REGION GTS PRINCIPAL COMPANY NAME OF OPERATIONS OWNERSHIP PARTNER(S) BUSINESS ------------ -------------- ------------ ------------------- ------------------ CIS Sovintel.................................... Russia 50% Rostelecom International Long Distance; Local Access TCM......................................... Russia 50%(1) MTU Inform and Local Access Lines others TeleRoss.................................... Russia 50%(2) Various local PTOs Domestic Long Distance Sovam....................................... Russia 100%(3) N/A Data and Internet GTS Cellular................................ CIS 24-70%(4) Primarily various Basic Cellular local PTOs WESTERN EUROPE HER......................................... Western Europe 89%(5) Two railways Carriers' Carrier GTS-Monaco Access........................... Monaco 50% Principality of Carriers' Carrier; Monaco International Gateway CENTRAL EUROPE GTS-Hungary................................. Hungary 99% -- VSAT Network EuroHivo.................................... Hungary 70%(6) Microsystems Paging Services Telecom Rt.; Gerard Aircraft Sales and Leasing Company CzechNet.................................... Czech Republic 100% -- International Long Distance; Data and Internet ASIA V-Tech...................................... China 75% Shanghai Science VSAT Network and Technology Investment Corporation Beijing Tianmu.............................. China 47% China International VSAT Network Travel Service Telecom Co., Ltd.(7) CDI......................................... India 100% -- Voice, Data and Internet
- - - - --------------- (1) GTS holds a 50% indirect interest in TCM through its 52.6% interest in GTS-Vox Limited, an intermediate holding company. The Company is currently engaged in negotiations to purchase the remaining minority ownership interest in GTS-Vox Limited. If such purchase is consummated, the Company would have a 95% interest in TCM. (2) TeleRoss consists of (i) a wholly owned subsidiary that operates a domestic long distance network (the "TeleRoss Operating Company") and (ii) fourteen joint ventures that are 50% beneficially-owned by GTS (the "TeleRoss Ventures"). See "Business -- Russia and the CIS -- TeleRoss." (3) During the first quarter of 1998, GTS purchased its minority partner's 33.3% interest in Sovam, thereby making Sovam a wholly owned subsidiary of GTS. (4) GTS conducts its cellular operations through (i) Vostok Mobile B.V. ("Vostok Mobile"), a wholly owned GTS subsidiary, which owns between 50% and 70% of a series of 12 cellular joint ventures in various regions in Russia, (ii) PrimTelefone, a 50% owned venture in Vladivostok and four other cities in the Primorsky region of Russia and (iii) Bancomsvyaz, an approximately 24% beneficially owned venture in Kiev, Ukraine. The Company is currently implementing a restructuring of the capital and ownership of Bancomsvyaz. GTS intends to enter into the cellular markets of additional Russian regions through Vostok Mobile. See "Business -- Russia and the CIS -- GTS Cellular." (5) As a result of the sale in March 1998 by one of the other shareholders in HER of its ownership interest, GTS currently owns approximately 89% of HER. See "Business -- Western Europe -- HER -- HER Recapitalization." The Company's interest may decrease by up to 4.5% due to the outstanding stock options for common shares of HER issued to certain HER executives under the new HER stock option plan established in the fourth quarter of 1997. See "Executive Compensation and Other Information -- HER 1994 Stock Option Plan." (6) The Company has reached a definitive agreement to sell its ownership interest in EuroHivo. The closing of this transaction is conditioned upon regulatory approval of the share transfer and customary conditions precedent. The Company does not anticipate that the closing of this transaction will have a material effect on the Company's results from operations and financial condition. (7) GTS owns 75% of GTS China Investments LLC ("GCI"), which owns 90% of American China Investment Corporation ("ACIC"). ACIC owns 70% of the Beijing Tianmu China joint venture company. 3 9 BUSINESS STRATEGY GTS seeks to develop businesses to meet the rapidly expanding market demand for telecommunications services. GTS's goal in emerging markets is to establish itself as the leading alternative to the incumbent telecommunications service providers and as a premier provider of value-added services. In addition, the Company seeks to position itself as the leading independent carriers' carrier within Western and Central Europe through the development of a pan-European fiber optic network and an international gateway in Monaco. In addition, the Company has recently developed a business plan to offer facilities-based telecommunications products and services to businesses and other high usage customers in certain metropolitan markets throughout Europe. GTS believes that it will be able to successfully operate its businesses and develop business opportunities by pursuing the following strategies: - Identify and Seize Early Market Opportunities. GTS's primary strategy is to identify less developed markets in which the incumbent operator offers inadequate service and where liberalization of telecommunications regulations may be pending or has occurred. The Company believes that entering these less developed markets quickly is a key competitive advantage in the global telecommunications market. GTS leverages its management's knowledge of the markets in which the Company operates to assess and react quickly when attractive business opportunities arise. - Establish Joint Ventures with Experienced Local Partners. GTS seeks to establish and maintain strategic partnerships and relationships with key telecommunications operators and service providers in the countries in which it operates. The Company believes that these relationships increase its ability to anticipate and respond to changes in the regulatory and legal environment and assist with license renewal and expansion of its operating companies. - Retain Significant Operational Control. In general, GTS actively participates in the management of its ventures by (i) providing most of the funding for the ventures' operations, (ii) selecting key members of the local management team, (iii) developing business plans and marketing strategies together with local management, (iv) monitoring operating functions, (v) maintaining close working relationships with local partners and (vi) integrating its networks and businesses in a manner which is consistent with the Company's overall strategic objectives. - Build Infrastructure to Provide High Quality Services. GTS continues to develop and expand its network infrastructure. The Company believes that its networks offer service, quality and cost advantages over incumbent providers as a result of the Company's customer support, network monitoring, management systems and its ability to integrate and co-market its service offerings. - Leverage Management Depth and Experience. GTS's management has significant experience in the development and operation of telecommunications businesses outside the United States. The Company believes that this experience, together with the Company's extensive operations, has provided its management with the ability to identify, evaluate and pursue international telecommunications business opportunities. Additionally, GTS has assembled a management team comprised of executives with extensive experience managing telecommunications companies in the respective local markets. GTS believes that its management team possesses a broad knowledge of relevant political and regulatory structures, as well as the cultural awareness and fluency with international and local business practices necessary to implement the Company's objectives. - Access Capital Effectively. In general, the Company's financing strategy is to establish parent level funding to meet general corporate needs and the costs of start-ups and acquisitions and, when it is possible and cost-effective, to finance ongoing operations at the venture level. From 1993 through 1997, the Company raised privately approximately $268 million in equity and approximately $215 million of debt (of which approximately $74 million was raised through shareholders). In addition, HER completed a $265 million private placement of senior notes (of which $56.6 million was placed in escrow for the first two years' interest payments) in 1997. On February 10, 1998, the Company completed an initial public offering ("IPO") of Common Stock in which the Company sold 4 10 12,765,000 shares and realized aggregate net proceeds of approximately $235.6 million. On the same date, the Company also sold $105 million aggregate principal amount of 9 7/8% Senior Notes due 2005 (the "9 7/8% Notes") and realized aggregate net proceeds of approximately $100.5 million, of which $19.6 million was placed in escrow to cover the first four scheduled payments of interest on the 9 7/8% Notes. In addition to its overall business strategy, GTS has developed market strategies to achieve its goals in emerging markets and Western Europe as well as its preliminary business plan to offer comprehensive telecommunications services in Europe. Emerging Markets. The Company pursues its goals in emerging markets through a three-stage approach of market entry, market expansion and market integration. - Market Entry. GTS identifies a market as a suitable target for entry based upon: (i) superior growth prospects for such market, demonstrated by growing demand for high quality telecommunications services; (ii) the provision of inadequate services by incumbent providers, typically resulting from the incumbents' unwillingness to offer high quality services with reliable customer support at attractive prices; and (iii) attractive regulatory environments in which emerging alternative telecommunications providers such as GTS have, or are expected to have over a clearly defined time horizon, the ability to compete on a substantially equal basis with the incumbent providers in terms of certain services and the cost of providing those services. Once the Company has identified a market as suitable for entry, the Company seeks to establish its presence in that market by establishing a venture with a strong local partner or partners. In general, GTS maintains a significant degree of operational control in such ventures. Through such ventures, the Company benefits from its partners' ability to provide infrastructure, regulatory expertise and personnel that will provide the Company with a competitive advantage in entering that market. When entering a new market, GTS's strategy is to provide its customers with service of higher quality than that provided by incumbents. - Market Expansion. Having entered a market successfully and established a limited service offering to its targeted customer base, GTS then seeks to expand the range of services it offers to existing and potential customers and to further develop its relationships with local partners. By broadening its service offerings and providing a bundled service offering, the Company expects to both expand its customer base and increase the Company's share of each customer's telecommunications spending. GTS also expects to achieve increased economies of scale through the common use of administrative and operating functions already in place. The Company also seeks to expand its targeted geographic market by forming new partnerships and installing infrastructure and offering services in additional geographic regions, allowing the Company to further enhance its operating leverage and ability to service its customers' telecommunications needs. - Market Integration. GTS ultimately intends to integrate and co-market its service offerings in each of the markets in which it operates. The Company believes such integration will enable it to enhance its operating efficiency by leveraging its distribution channels, infrastructure, networks and management information systems. As customers develop a need for a broader variety of telecommunications services, the Company believes that GTS's integrated operations will represent an attractive service alternative for customers seeking a single provider that can meet all their telecommunications needs. Western Europe. The Company believes it is well-positioned to establish itself as the leading independent carriers' carrier within Western Europe through the development of HER's pan-European fiber optic network and the operation of GTS-Monaco Access's international gateway in partnership with, and utilizing the gateway infrastructure of, the Principality of Monaco. HER and GTS-Monaco Access seek to complement and enhance the services provided by PTOs and New Entrants in a way that helps them to more successfully meet the needs of their end-user customers. HER has been able to enter the market ahead of competition and encourage a wide variety of carriers to use its network with service offerings that meet their needs. To establish itself as the leading carriers' carrier for international telecommunications within Europe, HER intends to provide its customers with significantly higher quality transmission and advanced network capabilities at a competitive price by utilizing advanced, uniform technology across the region and providing redundant routing for higher levels of reliability. 5 11 European Services Strategy In addition, the Company has recently developed a business plan to offer, through one or more new subsidiaries, facilities-based telecommunications products and services to businesses and other high usage customers in certain metropolitan markets throughout Europe (the "European Services Strategy"). The Company believes that the size and growth potential of the European market combined with increasing liberalization of European telecommunications regulations provides the Company with the opportunity to successfully develop local networks and other end-user services. The Company is evaluating developing competitive local exchange carriers ("CLECs") in up to 12 European cities. Implementation of this strategy may involve one or more of the following: (i) the construction of fiber loop networks, (ii) the purchase or lease of dark fiber, (iii) obtaining of high frequency microwave licenses for "wireless fiber," or (iv) partnership with, or acquisition of, resellers or facilities-based CLECs. In evaluating potential markets the Company will consider, among other factors, the following characteristics of each market: (i) its business concentration, (ii) the national and local regulatory environment, (iii) the technical difficulties of local network construction and (iv) the extent of existing competition. Due to the preliminary nature of the Company's business plan with respect to its European Services Strategy, the Company cannot estimate with certainty the amount and timing of the Company's future capital requirements to implement such strategy. Management believes, however, that if the European Services Strategy is implemented it is likely that the Company will need to raise additional capital above that being raised in the Offerings. See "Risk Factors -- Risks Relating to European Services Strategy" and "Business -- Western Europe -- European Services Strategy." FINANCING PLAN In general, the Company's strategy is to finance general corporate cash needs, the development of start-up ventures and acquisitions through the parent company and, when possible and cost effective, to finance ongoing operations at the venture level. The Company believes that its existing cash balances and cash flow from operations will be sufficient to fund its expected capital needs under its current business plan, excluding any funds expended in connection with the potential implementation of the Company's European Services Strategy. The Company contemplates that following the consummation of the Offerings, it will raise additional debt financing through a newly formed subsidiary of the Company, the proceeds of which will be applied toward the implementation of the Company's European Services Strategy. The size and timing of such financing have not yet been determined by the Company. The actual amount and timing of the Company's future capital requirements, however, may differ materially from management's estimates and, therefore, GTS may require additional capital to execute its current business plan and to fund expected operating losses, as well as to consummate future acquisitions and exploit opportunities to expand and develop its businesses, part of which may be provided with proceeds of the Offerings. Management expects that GTS and its ventures will incur over $510 million of capital expenditures during the next three years, of which approximately $171 million will be incurred in the last three quarters of 1998. Of these amounts, approximately $290 million will be used to fund construction of the HER network and approximately $180 million will be applied to the expansion of the Company's businesses in the CIS, with the remainder to be used for the development of the Company's other businesses. The Company also will need to fund operating losses for a number of its ventures for at least the next 12 months. In addition, as part of its business strategy, the Company regularly evaluates potential acquisitions and joint ventures. The Company believes that attractive acquisition opportunities currently exist in the markets in which it operates in Western and Central Europe and the CIS. The Company continuously considers a number of potential transactions, some of which may involve the contribution of certain of its Russian businesses in exchange for an interest of equivalent or greater value in the surviving entity and, if consummated, may be material to the Company's operations and financial condition. The Company has no definitive agreement with respect to any acquisition or joint venture, although from time to time it has discussions with other companies and assesses opportunities on an on-going basis. The Company expects to use the net proceeds of the Offerings primarily to implement the Company's European Services Strategy. In addition, a portion of the net proceeds may be used to further develop the Company's businesses in Central Europe and Russia, as well as for potential acquisitions, other business development opportunities and general corporate purposes. If the New Convertible Bond Offering is not consummated, the Company will need to find additional sources of capital to replace the 6 12 funding that would have been provided by the New Convertible Bond Offering. See "Risk Factors -- Additional Capital Requirements," "Risk Factors -- Risks Relating to European Services Strategy", "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" and "Use of Proceeds." As of March 31, 1998, certain affiliates of George Soros, Alan B. Slifka and certain affiliates, and certain affiliates of Capital Research International beneficially owned approximately 19.2%, 10.8% and 9.7% of the Common Stock (including rights to acquire Common Stock), respectively. See "Principal and Selling Stockholders." * * * The Company was founded in 1983 as a not-for-profit company under the name San Francisco/Moscow Teleport, Inc. The Company was incorporated as a California for-profit corporation on September 25, 1986, and by way of a reincorporation merger, merged with and into SFMT, Inc., a Delaware corporation formed for that purpose on September 13, 1993. The Company was renamed Global TeleSystems Group, Inc., on February 22, 1995. The Company's principal business office is located at 1751 Pinnacle Drive, North Tower-12th Floor, McLean, Virginia 22102, United States, and its telephone number is (703) 918-4500. 7 13 THE STOCK OFFERINGS Common Stock offered hereby: U.S. Offering...................................... 6,274,800 shares International Offering............................. 4,183,200 shares ---------- Total...................................... 10,458,000 shares Common Stock offered by: The Company........................................ 2,614,500 shares Selling Stockholders............................... 7,843,500 shares ---------- Total...................................... 10,458,000 shares Common Stock to be outstanding after the Offerings(1)....................................... 54,654,640 shares Use of Proceeds to the Company....................... The net proceeds of the Stock Offerings will be approximately $93.8 million (at an assumed offering price of $38.25 per share), after deducting estimated commissions and offering expenses. The Company intends to use the net proceeds from the Offerings primarily toward the implementation of the Company's European Services Strategy. In addition, a portion of the net proceeds may be used to further develop the Company's businesses in Central Europe and Russia as well as for business development opportunities, potential acquisitions and for general corporate purposes. The consummation of the Stock Offerings is not conditioned upon the consummation of the New Convertible Bond Offering. If the New Convertible Bond Offering is not consummated, the Company will need to find additional sources of capital to replace the funding that would have been provided by the New Convertible Bond Offering. See "Use of Proceeds." Trading.............................................. The Common Stock is traded on the Nasdaq National Market and the EASDAQ Market authority under the symbol "GTSG."
- - - - --------------- (1) Excludes at March 31, 1998 (i) 7,777,776 shares of Common Stock reserved for issuance upon exercise of outstanding warrants at an exercise price of $9.33 per share, (ii) 5,918,972 shares of Common Stock reserved for issuance upon exercise of outstanding stock options at a weighted average exercise price of $12.01 per share, (iii) 713,311 shares of Common Stock reserved for issuance upon exercise of a put right associated with a 1996 financing agreement, as amended, (iv) 6,921,850 shares issuable upon conversion of the Convertible Bonds (as defined hereinafter), (v) 560,820 shares of Common Stock reserved for issuance pursuant to the TCM business partnership agreement as deferred consideration to TCM's partners and (vi) shares of Common Stock issuable in connection with the New Convertible Bonds. See "Certain Related Party Transactions." RISK FACTORS See "Risk Factors" beginning on page 11 for a discussion of certain factors that should be considered by prospective investors in evaluating an investment in the Offered Securities. 8 14 SUMMARY HISTORICAL CONSOLIDATED FINANCIAL DATA The following summary historical consolidated financial data as of and for the years ended December 31, 1993, 1994, 1995, 1996 and 1997 are derived from the Company's audited Consolidated Financial Statements. The following unaudited summary historical consolidated financial data as of March 31, 1998 and for the three months ended March 31, 1997 and 1998 are derived from the Company's unaudited Consolidated Financial Statements. The summary historical consolidated financial data presented below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations," and the audited Consolidated Financial Statements and related notes thereto appearing elsewhere in this Prospectus. Under generally accepted accounting principles, a majority of the Company's ventures are accounted for by the equity method of accounting. Under this method, the operating results of the ventures are included in the Company's Consolidated Statement of Operations as a single line item, "Equity in (losses) earnings of ventures." The Company recognizes 100% of the losses in ventures where the Company bears all of the financial risk (which includes all of the Company's significant ventures except for Sovintel and, historically, HER). Also, the assets, liabilities and equity of the ventures are included in the Company's Consolidated Balance Sheets as a single line item, "Investments in and advances to ventures." See Note 3 to the Company's audited Consolidated Financial Statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Overview." Financial information about the Company's equity ventures is included below under "Supplemental Information -- Summary Historical Financial Data -- Combined Equity Investments."
THREE MONTHS ENDED YEARS ENDED DECEMBER 31, MARCH 31, ------------------------------- ------------------- 1995 1996 1997(1) 1997 1998 -------- -------- --------- -------- -------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Revenues, net.......................... $ 8,412 $ 24,117 $ 47,098 $ 8,387 $ 22,817 Gross margin........................... 16 5,176 4,379 1,963 3,794 Operating expenses..................... 41,014 52,955 78,410 13,021 22,686 Equity in earnings (losses) of ventures............................. (7,871) (10,150) (14,599) (3,420) 3,412 Other income (expense)................. 11,034 (8,729) (29,551) (2,866) (10,794) Loss before extraordinary loss......... (40,400) (67,991) (116,986) (17,733) (24,473) Extraordinary loss(2).................. -- -- -- -- (12,704) Net loss............................... (40,400) (67,991) (116,986) (17,733) (37,177) Loss per share before extraordinary loss................................. (1.61) (2.22) (3.26) (0.51) (0.54) Extraordinary loss per share........... -- -- -- -- (0.28) Net loss per share..................... (1.61) (2.22) (3.26) (0.51) (0.82)
DECEMBER 31, MARCH 31, 1997 1998 ------------ ---------- (IN THOUSANDS) BALANCE SHEET DATA (AT END OF PERIOD): Cash and cash equivalents................................... $ 318,766 $ 507,895 Property and equipment, net................................. 236,897 270,641 Investments in and advances to ventures..................... 76,730 88,083 Total assets................................................ 780,461 1,048,550 Total debt.................................................. 639,359 685,009 Minority interest and stock subject to repurchase........... 31,255 12,470 Shareholders' equity........................................ 26,967 254,841
- - - - --------------- (1) As a result of the Company's increase in ownership interest and amendment to the HER Shareholders Agreement that was completed on July 16, 1997, the Company accounts for its ownership interest in HER under the consolidation method of accounting. Prior to this date, the Company accounted for HER under the equity method of accounting. (2) The Company recognized a $12.7 million extraordinary charge to earnings in the three months ended March 31, 1998, as a result of the Company's early extinguishment of certain related party debt obligations. The nature of the charge is comprised of the write-off of $11.6 million of unamortized debt discount and $1.1 million of unamortized debt issuance costs that were deferred as financing costs and were being amortized over the original maturity of the debt. 9 15 SUPPLEMENTAL INFORMATION -- SUMMARY HISTORICAL FINANCIAL DATA -- COMBINED EQUITY INVESTMENTS The following unaudited summary historical financial data -- equity investments for the years ended December 31, 1995, 1996 and 1997, and for the three months ended March 31, 1997 and 1998 are derived from the Company's financial records. It is intended to supplement the aforementioned summary historical consolidated financial data, which were derived from the Company's audited Consolidated Financial Statements. The Company believes that this information provides additional insight on the Company's unconsolidated equity method investments. Generally accepted accounting principles prescribe inclusion of revenues and expenses for consolidated interests (generally interests of more than 50%, absent some other factors), but not for equity interests (generally interests of 20% to 50%) or cost interests (generally interests of less than 20%). Equity accounting ordinarily results in the same net income as consolidation; however, the net operating results are reflected on one line within the income statement. More detailed financial information about the Company's equity investments is included under "Supplemental Information -- Selected Historical Financial Data -- Combined Equity Investments."
THREE MONTHS ENDED YEAR ENDED DECEMBER 31, MARCH 31, ----------------------------- ------------------- 1995 1996 1997 1997 1998 ------- -------- -------- -------- -------- (IN THOUSANDS) STATEMENT OF OPERATIONS DATA: Revenues, net............................ $54,051 $143,472 $226,160 $48,026 $63,683 Cost of revenues......................... 33,011 80,426 127,732 26,821 36,387 Operating expenses....................... 22,958 55,018 74,845 14,145 12,792 Net (loss) income........................ (6,380) (5,220) 4,330 1,966 8,985 Income (loss) recognized by GTS.......... (7,871) (10,150) (14,599) (3,420) 3,412 ADJUSTMENTS FOR INTER-AFFILIATE TRANSACTIONS(1): Revenues, net............................ (2,270) (15,385) (24,927) (5,933) (8,890) Cost of revenues......................... (2,215) (13,562) (23,250) (4,760) (8,105) Operating expenses....................... (6,967) (8,083) (8,357) (2,875) 4,158
- - - - --------------- (1) The adjustment amounts represent the effect of inter-affiliate transactions between the Company's consolidated and equity method ventures. More detailed information about inter-affiliate transactions is included under "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Accounting Methodology." 10 16 RISK FACTORS ADDITIONAL CAPITAL REQUIREMENTS The Company anticipates that the implementation of its European Services Strategy may require significant amounts of capital in addition to that portion of the net proceeds of the Offerings anticipated to be expended in connection therewith. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources" "Business -- Western Europe -- European Services Strategy." In addition, as part of its business strategy, the Company regularly evaluates potential acquisitions and joint ventures. The Company believes that attractive acquisition opportunities currently exist in the markets in which it operates in Western and Central Europe and the CIS. The Company continuously considers a number of potential transactions, some of which may involve the contribution of certain of its Russian businesses in exchange for an interest of equivalent or greater value in the surviving entity, that, if consummated, may be material to the Company's operations and financial condition. The Company has no definitive agreement with respect to any material acquisition or joint venture, although from time to time it has discussions with other companies and assesses opportunities on an on-going basis. The Company may fund such acquisitions or joint ventures with a portion of the net proceeds from the Offerings or may require additional capital to fund such acquisitions or joint ventures. The Company believes that its existing cash balances and cash flows from operations will be sufficient to fund its expected capital needs under its current business plan excluding any funds expended in connection with the potential implementation of the Company's European Services Strategy. The actual amount and timing of the Company's future capital requirements, however, may differ materially from management's estimates. In particular, the accuracy of management's estimates are subject to changes and fluctuations in the Company's revenues, operating costs and development expenses, which can be affected by the Company's ability to (i) effectively and efficiently manage the expansion of the HER network and operations, (ii) obtain infrastructure contracts, rights-of-way, licenses and other regulatory approvals necessary to complete and operate the HER network, (iii) negotiate favorable contracts with suppliers, including large volume discounts on purchases of capital equipment and (iv) access markets, attract sufficient numbers of customers and provide and develop services for which customers will subscribe. The Company's revenues and costs are also dependent upon factors that are not within the Company's control such as regulatory changes, changes in technology, increased competition and various factors such as strikes, weather, and performance by third-parties in connection with the Company's operations. Due to the uncertainty of these factors, actual revenues and costs may vary from expected amounts, possibly to a material degree, and such variations are likely to affect the Company's future capital requirements. Historically, GTS has experienced liquidity problems resulting in part from the Company's need to meet the capital requirements of certain of its joint ventures in excess of forecast amounts. In addition, certain of the Company's joint ventures have not met management's financial performance expectations or have not been able to secure local country financing and thus have not been able to generate the expected cash inflows. In addition, if the Company expands its operations at an accelerated rate or consummates acquisitions, the Company's funding needs will increase, possibly to a significant degree, and it will expend its capital resources sooner than currently expected. In addition, due to the preliminary nature of the Company's business plan with respect to its European Services Strategy, the Company cannot estimate with any degree of certainty the amount and timing of the Company's future capital requirements to implement such strategy, which the Company anticipates will be dependent on a number of factors including, among others, the demand for the Company's services, the markets in which the Company builds or buys networks and regulatory, technological and competitive developments. The Company may also be required to repay its Convertible Bonds upon maturity in the year 2000 to the extent such Convertible Bonds are not converted into Common Stock. Furthermore, the consummation of the Stock Offerings is not conditioned upon the consummation of the New Convertible Bond Offering, and there can be no assurance that the New Convertible Bond Offering will be consummated. If the New Convertible Bond Offering is not consummated, the Company will need to find additional sources of capital to replace the funding that would have been provided by the New Convertible Bond Offering. As a result of the foregoing, or if the Company's capital resources otherwise prove to be insufficient, the Company may need to raise additional capital. See "-- Government Regulation," "-- Competition," "-- Technology," "-- HER Network Roll-out," "Management's Discussion and Analysis of Financial Condition and Results of Operations," and "Use of Proceeds." 11 17 If the Company decides to raise additional funds through the incurrence of debt, it may become subject to additional or more restrictive financial covenants and its interest obligations will increase. If the Company decides to raise additional funds through the issuance of equity, the interests of holders of the Common Stock will be diluted. The Company presently contemplates that following the consummation of the Offerings, it will raise additional debt financing through a newly formed subsidiary of the Company, the proceeds of which will be applied toward the implementation of the Company's European Services Strategy. The size and timing of such financing have not yet been determined by the Company. There can be no assurance that additional financing will be available to GTS on favorable terms or at all, and failure to generate sufficient funds in the future, whether from operations or by raising additional debt or equity capital, may require the Company to delay or abandon some or all of its anticipated expenditures, to sell assets, or both, and could affect the Company's ability to compete, either of which could have a material adverse effect on the operations of the Company, and could affect the value of the Common Stock. See "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Use of Proceeds." SUBSTANTIAL LEVERAGE GTS is, and will continue to be, highly leveraged as a result of the substantial indebtedness it has incurred and intends to incur to pursue the implementation of its business plans. On a pro forma consolidated basis, after giving effect to the issuance of the New Convertible Bonds, the Company would have had approximately $1.0 billion aggregate principal amount of indebtedness outstanding at March 31, 1998. GTS's debt instruments permit the Company and its subsidiaries to incur certain additional indebtedness to fund expansion of the Company's businesses and for other permitted purposes. In addition, the Company contemplates that following the consummation of the Offerings, it will raise additional debt financing through a newly formed subsidiary of the Company, the proceeds of which will be applied toward the implementation of the Company's European Services Strategy. The size and timing of such financing have not yet been determined by the Company. The degree to which the Company is leveraged could have important consequences for holders of the New Convertible Bonds, including (i) limiting the Company's ability to refinance its existing indebtedness or obtain additional financing to fund future working capital, capital expenditures and other general corporate requirements, (ii) requiring the dedication of a substantial portion of the Company's cash flow from operations to the payment of principal of, and interest on, its indebtedness, thereby reducing the availability of such cash flow to fund working capital, capital expenditures or other general corporate purposes, (iii) limiting the Company's flexibility in planning for, or reacting to, changes in its business and the telecommunications industry, (iv) limiting the Company's ability to obtain additional financing to make capital expenditures and acquisitions, (v) limiting the Company's ability to withstand adverse economic conditions or take advantage of significant business opportunities that may arise, (vi) limiting the Company's ability to invest in new or developing technologies, (vii) limiting the Company's ability to respond to changes affecting the implementation of its financing, construction or operating plans and (viii) placing the Company at a competitive disadvantage with respect to less-leveraged competitors. In addition, the Company's operating and financial flexibility will be limited by covenants contained in agreements governing the indebtedness of the Company. Among other things, these covenants limit or may limit the ability of the Company and its subsidiaries to incur additional indebtedness, make capital expenditures, pay dividends or make distributions on capital stock of the Company or make certain other restricted payments, create certain liens upon assets, dispose of certain assets or enter into certain transactions with affiliates. There can be no assurance that such covenants will not materially and adversely affect the Company's ability to finance its future operations or capital needs or to engage in other business activities which may be in the interest of the Company. The Company must substantially increase its net cash flow in order to meet its debt service obligations, and there can be no assurance that the Company will be able to meet such obligations. If the Company is unable to generate sufficient cash flow or otherwise obtain funds necessary to make required payments, or if it otherwise fails to comply with the various covenants under its indebtedness, it would be in default under the terms thereof, which would permit the holders of such indebtedness to accelerate the maturity of such indebtedness and could cause defaults under other indebtedness of the Company. 12 18 HISTORY OF OPERATING LOSSES The Company has historically sustained substantial operating and net losses. The Company had net losses of $2.4 million in 1993, $12.0 million in 1994, $40.4 million in 1995, $68.0 million in 1996, $117.0 million in 1997 and $37.2 million for the three months ended March 31, 1998. The Company's cumulative net losses totalled $280.1 million from inception through March 31, 1998. Further development of the Company's business, including the Company's European Services business, will require significant additional expenditures and the Company expects that it will have significant operating and net losses and will record significant net cash outflow, before financing, in coming years. There can be no assurance that the Company's operations, including the Company's European Services business, will achieve or sustain profitability or positive cash flow in the future. If the Company cannot achieve and sustain operating profitability or positive cash flow from operations, it may not be able to meet its debt service obligations or working capital requirements which would have a material adverse effect on the operations of the Company and could affect the value of the Common Stock. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." HER NETWORK ROLL-OUT HER's ability to achieve its strategic objective will depend in large part on the successful, timely and cost-effective completion of the HER network. Although HER currently operates commercially over a portion of the network linking Brussels, Antwerp, Rotterdam, Amsterdam, London, Paris, Frankfurt, Strasbourg, Zurich and Geneva, the development of the remainder of the network may be delayed or adversely affected by a variety of factors, uncertainties and contingencies. Many of these factors, such as strikes, natural disasters and other casualties, are beyond HER's control. In addition, HER will need to negotiate and conclude additional agreements with various parties regarding, among other things, rights-of-way and development and maintenance of the network infrastructure and equipment. Historically, HER has experienced substantial delays in concluding these agreements and developing its network. There can be no assurance that HER will be successful in concluding necessary agreements, or that delays in concluding such agreements will not materially and adversely affect the speed or successful completion of the network. The successful and timely completion of the network will also depend on, among other things, (i) the availability to HER of substantial amounts of additional capital and financing, (ii) timely performance by various third parties of their contractual obligations to engineer, design and construct portions of the network and (iii) HER's ability to obtain and maintain applicable governmental approvals. HER expects to roll out full telecommunications service over the initial five country network and Switzerland in the second quarter of 1998, and the 18,000 kilometer network to be operational during the year 2000. Although HER believes that its cost estimates and the build-out schedule are reasonable, there can be no assurance that the actual construction costs or time required to complete the network build-out will not substantially exceed current estimates. Any significant delay or increase in the costs associated with development of the HER network could have a material adverse effect on HER and the Company. Development of the HER network is capital intensive. Management expects that approximately $290 million in capital expenditures will be incurred in connection with the buildout of the HER network. HER raised approximately $265 million in a private placement of its senior notes in August 1997 (of which $56.6 million has been placed in escrow for the first two years' interest payments on the notes). In addition, in connection with the HER Recapitalization (as defined below), the Company, through a subsidiary, GTS-Hermes, made a contribution of approximately $51.8 million to HER. The Company believes that the net proceeds of such note sale, combined with the $51.8 million contribution and HER's projected internally generated funds, should be sufficient to fund HER's expected capital expenditures. However, the actual amount and timing of HER's future capital requirements may differ materially from management's estimates. Thus, additional financing may be needed to construct the HER network and there can be no assurance that such additional financing will be available on terms acceptable to the Company or at all. Failure to obtain necessary financing may require HER to delay or abandon its plans for deploying the remainder of the network and would adversely affect the viability of HER, or may require the Company to make additional capital contributions to HER at the expense of the Company's other operations, either of which could have a material adverse effect on the operations of the Company and could affect the value of the Common Stock. HER's 13 19 revenues and the cost of deploying its network and operating its business will depend upon a variety of factors including, among other things, HER's ability to (i) effectively and efficiently manage the expansion of its network and operations, (ii) negotiate favorable contracts with suppliers, (iii) obtain additional licenses, regulatory approvals, rights-of-way and infrastructure contracts to complete and operate the network, (iv) access markets and attract sufficient numbers of customers and (v) provide and develop services for which customers will subscribe. HER's revenues and costs are also dependent upon factors that are not within HER's control such as regulatory changes, changes in technology, increased competition and various factors such as strikes, weather and performance by third-parties in connection with the development of the network. Due to the uncertainty of these factors, actual costs and revenues may vary from expected amounts, possibly to a material degree, and such variations would likely affect HER's future capital requirements. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." HER must obtain additional infrastructure provider agreements for the long-term lease of dark fiber, rights-of-way and other permits to install fiber optic cable from railroads, utilities and governmental authorities to build out the network. There can be no assurance that HER will be able to maintain all of its existing agreements, rights and permits or to obtain and maintain the additional agreements, rights and permits needed to implement its business plan on acceptable terms. Loss of substantial agreements, rights and permits or the failure to enter into and maintain required arrangements for the HER network could have a material adverse effect on HER's business. In addition, HER depends on third parties for leases of dark fiber for substantial portions of its network. There can be no assurance that HER will be able to enter into and maintain required arrangements for leased portions of the HER network, which could have a material adverse effect on HER's business. To the extent that HER is unable to enter into or maintain such arrangements, such inability could have a material adverse effect on HER's business, as well as on the operations of the Company and could affect the value of the Common Stock. In order to operate and, in the case of some countries, even to construct the network in accordance with current plans, HER must obtain the necessary regulatory approvals. To date, HER has obtained licenses, authorizations and/or registrations in the United Kingdom, the Netherlands, Belgium, Germany and France and has obtained a provisional concession to operate in Switzerland. HER expects to obtain a permanent concession from the Swiss regulatory authority by the end of the third quarter 1998. In addition, HER intends to file applications in other countries in anticipation of service launch in accordance with the HER network roll-out plan. The terms and conditions of these licenses, authorizations or registrations may limit or otherwise affect HER's scope of operations. There can be no assurance that HER will be able to obtain, maintain or renew licenses, authorizations or registrations to provide the services it currently provides and plans to provide, that such licenses, authorizations or registrations will be issued or renewed on terms that are commercially viable or that the licenses, authorizations or registrations required in the future can be obtained by HER. The loss of, or failure to obtain, these licenses, authorizations or registrations or a substantial limitation upon the terms of these licenses, authorizations or registrations could have a material adverse effect on HER. See "Business -- Western Europe -- HER -- Licenses and Regulatory Issues." RISKS RELATING TO EUROPEAN SERVICES STRATEGY Preliminary Nature of European Services Strategy. The Company's European Services Strategy is preliminary. The Company's determination to proceed with its European Services Strategy will depend on its ability to assess potential markets, obtain required governmental authorizations, franchises and permits, identify appropriate acquisition candidates, implement efficient information processing systems for billing and customer service and develop a sufficient customer base. The failure of any of the foregoing may require the Company to modify, delay or abandon some or all of its preliminary plans with respect to its European Services Strategy. In addition, due to the preliminary nature of its European Services Strategy, the Company cannot estimate with certainty the amount and timing of the Company's future capital requirements to implement such strategy. Furthermore, if the New Convertible Bond Offering is not consummated, the Company may not have sufficient funding to satisfy the capital requirements of the European Services Strategy and may require alternative sources of funding. There can be no assurance that the failure to consummate the New Convertible Bond Offering will not cause delays and limitations or not have a material adverse effect on the implementation of the European Services Strategy. Further development of the 14 20 Company's business, including the Company's European Services business, will require significant additional expenditures and the Company expects that it will have significant operating and net losses and will record significant net cash outflow, before financing, in coming years. There can be no assurance that the Company's operations, including the Company's European Services business, will achieve or sustain profitability or positive cash flow in the future. See "-- Additional Capital Requirements," "Management's Discussion and Analysis of Financial Condition and Results of Operations," and "Business -- Western Europe -- European Services Strategy." Regulatory. The Company's plans to provide an expanded array of telecommunications services in Europe, including local, long distance, international, data and Internet services, will subject the Company to significant additional regulation at the EU, national and local levels. Delays in receiving required regulatory approvals, or the enactment of adverse regulations or regulatory requirements, may delay or prevent the Company from offering its services in many European markets, restrict the types of services offered by the Company, constrain the Company's deployment of its networks and otherwise adversely affect the Company's operations. There can be no assurance that the Company will be able to obtain the necessary regulatory approvals on a timely basis or that the Company will not otherwise be affected by regulatory developments, any of which may have a material adverse effect on the Company. Competition. The provision of telecommunications services in Europe is extremely competitive and the Company's success will depend upon its ability to compete with a variety of telecommunications providers in each of its markets. The Company's competitors will include PTOs, alliances among telecommunications companies (such as Global One, an alliance among Sprint, Deutsche Telekom and France Telecom), facilities-based competitors (including WorldCom Inc. ("WorldCom"), Viatel Inc. ("Viatel"), Esprit Telecom Group plc ("Esprit"), Econophone, Inc. ("Econophone"), Primus Telecommunications Group, Incorporated ("Primus") and Cable & Wireless, plc ("Cable & Wireless"), resellers, data providers, Internet service providers and other bundled services providers. The Company may also face competition in one or more of its markets from competitors utilizing new or alternative technologies or new applications of existing technologies, including cable television companies, wireless telephone companies, microwave carriers and satellite companies. Many of the Company's competitors will have established customer bases and extensive brand name recognition, and many of such competitors will have greater financial, management and other resources than the Company. The Company will compete primarily on the basis of price and, to a lesser extent, on the type and quality of services it offers. Many of the Company's potential competitors have the ability to use their substantial financial resources to cause severe price competition in the markets in which the Company plans to operate, which would force the Company to lower its prices to remain competitive. The Company also expects to experience significant customer attrition as a result of the highly competitive nature of its markets, and it may be difficult for the Company to attract and retain a sufficient customer base. There can be no assurance that the Company will be able to effectively market its expanded service offerings or that competitive pressures will not have a material adverse effect on the Company. Entering New Markets. The Company will have to make significant operating and capital investments in order to implement its European Services Strategy and there are numerous operating complexities associated with providing these services. The Company will be required to develop new products and services and will need to establish direct and/or indirect sales channels to market its offerings. Sophisticated information and processing systems will be vital to the Company's success and the Company will need to implement and integrate the necessary provisioning, billing and collection systems for its services. The Company has no prior experience in offering expanded services in Europe or in targeting the European business and government customers. The Company may also rely upon third party vendors and contractors for network buildouts and information systems upgrades, and will need to obtain rights of way and other consents to develop its networks. There can be no assurance that the Company will successfully be able to implement its European Services Strategy on a timely basis, or at all, and any delays in one or more of the Company's targeted markets may have a material adverse effect on the Company. 15 21 Reliance on PTOs and Other Telecommunications Service Providers. In order to compete successfully with its expanded European services offerings, the Company will need to negotiate interconnection agreements with, and may need to negotiate collocation agreements and lease trunking capacity from, the PTOs and other local service providers operating in the Company's target markets. There can be no assurance that such interconnection and other agreements with the local service providers can be reached on terms that are satisfactory to the Company. With respect to its long distance and international services, the Company will need to negotiate resale agreements with long distance and international carriers. Such agreements frequently contain minimum volume commitments and the Company may be obligated to pay underutilization charges if it overestimates its need for transmission capacity. If the Company underestimates its need for transmission capacity, it may be required to obtain capacity through more expensive means. Acquisition-Related Risks. The Company may enter its targeted markets through acquisitions. If acquisitions are consummated, the Company will be subject to certain risks, including, among others, the difficulty of assimilating the acquired operations and personnel, the potential disruption of the Company's ongoing business and diversion of resources and management time and the potential impairment of relationships with employees or customers as a result of changes in management. In addition, the Company's ability to consummate acquisitions may be constrained by its high degree of leverage and by the terms of its outstanding indebtedness. There can be no assurance that any acquisitions will be made, that the Company will be able to obtain any additional financing needed to finance such acquisitions and, if any acquisitions are made, that the acquired business will be successfully integrated into the Company's operations or that they will perform as expected. Potential Adverse Impact on HER. Many of the Company's planned service offerings will compete with the services offered by the PTOs, New Entrants and other customers HER targets as an independent carrier's carrier. To the extent that the Company's subsidiaries offering such services contract with HER for capacity, the Company expects that such arrangements will be entered into on an arms' length basis. However, the Company's European Services Strategy could affect the perception of HER as an independent operator and could negatively impact HER's ability to attract and retain customers which could, in turn, have a material adverse effect on the Company. RISKS RELATING TO REORGANIZATION OF RUSSIAN TELECOMMUNICATIONS INDUSTRY Svyazinvest was established by the Russian government in 1994 to hold the government's interest in 88 regional telecommunication companies. In April 1997, President Yeltsin approved the transfer of additional government-owned telecommunications assets, including the government's 51% stake in Rostelecom (the government controlled international and long distance operator), to Svyazinvest. On July 30, 1997, Mustcom Ltd., a Cyprus-based company that represents the interests of a consortium which includes ICFI Cyprus, Renaissance International Ltd., Deutsche Morgan Grenfell, Morgan Stanley, and an affiliate of George Soros, purchased a 25% stake in Svyazinvest for $1.87 billion. As of March 31, 1998, affiliates of George Soros beneficially owned 19.2% of the Company's Common Stock. The President has also authorized the sale of another 24% of Svyazinvest at a future date. This sale is scheduled to occur in the second half of 1998 and is currently reserved solely for Russian investors. The Russian government has announced that it will retain a controlling 51% interest in Svyazinvest. As a result of the government's actions, a single entity, Svyazinvest, now owns a majority interest in most of the Company's principal venture partners and other telecommunication service providers in Russia which together provide a range of international and domestic long distance and local telecommunications services throughout Russia. The consolidation of many of its partners under Svyazinvest and the possible sale of a significant interest in Svyazinvest to foreign and/or Russian investors will likely subject the Company to more coordinated competition from Svyazinvest, and may lead to material adverse changes in the business relationships between the Company and such partners, which business relationships represent a material component of the Company's business strategy in Russia. There can be no assurance that the continuing privatization of Svyazinvest, or the evolution of government policy regarding Svyazinvest and Rostelecom, will not have a material adverse effect on the Company or its ventures. See 16 22 "-- Competition," "-- Dependence on Certain Local Parties; Absence of Control" and "Business -- Russia and the CIS -- Overview" and "Principal and Selling Stockholders." MANAGING RAPID GROWTH As a result of the Company's past and expected continued growth and expansion, significant demands have been placed on the Company's management, operational and financial resources and on its systems and controls. The Company continues to construct segments of the HER network, expand its operations within Russia and the CIS and expand into additional geographic and service markets when business and regulatory conditions warrant. In order to manage its growth effectively, the Company must continue to implement and improve its operational and financial systems and controls, purchase and utilize additional telecommunications facilities and expand, train and manage its employee base. Inaccuracies in the Company's forecasts of market demand could result in insufficient or excessive telecommunications facilities and disproportionate fixed expenses for certain of its operations. There can be no assurance that the Company will be able to construct and operate the entire HER network as currently planned, expand with the markets in which its ventures are currently operating or expand into additional markets at the rate presently planned by the Company, or that any existing regulatory barriers to such expansion will be reduced or eliminated. As the Company proceeds with its development and expansion, there will be additional demands on the Company's customer support, sales and marketing and administrative resources and network infrastructure. There can be no assurance that the operating and financial control systems and infrastructure of the Company and its ventures will be adequate to maintain and effectively manage future growth. The failure to continue to upgrade the administrative, operating and financial control systems or the emergence of unexpected expansion difficulties could materially and adversely affect the Company's business, results of operations and financial condition. RISKS RELATING TO EMERGING MARKETS Substantially all of the Company's revenue to date has been derived from operations in emerging markets, where the Company's businesses are subject to numerous risks and uncertainties, including political, economic and legal risks, such as unexpected changes in regulatory requirements, tariffs, customs, duties and other trade barriers, difficulties in staffing and managing foreign operations, problems in collecting accounts receivable, political risks, fluctuations in currency exchange rates, foreign exchange controls which restrict or prohibit repatriation of funds, technology export and import restrictions or prohibitions, delays from customs brokers or government agencies, seasonal reductions in business activity, and potentially adverse tax consequences resulting from operating in multiple jurisdictions with different tax laws, which could materially adversely impact the Company's business, results of operations and financial condition. The political systems of many of the emerging market countries in which the Company operates or plans to operate are slowly emerging from a legacy of totalitarian rule. Political conflict and, in some cases, civil unrest and ethnic strife may continue in some of these countries for a period of time. Many of the economies of these countries are weak, volatile and reliant on substantial foreign assistance. Expropriation of private businesses in such jurisdictions remains a possibility, whether by an outright taking or by confiscatory tax or other policies. There can be no assurance that GTS's operations will not be materially and adversely affected by such factors or by actions to expropriate or seize its operations. The success of free market reforms undertaken in certain of the emerging market countries in which the Company operates is also uncertain, and further economic instability may occur. These factors may reduce and delay business activity, economic development and foreign investment. Legal systems in emerging market countries frequently have little or no experience with commercial transactions between private parties. The extent to which contractual and other obligations will be honored and enforced in emerging market countries is not entirely free from doubt. Accordingly, there can be no assurance that difficulties in protecting and enforcing rights in emerging market countries will not have a material adverse effect upon GTS and its operations. Additionally, the Company's businesses operate in uncertain regulatory environments. The laws and regulations applicable to GTS's activities in emerging market countries are in general new and subject to change and, in some cases, incomplete. There can be no assurance that local laws and regulations will become stable in the future, or that changes thereto will not materially adversely affect the operations of the Company, the ability of the Company to pay the principal of, 17 23 and the interest on, the New Convertible Bonds and could affect the value of the Common Stock. Additionally, telecommunications regulations in the more developed Western European markets in which GTS participates are currently undergoing changes initiated by the Commission of the European Union. See "Business." RISKS RELATING TO RUSSIA AND THE CIS Substantially all of the Company's revenue to date have been derived from operations in Russia and the CIS. Foreign companies conducting operations in the former Soviet Union face significant political, economic, and legal risks. The Company continuously evaluates a number of potential transactions, some of which may involve the contribution of certain of its Russian businesses in exchange for an interest of equivalent or greater value in the surviving entity and, if consummated, may be material to the Company's operations and financial condition and could increase its exposure to such risks. Political. The political systems of Russia and the other independent countries of the CIS, which are in a stage of relative infancy, are vulnerable to instability due to the populace's dissatisfaction with reform, social and ethnic unrest and changes in government policies. Such instability could lead to events that could have a material adverse effect on the Company's operations in these countries. In recent years, Russia has been undergoing a substantial political transformation. During this transformation, legislation has been enacted to protect private property against expropriation and nationalization. However, due to the lack of experience in enforcing these provisions during the period they have been in effect and due to potential political changes in the future, there can be no assurance that such protections would be enforced in the event of an attempted expropriation or nationalization. Expropriation or nationalization of the Company, its assets or portions thereof, whether by an outright taking or by confiscatory tax or other policies potentially without adequate compensation, would have a material adverse effect on the operations of the Company and could affect the value of the Common Stock. The various government institutions and the relations between them, as well as the government's policies and the political leaders who formulate and implement them, are subject to rapid and potentially violent change. For example, the Constitution of the Russian Federation gives the President of the Russian Federation substantial authority, and any major changes in, or rejection of, current policies favoring political and economic reform by the President may have a material adverse effect on the Company. In March 1998, President Yeltsin dismissed his entire cabinet, including Prime Minister Victor Chernomyrdin, citing, among other things, a need for more dynamism and initiative in the Russian government. It is unclear, however, how the change will affect governmental policy. In addition, it is uncertain whether the resolution of these and other issues could have a material adverse effect on the Company. Furthermore, the political and economic changes in Russia have resulted in significant dislocations of authority. The local press and international press have reported that significant organized criminal activity has arisen and high levels of corruption among government officials exist where the Company operates. While the Company does not believe it has been adversely affected by these factors to date, no assurance can be given that organized or other crime will not in the future have a material adverse effect on the Company. Economic. Over the past five years the Russian government has enacted reforms to create the conditions for a more market-oriented economy. Despite some progress in implementing its reforms, including progress in reducing inflation and stabilizing the currency and industrial production, there remains generally rising unemployment and underemployment, high government debt relative to gross domestic product and high levels of corporate insolvency. No assurance can be given that reform policies will continue to be implemented and, if implemented, will be successful, that Russia will remain receptive to foreign trade and investment or that the economy will improve. In addition, Russia, the CIS and other emerging countries in which the Company operates currently receive substantial financial assistance from several foreign governments and international organizations. To the extent any of this financial assistance is reduced or eliminated, economic development in Russia, the CIS and such other countries may be adversely affected. 18 24 Russian and CIS businesses have a limited operating history in market-oriented conditions. The relative infancy of the business culture is reflected in the Russian banking system's under-capitalization and liquidity crises. There have been concerns about rumors that many Russian banks continue to have cash shortages. The Russian Central Bank has reduced banks' reserve requirements in order to inject more liquidity into the Russian financial system, but has stressed that it will not bail out the weaker banks. Many of these banks are expected to disappear over the next several years as a result of bank failure and anticipated consolidation in the industry. A general Russian banking crisis could have a material adverse effect on the Company's financial performance and the viability of the Company's receivables, as well as on the operations of the Company, and could affect the value of the Common Stock. In May and early June 1998, the Russian Central Bank and other Russian governmental authorities adopted a number of measures, including increasing the inter-bank lending rate charged by the Russian Central Bank and the rate offered on sovereign debt obligations, in order to maintain the value of the ruble and reduce the risk of the flight of foreign capital from the Russian economy. Although these measures appear to have stabilized the ruble to date, there can be no assurance that there will not be a significant and sudden decline in the value of the ruble and consequent loss of investor confidence in the Russian economy. Such a devaluation of the ruble could have a material adverse effect on the Company and its financial condition and results of operations and the Russian economy generally. See "-- Currency and Exchange Rates." Regulation of the Telecommunications Industry. The Russian telecommunications system is currently regulated largely through the issuance of licenses. There is currently no comprehensive legal framework with respect to the provision of telecommunications services in Russia, although a number of laws, decrees and regulations govern or affect the telecommunications sector. As a result, ministry officials have a fairly high degree of discretion to regulate the industry. Although telecommunication licenses may not be transferred under Russian law, the Russian Ministry of Communications (the "MOC") has adopted the position that licensees may enter into agreements with third parties in connection with the provision of services under the licensee's license; however, the MOC does not generally review agreements entered into by licensees. There can be no assurances that the current or future regulation of the Russian telecommunications systems will not have a material adverse effect on the Company. Current Russian legislation governing foreign investment activities does not prohibit or restrict foreign investment in the telecommunications industry. However, on February 28, 1997, the State Duma, the lower house of parliament, approved, on the first reading, draft foreign investment legislation which would restrict any significant future foreign investment in numerous sectors of the Russian economy, including telephone and radio communications. It is unlikely that such restrictive legislation will be enacted, unless the political climate changes dramatically. See "-- Political." More likely is the emergence of restrictions on foreign investment in strategic industries, which could result in foreign ownership limitations in industries such as telecommunications which are not uncommon in many countries. The draft legislation has been referred to the Russian government for comment. For such draft legislation to become Federal law, it must be passed by a majority vote of the State Duma at another two readings, then be approved by a majority of the Federation Council, the upper house of parliament, and signed by the President of the Russian Federation. Rejection of such legislation by the Federation Council can be overridden by a two-thirds majority of the State Duma. Rejection of such legislation by the President can be overridden by a two-thirds majority of each of the Federation Council and the State Duma. As of March 1998, there had not been any readings of the draft legislation beyond the first reading. There can be no assurance that future regulation of foreign investment in the telecommunications industry will not have a material adverse effect on the Company. On June 10, 1998, Vostok Mobile (as defined herein) received a letter dated June 8, 1998 (the "RFCCI Letter") from the Russian Federation Committee for Communications and Information (the successor to the MOC) addressed generally to the management of cellular operators utilizing the AMPS and D-AMPS standards. The RFCCI Letter stated that the offering of roaming services by such operators does not comply with certain normative documents referenced in the letter and is in breach of the licenses granted to such operators. The Company is in the process of evaluating the implications of the RFCCI Letter. Although the matter is not free from doubt, the Company believes, based on its preliminary review, that the "normative documents" referred to in the letter represent policy statements rather than legally binding legislative 19 25 pronouncements. However, the RFCCI Letter may signal a potential future change in the application of Russian telecommunications policy toward the provision of roaming services by AMPS and D-AMPS based cellular providers. The Company is unable to predict whether and in what form the positions set forth in the Letter will be implemented as new regulation or directly applied as a basis for suspension, revocation or renewal of current licenses in whole or in part. If regulations were adopted implementing the positions set forth in the RFCCI Letter, or other actions were taken to directly apply such positions, such regulations or actions could adversely affect Vostok Mobile's ability to compete with GSM or NMT-based cellular providers not bound by the prohibition on roaming activities applicable to operators using the AMPS and D-AMPS standard. There can be no assurance that such regulation will not be adopted or such actions will not be taken and that, if adopted or taken, as applicable, they will not have a material adverse effect on Vostok Mobile or the Company. See "Business -- Russia and the CIS -- GTS Cellular -- Vostok Mobile," "-- Licenses and Regulatory Issues" and "Competition." In addition, a lack of consensus exists over the manner and scope of government control over the telecommunications industry. Because the telecommunications industry is widely viewed as strategically important to Russia, there can be no assurance that recent government policies liberalizing control over the telecommunications industry will continue. Any change in or reversal of such governmental policies could have a material adverse effect on the Company. See "Business -- Russia and the CIS -- Licenses and Regulatory Issues." Legal Risks. As part of the effort to transform their economies into more market-oriented economies, the Russian and other CIS governments have rapidly introduced laws, regulations and legal structures intended to give participants in the economy a greater degree of confidence in the legal validity and enforceability of their obligations. Risks associated with the legal systems of Russia and the other independent republics of the CIS include (i) the untested nature of the independence of the judiciary and its immunity from economic, political or nationalistic influence; (ii) the relative inexperience of judges and courts in commercial dispute resolutions and generally in interpreting legal norms; (iii) inconsistencies among laws, presidential decrees, government resolutions and ministerial orders; (iv) frequently conflicting local, regional and national laws, rules and regulations; (v) the lack of legislative, judicial or administrative guidance on interpreting the applicable rules; and (vi) a high degree of discretion on the part of government authorities and arbitrary decision making which increases, among other things, the risk of property expropriation. The result has been considerable legal confusion, particularly in areas such as company law, commercial and contract law, securities and antitrust law, foreign trade and investment law and tax law. Accordingly, there can be no assurance that the Company will be able to enforce its rights in any disputes with its joint venture partners or other parties in Russia or the CIS or that its ventures will be able to enforce their respective rights in any disputes with partners, customers, suppliers, regulatory agencies or other parties in Russia or that the Company can be certain that it will be found to be in compliance with all applicable laws, rules and regulations. Russia has adopted currency and capital transfer regulations designed to prevent the flight of capital from its borders. These regulations require certain licenses for the movement of capital, which includes the incurrence and repayment of indebtedness and the payment of capital contributions in foreign exchange to Russian entities. The Company is resolving licensing issues with respect to certain intercompany loans and capital contributions with the applicable government agencies and believes that any licensing irregularities that may arise will not have a material adverse effect on its financial condition or results of operations. There can be no assurance, however, that Russian government authorities will not take an unexpected adverse position which could materially adversely affect the Company's business. Taxes. Generally, taxes payable by Russian companies are substantial. In addition, taxes payable by Russian companies are numerous and include taxes on profits, revenue, assets and payroll as well as value-added tax ("VAT"). Moreover, statutory tax returns of Russian companies are not consolidated and therefore, each company must pay its own Russian taxes. Because there is no consolidation provision, dividends are subject to Russian taxes at each level. Currently, dividends are taxed at 15% and the payor is required to withhold the tax when paying the dividend, except with respect to dividends to foreign entities that qualify for an exemption under treaties on the avoidance of double taxation. To date, the system of tax collection has been relatively ineffective, resulting in the continual imposition of new taxes in an attempt to raise government 20 26 revenues. This history, plus the existence of large government budget deficits, raises the risk of a sudden imposition of arbitrary or onerous taxes, which could adversely affect the Company. Because of uncertainties associated with the laws and regulations of the Russian tax system and the increasingly aggressive interpretation, enforcement and collection activities of the Russian tax authorities, the Company's Russian taxes may be in excess of the estimated amount expensed to date and accrued on the Company's balance sheets. It is the opinion of management that the ultimate resolution of the Company's Russian tax liability, to the extent not previously provided for, will not have a material adverse effect on the financial condition of the Company. However, depending on the amount and timing of an unfavorable resolution of this contingency, it is possible that the Company's future results of operations or cash flows could be materially affected in a particular period. In various foreign jurisdictions, the Company is obligated to pay VAT on the purchase or importation of assets, and for certain other transactions. In many instances, VAT can be offset against VAT which the Company collects and otherwise would remit to the tax authorities, or may be refundable. Because the law in some jurisdictions is unclear, the local tax authorities could assert that the Company is obligated to pay additional amounts of VAT. In the opinion of management, any additional VAT which the Company may be obligated to pay would not be material. ADEQUACY OF MANAGEMENT, LEGAL AND FINANCIAL CONTROLS IN EMERGING MARKETS Many of the emerging market countries in which the Company operates, particularly in Russia and the CIS where the Company has to date derived most of its revenues, are deficient in management and financial reporting concepts and practices, as well as in modern banking, computer and other control systems. The Company historically has had difficulty in hiring and retaining a sufficient number of qualified employees to work in these markets. As a result of these factors, the Company has experienced difficulty in establishing management, legal and financial controls, collecting financial data and preparing financial statements, books of account and corporate records and instituting business practices that meet Western standards. The Company has a policy worldwide of complying with all applicable laws and seeks to ensure that all persons in its employ comprehend and comply with such laws. The application of the laws of any particular country, however, is not always clear, particularly in emerging market countries where commercial practices differ significantly from practices in the United States and other Western countries and the legal and regulatory frameworks are less developed. In addition, some practices, such as the payment of fees for the purpose of obtaining expedited customs clearance and other commercial benefits, that may be common methods of doing business in these markets might be unlawful under the laws of the United States. As a result of the difficulty the Company historically has experienced in emerging markets in instituting business practices that meet Western reporting and control standards, it historically has been unable to ascertain whether certain practices by its ventures, which were not in accordance with Company policy, were in compliance with applicable U.S. and foreign laws. If it were to be determined that the Company or any of its ventures were involved in unlawful practices and were the factual and legal issues relating thereto to be resolved adversely, the Company or its ventures could be exposed, among other things, to significant fines, risk of prosecution and loss of its licenses. See "-- Risks Relating to Emerging Markets" and "-- Government Regulation." In light of these circumstances, in the second half of 1996 the Company increased its efforts to improve its management and financial controls and business practices. The Company recruited a more experienced financial and legal team, including a new Chief Financial Officer of the Company, a senior finance officer overseeing all of the regions in which the Company operates, a senior finance officer for the CIS region, and a senior legal officer for the CIS region. The Company also established a Treasury group and adopted a more rigorous Foreign Corrupt Practices Act ("FCPA") compliance program. The Company has developed and implemented a training program for employees regarding U.S. legal and foreign local law compliance. The Company also appointed a Compliance Officer responsible for monitoring compliance with such laws and training Company personnel around the world. In connection with these developments, the Company expanded its corporate business practices policy to include, in addition to compliance with U.S. laws such as the FCPA, compliance with applicable local laws such as the conflict of interest rules under the 1996 Russian Joint Stock Company Law, currency regulations and applicable tax laws. 21 27 In early 1997, the Company retained special outside counsel to conduct a thorough review of certain business practices of the Company in the emerging markets in which the Company operates in order to determine whether deficiencies existed that needed to be remedied. As a result of this review, the Company replaced certain senior employees in Russia and instituted additional and more stringent management and financial controls. As a result of the review, the Company has not identified any violations of law that management believes would have a material adverse effect on the Company's financial condition. There can be no assurances, however, that if the Company or any of its ventures were found by government authorities to have committed violations of law that, depending on the penalties assessed and the timing of any unfavorable resolution, the Company's future results of operations and cash flows would not be materially adversely affected in a particular period. Although the Company believes that this review was properly conducted and was sufficient in scope, there can be no assurance that all potential deficiencies have been identified or that the control procedures and compliance programs initiated by the Company will be effective. If the Company or any of its ventures are ever found to have committed violations of law, depending on the penalties assessed and the timing of any unfavorable resolution, the Company's future results of operations and cash flows could be materially adversely affected in a particular period. Management believes, however, that the actions taken during the past twelve months to strengthen the Company's management, financial controls and legal compliance, coupled with the implementation of the recent recommendations from the review and the oversight provided through the Audit Committee of the Board of Directors of the Company to ensure compliance, will be adequate to address the recurrence of any past possible deficiencies. DEPENDENCE ON CERTAIN LOCAL PARTIES; ABSENCE OF CONTROL Many GTS operations including Sovintel, TeleRoss and GTS Cellular have been developed in cooperation or partnership with key local parties, such as regional PTOs. The Company is substantially dependent on its local partners to provide marketing expertise and knowledge of the local regulatory environment in order to facilitate the acquisition of necessary licenses and permits. Any failure by the Company to form or maintain alliances with local partners, or the preemption or disruption of such alliances by the Company's competitors or otherwise, could adversely affect the Company's ability to penetrate and compete successfully in the emerging markets it operates in or enters. In addition, in the uncertain legal environments in which GTS operates, certain GTS businesses may be vulnerable to local government agencies or other parties who wish to renegotiate the terms and conditions of, or terminate, their agreements or other understandings with GTS. While the Company may have the right to nominate key employees, direct the operations and determine the strategies of such joint ventures, under the terms of their respective constituent documents, the Company's partners in some of the ventures have the ability to frustrate the exercise of such rights. Significant actions by most of GTS's ventures, such as approving budgets and business plans, declaring and paying dividends, and entering into significant corporate transactions effectively require the approval of GTS's local partners. Further, the Company would be unlikely as a practical matter to want to take significant initiatives without the approval of its joint venture partners. Accordingly, the absence of unilateral control by the Company over the operations of its joint ventures could have a material adverse effect on the operations of the Company and could affect the value of the Common Stock. In addition, the Company and its venture partners frequently compete in the same markets. For example, Rostelecom, GTS's partner in Sovintel, is the dominant international and domestic long distance carrier in Russia. In addition, many of the regional telephone companies partnered with GTS in the TeleRoss Ventures offer cellular services in direct competition with certain of the operations of GTS Cellular. Such competition with its partners may lead to conflicts of interest for GTS and its partners in the operations of their ventures. There can be no assurance that any such conflicts will be resolved in favor of GTS. In addition, the combination under Svyazinvest of the Russian government's majority interest in Rostelecom and 85 of the regional telephone companies gives Svyazinvest a majority interest in entities that provide international and domestic long distance and local telecommunications services throughout Russia and may expose the Company to more coordinated competition from its partners in the Russian telecommunications market. See "-- Risks Relating to Reorganization of Russian Telecommunications Industry." 22 28 GOVERNMENT REGULATION As a multinational telecommunications company, GTS through its ventures is subject to varying degrees of regulation in each of the jurisdictions in which its ventures provide services. Local laws and regulations, and the interpretation of such laws and regulations, differ significantly among the jurisdictions in which the Company and its ventures operate. There can be no assurance that future regulatory, judicial and legislative changes will not have a material adverse effect on the Company, that regulators or third parties will not raise material issues with regard to the Company's or its ventures' compliance or noncompliance with applicable regulations or that any changes in applicable laws or regulations will not have a material adverse effect on the Company or any of its ventures. Many of GTS's ventures require telecommunications licenses, most of which have been granted for periods of three to ten years. The terms and conditions of these licenses may limit or otherwise affect the ventures' scope of operations. The Company has had favorable experience obtaining, maintaining and renewing licenses in the past. However, there can be no assurance that it will be able to obtain, maintain or renew licenses to provide the services it currently provides and plans to provide, that such licenses will be issued or renewed on terms or with fees that are commercially viable, or that licenses required by future ventures can be obtained by the Company or its partners. The loss of or a substantial limitation upon the terms of these telecommunications licenses could have a material adverse effect on the Company. See each section under "Business" entitled "Licenses and Regulatory Issues." A substantial portion of HER's strategy is based upon the timely implementation of regulatory liberalization of the European Union ("EU") telecommunications market on January 1, 1998 under existing European Community ("EC") directives. Although EU member states have a legal obligation to liberalize their markets in accordance with their requirements, certain more detailed aspects of the EU regulatory framework to apply in the liberalized environment after January 1, 1998 still remain to be adopted. In addition, Ireland, Portugal, Spain, Luxembourg and Greece have been granted extensions from the January 1, 1998 deadline. There can be no assurance that each EU member state will proceed with the expected liberalization on schedule, or at all, or that the trend toward liberalization will not be stopped or reversed in any of the countries. Accordingly, HER faces the risk that it will establish the HER network and make capital expenditures in a given country in anticipation of regulatory liberalization which does not subsequently occur. In order to give effect to EC directives in each member state, national governments must pass legislation liberalizing their respective markets. This applies not only to the liberalization requirements set out in existing EC directives, but also to requirements set out in directives which have yet to be adopted. The implementation of EC directives in the telecommunications sector has been inconsistent or ambiguous in some EU member states. Such implementation could limit, constrain or otherwise adversely affect HER's ability to provide certain services. Furthermore, national governments may not necessarily pass legislation implementing an EC directive in the form required, or at all, or may pass such legislation only after a significant delay. Even if a national legislature enacts appropriate regulation within the time frame established by the EU, there may be significant resistance to the implementation of such legislation from PTOs, regulators, trade unions and other sources. Further, HER's provision of services in Europe may be materially adversely affected if any EU member state imposes greater restrictions on non-EU international services than on international services within the EU. These and other potential obstacles to liberalization could have a material adverse effect on HER's operations by preventing HER from establishing its network as currently intended, as well as a material adverse effect on the Company. COMPETITION GTS faces significant competition in all of its existing telecommunications businesses and for the types of acquisition and development opportunities it seeks in both emerging and Western European markets. GTS's competition in these markets includes national PTOs, multinational telecommunications carriers, other telecommunications developers and certain niche telecommunications providers. In addition, certain of the Company's joint venture partners, including Rostelecom and the regional telephone companies in Russia, certain of HER's rail-based shareholders and other entities in the emerging markets in which the Company operates, are also competitors of the Company. As a result of the recent combination under Svyazinvest of the government's majority interest in Rostelecom and 85 of the regional telephone companies, the Company may 23 29 in the future be subject to more coordinated competition from its partners in the Russian telecommunications market. Although the Company believes it has a favorable and cooperative relationship with its joint venture partners, there can be no assurance that these partners will continue to cooperate with the Company in the future or that they will not increase competitive pressures on the Company. Any measures taken by the partners that reduce the level of cooperation with the Company could jeopardize the Company's ability to participate in the management and operation of its joint ventures and could have a material adverse effect on the Company. WorldCom recently announced the construction of a pan-European fiber network, the first phase of which is expected to connect London, Amsterdam, Brussels, Frankfurt and Paris. Although the Company believes that the proposed WorldCom pan-European network is primarily intended to carry WorldCom traffic, WorldCom has stated that any excess capacity on such network will be used to provide a competitive "carriers' carrier" service. Viatel also recently announced its intention to build a pan-European fiber optic network connecting select cities in Belgium, France, the Netherlands and the United Kingdom and certain key business centers in Germany. Excess capacity would be available for other carriers. Viatel has stated that it expects construction to begin in spring 1998 and the network to become operational during the first quarter of 1999. In addition, Esprit plc also recently announced plans to construct an SDH fiber optic ring that will connect the United Kingdom, France, the Netherlands and Belgium. PTT Netherlands has announced similar plans to build a pan-European network. HER also competes with respect to its "point-to-point" transborder service offering against circuits currently provided by PTOs through International Private Leased Circuits. In addition, the liberalization of the European telecommunications market is likely to attract additional entrants to both the "point-to-point" and other telecommunications markets. There can be no assurance that HER will compete effectively against its current or future competitors. Many of the Company's competitors have technical, financial, marketing and other resources substantially greater than those of GTS. There can be no assurance that the Company will be able to overcome successfully the competitive pressures to which it is subject, both in the markets in which it currently operates and in markets into which it might expand. See each section under "Business" entitled "Competition." In addition, many of the Company's current and potential competitors are not subject to, or constrained by the prohibitions of, the FCPA, including the prohibition against making payments to government officials in order to obtain commercial benefits. The Company is subject to and seeks to comply with the limitations and prohibitions of such law, and accordingly may be subject to competitive disadvantages to the extent that its competitors are able to secure business, licenses or other preferential treatment through the making of such payments. Accordingly, there can be no assurances that the Company will be able to compete effectively against companies free from such limitations in the emerging markets where such commercial practices are commonplace. See "-- Adequacy of Management, Legal and Financial Controls in Emerging Markets." CONTROL BY CERTAIN STOCKHOLDERS Certain persons control substantial portions of the Company's voting stock. At March 31, 1998, Soros Foundation-Hungary and certain of its affiliates (collectively the "Soros Foundations"), Alan B. Slifka and certain of his affiliates, and affiliates of Capital Research International beneficially owned approximately 19.2%, 10.8% and 9.7%, respectively, of the Common Stock (including rights to acquire Common Stock). See "Principal and Selling Stockholders." In addition, two persons affiliated with the Soros Foundations currently serve on the Company's Board of Directors (the "Board of Directors"). Consequently, these entities are in a position to exercise control over the outcome of matters submitted for stockholder actions, including the election of members to the Board of Directors, and are able to influence the management and affairs of the Company. The Company has agreed to register within 45 days after the consummation of the Stock Offerings pursuant to a shelf registration statement all of the shares of the Company's Common Stock (and securities convertible into or exercisable for shares of Common Stock) owned by Alan B. Slifka and his affiliates and the affiliates of George Soros that are not sold in the Stock Offerings. See "-- Shares Eligible for Future Sale; 24 30 Registration Rights; Potential Adverse Impact on Market Price from Sales of Common Stock," "Management," and "Principal and Selling Stockholders." CURRENCY AND EXCHANGE RISKS All of GTS's operations are conducted outside the United States. A substantial portion of the Company's anticipated revenues (as well as the majority of its operating expenses) will be in foreign currency. As a result, the Company will be subject to significant foreign exchange risks. In particular, GTS's ventures in countries whose currencies are considered "soft currencies" subject the Company to the risk that it will accumulate currencies which may not be readily convertible into hard currency and which may be subject to significant limitations on repatriation. The Company historically has not entered into hedging transactions to limit its foreign currency risk exposure. In April 1998, the Company's subsidiary, HER, executed a currency swap transaction to limit its currency exposure associated with the $265 million aggregate principal amount of 11.5% senior notes that HER issued in August 1997. There can be no assurance that GTS's operations will not be adversely affected by such factors. In addition, these factors may limit the ability of the Company to reinvest earnings from ventures in one country to fund the capital requirements of ventures in other countries. In Russia, where the Company has derived most of its revenue to date, the ruble has generally experienced a steady depreciation relative to the U.S. Dollar over the past three years, although there has been some instability in the ruble exchange rate over this period of time. The Company's tariffs are denominated in U.S. Dollars but charges are invoiced and collected in rubles, while the Company's major capital expenditures are generally denominated and payable in various foreign currencies. To the extent such major capital expenditures involve importation of equipment and the like, current law permits the Company to convert its ruble revenues into foreign currency to make such payments. The ruble is generally not convertible outside Russia although, in late April 1998, the Chicago Mercantile Exchange announced that the ruble is a currency that will be available for futures and options trading. A market exists within Russia for the conversion of rubles into other currencies, but it is limited in size and is subject to rules limiting the purposes for which conversion and payment may be effected. The limited availability of other currencies may tend to inflate their values relative to the ruble and there can be no assurance that such a market will continue to exist indefinitely. Moreover, the banking system in Russia is not yet as developed as its Western counterparts and considerable delays may occur in the transfer of funds within, and the remittance of funds out of, Russia. Any delay in converting rubles into a foreign currency in order to make a payment or delay in the transfer of such foreign currency could have a material adverse effect on the Company. In addition, since November 1997, Russian monetary authorities have pegged the ruble/U.S. dollar exchange rate to fluctuate within a certain narrow range. It is uncertain whether the Russian authorities will be able to maintain this exchange rate and there can be no assurance that there will not be a significant and sudden decline in the value of the ruble. Such a devaluation of the ruble could have a material adverse effect on the Company and its results of operations and the Russian economy generally. EXCHANGE CONTROLS AND REPATRIATION RISKS RELATING TO RUSSIAN SECURITIES Russia has adopted currency and capital transfer regulations designed to prevent the flight of capital from its borders. These regulations require certain licenses for the movement of capital, which includes the incurrence and repayment of indebtedness and the payment of capital contributions in foreign exchange to Russian entities. The Company is resolving licensing issues with respect to certain intercompany loans and capital contributions with the applicable government agencies and believes that any licensing irregularities that may arise will not have a material adverse effect on its financial condition or results of operations. There can be no assurance, however, that Russian government authorities will not take an unexpected adverse position which could materially affect the Company's business. 25 31 No assurance can be given that Russian foreign investment and currency legislation will continue to permit repatriation of the proceeds from investments. Furthermore, no assurance can be given that further restrictions will not be imposed on the conversion of ruble earnings into foreign currency for purposes of making dividend payments or on the repatriation of profits. If any such further restrictions were imposed, they would have a material adverse effect on the Company's interests in Russia. DEPENDENCE ON KEY PERSONNEL The Company believes that its growth and future success will depend in large part upon the efforts of a small number of key executive officers, as well as on its ability to attract and retain highly skilled and qualified personnel to work in the emerging markets in which it operates. The Company has also replaced or reassigned executive officers and senior personnel. The competition for qualified personnel in the telecommunications industry is intense, particularly in emerging markets where the Company operates and, accordingly, there can be no assurance that the Company will be able to hire and retain qualified personnel. Although the Company believes it has maintained a strong management team, despite the change of personnel in Russia and the CIS, there can be no assurance as to what effect such personnel changes will have on the Company's operations in Russia and the CIS. DEPENDENCE ON EFFECTIVE INFORMATION SYSTEMS To complete its billing, the Company must record and process massive amounts of data quickly and accurately. While the Company believes its ventures' management information systems are currently adequate, certain of such systems will have to grow as the ventures' businesses expand. The Company believes that the successful expansion of its information systems and administrative support will be important to its continued growth, its ability to monitor and control costs, to bill customers accurately and in a timely fashion and to achieve operating efficiencies. There can be no assurance that the Company will not encounter delays or cost-overruns or suffer adverse consequences in implementing these systems. Any such delay or other malfunction of the Company's management information systems could have a material adverse effect on the Company's business, financial condition and results of operations. TAXES; AVAILABILITY OF NET OPERATING LOSS CARRYFORWARDS The tax rules and regimes prevailing in certain emerging market countries in which the Company operates or plans to operate are, in many cases, new and rapidly changing. Repatriation of profits may result in additional taxes. In addition, other forms of taxation, including VAT, excise taxes and import duties, change at an unpredictable pace and may have an adverse effect on the Company's operations. Availability of tax holidays and provisions of tax treaties with the United States are subject to changes which may affect GTS's utilization of certain tax benefits in the countries in which it operates as well as in the United States. Certain ventures in the CIS and Hungary are operating under tax holidays granted by local governments. Tax holidays are for periods ranging from five to several years after achieving profitability under local tax regulations. In addition to these holidays, certain of the Company's foreign ventures have foreign tax loss carryforwards in excess of $60.0 million. As of December 31, 1997, the Company had net operating loss carryforwards for U.S. federal income tax purposes of approximately $110 million expiring in fiscal years 2003 through 2012. Because of the "change in ownership" provisions of the Tax Reform Act of 1986, the utilization of the Company's net operating loss carryforwards will be subject to an annual limitation as a result of the consummation of the IPO and the Offerings. The Company's financial statements do not reflect any provision for benefits that might be associated with the U.S. and non-U.S. loss carryforwards. There can be no assurance that such loss carryforwards will be allowed, in part or full, by local tax authorities against future income. TECHNOLOGY The telecommunications industry is subject to rapid and significant changes in technology and such technological advances may reduce the relative effectiveness of existing technology and equipment. The 26 32 Company obtains telecommunications equipment from a number of vendors, upon whom it is dependent for the adaptation of such equipment to meet varying local telecommunications standards. The cost of implementation of emerging and future technologies could be significant. There can be no assurance that the Company will maintain competitive services or that the Company will obtain appropriate new technology on a timely basis or on satisfactory terms. Any failure by the Company to maintain competitive services or obtain new technologies could have a material adverse effect on the Company's business, financial condition and results of operations. Development and operation of the HER network are also subject to certain technological risks. The network has been designed to utilize SDH technology. While SDH represents an advanced, new transmission technology, HER's ability to upgrade technology from this platform may be important in establishing and/or maintaining a cost advantage over competitive carriers. There can be no assurance that the HER network will achieve the technical specifications for which it was designed or that HER will be able to upgrade the network as technological improvements in telecommunications equipment are introduced. Failure to achieve current specifications for, or future upgrades of, the network may materially and adversely affect the viability of the HER network and could have a material adverse effect on the prospects of GTS and the operations of the Company and could affect the value of the Common Stock. DIFFICULTY IN OBTAINING RELIABLE MARKET INFORMATION The Company operates in markets in which it is difficult to obtain reliable market information. The Company's business planning has been based on certain assumptions concerning subscriber base, usage levels, pricing and operating expenses based on the Company's experience and the Company's own investigation of market conditions in the emerging market countries in which it operates. No assurances can be given as to the accuracy of such assumptions, and such assumptions may not be indicative of the actual performance of the Company's operations. DILUTION The offering price per share of the Common Stock offered hereby may exceed the net tangible book value per share of the Common Stock. In addition, the net tangible book value per share of the Common Stock will decrease upon the exercise of outstanding options and warrants. Accordingly, purchasers of the Common Stock offered hereby may incur an immediate and substantial dilution. See "Dilution." SHARES ELIGIBLE FOR FUTURE SALE; REGISTRATION RIGHTS; POTENTIAL ADVERSE IMPACT ON MARKET PRICE FROM SALES OF COMMON STOCK Sales of substantial amounts of Common Stock in the public market following the Stock Offerings could adversely affect the market price of the Common Stock and adversely affect the Company's ability to raise capital at a time and on terms favorable to the Company. As of March 31, 1998, after giving effect to the Stock Offerings, there would have been 54,654,640 shares of Common Stock outstanding (i) assuming no exercise of the Underwriters' over-allotment options and (ii) excluding (w) 10,488,807 shares for which outstanding warrants and vested options are exercisable, (x) 713,311 shares reserved for issuance upon exercise of a put right, (y) 6,921,850 shares into which the Convertible Bonds are convertible and (z) the shares into which the New Convertible Bonds are convertible. Of the 54,654,640 shares, (i) the 12,765,000 shares registered in the IPO and the 10,458,000 shares registered in the Stock Offerings will be freely tradable without restriction under the Securities Act (except that any shares held by "affiliates" of the Company may generally be resold only in compliance with applicable provisions of Rule 144, as described below) and (ii) 16,974,029 additional shares may be resold under Rule 144 without restriction under the Securities Act and an additional 18,136,552 shares may be resold under Rule 144 subject to the volume and manner limitations therein (in each case, subject to the lock-up agreements entered into in connection with the IPO, which agreements prohibit the sale of such shares until 27 33 August 5, 1998). In addition, the shares into which the New Convertible Bonds are convertible will be freely tradable without restriction under the Securities Act. In addition, the Company has caused to become effective (i) a registration statement on Form S-1 covering the resale of the Convertible Bonds and the shares of Common Stock into which the Convertible Bonds are convertible and (ii) two registration statements on Form S-8 covering the resale of shares of Common Stock issued to employees, officers and directors of the Company pursuant to employee benefit plans. Furthermore, the Company has agreed to register within 45 days after consummation of the Stock Offerings pursuant to a shelf registration statement all of the shares of the Company's Common Stock (and securities convertible into or exercisable for shares of Common Stock) owned by Alan B. Slifka and his affiliates and affiliates of George Soros that are not sold in the Stock Offerings (the "Affiliate Shares") in consideration of such shareholders' undertaking to be bound by certain restrictions on their ability to resell such Affiliate Shares under such shelf registration statement for specified periods after the consummation of the Offerings (the "Restrictions"). Under the Restrictions, holders of Affiliate Shares will be prevented from selling any such shares during the first six months after the closing date of the Offerings and will be able to sell (i) 50% of such shares after the six month anniversary of the closing date of the Offerings, (ii) 75% of such shares after the nine month anniversary of the closing date of the Offerings and (iii) 100% of such shares after the twelve month anniversary of the closing date of the Offerings. Holders of approximately 29,623,784 shares of Common Stock and warrants to purchase 7,777,776 shares of Common Stock, and an affiliate of the Company with an option with respect to 438,311 shares of Common Stock, have certain demand and piggy-back registration rights. No predictions can be made about the effect, if any, that future sales of Common Stock or the availability of the Common Stock for sale would have on the market price for the Common Stock. Sales of large numbers of shares of Common Stock in the public market pursuant to Rule 144 or pursuant to an effective registration statement under the Securities Act, or the perception that sales could occur, may have an adverse effect on the market price for the Common Stock. See "Shares Eligible for Future Sale" and "Description of Capital Stock -- Prior Purchase Agreements -- Registration Rights." ABSENCE OF DIVIDENDS The Company has not paid any dividend on its Common Stock and does not intend to pay dividends in the foreseeable future. In addition, the indenture governing the Notes will contain dividend restrictions. In the event that the Company and/or certain operating companies of the Company enter into future financings, the terms of such financings may include dividend restrictions. See "Dividend Policy." ANTI-TAKEOVER PROVISIONS The Company is subject to Section 203 of the Delaware General Corporation Law that contains certain anti-takeover provisions which prohibit a "business combination" between a corporation and an "interested stockholder" within three years of the stockholder becoming an "interested stockholder" except in certain limited circumstances. The business combination provisions of Section 203 of the Delaware General Corporation Law may have the effect of deterring merger proposals, tender offers or other attempts to effect changes in control of the Company that are not negotiated and approved by the Board of Directors. Accordingly, stockholders of the Company could be prevented from realizing a premium on their shares in a transaction not approved by the Board of Directors. In addition, the Company's Certificate of Incorporation and/or By-Laws have several provisions that could also have the effect of delaying or preventing a change of control of the Company. Specifically, the Company's Certificate of Incorporation and/or By-Laws provide for a classified Board of Directors serving staggered three-year terms, restrictions on who may call a special meeting of stockholders, a prohibition on stockholder action by written consent, restrictions on the removal of directors and supermajority voting requirements with respect to certain amendments to the Certificate of Incorporation. The Company's Certificate of Incorporation also grants the Board of Directors the authority to issue up to 10,000,000 shares of preferred stock in one or more series and to determine the rights, voting powers, dividend rate, conversion rights, redemption price, liquidation preference and other terms of such preferred stock without any further vote or action by the stockholders. Further, the Company has adopted a 28 34 stockholders rights plan and in connection therewith, 200,000 shares of preferred stock have been authorized as Series A Preferred Stock (as defined herein). The foregoing provisions, and any issuance of preferred stock (including Series A Preferred Stock) with voting or conversion rights, may adversely affect the voting power of the holders of Common Stock and may have the effect of delaying or preventing a change of control of the Company or adversely affect the market price of the Common Stock. See "Description of Capital Stock -- Certain Charter and By-Law Provisions." ENFORCEABILITY OF JUDGMENTS Substantially all of the assets of the Company (including all of the assets of the Company's operating ventures) are located outside the United States. As a result, it will be necessary for investors to comply with foreign laws in order to enforce judgments obtained in a United States court (including those with respect to federal securities law claims) against the assets of the operating ventures, including foreclosure upon such assets, and there can be no assurance that any U.S. judgments would be enforced under any such foreign laws. VOLATILITY OF STOCK PRICE The market price for the Common Stock could be subject to significant fluctuations in response to various other factors such as announcements of new contracts, technological innovations or new products by the Company or its competitors, other announcements concerning the Company or its competitors, changes in government regulations, fluctuations in the Company's quarterly and annual operating results and general market conditions. In addition, the stock markets have in recent years experienced significant price fluctuations. Those fluctuations often have been unrelated to the operating performance of the specific companies whose stock is traded. Market fluctuations, as well as economic conditions, may adversely affect the market price of the Common Stock. USE OF PROCEEDS The aggregate net proceeds of the Stock Offerings to the Company are estimated to be approximately $93.8 million after deducting estimated expenses of the Stock Offerings payable by the Company. The Company will not receive any of the proceeds from shares of Common Stock sold by the Selling Stockholders. The Company intends to use the net proceeds from the Offerings primarily toward the implementation of the Company's European Services Strategy. In addition, a portion of the net proceeds may be used to further develop the Company's businesses in Central Europe and Russia, for other business development opportunities, and for general corporate purposes. If the New Convertible Bond Offering is not consummated, the Company will need to find additional sources of capital to replace the funding that would have been provided by the New Convertible Bond Offering. Also, as part of its business strategy, the Company regularly evaluates potential acquisitions and joint ventures, including the acquisition of minority interests in existing joint ventures. Some of such transactions may involve the contribution of certain of the Company's Russian businesses in exchange for an interest of an equivalent or greater value in the surviving entity and, if consummated, may be material to the Company's operations and financial condition. The Company has no definitive agreement with respect to any material acquisition or joint venture, although from time to time it has discussions with other companies and assesses opportunities on an ongoing basis. Pending any use of its net proceeds from the Offerings in the manner described above, the Company intends to invest the proceeds in short-term investment grade obligations, bank deposits, U.S. government securities or similar instruments. 29 35 PRICE RANGE OF COMMON STOCK The Common Stock has been traded on the Nasdaq since February 5, 1998, the date of the IPO, under the symbol "GTSG." The following table sets forth, for the periods indicated, the high and low closing bid prices per share of the Common Stock as reported on the Nasdaq National Market.
HIGH LOW ------ ------ Quarter ending March 31, 1998............................... $49.00 $25.94 Quarter ending June 30, 1998 (through June 8, 1998)......... $47.38 $35.38
The closing bid price for the Common Stock as reported on the Nasdaq National Market on June 8, 1998 was $38.00. As of June 5, 1998, there were approximately 176 holders of record of the Company's Common Stock. DIVIDEND POLICY GTS has not paid any dividend on its Common Stock and does not intend to pay dividends in the foreseeable future. In addition, the indenture governing the Company's 9 7/8% Notes contains restrictions on the making of restricted payments (in the form of the declaration or payment of certain dividends or distributions, the purchase, redemption or other acquisition of any capital stock of the Company, the voluntary prepayment of pari passu or subordinated indebtedness and the making of certain investments, loans and advances) unless no Default or Event of Default (each, as defined in such indenture) exists, its leverage ratio does not exceed 6.0 to 1.0 and such restricted payments do not exceed the Basket (as defined in such indenture). DILUTION At March 31, 1998, the net tangible book value of the Common Stock was $196.8 million in the aggregate, or $3.78 per share of Common Stock. "Net tangible book value per share" represents the amount of total tangible assets of the Company reduced by the amount of total liabilities and divided by the number of shares of Common Stock outstanding. After giving effect to the Stock Offerings, the pro forma net tangible book value of the Common Stock would be $290.5 million in the aggregate, or $5.32 per share. This represents an increase in net tangible book value of $1.54 per share of Common Stock to existing shareholders and an immediate dilution per share of $32.93 to new investors purchasing shares of Common Stock in the Stock Offerings. "Dilution per share" represents the difference between the price per share to be paid by new investors and the pro forma net tangible book value per share after the Stock Offerings. The following table illustrates the dilution per share as described above: Offering price per share.................................... $38.25 Net tangible book value per share at March 31, 1998......... $3.78 Increase in net tangible book value per share attributable to the Stock Offerings.................................... 1.54 ----- Pro forma net tangible book value per share after the Stock Offerings................................................. 5.32 ------ Dilution per share to new investors in the Stock Offerings................................................. $32.93 ======
SHARES OF TOTAL COMMON STOCK CONSIDERATION AVERAGE PRICE -------------------- ---------------------- PER SHARE OF NUMBER PERCENT AMOUNT PERCENT COMMON STOCK ---------- ------- ------------ ------- ------------- Current stockholders........... 52,040,140 4.8% $554,391,000 84.7% $10.65 New investors.................. 2,614,500 95.2 100,004,625 15.3 $38.25 ---------- ----- ------------ ----- Total................ 54,654,640 100.0% $654,395,625 100.0% ========== ===== ============ =====
The above computations assume no exercise of any outstanding options or warrants. At March 31, 1998, there were outstanding options to purchase 5,918,972 shares of Common Stock at a weighted average exercise price of $12.01 per share and warrants to purchase 7,777,776 shares of Common Stock at an exercise price of $9.33 per share. To the extent outstanding options are exercised, there will be further dilution to new investors. See "Certain Related Party Transactions," "Management" and Note 7 to the audited Consolidated Financial Statements of the Company. 30 36 CAPITALIZATION The following table sets forth the consolidated capitalization of the Company as of March 31, 1998 and as adjusted to give effect to the Offerings. The consummation of the Stock Offerings is not conditioned upon the consummation of the New Convertible Bond Offering, and there can be no assurance that the New Convertible Bond Offering will be consummated.
AS ADJUSTED AS ADJUSTED FOR THE FOR THE AS ADJUSTED STOCK NEW CONVERTIBLE FOR THE ACTUAL OFFERINGS BOND OFFERING OFFERINGS --------- ----------- --------------- ----------- (IN THOUSANDS, EXCEPT SHARE DATA) Cash and cash equivalents.......... $ 507,895 $ 601,655 $ 846,569 $ 940,329 ========= ========== ========== ========== Related party debt maturing within one year......................... $ 10,023 $ 10,023 $ 10,023 $ 10,023 Debt maturing within one year...... 8,882 8,882 8,882 8,882 Current portion of capital lease obligations...................... 19,250 19,250 19,250 19,250 --------- ---------- ---------- ---------- Current debt............. 38,155 38,155 38,155 38,155 Long-term obligations (net of current portion) Related party debt, less current portion....................... 3,530 3,530 3,530 3,530 9 7/8% Senior Notes due 2005..... 105,000 105,000 105,000 105,000 HER Senior Notes due 2007........ 265,000 265,000 265,000 265,000 New Convertible Bonds............ -- -- 350,000 350,000 Convertible Bonds................ 134,907 134,907 134,907 134,907 Capital leases................... 136,988 136,988 136,988 136,988 Other long-term debt, less current portion............... 1,429 1,429 1,429 1,429 --------- ---------- ---------- ---------- Long term debt........... 646,854 646,854 996,854 996,854 --------- ---------- ---------- ---------- Total debt............... 685,009 685,009 1,035,009 1,035,009 --------- ---------- ---------- ---------- Minority interest.................. 12,470 12,470 12,740 12,470 Shareholders' equity(1): Common stock, $0.10 par value (135,000,000 shares authorized; 52,040,140 shares issued and outstanding, actual; 54,654,640 shares issued and outstanding, as adjusted)..................... 5,204 5,465 5,204 5,465 Additional paid-in capital......... 539,911 633,410 539,911 633,410 Accumulated deficit................ (280,061) (280,061) (280,061) (280,061) Other.............................. (10,213) (10,213) (10,213) (10,213) --------- ---------- ---------- ---------- Total shareholders' equity................. 254,841 348,601 254,841 348,601 --------- ---------- ---------- ---------- Total capitalization............... $ 952,320 $1,046,080 1,302,320 $1,396,080 ========= ========== ========== ==========
- - - - --------------- (1) Excludes at March 31, 1998 (i) 7,777,776 shares of Common Stock reserved for issuance upon exercise of outstanding warrants at an exercise price of $9.33 per share, (ii) 5,918,972 shares of Common Stock reserved for issuance upon exercise of outstanding stock options at a weighted average exercise price of $12.01 per share, (iii) 713,311 shares of Common Stock reserved for issuance upon exercise of a put right associated with a 1996 financing agreement, as amended, (iv) 6,921,850 shares issuable upon conversion of the Convertible Bonds, (v) 560,820 shares of Common Stock reserved for issuance pursuant to the TCM business partnership agreement as deferred consideration to TCM's partners and (vi) shares of Common Stock issuable in connection with the New Convertible Bonds. See "Certain Related Party Transactions." 31 37 SELECTED HISTORICAL CONSOLIDATED FINANCIAL DATA The following selected historical consolidated financial data as of and for the years ended December 31, 1993, 1994, 1995, 1996 and 1997 are derived from the Company's audited Consolidated Financial Statements. The following unaudited selected historical consolidated financial data as of March 31, 1998 and for the three months ended March 31, 1997 and 1998 are derived from the Company's unaudited Consolidated Financial Statements. The selected financial data presented below should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the audited Consolidated Financial Statements and related notes thereto appearing elsewhere in this Prospectus. Under generally accepted accounting principles, many of the Company's ventures are accounted for by the equity method of accounting. Under this method, the operating results of the ventures are included in the Company's Consolidated Statement of Operations as a single line item, "Equity in (losses) earnings of ventures." The Company recognizes 100% of the losses in ventures where the Company bears all of the financial risk (which includes all of the Company's significant ventures except for Sovintel and, historically, HER). Also, the assets, liabilities and equity of the ventures are included in the Company's Consolidated Balance Sheets as a single line item "Investments in and Advances to Ventures." See Note 3 to the Company's audited Consolidated Financial Statements and "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Overview." Financial information about the Company's equity ventures is included below under "Supplemental Information -- Selected Historical Financial Data -- Combined Equity Investments."
THREE MONTHS ENDED YEARS ENDED DECEMBER 31, MARCH 31, ---------------------------------------------------- ------------------- 1993 1994 1995 1996 1997(1) 1997 1998 ------- -------- -------- -------- --------- -------- -------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Revenues, net.................................... $ 328 $ 2,468 $ 8,412 $ 24,117 $ 47,098 $ 8,387 $ 22,817 Gross margin..................................... 328 23 16 5,176 4,379 1,963 3,794 Operating expenses............................... 3,340 12,863 41,014 52,955 78,410 13,021 22,686 Equity in earnings (losses) of ventures.......... 472 (135) (7,871) (10,150) (14,599) (3,420) 3,412 Other income (expense)........................... 100 990 11,034 (8,729) (29,551) (2,866) (10,794) Loss before extraordinary loss................... (2,440) (11,985) (40,400) (67,991) (116,986) (17,733) (24,473) Extraordinary loss(2)............................ -- -- -- -- -- -- (12,704) Net loss......................................... (2,440) (11,985) (40,400) (67,991) (116,986) (17,733) (37,177) Loss per share before extraordinary loss......... (0.26) (0.69) (1.61) (2.22) (3.26) (0.51) (0.54) Extraordinary loss per share(2).................. -- -- -- -- -- -- (0.28) Net loss per share............................... (0.26) (0.69) (1.61) (2.22) (3.26) (0.51) (0.82)
AT MARCH 31, 1993 1994 1995 1996 1997(1) 1998 ------- -------- -------- -------- --------- ------------------- (IN THOUSANDS) BALANCE SHEET DATA (AT END OF PERIOD): Cash and cash equivalents........................ $ 3,641 $ 29,635 $ 9,044 $ 57,874 $ 318,766 $ 507,895 Property and equipment, net...................... 829 8,393 29,523 35,463 236,897 270,641 Investments in and advances to ventures.......... 794 13,841 56,153 104,459 76,730 88,083 Total assets..................................... 5,968 61,957 115,621 237,378 780,461 1,048,550 Total debt....................................... 725 2,152 27,454 85,547 639,359 685,009 Minority interest and stock subject to repurchase..................................... -- 8 5,273 6,248 31,255 12,470 Shareholders' equity............................. 4,685 54,684 55,322 113,668 26,967 254,841
- - - - --------------- (1) As a result of the Company's increase in ownership interest and amendment to the HER Shareholders Agreement that was completed on July 16, 1997, the Company accounts for its ownership interest in HER under the consolidation method of accounting. Prior to this date, the Company accounted for HER under the equity method of accounting. (2) The Company recognized a $12.7 million extraordinary charge to earnings in the three months ended March 31, 1998, as a result of the Company's early extinguishment of certain related party debt obligations. The nature of the charge is comprised of the write-off of $11.6 million of unamortized debt discount and $1.1 million of unamortized debt issuance costs that were deferred as financing costs and were being amortized over the original maturity of the debt. 32 38 SUPPLEMENTAL INFORMATION -- SELECTED HISTORICAL FINANCIAL DATA -- COMBINED EQUITY INVESTMENTS The following unaudited selected historical financial data -- equity investments for the years ended December 31, 1995, 1996 and 1997 and for the three months ended March 31, 1997 and 1998, are derived from the Company's financial records. It is intended to supplement the aforementioned selected historical consolidated financial data. The financial data set forth below represents 100% of the results of operations for each of the entities. The Company believes that this information provides additional insight on the Company's unconsolidated equity method investments. Generally accepted accounting principles prescribe inclusion of revenues and expenses for consolidated interests (generally interests of more than 50%, absent some other factors), but not for equity interests (generally interests of 20% to 50%) or cost interests (generally interests of less than 20%). Equity accounting ordinarily results in the same net income as consolidation; however, the net operating results are reflected on one line within the income statement.
OWNERSHIP COST OF OPERATING NET INTEREST(1) REVENUES REVENUES EXPENSES INCOME/(LOSS) ----------- -------- -------- --------- ------------- (IN THOUSANDS, EXCEPT OWNERSHIP INTEREST) YEAR ENDED DECEMBER 31, 1995 Sovintel............................................. 50% $44,292 $26,247 $ 7,047 $ 7,648 TCM.................................................. 50% 49 -- 57 (7) TeleRoss............................................. 50% 176 59 242 (193) Sovam................................................ 66.7% 4,434 2,914 3,273 (1,789) GTS Cellular Companies............................... 50%(2) 4,574 2,834 2,960 (2,165) Other................................................ 50%(2) 526 957 9,379 (9,874) -------- -------- ------- ------- Total.......................................... 54,051 33,011 22,958 (6,380) ADJUSTMENTS FOR INTER-AFFILIATE TRANSACTIONS(3)...... (2,270) (2,215) (6,967) YEAR ENDED DECEMBER 31, 1996 Sovintel............................................. 50% $75,040 $43,910 $10,411 $14,762 TCM.................................................. 50% 16,507 3,330 1,854 8,874 TeleRoss............................................. 50% 2,413 832 2,293 (841) Sovam................................................ 66.7% 11,671 8,236 5,714 (2,138) GTS Cellular Companies............................... 50%(2) 25,778 11,883 13,614 (3,406) Other................................................ 50%(2) 12,063 12,235 21,132 (22,471) -------- -------- ------- ------- Total.......................................... 143,472 80,426 55,018 (5,220) ADJUSTMENTS FOR INTER-AFFILIATE TRANSACTIONS(3)...... (15,385) (13,562) (8,083) YEAR ENDED DECEMBER 31, 1997 Sovintel............................................. 50% $113,962 $72,629 $17,020 $18,464 TCM.................................................. 50% 29,308 7,169 3,286 12,512 TeleRoss............................................. 50% 6,794 2,138 3,612 71 Sovam................................................ 66.7% 17,808 10,684 5,653 780 GTS Cellular Companies............................... 50%(2) 44,275 21,355 17,678 (906) Other................................................ 50%(2) 14,013 13,757 27,596 (26,591) -------- -------- ------- ------- Total.......................................... 226,160 127,732 74,845 4,330 ADJUSTMENTS FOR INTER-AFFILIATE TRANSACTIONS(3)...... (24,927) (23,250) (8,357) THREE MONTHS ENDED MARCH 31, 1997 Sovintel............................................. 50% $25,162 $14,763 $ 3,855 $ 4,695 TCM.................................................. 50% 6,326 1,535 600 2,910 TeleRoss............................................. 50% 1,529 284 674 515 Sovam................................................ 66.7% 3,703 2,388 1,359 (118) GTS Cellular Companies............................... 50%(2) 8,045 3,665 3,590 (877) Other................................................ 50%(2) 3,261 4,186 4,067 (5,159) -------- -------- ------- ------- Total.......................................... 48,026 26,821 14,145 1,966 ADJUSTMENTS FOR INTER-AFFILIATE TRANSACTIONS(3)...... (5,933) (4,760) (2,875) THREE MONTHS ENDED MARCH 31, 1998(4) Sovintel............................................. 50% $32,404 $21,957 $ 4,646 $ 4,345 TCM.................................................. 50% 9,456 2,578 852 3,847 TeleRoss............................................. 50% 2,392 717 978 325 GTS Cellular Companies............................... 50%(2) 14,905 6,775 5,192 1,415 Other................................................ 50%(2) 4,526 4,360 1,124 (947) -------- -------- ------- ------- Total.......................................... 63,683 36,387 12,792 8,985 ADJUSTMENTS FOR INTER-AFFILIATE TRANSACTIONS(3)...... (8,890) (8,105) 4,158
- - - - --------------- (1) The ownership interest column indicates the Company's legal ownership percentage for the respective equity investments. The information is being provided to assist an investor or analyst in determining the Company's legal rights associated with the presented financial data. See Note 3 in the Company's audited Consolidated Financial Statements for additional disclosures related to the Company's equity investments. (2) The Company generally maintains a 50% ownership interest in these equity investments. See Note 3 in the Company's audited Consolidated Financial Statements for additional disclosures related to the Company's equity investments. (3) The adjustment amounts represent the effect of inter-affiliate transactions between the Company's consolidated and equity method ventures. More detailed information about inter-affiliate transactions is included under "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Accounting Methodology." (4) As a result of the Company's purchase of the minority partner's 33.3% interest in Sovam during the first quarter of 1998, the Company accounts for its ownership interest in Sovam under the consolidation method of accounting. Prior to this date, the Company accounted for Sovam under the equity method of accounting. 33 39 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following is a discussion of the financial condition and results of operations of the Company as of March 31, 1998 and December 31, 1997 and 1996 and for the three months ended March 31, 1998 and 1997 and for the years ended December 31, 1997, 1996 and 1995. The following discussion should be read in conjunction with the Company's Consolidated Financial Statements and the notes related thereto. SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS Certain statements contained in "Management's Discussion and Analysis of Financial Condition and Results of Operations" including, without limitation, those concerning (i) projected traffic volume, (ii) future revenues and costs, (iii) changes in the Company's competitive environment and (iv) the performance of future equity-method investments, contain forward-looking statements concerning the Company's operations, economic performance and financial condition. Because such statements involve risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. OVERVIEW Business. GTS is a provider of a broad range of telecommunications services to businesses, other telecommunications service providers and consumers in Russia and the CIS, Central Europe and Asia. In Western Europe, through HER, GTS is developing and operating the initial segment of a pan-European high capacity fiber optic network which is designed to interconnect a majority of the largest Western and Central European cities and to transport international voice, data and multimedia/image traffic for other carriers throughout Western and Central Europe. GTS's strategy to develop its businesses generally has been to establish joint ventures with a strong local partner or partners while maintaining a significant degree of operational control. The Company's business activities consist of the ownership and operation of (i) international long distance businesses, which operate through international gateways that provide international switching services and transmission capacity, (ii) local access networks, which provide local telephone service, (iii) cellular networks, which provide wireless telecommunications services, (iv) a domestic long distance business, (v) data networks and (vi) carriers' carrier networks, which provide high volume transmission capacity to other carriers. The Company began to acquire interests in numerous telecommunications ventures beginning in 1994 and continued to acquire such interests throughout 1995 and 1996. Ventures with significant financial results in 1994 included Sovintel (an international long distance and domestic and local access telecommunications service provider) and GTS-Hungary (a VSAT network telecommunications service provider); ventures that incurred start-up costs associated with building out their business infrastructure in 1994 included Sovam (a data and internet telecommunications service provider) and EuroHivo (a paging telecommunications service provider). In 1995, TeleRoss (a domestic long distance telecommunications service provider) and GTS Cellular (a basic cellular telecommunications service provider) began operations and expanded into numerous regions within the CIS by the end of 1996. Telecommunications of Moscow ("TCM") (a local access telecommunications service provider) began operations in 1996. HER (a carriers' carrier telecommunications service provider) began its network build-out in 1995, began limited operations at the end of 1996 and expects to continue to develop its network during 1998 and beyond. The fact that these ventures are in various stages of development affects the discussion of comparative results below. See "Business." GTS has invested significantly in its ventures through capital contributions and loans. In addition, the Company has made a significant commitment to its businesses and ventures through the provision of management assistance and training. GTS has also incurred significant expenses in identifying, negotiating and pursuing new telecommunications opportunities. GTS and certain of its ventures are experiencing continuing losses and negative operating cash flow primarily because the businesses are in the developmental and start-up phases of operations. Management recognizes that the Company must generate additional capital resources in order to continue its operations and meet its new development initiatives. The ultimate recoverability of the Company's investments in and advances to ventures is dependent on many factors 34 40 including, but not limited to, the ability of the Company to obtain sufficient financing to continue to meet its capital and operational commitments, the economies of the countries in which it does business and the ability of the Company to maintain the necessary telecommunications licenses. The Company's businesses are developing rapidly. Some of the businesses operate in countries with emerging economies which have uncertain economic, political and regulatory environments. The general risks of operating businesses in the CIS and other developing countries include the possibility for rapid change in government policies including telecommunications regulations, economic conditions, the tax regime and foreign currency regulations. See "Risk Factors." ACCOUNTING METHODOLOGY Accounting for Business Ventures. Wholly owned subsidiaries and majority-owned ventures where the Company has unilateral operating and financial control are consolidated. Those ventures where the Company exercises significant influence, but does not exercise unilateral operating and financial control, are accounted for by the equity method. The Company has certain majority-owned ventures that are accounted for by the equity method as a result of minority shareholder rights, super-majority voting conditions or other governmentally imposed uncertainties so severe that they prevent the Company from obtaining unilateral control of the venture. Profit and Loss Accounting. The Company recognizes profits and losses in accordance with its underlying ownership percentage or allocation percentage as specified in the agreements with its partners; however, the Company recognizes 100% of the losses in ventures where the Company bears all of the financial risk (which includes all of the Company's significant ventures except for Sovintel and, historically, HER). Accordingly, the portion of the losses that would normally be assigned to the minority interest partner ("Excess Losses") is recognized by the Company. When such ventures become profitable, the Company recognizes 100% of the profits until such time as the Excess Losses previously recognized by the Company have been recovered. As of March 31, 1998, $5.3 million and $8.9 million represent the net unrecovered Excess Losses for the Company's consolidated and equity method investments, respectively, that is expected to favorably benefit future period results from operations upon the Company's existing business ventures becoming profitable. This accounting policy was adopted prior to 1995; however, 1995 was the first year that the excess loss amount was deemed material for recognition within the Company's accounting records. For the period from January 1, 1997, through August 31, 1997, the Company recognized 100% of HER's losses due to GTS being the financing partner during this period. As a result of HER's issuance of $265 million aggregate principal amount of senior notes (of which $56.6 million was placed in escrow for the first two years' interest payments) in August 1997, the Company no longer considers itself as the financing partner. Inter-Affiliate Transactions. Several of the Company's ventures have entered into business arrangements through which they provide integrated solutions for their customers by leveraging each others' telecommunications infrastructure. These arrangements have historically been focused primarily within a region; however, as GTS has increased its geographic coverage and telecommunication capabilities, these arrangements have expanded between regions. In accordance with generally accepted accounting principles, all significant intercompany accounts and transactions are eliminated upon consolidation. Turnover Taxes. The Company's ventures within the CIS region incur a 4% turnover tax that is based on the revenues earned. The Company includes these taxes as a component of its operating expenses, since these taxes are incidental to the revenue cycle. 35 41 The following table summarizes the accounting methodology for the principal business ventures through which the Company conducts its business.
COUNTRY/REGION EFFECTIVE GTS ACCOUNTING COMPANY NAME OF OPERATIONS OWNERSHIP METHODOLOGY ------------ -------------- ------------- ------------ CIS Sovintel.................................... Russia 50% Equity TCM......................................... Russia 50%(1) Equity TeleRoss Operating Company.................. Russia 100%(2) Consolidated TeleRoss Ventures........................... Russia 50%(3) Equity Sovam....................................... Russia 100%(4) Consolidated(4) GTS Cellular................................ CIS 24%-70%(5) Equity Western Europe HER......................................... Western Europe 89%(6) Consolidated(6) GTS-Monaco Access........................... Monaco 50% Equity Central Europe GTS-Hungary................................. Hungary 99% Consolidated EuroHivo.................................... Hungary 70%(7) Equity CzechNet.................................... Czech Republic 100% Consolidated Asia V-Tech...................................... China 75% Equity Beijing Tianmu.............................. China 47% Equity CDI......................................... India 100% Consolidated
- - - - --------------- (1) The Company is currently engaged in negotiations to purchase the remaining minority ownership interest in GTS-Vox Limited. If such purchase is consummated, the Company would have a 95% interest in TCM. (2) The TeleRoss Operating Company is comprised of a wholly owned subsidiary that operates a domestic long distance network and holds the applicable operating license for TeleRoss and performs the customer invoicing and collection functions for telecommunications services. TeleRoss Operating Company is accounted for under the consolidation method of accounting because GTS has unilateral control over the operations and management decisions. TeleRoss Operating Company's operations are further discussed in "-- Results of Operations -- Consolidated Ventures" and "Business -- Russia and the CIS -- TeleRoss." A significant portion of TeleRoss Operating Company's costs of revenue consists of settlement fees paid to the TeleRoss Ventures, with such fees being recorded as revenue by the TeleRoss Ventures. In 1996 and 1997, all of the TeleRoss Ventures' revenue was derived from such fees. Any decline in the business or operations of the TeleRoss Ventures would have a material adverse effect on the results of TeleRoss Operating Company. (3) TeleRoss Ventures is comprised of fourteen operating joint ventures, that are 50% beneficially owned by GTS, which originate traffic and provide local termination of calls through agency arrangements with TeleRoss Operating Company. GTS does not exercise unilateral control over the TeleRoss Ventures, and therefore, they are appropriately accounted for under the equity method of accounting. TeleRoss Ventures' operations are further discussed in "-- Results of Operations -- Non-Consolidated Ventures." (4) GTS purchased the remaining 33% interest in Sovam in February 1998 and as a result Sovam is now accounted for by the consolidation as opposed to the equity method of accounting. (5) GTS conducts its cellular operations through (i) Vostok Mobile, a wholly owned GTS venture that owns between 50% and 70% of a series of 12 cellular joint ventures in various regions in Russia, (ii) PrimTelefone, a 50% owned venture in Vladivostok, Russia and (iii) Bancomsvyaz, an approximately 24% beneficially owned venture in Kiev, Ukraine. The Company is currently implementing a restructuring of the capital and ownership of Bancomsvyaz. (6) As of July 16, 1997, HER is accounted for by the consolidation as opposed to the equity method of accounting. In addition, in March 1998, GTS acquired an additional 10% interest in HER. (7) The Company has reached a definitive agreement to sell its ownership interest in EuroHivo. The closing of this transaction is conditioned upon regulatory approval of the share transfer and customary conditions 36 42 precedent. The Company does not anticipate that the closing of this transaction will have a material effect on the Company's results from operations and financial condition. RESULTS OF OPERATIONS -- CONSOLIDATED VENTURES Three Months Ended March 31, 1998 compared to Three Months Ended March 31, 1997 Management's discussion included within "-- Results of Operations -- Consolidated Ventures" reflects the following significant operating ventures: TeleRoss Operating Company, Sovam, GTS-Hungary, the Czech Companies and HER. Although the Company was not able to follow consolidation method of accounting for Sovam and HER in the three months ended March 31, 1997, the Company has included, for comparative purposes, a discussion of their financial performance for the three months ended March 31, 1997 in the discussion of "Results of Operations -- Consolidated Ventures". See "-- Results of Operations -- Non-Consolidated Ventures (Equity Investees)" for a discussion of the operating results of Sovintel, TCM, TeleRoss Ventures, GTS Cellular and GTS-Monaco Access. Revenue. The Company's consolidated revenue was $22.8 million and $8.4 million for the three months ended March 31, 1998 and 1997, respectively. The $14.4 million growth in revenue was primarily attributable to the inclusion of Sovam and HER in the Company's consolidated financial results, with Sovam and HER contributing $5.9 million and $4.7 million in revenue, respectively. The remaining growth was attributable to the TeleRoss Operating Company, as its revenue increased $2.7 million year over year. The CIS region's consolidated revenue was $13.8 million and $5.2 million for the three months ended March 31, 1998 and 1997, respectively. TeleRoss Operating Company generated revenue of $7.1 million and $4.4 million, representing 51.4% and 84.6% of the region's consolidated revenue for the three months ended March 31, 1998 and 1997, respectively. The growth in the TeleRoss Operating Company revenue from March 1997 to March 1998 was the result of the increase in traffic volume generated by the TeleRoss Ventures due to the increase in the number of cities and number of VSAT's installed at customer locations outside of cities in which they have a presence. Sovam generated revenue of $5.9 million and $3.7 million for the three months ended March 31, 1998 and 1997 (Sovam was an equity method company in 1997), respectively. The growth in Sovam revenue is primarily attributable to the expansion of Sovam's network throughout Russia and the CIS and the wider variety of service offerings. HER generated $4.7 million of revenue in the three months ended March 31, 1998, compared to $0.2 million in the same period in 1997 (HER was an equity method company prior to July 1997). The growth in revenue is attributable to the deployment of the network; i.e. the Brussels-Amsterdam route generated revenue in 1997 whereas the Brussels-Amsterdam-London-Paris route generated revenue in 1998. The Central Europe region's consolidated revenue was $3.9 million in the three months ended March 31, 1998, compared to $2.8 million in the same period of 1997. The Company's operations in both Hungary and the Czech Republic experienced year-over-year revenue growth of 39.3%. This growth is attributable to the expansion of the customer base and product offerings of these businesses. Gross Margin. GTS's consolidated gross margin was $3.8 million, or 16.7% of revenue, for the three months ended March 31, 1998 and $2.0 million, or 23.8% of revenue, for the three months ended March 31, 1997. Sovam contributed $2.8 million to consolidated gross margin for the three months ended March 31, 1998. For comparative purposes, Sovam had a gross margin of $1.3 million for three months ended March 31, 1997 (Sovam was an equity method company in 1997). Sovam had gross margin as a percentage of revenues of 47.5% and 35.1%, for the three months ended March 31, 1998 and 1997, respectively. The increase in gross margin, both amount and as a percentage of revenue, reflects the higher margin service offerings that Sovam is currently providing and also management's focus to improve its cost structure; i.e. the negotiation of improved channel costs from suppliers and controlled growth in both personnel and capital expenditures. The TeleRoss Operating Company contributed gross margin of $1.0 million and $1.5 million for the three months ended March 31, 1998 and 1997, respectively, or 14.1% and 34.1% of TeleRoss Operating Company revenue for the respective periods. The decrease in margin, both amount and as a percentage of revenue, reflects the high fixed 37 43 cost component of its network hub in Moscow. The Central European region contributed $1.3 million to gross margin in both the three months ended March 31, 1998 and March 31, 1997, respectively, or 33.3% and 44.8% of Central European revenue for the respective periods. The decrease in gross margin as a percentage of revenue primarily reflects the startup activities of the GTS Net product offering in Hungary. HER had an unfavorable effect on consolidated gross margins of $(1.4) million for the three months ended March 31, 1998. For comparative purposes, HER had an unfavorable gross margin of $(1.2) million for three months ended March 31, 1997 (HER was an equity method company prior to July 1997.) Operating Expenses. Consolidated operating costs were $22.7 million and $13.0 million for the three months ended March 31, 1998 and 1997, respectively. The increase in operating costs is attributable to the inclusion of HER and Sovam in the Company's consolidated financial results, the growth in expenditures associated with building business infrastructure for primarily the TeleRoss Operating Company and costs attributable to increasing the corporate staff. Equity in (Losses)/Earnings of Ventures. GTS recognized earnings of $3.4 million for its investments in non-consolidated ventures in the three months ended March 31, 1998 as compared to recognizing losses of $3.4 million in the same period a year ago. This improvement was primarily the result of HER no longer being an equity method investee, and TCM's year-over-year net income improvement. Included in the March 31, 1998 results were $0.1 million of additional earnings associated with our recovery of prior period excess losses recognized. Included in the March 31, 1997 results were $2.7 million of additional losses as a result of the application of the Company's previously discussed profit and loss accounting. Sovintel and TCM generated combined earnings of $4.1 million and $3.9 million for the three months ended March 31, 1998 and 1997, respectively, which offset the losses generated by other ventures that are in the early stages of operations. See "Results of Operations -- Non-Consolidated Ventures (Equity Investees)" for a discussion of the results of operations of the Company's significant equity investees. Interest, Net. GTS incurred interest expense of $16.5 million and $3.7 million for the three months ended March 31, 1998 and 1997, respectively. The significant increase in interest expense was due to the $409.8 million increase in debt raised in 1997. See "-- Liquidity and Capital Resources." GTS earned interest income of $7.1 million and $1.3 million for the three months ended March 31, 1998 and 1997, respectively, primarily as a result of investing the proceeds from the Company's 1997 and 1998 capital raising efforts. See "-- Liquidity and Capital Resources." Provision for Income Taxes. The Company's consolidated tax provision was $0.6 million and $0.4 million for the three months ended March 31, 1998 and 1997, respectively. The Company's financial statements do not reflect any provision for benefits that might be associated with the U.S. and non-U.S. loss carryforwards. There can be no assurance that such non-U.S. loss carryforwards will be allowed, in part or in full, by local tax authorities against future income. Extraordinary Loss. The Company recognized a $12.7 million extraordinary charge to earnings in the three months ended March 31, 1998, as a result of the Company's early extinguishment of certain related party debt obligations. The nature of the charge is comprised of the write-off of $11.6 million of unamortized debt discount and $1.1 million of unamortized debt issuance costs that were deferred as financing costs and were being amortized over the original maturity of the debt. Year Ended December 31, 1996 compared to Year Ended December 31, 1995 and compared to Year Ended December 31, 1994 Management's discussion included within "-- Results of Operations -- Consolidated Ventures" reflects the following significant operating ventures: TeleRoss Operating Company, GTS-Hungary, the Czech Companies and HER (for 1997). See "Results of Operations -- Non-Consolidated Ventures (Equity Investees)" for a discussion of the operating results of Sovintel, TCM, Sovam, TeleRoss Ventures, GTS Cellular, HER (prior to 1997), GTS-Monaco Access, EuroHivo and the Asia business ventures. Revenue. The Company's consolidated revenue was $47.1 million, $24.1 million and $8.4 million for the years ended December 31, 1997, 1996, and 1995, respectively. The growth in revenue was attributable to the 38 44 commencement in 1995 of commercial operations by TeleRoss Operating Company, as well as the continued expansion of services and customer base in Central Europe, and HER's initial Amsterdam to Brussels route and further expansion to London and Paris during 1997. The CIS region's consolidated revenue was $27.1 million, $12.7 million, and $3.8 million for the years ended December 31, 1997, 1996 and 1995 respectively. TeleRoss Operating Company generated revenue of $24.7 million, $9.2 million and $3.8 million, representing 91.1%, 72.4% and 100% of the region's consolidated revenue for the years ended December 31, 1997, 1996 and 1995, respectively. Service revenue represented 81.8%, 64.1% and 21.1% of TeleRoss Operating Company's revenue for the years ended December 31, 1997, 1996 and 1995, respectively, with the balance of its revenue in such periods principally represented by installation and equipment sales. The growth in revenue was a result of increased traffic volume generated by the TeleRoss Ventures as they expanded to 13 cities for the year ended December 31, 1997, added customers in existing cities and installed several VSATs at customer locations outside of cities in which they have a presence. Within the Central Europe region, GTS-Hungary and the Czech Companies accounted for 100% of the revenue earned, of which GTS-Hungary and the Czech Companies provided $8.5 million and $5.1 million of the Company's consolidated revenue in 1997, respectively, compared to $6.9 million and $2.3 million in 1996, respectively, and $4.2 million and $0.3 million in 1995, respectively. The growth in revenue of GTS-Hungary from 1995 to 1997 was due to the expansion of its customer base and the introduction of microwave technology services. The Hungary state lottery accounted for 50.6%, 55.3% and 65.0% of GTS-Hungary's revenue in 1997, 1996 and 1995, respectively. The growth in revenue of the Czech Companies was generated through increases in voice traffic carried from twenty-five buildings at December 31, 1997, as compared to sixteen buildings at December 31, 1996. All of Western Europe's consolidated revenue of $5.4 million for the year ended December 31, 1997 was derived from HER. Gross Margin. GTS's consolidated gross margin was $4.4 million, or 9.3% of revenue, for the year ended December 31, 1997, $5.2 million, or 21.6% of revenue, for the year ended December 31, 1996 and $0.02 million, or 0.0% of revenue, for the year ended December 31, 1995. The CIS region had a gross margin of $4.0 million, $0.8 million and $(0.9) million for the years ended December 31, 1997, 1996 and 1995, respectively. TeleRoss Operating Company had a gross margin of $3.5 million, or 14.2% of revenues, for the year ended December 31, 1997 and a negative gross margin of $(1.0) million for each of the years ended December 31, 1996 and 1995, which was the result of the high fixed cost component of its network hub in Moscow. GTS-Hungary and the Czech Companies comprised 100% of the Central Europe region's gross margin. GTS-Hungary had a gross margin of $3.5 million, $3.0 million, and $1.7 million, representing 41.2%, 43.4%, and 40.5% of GTS-Hungary's revenue for the years ended December 31, 1997, 1996 and 1995, respectively. The favorable gross margin trend reflected the increased utilization of GTS-Hungary's 1,000 VSAT capacity hub located in Budapest. The Czech Companies had a gross margin of $1.5 million, $0.3 million and $(0.1) million for the years ended December 31, 1997, 1996 and 1995, respectively. HER incurred a negative gross margin of $(4.6) million for the year ended December 31, 1997, which was primarily due to the initial cost structure of the new routes and minimal revenue generated. Operating Expenses. Consolidated operating costs were $76.7 million, $52.9 million, and $41.0 million for the years ended December 31, 1997, 1996 and 1995, respectively. The increase in operating costs reflected the growth in expenditures associated with building business infrastructure for primarily the TeleRoss Operating Company and GTS-Hungary, the inclusion of HER's operating expenses in 1997 and increasing corporate staff. Equity in (Losses)/Earnings of Ventures. GTS recognized losses from its investments in non-consolidated ventures of $14.6 million, $10.2 million and $7.9 million for the years ended December 31, 1997, 1996 and 1995, respectively. Included in these losses were $3.6 million, $5.7 million and $5.2 million for the years ended December 31, 1997, 1996 and 1995, respectively, that related to GTS's ownership share of the losses. Also included in the losses for the year ended December 31, 1997 was a write-off of approximately 39 45 $5.4 million which represented the net balance of certain investments in and advances to ventures in Asia (primarily Beijing Tianmu and V-Tech) and Central Europe (EuroHivo) that were stated in excess of their net realizable value. The Company followed the authoritative guidance as prescribed by APB No. 18, "The Equity Method of Accounting for Investments in Common Stock," for its determination of the $5.4 million charge. The Company's recoverability analysis was based on its projected undiscounted cash flows of their equity investees, since this is the lowest level of cash flow information available. The underlying reasons for the write-down of the Company's investments were the result of the problems that are more specifically addressed in "Results of Operations -- Non-Consolidated Ventures (Equity Investees) -- Asia," "Business -- Central Europe" and "Business -- Asia." Additionally, included within GTS's ownership share of the losses incurred and the Excess Losses for the year ended December 31, 1997 is approximately $14.4 million of losses (of the $14.4 million, approximately $13.5 million related to the write-off of advances to several Chinese-owned operating telecommunications companies to which the Company provides technical and financial assistance, and $0.9 million related to the write-off of inventories, receivables, and other assets) which represented the Company's share of asset write-offs recorded by certain of the ventures in Asia (Beijing Tianmu and V-Tech). See "-- Results of Operations -- Non-Consolidated Ventures (Equity Investees) -- Asia." The Company would have recognized earnings from its investments in non-consolidated ventures of $5.2 million for the year ended December 31, 1997, had the Company not recognized the write-downs of investments and assets of approximately $5.4 million and $14.4 million, respectively. The write-down of Central Europe's investment in EuroHivo was a result of the Company's decision in the third quarter to recognize the contingent liabilities associated with the expected liquidation and discontinuation of EuroHivo's operations as of September 30, 1997. In addition, the Company's results were negatively affected due to the recognition of Excess Losses of $5.6 million, $4.5 million and $2.7 million for the years ended December 31, 1997, 1996 and 1995, respectively. See "-- Overview." The Company's losses from its ventures were primarily the result of most of its ventures being in the early stages of operations. Sovintel and TCM, however, generated combined earnings of $15.5 million, $11.8 million and $3.8 million for the years ended December 31, 1997, 1996 and 1995, respectively, which partially offset losses generated by other ventures. Other Non-Operating Income. Favorably affecting the 1995 results was the non-recurring $10.3 million gain that the Company recognized as a result of its cash settlement of certain claims with a third party in 1995. Interest, Net. GTS incurred interest expense of $39.1 million, $11.1 million and $0.7 million for the years ended December 31, 1997, 1996 and 1995, respectively. Interest expense is comprised of interest incurred from debt maturing within one year, long-term debt obligations, capital lease obligations, amortization of debt discount on the long-term debt obligations and various other debt obligations. The significant increase in interest expense was due to the $409.8 million increase in debt raised in 1997. See "-- Liquidity and Capital Resources." GTS earned interest income of $11.4 million, $3.6 million and $2.2 million for the years ended December 31, 1997, 1996 and 1995, respectively, primarily as a result of investing the proceeds from private placements of common stock in various highly liquid investments. Provision for Income Taxes. The Company's consolidated tax provision was $2.5 million, $1.4 million and $2.6 million for the years ended December 31, 1997, 1996 and 1995, respectively. The Company's financial statements do not reflect any provision for benefits that might be associated with the U.S. and non-U.S. loss carryforwards. There can be no assurance that such non-U.S. loss carryforwards will be allowed, in part or in full, by local tax authorities against future income. RESULTS OF OPERATIONS -- NON-CONSOLIDATED VENTURES (EQUITY INVESTEES) Three Months Ended March 31, 1998 compared to Three Months Ended March 31, 1997 RUSSIA -- CIS Sovintel. Sovintel's revenue for the three months ended March 31, 1998 and 1997 was $32.4 million and $25.2 million, respectively. The increase in revenue was primarily the result of telecommunications service revenue, which increased to $23.8 million for the three months ended March 31, 1998 from $19.1 million for the three months ended March 31, 1997, due to the Moscow customer base growth and traffic from other GTS 40 46 ventures that generated increased volume of outgoing international and domestic minutes carried by Sovintel. Sovintel realized a 91% increase in outgoing international and domestic minutes in the three months ended March 31, 1998, as compared with the same period a year-ago. Revenue from incoming international minutes decreased slightly to $2.5 million for the three months ended March 31, 1998, from $2.7 million for the three months ended March 31, 1997. Sovintel's non-traffic-related revenue of $8.6 million and $6.1 million for the three months ended March 31, 1998 and 1997, respectively, was primarily attributable to port sales and monthly port fees revenue. Sovintel's gross margin was $10.4 million in both the three months ended March 31, 1998 and 1997, respectively, or 32.1% and 41.3% of revenue for the respective periods. The decrease in gross margin as a percentage of revenue was attributable to a general price decrease in international and domestic revenue due to competitive pressures and a higher percentage of domestic minutes, which yield a lower margin. Operating expenses were $4.6 million and $3.9 million, or 14.2% and 15.5% of total revenue, for the three months ended March 31, 1998 and 1997, respectively. The increase in operating expenses was related to increases in turnover taxes associated with revenues and also increased personnel, advertising and sales force costs required to support Sovintel's growth. Income tax expense was $1.3 million and $1.7 million for the three months ended March 31, 1998 and 1997, respectively. The increase in income tax expense was attributable to Sovintel's profitable operations. TCM. TCM's revenue was $9.5 million and $6.3 million for the three months ended March 31, 1998 and 1997, respectively. TCM had a gross margin of $6.9 million and $4.8 million, or 72.6% and 76.2% of total revenue. The decrease in gross margin as a percentage of revenue was attributable to higher infrastructure and settlement costs. TCM had operating expenses of $0.9 million and $0.6 million, or 9.5% and 9.5% of total revenue, for the three months ended March 31, 1998 and 1997, respectively. TeleRoss Ventures. Revenue for the TeleRoss Ventures for the three months ended March 31, 1998 and 1997 was $2.4 million and $1.5 million, respectively. Revenues resulted from settlement fees charged to TeleRoss Operating Company. The growth in revenue reflects the growth of the customer base. Gross margins for the three months ended March 31, 1998 and 1997 were $1.7 million and $1.2 million, respectively. Operating expenses of $1.0 million and $0.6 million were incurred for the three months ended March 31, 1998 and 1997, respectively. GTS Cellular. The Company operates three cellular networks through differing ownership structures: Vostok Mobile, PrimTelefone and Bancomsvyaz. Revenue for Vostok Mobile was $7.3 million and $5.0 million for the three months ended March 31, 1998 and 1997, respectively. Vostok Mobile's gross margin was $3.7 million and $2.8 million, or 50.7% and 56.0% of total revenue, and operating expenses were $2.6 million and $2.1 million for the three months ended March 31, 1998 and 1997, respectively. Revenue for PrimTelefone was $3.7 million and $2.5 million for the three months ended March 31, 1998 and 1997, respectively. PrimTelefone's gross margin was $2.1 million and $1.7 million, or 56.8% and 68.0% of total revenue, and operating expenses were $1.1 million and $0.6 million for the three months ended March 31, 1998 and 1997, respectively. Revenue for Bancomsvyaz was $4.2 million and $0.6 million for the three months ended March 31, 1998 and 1997, respectively. Bancomsvyaz's gross margin was $2.4 million and $(0.04) million, or 57.1% and (6.7)% of total revenue, and operating expenses were $1.8 million and $1.0 million for the three months ended March 31, 1998 and 1997, respectively. WESTERN EUROPE GTS-Monaco Access: Total revenue was $4.5 million and $1.9 million and gross margin was $0.2 million and $0.02 million for the three months ended March 31, 1998 and 1997, respectively. 41 47 Year Ended December 31, 1996 compared to Year Ended December 31, 1995 and compared to Year Ended December 31, 1994 RUSSIA -- CIS Sovintel. Sovintel's revenue for the years ended December 31, 1997, 1996 and 1995 was $114.0 million, $75.0 million and $44.3 million, respectively. The increase in revenue was primarily the result of telecommunications service revenue, which increased to $85.4 million for the year ended December 31, 1997 from $50.8 million and $26.8 million for the years ended December 31, 1996 and 1995, respectively, due to the Moscow customer base growth and traffic from other GTS ventures that generated increased volume of outgoing international and domestic minutes carried by Sovintel. Revenue from incoming international minutes also increased to $13.1 million for the year ended December 31, 1997, from $6.8 million and $2.2 million for the years ended December 31, 1996 and 1995, respectively. Included in Sovintel's traffic revenue for 1997 and 1996 was $12.4 million and $5.0 million, respectively, that was related to customers using phone numbers provided by TCM. This revenue was derived primarily from international/long distance traffic and local traffic. Sovintel and TCM have an arrangement whereby Sovintel reimburses TCM 50% of installation charges, monthly fees and local traffic revenues and approximately 33% of international/long distance billings from TCM-supplied phone numbers. Sovintel's non-traffic-related revenue of $28.6 million, $24.2 million and $17.5 million for the years ended December 31, 1997, 1996 and 1995, respectively, was primarily attributable to port sales and monthly port fees revenues. Sovintel's gross margin was $41.3 million, $31.1 million and $18.0 million, or 36.2%, 41.5% and 40.6% of revenue, for the years ended December 31, 1997, 1996 and 1995, respectively. The decrease in gross margin percentage was attributable to a general price decrease in international and domestic revenues due to competitive pressures and a higher percentage of domestic minutes, which yield a lower margin. Operating expenses were $17.0 million, $10.3 million and $7.1 million, or 14.9%, 13.7% and 16.0% of total revenue, for the years ended December 31, 1997, 1996 and 1995, respectively. The increase in operating expenses was related to increases in turnover taxes associated with revenues and also increased personnel, advertising and sales force costs required to support Sovintel's growth. Income tax expense was $5.7 million, $5.2 million and $2.6 million for the years ended December 31, 1997, 1996 and 1995, respectively. The increase in income tax expense was attributable to Sovintel's profitable operations. TCM. TCM's revenue was $29.3 million and $16.5 million for the years ended December 31, 1997 and 1996, respectively. TCM had minimal activities in 1995. TCM had a gross margin of $22.1 million and $13.2 million, or 75.4% and 80.0% of total revenue. The decrease in gross margin as a percentage of revenue was attributable to higher infrastructure and settlement costs. TCM had operating expenses of $3.3 million and $1.9 million, or 11.3% and 11.5% of total revenue, for the years ended December 31, 1997 and 1996, respectively. Sovam. Sovam's revenue was $17.8 million, $11.7 million and $4.4 million for the years ended December 31, 1997, 1996 and 1995, respectively. The increase in revenues is primarily attributable to the expansion of Sovam's network throughout Russia and the CIS and the wider variety of service offerings, including the introduction of Russia On Line services. Gross margin was $7.1 million, $3.4 million and $1.5 million, or 39.9%, 29.1% and 34.1% of total revenue for the years ended December 31 in 1997, 1996 and 1995, respectively. Operating expenses were $5.7 million, $5.7 million and $3.3 million, or 32.0%, 48.7% and 75.0% of total revenue, for the years ended December 31, 1997, 1996 and 1995, respectively. TeleRoss Ventures. Revenue for the TeleRoss Ventures for the years ended December 31, 1997, 1996 and 1995 was $6.8 million, $2.4 million and $0.2 million, respectively. Revenues resulted from settlement fees charged to TeleRoss Operating Company. The growth in total revenue was the result of steady growth in sales 42 48 of core switched voice services in the five cities serviced in 1995, an additional seven new cities in the network in 1996 and an additional city in 1997. Gross margin for the years ended December 31, 1997, 1996 and 1995 was $4.7 million, $1.6 million and $0.1 million, respectively. Operating expenses of $3.6 million, $2.3 million and $0.2 million were incurred for the years ended December 31, 1997, 1996 and 1995, respectively. GTS Cellular. The Company operates three cellular networks through differing ownership structures: Vostok Mobile, PrimTelefone and Bancomsvyaz. Revenue for Vostok Mobile was $25.8 million, $16.5 million and $2.0 million for the years ended December 31, 1997, 1996 and 1995, respectively. Vostok Mobile's gross margin was $13.6 million, $9.3 million and $1.1 million, or 52.7%, 56.4% and 55.0% of total revenue, and operating expenses were $10.1 million, $9.2 million and $4.7 million for the years ended December 31, 1997, 1996 and 1995, respectively. Revenue for PrimTelefone was $12.1 million, $8.4 million and $2.2 million for the years ended December 31, 1997, 1996 and 1995, respectively. PrimTelefone's gross margin was $6.6 million, $4.7 million and $0.6 million, or 54.5%, 56.0% and 27.3% of total revenue, and operating expenses were $3.6 million, $3.7 million and $0.7 million for the years ended December 31, 1997, 1996 and 1995, respectively. Bancomsvyaz did not have significant operations until 1997. Revenue for Bancomsvyaz was $7.2 million and gross margin was $2.8 million, or 38.9% of total revenue, for the year ended December 31, 1997. Operating expenses were $4.9 million for the year ended December 31, 1997. Western Europe HER. HER earned a small revenue stream in 1996 and no revenue in 1995. Operating expenses were $10.6 million and $6.7 million for the years ended December 31, 1996 and 1995, respectively. The increase in selling, general and administrative expenses reflected HER's continued transition from the start-up phase to the operational phase. In 1997, HER was included in the consolidated results of the Company. GTS-Monaco Access. Limited international traffic was carried from GTS subsidiaries through GTS-Monaco Access for termination worldwide during 1995 which resulted in minimal revenues earned. Total revenue was $13.0 million and $3.9 million and gross margin was $0.2 million and $(0.4) million for the years ended December 31, 1997 and 1996, respectively. Central Europe EuroHivo. EuroHivo's operating results were minimal for the years ended December 31, 1997, 1996 and 1995. In September 1997, the Company recorded a $2.4 million charge to recognize the liabilities associated with the planned liquidation and discontinuance of EuroHivo's operations. See Footnote 3 in the Company's audited financial statements for additional disclosures related to EuroHivo. Asia Most of the Company's ventures within the Asia region were in the start-up phase and had not commenced operations in 1996. The non-consolidated ventures in the Asia region had revenue of $7.0 million for the year ended December 31, 1996, and had minimal revenues in 1997 and 1995. The revenue in 1996 consisted principally of equipment sales. The Company believes that future revenue will be derived primarily from providing telecommunications engineering and consulting services. During the year ended December 31, 1997, the V-Tech and Beijing Tianmu business ventures (the "Asia Ventures") determined that a charge of $14.4 million (GTS's portion) was appropriate as a result of the write-off of $13.5 million of advances to several Chinese-owned operating telecommunications companies to which the Asia Ventures provide technical and financial assistance and $0.9 million related to the write-off of inventories, receivables and other assets. The Asia Ventures followed the authoritative guidance as prescribed by SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," for their determination of the $13.5 million charge as they believed that the advances, as 43 49 evidenced by legal agreements between the Asia Ventures and the underlying operating telecommunications companies, represents long-lived assets. (The Asia Ventures would have reflected the same charge had they followed the authoritative accounting guidance as prescribed by APB No. 18 or SFAS No. 5, "Accounting for Contingencies.") The Asia Ventures recoverability analysis was based on their projected undiscounted cash flows of their respective operations since this is the lowest level of cash flow information available. The underlying reasons for the write-offs were the result of problems dealing with one of the Asian partners, the inability of the Chinese operating telecommunications companies to develop markets for their services, and technical problems, all of which surfaced during the third quarter of 1997. See Footnote 3 in the Company's audited financial statements for additional disclosures related to the Company's Asia operations and "Business -- Asia." LIQUIDITY AND CAPITAL RESOURCES The Company The telecommunications business is capital intensive. The Company generally is the primary source of funding for its ventures, both for working capital and capital expenditures. Under a typical arrangement, GTS's venture partner contributes the necessary licenses or permits under which the venture will conduct its business, office space and other equipment. GTS's contribution is generally cash and equipment, but may consist of other specific assets as required by the joint venture agreement. The Company has raised capital through the issuance of equity securities and through various debt agreements. The issuance of equity securities has raised $238.7 million, $36.4 million, $107.7 million, $42.1 million and $62.1 million in 1998, 1997, 1996, 1995 and 1994, respectively, net of placement fees, for a total of $487.0 million. In addition, the Company and HER received $105.0 million, $409.8 million, $60.0 million and $23.3 million in 1998, 1997, 1996 and 1995, respectively, for a total of $598.1 million under various debt agreements. Included within the debt proceeds identified above, the Company received $3.5 million, $60.0 million and $10.0 million in 1997, 1996 and 1995, respectively, from lenders who are affiliated with, and are considered related parties to, the Company as a result of their (or their affiliates) ownership of the Company's Common Stock. The Company had working capital of $474.5 million and $23.0 million as of March 31, 1998 and 1997, respectively. The Company had an accumulated deficit of $280.1 million as of March 31, 1998, including net losses of approximately $37.2 million and $17.7 million for the three months ended March 31, 1998 and 1997, respectively. During 1998, the Company has incurred and expects to continue to incur substantial expenditures to fund the working capital requirements of its ventures, to provide capital equipment for certain of its ventures, and to engage in new development and acquisitions. GTS will require substantial capital investment to execute its business plans and to fund expected operating losses. Management expects that GTS and its ventures will incur over $510.0 million of capital expenditures and investments in ventures during the next three years, of which approximately $171.0 million will be incurred in the last three quarters of 1998. The Company obtained funds in 1998 through a variety of financing arrangements, including (i) the Company raised approximately $255.3 million in gross proceeds from an initial public stock offering of 12.8 million common shares at $20.00 per share, and (ii) the Company issued $105.0 million in gross proceeds of 9.875% senior notes due February 15, 2005, of which $19.6 million was placed in escrow to fund the first two years' interest payments. The IPO constituted a "Complying Public Equity Offering" under the Company's Convertible Bonds. As a result, the conversion price of the Convertible Bonds is $20.00 per share. The Company believes that its existing cash balances and cash flow from operations will be sufficient to fund its expected capital needs under its current business plan, excluding any funds expended in connection with the potential implementation of the Company's business plan with regard to its European Services Strategy. The Company contemplates that following the consummation of the Offerings, it will raise additional debt financing through a newly formed subsidiary of the Company, the proceeds of which will be applied toward the implementation of the Company's European Services Strategy. The size and timing of such financing have not yet been determined by the Company. The actual amount and timing of the Company's future capital requirements, however, may differ materially from management's estimates and, 44 50 therefore, GTS may require additional capital to execute its current business plan and to fund expected operating losses, as well as to consummate future acquisitions and exploit opportunities to expand and develop its businesses. The actual amount and timing of the Company's future capital requirements may differ materially from management's estimates. In particular, the accuracy of management's estimates is subject to changes and fluctuations in the Company's revenues, operating costs and development expenses, which can be affected by the Company's ability to (i) effectively and efficiently manage the expansion of the HER network and operations, (ii) obtain infrastructure contracts, rights-of-way, licenses and other regulatory approvals necessary to complete and operate the HER network, (iii) negotiate favorable contracts with suppliers, including large volume discounts on purchases of capital equipment and (iv) access markets, attract sufficient numbers of customers and provide and develop services for which customers will subscribe. The Company's revenues and costs are also dependent upon factors that are not within the Company's control such as regulatory changes, changes in technology, increased competition and various factors such as strikes, weather, and performance by third parties in connection with the Company's operations. Due to the uncertainty of these factors, actual revenues and costs may vary from expected amounts, possibly to a material degree, and such variations are likely to affect the Company's future capital requirements. Historically, GTS has experienced liquidity problems resulting in part from the Company's need to meet the capital requirements of certain of its joint ventures in excess of forecast amounts. In addition, certain of the Company's joint ventures have not met management's financial performance expectations or have not been able to secure local country financing and thus have not been able to generate the expected cash inflows. In addition, if the Company expands its operations at an accelerated rate or consummates acquisitions, the Company's funding needs will increase, possibly to a significant degree, and it will expend its capital resources sooner than currently expected. Furthermore, the consummation of the Stock Offerings is not conditioned upon the consummation of the New Convertible Bond Offering, and there can be no assurance that the New Convertible Bond Offering will be consummated. If the New Convertible Bond Offering is not consummated, the Company will need to find additional sources of capital to replace the funding that would have been provided by the New Convertible Bond Offering. The Company may also be required to repay its Convertible Bonds upon maturity in the year 2000 to the extent such bonds are not converted into Common Stock. As a result of the foregoing, or if the Company's capital resources otherwise prove to be insufficient, the Company will need to raise additional capital. There can be no assurance that the Company will be able to consummate additional financing on favorable terms. As a result, the Company may be subject to additional or more restrictive financial covenants, its interest obligations may increase significantly and its existing shareholders may be adversely diluted. Failure to generate sufficient funds in the future, whether from operations or by raising additional debt or equity capital, may require the Company to delay or abandon some or all of its anticipated expenditures, to sell assets, or both, either of which could have a material adverse effect on the operations of the Company. HER Construction of the HER fiber optic network is one of the Company's most significant business activities. The buildout of the network is expected to require approximately $290.0 million of capital expenditures. See "Business -- Western Europe -- HER". Through March 31, 1998, approximately $64.7 million has been spent on network capital expenditure. In August 1997, HER completed the issuance of $265.0 million in gross proceeds of 11.5% Senior Notes due in August 2007. The Senior Notes are general unsecured obligations of HER. The Company believes that the net proceeds of such note sale, combined with HER's projected internally generated funds, should be sufficient to fund HER's expected capital expenditures. However, the actual amount and timing of HER's future capital requirements may differ materially from management's estimates. Any failure to obtain necessary financing may require HER to delay or abandon its plans for deploying the remainder of the network and would jeopardize the viability of HER, or may require the Company to make additional capital contributions to HER at the expense of the Company's other operations, either of which could have a material adverse effect on the operations of the Company. There can be no assurance that GTS or its partners in HER would have sufficient capital to make contributions to HER, or that they would be willing to do so. 45 51 EUROPEAN SERVICES STRATEGY The aforementioned discussion of capital requirements does not include any capital spending that will be required for the implementation of the Company's European Services Strategy. Due to the preliminary nature of the Company's business plan for such strategy, the Company cannot estimate with any degree of certainty the amount and timing of the Company's future capital requirements for such implementation, which will be dependent on many factors, including the success of the Company's European services business, the rate at which the Company expands its networks and develops new networks, the types of services the Company offers, staffing levels, acquisitions and customer growth, as well as other factors that are not within the Company's control, including competitive conditions, regulatory developments and capital costs. Management believes, however, that if the European Services Strategy is implemented it is likely that the Company will need to raise additional capital above that being raised in the Offerings. The Company expects that it will have significant operating and net losses and will record significant net cash outflow, before financing, in coming years including in connection with its European services business. There can be no assurance that the Company's operations, including the Company's European services business, will achieve or sustain profitability or positive cash flow in the future. See "Risk Factors -- Additional Capital Requirements." LIQUIDITY ANALYSIS The Company had cash and cash equivalents of $507.9 million and $30.7 million as of March 31, 1998 and 1997, respectively. The Company had restricted cash of $77.2 million and $1.5 million as of March 31, 1998 and 1997, respectively. The restricted cash at March 31, 1998 primarily represents amounts held in escrow to pay the first two years interest payments on the $105 million of the 9 7/8% Notes and $265.0 million of the 11 1/2% Senior Notes of HER. During the three months ended March 31, 1998 and 1997, the Company used $27.4 million and $13.4 million, respectively, of cash for operating activities. Cash used for investing activities was $37.0 million and $11.6 million for the three months ended March 31, 1998 and 1997, respectively. Included in the cash used for investing activities for the three months ended March 31, 1998 is $10.2 million to acquire an additional 10.3% interest in HER. The use of cash in operations and for investing activities reflected primarily the development and buildout of existing telecommunications networks and the funding of fully operational ventures. There can be no assurance that the Company's operations will achieve or sustain profitability or positive cash flow in the future. If the Company cannot achieve and sustain operating profitability or positive cash flow from operations, it may not be able to meet its debt service obligations or working capital requirements. In February 1998, as contemplated by the Company approximately $85.2 million of the net proceeds from the IPO and of the 9 7/8% Notes were applied by the Company to repay $70.0 million plus accrued interest of debt from lenders who are affiliated with, and are considered related parties to, the Company as a result of their (or their affiliates) ownership of the Company's Common Stock. Substantially all of the Company's operations are in foreign countries and therefore the Company's consolidated financial results are subject to fluctuations in currency exchange rates. The Company's consolidated operations transact their business in the following significant currencies: Russian Ruble, Hungarian Florint, Belgian Franc and the European Currency Unit (ECU). For those operating companies that transact their business in currencies that are not readily convertible, the Company attempts to minimize its exposure by indexing its invoices and collections to the applicable dollar/foreign currency exchange rate to the extent its costs (including interest expense, capital expenditures and equity) are incurred in U.S. dollars. Although the Company is attempting to match revenues, costs, borrowing and repayments in terms of their respective currencies, the Company may experience economic loss and a negative impact on earnings with respect to holdings solely as a result of foreign currency exchange rate fluctuations, which include foreign currency devaluations against the U.S. dollar. Furthermore, certain of the Company's operations have notes payable and notes receivable which are denominated in a currency other than their own functional currency or loans linked to the U.S. dollar. The Company may also experience economic loss and a negative impact on earnings related to these monetary assets and liabilities. See "Risk Factors -- Risks Relating to Russia and the 46 52 CIS -- Currency and Exchange Risks -- Exchange Controls and Repatriation Risks Relating to Russian Securities." The Company has developed risk management policies that establish guidelines for managing foreign exchange risk. The Company is currently evaluating the materiality of foreign exchange exposures in different countries and the financial instruments available to mitigate this exposure. The Company's ability to hedge its exposure is limited since certain of its operations are located in countries whose currencies are not easily convertible. Financial hedge instruments for these countries are nonexistent or limited and also pricing of these instruments is often volatile and not always efficient. The Company is designing reporting processes to monitor the potential exposure on an ongoing basis and expects to implement this process before the end of 1998. The Company will use the output of this process to execute financial hedges to cover foreign exchange exposure when practical and economically justified. In April 1998, HER consummated a transaction to hedge the foreign exchange exposure resulting from the issuance of $265.0 million 11 1/2% Senior Notes by HER. YEAR 2000 COMPLIANCE The Company is currently in the process of assessing its year 2000 compliance costs and of converting its computer systems, where necessary, to year 2000 compliant software. This process includes obtaining confirmations from the Company's primary vendors that plans are being developed or are already in place to address processing of transactions in the year 2000. The Company does not expect that the cost of converting such systems will be material to its financial condition or results of operations. The Company currently believes it will be able to achieve year 2000 compliance by the end of 1999, and currently does not anticipate any material disruption in its operations as the result of any failure by the Company to be in compliance or that year 2000 compliance costs will have a material effect on the Company's earnings. 47 53 BUSINESS INTRODUCTION The Company is a provider of a broad range of telecommunications services to businesses, other telecommunications service providers and consumers in Russia, the Commonwealth of Independent States ("CIS") and Central Europe. Through its subsidiary Hermes Europe Railtel B.V. ("HER"), GTS is developing, and operating the initial segments of, a pan-European high capacity fiber optic network that is designed to interconnect a majority of the largest Western and Central European cities and to transport international voice, data and multimedia/image traffic for other carriers throughout Western and Central Europe. GTS's strategy to develop its businesses generally has been to establish joint ventures with a strong local partner or partners while maintaining a significant degree of operational control. The Company's business activities consist of the ownership and operation of (i) international long distance businesses, which operate through international gateways that provide international switching services and transmission capacity, (ii) local access networks, which provide local telephone service, (iii) cellular networks, which provide wireless telecommunications services, (iv) a domestic long distance business, (v) data networks and (vi) carriers' carrier networks, which provide high volume transmission capacity to other carriers. In addition, the Company has recently developed a business plan to offer facilities-based telecommunications products and services to businesses and other high-usage customers in certain metropolitan markets throughout Europe. See "-- Business Strategy -- European Services Strategy" and "-- Western Europe -- European Services Strategy." In Russia and the CIS, GTS's objective is to become the premier alternative telecommunications operator. To attain its objective, the Company has partnered with regional telephone companies and with Rostelecom, the national long distance carrier in Russia. The Company currently operates in 27 oblasts (regions) and the city of Moscow in Russia, as well as in 13 additional cities in the CIS, and believes it is well-positioned to become the leading independent telecommunications service provider in Russia. These businesses include: (i) EDN Sovintel ("Sovintel"), which provides Moscow, and recently St. Petersburg, with international long distance and local telephone services and access to the major domestic long distance carriers; (ii) TeleCommunications of Moscow ("TCM"), which provides local access services in Moscow; (iii) TeleRoss (as defined below), which provides domestic long distance services in fifteen cities in Russia, including Moscow, as well as Very Small Aperture Terminal ("VSAT") service to customers outside its primary long distance satellite network; (iv) Sovam Teleport ("Sovam"), which provides data services, including high-speed data transmission, electronic mail, Internet access services, as well as Russia On Line, the first Russian language Internet service; and (v) the Company's cellular operations ("GTS Cellular"), which operate cellular networks in thirteen regions in Russia and also in Kiev, Ukraine, with licenses covering regions with an aggregate population of approximately 28 million people at March 31, 1998. Whenever practical, GTS's businesses integrate and co-market their service offerings in Russia and the CIS, utilizing TeleRoss as the domestic long distance provider, Sovintel as the international gateway, TCM and GTS Cellular for local access, and Sovam as the data communications and Internet access network for business applications and on-line services. Together, GTS's Russian and CIS ventures carried approximately 442 million and 147 million minutes of traffic for the year ended December 31, 1997 and the quarter ended March 31, 1998, respectively, and had approximately 38,000 customers, including approximately 27,500 cellular subscribers, as of March 31, 1998. See "-- Russia and the CIS." In Western Europe, GTS believes that it is well-positioned to establish itself as the leading independent carriers' carrier through the development of two ventures, HER and GTS-Monaco Access S.A.M. ("GTS-Monaco Access"). HER's objective is to become the leading pan-European carriers' carrier by providing centrally managed cross-border telecommunications transmission capacity to telecommunications companies including traditional public telecommunications operators ("PTOs") and new entrants, such as alternative carriers, global consortia of telecommunications operators, international carriers, Internet backbone networks, resellers, value-added networks and other service providers ("New Entrants") on an approximately 18,000 kilometer pan-European high capacity fiber optic network designed to interconnect a majority of the largest Western and Central European cities. As of April 30, 1998, HER's network linked Brussels, Antwerp, 48 54 Rotterdam, Amsterdam, London, Paris, Frankfurt, Strasbourg, Zurich and Geneva. By the second quarter of 1998, HER expects this segment of the network to deliver managed transport services over approximately 3,000 kilometers of fiber optic cable linking, in addition to the cities discussed above, the cities of Dusseldorf, Stuttgart, and Munich. The full 18,000 kilometer network is expected to become fully operational during the year 2000. HER also plans to lease capacity on a transatlantic cable linking the European network to North America and is exploring various interconnectivity options to Russia and Asia. Such intercontinental interconnectivity will help HER satisfy the needs of its European customers with respect to outgoing traffic and to attract additional non-European customers with traffic terminating in Europe. HER commenced commercial service over the Brussels-Amsterdam portion of the network in late 1996, and the London-Paris portion in November 1997. GTS-Monaco Access operates an international gateway in Monaco in partnership with, and utilizing the existing gateway infrastructure of, the Principality of Monaco and provides transit and routing of international calls to other telecommunications operators. Through its HER and GTS-Monaco Access ventures, GTS is building a new network for transporting voice, data and multimedia/image traffic for other carriers throughout Western and Central Europe and for worldwide international voice, data and multimedia/image traffic that either originates or terminates in, or transits through, Western and Central Europe. See " -- Western Europe." In Central Europe, GTS's objective is to become one of the leading alternative telecommunications providers in the region. GTS currently provides private data communications services to government and commercial customers in Hungary and the Czech Republic. In the Czech Republic, the Company provides outgoing voice services and operates an international gateway and a data services network. In Hungary, GTS operates a VSAT network, which GTS believes is the largest VSAT network in Central Europe as measured by number of VSAT sites. The Company has also signed an agreement to provide international data services in Poland, subject to the receipt of necessary governmental approvals. GTS's strategy is to expand its service offerings as the regulatory environment permits, leverage its existing VSAT and international gateway infrastructure where possible and provide a broad range of services to its target markets. See " -- Central Europe." GTS does not currently own or operate significant telecommunication assets in Asia. GTS's objective is to capitalize on opportunities as they arise in the telecommunications markets in China and India. See "-- Asia." BUSINESS STRATEGY GTS seeks to develop businesses to meet the rapidly expanding market demand for telecommunications services. GTS's goal in emerging markets is to establish itself as the leading alternative to the incumbent telecommunications service providers and as a premier provider of value-added services. In addition, the Company seeks to position itself as the leading independent carriers' carrier within Western and Central Europe through the development of a pan-European fiber optic network and an international gateway in Monaco. In addition, the Company has recently developed a business plan to offer facilities-based telecommunications products and services to businesses and other high-usage customers in certain metropolitan markets throughout Europe. See "-- Western Europe -- European Services Strategy." GTS believes that it will be able to successfully operate its businesses and develop business opportunities by pursuing the following strategies: - Identify and Seize Early Market Opportunities. GTS's primary strategy is to identify less developed markets in which the incumbent operator offers inadequate service and where liberalization of telecommunications regulations may be pending. The Company believes that entering these less developed markets quickly is a key competitive advantage in the global telecommunications market. GTS leverages its management's knowledge of the markets in which the Company operates to assess and react quickly when attractive business opportunities arise. - Establish Joint Ventures with Experienced Local Partners. GTS seeks to establish and maintain strategic partnerships and relationships with key telecommunications operators and service providers in the countries in which it operates. The Company believes that these relationships increase its ability to 49 55 anticipate and respond to changes in the regulatory and legal environment and assist with license renewal and expansion of its operating companies. - Retain Significant Operational Control. In general, GTS actively participates in the management of its ventures by (i) providing most of the funding for the ventures' operations, (ii) selecting key members of the local management team, (iii) developing business plans and marketing strategies together with local management, (iv) monitoring operating functions, (v) maintaining close working relationships with local partners and (vi) integrating its networks and businesses in a manner which is consistent with the Company's overall strategic objectives. - Build Infrastructure to Provide High Quality Services. GTS continues to develop and expand its network infrastructure. The Company believes that its networks offer service, quality and cost advantages over incumbent providers as a result of the Company's customer support, network monitoring, management systems and its ability to integrate and co-market its service offerings. - Leverage Management Depth and Experience. GTS's management has significant experience in the development and operation of telecommunications businesses outside the United States. The Company believes that this experience, together with the Company's extensive operations, has provided its management with the ability to identify, evaluate and pursue international telecommunications business opportunities. Additionally, GTS has assembled a management team comprised of executives with extensive experience managing telecommunications companies in the respective local markets. GTS believes that its management team possesses a broad knowledge of relevant political and regulatory structures, as well as the cultural awareness and fluency with international and local business practices necessary to implement the Company's objectives. - Access Capital Effectively. In general, the Company's financing strategy is to establish parent level funding to meet general corporate needs and the costs of start-ups and acquisitions and, when it is possible and cost-effective, to finance ongoing operations at the venture level. From 1993 through 1997, the Company raised privately approximately $268 million in equity and approximately $215 million of debt (of which approximately $74 million was raised through shareholders). In addition, HER completed a $265 million private placement of senior notes (of which $56.6 million was placed in escrow for the first two years' interest payments) in 1997. On February 10, 1998, the Company completed an IPO of Common Stock in which the Company sold 12,765,000 shares and realized aggregate net proceeds of approximately $235.6 million. On the same date, the Company also sold $105 million aggregate principal amount of 9 7/8% Notes and realized aggregate net proceeds of approximately $100.5 million, of which $19.6 million was placed in escrow to cover the first four scheduled payments of interest on the 9 7/8% Notes. In addition to its overall business strategy, GTS has developed market strategies to achieve its goals in emerging markets and Western Europe as well as its preliminary business plan to offer comprehensive telecommunications services in Europe. Emerging Markets. The Company pursues its goals in emerging markets through a three-stage approach of market entry, market expansion and market integration. - Market Entry. GTS identifies a market as a suitable target for entry based upon: (i) superior growth prospects for such market, demonstrated by growing demand for high quality telecommunications services; (ii) the provision of inadequate services by incumbent providers, typically resulting from the incumbents' unwillingness to offer high quality services with reliable customer support at attractive prices; and (iii) attractive regulatory environments in which emerging alternative telecommunications providers such as GTS have, or are expected to have over a clearly defined time horizon, the ability to compete on a substantially equal basis with the incumbent providers in terms of certain services and the cost of providing those services. Once the Company has identified a market as suitable for entry, the Company seeks to establish its presence in that market by establishing a venture with a strong local partner or partners. In general, GTS maintains a significant degree of operational control in such ventures. Through such ventures, the Company benefits from its partners' ability to provide infrastruc- 50 56 ture, regulatory expertise and personnel that will provide the Company with a competitive advantage in entering that market. When entering a new market, GTS's strategy is to provide its customers with service of higher quality than that provided by incumbents. - Market Expansion. Having entered a market successfully and established a limited service offering to its targeted customer base, GTS then seeks to expand the range of services it offers to existing and potential customers and to further develop its relationships with local partners. By broadening its service offerings and providing a bundled service offering, the Company expects to both expand its customer base and increase the Company's share of each customer's telecommunications spending. GTS also expects to achieve increased economies of scale through the common use of administrative and operating functions already in place. The Company also seeks to expand its targeted geographic market by forming new partnerships and installing infrastructure and offering services in additional geographic regions, allowing the Company to further enhance its operating leverage and ability to service its customers' telecommunications needs. - Market Integration. GTS ultimately intends to integrate and co-market its service offerings in each of the markets in which it operates. The Company believes such integration will enable it to enhance its operating efficiency by leveraging its distribution channels, infrastructure, networks and management information systems. As customers develop a need for a broader variety of telecommunications services, the Company believes that GTS's integrated operations will represent an attractive service alternative for customers seeking a single provider that can meet all their telecommunications needs. Western Europe. The Company believes it is well-positioned to establish itself as the leading independent carriers' carrier within Western Europe through the development of HER's pan-European fiber optic network and the operation of GTS-Monaco Access's international gateway in partnership with, and utilizing the gateway infrastructure of, the Principality of Monaco. HER and GTS-Monaco Access seeks to complement and enhance the services provided by PTOs and New Entrants in a way that helps them to more successfully meet the needs of their end-user customers. HER has been able to enter the market ahead of competition and encourage a wide variety of carriers to use its network with service offerings that meet their needs. To establish itself as the leading carriers' carrier for international telecommunications within Europe, HER intends to provide its customers with significantly higher quality transmission and advanced network capabilities at a competitive price by utilizing advanced, uniform technology across the region and providing redundant routing for higher levels of reliability. European Services Strategy In addition, the Company has recently developed a business plan to offer, through one or more new subsidiaries, facilities-based telecommunications products and services to businesses and other high usage customers in certain metropolitan markets throughout Europe. The Company believes that the size and growth potential of the European market combined with increasing liberalization of European telecommunications regulations provides the Company with the opportunity to successfully develop local networks and other end-user services. The Company is evaluating developing CLECs in up to 12 European cities. Implementation of this strategy may involve one or more of the following: (i) the construction of fiber loop networks, (ii) the purchase or lease of dark fiber, (iii) obtaining of high frequency microwave licenses for "wireless fiber," or (iv) partnership with, or acquisition of, resellers or facilities-based CLECs. In evaluating potential markets the Company will consider among others the following characteristics of each market: (i) its business concentration, (ii) the national and local regulatory environment, (iii) the technical difficulties of local network construction and (iv) the extent of existing competition. See "Risk Factors -- Risks Relating to European Services Strategy" and "Business -- Western Europe -- European Services Strategy." RUSSIA AND THE CIS OVERVIEW GTS is a leading provider of a broad range of telecommunications services in Russia. GTS's services include international long distance services, domestic long distance services, high speed data transmission and 51 57 Internet access, cellular services and local access services. GTS was among the first foreign telecommunications operators in the CIS, where it began offering data links to the United States in 1986, international long distance services in 1992, local access to its networks in 1994 and cellular services in 1995. GTS has developed these businesses into a leading provider of telecommunications service offerings in Russia by building its own infrastructure, including a fully digital overlay network and interconnections with its local Russian telecommunications partners. The Company believes that evolving changes in government policy over the last several years and the overall inadequacy of basic telecommunications services throughout Russia have created a significant opportunity. Before 1990, all international, domestic long distance and local telecommunications in the Soviet Union were provided by a monopoly state telecommunications company managed by the Ministry of Posts and Communications. In 1990, the Council of Ministers established a joint-stock company called Sovtelecom and transferred to it all of the telecommunications assets and operations of the Soviet Ministry of Posts and Communications. Following the dissolution of the Soviet Union in 1991, the name of the company was changed to Intertelecom. In 1992, the Russian government decided to split Intertelecom into several components to foster privatization, competition and investment. The international and long-distance assets and operations were combined into Rostelecom, creating a monopolistic service provider. The local telecommunications assets and operations were broken up into 88 independent regional joint-stock companies, seven of which serve cities, including the Moscow City Telephone Network and the Petersburg Telephone Network. Most of the regional companies have a telecommunications trunk operator and provide a domestic long distance service within their service region. Domestic long distance calls to and from areas outside the companies' service area, as well as international calls, are switched to and from Rostelecom, which forwards the calls to and from another regional company or a foreign carrier for international calls. Exceptions to this rule include the seven city operators. In Moscow and St. Petersburg, the trunk operators have been isolated into separate, long distance companies called Moscow MMT and St. Petersburg MMT. All domestic long distance and international calls originating from or terminating in Moscow and St. Petersburg are switched through the MMTs, which forward the calls to and from Rostelecom. Following the former Soviet Union's transformation from a centralized economy to a more market-oriented economy, increased demand from emerging private businesses and from individuals, together with the poor state of the public telephone network, has led to rapid growth in the telecommunications sector in Russia and the CIS. In 1991 the Ministry of Communications (the "MOC") was established as the Russian successor to the Soviet Ministry of Posts and Communications to regulate and improve the Russian telecommunications industry. The MOC was later designated as the government's representative for its ownership share of the 88 regional operating companies, the assets currently held by Svyazinvest (then the monopoly international and domestic long distance service provider), and the principal regulatory authority for national radio, television and satellite operating companies. This enabled the MOC and operating organizations to begin the privatization process, attract foreign investment and initiate joint ventures with foreign partners. Although it remains subject to certain restrictions, significant progress in privatization of the telecommunications industry in Russia and the CIS has occurred. Under Russian law, state-owned enterprises within the telecommunications sector were subject to privatization but only pursuant to a decision of the Russian government in each individual case and with the state retaining a certain percentage of the stock of the privatized entity for three years, subject to extension for national security reasons. At present, virtually all of the former state telecommunications enterprises have been privatized and, subject to the above restrictions, shares of the newly formed joint stock companies have been sold to the public. Also, a significant number of private operators provide a wide variety of telecommunications services pursuant to licenses from the MOC to a growing number of customers throughout Russia. According to the MOC, more than 6,000 licenses have been granted to telecommunications operators in Russia, a large portion of which is assumed to represent licenses reissued to the same operators as a result of their reorganization or obligation to hold such licenses on counterfeit-proof paper. In October 1994, the President authorized the establishment of Svyazinvest with the stated purpose of fostering greater efficiency and economies of scale within the industry through competition. As a wholly 52 58 government-owned company, Svyazinvest was granted a controlling stake in approximately 85 regional telecommunications companies in order to compete in these respective markets. Svyazinvest was also given control of more than 20 million of the 25.5 million telephone lines in Russia, except in Moscow and St. Petersburg. In April 1997, President Yeltsin approved the transfer of the federal government's 51% stake in Rostelecom, as well as similar stakes in Central Telegraph (the national PTO), the Ekaterinburg City Telephone Network and Giprosvyaz (a telecommunications research institute), to Svyazinvest. On July 30, 1997, Mustcom Ltd., a Cyprus-based company that represents the interests of a consortium which includes ICFI Cyprus, Renaissance International Ltd., Deutsche Morgan Grenfell, Morgan Stanley, and an affiliate of George Soros, purchased a 25% stake in Svyazinvest for $1.87 billion. The President has also authorized the sale of another 24% of Svyazinvest at a future date. This sale is scheduled to occur in the second half of 1998 and is currently reserved solely for Russian investors. The Russian government has announced that it will retain a controlling 51% interest in Svyazinvest. The Russian government's interest in Svyazinvest is held by the MOC, which was reclassified as the State Committee on Telecommunications and Informatics during a recent government reorganization. The MOC remains the central body of federal authority in the Russian Federation, having responsibility for state management of the communications industry and supervisory responsibility for the condition and development of all types of communications. Despite the recent changes in the Russian telecommunications industry, the level of telecommunications service generally available from most public operators in Moscow remains significantly below that available in cities of Western Europe and the United States, although in recent years, the Moscow local telephone infrastructure has benefited from significant capital investment. By 1995, there were approximately 16 lines per 100 persons in Russia and 45 lines per 100 persons in Moscow. In comparison, there were 60 and 58 lines per 100 persons in the United States and Western Europe, respectively. In addition, the quality of services, reflected as the percentage of digital switching in local telephone networks, currently is approximately 12% in Russia compared to 65% and 66% in the United States and Western Europe, respectively. Outside Moscow (and to a lesser extent St. Petersburg), most standard Russian telecommunications equipment is obsolete. For example, many of the telephone exchanges are electromechanical and most telephones still use pulse dialing. The Russian population is over 145 million, of which approximately two- thirds is concentrated in urban areas. The telecommunications market in Russia currently includes a number of operators that compete in different service offering segments -- local, inter-city, international, data and cellular services. In large measure, the relative lack of economic development in the regions accounts for the lack of improvement in local telecommunications infrastructure. Although the regions still generally rely on an outdated infrastructure inherited from the former Soviet Union, they are starting to resort to sophisticated sources of finance, such as municipal bond offerings, in order to upgrade it. Growth in the Russian telecommunications industry has been principally driven by businesses in Moscow requiring international and domestic long distance voice and data services and by consumers using mobile telephony. This growth has been most significant as multinational corporations have established a presence in Moscow and Russian businesses have begun to expand. The service sector, which includes operations in distribution, financial services and professional services and tends to be the most telecommunications-intensive service sector of the economy, is growing rapidly in Moscow. Since moving to a more market-oriented economy, the economic conditions in the outlying regions in Russia have also generally improved. The telecommunications industry in the outlying regions has experienced recent growth, principally as a result of growth in the industrial sector as well as the establishment of satellite offices in the regions by multinational corporations and growing Russian businesses. The extent of overall market growth will depend in part on the rate at which the Russian economy expands, although recent revenue growth in the sector has been significant (in spite of a declining economy in certain regions) because of increasing traffic from pre-existing customers and the normalization of tariffs for business services. The Company believes it is well-positioned to take advantage of market growth factors due to (i) its early market entry, (ii) its strong infrastructure position in Moscow, by far the most important regional market, 53 59 (iii) the local market experience of its local partners, (iv) the extent of its existing customer base and (v) its extensive range of international and domestic telecommunications services. GTS believes it is the only operator in Russia currently capable of providing a broad range of service offerings and marketing them as a single end-to-end service offering for its customers. STRATEGY GTS's objective is to become the premier alternative carrier in Russia and other key growth markets of the CIS. To attain this objective, the Company has developed and implemented the following strategy: - Develop Strong Local Partnerships. The Company has and continues to develop its Russian and CIS business through alliances with experienced local partners. These ventures combine the management, financial and marketing expertise of GTS together with its partner's ability to provide infrastructure and local regulatory experience. GTS believes that these relationships lend it credibility and increase its ability to anticipate and respond to the evolving regulatory and legal environment. GTS maintains a significant degree of managerial and operational control in its joint ventures through its foundation documents, which enable GTS to develop them in a manner consistent with its overall strategic objectives. - Expand Customer Base. The Company continues to expand its customer base through the provision of basic telephone and digital services in markets where such services are not currently provided. Once they have established a presence in a market, the Company's ventures seek for opportunities to expand further into neighboring regions and cities. - Increase Range of Digital Services. As its business customers expand their operations throughout Russia and the CIS and as their telecommunications needs become more sophisticated, the Company seeks to increase its revenues by expanding the range of integrated digital services offered to its customers. - Offer High Quality Telecommunications Service and Customer Service. The Company continues to invest in and build sophisticated high-speed digital networks and other infrastructure through which customers can gain local access to the Company's services. In addition to providing advanced, high quality network infrastructure, the Company emphasizes and offers its customers a level of customer service which the Company believes cannot be found elsewhere in the market. To date, GTS has made substantial progress employing this strategy. The Company provides digital voice, data, internet and local services in Moscow through its Sovintel, Sovam and TCM ventures and provides these same services to fourteen additional Russian cities through its TeleRoss long distance network. The Company believes that attractive acquisition opportunities currently exist in the markets in which it operates in Russia and the CIS. The Company continuously considers a number of potential transactions, some of which may involve the contribution of certain of its Russian businesses in exchange for an interest of equivalent or greater value in the surviving entity and, if consummated, may be material to the Company's operations and financial condition. OPERATIONS GTS provides a broad range of telecommunications services in Russia, including international long distance services, domestic long distance services, cellular services, high speed data transmission, Internet access and local access services. These services are supported by operator assistance, itemized call reporting and billing, and other value-added capabilities that leverage GTS's investment in advanced switching, data collection and processing equipment. GTS also provides customized systems integration, including PABXs, key systems, wiring and interconnectivity. GTS's own infrastructure is supplemented with dedicated and leased capacity to allow GTS to bypass the severely congested and poorly maintained local, domestic and long distance circuits of the Russian carriers. 54 60 Whenever practical, GTS's business units integrate and co-market their service offerings, utilizing TeleRoss as the long distance provider, Sovintel as the international gateway, TCM and GTS Cellular for local access, and Sovam as the data communications and Internet access network for business applications and on-line services. Through this integrated marketing approach, GTS is able to provide comprehensive telecommunications solutions to multinational corporations operating throughout Russia and the CIS. Several of the TeleRoss Ventures and the cellular joint ventures were not operational, or had just commenced operating, in 1995. As a result, TeleRoss and GTS Cellular did not generate significant revenues in 1995. The following table sets forth certain operating data related to the Company's operating ventures in Russia and the CIS.
AT AND FOR THE AT AND FOR THE THREE MONTHS YEAR ENDED ENDED DECEMBER 31, MARCH 31, -------------- -------------- 1996 1997 1997 1998 ----- ----- ----- ----- Cities In Service....................................... 33 40 33 45 Total Voice Minutes (millions)(1) Inter-city............................................ 15.8 57.1 8.6 22.4 Local................................................. 133.0 269.1 44.9 92.3 International Outgoing................................ 20.5 46.0 8.6 14.8 Incoming.............................................. 33.2 69.9 14.8 17.6 Total Data Customers (thousands)........................ 6.2 9.9 7.2 10.5 Total Cellular Subscribers (thousands).................. 9.8 23.4 11.5 27.5
- - - - --------------- (1) Amounts include minutes between Company affiliates. 19.4 million of the collective Total Voice Minutes of Bancomsvyaz, PrimTelefone and Vostok Mobile presented for the three months ended March 31, 1998 are based on historical splits and do not represent actual figures. SOVINTEL GTS owns 50% of Sovintel, a joint venture with Rostelecom, the national long distance carrier. Sovintel was founded in 1990 by GTS, Rostelecom and GTE Spacenet, with GTS acquiring GTE Spacenet's interest in 1994. Sovintel markets a broad range of high quality telecommunications services by (i) directly providing international direct dial access to over 170 countries and private line dedicated voice channels and (ii) leveraging the infrastructure and services of the other GTS ventures, including TeleRoss, TCM and Sovam. In addition, Sovintel provides and installs for its customers equipment such as PABXs, key systems and wiring and provides maintenance and other value-added services. Sovintel customers, which primarily consist of businesses, hotels and Moscow-based cellular operators, are able to access these telecommunications services through Sovintel's fully-digital overlay network in Moscow. In addition, Sovintel has recently commenced construction of a limited network in St. Petersburg that is interconnected to Sovintel's Moscow network and is intended to support Sovintel's Moscow clients which have a presence in St. Petersburg. Sovintel serviced over 46,800 Moscow telephone numbers, or "ports," for business customers and cellular providers and had over 290 employees as of March 31, 1998. Sovintel has constructed and operates a fully-digital overlay network in and around Moscow which consists of (i) an approximately 600-kilometer fiber optic ring, (ii) over 390 PABXs linked to the fiber optic ring, (iii) a fully-digital microwave network, (iv) a wireless local loop and (v) an international gateway connected to the fiber optic ring. In addition, Sovintel leases dedicated international long distance channels. Customers are connected to the Sovintel network via last mile connections to over 390 PABXs that provide "points-of-presence" in and around Moscow. The PABXs are connected to the network through a direct fiber connection or a digital microwave network. Some of Sovintel's new customers are temporarily connected to the network through a wireless local loop. The wireless local loop provides a significant competitive advantage because it allows Sovintel to connect customers to its network more quickly than alternative methods. As these customers are provided permanent connections to Sovintel's network through direct connections to the PABXs, additional customers are rolled onto the wireless local loop. 55 61 [GTS SOVINTEL MOSCOW NETWORK] After a customer is connected to the Sovintel network, local telephone services are provided through the Sovintel fiber optic ring's interconnection with the switches of either TCM or MTU Inform. These switches provide access to local telephone service in Moscow through interconnections with the Moscow city telephone network ("MGTS") and the principal Moscow cellular providers. Sovintel provides its customers access to domestic long distance service through the TeleRoss long distance network, or through Rostelecom's network in cities not currently served by TeleRoss. International service is provided primarily through the Sovintel international gateway, which transmits international traffic via dedicated international leased long distance channels. Sovintel's customers also can receive high speed data services through Sovintel's interconnection with the Sovam data network. Accordingly, from a customer's perspective, Sovintel offers a broad range of telecommunication services. 56 62 The following table sets forth certain operating data related to Sovintel's operations:
AT AND FOR THE THREE MONTHS ENDED AT AND FOR THE YEAR ENDED DECEMBER 31, MARCH 31, --------------------------------------- ------------------- 1995 1996 1997 1997 1998 -------- ---------------- --------- -------- -------- MINUTES OF USE(1) International Number of Minutes......... 10,516 20,839 43,664 8,405 14,080 Average Rate Per Minute... $ 2.06 $ 1.55 $ 1.12 $ 1.39 $ 0.96 Domestic Long Distance Number of Minutes......... 2,047 10,098 26,606 4,707 10,992 Average Rate Per Minute... $ 0.86 $ 0.65 $ 0.52 $ 0.60 $ 0.46 Moscow (Local) Fixed Line Number of Minutes......... -- -- 3,501 478 1,245 Average Rate Per Minute... -- -- $ 0.05 $ 0.07 $ 0.03 Moscow (Local) Cellular Number of Minutes......... 21,478 83,673 118,447 22,639 33,611 Average Rate Per Minute... $ 0.06 $ 0.08 $ 0.08 $ 0.08 $ 0.08 Incoming Number of Minutes......... 3,839 24,306 43,626 10,690 7,321 Average Rate Per Minute... $ 0.58 $ 0.28 $ 0.30 $ 0.25 $ 0.34 PORTS Number of Ports (cumulative).............. 6,079 29,646 43,976 38,491 46,800 NUMBER OF PRIVATE LINE CHANNELS International................ 26 89 201 105 229 Inter- and Intra-City........ 26 103 243 130 278 APPROXIMATE EQUIPMENT SALES (THOUSANDS).................. $ 1,400 $ 2,200 $ 3,400 $ 600 $ 1,000
- - - - --------------- (1) Minutes in thousands. Amounts include minutes among affiliates. Services. Sovintel markets a broad range of high quality telecommunications services by (i) directly providing international direct dial access to over 170 countries and private line dedicated voice services and (ii) by leveraging the infrastructure and services of the other GTS ventures. Sovintel's services include: - Switched International, Domestic Long Distance and Local Services. Customers are provided switched international long distance services directly through Sovintel's international gateway in Moscow and its leased long distance channels. Domestic long distance services are marketed by Sovintel and provided either through the TeleRoss long distance network or, where the call destination is not served by TeleRoss, through Rostelecom's network. Local call service is provided by Sovintel indirectly as a result of its interconnection, through TCM or MTU Inform, with the Moscow city telephone network. Based on its familiarity with the market, the Company believes that Sovintel's services are distinguished by a higher level of quality than those of its competitors, particularly with respect to call completion rates for its domestic long distance and local call services. In addition, the Company trains its employees to provide customer service at a level which is comparable to that provided by Western telecommunications companies. As a result, the Company believes that customers choose Sovintel over its competitors because it has earned a reputation for providing high quality telecommunications services through an experienced and professional customer service staff. - Private Line Channels. Private line channels, which are provided over dedicated leased lines, are principally utilized by customers with high-volume data traffic needs, such as Sovam and large data providers. Private line customers have access to intra-city service in Moscow through Sovintel's fiber optic ring and to inter-city service between Moscow and St. Petersburg via fiber leased by Sovintel, in each case benefiting from Sovintel's high quality infrastructure. Private line domestic long distance 57 63 service is provided through TeleRoss and, for cities not served by TeleRoss, through Rostelecom. International private line service is provided through dedicated leased fiber channels from Rostelecom. - Equipment Sales, Installation Services and Project Planning and Management Services. In providing the above services to its customers, Sovintel installs and maintains equipment on its customers' premises, including PABXs, key systems and wiring. Sovintel also provides project planning and management services, including system design and management, to its customers. - World Access Service. Customers are able to access Sovintel's international long distance services through the World Access Card, which provides customers either direct or calling-card-based portable access to domestic and international long distance service. The calling card can be used in 16 Russian cities, including Moscow and St. Petersburg, and 23 countries. Sovintel complements its service offerings by providing a wide range of value-added services, including operator assistance, maintenance and customer support and itemized call reporting and billing. Customers and Pricing. Sovintel's customers consist primarily of high-volume business and professional customers, such as IBM, Credit Suisse Group and Reuters, other multinational corporations and Russian enterprises, a number of premium Moscow hotels and other telecommunications carriers. In addition, Sovintel is one of the primary providers of domestic and international long distance service for the major cellular service providers in Moscow, including VimpelCom, MTS and Moscow Cellular. Sovintel's customers typically demand a higher level of service than generally available in the market. Sovintel further provides to its large corporate customers data services such as frame relay and Internet access contracted from Sovam in order to offer "one-stop shopping" telecommunications solution to these customers, who increasingly require this type of service. The pricing structure for international and domestic long distance calls is based upon traffic volume and overall market rates, with Sovintel's rates varying depending on the time and destination of the call. Local calls, other than calls placed to cellular phones, are completed without charge. Sovintel expects to continue its practice of not charging to complete local calls unless and until the MGTS begins to charge for completion of such calls. Sovintel prices its international long distance services slightly below those of its principal competitors, and has recently reduced its rates in anticipation of increased competitive pricing pressures. Sovintel's average revenue per minute for outgoing international long distance calls has declined from approximately $2.35 per minute for the year ended December 31, 1994 to approximately $0.96 per minute for the three months ended March 31, 1998. Sovintel is experiencing increased pricing pressure from competitors. Sovintel prices domestic long distance services in line with those of its principal competitors. Due to its obligations under certain agreements with affiliated entities, however, Sovintel's margins for these services are declining. Prices for domestic long distance services have increased significantly over the last several years, although such prices stabilized in the second half of 1996. Sovintel's private line services are priced competitively. Sovintel provides private line channels by releasing lines it leases from Rostelecom. The lines are leased by Sovintel from Rostelecom at wholesale rates and leased by Sovintel to its customers at prices in line with Rostelecom's retail rate. Customers are billed monthly, with larger-volume customers receiving discounts of up to 25%. Customers using international services, domestic long distance or data services are billed in U.S. dollars. To the extent permitted by law, payment is made either in U.S. dollars or in rubles at the ruble/dollar exchange rate at the time of payment, plus a conversion charge in order to minimize the impact of currency fluctuations. Sovintel currently bills on an invoicing system that was internally developed. Currently, the system is adequate for Sovintel's present customer base; however, the Company is evaluating alternatives for upgrading the system in anticipation of future growth. Sales and Marketing. Sovintel's sales and marketing strategy targets large multinational and Russian businesses both directly and through contacts with real estate developers and business center managers in the greater Moscow area. These developers and managers typically determine which telecommunications service provider will service their respective properties. By identifying and building relationships with these developers and managers at an early stage (typically up to one year prior to the completion of a new building project), 58 64 Sovintel seeks to enhance the likelihood of winning the service contract. In addition to its traditional target market, Sovintel has recently begun to market its services to smaller businesses. Sovintel utilizes a departmentalized sales force in order to focus its sale efforts on the different segments within its target market. The sales force is comprised of 40 sales personnel, including 15 account managers, all of whom specialize in serving specific targeted industries. Dedicated marketing and customer support personnel provide technical support, customer service, training, market monitoring and promotional functions for Sovintel. Sovintel's sales and marketing personnel are paid through a combination of salary, commissions and incentive bonuses. Ownership and Control. Sovintel is a joint venture between a wholly owned entity of GTS and Rostelecom, with each having a 50% ownership interest. Under Sovintel's charter, GTS and Rostelecom each have the right to appoint three of the six members of Sovintel's managing board. Rostelecom has the right to nominate the Director General (the highest ranking executive officer at Sovintel), while GTS has the right to nominate the First Deputy Director General (the next-highest ranking executive officer at Sovintel). In practice, the Director General and the First Deputy Director General together perform the role of a chief executive officer. Certain business decisions, including the adoption of Sovintel's annual budget and business plan as well as the distribution of profits and losses, require the approval of both GTS and Rostelecom. Neither GTS nor Rostelecom are obligated to fund Sovintel's operations or capital expenditures. Losses and profits of Sovintel are allocated to the partners in accordance with their ownership percentages, in consideration of funds at risk. As of March 31, 1998, GTS and Rostelecom have each made equity contributions of $1.0 million to Sovintel. The Sovintel joint venture agreement does not have an expiration date. See "Risk Factors -- Dependence on Certain Local Parties; Absence of Control" and "Management's Discussion and Analysis of Financial Condition and Results of Operations--Accounting Methodology--Profit and Loss Accounting." TCM GTS beneficially owns approximately 50% of TCM, a joint venture founded in 1994 that provides a licensed numbering plan and interconnection to the Moscow city telephone network for carriers needing basic local access service in Moscow. GTS's partners in TCM are MTU-Inform and a group of entrepreneurs with extensive telecommunications experience. TCM is currently licensed to provide 100,000 numbers in Moscow, of which over 60,000 have been leased. In addition, TCM expects to lease an additional 30,000 numbers to VimpelCom, TCM's primary customer, during 1998. TCM is currently negotiating with MGTS for the construction of up to an additional 50,000 numbers and if these negotiations are successfully completed TCM may lease up to 25,000 numbers to VimpelCom in the last three quarters of 1998. Any such construction, however, is subject to completion of negotiations with TCM, obtaining necessary regulatory approvals and the availability of such numbers in the portion of the MGTS numbering plan in which TCM plans to construct such numbers. There can be no assurance that TCM will obtain additional numbers. TCM's switching facilities are fully integrated with the networks of Rostelecom, Sovintel, and MGTS, allowing it to provide high quality digital service to its customers. Services. TCM acts as a local gateway by providing numbers and ports to carriers in Moscow, including Sovintel, VimpelCom, MTS and Moscow Cellular, and thus providing interconnectivity to the Moscow city telephone network. Access to the Moscow city telephone network provides customers with the higher quality and broader range of services available in Moscow, such as the services provided by Sovintel. Access from outlying regions is typically obtained through a domestic long distance service provider such as TeleRoss. See "-- Sovintel" and "-- TeleRoss." Customers and Pricing. TCM provides its services on the wholesale level to primary carriers. VimpelCom is TCM's primary customer and accounts for substantially all of TCM's revenues. Hence the loss of VimpelCom as a customer would have a material adverse effect on the Company. TCM also provides ports to Sovintel and to other network operators. TCM's ports are leased principally to carriers in Moscow. Although local access services are priced upon the basis of supply and demand factors in the local market, in general, for each port cellular operators pay an approximately $360 installation fee and a $15 flat monthly fee plus a per minute charge for traffic while other carriers pay a larger initial fee of approximately $500 and a monthly fee of approximately $25. Local access services are typically provided pursuant to five-year contracts that may be renewed upon expiration for additional one-year periods. TCM has entered into an agreement with Sovintel 59 65 pursuant to which billing and collecting functions for TCM-Sovintel joint customers are performed by Sovintel, with Sovintel remitting such amounts (less applicable settlement charges and administrative costs) to TCM. The rapid growth of cellular services in markets like Moscow has placed a premium on new numbers, which has translated into attractive prices for these numbers. TCM, however, believes these prices will decline over time. Ownership and Control. GTS's indirect interest in TCM is represented by its approximately 52% interest in a holding company, which owns 95% of TCM. This structure provides GTS with 50% beneficial ownership interest in TCM. The Company is currently engaged in negotiations to acquire the ownership interest from the group of entrepreneurs. If such purchase is consummated, the Company would have a 95% interest in TCM. Decisions of the holding company regarding TCM require unanimous board approval and neither GTS nor its partner in the holding company is obligated to fund operations or capital expenditures of the holding company. In addition, neither the holding company nor the TCM shareholders are obligated to fund operations or capital expenditures of TCM. At both the holding company and TCM level, losses and profits are allocated to the partners in accordance with their ownership percentages, in consideration of funds at risk. GTS acquired its indirect, 50% beneficial interest in TCM for approximately $700,000 and certain additional consideration. As of March 31, 1998, GTS had no outstanding loans relating to TCM. None of the operative charters and agreements relating to the holding company or TCM have expiration dates. See "Risk Factors -- Dependence on Certain Local Parties; Absence of Control" and "Management's Discussion and Analysis of Financial Condition and Results of Operations--Accounting--Methodology Profit and Loss Accounting." TELEROSS TeleRoss, which began operations in 1995, consists of a wholly owned subsidiary of GTS that operates a domestic long distance network (the "TeleRoss Operating Company") and fourteen joint ventures that are 50% beneficially-owned by GTS that originate traffic and provide local termination of calls (the "TeleRoss Ventures" and, together with TeleRoss Operating Company, "TeleRoss"). The TeleRoss domestic long distance network serves fifteen major Russian cities, including Moscow and, through VSAT technology, 25 customers located outside these cities. TeleRoss provides digital domestic long distance services and other value-added services through its own infrastructure as well as access to Sovintel's international gateway services and access to the Moscow city telephone network through TCM's switching facilities. Sovam uses the TeleRoss digital channels to provide regional data service and has co-located its access facilities with TeleRoss. As of March 31, 1998, TeleRoss employed approximately 210 persons of which approximately 100 people were based in Moscow and approximately 110 people were deployed in the regions in which TeleRoss operates. TeleRoss's licenses cover the city of Moscow and a total of 39 regions throughout Russia. Most of the fourteen cities in which TeleRoss primarily operates are regional capitals, with an aggregate population of approximately 13 million. TeleRoss's licenses cover the entire oblast surrounding these cities, with populations totaling approximately 41 million persons, and GTS intends eventually to extend the reach of the TeleRoss network beyond the regional capitals to the surrounding areas. The cities in which TeleRoss currently offers its services are: Arkhangelsk, Ekaterinburg, Irkutsk, Khabarovsk, Krasnodar, Nizhni Novgorod, Novosibirsk, Samara, Syktyvkar, Tyumen, Ufa, Vladivostok, Volgograd and Voronezh. The TeleRoss network architecture involves local city switches connected to remote earth stations which communicate via satellite to a Moscow-based hub. This hub consists of the network control center, earth station equipment, multiplexing equipment and a switch. The earth stations, hub and related equipment are owned by TeleRoss, which gives TeleRoss the flexibility to redeploy network assets to other locations as necessary. The hub interconnects to Sovintel's network providing access to Sovam's data networks, TCM's switching facilities and Sovintel's international gateway, which transports international traffic via dedicated international leased satellites and fiber channels and provides access to Rostelecom's long distance networks. Outside of Moscow, TeleRoss's local joint venture partners provide interconnection to the local public telephone networks in each of the cities it serves. In addition to providing services through its network, TeleRoss currently serves 25 customers in additional cities through VSAT technology which links the customers via satellite to the Moscow hub. 60 66 The following table sets forth certain operating data related to TeleRoss's operations:
AT AND FOR THE AT AND FOR THE YEAR THREE MONTHS ENDED ENDED DECEMBER 31, MARCH 31, ------------------- ------------------ 1996 1997 1997 1998 ------- -------- ------- ------- MINUTES OF USE(1) Domestic Minutes (thousands)................. 4,035 23,233 3,227 9,599 Average Rate Per Domestic Minute............. $ 0.99 $ 0.63 $ 0.81 $ 0.53 International Minutes (thousands)............ 272 744 123 242 Average Rate Per International Minute........ $ 2.76 $ 2.47 $ 2.64 $ 2.22 NUMBER OF CITIES SERVED(2)..................... 13 14 13 15 WORLD CONNECT DIAL/RUSSIA Number of Connect Dial Ports................. 472 1,112 716 1,514 Average Revenue Per Port Per Month........... $ 767 $ 370 $ 436 $ 400 MOSCOW CONNECT Number of Ports.............................. 49 78 50 80 Average Revenue Per Port Per Month........... $1,165 $ 1,358 $1,300 $1,409 DEDICATED CIRCUITS Number of Dedicated Channels................. 33 60 77 70 Average Price Per Channel.................... $4,553 $ 4,140 $5,504 $3,428 WORLD ACCESS SERVICE Number of World Access Card Users............ 3,929 4,595 4,317 4,708 Average Revenue Per Card Per Month........... $ 52 $ 48 $ 54 $ 43 VSAT SERVICES Number of VSATs.............................. 12 24 15 25
- - - - --------------- (1) Includes minutes among affiliates. (2) Includes connection to Moscow. Services. Through its network and VSAT offerings, TeleRoss offers the following services: - Carriers' Carrier Services. TeleRoss provides services as a "carriers' carrier," providing domestic long distance carrier services to cellular operators, Sovintel, the TeleRoss Ventures' regional partners and competitive bypass operators from the cities in which the TeleRoss Ventures operate, and to customers in remote cities using VSAT stations. These services are provided to and from Moscow, and are provided by TeleRoss at wholesale rates competitive with those offered by Rostelecom. TeleRoss also provides private line channels to Sovam in cities where the TeleRoss Ventures operate. In addition, TeleRoss has recently received a license to provide international private line service. - World Connect Dial/Russia Connect Dial. Customers in TeleRoss's cities are provided dedicated local access to the regional TeleRoss switch through lines leased from the TeleRoss Venture's regional joint venture partner. These customers then have access to the domestic long distance service provided by TeleRoss, international long distance service provided by Sovintel and are fully integrated into the local phone networks operated by the applicable TeleRoss Venture's partner and to the Moscow city telephone network through TCM. - Moscow Connect. Customers are provided with dedicated last mile connection over lines leased from the regional joint venture partner which lines are connected to a local TeleRoss switch. The TeleRoss network and its interconnection to TCM provide customers with a Moscow dial tone which allows users in remote locations better access to Moscow's advanced telecommunications infrastructure. In addition, Moscow Connect service provides better call quality at lower rates for domestic and international long distance. Moscow Connect also facilitates communications between users and their Moscow-based associates as calls can be made to and from Moscow without the use of prefixes and without long distance charges accruing to the Moscow-based parties. 61 67 - Dedicated Circuits. Customers are provided with point-to-point clear channel circuits within Russia and internationally through the TeleRoss backbone and its interconnection with Sovintel's international gateway in Moscow. Dedicated circuits are generally used by news services, banks and other commercial customers who require high capacity and high quality service. This service can be used for voice or data, depending on the user's needs. In providing dedicated circuits, TeleRoss competes against other alternative communications providers, however, TeleRoss believes that it has a distinct price advantage over its competitors because of the use of its own infrastructure and the bulk purchase of satellite capacity. - World Access Service. TeleRoss and Sovintel co-market World Access Service to their customers in each of the cities they serve through two products: World Access Direct and World Access Card. Through World Access Direct, TeleRoss customers can access domestic long distance and international service anywhere within the customer's city through the local telephone network. The World Access Card is a calling card which allows TeleRoss customers portable access to domestic long distance and international service from 16 Russian cities, including Moscow and St. Petersburg, and 23 countries. This service is provided through Sovintel's infrastructure. - VSAT Services. For customers that are located outside the cities serviced by TeleRoss or that cannot be physically linked to TeleRoss's regional switches, TeleRoss offers VSAT service which connects these customers directly to TeleRoss's Moscow-based hub through a VSAT antenna installed at the customer's location. Both dedicated and switched services are provided through these VSAT arrangements. In addition to continuing the development of its core domestic long distance business, TeleRoss's strategy includes the development of local access networks to capitalize on demand for local phone service and to capture additional customers for its long distance and value-added service offerings. Outside Moscow, TeleRoss has primarily pursued a strategy whereby it develops its own intra-city trunking network with copper based or fiber optic facilities leased from the regional joint venture partners. As of March 31, 1998, TeleRoss, in conjunction with regional joint venture partners, has installed approximately 30 kilometers of fiber optic cable in three cities and plans to install an aggregate of approximately 100 kilometers of additional fiber optic cable in up to an additional 6 cities over the next 21 to 27 months. Customers who obtain local phone numbers from TeleRoss's venture partners are directly interconnected to the local telephone company and to the Company's long distance network and Sovintel's international gateway and may obtain a broad range of value-added services offered by the Company. Customers and Pricing. TeleRoss's customers include businesses and other telecommunications service providers such as carriers, PTOs, cellular operators, Sovintel and Sovam. TeleRoss's business customers consist of large multinational and Russian businesses in each of the regions it services, as well as medium and small-sized businesses. Between 1993 and mid-1996, consumer prices in TeleRoss's industry increased significantly as a result of Rostelecom raising its prices in an effort to raise capital for investment and development of its network infrastructure, although prices have stabilized over the past nine months and Rostelecom has indicated that it plans to decrease prices by up to 10% during 1998. During the first quarter of 1998, TeleRoss increased sales to carriers, which sales were made at wholesale rates, resulting in a decrease in the average rate per minute for TeleRoss. TeleRoss strategically prices its domestic long distance services at a slight premium over similar services offered by Rostelecom to account for a higher quality of service, but in line with the prices offered by regional competitors. Sales and Marketing. TeleRoss markets its services to carriers and businesses through direct sales channels. As of March 31, 1998, TeleRoss employed 31 sales and marketing personnel, approximately half of which are based in Moscow with the other half deployed regionally to identify and contact prospective customers. The Moscow-based sales and marketing personnel are organized into industry groups in order to better identify and serve customer needs. Each region is typically served by one or two sales representatives. TeleRoss's sales efforts are supported by market research and promotional activities carried out at the joint venture level and tailored to the specific market base of each region. TeleRoss's marketing strategy is to attract carrier customers by focusing on those carriers with high volume minutes operating in regions where TeleRoss 62 68 has a competitive advantage. Through cross-marketing agreements with Sovintel and Sovam, TeleRoss markets many of the other service offerings of GTS's Russian businesses to customers throughout its service regions. Billing functions and the monitoring of quality control and technical issues are performed centrally through the Moscow-based hub. Ownership and Control. TeleRoss consists of the TeleRoss Operating Company, and the 50% beneficially owned TeleRoss Ventures. GTS controls TeleRoss Operating Company (which holds the network license) and co-manages the TeleRoss Ventures under the terms of the applicable TeleRoss Ventures' foundation agreements and charters. Under some of these charters, GTS generally has the right to designate the Chairman of the board of directors, and GTS's local partner has the right to designate the Deputy Chairman, for the first two-year term (and thereafter GTS and the local partner nominate the Chairman and Deputy Chairman for approval by the entire board on a rotating basis). The foundation agreements and charters do not have expiration dates. While GTS has significant influence within these ventures, decisions, including the decision to declare and pay dividends, are generally subject to GTS's partner's approval. See "Risk Factors -- Dependence on Certain Local Parties; Absence of Control." Neither GTS nor its respective joint venture partners are obligated to fund operations or capital expenditures of the TeleRoss Ventures. Losses and profits are allocated to the partners in accordance with their ownership percentages, in consideration of funds at risk. As of March 31, 1998, GTS and its partners had each made equity contributions aggregating $1.9 million to the various TeleRoss Ventures. Contributions made by the partners include contributions of cash and intangible assets, such as licenses. In addition, the various TeleRoss Ventures had outstanding loans and interest of $2.1 million to GTS and $0.45 million to Citibank as of March 31, 1998. In addition, as of March 31, 1998, GTS had made equity contributions of $5.8 million to the TeleRoss Operating Company and the TeleRoss Operating Company had outstanding loans and interest of $32.7 million to GTS and $4.7 million to Citibank. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Accounting Methodology -- Profit and Loss Accounting." SOVAM Sovam is a venture that is wholly owned by GTS. Sovam was founded in 1990 as a venture equally owned by GTS and the Institute for Automated Systems ("IAS"). In 1992, Cable & Wireless acquired a 33% ownership interest in Sovam, which interest was subsequently acquired by GTS in 1994, bringing GTS's ownership interest to 66.7%. GTS purchased IAS's interest in Sovam in February 1998, thereby making Sovam a wholly owned subsidiary of GTS. Sovam provides high-speed data communications services, electronic mail and database access over a high-speed packet/frame relay network in 34 major Russian and CIS cities. Sovam also offers Russia On Line, the first Russian language Internet service, which provides direct access to the Internet as well as access to a wide range of local and international information services and databases. (Russia On Line(TM) is a trademark of the Company.) As of March 31, 1998, Sovam had approximately 1,541 data service customers and approximately 4,560 Russia On Line customers (which includes approximately 890 trial subscribers). Sovam employed approximately 148 persons in Moscow and other regions of the CIS as of March 31, 1998. Sovam provides equipment and maintains marketing and technical support personnel at each location either through its own infrastructure or through the infrastructure of partners, including TeleRoss. In addition to serving the Moscow and St. Petersburg markets, Sovam co-locates its operations with the TeleRoss Ventures, offering its services in all TeleRoss cities, and also serves 21 additional cities in Russia and the CIS. Sovam operates under its own license within Russia while services elsewhere in the CIS are provided through applicable local partner licenses. The local partners of the TeleRoss Ventures provide facilities, assist in the provision of leased lines to Sovam customers that allow them to connect with Sovam's local data switches and also provide technical support. Sovam utilizes Sovintel's international capabilities and, in TeleRoss-served locations, TeleRoss's satellite overlay network, to take data through its local data switches and over the leased lines to its customers. Customers may obtain virtual private data networks without investing in, acquiring, installing and maintaining their own network nodes and switches. 63 69 The following table sets forth certain operating data related to Sovam's operations:
AT AND FOR THE AT AND FOR THE YEAR ENDED THREE MONTHS ENDED DECEMBER 31, MARCH 31, -------------------------- ------------------ 1995 1996 1997 1997 1998 ------ ------ ------ ------- ------- BASIC DATA SERVICE Percentage of Total Sovam Revenue... 91% 79% 81% 80% 79% Number of Customers................. 1,587 1,726 1,571 1,779 1,541 Average Revenue Per Month Per Customer......................... $ 201 $ 446 $ 728 $ 554 $ 940 Number of Cities in Service......... 11 25 30 27 34 EQUIPMENT AND HARDWARE SALES Percentage of Total Sovam Revenue... 8% 14% 8% 10% 10% RUSSIA ON LINE SERVICE Percentage of Total Sovam Revenue... 1% 7% 11% 10% 11% Number of Subscribers(1)............ 407 1,854 3,159 2,751 3,666 Average Revenue Per Month Per Subscriber....................... $ 49 $ 52 $ 64 $ 49 $ 63
- - - - --------------- (1) In addition to the subscribers included above, Sovam frequently connects potential Russia On Line subscribers on a complimentary one-month trial basis. As of March 31, 1998, there were approximately 894 such potential subscribers. Services. Sovam's service offerings are comprised of data services, equipment and hardware sales and its Russia On Line services. - Data Services. Sovam provided high speed connectivity, electronic mail, database access and fax services to approximately 1,541 customers as of March 31, 1998, in Russia and the CIS. Sovam customers can use electronic mail systems to send and receive messages and data and to access public and private data networks (including the Internet) worldwide. Customers may obtain virtual private data networks without investing in, acquiring, installing and maintaining their own network nodes and switches. In addition, Sovam offers its customers value-added data services. For example, Sovam offers "one-stop shopping" for hardware, software, installation and maintenance support and products such as "SovamMail," an e-mail service which allows customers to use Sovam's data network to send telex or facsimile messages to overseas recipients worldwide. Data services are currently available in 34 cities throughout Russia and the CIS, including Moscow, St. Petersburg, each of the cities served by TeleRoss and some cities outside of the TeleRoss network. - Equipment and Hardware Sales. Sovam sells communications equipment and hardware, and provides related installation, maintenance and support functions, to its customers. Sovam's primary customers in the equipment and hardware market are banking clients who use the equipment to interface with Sovam's network. - Russia On Line. Russia On Line is the first Russian language, as well as the first dual language, graphical user interface online service for accessing domestic and international information sources designed to appeal to a wide commercial audience. This service, which is distributed via GTS's domestic long distance infrastructure, provides customers with access to international databases (including the Internet), as well as an array of proprietary Russian and English language information services, such as news stories and market updates. Sovam had 4,560 Russia On Line subscribers (which includes approximately 894 trial subscribers) as of March 31, 1998. Sovam has developed a modified version of Netscape's Internet browser, which utilizes the Cyrillic alphabet, as part of its Russia On Line package. Sovam's enhanced Russian version of Netscape's browser is provided by Sovam to its customers under a distribution agreement with Netscape. In addition, Sovam has also 64 70 entered into agreements with equipment manufacturers, including an affiliate of Motorola, to include Russia On Line software with their products. Customers and Pricing. Sovam's data communications customers consist primarily of banking and financial services organizations and large multinational companies, while Sovam's Russia On Line customers consist of a wide variety of commercial enterprises. Sovam charges customers an installation fee when service is commenced and a charge for any equipment which is installed. Thereafter, customers are billed on a monthly basis for leased line fees, port access charges and charges for data and Russia On Line services rendered during the month. Data services are priced on a two-tier structure with high volume users generally negotiating a flat-rate fee and lower volume users paying a volume-based fee which on average was $446 and $728 per subscriber in 1996 and 1997, respectively. Russia On Line customers pay a fixed monthly access charge plus an additional volume-based fee. Customers are billed in dollars and payment is remitted in rubles and, to the extent permitted by law, in dollars, with a 2% to 5% conversion fee added to ruble-denominated payments. Sales and Marketing. Sovam employs a dedicated sales and marketing force comprised of three non-Russian nationals and 30 Russian nationals, 25 of which are based in Moscow with the remainder deployed in the other Russian and CIS regions. Salespersons are paid a fixed salary supplemented by sales commissions and performance-based bonuses. Sovam's sale efforts are focused primarily on the banking and financial communities and large multinational companies, although small and medium sized entities are also emerging as potential Sovam customers. Bundled service packages, which include Sovam's data and Internet service, Sovintel's international service and TeleRoss's long distance service, are frequently marketed together in order to offer customers a comprehensive telecommunications solution. In addition to data communications services, Sovam offers its customers hardware, installation and maintenance service and is a distributor of Northern Telecom equipment. Ownership and Control. At December 31, 1997, GTS owned 66.7% of Sovam and IAS owned the remaining 33.3%. GTS purchased IAS's interest in Sovam in February 1998, thereby making Sovam a wholly owned subsidiary of GTS. See "Management's Discussion and Analysis of Financial Condition and Results of Operation -- Accounting Methodology -- Profit and Loss Accounting." GTS CELLULAR GTS Cellular operates three cellular businesses in Russia and Ukraine. In Russia, GTS has a wholly owned subsidiary Vostok Mobile (which is organized in The Netherlands), which currently operates twelve AMPS cellular companies in Russian regions west of the Urals under the trade name Unicel. Vostok Mobile owns between 50% and 70% of these cellular joint ventures (the "Unicel Ventures") in Russia. In addition, GTS intends to enter into the cellular markets of additional Russian regions through its Vostok Mobile venture. GTS also participates in PrimTelefone, a 50% owned joint venture that operates an NMT network in Vladivostok and four other cities in the Primorsky region of Russia. In Ukraine, GTS has an approximately 24% beneficial interest in Bancomsvyaz which operates a GSM (DCS-1800) cellular network in Kiev, and an international overlay network in Ukraine. GTS Cellular entities possess licenses covering major Russian and Ukrainian markets (excluding Moscow and St. Petersburg) with an aggregate 1997 population of approximately 28 million people. The Company is currently engaged in negotiations to restructure the capital and ownership of Bancomsvyaz. 65 71 GTS currently offers cellular services in the following regions as of March 31, 1998:
GTS'S OPERATING ECONOMIC NUMBER OF COMPANY INTEREST(1)(2) CITY SUBSCRIBERS --------- -------------- ---- ----------- RUSSIA Vostok Mobile(2) Arkhangelsk Mobile Networks.......... 50.0% Arkhangelsk 706 Astrakhan Mobile..................... 50.0% Astrakhan 1,370 Altaisvyaz(3)........................ 50.0% Barnaul 199 Chuvashi Mobile...................... 70.0% Cheboksary 1,348 Lipetsk Mobile....................... 70.0% Lipetsk 1,610 Murmanskaya Mobilnaya Set............ 50.0% Murmansk 1,607 Penza Mobile......................... 60.0% Penza 818 Saratov Mobile....................... 50.0% Saratov 2,218 Parma Mobile......................... 50.0% Syktyvkar 522 Volgograd Mobile..................... 50.0% Volgograd 1,912 Votec Mobile......................... 50.0% Voronezh 2,266 Mar Mobile........................... 50.0% Yoshkar-ola 549 PrimTelefone............................ 50.0% Vladivostok(4) 6,980 UKRAINE Bancomsvyaz............................. 24.0%(5) Kiev 5,401 ------ Total........................... 27,506 ------
- - - - --------------- (1) Represents the indirect economic interest of GTS in each entity. (2) Prior to September 26, 1997, GTS owned 62% of Vostok Mobile. On September 26, 1997, GTS acquired the minority interest in Vostok Mobile, making Vostok Mobile a wholly owned subsidiary of GTS. Vostok Mobile owns between 50% and 70% of a series of 12 operational cellular joint ventures in various regions in Russia. As of March 31, 1998, the subsidiaries of the Company have obtained licenses to act as a cellular operator in the cities of Bryansk, Kostroma, Yaroslavl and Novgorod. As of March 1998, the Company has not yet begun to provide services in these cities. Moreover, GTS intends to enter into the cellular markets of additional Russian regions through its Vostok Mobile venture. (3) Joint venture acquired in October 1997; cellular operations commenced in February 1998. (4) Includes Vladivostok and four other cities in the Primorsky region. (5) The Company is currently implementing a restructuring of the capital and ownership of Bancomsvyaz. 66 72 The following table sets forth certain operating data related to GTS Cellular's operations:
AT AND FOR THE AT AND FOR THE THREE MONTHS YEAR ENDED ENDED DECEMBER 31, MARCH 31, ------------------ ----------------- 1996 1997 1997 1998 ------- ------- ------- ------- Vostok Mobile Total Subscribers............................ 6,884 13,561 7,763 15,125 Average Revenue Per Subscriber Per Month..... $ 128 $ 146 $ 135 $ 108 Minutes of Use(1)(thousands)................. 10,561 27,771 5,302 8,453 Population Covered by Licenses (thousands)... 18,400 18,400 18,400 21,100 Population Covered by Networks (thousands)... 6,500 6,500 6,500 6,800 Subscriber Penetration of Population Covered by Networks............................... 0.11% 0.21% 0.12% 0.21% PrimTelefone Total Subscribers............................ 2,822 6,152 3,344 6,980 Average Revenue Per Subscriber Per Month(2).................................. $ 236 $ 188 $ 192 $ 186 Minutes of Use(1)(thousands)................. 6,919 14,270 2,453 5,697 Population Covered by Licenses (thousands)... 2,200 2,270 2,200 2,270 Population Covered by Networks (thousands)... 1,175 1,175 1,175 1,175 Subscriber Penetration of Population Covered by Networks(2)............................ 0.24% 0.52% 0.28% 0.59% Bancomsvyaz Cellular Network Total Subscribers........... 121 3,664 424 5,401 Average Revenue Per Subscriber Per Month..... $ 62 $ 160 $ 172 $ 130 Minutes of Use(1)(thousands)................. 9 5,085 266 5,302 Population Covered by Licenses (thousands)... 4,500 4,536 4,500 4,536 Population Covered by Networks (thousands)... 1,669 2,507 1,669 2,507 Subscriber Penetration of Population Covered by Networks............................... 0.01% 0.15% 0.02% 0.22% Overlay Network Minutes of Use(1)(thousands)................. -- 4,909 130 3,299 Number of Ports.............................. -- 751 150 1,092 Average Revenue Per Minute................... -- $ 0.34 $ 0.58 $ 0.28
- - - - --------------- (1) Includes minutes among affiliates. (2) Operating data is calculated using active subscribers only. Vostok Mobile. Through Vostok Mobile, GTS currently operates twelve cellular joint ventures in Russia. Vostok Mobile owns between 50% and 70% interests in each of the twelve Unicel Ventures with, in most cases, regional telephone companies, owning the remaining ownership interest. The Unicel Ventures each operate an AMPS-based cellular network, which was chosen principally because of the lower licensing fees and equipment costs associated with AMPS operations. The Company believes that the Unicel Ventures' AMPS-based networks can be upgraded to digital AMPS ("D-AMPS") for an incremental capital investment. Cellular networks which utilize digital technology, such as D-AMPS, DCS and GSM offer several advantages over analog technology including improved overall signal and sound quality, improved call security, potentially lower incremental infrastructure costs for additional subscribers and the ability to provide enhanced data transmission services, such as facsimile and e-mail. Digital technology also provides increased system capacity. The ventures intend to convert to D-AMPS at such time as there exists sufficient competitive pressures and/or market demand for digital services to merit the additional investment. AMPS technology is widely used by other cellular networks throughout Russia, making roaming commercially feasible. The Unicel Ventures have entered into roaming agreements with other AMPS-based cellular providers, which allow their subscribers to manually roam throughout Russia. Manual roaming, as opposed to automated roaming, requires subscribers to notify their local cellular providers of their travel plans in order to receive roaming capability. Vostok Mobile and VimpelCom have agreed upon automated roaming 67 73 standards and Vostok Mobile expects automated roaming to be available to its subscribers during the second half of 1998 although the introduction of such service may be delayed or even suspended as a result of the RFCCI Letter as described below. On June 10, 1998, Vostok Mobile received a letter from the Russian Federation Committee for Communications and Information (the successor to the MOC) (the "RFCCI") addressed generally to the management of cellular operators utilizing the AMPS and D-AMPS standards. The RFCCI Letter stated that the offering of roaming services by such operators does not comply with the Concept for the Development of Mobile Radio Communications in Russia by the Year 2010 (the "Concept") and the Main Provisions on the Prospects of Developing an Interconnected Network of the Russian Federation by the Year 2005 (the "Main Provisions"), as approved in two decisions of the Russian State Commission on Electrosvyazes in 1994 and 1995. The RFCCI Letter proposes that (i) such operators strictly observe the Concept until 2010 and (ii) the State Communications Supervision Committee consider roaming activity by such operators to be in violation of their licenses and undertake measures to halt such roaming activity, including terminating interconnections necessary for such roaming. The Company is in the process of evaluating the implications of the RFCCI Letter. Although the matter is not free from doubt, the Company believes, based on its preliminary review, that the Concept and the Main Provisions referred to in the RFCCI Letter represent policy statements rather than legally binding legislative pronouncements. However, the RFCCI Letter may signal a potential future change in the application of Russian telecommunications policy toward the provision of roaming services by AMPS and D-AMPS based cellular providers. The Company intends vigorously to contest the positions expressed in the RFCCI Letter, particularly if actions are initiated to curtail the roaming services that the Unicel Ventures currently offer. Currently, revenues derived from roaming services do not represent a significant portion of Vostok Mobile's total revenue. The Company is unable to predict whether and in what form the positions set forth in the Letter will be implemented as new regulation or directly applied as a basis for suspension, revocation or renewal of current licenses in whole or in part. If regulations were adopted implementing the positions set forth in the RFCCI Letter, or other actions were taken to directly apply such positions, such regulations or actions could adversely affect the Unicel Ventures' ability to compete with GSM or NMT-based cellular providers not bound by any such prohibition on roaming activities applicable to operators using the AMPS and D-AMPS standard. There can be no assurance that such regulation will not be adopted or such actions will not be taken and that, if adopted they, will not have a material adverse effect on Vostok Mobile or the Company. See "Risk Factors -- Risks Relating to Russia and the CIS -- Regulation of the Telecommunications Industry," "Business -- Russia and the CIS -- Licenses and Regulatory Issues" and "Competition." The Unicel Ventures, collectively, are licensed to provide cellular service to regions with an aggregate population of approximately 21.1 million people and the cellular networks of these ventures cover populations of approximately 6.8 million people. Over the next five years, Vostok Mobile plans to expand the coverage of the cellular networks to approximately 9.8 million people. Each region in which the Unicel Ventures operates, has the potential for five licensed operators, including one operator for each of the AMPS, NMT and GSM cellular standards and two operators in the DCS cellular standard, and the Company is experiencing increased competition and expects such competition to increase further. Each of the Unicel Ventures operates independently within uniform guidelines established by Vostok Mobile. The Unicel Ventures employ local engineering and marketing personnel, which helps the ventures maximize their presence in their respective markets and maintain quality control. Vostok Mobile and its ventures employed approximately 386 persons as of March 31, 1998, with 340 persons employed regionally. PrimTelefone. GTS's cellular operations in Vladivostok are conducted through PrimTelefone, a 50% owned GTS subsidiary, with the local electrosviaz owning the remaining 50%. PrimTelefone began operations in 1995 and operates an NMT-450 network in Vladivostok and four other cities in the Primorsky region. PrimTelefone entered and penetrated the Vladivostok market by leveraging its network design and full interconnection with the city telephone network. As a result, PrimTelefone's total subscriber base has grown to 6,980 (including 5,708 active subscribers) as of March 31, 1998, capturing half of the Vladivostok cellular market. PrimTelefone has also updated its billing system, which allows it to offer automated roaming. PrimTelefone competes with a GSM operator and an AMPS operator, both of which are fully interconnected 68 74 to the city telephone network and provide wide city coverage. PrimTelefone employs approximately 62 persons which include dedicated sales, marketing and customer service personnel. PrimTelefone holds a license to provide cellular service to a region having a population of approximately 2.3 million people and, as of March 31, 1998, its cellular network covered an area with a population of approximately 1.2 million people. PrimTelefone plans to expand its network's coverage to approximately 1.7 million people over the next five years. Bancomsvyaz. GTS owns a 50% economic interest in an intermediate holding company which holds an approximately 48% interest in Bancomsvyaz, giving GTS an indirect approximately 24% economic interest in Bancomsvyaz. The remaining approximately 52% interest in Bancomsvyaz is owned by three Ukrainian companies and a Ukrainian national. One of the Ukrainian companies, which is a wholly owned indirect subsidiary of GTS, owns 20% of Bancomsvyaz. The Company is currently implementing a restructuring of the capital and ownership of Bancomsvyaz which will result in the GTS intermediate holding company purchasing the Ukrainian national's interest in Bancomsvyaz, thereby increasing such holding company's interest in Bancomsvyaz to 49% and GTS's interest in Bancomsvyaz to approximately 69%. Bancomsvyaz is co-managed by GTS and its Ukrainian partners, with such partners appointing the General Director and GTS appointing the Chief Operating Officer, Chief Financial Officer and two Business Line directors. The current General Director has been active in the development of the telecommunications industry in Ukraine. Through Bancomsvyaz, GTS participates in the operation of a cellular network and an international overlay network. With approximately 122 employees, Bancomsvyaz markets its services and closely monitors technical and quality-related issues. Cellular network. Bancomsvyaz operates a cellular network in Kiev under the trade name Golden Telecom GSM. The operation utilizes DCS-1800 cellular technology and operates under a cellular license that covers Kiev City and Kiev Oblast. Bancomsvyaz began cellular operations in 1996 by covering the city center of Kiev and expanded its coverage to include the entire city in 1997. Bancomsvyaz provides GSM cellular roaming with the UK, France, Germany, and the United States in addition to fourteen other GSM countries. Roaming agreements have also been signed with another fourteen operators and the Iridium consortium. Bancomsvyaz holds a license to provide cellular service to a region having a population of approximately 4.5 million people and, as of March 31, 1998, its cellular network covered an area with approximately 2.5 million people. Bancomsvyaz plans to expand its network's coverage to approximately 3.2 million people over the next five years. Overlay network. Bancomsvyaz provides local exchange carrier services and international gateway services through its overlay network in Kiev. Bancomsvyaz currently owns and operates a partitioned mobile switch for both its cellular and overlay businesses. A second switch, to be commissioned in July, has been ordered. All future overlay traffic will be on this switch. Bancomsvyaz has fourteen central offices in the city and also provides last mile connections (both copper and fibre optic) from the central offices to customers. A 24 kilometers fiber optic ring has been constructed in Kiev. By year end it is planned to incorporate three additional rings bringing the total fiber optic network to 69 kilometers. Local traffic is routed to the local telephone network. International outgoing and income traffic is routed via fiber optic cable to the GTS-Monaco Access international gateway and Sovintel in Moscow. Bancomsvyaz emphasizes its high quality service and markets primarily to multinational companies, real estate developers and hotels. Bancomsvyaz is also negotiating with several international operators to provide other access routes for international outgoing and incoming traffic. Sales and Marketing. The GTS Cellular entities have direct sales teams and have also entered into agreements with local distributors to more effectively reach their target markets. Particular emphasis is placed on product branding. Vostok Mobile's sales and marketing efforts are focused on the branding of its trade name, Unicel, which is marketed and promoted at the local level by each of the Unicel Ventures. By promoting the Unicel trade name, local ventures can emphasize their relationships with Vostok Mobile and the other Unicel Ventures, allowing customers to view the Unicel Ventures as integrated parts of a large 69 75 cellular organization rather than as lone, independent operators. Bancomsvyaz operates under the trade name Golden Telecom. Customers and Pricing. GTS Cellular's customers are primarily large, mid-sized and start-up businesses and wealthy individuals. Increases in the number of customers for GTS Cellular's ventures is typically linked to the economic health of the region in which such venture operates. Cellular service is generally a premium service in the cities in which GTS Cellular operates and is priced as such. Each venture begins with at least two tariff plans, a "standard" tariff plan and a "premium" tariff plan, which includes a fixed amount of airtime at a discounted per-minute rate. Each plan prices late night and weekend calls at off-peak rates. The Company expects that prices will decrease as competition increases. Connection fees are minimized in order to reduce license fees in AMPS regions (which are partially calculated by reference to connection fees), as well as to keep market entry costs low. GTS Cellular has benefited from high margins generated by the sale of handsets, which are marked up in line with other cellular operators in Russia and the CIS. Value-added services, such as call forwarding and conference calling, when available, are priced nominally and discounted when sold in packages. Cellular accounts are recorded in dollars and customers remit payment in rubles at the exchange rate on the date of the bill and, in instances permitted by law, in dollars. Payments in rubles are applied at the rate of exchange on the date of payment. In order to lessen risks to its receivables, the Company and its cellular ventures require advance payment from all customers with prepayments averaging approximately $200 per customer or six to eight weeks of service. Ownership and Control. GTS Cellular's Russian operations (except for the Vladivostok operations) are conducted through ventures that are owned between 50% and 70% by Vostok Mobile, a wholly owned subsidiary of GTS. GTS Cellular's Vladivostok and Ukrainian operations are conducted through ventures which require partner approval for most decisions. The applicable foundation agreements and charters do not have expiration dates. See "Risk Factors-- Dependence on Certain Local Parties; Absence of Control." Neither GTS nor any of its respective partners in its Vladivostok or Ukrainian operations are obligated to fund operations or capital expenditures. Losses and profits of all such ventures are allocated to the partners in accordance with their ownership percentages, in consideration of funds at risk. As of March 31, 1998, GTS and its partners had made equity contributions aggregating $15.8 million and $15.3 million, respectively, to the various GTS Cellular Ventures. Contributions made by the partners include contributions of cash and intangible assets, such as licenses. In addition, the various GTS Cellular Ventures had outstanding loans of $21.5 million to GTS as of March 31, 1998. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Accounting Methodology -- Profit and Loss Accounting." LICENSES AND REGULATORY ISSUES Telecommunications operators in Russia are nominally subject to the regulations of the Regional Communications Committee (the "RCC"). As a practical matter, national telecommunications authorities of the individual CIS countries and certain regional and local authorities generally regulate telecommunications operators in their markets through their power to issue licenses and permits. The Communications Law sets out a comprehensive legal and regulatory framework for the sector. It also sets forth general principles for the right to carry on telecommunications activities, describes government involvement in telecommunications regulation and operation, establishes the institutional framework involved in regulation and administration of telecommunications, and deals with various operational matters, such as ownership of networks, protection of fair competition, interconnection, privacy and liability. This institutional framework is implemented by separate legislation. Licenses to provide telecommunications services are issued by the MOC on the basis of a decision by the Licensing Commission at the MOC. No new licensing regulations have been issued since the enactment of the Communications Law and in practice the MOC continues to issue licenses based on the Licensing Regulations. Under the Licensing Regulations, licenses for rendering telecommunications services may be issued and renewed for periods ranging from 3 to 10 years and several different licenses may be issued to one person. Once the licenses are received, the licensee is required to register its right to hold and operate under the license with Gossvyaznadzor, the national authority responsible for monitoring compliance with regulatory 70 76 and technical norms. Renewals may be obtained upon application to the MOC and verification by appropriate government authorities that the licensee has conducted its activities in accordance with the licenses. Officials of the MOC have fairly broad discretion with respect to both the issuance and renewal procedures. Both the Communications Law and the Licensing Regulations provide that a license may not be transferred. However, regional authorities are sometimes in a practical position to limit these national authorities. In August 1995, the Russian government created Svyazinvest, a holding company, to hold the federal government's interests in the majority of Russian local telecommunications operators. Such entities at the oblast and krai levels (administrative regions within Russia) and two cities -- Moscow and St. Petersburg -- exercise significant control over their respective local telephone networks. License procedures for the Company's cellular services include frequency licensing from the MOC through a two step process. A license must first be obtained from the MOC for permission to operate mobile cellular services on a commercial basis in a specific standard and frequency bandwidth. Thereafter, an approval to use specific frequencies within the band must be received from the State Radio Frequencies Commission. Once the licenses are received, Gossvyaznadzor confirms the rights of an operator to offer radio frequency transmissions on specific frequencies, administers type acceptance procedures for radio communications equipment and monitors compliance with licensing constraints. In each instance, the Company is required to obtain additional licenses and permits with respect to the use of equipment and the provision of services. Telecommunications laws and regulations in Ukraine are similar in many respects to those of Russia but are subject to greater risks and uncertainties. Regulations currently prohibit foreign entities from directly owning more than 49% of any telecommunications operating company. GTS's Ukrainian joint venture agreements provide it with the option of purchasing an additional one percent of the cellular network if these rules are liberalized. The Ukrainian government has required substantial frequency permit fees in connection with providing GSM service in Ukraine, and has notified Bancomsvyaz that it has levied a $2.9 million frequency license fee on Bancomsvyaz's license. At this time, the Company has been granted an extension until July 1998 for payment of such fee, and there is a possibility this fee may be reduced. Issuance of this license is contingent on the payment of such fee. The Company does not believe the outcome will have a material adverse effect on the Company. There can be no assurance that additional fees will not be imposed in the future. GTS's subsidiaries and ventures hold the following licenses in Russia and Ukraine: Switched Services. In Russia, the Company holds two licenses. The first license was reissued to Sovintel in November 1996 and authorizes Sovintel to operate as an international overlay network with the ability to interconnect with the Moscow region and St. Petersburg public switched telecommunications network ("PSTN"). This license ultimately requires Sovintel to provide service to at least 50,000 subscribers and expires in May 2000. It was amended in February 1997 to cover the Leningrad region. The second license was reissued to SFIT, Ltd., a wholly owned subsidiary of GTS in February 1997, for provision of intercity services in 39 regions and in Moscow with ability to interconnect with the PSTN. In Kiev, Ukraine, the company holds a license for provision of overlay network services, including international services, in the name of its affiliate, Bancomsvyaz. In addition, Sovintel is an ITU recognized private operating agency ("RPOA"), which enables it to maintain a separate dialing code (7-501) that can be directly dialed from over 170 countries. Sovintel's status as an RPOA also enables it to terminate calls directly with other operators. Leased Circuits. In September 1996 the MOC issued to Sovintel a five-year license to lease local, intercity and international circuits in the territory of Moscow, Moscow region and St. Petersburg, valid until September 2001. The total number of circuits leased is approximately 500 and may be increased up to a total authorized capacity of 2,500. Data Services. In August 1996, the MOC reissued to Sovam a 2 1/2-year license, effective July 1996, to provide data transmission services via a dedicated network to a number of oblasts and other regions covering a large portion of Russia. The license permits a network capacity of not less than 5,000 customers, allows it to interconnect with other data transfer networks in Russia, and expires January 1, 71 77 1999. The Company's purchase of IAS's 33.3% interest in Sovam requires that Sovam re-register its license. The Company expects that the license will be re-registered. Local Access Services. In January 1997, the MOC has licensed TCM to provide local telephone service in Moscow to not less than 100,000 subscriber local access lines. The license expires in May 2006. TCM is currently negotiating with MGTS to provide up to an additional 50,000 numbers. This would require an extension to its license, when its current capacity is reached. Cellular Services. In connection with cellular operations, Russian law apportions the responsibility for regulating and licensing cellular businesses between national and regional regulators. National telecommunications regulators have been assigned the responsibility of regulating and licensing cellular businesses utilizing the GSM and NMT-450 cellular standards prevalent in Europe. These regulators have auctioned licenses to provide these services to a number of ventures that have included large, well capitalized western telecommunications providers such as U S WEST and Nokia during the last four years. Regional telecommunications authorities have been given the rights to supervise the observance of licenses by cellular businesses utilizing AMPS cellular standard service, which is prevalent in the United States. However, AMPS licenses are issued by the MOC. GTS believes that, in many instances, cellular operators obtaining AMPS standard licenses, particularly those in second tier cities, pay license fees that are lower than those paid for the GSM and NMT-450 "national standards". Licenses for cellular providers have a term of approximately 10 years. The Company's thirteen Russian cellular companies have licenses which expire between 2005 and 2007. One of the companies initially received an operating license in 1994, six companies initially received an operating license in 1995, five companies initially received an operating license in 1996 and one company initially received an operating license in 1997. Additionally, Vostok Mobile has received licenses for four cities where it intends to begin operations later this year. On June 10, 1998, Vostok Mobile received the RFCCI Letter addressed generally to the management of cellular operators utilizing the AMPS and D-AMPS standards. The RFCCI Letter stated that the offering of roaming services by such operators does not comply with certain normative documents referenced in the letter and is in breach of the licenses granted to such operators. The Company is in the process of evaluating the implications of the RFCCI Letter. Although the issue is not free from doubt, the Company believes, based on its preliminary review, that the "normative documents" referred to in the Letter represent policy statements rather than legally binding legislative pronouncements. However, the RFCCI Letter may signal a potential future change in the application of Russian telecommunications policy toward the provision of roaming services by AMPS and D-AMPS based cellular providers. See "Risk Factors -- Risks Relating to Russia and the CIS -- Regulation of the Telecommunications Industry," "Business -- Russia and the CIS -- GTS Cellular -- Vostok Mobile" and "-- Competition." Bancomsvyaz holds a license for provision of DCS-1800 mobile services in the Kiev oblast. COMPETITION Overview. GTS faces significant competition in virtually all of its existing telecommunications businesses in the CIS. Many of the Company's competitors and potential competitors, which include large multinational telecommunications companies, have substantially greater financial and technical resources than the Company and have the ability to operate independently or with global or local partners and to obtain a dominant position in these markets. The Company believes that it has certain competitive advantages in each of these markets because of its operating history, its ability to bundle a broad range of telecommunications services in the region and its ability to make rapid decisions in pursuing new business opportunities and addressing customer service needs. The Company also believes that its local partnerships and reliance on nationals in the management of its businesses and joint ventures provide it with better knowledge of local political and regulatory structures, cultural awareness and access to customers. 72 78 International Services. Sovintel faces significant competition from more than ten other existing service providers in Moscow, including Rostelecom and joint ventures between local parties and multinational telecommunications providers. Large competitors include the "Combellga" joint venture, an RPOA operator in which Alcatel and the Belgian PTO participate as foreign investors, "Comstar", a joint venture between GPT Plessey and MGTS, providing services similar to those provided by the Company, TelMos, a joint venture between AT&T, MGTS, Global One, through its Moscow based ventures, and Peterstar, in Petersburg, which is part of the PLD Telekom group. Several smaller companies, such as DirectNet, and Aerocom provide high-volume and carrier's carrier services in Moscow. Bancomsvyaz competes in the switched international traffic market with the Kiev electrosviaz and UTel, a joint venture that includes Western partners with substantial capital and technical resources who together hold a dominant share of the Kiev market. The Company expects that market consolidation will take place among the competitive field in international services. Domestic Long Distance Services. The Company believes its major competitors in the Russian domestic long distance market consist of Rostelecom, the electrosvyazs, including those which are partners in the Company's TeleRoss Ventures, and a variety of ventures that include foreign partners with substantial financial resources. The most significant of such competitors include: Global One, through its regional operations; Rustel, a venture that includes Rostelecom, other Russian partners and International Business Communication Systems, a Massachusetts telecommunications firm; Belcom, a private company in which Comsat has a majority interest and which provides VSAT services primarily to the energy sector; Satcom, a Russian joint venture licensed to provide local, long distance and international service over private and public switched networks; Teleport TP, a satellite overlay company jointly owned by Rostelecom and Petersburg Long Distance that provides satellite teleports in cities throughout Russia; and Comincom, a Russian private venture. In the Russian far east, TeleRoss competes with Vostok Telecom, which is owned by the Japanese companies KDD and NIC and certain Russian partners; and Nakhodka Telecom, which is owned by Cable & Wireless and certain Russian partners. GTS both cooperates and competes with Rostelecom. Rostelecom provides only international and long distance services to international carriers and regional electrosviazs, and does not provide end-to-end customer services. GTS provides last mile, account management, and transit services for Rostelecom in Moscow, and uses Rostelecom channels and switches for both international and long distance services. GTS provides long distance and international services on an end-to-end basis, using service elements of Rostelecom, the electrosviazs and its own resources. However, Rostelecom does compete with TeleRoss, in that TeleRoss provides intercity services to customers, using satellite channels provided by other state agencies (Intersputnik), and provides transit services to various electrosviazs, on a traffic overflow basis. GTS believes that it enjoys a number of competitive advantages in the Russian domestic long distance market, the most important being the maturity of its international and data service businesses in Russia. This provides GTS with access to the services, customers, products, licenses and facilities of its other businesses. The Company also believes that it has more experienced management, a more comprehensive strategy to build out a nationwide long distance network and stronger relationships with many regional telephone companies and with satellite capacity providers, such as Intersputnik, than most of its competitors. In addition, the Company believes that it does not have any significant competitor in the regional inter-city market (i.e., calls between Russian cities other than Moscow or St. Petersburg). Data Services. Sovam has several primary competitors in the market for data services: Global One, which began packet-switched service in Moscow and St. Petersburg in June 1992, under the Sprint Networks venture; Demos, an Internet service provider; and Relcom, a cooperative affiliation of computer users that relies on an older generation of technology that supplies slower and lower-cost messaging facilities to customers (primarily domestic commodities traders) that do not require higher levels of service. In addition MCI and Rostelecom have recently announced their agreement to create a national Internet access network utilizing Rostelecom's domestic network and MCI's international infrastructure. Rostelecom has also announced the formation of a new Internet services company called RTK Internet, with Relcom as its partner. Although Sovam's business has grown quickly, the Company believes that Global One is the market leader. 73 79 GTS believes that other potential competitors, including foreign PSTNs, Infotel, Infocom and Glasnet, are also active in this market. Although the Company faces significant competition in this market, it believes that it enjoys certain competitive advantages, including the ability to reach a wide area throughout Russia through TeleRoss, innovative service offerings such as Russia On Line, the maturity of its business in the key banking services segment, high levels of customer service and support, and high speed digital channels through TeleRoss. Local Access Services. The Company believes that its major competition in the Moscow local access market consists of a number of ventures with Western partners, including Telmos (which includes AT&T), Comstar (which includes GPT Plessey), and Combellga. However, since TCM has obtained an allocation of up to 100,000 numbers, the Company believes that TCM will account for a substantial proportion of the new capacity to come onto the market within the next five years. Cellular Services. Most Russian cellular markets have the potential for five licensed operators, including one operator for each of the GSM and NMT-450 cellular standards, which Russia has adopted as national standards, one operator using the AMPS cellular standard, which has been set as a regional standard and two operators in the DCS Cellular Standard. Many large Western telecommunications operators, including U S WEST, Deutsche Telekom, STET, Midcom and Millicom, have participated in auctions for licenses to provide GSM and NMT-450 cellular service to certain significant Russian urban centers. In addition, a CDMA auction recently occurred which could result in one or more CDMA "fixed wireless" providers entering the markets, where GTS has cellular operations. GTS is currently pursuing the development of CDMA operations in the CIS. In Ukraine, Bancomsvyaz competes primarily with an NMT operator and a GSM operator in Kiev. Additional GSM licenses were auctioned off in early 1997 and other GSM operators may enter other markets in 1998. On June 10, 1998, Vostok Mobile received the RFCCI Letter addressed generally to the management of cellular operators utilizing the AMPS and D-AMPS standards. The RFCCI Letter stated that the offering of roaming services by such operators does not comply with certain normative documents referenced in the letter and is in breach of the licenses granted to such operators. The Company is in the process of evaluating the implications of the RFCCI Letter. Although the matter is not free from doubt, the Company believes, based on its preliminary review, that the "normative documents" referred to in the Letter represent policy statements rather than legally binding legislative pronouncements. However, if regulations were adopted implementing the positions set forth in the RFCCI Letter or other actions were taken to directly apply such positions, such regulations or actions could adversely affect Vostok Mobile's ability to compete with GSM or NMT-based cellular providers not bound by any such prohibition on roaming activities applicable to operators using the AMPS and D-AMPS standard. See "Risk Factors -- Risks Relating to Russia and the CIS -- Regulation of the Telecommunications Industry." WESTERN EUROPE OVERVIEW GTS seeks to position itself as the leading independent carriers' carrier within Western Europe through the development of two ventures, HER and GTS-Monaco Access. HER's objective is to become the leading pan-European carriers' carrier by providing centrally managed cross-border telecommunications transmission capacity to telecommunications companies including traditional PTOs and New Entrants on an approximately 18,000 kilometer high capacity fiber optic network designed to interconnect a majority of the largest Western and Central European cities. As of April 30, 1998 HER's network connects Belgium, the Netherlands, the UK, France, Germany and Switzerland linking the cities of Brussels, Antwerp, Rotterdam, Amsterdam, London, Paris, Frankfurt, Strasbourg, Zurich and Geneva. In the second quarter of 1998, the network is expected to deliver managed transport services over approximately 3,000 kilometers of fiber optic cable and is planned to include the cities of Dusseldorf, Munich and Stuttgart. The full 18,000 kilometer network is expected to become fully operational during the year 2000. HER also plans to lease capacity on a transatlantic cable linking the European network with North America and is exploring various interconnectivity options to Russia and Asia. Such intercontinental interconnectivity will help HER satisfy the needs of its European customers with respect to outgoing traffic and attract additional non-European customers with traffic 74 80 terminating in Europe. HER commenced commercial service over the Brussels-Amsterdam portion of the network in late 1996, the London-Paris portion in November 1997 and Frankfurt, Zurich and Geneva were added to the network in April 1998. GTS-Monaco Access operates an international gateway in Monaco in partnership with, and utilizing the existing gateway infrastructure of, the Principality of Monaco and provides transit and routing of international calls to other telecommunications operators. Through its HER and GTS-Monaco Access ventures, GTS is building a new network for transporting voice, data and multimedia/image traffic for other carriers throughout Western and Central Europe and for worldwide international voice, data and multimedia/image traffic that either originates or terminates in, or transits through, Western and Central Europe. The Company believes that the international segment of the Western and Central European telecommunications market will be an attractive market for new telecommunications entrants because of its large size, the high operating costs and low productivity of current providers, and the barriers to entry created by the need to control a network and its rights-of-way. The European telecommunications market has historically been dominated by monopoly PTOs. This system has ensured the development of broad access to telecommunications services in Europe, but it has also restricted the growth of high quality and competitively priced pan-European voice and data services. The current liberalization occurring in Europe is intended to address these structural deficiencies by breaking down PTO monopolies, allowing new telecommunications operators to enter the market and increasing the competition within the European telecommunications market. In March 1996, the European Commission adopted a directive (the "Full Competition Directive") requiring the full liberalization of all telecommunications services in most EU member states by January 1, 1998. The Company expects that full liberalization in these European countries will lead to the emergence of New Entrants with new and competitive service offerings. HER expects this increase in competition will result in lower prices and a substantial increase in the volume of traffic and range of telecommunication services provided. HER believes that as a result of the increased call volume and growth in value added services, participants in these markets will require significant amounts of new cross-border telecommunications transport capacity to provide their services. The HER network will offer PTOs and New Entrants an attractive alternative for the transport of cross-border European telecommunications traffic. In the traditional system, PTOs own and control circuits only within their national borders, and as a result, cross-border traffic must be passed from one PTO to another PTO at the national boundary. No single PTO therefore owns or controls end-to-end circuits for cross-border calls. The alternative for carriers of this traffic will be to build their own transport capacity or use International Private Leased Circuits ("IPLCs") which are provisioned by combining half-circuits on the networks of two or more PTOs. The Company believes that there are a number of problems with these options that result in HER being well-positioned to become the leading independent carriers' carrier in Western and Central Europe. In particular, building their own transport capacity is unlikely to be an attractive option for most carriers because of the high traffic volumes required to justify the expense, the need to focus resources on marketing and customer service, the time commitment and the regulatory and administrative complexities involved, particularly in obtaining the rights of way across national borders. Likewise, IPLCs provided by the PTOs also have a number of disadvantages, including high prices, lack of end-to-end quality control, lack of redundancy, low quality due to diversity of network systems and equipment, limited availability of bandwidth and long lead times for provisioning. See "Risk Factors -- HER Network Roll-out" and "Risk Factors -- Competition." HER HER's objective is to become the leading pan-European carriers' carrier by providing centrally managed cross-border telecommunications transmission capacity to telecommunications companies including PTOs and New Entrants. HER intends to offer these target customers a better transport system than is currently available in Europe with a higher and more consistent level of transmission quality, redundancy, network functionality and service across Europe at lower prices. Development of the HER network is dependent upon, among other things, HER's continuing ability to obtain the necessary financing, rights-of-way, licenses and other regulatory approvals in a timely and cost-effective manner. 75 81 HER is developing an approximately 18,000 kilometer, pan-European high capacity fiber optic network designed to interconnect a majority of the largest Western and Central European cities. Each access point of the network will be placed in operation as it is linked to the network. HER intends to build the network using the most accessible and cost-efficient infrastructure base in each of the regions served, including using rights-of-way and existing infrastructure of railways, motorways, pipeline companies, waterways and power companies. HER plans a flexible approach to the network build-out plan and intends to fine-tune the scope, route and design of the network based upon the evaluation of customer demand. Historically, HER has experienced substantial delays in concluding these agreements and developing its network. There can be no assurance that HER will be successful in concluding necessary agreements, or that delays in concluding such agreements will not materially and adversely affect the speed or successful completion of the network. The successful and timely completion of the network will also depend on, among other things, (i) the availability to HER of substantial amounts of additional capital and financing, (ii) timely performance by various third parties of their contractual obligations to engineer, design and construct portions of the network and (iii) HER's ability to obtain and maintain applicable licenses and authorizations. HER expects to roll-out full telecommunications service over Belgium, the Netherlands, the UK, France, Germany and Switzerland in the second quarter of 1998, as discussed below, and the 18,000 kilometer network to be operational during the year 2000. Although HER believes that its cost estimates and the build-out schedule are reasonable, there can be no assurance that the actual construction costs or time required to complete the network build-out will not substantially exceed current estimates. Any significant delay or increase in the costs associated with development of the HER network could have a material adverse effect on HER and the Company. HER expects to continue to roll-out full telecommunications transport service on the initial network in Belgium, the Netherlands, the UK, France, Germany and Switzerland linking the additional cities of Dusseldorf, Stuttgart and Munich, by June 30, 1998. This initial network is expected to cover countries which, in 1995, originated over 60% of all outgoing calls and terminated over 60% of all incoming calls in the countries to be served by the full network. HER's Network Operations Center located in Brussels, Belgium and its backup center located in Antwerp, Belgium are fully operational and house network management and customer support services which operate 24 hours a day, seven days a week. Billing and customer service functions are also operational. Network coverage is planned to be expanded to include the cities of Berlin, Stockholm, Copenhagen, Luxembourg and Milan by the end of 1998. By the year 2000, the 18,000 kilometer HER network is expected to have points of presence in at least 33 cities in 15 European countries, including Southern and Central Europe. HER also plans to lease capacity on a transatlantic cable linking the European network with North America and is exploring various interconnectivity options to Russia and Asia. HER has entered into agreements for the construction and/or lease of fiber optic routes for the initial network in Belgium, the Netherlands, the UK, France, Germany and Switzerland. Additional contracts have been concluded in Denmark, Sweden, Spain and Italy. HER continues to negotiate rights-of-way and other infrastructure arrangements in order to extend its network in Western Europe. HER will need to negotiate similar agreements to complete the network in four Central European countries. Buildout of the HER network is subject to numerous risks and uncertainties that could delay deployment or increase the costs of the network, or make the network commercially unfeasible. See "Risk Factors -- HER Network Roll-out." HER was formed on July 6, 1993 by HIT Rail B.V. ("HIT Rail"). HIT Rail was incorporated in 1990 by eleven national railways to carry out telecommunications engineering activities in order to construct and exploit a data communications network for railway traffic. GTS-Hermes, Inc., a Delaware corporation ("GTS-Hermes") purchased a 34.4% interest in HER in 1994 and has increased its interest to 50% in 1995 and to 79% in 1997. In March 1998, GTS-Hermes increased its ownership of HER to approximately 89% by purchasing a portion of HIT Rail's ownership interest in HER. GTS-Hermes is a wholly owned subsidiary of GTS. In an effort to expand its presence in Europe, HER has formed wholly owned subsidiaries in the Netherlands, Ireland, the United Kingdom, Germany, France, Italy and Spain to conduct marketing and other activities. In Belgium, the activities of the Network Operations Center have been transferred to HER Network Services B.V.B.A. (formerly Hermes Europe Railtel N.V.), a wholly owned subsidiary of HER. 76 82 Following the development of its corporate structure, HER will be a holding company with limited assets and will operate its business through subsidiaries. BUSINESS AND MARKETING STRATEGY The overall strategy of HER is to offer PTOs and New Entrants pan-European cross-border telecommunications transport services to help them, in turn, more successfully meet the needs of their end-user customers. The HER network also provides a vehicle through which a carrier can compete in markets where it does not own infrastructure. HER expects to enter the market ahead of similar competition and encourage a wide variety of carriers to use its network with service offerings that meet their needs. HER's primary service offerings are large-capacity circuits for "wholesale" customers such as PTOs and New Entrants. HER's focus on carriers is designed to complement and not compete with carriers' own business objectives in providing services to end-users. To establish HER as the leading carriers' carrier for international telecommunications within Europe, HER offers its customers significantly higher quality transmission and extended/advanced network capabilities at a competitive price by focusing on the following: - High Capacity International Network Facilities. The HER network is designed to offer its customers access to high capacity network facilities outside their domestic markets, providing cross-border capabilities without requiring customers to invest in network infrastructure or being constrained by a narrow range of capacity offerings. With Wavelength Division Multiplexing ("WDM") upgrades, HER's fiber deployment plan provides for a minimum of 120 optical wavelengths. - Uniform Network Architecture. The HER network is designed to offer managed transport services from country to country and across multiple countries utilizing a single uniform network, in contrast to services currently available that use multiple providers over several networks with varying technologies and each under the control of separate, not necessarily compatible, network control systems. The HER network's uniform technology enhances service by providing quality and reliability as well as uniformity of features throughout the network. - Diverse Routing. The HER network architecture includes diverse, redundant routes that are designed to provide high levels of reliability. The network is designed to provide availability of over 99.98% for most routes and to provide customers with a wide range of telecommunications transmission capacity. To achieve this level of reliability without the use of a network similar to the HER network, HER believes that carrier customers would need to purchase additional dedicated circuits to provide for redundancy. - Rapid Provisioning. HER services provide access to the network, such that additional capacity can be provided to customers on the HER network on a rapid basis. This access provides a level of capabilities that HER believes is unavailable in Europe today. This ability to rapidly provide service is largely due to HER's development of capacity substantially in excess of HER's forecasted requirements. - Flexibility. HER services are focused on providing customers flexibility across the network through which the customer may minimize risk by enabling network rerouting, eventually even under customer direct control. - Advanced Technology. HER is deploying SDH and WDM technology which is upgradeable and will permit significant expansion of transmission capacity without increasing the number of fiber pairs in the network. This technology also provides the basis for structuring advanced operating features, such as virtual private network service and ATM-based services. - Innovative Pricing. Currently the price of high-bandwidth circuits on transborder European routes is artificially high and not necessarily related to the cost of such circuits. HER offers competitive pricing. HER also offers highly tailored contract terms and volume discounts, which allow carrier customers to plan more efficiently the fixed costs of their service portfolio. Customers can select varying capacity, access, guaranteed availability and contract terms at competitive prices. Customers sourcing from PTOs are generally limited to order from a very narrow set of capabilities offered under inflexible pricing plans. 77 83 Although HER and GTS have relationships with certain PTOs or other access providers for specific projects, they do not have wide-ranging alliances with any of the major consortia or large Western telecommunications companies. Additionally, HER's strategy calls for it to focus on carriers' carrier services, so that it will limit overlap of target markets with its carrier customers in end user markets. HER believes that this independence will make it an attractive service provider for carriers who may otherwise be reluctant to obtain services from other providers of intra-European transport that also may be their competitors in the retail market. The Company intends to offer comprehensive, facilities-based telecommunications products and services to business and other high-usage customers in certain metropolitan markets in Europe. See "-- European Services Strategy." Many of the Company's planned service offerings will compete directly with services offered by HER's customers, which may affect the perception of HER as an independent carrier's carrier. There can be no assurance that the Company's European Services Strategy will not negatively impact HER's ability to attract and retain customers which would have a material adverse affect on HER and the Company. SERVICES HER's primary service is large capacity cross-border European circuits provided to carriers and service providers over an integrated, managed pan-European network structure thus providing a service for wholesale customers such as PTOs and New Entrants. The HER network, based on SDH and WDM technology, provides for digital transmission capability upon which a broad range of advanced functionality may be built and which offers network availability, flexibility, bandwidth speeds and error performance not otherwise available to carriers for transport of telecommunications traffic across national borders in Western and Central Europe. The network is designed to provide customers with a wide variety of bandwidth speeds, ranging from VC12/E1 Standard (equivalent to 2.048 Mbps) to STM-1/E4 Standard (equivalent to 155 Mbps) and beyond. HER will provide high quality cross-border transmission services for licensed or otherwise authorized telecommunications providers. Services are based on the principle of adding greater value than currently available in the market while retaining competitive prices. Point-to-Point Transmission Capacity. The current market for cross-border transport is served by IPLCs provided by PTOs. IPLCs are formed by combining half-circuits from two PTOs between customer locations, often with additional PTOs providing transit segments. Under the IPLC service, overall service quality guarantees generally are not provided and only a limited range of bandwidth is available, usually only E1 and in certain instances, E3. The Company believes that HER's Point-to-Point Transmission Capacity will be a major improvement to the PTO-based approach because it provides a greater range of bandwidths (from 2 Mbps (E1 or VC-12) to 140/155 Mbps (E4 or VC-4)) and allows customers to choose a service level agreement with guarantees appropriate for their applications, including guarantees for on-time service delivery and service availability. Point-to-Point Transmission Capacity consists of two services, "Integrated" and "Node-to-Node." The HER "Integrated" service provides an end-to-end service between customer-specified locations where the customer can request for HER to arrange for "last mile" services from the HER node location to the customer's location. The HER "Node-to-Node" service can be selected when the customer prefers to provide its own services to reach the local HER node location. In Node-to-Node Service, HER guarantees service only on its portion of the network between HER nodes. Both services are competitively priced relative to current service offerings. A premium is charged for the highest guaranteed level of service which incorporates an end-to-end, fully diverse, protected, "Integrated" service. The customer can choose flexible contract terms from one to five or more years' duration, with discount schemes designed to ensure that HER remains a cost-effective solution. 78 84 Virtual Infrastructure Service. Carriers and operators that plan to expand their operations to become pan-European service providers as the European marketplace is liberalized require a flexible and cost-effective means of telecommunications transport. To date such service providers obtain international transport service by leasing IPLCs. Leasing IPLCs requires a carrier to lease channels on a segment-by-segment basis from multiple PTOs, linking the target cities under arrangements having fixed capacity and pricing structure for each segment of the carrier's network. Leasing IPLCs has several disadvantages, including (i) difficulty in obtaining discount/volume pricing schemes since there is no single provider of pan-European coverage, (ii) delays in implementation due to numerous contractual negotiations and having to interconnect numerous IPLCs, (iii) limited availability of pan-European leased capacity at high bandwidth and (iv) variability of quality due to multiple operators and the absence of a single uniform network. Operators could also construct their own network, which is expensive, time-consuming and complex and which may not be justified by such operators' traffic volume. See "Risk Factors -- Competition." HER's Virtual Infrastructure Service will offer a new solution and an attractive alternative to leasing IPLCs or building infrastructure. This service will enable HER's customers to obtain a uniform pan-European or cross-border network under one service agreement by allowing the customer to select any number of cities along the HER network at a pricing structure based on the overall amount of leased capacity for the customer's entire network. The key feature behind Virtual Infrastructure Service is that it gives the customer the ability to add or reconfigure capacity in 24 hours between locations connected in the Virtual Infrastructure Service, thereby enabling the customers to respond almost immediately to changes in traffic. By being able to transfer capacity among the network routes, HER's customers are able to avoid over- and under-utilization of leased channels. This service offering provides a customer with the benefits of ownership (rapid provisioning, freedom to rearrange and control) with a "pay-as-you-go" managed service offering, without the burdens of up-front investment and costs required to build a network, and without having to manage the on-going maintenance and operation of the network. The service would be delivered through pre-installed physical facilities at each of the customer locations. These facilities are designed to ensure that most growth or changes in customer requirements can be addressed purely by remote logical reconfiguration from the HER Network Operations Center. This remote network management ability is inherent in SDH technology and allows rapid provisioning and high quality of service. Ring Service. Most medium to large carriers and operators purchase network capacity in excess of actual requirements, and prefer to have physical configuration control over their networks. The HER Ring Service connects multiple customer locations with multiple VC-4 paths in a ring configuration. The customer has direct control over the configuration of the VC-3 and VC-12 paths within the ring, and has exclusive control over the routing. Additional ring capacity can be added with no service interruption and additional customer locations may be added to the ring with minimal service interruption. Because HER is not required to configure 'idle' bandwidth or to manage the 'SDH subnet' this service can be provided at a very competitive rate vis-a-vis other point-to-point services. Sales of HER's Services are conducted through its subsidiary Hermes Europe Railtel (Ireland) Limited. HER is exploring the development of additional distribution channels using local or regional network access providers. Currently the price of cross-border pan-European calls are often significantly higher than the underlying cost of transport and terminating such calls and higher than the price of intra-country calls or transborder calls to and from liberalized markets. The low cost of operating the network enables HER to attractively and competitively price services in the face of declining overall tariffs for telecommunication services. HER's low-cost basis is due to, among other things, its use of up-to-date technology without the burden of legacy networks, which requires fewer employees to operate. The term of a typical customer agreement currently ranges from 1 to 3 years. The customer agrees to purchase, and HER agrees to provide, cross-border transmission services. In general the customer agrees to pay certain non-recurring charges upfront and recurring charges on an annual basis, payable in twelve monthly installments. If the customer terminates the service order prior to the end of the contract term, it is generally required to pay HER a cancellation charge equal to three months service for each of the twelve months 79 85 remaining in the contract term. HER guarantees transmission services to a certain service level. If such levels are not met or HER fails to deliver service by the committed delivery date, the customer is eligible for a credit against charges otherwise payable in respect of the relevant link. CUSTOMERS HER's high capacity, SDH-based fiber optic network is designed to enable PTOs and New Entrants to integrate high quality, cross-border capacity into their end user offerings. As of March 31, 1998 29 customers were under contract for service on the HER network including PTOs, global consortia of PTOs, internet service providers, alternative carriers, an international carrier, value added networks ("VANs") and resellers. HER has sold capacity of approximately 1,221 E1 equivalents (cumulative through end of contract) as of March 31, 1998. The type and quality of HER's customers validates the concept of the HER network, and illustrates the type of customers who will be attracted to the full network. The success of this limited network also demonstrates the demand for cross-border transport services. In total, HER is targeting seven major market segments or customer groups which can be characterized as follows: - Existing PTOs. This customer segment consists of the traditional European PTOs that generally participate in the standard bilateral agreements for cross-border connectivity. Hermes provides a vehicle for PTOs to compete in non-domestic markets both before and after January 1, 1998. As of January 1, 1998, both reserved and non-reserved traffic can be transported by alternative infrastructure providers, thus vastly expanding the available PTO market for HER. - Global Consortia of Telecommunications Operators. Many of the largest PTOs and international carriers have pooled resources and formed consortia in order to compete more effectively in important telecommunications markets such as those in Western Europe particularly outside their home markets. Prior to liberalization of the provision of switched voice services in Western European markets, one of the primary objectives of these consortia is to provide non-reserved pan-European services to multinational business customers, including X.25/frame relay (high speed data network) service and closed-user group voice services. Under the current regulatory framework, consortia would otherwise be required to purchase leased lines at negotiated retail rates, even within their home countries. HER believes that it provides an attractive alternative at better pricing in those environments where such a consortium does not already own its infrastructure. Furthermore, HER believes that it is well positioned to provide cross-border connectivity between different domestic infrastructures of these alliances. - International Carriers. This customer segment consists of non-European carriers with traffic between European and other international gateways. Such carriers include Teleglobe, GTS-Monaco Access and eventually the U.S. Regional Bell Operating Companies. HER can provide these customers a pan-European distribution network to gather and deliver traffic to and from their own and other hubs. - Alternative Carriers. This segment consists of second carriers, cable TV and mobile carriers and competitive access providers. These new carriers have chosen to compete with the incumbent PTOs in their respective countries, and the Company believes that they would look favorably to an alternative such as HER. HER believes that this segment will sustain the largest growth as competition emerges in Europe. HER also believes that non-PTO competitors in Europe will prefer to use a non-PTO alternative like HER to meet their cross-border telecommunication transport needs. - Internet Backbone Networks. Internet backbone networks are a fast emerging segment and are expected to generate significant requirements for the services HER offers. These require large capacity international connectivity services between Internet nodes (point of interconnection between local Internet service providers) in all local European markets. The Internet segment is experiencing significant growth in demand for transmission capacity. - Resellers. Resellers are carriers that do not own transmission facilities, but obtain communications services from another carrier for resale to the public. Resellers are also a growing segment of the market and are expected to increase in conjunction with the liberalization of the European telecommu- 80 86 nications market. In the U.S., for example, resellers were a significant factor in the expansion of competition. - VANs and other Service Providers. VANs are data communications systems in which special service features enhance the basic data transmission facilities offered to customers. Many of these networks are targeted to the data transfer requirements of specific international customer segments such as airlines and financial institutions. VANs' basic network transmission requirement is to connect data switches or processors. VANs currently purchase their own international circuits and build additional resiliency into their network infrastructure. HER will allow them to meet these needs cost-effectively, and to extend their services to new markets or customers without substantial capital investment. HER expects that additional demand for alternative service providers will come from increased usage of dedicated circuits for Internet access, private lines for the deployment of wide-area networks by large corporations, "single source" local and long distance services by small and medium-sized businesses and emerging broad band applications such as cable TV programming distribution (other than broadcast) to the end user. NETWORK DESIGN Network Architecture. The network architecture is based on a highly meshed flat topology which covers a wide geographical area with large distances between individual network nodes. This architecture enables rerouting of traffic at electronic speeds in the event of a network failure. This approach also lowers network cost by enabling each node to be sized to match anticipated traffic volumes rather than to a standard capacity. Individual nodes can be configured to connect any trunk to any other in the nodes, thus allowing efficient transmission of traffic. Each node will be connected to at least two other nodes enabling rerouting of traffic in the event of a network failure. HER believes that its network will be the first cross border pan-European network with such redundancy. The HER network has been designed to be controlled by a single network management center and supported by advanced operational support systems. A centralized network center can pinpoint potential service impacting problems and reroute traffic much more quickly than networks controlled by separate network centers operated by PTOs in different countries. HER primarily uses Alcatel for the supply of transmission equipment and will use CIENA Communications Inc. ("CIENA") for initial WDM deployment. HER's advanced operational support systems allow it to correct network failures and isolate equipment faults with greater speed and at a lower cost than is the case with heterogeneous multi-operator networks. Critical elements of the network, including network maintenance and control systems, are designed with redundancy in order to ensure a high quality of service. The network design has several important resilience features including: multiple paths to each node, built-in hardware redundancy and redundant power supplies. For all network routings, there will be at least two paths. Should service failure occur on one route, the network is designed to automatically re-route traffic to another route. HER believes that these techniques will result in performance of 99.98 percent or better for premium service customers for most routes. HER expects to operate the entire network and to own substantially all of the network equipment as well as some segments of the fiber optic cable. A substantial part of the fiber is leased on a long-term basis. Long-term leases for fiber are advantageous to HER because they reduce the capital expense burden of building large quantities of capacity before they can be used. Where HER leases dark fiber, the infrastructure provider will generally be responsible for maintaining such fiber optic cable. HER will enter into agreements with equipment vendors and infrastructure providers and other third parties to supply and/or maintain the equipment for the HER network. See "Risk Factors -- HER Network Roll-out." Network Capacity. The initial network consists of Synchronous Digital Hierarchy ("SDH") STM-16 links managed by equipment and operating centers owned by HER and running on dark fiber leased from infrastructure providers or built by HER on leased rights of way. The most important types of equipment used or to be used in this network are Add-Drop Multiplexors ("ADMs") and regenerators and a variety of optical amplifiers for boosting optical signals. Furthermore, fibers will be multiplexed using WDM, also as required. 81 87 HER has entered into an agreement with CIENA for the supply of WDM equipment which, if fully utilized, is capable of increasing the networks capacity by 40 times (from 2.5 Gb/s to 100 Gb/s). Additional capacity can also be achieved by adding new fiber accesses to a given city over alternative routes, thereby achieving more meshing and the resulting improved network availability. Network Agreements. HER has entered into agreements and letters of intent with various infrastructure providers for construction and/or dark fiber lease of portions of the HER network. HER's agreements for leases of portions of the network typically required the infrastructure provider to provide a certain number of pairs of dark fiber and node and/or regenerator sites along the network route commencing on certain dates provided by HER. The term of a lease agreement typically ranges from 10 to 18 years. An agreement typically contains optical specification standards for the fiber and methods of testing. HER is allowed to use the cable for the transmission of messages and in other ways, including increasing capacity. The infrastructure provider also provides space for the location of equipment and spare parts and guarantees the provision of power and other utilities together with environmental controls and security to ensure the proper functioning of the equipment. The infrastructure provider is typically responsible for maintenance of the cable and the provision of first line maintenance to equipment and permits HER access to such facilities. Access arrangements to the nodes are also provided so that connection may be made to HER customers or to the rest of the network. An agreement also provides for an annual price for the provision of fiber and for the facilities and maintenance. The agreements typically provide for termination by the parties only for material breach, with a 90 day minimum cure period. The agreements typically contain a transition period after termination of the agreement to allow HER to continue to serve its customers until it can reach agreement with an alternative infrastructure provider. 82 88 Local Access. Access to the HER network will be provided to clients through SDH access lines including at the STM-1 or STM-4 level. However, customers who continue to use the older PDH technology may also access the HER network. In each city, as a HER point of presence is deployed, HER may contract with a local access network supplier for "last mile" services to customer locations. HER will not invest in building local access infrastructure but such connectivity can be supplied on a case-by-case basis via preferred local access partner arrangements. Currently, HER has contracted with local access providers to connect the HER network to intra-city networks in each city on the network. Pursuant to this agreement, HER can offer its carrier customers local connectivity in those cities. Various Local Access Network Suppliers may also be interested in HER for the purpose of linking the business centers in which they are active. Therefore, the Company believes that the relationships between HER and local access network suppliers can benefit both parties. Set forth below is an illustration of the connection between the HER network and local access providers. [SDH/WDM NETWORK CHART] Network Routes. HER expects to have an aggregate of approximately 10,000 kilometers completed at the end of 1998 and the entire 18,000 kilometer network completed by the year 2000. Hermes also plans to lease capacity on a transatlantic cable linking the European network with North America in 1999. The routes planned to be operational in June 1998 are currently under construction. "Under construction" means that with respect to each of the segments that make up each of these routes, one of the following is occurring: (i) HER has contracted to build or is contracting to build the fiber optic cable segment, and (ii) HER has leased or will lease such segment of dark fiber optic cable from a third party who has built or is currently building such segment. The dates set forth above may be subject to delays due to a variety of factors, many of which are beyond the control of the Company. See "Risk Factors -- HER Network Roll-out." HER is deploying the network along the rights-of-way of a variety of alternative sources, including railways, motorways, waterways, pipelines and utilities. The rights-of-way of HER-built portions of the network will be provided pursuant to long-term leases or other arrangements entered into with railways, 83 89 highway commissions, pipeline owners, utilities or others. It is the policy of HER to evaluate multiple alternative infrastructure suppliers in order to maximize flexibility. As a result of its network development activities to date, HER has gained access to infrastructure for its network routes which, in certain cases, HER believes will be difficult for its competitors to duplicate. See "Risk Factors -- HER Network Roll-Out." COMPETITION The European and international telecommunications industries are competitive. HER's success depends upon its ability to compete with a variety of other telecommunications providers offering or seeking to offer cross-border services, including (i) the respective PTO in each country in which HER operates and (ii) global alliances among some of the world's largest telecommunications carriers. HER expects that some of these potential competitors may also become its customers. HER believes that the ongoing liberalization of the European telecommunications market will attract New Entrants to the market and increase the intensity of competition. Competitors in the market compete primarily on the basis of price and quality. HER intends to focus on these factors and on service innovation as well. HER business plan anticipates substantial head-to-head competition as well as indirect competition. WorldCom recently announced plans to construct a pan-European fiber network, the first phase of which is expected to connect London, Amsterdam, Frankfurt, Brussels and Paris. Although the Company believes that the proposed WorldCom pan-European network is primarily intended to carry WorldCom traffic, WorldCom has stated that any excess capacity on such network will be used to provide a competitive carrier's carrier service. Viatel also recently announced its intention to build a pan-European fiber optic network connecting select cities in Belgium, France, the Netherlands and the United Kingdom and certain key business centers in Germany. Excess capacity would be available for other carriers. Viatel has stated that it expects construction to begin in spring 1998 and the network to become operational during the first quarter of 1999. In addition, Esprit also recently announced plans to construct an SDH fiber optic ring network that will connect the United Kingdom, France, the Netherlands and Belgium. PTT Netherlands has announced similar plans to build a pan-European network. HER also competes with respect to its "point-to-point" transborder service offering against circuits currently provided by PTOs through International Private Leased Circuits. In addition, the liberalization of the European telecommunications market is likely to attract additional entrants to both the "point-to-point" and other telecommunications markets. If HER's competitors, many of whom possess greater technical, financial and other resources than HER, devote significant resources to the provision of pan-European, cross-border telecommunications transport services to carriers, such action could have a material adverse effect on HER's business, financial condition and results of operations. There can be no assurance that HER will be able to compete successfully against such new or existing competitors. See " Risk Factors -- Competition." HER RECAPITALIZATION During 1997, HER completed a recapitalization (the "HER Recapitalization"), wherein HER extended rights to subscribe to additional shares of HER to GTS-Hermes, HIT Rail and the eleven railways comprising the HIT Rail consortium. Pursuant thereto, GTS-Hermes and two of the eleven railways that comprise the HIT Rail consortium have exercised their subscription rights, while HIT Rail and the other nine railways have declined to exercise their subscription rights. HER has issued (i) 150,592 shares to GTS-Hermes in exchange for the conversion of loans and additional consideration, (ii) 24,007 shares to HIT Rail in exchange for the conversion of loans, (iii) 11,424 shares to Societe Nationale des Chemins de Fer Belges S.A. de Droit Public/Nationale Maatschappij der Belgische Spoorwegen N.V. Van Publiek Recht (the Belgian national railway) ("SNCB/NMBS") and (iv) 4,365 shares to AB Swed Carrier (a wholly owned subsidiary of SJ, the Swedish national railway). As a result, GTS-Hermes owned 79.1%, HIT Rail owns approximately 12.6%, SNCB/NMBS owns 6.0% and AB Swed Carrier owns 2.3% of the issued HER shares. Pursuant to the HER 84 90 Recapitalization, HER, GTS-Hermes, HIT Rail, SNCB/NMBS and AB Swed Carrier have executed a new Shareholders Agreement, the principal terms of which are set forth below. In March 1998, Hit Rail sold all of its shares in HER to GTS-Hermes, SNCB/NMBS and AB Swed Carrier. As a result of such sale, GTS- Hermes, SNCB/NMBS and AB Swed Carrier currently own 170,307, 13,610, and 6,551 shares of HER, respectively, or 89.4%, 7.2%, and 3.4%, respectively of HER. Under the new Shareholders Agreement, actions to be taken by shareholders will be adopted by a simple majority vote with the exception of certain actions which will require at least 85% of the votes cast: (i) purchase by HER of its own shares and any redemption thereof, (ii) exclusion of preemptive rights in the case of the issuance of new shares and the transfer of shares held by HER, except in the event of a public listing of the shares or of new shares or of an offering of shares or options on new shares (warrants) to professional investors in order to obtain further funding, (iii) winding up or dissolution of HER, (iv) any amendment to the articles of association other than those pertaining to increases in the authorized capital of HER or to convert HER into an N.V. ("Naamloze Vennootschap") to enable a public listing of shares or new shares, (v) any amendment to the scope of HER's business, (vi) the declaration of dividends and (vii) the admission of new shareholders to the Shareholders Agreement. In addition, the Shareholders Agreement provides that (a) if GTS-Hermes is the owner of at least 50% of the issued shares, then it will have the right to make a binding nomination for the appointment of half of the members of the Board of Supervisory Directors or (b) if GTS-Hermes is the owner of at least two-thirds of the issued shares, then it will have the right to make a binding nomination for the appointment of half of the members of the Board of Supervisory Directors plus one member more, appointed pursuant to nominations by all other shareholders. As long as HIT Rail is the owner of at least one share, HIT Rail will be entitled to make a binding nomination for the appointment of at least one member of the Supervisory Board. The Shareholders Agreement also provides that shareholders who participated in the capital restructuring other than GTS-Hermes and HIT Rail with a shareholding of at least 6.8% subject to adjustment in the discretion of the other shareholders will be entitled to make a binding nomination for the appointment of one member of the Board of Supervisory Directors. Shareholders who participated in the capital restructuring other than GTS-Hermes and HIT Rail who hold fewer than 6.8% of the issued share capital of HER will be entitled on a rotating basis to make one binding nomination for the appointment of a member of the Board of Supervisory Directors for two-year periods. As a result of the March 1998 sale by HIT Rail of all of its shares in HER, HIT Rail no longer has any rights or obligations, except as set forth below, under the Shareholders Agreement and GTS-Hermes, acting alone, can approve all the matters described above which require an 85% HER shareholder vote. Articles of Association and Shareholders Agreement Under the Articles of Association and the Shareholders Agreement, HER's shareholders have preemptive rights in connection with issuances of ordinary shares and options on shares to be issued in proportion to the total nominal value of the shares held by it. Preemptive rights can be exercised for four weeks after the date the notice of the offer is received by the shareholders. The Shareholders Agreement provides that HER or its designated vendor will provide fiber capacity in its network for use by the shareholders of HER on fair commercial terms, use, quantity and price to be negotiated on a bilateral basis. In the Shareholders Agreement, HIT Rail has covenanted to (i) use its best efforts to establish such commercial agreements between individual HIT Rail shareholders and HER, to obtain rights of way from individual HIT Rail shareholders and to cooperate in obtaining such licenses as may advance the business of HER, (ii) use its best efforts to ensure that the HIT Rail shareholders cooperate in obtaining such license in accordance with the business plan of HER and as may be necessary or advisable in furtherance of HER's business, (iii) will not, so long as both HIT Rail and GTS-Hermes are shareholders of HER and for one year after HIT Rail ceases to be a shareholder, agree with any entity other than GTS-Hermes or HER to assist or cooperate in the development of any pan-European telecommunications operator and (iv) use its best efforts to obtain on HER's behalf such materials as may be required and arrange inspection visits of selected rights of way for the purpose of making initial cost estimates. The foregoing summary of the Shareholders Agreement does not purport to be complete and is qualified in its entirety by reference to the Shareholders Agreement. 85 91 LICENSES AND REGULATORY ISSUES A summary discussion of the regulatory framework in the countries of the network in the first five countries and the next five countries into which HER expects to develop the network is set forth below. This discussion is intended to provide a general outline, rather than a comprehensive discussion, of the more relevant regulations and current regulatory posture of the various jurisdictions. National authorities in individual member states of the EU are responsible for regulating the operation (and in some cases the construction) of telecommunications infrastructure. HER believes that the adoption of the Full Competition Directive and the various related Directives adopted by the European Parliament and the Council of the EU have resulted in the removal of most regulatory barriers to the operation of telecommunications infrastructure in the countries of the initial network in Belgium, the Netherlands, UK, France, Germany and Switzerland. HER requires licenses, authorizations or registrations in all countries to operate the network. There can be no assurance that HER will be able to obtain such licenses, authorizations or registrations or that HER's operations will not become subject to other regulatory, authorization or registration requirements in the countries in which it plans to operate. Licenses, authorizations or registrations have been obtained in the United Kingdom, the Netherlands, Belgium, France and Germany and a trial concession has been granted in Switzerland. HER intends to file applications in other countries in anticipation of service launch in accordance with the network roll-out plan. On June 28, 1990, the European Commission, in an effort to promote competition and efficiency in the European Union, issued a directive (the "1990 Directive") requiring EU member states to immediately liberalize all telecommunication services with the exception of voice telephony to the general public (basic voice services provided over the public switched voice network). This step liberalized value added services and voice services over corporate networks and/or "closed user groups," although the exact definitions of the terms used in the 1990 Directive were not altogether clear. On July 22, 1993, the Council of EU agreed that all voice telephony services in EU member states should be liberalized by January 1, 1998 subject to additional transitional periods of up to five years to allow member states with less developed networks to achieve the necessary adjustments. It was agreed that such exemptions would be granted to Spain, Ireland, Greece and Portugal, subject to formal application and satisfaction of certain requirements. Luxembourg, because of the small size of its market, would be eligible for a special transitional period of up to two years. In April 1995, a communication from the European Commission sought to clarify the types of services that were liberalized by the 1990 Directive, stating that the burden of proof as to why a service should be considered "reserved" and therefore not open to competition should be upon the PTOs and the regulatory authorities of member states. Along with this statement came the threat of formal procedures under the Treaty of Rome against member states that do not implement the 1990 Directive "within a reasonable time." Procedures have been brought so far against Italy, Greece, Germany and Spain for failing to apply the requirements of the 1990 Directive. On March 13, 1996, the European Commission adopted the Full Competition Directive extending the 1990 Directive to all services, requiring that licensing procedures for these services be transparent and non-discriminatory, requiring member states to fully liberalize alternative infrastructure to allow a competitive market for "non-reserved" services such as data, value added services and non-public (closed-user group) switched voice services by July 1, 1996 and mandating open competition in all public telecommunications services, including voice telephony to the general public, by January 1, 1998 (except for countries to which grace periods were granted in accordance with the 1993 Council Resolution). On April 10, 1997, the European Parliament and the Council of Ministers adopted a Directive on a common framework for general authorizations and individual licenses in the field of telecommunications services, including networks. Licenses must be awarded through open, non-discriminatory and transparent procedures and applications will be required to be dealt with in a timely fashion. The number of licenses may 86 92 only be restricted to the extent required to ensure the efficient use of radio frequencies or for the time necessary to make available sufficient numbers in accordance with EC law. On June 11, 1997, the European Parliament and the Council of Ministers adopted a Directive on interconnection with regard to ensuring universal service and interoperability through application of Open Network Provision ("ONP") principles; among other things this requires Member States to ensure that PTOs with significant market power should provide interconnection on the basis of cost-oriented charges. On February 26, 1998, the European Parliament and the Council of Ministers adopted a Directive on the application of ONP top voice telephony and on universal service. HER believes that many European countries have revised telecommunications regulations to comply with the 1990 Directive and the Full Competition Directive and that such changes will enhance HER's ability to obtain other necessary regulatory approvals for its operations. As a multinational telecommunications company, HER is subject to varying degrees of regulation in each of the jurisdictions in which it provides its services. Local laws and regulations and the interpretation of such laws and regulations, differ significantly among the jurisdictions in which HER operates. There can be no assurance that future regulatory, judicial and legislative changes will not have a material adverse effect on HER, that domestic or international regulators or third parties will not raise material issues with regard to HER's compliance or noncompliance with applicable regulations or that regulatory activities will not have a material adverse effect on HER. See "Risk Factors -- Government Regulation." The regulatory framework in certain jurisdictions in which HER provides its services is briefly described below. United Kingdom Since the elimination in 1991 of the United Kingdom telecommunications duopoly consisting of British Telecommunications and Mercury, it has been the stated goal of Oftel, the United Kingdom telecommunications regulatory authority, to create a competitive marketplace from which detailed regulation could eventually be withdrawn. The United Kingdom has already liberalized its market beyond the requirements of the Full Competition Directive, and most restrictions on competition have been removed in practice as well as in law. HER has received a license from the Secretary of State for Trade and Industry which grants it the right to run a telecommunications system or systems in the United Kingdom connected to an overseas telecommunications system and to provide international services over such systems. Like the licenses granted to other providers of international facilities-based services, the license granted to HER on December 18, 1996 was for an initial six months' duration and thereafter is subject to revocation on one month's notice in writing. The short duration of these initial licenses was adopted for administrative convenience on the opening-up of the United Kingdom market for international facilities-based services. The Department of Trade and Industry ("DTI") has confirmed that it intends to replace the initial licenses with new licenses and that it would not revoke an initial license without replacing it with another license giving an equivalent authorization. The DTI is currently discussing with license holders the arrangements to put these new licenses into effect and although the DTI has indicated that the new licenses are expected to be of 25 years' duration, there can be no certainty that this will be the case or that the new licenses will not contain terms or conditions unfavorable to HER. The Netherlands On July 1, 1997, the Dutch government abolished the prohibition on the use of fixed infrastructure for the provision of public voice telephony, thereby complying with the requirements of the Full Competition Directive six months ahead of schedule. On August 1, 1996, HER was granted an authorization for the installation, maintenance and use of a fixed telecommunications infrastructure. An entirely new Telecommunications Bill was introduced to the Second Chamber (the House of Representatives) of the Parliament on September 15, 1997 and is expected to be enacted in the near future. The new Telecommunications Act is intended to confirm the full liberalization of the telecommunications market according to European Community standards. It is not expected that the new Telecommunications Act will detrimentally affect the conduct of business by HER. 87 93 Belgium Belgium has implemented the "alternative infrastructure" provider provision of the Full Competition Directive. The decision-making process regarding the adoption of the full package of liberalization legislation (including licensing regimes for voice telephony and public network infrastructure) is in the final stages and is anticipated to be completed by mid -- 1998. Given the fact that the implementation of the EC Directives is late, the Belgian authorities have made public that they will work during the first months of 1998 with a system of provisional licenses. HER has already obtained, through a wholly owned subsidiary, a license in February 1997 from the Belgian regulatory authority to build infrastructure between major Belgian population centers and the relevant border crossings. HER also has an authorization to provide liberalized services using alternative infrastructure. The liberalization legislation is expected to require all previously licensed operators to apply for new licenses or authorizations. HER expects that, in such event, its existing licenses and authorizations would be renewed in due course, although there can be no assurance that this will be the case. Germany Germany has approved legislation to implement the Full Competition Directive and remove all remaining restrictions on competition from January 1998. HER was granted a license by the German regulatory authorities on July 18, 1997. The license permits HER to operate the portions of the network in Germany connecting Dusseldorf, Frankfurt and Stuttgart; Dusseldorf to the Dutch border; and Stuttgart to the French and Swiss borders. HER has applied for a license covering all of Germany in order to enable it to operate the remaining portions of the network in Germany. France A new regulatory agency, the Autorite de Regulation des Telecommunications ("ART"), was established in France effective January 1, 1997. In 1996, France approved legislation to implement the Full Competition Directive and to remove all remaining restrictions on competition from January 1998. HER applied for an authorization to operate its network in specific regions of France, which was approved on October 22, 1997. HER filed an application with ART for a geographical extension of its license in order to extend its network in France to reach Italy and Spain, although there is no assurance that the extension will be granted. In October 1997, HER obtained authorization to operate its network in specific regions of France. Such authorization requires prior notification to and approval of the ART of any substantial changes in the capital of HER or its controlling shareholder. HER has notified the ART of the Company's IPO and of the March 1998 increase to approximately 89% of GTS-Hermes' ownership interest in HER. Switzerland The Swiss Parliament has passed a Telecommunications Law which entered into force on January 1, 1998. Although Switzerland is not a Member State of the EU, the effect of the law is largely to mirror the EC telecommunications liberalization Directives, and therefore, from that date existing voice telephony monopoly will be abolished and such services will be fully liberalized. An independent national regulatory authority has previously been established. HER obtained a trial concession on October 30, 1997, in order to roll out its network and to provide its services in advance of the full liberalization coming into effect on January 1, 1998. This concession expired on December 31, 1997. HER has filed an application for a concession for the operation of a telecommunications infrastructure and was granted a provisional concession on March 16, 1998. The provisional concession takes retroactive effect as of January 1, 1998 and HER expects that the Swiss regulatory authority will grant HER a final concession by the end of the third quarter 1998. However, no assurance can be given that such final concession will be granted or granted on terms acceptable to HER. Italy Although in the past Italy has been dilatory in implementing EC liberalization measures, Italy enacted legislation on July 31, 1997 creating an independent national regulatory authority for the telecommunications and audiovisual sectors. The regulatory authority is expected to start work in June 1998. On September 19, 1997, Italy enacted a regulation implementing all EC directives in the telecommunications sector and since 88 94 then specific laws relating to licensing and interconnection have been approved. HER applied for a license to provide its services on May 25, 1998. Spain Under the Full Competition Directive, Spain was granted the right to request a delay of up to five years in liberalizing fully its telecommunications market. However, the Spanish government and the European Commission have agreed that full liberalization should take place by December 1, 1998. In order to ensure effective liberalization from that date, the Commission Decision granting the eleven-month extension sets out a timetable of interim measures leading up to full liberalization. These measures include the passing of legislation authorizing regional cable operators to provide telecommunications services and the adoption of a new General Telecommunications Bill effectively transposing EC Directives into Spanish law. Further, RETEVISION, S.A. has been granted a second national operator's license to compete with the national PTO, and Spain has agreed to grant a third national operator license in early 1998. In April 1998, Spain adopted its new telecommunications law ("LGT"). The LGT will be implemented through the use of secondary legislation that should be adopted by August 1998. The LGT and the secondary legislation should result in the full liberalization of the Spanish telecommunications market. HER intends to apply for a license to provide its services in due course. Sweden Full liberalization of the Swedish telecommunications market occurred in 1993. A new Telecommunications Act was passed this year to reinforce the powers of the national regulatory authority, to ensure conformity with EC Directives and to supplement the pre-existing licensing regime with a general authorization regime for services other than telephony services, mobile services and leased lines. HER intends to register to provide its services in due course. Denmark With the liberalization of infrastructure as of July 1, 1997, Denmark has fully liberalized its telecommunications markets in accordance with the requirements of the relevant EC Directives. An independent national regulatory authority has been established. According to the Danish rules, HER will not require any regulatory approval in order to install or operate the network in Denmark. In addition to the discussion above, HER intends to file applications in other countries in anticipation of service launch in accordance with the HER network roll-out plan. The terms and conditions of HER's licenses, authorizations or registrations may limit or otherwise affect HER's scope of operations. There can be no assurance that HER will be able to obtain, maintain or renew licenses, authorizations or registrations to provide the services it currently provides and plans to provide, that such licenses, authorizations or registrations will be issued or renewed on terms or with fees that are commercially viable, or that the licenses, authorizations or registrations required in the future can be obtained by HER. The loss of, or failure to obtain, these licenses, authorizations or registrations or a substantial limitation upon the terms of these licenses, authorizations or registrations could have a material adverse effect on HER and the Company. GTS-MONACO ACCESS GTS owns a 50% interest in and manages GTS-Monaco Access, a joint venture with the Principality of Monaco created to develop Monaco's existing international telecommunications infrastructure into an international gateway hub for transport of international traffic to European and overseas destinations. The Principality has constructed and operates a sophisticated gateway infrastructure that includes an international digital switching center and a satellite earth station to support significant amounts of carriers' carrier traffic. Through Monaco's network, GTS-Monaco Access is linked to approximately 170 countries worldwide through its network. GTS believes that this partnership provides it with the opportunity to build a strong international gateway presence in lucrative Western European markets. 89 95 GTS-Monaco Access offers competitively priced international switching and transit services, primarily to the "wholesale" international gateway and carrier-to-carrier portion of the international calling market, as distinguished from "retail" services offered to end users. Basic service offerings include (i) international switched traffic; (ii) international private lines; (iii) facilities management, including billing, customer management and fault reduction systems; (iv) resale distribution for Internet service providers; and (v) prepaid calling card platform services. With the cooperation of Monaco Telecom ("MT"), GTS-Monaco Access is entitled to exercise the privileges of signatories to international treaties such as the ITU, and to international satellite agreements, such as Intelsat, Inmarsat and Eutelsat. Other signatories are generally PTOs and other quasi-governmental telecommunications entities. GTS-Monaco Access purchases capacity on international fiber routes at rates available only to recognized operators which are substantially below the rates charged to other service providers. These fiber-based facilities are an important element for GTS-Monaco Access's core network and provide it with capacity that may be leased or resold to customers. Monaco inaugurated its independent country code, 377, on June 21, 1996, which made it eligible for certain privileges, including special terms (generally reserved for PTOs) in connection with transmission agreements, transit agreements, settlements and low-cost accounting rates with select carriers. GTS's partner in GTS-Monaco Access is an investment fund designated by the Principality of Monaco to represent its interests. GTS-Monaco Access functions in cooperation with MT under a commercial agreement governing, among other things, the terms of use of existing facilities, access to and acquisition of new international infrastructure. GTS exercises operational control of the joint venture, and provides managerial and financial support, international telecommunications expertise and strategic planning. Neither GTS nor its partner is obligated to fund operations or capital expenditures of GTS-Monaco Access. Losses and profits of GTS-Monaco Access are allocated to the partners in accordance with their ownership percentages, in consideration of funds at risk. As of March 31, 1998, GTS and its partner had each made equity contributions of $0.8 million to GTS-Monaco Access. In addition, GTS-Monaco Access had outstanding loans of $2.7 million to GTS as of March 31, 1998. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Accounting Methodology -- Profit and Loss Accounting." The agreement between GTS-Monaco Access and MT, by its terms, continues in operation until 2020. MT, 50% partner in GTS-Monaco Access and the local telephone operator for the Principality of Monaco, is presently seeking a partner to purchase a minority stake in MT. The sale of such stake, if undertaken, should not be dilutive to the economic interest of the Company in GTS-Monaco Access although the impact of such sale on the strategic view of MT toward GTS-Monaco Access cannot be determined at this time. BUSINESS AND MARKETING STRATEGY GTS's strategy for developing GTS-Monaco Access into an international gateway hub includes the following: - Develop Advanced Carrier Services Offerings. GTS-Monaco Access may develop its "advanced carrier services" offerings to include global 0800 services and international free phone services, which GTS believes will broaden customer relationships, enhance revenues and help to protect it from price-based competition. - Develop Relationships to Broaden Service Offerings. GTS-Monaco Access may develop relationships to broaden its service offerings. GTS-Monaco Access has entered into agreements with UUNET, one of its gateway customers, to provide wholesale Internet access to GTS-Monaco Access's carrier customers in a number of Western European countries. The agreement allows these services to be "cobranded" with GTS's affiliates. - Pricing. Price is a critical factor in the market for international switching as competition increases due to expanding international capacity, advances in technology and falling regulatory barriers. GTS- Monaco Access intends to price its services competitively with the prevailing price for comparable inter-PTO transit and gateway services. GTS-Monaco Access is not bound by legacy systems, infrastructure and personnel levels and can, therefore, manage competitive cost operations. 90 96 - Leverage Non-Aligned Position. Because GTS's Western European activities are not allied with any of the major consortia or large Western European telecommunications companies, GTS-Monaco Access may be considered an attractive service provider for Western European carriers who may otherwise be reluctant to obtain services from the larger operators of international gateways that are often their competitors in the retail market. - Exploit GTS Synergies. GTS-Monaco Access may ally with other GTS companies in Europe and the CIS. GTS-Monaco Access is expected to realize significant reductions in its cost structure through access to low-cost pan-European transmission capacity through alternative infrastructure providers such as HER, Sovintel and C-Datacom International, Inc., GTS's Indian venture, already route international traffic through GTS-Monaco Access's gateway. CUSTOMERS Targeted customers for GTS-Monaco Access include: - Non-Aligned PTOs. GTS believes that various large American and Western European PTOs that lack adequate international switching and transport facilities of their own may be persuaded to purchase international services from GTS-Monaco Access, rather than from competing PTOs or consortia. - Mobile Carriers. GTS believes that some of the non-PTO mobile carriers, which currently provide only a small percentage of Western European mobile telecommunications traffic, may prefer the "independent" international gateway service offerings of GTS-Monaco Access to those of their PTO competitors. - Internet Service Providers. Growth in Internet usage creates a significant opportunity for a nonaligned Internet access provider such as GTS-Monaco Access, since many Internet service providers will be in direct competition with PTO-owned services in large European markets. - Second Carriers/Resellers. GTS believes that many second carriers will seek to enter new markets quickly without investing in international switching capacity. - Established ("Aligned") PTOs. This customer segment will be a niche market for GTS-Monaco Access. As markets are deregulated and carriers become increasingly competitive, traditional friendly correspondent relations may become strained, and opportunities may emerge to leverage GTS's non-aligned status to route traffic between rivals or to displace incumbents for transit relationships. - Other GTS Companies. GTS-Monaco Access currently provides gateway services indirectly to Sovintel, CDI and other GTS companies that aggregate traffic or provide international long distance services. It may also provide these services to HER. In January 1998, GTS-Monaco Access terminated its relationship with a major traffic partner as a result of which GTS expects that the venture will lose approximately $6 million of revenues in 1998. Although GTS-Monaco Access is putting in place plans to replace such revenues from other sources, no assurance can be provided that such revenues will be replaced in the current fiscal year. NETWORK GTS has enhanced MT's existing technology platform of digital switching, fiber optic transmission, satellite and submarine cable facilities by interconnecting this existing network infrastructure to multiple terrestrial routes covering Europe and to undersea fiber optic cables connecting the GTS-Monaco Access network to Asia and the Americas. The network infrastructure of GTS-Monaco Access is complementary with that of HER, with each serving the carriers' carrier market from different perspectives; HER for bandwidth services and GTS-Monaco Access for switched call terminations and other carrier services. 91 97 LICENSES AND REGULATORY ISSUES Because it operates in coordination with MT, the licensed operator of the Monaco public network, and in indirect partnership with the government, GTS-Monaco Access's telecommunications activities in Monaco require no telecommunications license. Because the Principality of Monaco is not an EU member state, GTS-Monaco Access's telecommunications activities in the Principality are not directly subject to European Community law. However, GTS-Monaco Access will have to comply with EU regulation to the extent it does business in EU member states or its business has an effect on trade between EU member states. The regulatory requirements established by the EU create general guidelines under which the national agencies of EU member states regulate. Accordingly, local laws and regulations may differ significantly among these jurisdictions, and the interpretation and enforcement of such laws and regulations may vary. Local rules are sometimes based on the informal views of the local ministries which, in some cases, are subject to influence by the local PTOs. In certain of the Company's existing and target markets, there are laws and regulations which affect the number and types of customers which the Company can address. For instance, certain countries may and do require licenses for communication companies to interconnect to the public network to originate traffic. In addition, one of the services provided by GTS-Monaco Access is a form of transit service, known in the industry as "re-filing." Re-filing is the practice of routing traffic through a third country in order to take advantage of disparities in settlement rates between different countries, allowing traffic to a potential country to be treated as if it originated in the third country that enjoys lower settlement rates with the destination country, thereby resulting in lower overall costs on an end-to-end basis. Re-filing is prevalent in the industry even though the practice is technically in contravention of ITU regulations. In practice, because of the widespread non-observance of these regulations, such a contravention normally does not give rise to specific legal problems. However, their enforceability essentially depends on the status given to ITU obligations by Member countries' domestic laws. Accordingly, there can be no assurance that GTS-Monaco Access's re-filing services might not be disrupted or be the subject of legal process at some time in the future. In such event, within the EU a defense may be available that the ITU regulations are anti-competitive and contravene the Treaty of Rome, although there can be no certainty that such a defense would succeed. COMPETITION GTS-Monaco Access faces competition from consortia of telecommunications operators, large PTOs and other international telephone operators with advanced network infrastructures, access to large quantities of long-haul capacity and established customer bases. PTOs currently providing large amounts of international traffic have already established direct routes, transit arrangements and correspondent relations and many have excess capacity that they resell in competition with GTS-Monaco Access. With the advent of deregulation in the Western European telecommunications markets in 1998, opportunities for the establishment of international gateways will likely develop in Europe and as a result competition in the market for GTS-Monaco Access's services will increase. GTS-Monaco Access intends to evaluate additional locations in Europe for the establishment of international hubs based upon prospective costs and the availability of call routing at these locations. GTS-Monaco Access plans to locate these prospective points of presence in cities served by HER and to allow the termination of traffic through HER. GTS-Monaco Access may benefit from the establishment of these points of presence by incurring reduced transmission expenses. While the Company believes that GTS-Monaco Access will be able to compete effectively in certain identified market segments because most of its targeted customers are in new and fast growing markets and have not established long-term relationships with international gateway providers, and because it has equal access to advanced infrastructure and international fiber routes, potential access to low cost transport from HER and an "independent" status that allows it to service a worldwide range of potential customers, the Company intends continually to review the competitiveness of GTS-Monaco Access with respect to its competitors. 92 98 EUROPEAN SERVICES STRATEGY General. In order to capitalize on the increasing liberalization of telecommunications regulation in Europe, GTS intends to offer through one or more subsidiaries facilities-based telecommunications products and services primarily to business and other high-usage customers in certain metropolitan markets throughout Europe. GTS presently provides end user services in Russia, the CIS and Central Europe and carriers' carrier services in Western Europe and has experience in developing cross-border networks in Western Europe through HER. Management has developed a business plan for the Company's European Services Strategy that calls for the Company to leverage its experience in developing and operating local, national and international telecommunications networks by building, acquiring or leasing technologically advanced fiber optic networks and establishing CLEC service capabilities in up to 12 metropolitan markets throughout Europe, as regulatory conditions permit, within three years after the Company commences implementing its European Services Strategy. Currently the regulatory regimes in Europe vary from country to country and some countries do not permit competitive local exchange carriers to operate. See "Risk Factors -- Risks Relating to European Services Strategy." Market and Business Strategy. GTS believes that the size and growth potential of the European telecommunications market, and the increasing liberalization of telecommunications regulations in Europe, offer considerable opportunities to expand into end-user services into metropolitan markets throughout Europe. The size of the European telecommunications services market is estimated to be approximately $188 billion in 1998. The Company estimates that the total European addressable market (defined as non-residential core voice, enhanced voice, non-residential international voice, data, leased line voice and internet) in 1998 is approximately $96.5 billion, which is estimated to grow at a compound annual growth rate of approximately 13.7% to approximately $306.7 billion by 2007. Through construction of owned facilities or acquisition or partnership with other providers, GTS intends to enter up to 12 European metropolitan markets. The Company's strategy with respect to entry into a specific market will be determined through an analysis of a number of demographic, economic and telecommunications demand and spending characteristics, including business concentration; presence of governmental, financial and business end-user customers; local economic trends and prospects; demand for switched and non-switched telecommunications services; feasibility of construction; presence of existing and potential competitors; the regulatory environment; the market's proximity to HER's network; and the presence of potential CLEC or reseller acquisition candidates. In targeting cities in which its entry strategy will be the construction of a fiber network, the Company will initially focus on cities in which there are no CLEC competitors or only one other such competitor. Management's current intention is to enter two metropolitan markets within 12 months after the Company initiates implementing the European Services Strategy and to provide services in all 12 target metropolitan markets within three years after such commencement date. The Company expects to use one or more of the following strategies to enter a market: (i) construction of a fiber-loop network; (ii) purchase or long-term lease of dark fiber; (iii) obtaining of high frequency microwave licenses for "wireless fiber," (iv) partnership with or acquisition of a local facilities-based CLEC or (v) acquisition or development of a local reseller. In the case of market entry through a reseller, it is the Company's objective to build or acquire facilities when economically justifiable. There are a number of risks attendant with each of these strategies and there can be no assurance that the Company will be successful in pursuing any of these strategies. See "Risk Factors -- Risks Relating to European Services Strategy." Customers. The Company plans to offer its products and services primarily to telecommunications-intensive businesses for which reliable telecommunications services are critical, using the Company's facilities where available and/or reselling other carriers' facilities as needed. These business segments include financial services companies, multi-national companies, governmental agencies, resellers, internet service providers ("IPs"), disaster recovery service providers and wireless communications companies. Products and Services. The Company intends to offer a broad array of competitively priced, comprehensive services to meet customer telecommunications service requirements, including private line services, local, 93 99 national and international switched telephony services, high-speed LAN interconnection services, virtual private network services, video transmission services and IP based services, including IP telephony and data transmission services. According to industry sources, bandwidth demand for data in the United States is currently growing significantly faster than voice and the Company expects that this trend will develop in Europe as competitively priced capacity becomes available. Additionally, the Company intends to develop competitively priced value-added telecommunications services that are tailored to the specific needs of individual customers. The types of services that the Company intends to offer include: - Switched Services. Switched services involve the transmission of voice, data or video to locations specified by end-users or carriers. The Company expects to have the technological capability to offer a full range of switched service, including local, national and international calls as well as enhanced services. The Company intends to own and operate switches and enter into interconnection agreements with other telecommunication service providers, including HER, in order to offer to customers cost-effective local, national and international calling services. Switched service features are expected to include, as allowed by local regulations, enhanced services such as conference calling, call forwarding, analog or digital connectivity, desk-to-desk calling, four digit dialing full network monitoring and maintenance, caller ID, voice mail/messaging and E-mail to voice-mail conversion. - Non-Switched Services. Non-switched services involve a fixed, dedicated communications link between two or more specific locations. Commonly this service is utilized by an end-user to provide a private communications medium between multiple business facilities or to another end-user/carrier. The Company expects to provide high capacity, advanced technology to deliver customer traffic with a lower cost and higher reliability as compared to the local PTO. Through its high capacity, high reliability and cost-efficient network, the Company intends to provide non-switched voice, data and video transmission between (i) end users, (ii) end users and carriers and (iii) multiple carriers, allowing its customers the option to bypass the older, less efficient technology and higher-priced services of the incumbent PTOs. - Other Services. The Company also intends to develop service offerings to take advantage of emerging market opportunities. Such services are expected to involve one or more of the following: frame relay, ISDN and ATM services; IP-based services, including intranet and extranet services, high capacity internet for multi-media applications, voice over IP and the establishment of a pan-European IP backbone in alliance with others; calling card services; and enhanced voice services. These products are expected to be developed and offered as customer demand dictates and as the relevant regulatory environment permits. The Company believes that there will be substantial demand for data and internet services by large business and other high-usage customers, and that a bundled service offering of national and international data and voice services will be attractive to this targeted customer base. Regulatory. The Company's preliminary plans with respect to its European Services Strategy will subject the Company to significant additional regulation at the EU, national and local level. The Company's determination as to which markets it may enter will depend in part on the Company's evaluation of the regulatory regime in such market. The detailed regulation varies from country to country. Delays in receiving required regulatory approvals and licenses, or the enactment of adverse regulations or regulatory requirements, may delay or prevent the Company from entering a particular market or offering its services in any European market, restrict the types of services offered by the Company, constrain the Company's deployment of its networks or otherwise adversely affect the Company's operations. There can be no assurance that the Company will be able to obtain the necessary regulatory approvals on a timely basis or that the Company will not otherwise be affected by regulatory developments, either of which may have a material adverse affect on the Company. See "Risk Factors -- Risks Relating to European Services Strategy." Competition. The telecommunications industry is highly competitive. Competition in the telecommunications industry is based largely on price, customer service, network quality, value-added services and customer relationships. Competition for the provision of local services in Europe is in its early stages of development. Generally, PTOs offer both local and long distance services and benefit greatly from their position as sole historic provider in the markets they serve. PTOs generally have a number of competitive 94 100 advantages over emerging competitors, such as the Company and other CLECs, due to substantially greater economic and human resources, close ties to local and national regulatory authorities and control over virtually all local telecommunications connectivity. Additionally, GTS believes that the market for the provision of local services is sufficiently attractive to cause additional CLECs, including multi-national carriers, to enter the market to offer products and services which would compete with the Company. The Company will compete with PTOs and, in certain markets, CLECs in the provision of high quality, integrated telecommunications services to end-users and resellers. CLEC competitors include, among others, COLT Telecom Group plc, which is providing service through networks in London, Frankfurt, Munich, Hamburg and Paris; and WorldCom, which has commenced the construction of a Pan-European fiber network, the first phase of which is expected to connect London, Amsterdam, Brussels, Frankfurt and Paris. GTS believes, based on its experience in providing end-user services in Russia, the CIS and Central Europe and carrier's services in Western Europe and in developing cross-border networks in Western Europe through HER, that it has the knowledge and ability to develop products and services which will be competitive with other CLECs in terms of content, quality and price. However, there can be no assurance that the Company will be able to translate such experience in other markets in order to compete effectively with PTOs or CLECs in the European markets it has targeted. See "Risk Factors -- Risks Relating to European Services Strategy." Network. In the markets which the Company determines to enter as a facilities-based CLEC, the Company intends to construct, acquire or lease facilities to operate advanced, competitive local telecommunications networks employing current transmission technology with dual ring architecture and central system monitoring and maintenance. The Company believes that a base of uniform, reliable networks, which employ the most current technology and support a broad array of high quality services, will allow the Company to compete cost-effectively against products and services offered by PTOs and, in certain markets, other CLECs. The Company's plan for its basic transmission platform is optical fiber deployed in rings, equipped with high-capacity SDH equipment. Such rings will provide redundancy by using dual paths for telecommunications transmissions and will extend to a customer facility either directly or on a point-to-point link from the rings. Such rings will finally connect to the customer through customer-dedicated or shared electronics on or near the customer premises. Network Construction. Prior to undertaking acquisition or construction of a network in a particular market, the Company will undertake an analysis of a number of factors, as discussed above, to determine whether such acquisition or construction is economically justifiable. Wherever appropriate, the Company will seek to purchase or lease dark fiber or utilize high-frequency short-haul microwave as a method of accelerated entry into a selected market. GTS expects that construction and installation services will be provided by independent contractors selected through a competitive bidding process. Company personnel are expected to provide project management services, including contract negotiation, construction supervision, testing and certification of installed facilities. The construction period of a network is expected to vary greatly, depending on such factors as network route kilometers, number of buildings involved in the initial installation and local construction regulations. Upon completion of the first phase of construction, or the initial loop, the Company expects to commence generating revenue. Further expansion of the network will be dictated by customer growth and customers' relative proximity to the initial loop. The initial capital requirement for implementing the European Services Strategy will be financed with a majority of the proceeds of the Offerings received by the Company. In addition, the Company contemplates that following the consummation of the Offerings, it will raise approximately $250 million of additional financing in the form of debt securities to be issued by a newly formed subsidiary of the Company. The proceeds will be applied toward the implementation of the Company's European Services Strategy. Due to the preliminary nature of the Company's business plan for such strategy, the Company cannot estimate with any degree of certainty the amount and timing of the Company's future capital requirements for such implementation, which will be dependent on many factors, including the success of the Company's European services business, the rate at which the Company expands its networks and develops new networks, the types of services the Company offers, staffing levels, acquisitions and customer growth, as well as other factors that are not within the Company's control including competitive conditions, regulatory developments and capital costs. 95 101 Management believes, however, that if the European Services Strategy is implemented, it is likely that the Company will need to raise additional capital above that being raised in the Offerings. If the New Convertible Bond Offering is not consummated, the Company will need to find additional sources of capital to replace the funding that would have been provided by the New Convertible Bond Offering. See "Risk Factors -- Additional Capital Requirements" and "Management's Discussion and Analysis of Financial Condition and Results of Operations -- European Services Strategy." Sales and Marketing. In each of its target markets, the Company intends to establish its own direct sales force. As the Company will be targeting large financial, corporate and governmental customers with demanding telecommunications service requirements, the Company expects that its internal sales force will include dedicated sales and customer service representatives. Billing and Information Systems. Sophisticated information and processing systems will be vital to the Company's success. Specifically, the Company will need to develop systems to enter, schedule, provision, and track a customer's order from the point of sale to the initiation of service and such systems will need to include, or interface with, trouble-shooting systems, billing, collection and customer service systems. The Company expects the development of its systems to require substantial capital and management resources. CENTRAL EUROPE In Central Europe, GTS's objective is to become one of the leading alternative telecommunications providers in the region. GTS currently provides private data communications services to government and commercial customers in Hungary and the Czech Republic. In the Czech Republic, the Company provides outgoing voice services and operates an international gateway and a data services network. In Hungary, GTS operates a VSAT network which GTS believes is the largest VSAT network in Central Europe as measured by number of VSAT sites. The Company has also signed an agreement to provide international data services in Poland, subject to receipt of necessary governmental approvals. GTS's strategy is to expand its service offerings as the regulatory environment permits, leveraging its existing VSAT and international gateway infrastructure where possible and providing a broad range of services to its target markets. Hungary GTS-Hungary. GTS-Hungary, a 99% owned subsidiary of GTS, is a leading provider of customized data services offering high quality, reliable virtual private network services to customers throughout Hungary and, through other GTS affiliates, other countries in Central Europe. GTS-Hungary provides these services through VSATs installed at customer sites throughout the country and a microwave-based high speed overlay network for points in the Budapest metropolitan area. Along with these data transmission services, GTS-Hungary provides high quality customer service including (i) significant system integration support in the initial implementation of the customers' networks and in on-going expansion and improvements and (ii) a unique maintenance and technical support service, which include "rapid response" service calls and 24-hour hub service operations support, which can be backed by financial guarantees when required. As of March 31, 1998, GTS-Hungary's VSAT network consisted of approximately 997 owned and operated VSAT sites which the Company believes makes it the largest VSAT-based network in Central Europe. GTS believes that its choice of VSAT technology as a way of quickly deploying a full range of business services nationwide will allow it to capture key customers and market segments. Such positioning, the Company believes, will enable GTS-Hungary to expand its service offerings as the Central European market matures and as regulatory authorities further privatize and deregulate the telecommunications industry. GTS-Hungary is undertaking a nationwide expansion of its microwave-based Budapest overlay network and plans to develop two fiber loops in Budapest. The expansion will increase GTS-Hungary's revenue base in the region and provide opportunities to leverage further its other service offerings. There can be no assurance, however, that the expansion will be completed on a timely and commercially feasible basis. The Hungarian state lottery is GTS-Hungary's largest customer, accounting for more than 50% of GTS-Hungary's total revenue for the year ended December 31, 1997 and the three months ended March 31, 1998. GTS-Hungary has also targeted its VSAT network services to business customers in the domestic service industry and other government organizations. Although GTS-Hungary continues to diversify its revenue and 96 102 customer base, the loss of the Hungarian state lottery as a customer would have a material adverse effect on GTS-Hungary's business. GTS-Hungary generally charges its data services customers a flat monthly fee for a fixed amount of usage and usage-based fees for use above the contractual amount. Customers are billed in Hungarian forints (indexed to U.S. dollars) on a monthly basis. Pricing is generally determined for an individual client based upon the size of traffic requirements. In general, GTS-Hungary's strategy is to minimize the initial customer investment in order to lower the barriers to purchase, while committing customers to long-term contracts. GTS-Hungary's major competitors include BankNet, Hungaro-DigiTel and MATAV, the Hungarian PTO, each of which operates a network with at least 200 VSAT sites. MATAV offers a broad range of services and has recently targeted the business sector that GTS serves. GTS believes that, while some of its competitors have stronger financial resources, GTS-Hungary remains the leading VSAT service provider in Hungary in terms of number of VSAT sites, the size and quality of its infrastructure and the quality of its service. GTS also believes it has distinguished itself from its competition by its superior customer service. Currently, all VSAT licenses in Hungary have been granted under temporary telecommunications regulations. The temporary licenses prohibit connection to public telecommunications networks or other international or domestic data-transmitting systems. In December 1993, GTS received a temporary service permit to provide data-transfer services utilizing a VSAT-based wireless communications system throughout Hungary. In March 1997 the government issued new telecommunications regulations which require all operations with temporary licenses to apply for permanent licenses by the end of April 1997. GTS-Hungary has submitted applications for the conversion of its temporary licenses to permanent ones. While no assurances can be given, GTS expects permanent licenses to be issued in due course. The failure to receive such licenses would have a material adverse effect on the business of GTS-Hungary. Neither GTS nor its partner in GTS-Hungary is obligated to fund operations or capital expenditures of GTS-Hungary. Losses and profits of GTS-Hungary are allocated to the partners in accordance with their ownership percentages, in consideration of funds at risk. As of March 31, 1998, GTS had made equity contributions of $12.5 million to GTS-Hungary, GTS' partner has not made any equity contributions as of December 31, 1997. In addition, GTS-Hungary had outstanding loans of $2.0 million to GTS as of March 31, 1998. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Accounting Methodology -- Profit and Loss Accounting." Further, the joint venture does not have an expiration date. EuroHivo. In addition to its network and data services, GTS also provides nationwide paging services primarily to the retail consumer market through its 70% owned joint venture, EuroHivo. During 1997, GTS concluded that EuroHivo was not a core business and was assessing offers to sell its interests in EuroHivo. In connection with this anticipated divestiture, the Company wrote-off its investment in EuroHivo in the third quarter of 1997. In April 1998, GTS entered into a definitive agreement to sell its interest in EuroHivo. Closing of such sale is subject to customary conditions precedent. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Results of Operations -- Consolidated Ventures." Czech Republic Czechnet. Czechnet, a wholly owned subsidiary of GTS, offers the only alternative international telephony service in the Czech Republic, as well as a full range of private data services, delivered through a combination of a fully digital microwave overlay network and an international satellite gateway in Prague and GTS-Hungary's VSAT network. Through an intercompany arrangement with GTS-Hungary, Czechnet provides all of the same VSAT services offered by GTS-Hungary. In addition, Czechnet offers high-speed Internet access service and is among the leading Internet access providers in the Czech Republic. Czechnet seeks to become the second carrier in the Czech Republic and is also targeting opportunities in Slovakia, based upon the historic relationship between the Czech and Slovak markets. 97 103 The Czechnet network consists of an earth station linked to GTS-Monaco Access and to British Telecom, a series of point-to-point and point-to-multipoint microwave connections providing dedicated access to the buildings served by Czechnet and individual VSATs based on, and controlled by, GTS-Hungary's hub in Budapest. Czechnet's target customers include real estate developers, hotels and multinational companies which require international voice or data services or Internet connectivity, where both GTS's own services and the services of GTS partners are sold. Czechnet provides outgoing international voice services and high-speed Internet access to large commercial buildings in Prague. As of March 31, 1998, Czechnet had concluded agreements with building owners to convert PABXs in 29 buildings in Prague. International voice services are offered at prices similar to those of the Czech PTO. Czechnet plans to pursue customers who require value-added services which may be offered at higher prices and better margins. Czechnet is licensed to provide international satellite and domestic private voice and data services. It received its operating licenses in 1994 and 1995 and began offering services in 1995. The licenses grant permission to install and operate up to 150 earth stations and, upon application, an additional 150 earth stations. The licenses currently prohibit the provision of switched voice services and the interconnection to public voice, telex and data networks and telecommunications networks of other providers. Czechnet is the only alternative international telephony provider licensed in the Czech Republic. As such, its only competitor is SPT Telecom, the Czech PTO. Should SPT decide to compete aggressively with Czechnet, it has the ability to discount prices below those which could be easily sustained by Czechnet. In data services, Telenor, GITY and Nextel (a subsidiary of SPT Telecom) are Czechnet's three major competitors for data services in the Czech Republic. GTS believes that its experience in establishing VSAT services in the region and its emphasis on integrated voice and data services provides Czechnet with a competitive advantage. Additionally, GTS's transmission facilities and infrastructure in Hungary and Monaco provide them with a relatively low cost infrastructure and, as a consequence, greater pricing flexibility than their competitors. With respect to Internet services, GTS believes that, although this market consists of a large number of small providers and that SPT Telecom will seek to enter this market, the dedicated, high-speed infrastructure that Czechnet is installing will provide superior services to its customers. ASIA Chinese law generally prohibits foreign investment or participation in the operation of telecommunications services, while Indian law requires foreign telecommunications operators to conduct certain telecommunications businesses, including basic switched telephony and cellular services, through joint ventures that are at least 51% owned by Indian partners. GTS believes that these restrictive regulations will eventually be liberalized and that its early entry into these markets and its strong relationships with influential commercial firms and with local, regional and national-level government entities will provide it with a strong competitive advantage over competitors that await more explicit regulatory regimes authorizing direct telecommunications investments. China GTS participates in the nationwide tourist industry VSAT network through GTS China Investments LLC, a company in which GTS holds a 75% interest and an affiliate of a shareholder of the Company owns a 25% interest. See "Certain Related Party Transactions." GTS China Investments LLC holds an indirect 63% interest in Beijing Tianmu Satellite Communications Technology Co. Ltd. ("Beijing Tianmu"), which provides technical, operational and financial support for the VSAT network. In addition, through Shanghai V-Tech Telecommunications Systems Co., Ltd. ("V-Tech"), a venture in which GTS holds a 75% interest, the Company provides financing, operational consulting, technical and engineering services to a Shanghai-based VSAT network operator. With respect to V-Tech, in addition to the Company's initial equity contribution of $3.75 million, GTS committed to fund up to an additional $3.0 million (all of which has been funded by the end of the third quarter of 1997). The joint venture expires in April 2015, and profits and losses are allocated according to 98 104 ownership interests in consideration of funds at risk. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Accounting Methodology -- Profit and Loss Accounting." GTS currently is evaluating adding additional partners to V-Tech which may reduce GTS's ownership interest in V-Tech. With respect to Beijing Tianmu, in addition to the Company's initial equity contribution of $8.75 million, GTS is responsible for arranging additional financing of up to $14.4 million, subject to the approval of the venture's Board of Directors, the majority of members of which are elected by GTS. The joint venture expires in March 2021, and profits and losses are allocated according to ownership interests, in consideration of funds at risk. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Accounting Methodology -- Profit and Loss Accounting." The Company is currently engaged in negotiations to sell its ownership interest in one of the Chinese ventures in consideration of an interest in the purchaser of the Company's interest in such venture. India In India, GTS is following the strategy it implemented in Moscow and is currently pursuing in Central Europe, in which it initially penetrates the telecommunications market by developing satellite-based international gateway networks to provide telecommunications services to targeted business customers. GTS's operations in India are conducted through C-Datacom International, Inc. ("CDI"), a wholly owned subsidiary which provides digital international private line communications to and from India for multiple applications, including data and voice. While not permitted to provide telephony services, CDI is currently in the process of installing an international gateway switch adjacent to GTS-Monaco Access's international gateway for the purpose of handling international traffic. EMPLOYEES On March 31, 1998, GTS, its consolidated subsidiaries and joint ventures in which GTS participates, employed approximately 1,715 persons. The Company believes its future success will depend on its continued ability to attract and retain highly skilled and qualified employees. The Company believes that its relations with its employees are good. Although GTS's employees are not unionized, unions represent employees of the Company's railroad partners in HER. Under the agreements contemplated between HER and its railroad partners, some of these employees will be required to construct and maintain certain portions of the HER network. There can be no assurances that unionized employees of HER's partners will not experience labor unrest. PROPERTIES The Company leases, under long-term leases, office space to serve as sales office and/or administrative facilities, including its 15,000 square-foot headquarters in McLean, Virginia with a five year lease expiring December, 2000. The Company has entered into a new lease for its headquarters in McLean covering 33,000 square feet, which lease will expire September, 2005. The Company expects to relocate to the new space in the first quarter 1999 and plans to sublease its current offices. The Company maintains regional headquarters offices in Moscow and Budapest, as well as facilities in McLean, Virginia and London. HER is headquartered just outside of Brussels, Belgium. HER leases, under long-term leases, portions of railroad, utility and other rights-of-way for its fiber-optic routes. HER is creating a fiber optic network consisting of optical fiber pairs, which are leased under long-term leases, and technical sites leased under long-term leases. See "Business -- Western Europe -- HER." LITIGATION In addition to routine legal proceedings incidental to the conduct of its business, the Company, GTS-Hungaro and GTS-Hungary are named as defendants in an action captioned USH Ventures and USH Telecom, L.L.C. v. Global TeleSystems Group, Inc. and GTS-Hungaro, Inc., Civil Action No. 97C-08-86, 99 105 commenced in August 1997, which is currently pending in the Superior Court of the State of Delaware in and for New Castle County. The complaint alleges breach of contract and interference with a business relationship. While it is not possible at this time to make a meaningful assessment of the outcome of this litigation, based upon information currently available and upon consultation with counsel, the Company does not believe that the outcome of this litigation will have a material adverse effect upon the financial condition of the Company. On March 27, 1998, V-Tech brought a claim for approximately $1.1 million against Gilat Satellite Networks, Ltd. ("Gilat"), the vendor of a Ku-band VSAT hub and system which V-Tech purchased in 1996, in an arbitration proceeding under the Rules of Arbitration of the ICC International Court of Arbitration. V- Tech has demanded in the request for arbitration that Gilat accept return of the equipment, which V-Tech has not accepted or commissioned because it has failed to meet contract specifications, and refund purchase amounts already paid under the contract, plus other sums. On June 2, 1998 Gilat filed a counterclaim against V-Tech seeking the balance due under the contract and other alleged damages, in the aggregate amount of $685,000. Gilat has stated its intention to join the Company as a third-party respondent to its counterclaim. Although it is not possible at this time to make an assessment of the outcome of the arbitration proceeding, the Company does not believe that Gilat's counterclaim, even if successfully asserted against the Company, would have a material adverse effect upon the Company's financial condition. 100 106 MANAGEMENT The directors, executive officers and key employees of the Company, their positions and their ages are as follows:
NAME AGE POSITIONS ---- --- --------- Alan B. Slifka(1)(4)(6)................ 68 Chairman of the Board of Directors Gerald W. Thames(1)(5)................. 51 President, Chief Executive Officer and Director Bruno d'Avanzo......................... 56 Executive Vice President and Chief Operating Officer William H. Seippel..................... 41 Executive Vice President of Finance and Chief Financial Officer Jan Loeber............................. 54 Senior Vice President -- HER Raymond I. Marks....................... 51 Senior Vice President -- Asia Stewart P. Reich....................... 53 Senior Vice President -- Russia Louis T. Toth.......................... 55 Senior Vice President -- Central Europe Grier C. Raclin........................ 45 Senior Vice President, General Counsel and Secretary Eileen K. Sweeney...................... 46 Senior Vice President -- Human Resources Corporate Kevin Power............................ 44 Managing Director -- GTS-Monaco Access Michael A. Greeley(2)(3)(5)............ 35 Director Bernard McFadden(1)(3)(4)(6)........... 64 Director Stewart J. Paperin(2)(3)(4)(6)......... 50 Director W. James Peet(1)(5).................... 43 Director Jean Salmona(2)(7)..................... 62 Director Joel Schatz(2)(5)...................... 61 Director Adam Solomon(1)(3)(7).................. 45 Director David Dey(2)(3)(7)..................... 60 Director Roger W. Hale(1)(4)(7)................. 54 Director Robert J. Amman(1)(4)(6)............... 60 Director
- - - - --------------- (1) Member of Executive Committee (2) Member of Audit and Budget Committee (3) Member of Compensation Committee (4) Member of Governance Committee (5) Term expires at annual meeting of stockholders in 1999 (6) Term expires at annual meeting of stockholders in 2000 (7) Term expires at annual meeting of stockholders in 2001 Biographical information on each of the foregoing officers follows: Alan B. Slifka, Chairman of the Board of Directors. Mr. Slifka has served as a director of GTS since 1990. Mr. Slifka is a New York investment banker and the Managing Principal of Halcyon/Alan B. Slifka Management Company LLC, an equity asset management firm specializing in nontraditional investments, specifically corporate event investing. Previously, Mr. Slifka was a partner of L.F. Rothschild, Unterberg, Towbin from 1961 to 1982. He is a director of Pall Corporation and is active in other business, civic and philanthropic affairs as founder, director or officer of numerous for-profit and not-for-profit corporations and foundations. Mr. Slifka served as acting Chief Executive Officer of GTS during most of 1993. Gerald W. Thames, President, Chief Executive Officer and Director. Mr. Thames joined GTS as Chief Executive Officer in February 1994, and has served as a director of GTS since February 1994. From 1990 to 1994, Mr. Thames was President and Chief Executive Officer for British Telecom North America and Syncordia, a joint venture company focused on the international outsourcing market. Mr. Thames has spent over 18 years in senior positions with telecommunications companies, where he was responsible for developing start-up telecommunications companies, including 15 years with AT&T, where he rose to the position of General Manager of Network Services for the Northeast Region of AT&T Communications. Bruno d'Avanzo, Executive Vice President and Chief Operating Officer. Mr. d'Avanzo joined GTS as Executive Vice President and Chief Operating Officer in August 1996. From 1994 to 1996, Mr. d'Avanzo was 101 107 Executive Vice President and Chief Operating Officer of Intelsat, the largest telecommunications satellite operator in the world. From 1992 to 1994, Mr. d'Avanzo was a senior executive with Olivetti Corporation, serving as Vice President and General Manager -- Europe and as Vice President -- U.S., Canada and South America. Mr. d'Avanzo also spent 15 years with Digital Equipment Corporation, a diversified computer manufacturer where his last position was Vice President -- European Sales and Marketing. William H. Seippel, Executive Vice President of Finance and Chief Financial Officer. Mr. Seippel joined GTS as Executive Vice President of Finance and Chief Financial Officer in October 1996. From July 1992 to October 1996, Mr. Seippel was Vice President -- Finance and Chief Financial Officer of Landmark Graphics Corporation. From August 1990 to July 1992, Mr. Seippel was Director of Finance for Covia, Inc., an affiliate of United Airlines. From April 1984 to August 1990, Mr. Seippel held the positions of Group Business Controller (1989 to 1990), Group Controller Sales/Marketing (1986 to 1989), and Product Line Controller (1984 to 1986) with Digital Equipment Corporation, a diversified computer manufacturer. Jan Loeber, Senior Vice President -- HER. Mr. Loeber joined GTS in January 1995. From October 1992 to December 1994, Mr. Loeber was a Managing Director of BT Securities Corporation. From April 1990 to September 1992, Mr. Loeber held positions as Managing Director of Unitel Ltd. (now One 2 One) in the United Kingdom, Group President of Nokia North America Inc., Vice President of ITT Corporation, and Marketing and Product Management Director of ITT Europe. Mr. Loeber also spent almost 10 years with AT&T, where his last position was Executive Director, Bell Laboratories. Mr. Loeber has over 22 years of experience in the telecommunications industry and an additional 9 years of experience in information technology with the Pentagon, IBM and Chemical Bank of New York. Raymond I. Marks, Senior Vice President -- Asia. Mr. Marks joined GTS as Senior Vice President -- Asia in July 1994. From October 1986 to June 1994, Mr. Marks served as Vice President and General Manager of GTE Spacenet Corporation, where he had overall responsibility for strategic planning, domestic and international business development, creation of joint ventures and international alliances, as well as the worldwide management of the marketing, sales and technical support organizations. Mr. Marks has also served as Vice President for the Digital Information Group for MCI Communications Corporation. Mr. Marks has 28 years of experience in the telecommunications and computer industries. Grier C. Raclin, Senior Vice President, General Counsel and Corporate Secretary. Mr. Raclin joined GTS as its Senior Vice President and General Counsel in September, 1997, and was elected Corporate Secretary of the Company in December 1997. Prior to joining GTS, Mr. Raclin served as Vice-Chairman and a Managing Partner of the Washington, D.C. office of Gardner, Carton & Douglas, a 250-attorney, corporate law firm based in Chicago, Illinois, where his practice was concentrated in the area of international telecommunications. Mr. Raclin received his undergraduate and law degrees from Northwestern University and attended the University of Chicago School of Business Executive Program. Stewart P. Reich, Senior Vice President -- Russia. Mr. Reich joined GTS as President -- GTS Russia in September 1997. From September 1992 to August 1997, Mr. Reich was President of UTEL, a joint venture of AT&T, Deutsche Telekom, PTT Telecom (Netherlands), and Ukrtelecom (a Ukrainian telecommunications company) which provides international and interregional telecommunications services in Ukraine. From 1982 to 1992, Mr. Reich held various positions at AT&T where his last position was Financial Manager, AT&T International Communications Switched Services. Mr. Reich was also employed for 20 years with Western Electric Company from 1961 to 1981. Eileen K. Sweeney, Senior Vice President -- Human Resources. Ms. Sweeney joined GTS as Senior Vice President -- Human Resources in November, 1997. Prior to joining GTS, Ms. Sweeney was President of Global Resource Associates, a consulting company specializing in international human resource issues. Prior to that time, Ms. Sweeney spent 10 years with ITT Corporation in a variety of human resource management positions, including eight years based in Europe and in the Middle East. Ms. Sweeney holds a Master's Degree in Business Administration from Simmons Graduate School of Management in Boston. Louis T. Toth, Senior Vice President -- Central Europe. Mr. Toth joined GTS as Senior Vice President -- Central Europe in July 1993. From February 1987 to July 1991, Mr. Toth served as President of 102 108 Dynaforce Inc. and as Partner and General Manager for the pan-European expansion of Andlinger & Company. Mr. Toth, who is currently based in London, has 23 years of telecommunications experience with ITT Corporation in Europe, Latin America and Asia. Kevin Power, Managing Director -- GTS Monaco Access. Prior to joining GTS Monaco Access in October 1995, Mr. Power was Vice President, Carrier Relations for the Company beginning in November 1994, where he was responsible for assisting and coordinating the carrier activities of the GTS group of companies. In 1988, Mr. Power was one of a group of five people who started the commercial operations of Orion Network Systems and he stayed with the company until the launch of its first satellite in 1994. His last position there was Vice President of Carrier Services. Prior to that, he held positions with INTELSAT, National Economic Research Associates (NERA) and the U.S. Department of Commerce. Biographical data on each of the directors, other than Mr. Thames, are as follows: Michael A. Greeley, Director. Mr. Greeley has served as a director of GTS since September 1996. Mr. Greeley is the Senior Vice President of GCC Investments, Inc., the investment group of GC Companies, Inc. From June 1989 to July 1994, Mr. Greeley was a Vice President at Wasserstein Perella & Co., Inc., an international investment bank, specializing in mergers and acquisitions and corporate finance transactions. Mr. Greeley is also a director of Teletrac, Inc., Crescent Communications, American Capital Access Holdings, LLC and Fuelman, Inc. By contractual arrangement, GCC Investments, Inc. has the right to designate one person for nomination to the Board of Directors as long as it holds not less than two and one-half percent of the issued and outstanding shares of the Common Stock on a fully diluted basis. Mr. Greeley is the designee of GCC Investments, Inc. to the Board of Directors. Bernard McFadden, Director. Mr. McFadden has served as a director of GTS since February 1994. Mr. McFadden currently serves as an independent consultant for GTS and is a GTS representative on the supervisory board of HER. Mr. McFadden's career in international telecommunications includes 32 years with ITT Corporation, where he served as President and Chief Executive Officer of ITT's Telecom International Group, and a four and one-half year assignment as President and Chief Operating Officer of Alcatel Trade International, S.A. Stewart J. Paperin, Director. Mr. Paperin has served as a director of GTS since March 1997. Mr. Paperin serves as Executive Vice President of the Soros Foundations (The Open Society Institute). In addition, he has served as the President of Capital Resource East since October 1993. Prior to that, Mr. Paperin was President of Brooke Group International, from 1990 to 1993 where he was responsible for investments in the former Soviet Union. Mr. Paperin also served as Chief Financial Officer of Western Union Corporation from 1989 to 1990. Mr. Paperin serves as a director of the Board of Penn Octane Corporation. W. James Peet, Director. Mr. Peet has served as a director of GTS since January 1996. Mr. Peet has been affiliated with The Chatterjee Group, an investment firm, since 1991. Mr. Peet is a director of: Viatel Global Communications, a public company, and several private companies. Immediately prior to joining The Chatterjee Group, Mr. Peet spent six years with McKinsey & Company. By contractual arrangement, The Chatterjee Group has the right to designate one person for nomination to the Board of Directors to serve a term of five years. Mr. Peet is the designee of The Chatterjee Group to the Board of Directors. Jean Salmona, Director. Mr. Salmona has served as a director of GTS since March 1996. Since 1989, Mr. Salmona has been Chairman and Chief Executive Officer of CESIA Consulting Group ("CESIA"), a consulting concern based in France that specializes in information and communications systems and technologies. Mr. Salmona is also Chairman and Director General, Data for Development International Association, a nongovernmental organization with consultative status to the United Nations Economic and Social Council. Mr. Salmona is a graduate of Ecole Polytechnique, Paris, Institut d'Etudes Politiques, Paris, and Ecole Nationale de la Statistique et de l'Administration Economique, Paris. Joel Schatz, Director. Mr. Schatz has served as a director of GTS since the inception of the Company. Mr. Schatz was a founder of the Company and served as its President from 1985 to 1991. Mr. Schatz is presently the Chairman and Chief Executive Officer of Datafusion, Inc., a company developing software to accelerate knowledge synthesis. 103 109 Adam Solomon, Director. Mr. Solomon has served as a director of the Company since June 1995. Mr. Solomon is also Chairman of Shaker Investments, Inc., a growth equity investment firm and Chairman of Signature International, L.P., a venture/development firm whose initial focus is redeveloping existing residential/golf communities, and a member of the board of directors of MetaSolv Software, Inc. Prior to that, Mr. Solomon spent eleven years with E.M. Warburg, Pincus & Co., Inc., where he was Managing Director from 1988 to 1992. While at E.M. Warburg, Pincus & Co., Inc., Mr. Solomon served as a member of the board of directors of LCI International, Inc., a regional long-distance carrier. David Dey, 60. Since 1995, Mr. Dey has served as an independent consultant, particularly to high technology start-up companies in Europe. In that capacity, he has served as Chairman of The Connections Group, a provider of branded Internet services and Web-based electronic mail, and as Chairman of STARTECH Scotland, a high technology incubator that focuses on telecommunications and software start-up companies. From 1992 to 1995, Mr. Dey served as Chief Executive Officer of Energis Communications, which grew from a start-up company to become the United Kingdom's third national telecommunications operation during his tenure. Mr. Dey was employed by British Telecom plc from 1987 to 1991, most recently as Managing Director of its Business Communications Division, and he held various management positions at IBM Corporation where he was employed from 1961 to 1985. Roger W. Hale, 54. Mr. Hale is Chairman, President and Chief Executive Officer of LG&E Energy Corp., a diversified energy services and marketing company with businesses in retail gas and electric utility services, energy marketing and trading, and power generation and project development. Mr. Hale has served in that capacity since August 1990. Previously, Mr. Hale served as Executive Vice President of Bell South Enterprises, Inc. from 1986 to 1989 and with AT&T Corporation from 1966 to 1986, serving in various management positions including Vice President of Marketing, Southern Region. Mr. Hale is a Director of H&R Block, Inc. and PNC Bank, Kentucky, Inc. Robert J. Amman, 60. Mr. Amman was elected to the Company's Board of Directors in May 1998. Mr. Amman was Chairman, President and Chief Executive Officer of John H. Harland Company, a printing firm, from 1995 to 1998. Previously, from 1994 to 1995, he served as Vice Chairman of First Financial Management Corporation, where he was responsible for the merchant services businesses consisting of Western Union, NaBanco, Telecheck, Nationwide Credit and International Banking Technologies. From 1988 to 1994, Mr. Amman served as President and Chief Executive Officer of Western Union Corporation, where he oversaw the transformation of the firm from a telecommunications to a financial services company. Mr. Amman is a member of the Executive and Governance Committees of the Board of Directors of the Company. EXECUTIVE COMPENSATION AND OTHER INFORMATION COMPENSATION OF DIRECTORS AND EXECUTIVE OFFICERS Each Director of GTS, except Mr. Thames, receives an annual directors' fee of $15,000. In addition, the fee paid to each Director, except for Mr. Thames, for attending any meeting of the Board of Directors is $1,500 per meeting, except for telephonic Board of Directors meetings of two hours or less, where the fee is $750 for each such meeting. Each Director, except Mr. Thames, who attends a committee meeting is entitled to a directors' fee of $1,000 per meeting, except for telephonic committee meetings of a duration of two hours or less, for which a fee of $500 is paid. GTS maintains the Global TeleSystems Group, Inc. Non-Employee Directors' Stock Option Plan that permits directors to share in the growth of the value of GTS through the grant and exercise of nonqualified stock options. See "-- Global TeleSystems Group, Inc. Non-Employee Directors' Stock Option Plan." In addition, on February 27, 1998 the Board of Directors granted to each of certain of its then incumbent members options to purchase 15,000 shares of Common Stock at an exercise price of $20 per share. Such grants are subject to approval of the Company's shareholders at its May 20, 1998 annual meeting. 104 110 GLOBAL TELESYSTEMS GROUP, INC. NON-EMPLOYEE DIRECTORS' STOCK OPTION PLAN The purpose of the Global TeleSystems Group, Inc. Non-Employee Directors' Stock Option Plan (the "Directors' Plan") is to permit eligible non-employee directors of GTS (each a "Non-Employee Director") to share in the growth of the value of GTS through the grant and exercise of nonqualified stock options. The total number of shares of Common Stock presently reserved and available for delivery under the Directors' Plan is 1,275,000. The Directors' Plan is administered by the compensation committee of the Board of Directors (the "Committee"). Only directors of GTS who are not employees of GTS or any subsidiary of GTS on the date on which an option is to be granted are eligible to participate in the Directors' Plan on such date. An option (a "Directors' Option") to purchase shares of Common Stock was granted to each Non-Employee Director on the effective date of the Directors' Plan and a Director's Option is granted to each new Non-Employee Director when he or she is first elected or appointed to serve as a director of GTS. One-half of the Directors' Options vests six months after the date of grant. An additional one quarter become exercisable on the date six months following the first annual meeting of GTS's shareholders to occur after such date of grant, and the remaining one quarter shares become exercisable on the date six months following the second annual meeting of GTS's shareholders to occur after such date of grant. An initial Directors' Option represents 22,250 shares of Common Stock. On the date of each annual meeting of GTS's shareholders, an additional Directors' Option to purchase 9,000 shares will be granted each year on the date of the Company's annual meeting to the individuals who will serve as elected Non-employee Directors of the Company during the next year. Directors' Options are nonqualified stock options which are subject to certain terms and conditions including those summarized below. The exercise price per share of Common Stock purchasable under a Directors' Option will be equal to 100% of the fair market value of Common Stock on the date of grant. Each Directors' Option will expire upon the earliest of (a) the tenth anniversary of the date of grant, (b) one year after the Non-Employee Director ceases to serve as a director of GTS due to death or disability, (except that, in the case of disability, if the Non-Employee Director dies within that one-year period, the Directors' Option is exercisable for a period of one year from the date of death), (c) three months after the Non-Employee Director ceases to serve as a director of GTS for any reason other than death or disability, (except that, if the Non-Employee Director dies within that three-month period, his or her Directors' Options are exercisable for a period of one year from the date of such death), and (d) three months after the Non-Employee Director ceases to be employed by GTS if such Non-Employee Director had become an employee of GTS (except that, if the Non-Employee Director dies within that three-month period, his or her Directors' Options are exercisable for a period of one year from the date of such death). Each Directors' Option may be exercised in whole or in part by giving written notice of exercise to GTS specifying the Directors' Option to be exercised and the number of shares to be purchased. Such notice must be accompanied by payment in full of the exercise price in cash or by surrender of shares of Common Stock or a combination thereof. Directors' Options granted under the Directors' Plan may not be sold, pledged, assigned or otherwise disposed of in any manner other than by will or by the laws of descent and distribution. At the time of grant, the Board of Directors may provide in connection with any grant made under the Directors' Plan that the shares of Common Stock received as a result of such grant are subject to a right of first refusal by GTS. The Board of Directors may amend, alter, suspend, discontinue or terminate the Directors' Plan at any time, except that any such action will be subject to the approval of GTS shareholders at the next annual meeting following such Board of Directors' action if such shareholder approval is required by any federal or state law or regulation or the rules of any stock exchange or automated quotation system on which Common Stock may then be listed or quoted, or if the Board of Directors determines in its discretion to seek such shareholder approval. The following table sets forth certain information regarding ownership of the Common Stock and rights to acquire Common Stock by (i) each of the Company's directors and (ii) each of the named officers and all 105 111 directors and executive officers of the Company as a group as of March 31, 1998. For the purposes of this table, a person or a group of persons is deemed to have "beneficial ownership" of any shares which such has the right to acquire within 60 days after such date, but such shares are not deemed to be outstanding for the purpose of computing the percentage ownership of any other person. BENEFICIAL STOCK OWNERSHIP OF DIRECTORS AND OFFICERS
NUMBER OF SHARES PERCENTAGE BENEFICIALLY BENEFICIALLY NAME OF BENEFICIAL OWNER OWNED(1)(2) OWNED(1) ------------------------ ----------- -------- Alan Slifka and affiliates................................. 5,643,331(3) 10.8% Bernard McFadden........................................... 37,500 * Michael A. Greeley......................................... 13,500(5) * Stewart J. Paperin......................................... 9,000(4) * W. James Peet.............................................. 13,500(4) * Jean Salmona............................................... 13,500 * Joel Schatz................................................ 500,250 * Adam Solomon............................................... 57,414 * Gerald W. Thames........................................... 740,924 1.4% Bruno d'Avanzo............................................. 44,419 * Jan Loeber................................................. 30,000(6) * Raymond I. Marks........................................... 299,687 * Louis T. Toth.............................................. 293,023 * David Dey.................................................. 400(7) * Roger W. Hale.............................................. 300(7) * Robert J. Amman............................................ 3,000(7) * Other officers............................................. 169,376 * All Directors and Executive Officers as a group (22 persons)................................................. 8,096,074 15.0%
- - - - --------------- * Less than 1% (1) The percentage of ownership is based upon 59,817,916 shares, comprised of 52,040,140 shares of Common Stock issued and outstanding, and warrants to purchase 7,777,776 shares of Common Stock. Excluded from the calculation are: 5,159,972 shares of Common Stock issued to employees under the Third Amended and Restated 1992 Stock Option Plan of the Company (the "Stock Option Plan"), of which 2,016,031 are vested at March 31, 1998; 759,000 options to purchase shares of Common Stock issued to employees prior to the adoption of the Stock Option Plan and options issued pursuant to the Global TeleSystems Group, Inc. Non-Employee Directors' Stock Option Plan (the "Directors' Plan") and the SFMT, Inc. Equity Compensation Plan (the "Equity Compensation Plan"); and an option to convert a debt put right to 713,311 shares of Common Stock. (2) Includes shares of Common Stock issuable upon the exercise of stock options and stock warrants within 60 days of March 31, 1998. (3) Includes 2,514,284 shares of Common Stock owned by Mr. Slifka, 49,500 shares of Common Stock held in trust for a minor child and options to purchase 225,000 shares of Common Stock; 2,563,041 shares of Common Stock owned by various Halcyon Partnerships which are managed by Halcyon/Alan B. Slifka Management Company LLC, of which Mr. Slifka is the Managing Principal and over which Mr. Slifka disclaims beneficial ownership; 67,500 shares of Common Stock held by GTS 1995 Partners, LP; 4,500 shares of Common Stock held by Kevah Konner, a Principal of Halcyon/Alan B. Slifka Management Company LLC; 19,656 shares of Common Stock held by John M. Bader, a Principal of Halcyon/Alan B. Slifka Management Company LLC; 49,500 shares of Common Stock owned by Randolph Slifka, Mr. Slifka's son, over all of which Mr. Slifka disclaims beneficial ownerships; 145,000 shares of Common Stock issuable upon the conversion of Convertible Bonds held by various Halcyon Partnerships which are managed by Halcyon/Alan B. Slifka Management Company LLC, over which Mr. Slifka disclaims 106 112 beneficial ownership; and 4,350 and 1,000 shares of Common Stock issuable upon the conversion of Convertible Bonds held by Mr. Bader and Mr. Konner, respectively, over which Mr. Slifka disclaims beneficial ownership. (4) Excludes the shares of Common Stock held by the George Soros affiliates over which Gary Gladstein, Stewart J. Paperin and W. James Peet disclaim ownership. (5) Excludes the 1,819,149 shares of Common Stock owned by Chestnut Hill Telecom Inc., an affiliate of Michael A. Greeley, over which Mr. Greeley disclaims ownership. (6) Includes 10,000 restricted shares of Common Stock. (7) These directors were elected at the Company's May 20, 1998 annual shareholders' meeting. Share ownership of those directors listed above is after such date. EXECUTIVE COMPENSATION The following table sets forth each component of compensation paid or awarded to, or earned by, the Chief Executive Officer and the four other most highly compensated executive officers serving as of December 31, 1997 (collectively, the "Named Executive Officers") for the years indicated. SUMMARY COMPENSATION TABLE
LONG-TERM COMPENSATION ------------------------ ANNUAL COMPENSATION AWARDS ----------------------------------------- ------------------------ RESTRICTED SECURITIES PAID OTHER ANNUAL STOCK UNDERLYING ALL OTHER SALARY BONUS COMPENSATION AWARD(S) OPTIONS COMPENSATION NAME AND PRINCIPAL POSITION YEAR ($) ($) ($) (#) (#) ($)(9) --------------------------- ---- -------- -------- ------------ ---------- ----------- ------------ Gerald W. Thames............... 1997 $375,417 $140,000 (1) -0- 141,195(5) $ 19,850 President and Chief Executive 1996 $325,000 $113,750 (1) -0- 112,500(5) $ 9,954 Officer Bruno d'Avanzo................. 1997 $340,000 $ 83,313(2) -0- -0- 104,475(5) $ 21,675 Executive Vice President and 1996 $141,667 $ 33,333(2) -0- -0- 83,025(5) $ 5,650 Chief Operating Officer Jan Loeber..................... 1997 $235,000 $ 78,608 $46,598(3) -0- 4,812(6) $179,450 Senior Vice President -- HER 1996 $235,000 $ 78,608 $42,806(3) 30,000(4) 3.5(7) $ 12,986 Raymond I. Marks............... 1997 $231,008 $ 49,826 (1) -0- 27,750(5) $ 12,250 Senior Vice President -- Asia 1996 $230,091 $ 46,200 (1) -0- 55,500(5) $ 13,788 Louis T. Toth.................. 1997 $204,750 $ 50,307 $60,106(8) -0- 45,000(5) $ 14,550 Senior Vice 1996 $203,937 $ 40,950 $ 33,602(8) -0- 43,500(5) $ 13,004 President -- Central Europe
- - - - --------------- (1) Perquisites and other personal benefits paid to the Named Executive Officer were less than the lesser of $50,000 and 10 percent of the total of annual salary and bonus reported for the Named Executive Officer. (2) Mr. D'Avanzo's bonuses in 1997 and 1996 include the first two installments of a $100,000 sign-on bonus that the Company agreed to pay in three equal annual installments when he was hired in 1996. (3) For 1997, the amount listed represents the sum of a cost of living allowance of $16,450, a tax equalization payment of $13,953 that compensates Mr. Loeber for the higher taxes he pays because he resides in Belgium instead of the United States, use of a car, which was valued at $4,547, and a gross-up payment of $11,648 for certain tax liabilities. For 1996, the amount listed represents the sum of a cost of living allowance of $16,450, paid home leave of 9,031, use of a car valued at $4,547 and a gross-up payment of $12,778 for certain tax liabilities. (4) Shares of restricted stock that vest in an amount of one-third each year on the three anniversary dates of grant, beginning on January 2, 1997. (5) Stock options awarded under the Stock Option Plan. (6) Stock options awarded under The Key Employee Stock Option Plan of Hermes Europe Railtel B.V.(the "HER Stock Option Plan"). 107 113 (7) Stock options awarded under the GTS-Hermes, Inc. Stock Option Plan (the "GTS-Hermes Stock Option Plan"), which will be terminated. The stock options granted to Mr. Loeber in 1997 and described in footnote (6) are in substitution for the 3.5 stock options granted to Mr. Loeber in 1996, which have been cancelled. (8) For 1997, the amount listed represents the sum of a cost of living allowance of $30,000, use of a car valued at $10,800, paid home leave of $12,501, and a gross-up payment for certain tax liabilities in the amount of $6,805. For 1996, the amount listed represents the sum of a cost of living allowance of $27,500 and paid home leave of $6,102 paid to Mr. Toth. (9) Amounts hereunder represent the sum of premiums paid by GTS for $1,000,000 in term life insurance for each Named Executive Officer and contributions by GTS under the 401(k) Plan, as defined below, to each Named Executive Officer's account, except for Mr. D'Avanzo who does not participate in the 401(k) plan because of his foreign citizenship. In the case of Mr. Loeber, the amount also includes $156,700 which represents the value, as of December 31, 1997 of 10,000 shares of restricted stock which vested in 1997. THE GTS 401(k) PLAN The GTS 401(k) Plan (the "401(k) Plan") is a defined contribution retirement benefit plan that is qualified for favorable tax treatment under Section 401 of the Code. All employees of GTS, subject to certain regulatory qualifications, including the Named Executive Officers, who are at least 21 years of age and have completed the minimum service requirement are eligible to participate in the 401(k) Plan. The 401(k) Plan participants may defer pre-tax income by contributing to the plan up to the maximum amount permitted by law. After-tax contributions are also permitted under the 401(k) Plan. GTS matches 50% of each participant's pre-tax contribution to the 401(k) Plan up to 5% of the participant's total compensation. In addition, GTS may, in its sole discretion and in a nondiscriminatory manner, contribute additional amounts as profit sharing to each participant's account. The amounts that are deposited into each participant's account are invested among various investment options according to the direction of the participant. Each participant's pre-tax and after-tax contributions are immediately vested and nonforfeitable. GTS's matching contribution and profit sharing allocations to each participant's account do not vest until the participant has completed three years of service with GTS, at which time the matching contribution and profit sharing allocations become 100% vested. Each participant is eligible to begin receiving benefits under the 401(k) Plan on the first day of the month coincident with or following the attainment of normal retirement age. There is no provision for early retirement benefits under the 401(k) Plan. THE SFMT, INC. EQUITY COMPENSATION PLAN The purpose of the SFMT, Inc. Equity Compensation Plan (the "Equity Compensation Plan") is to attract, retain and motivate key employees, officers and eligible independent contractors of GTS and to enable such individuals to own Common Stock and to have a mutuality of interest with other shareholders of GTS through the grant of restricted stock and other equity-based awards. The total number of shares of Common Stock that may be issued or transferred under the Equity Compensation Plan is four percent of the total number of shares of Common Stock outstanding at the beginning of the calendar year, subject to certain adjustments, which are described below. This threshold number may be increased by the number of shares (a) that were issued under the Equity Compensation Plan with respect to which no dividends were paid and (b) that were subsequently forfeited, in accordance with the terms of the Equity Compensation Plan. The Equity Compensation Plan is administered by the Committee. The chief executive officer of GTS has the authority to recommend the individuals to whom awards will be granted, subject to approval by the Committee. The Committee has full and binding authority to determine the fair market value of the Common Stock and the number of shares included in any awards, to establish terms and conditions of any award, to interpret the Equity Compensation Plan, to prescribe rules relating to the Equity Compensation Plan and to make all other determinations necessary to administer the Equity Compensation Plan. The Committee may condition the vesting of restricted stock upon the attainment of specified performance goals or such other 108 114 factors as the Committee may determine in its sole discretion. In the event that the Committee determines, in its sole discretion, that an award of restricted stock would not be appropriate with respect to any individual who has been recommended for an award by the chief executive officer, the Committee has the authority to grant to any such individual any other variety of equity-based compensation award, including, but not limited to, phantom stock, phantom units, stock appreciation rights, performance shares and performance units. The Committee does not, however, have the authority to grant stock options pursuant to the Equity Compensation Plan. Grants under the Equity Compensation Plan are determined by the Committee in its sole discretion. For this reason, it is not possible to determine the benefits or amounts that will be received by any individual employee or group of employees in the future. The Equity Compensation Plan will remain effective until November 14, 2004, unless earlier terminated by GTS. No restricted stock may be granted under the Equity Compensation Plan on or after November 14, 2000. During a specified period set by the Committee commencing with the date of any restricted stock award, the participant is not permitted to sell, transfer, pledge or otherwise encumber shares of restricted stock. Within these limits, the Committee, in its sole discretion, may provide for the lapse of such restrictions or may accelerate or waive such restrictions in whole or in part, based on service, performance and such other factors. Unless the Committee specifically determines otherwise, a restricted stock award granted under the Equity Compensation Plan vests one-third on the second anniversary of the date of grant, one-third on the third anniversary of the date of grant and one-third on the fourth anniversary of the date of grant. The Committee may impose such other restrictions on shares of Common Stock issued under the Equity Compensation Plan, including a right of first refusal by GTS that requires the participant to offer GTS any shares that the participant wishes to sell. The Equity Compensation Plan provides that, in the event of a change to the Common Stock (whether by reason of merger, consolidation, reorganization, recapitalization, stock dividend, stock split, combination or exchange of shares, or other change in the capital structure made without receipt of consideration), the Board of Directors will preserve the value of outstanding awards by making certain equitable adjustments in its discretion. The Board of Directors may amend, alter, suspend, discontinue or terminate the Equity Compensation Plan at any time, except that any such action will be subject to the approval of GTS shareholders at the first annual meeting following such action if such shareholder approval is required by any federal or state law or regulation or the rules of any stock exchange or automated quotation system on which Common Stock may then be listed or quoted, or if the Board of Directors determines in its discretion to seek such shareholder approval. THE AMENDED AND RESTATED 1992 STOCK OPTION PLAN OF GLOBAL TELESYSTEMS GROUP, INC. The 1992 Stock Option Plan of Global TeleSystems Group, Inc. (the "1992 Option Plan") was adopted by the Board of Directors of GTS and approved by stockholders in 1992 and has been subsequently amended, among other things, to increase the number of shares available for grant. The Board of Directors of GTS adopted the Fourth Amended and Restated Plan on April 9, 1998 (the "Amended 1992 Stock Option Plan"), subject to stockholder approval at the May 20, 1998 annual stockholders meeting: (i) to modify the provisions relating to the number of shares with respect to which options to purchase shares of Common Stock may be granted under the 1992 Stock Option Plan; (ii) to extend eligibility under the 1992 Stock Option Plan to nonemployee directors and independent contractors of the Company (as defined in the 1992 Stock Option Plan), its subsidiaries and affiliates; (iii) to provide the Stock Option Committee (as defined in the 1992 Stock Option Plan) with more flexibility to specify the terms of options granted under the 1992 Stock Option Plan; (iv) to specify that the options covering not more than 1.5 million shares of Common Stock may be granted to any employee during any calendar year; (v) to extend the term of the 1992 Stock Option Plan, as amended, to April 9, 2008 and (vi) to eliminate certain provisions that are not necessary or desirable in an option plan of a public company. As of March 31, 1998, there were approximately 1,800 employees, non-employee directors and independent contractors of GTS and its subsidiaries and affiliates who were eligible to 109 115 participate in the Amended 1992 Stock Option Plan. The Amended 1992 Stock Option Plan received stockholder approval at the May 20, 1998 annual stockholders meeting. The principal provisions of the Amended 1992 Stock Option Plan, as amended, are summarized below. A copy of the Amended 1992 Stock Option Plan is an exhibit to the Registration Statement in which this Prospectus is included and this summary does not purport to be complete and is qualified in its entirety by the terms of the Amended 1992 Stock Option Plan. The Amended 1992 Stock Option Plan provides for the grant of options to employees, non-employee directors, and independent contractors of GTS and any subsidiary or affiliate of GTS. A total of 9,568,688 shares of Common Stock are reserved for issuance to employees, non-employee directors and independent contractors under the Amended 1992 Stock Option Plan representing 18.5% of the outstanding shares of Common Stock on March 31, 1998. The Amended 1992 Stock Option Plan provides that the number of shares available for issuance under options granted pursuant to the Amended 1992 Stock Option Plan is the greater of 9,568,688 shares or 18.5% of the outstanding shares of Common Stock at the time of grant. A total of 1 million shares of Common Stock may be issued pursuant to options qualifying for tax purposes as incentive options under the Amended 1992 Stock Option Plan. The Amended 1992 Stock Option Plan is administered by the Stock Option Committee, which consists of not less than two directors appointed by the Board of Directors. The Stock Option Committee selects the employees, independent contractors and directors of GTS and its subsidiaries and affiliates to whom options will be granted. Options covering not more than 1.5 million shares of Common Stock may be granted to any employee during any calendar year. The option exercise price under the Amended 1992 Stock Option Plan may not be less than the exercise price determined by the Stock Option Committee (or 110% of the fair market value of the Common Stock on the date of grant of the option in the case of an incentive option granted to an optionee beneficially owning more than 10% of the outstanding Common Stock). The maximum option term is 10 years and one day (or five years in the case of an incentive option granted to an optionee beneficially owning more than 10% of the outstanding Common Stock). Options become vested and exercisable at the time and to the extent provided in the option agreement related to such option. The Stock Option Committee has the discretion to accelerate the vesting and exercisability of options. There is a $100,000 limit on the value of stock (determined at the time of grant) covered by incentive options that first become exercisable by an optionee in any calendar year. No option may be granted more than 10 years after the effective date of the Amended 1992 Stock Option Plan. Generally, during an optionee's lifetime, only the optionee (or a guardian or committee if the optionee is incapacitated) may exercise an option except that, upon approval by the Stock Option Committee, nonqualified options may be transferred to the spouse of the optionee and certain nonqualified options may be granted or transferred to the GTS Employee Stock Option Plan Trust for the benefit of one or more designated foreign employees, independent contractors or directors. Incentive stock options are non-transferable except at death. Payment for shares purchased under options granted pursuant to the Amended 1992 Stock Option Plan may be made either in cash or by exchanging shares of Common Stock of GTS (which shares have been held by the optionee for at least six months) with a fair market value of up to the total option exercise price and cash for any difference. Options may be exercised by directing that certificates for the shares purchased be delivered to a licensed broker-dealer as agent for the optionee, provided that the broker-dealer tenders to GTS cash or cash equivalents equal to the option exercise price plus the amount of any taxes that GTS may be required to withhold in connection with the exercise of the option. If an optionee's employment or service with GTS or a subsidiary or affiliate terminates by reason of death, retirement or permanent and total disability, his or her vested options may be exercised within one year after such death, retirement or disability, unless otherwise provided with respect to a particular option (but not later than the date the option would otherwise expire). If the optionee's employment or service with GTS or a subsidiary or affiliate terminates for any reason other than death, retirement or disability, options held by such optionee terminate 90 days after such termination, unless otherwise provided with respect to a particular 110 116 option (but not later than the date the options would otherwise expire), except that options terminate immediately upon termination of an employee or independent contractor for "cause" (as defined), unless the Stock Option Committee determines otherwise. Each option would be exercisable to the extent it had become vested before the termination of employment or service (unless otherwise provided in the option agreement). If the outstanding shares of Common Stock are increased or decreased or changed into or exchanged for a different number or kind of shares or securities of GTS, by reason of merger, consolidation, reorganization, recapitalization, reclassification, stock split-up, combination of shares, exchange of shares, stock dividend, spin-off or other distribution payable in capital stock, or other increase or decrease in such shares without receipt of consideration by GTS, an appropriate and proportionate adjustment will be made in the number and kinds of shares subject to the Amended 1992 Stock Option Plan, and in the number, kinds and per share exercise price of shares subject to the unexercised portion of options granted prior to any such change, in order to preserve the value of any granted options. Any such adjustment in an outstanding option, however, will be made without a change in the total price applicable to the unexercised portion of the option, but with a corresponding adjustment in the per share option price. Upon any dissolution or liquidation of GTS, or upon a reorganization, merger or consolidation in which GTS is not the surviving corporation, or upon the sale of substantially all of the assets of GTS to another corporation, or upon any transaction (including, without limitation, a merger or reorganization in which GTS is the surviving corporation) approved by the Board of Directors which results in any person or entity owning 80% or more of the total combined voting power of all classes of stock of GTS, the Amended 1992 Stock Option Plan and the options issued thereunder will terminate, unless provision is made in connection with such transaction for the continuation of the Amended 1992 Stock Option Plan, the assumption of such options or for the substitution for such options of new options covering the stock of a successor corporation or a parent or subsidiary thereof, with appropriate adjustments as to the number and kinds of shares and the per share exercise price. In the event of such termination, all outstanding options shall be exercisable in full during such period immediately prior to the occurrence of such termination as the Board of Directors in its discretion shall determine. The Board of Directors may further amend the Amended 1992 Stock Option Plan with respect to shares of the Common Stock as to which options have not been granted. However, GTS's stockholders must approve any amendment that would (i) change the requirements as to eligibility to receive incentive options; or (ii) increase the maximum number of shares in the aggregate for which incentive options may be granted (except for adjustments upon changes in capitalization); or (iii) otherwise to the extent required by applicable law, rule or regulation. The Board of Directors at any time may terminate or suspend the Amended 1992 Stock Option Plan. Unless previously terminated, the Amended 1992 Stock Option Plan will terminate automatically on April 9, 2008. No termination, suspension or amendment of the Amended 1992 Stock Option Plan may, without the consent of the person to whom an option has been granted, adversely affect the rights of the holder of the option. No grants of options have been made under the Amended 1992 Stock Option Plan. THE GTS 1996 TOP TALENT RETENTION PROGRAM GTS implemented the GTS 1996 Top Talent Retention Program (the "Program") which, for 1996 only, alters the terms offered to certain employees under the 1992 Option Plan. Employees who are offered participation in the Program must sign a "retention agreement," the terms of which are described below, in order to receive any 1992 Options during 1996. The Program has been offered to approximately 28 employees, and it provides that any 1992 Options granted to such participants will vest as follows: (i) one-half of any 1992 Option granted under the Program will vest at a rate of 25% per year beginning on the first anniversary of the initial date of grant and (ii) the remaining portion of any 1992 Option granted under the Program will vest one-quarter according to the achievement of performance revenue levels, and one-quarter according to the achievement of price levels of Common Stock, provided that all options will vest on the fifth anniversary of the date of grant regardless of whether such performance revenue and pricing levels are attained. 111 117 OPTION GRANTS IN THE LAST FISCAL YEAR The following table provides information on stock option grants to the Named Executive Officers in 1997 under the Stock Option Plan.
NUMBER OF % OF TOTAL SECURITIES OPTIONS UNDERLYING GRANTED TO EXERCISE OR GRANT DATE OPTIONS EMPLOYEES IN BASE EXPIRATION PRESENT NAME GRANTED(#) FISCAL YEAR PRICE($/SH.) DATE VALUE($)(2) ---- ---------- ------------ ------------ ---------- ----------- Gerald W. Thames..................... 88,695(1) 4.11 $13.33 02-03-07 $597,000 52,500(1) 2.43 15.67 10-10-07 415,300 Bruno d'Avanzo....................... 66,975(1) 3.11 13.33 02-03-07 450,700 37,500(1) 1.74 15.67 10-10-07 296,600 Jan Loeber........................... -- -- -- -- -- Raymond I. Marks..................... 27,750(1) 1.29 13.33 02-03-07 186,800 Louis T. Toth........................ 22,500(1) 1.04 13.33 02-03-07 151,400 22,500(1) 1.04 15.67 10-10-07 178,000
- - - - --------------- (1) Each option vests one-fourth on each of the first four anniversaries of the date of grant. (2) The present value of each grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions: dividend yield 0%, expected volatility of 0.50, risk-free interest rate of 5.79% and expected life of five years. AGGREGATED OPTION EXERCISES IN THE LAST FISCAL YEAR AND FISCAL YEAR-END OPTION VALUES The following table provides information on the number of options under the Stock Option Plan held by the Named Executive Officers at December 31, 1997, and the value of all unexercised options held by such persons as of that date.
NUMBER OF SECURITIES UNDERLYING UNEXERCISED VALUE OF UNEXERCISED OPTIONS AT IN-THE-MONEY OPTIONS FY-END(#)(1) AT FY-END($)(2) EXERCISABLE/ EXERCISABLE/ NAME UNEXERCISABLE UNEXERCISABLE ---- --------------- --------------------- Gerald W. Thames..................................... 676,562/327,133 $7,539,655/$1,321,913 Bruno d'Avanzo....................................... 27,675/159,825 64,676/285,874 Jan Loeber........................................... -- -- Raymond I. Marks..................................... 246,937/121,313 2,671,519/675,211 Louis T. Toth........................................ 256,537/97,613 3,090,927/355,013
- - - - --------------- (1) No options were exercised during the year ended December 31, 1997. (2) Based on $15.67 per share value of Common Stock as of December 31, 1997 less the exercise price. OPTION GRANTS IN THE LAST FISCAL YEAR -- HER STOCK OPTION PLAN (1) The following table provides information on stock option grants to one of the Named Executive Officers, Jan Loeber, in 1997 under the HER Stock Option Plan. As of December 31, 1997, Mr. Loeber was not granted in 1997, and does not hold, any options to purchase Common Stock.
% OF TOTAL NUMBER OF OPTIONS SECURITIES GRANTED TO UNDERLYING EMPLOYEES EXERCISE OR GRANT DATE OPTIONS IN FISCAL BASE EXPIRATION PRESENT NAME GRANTED(#) YEAR PRICE($/SH.) DATE VALUE($)(2) ---- ---------- ----------- ------------ ---------- ----------- Jan Loeber............................. 4,812 47.3 $83.12 2006 $2,234,019
112 118 - - - - --------------- (1) Each stock option vests one-third on each of the first three anniversaries of the date of grant. During the fourth quarter of 1997, HER established the HER Stock Option Plan to replace the GTS-Hermes Stock Option Plan. The options outstanding under the GTS-Hermes Plan were cancelled and replaced by options under the HER Stock Option Plan. (2) The present value of each grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions: dividend yield 0%, expected volatility of 0.50, risk-free interest rate of 5.79% and expected life of five years. AGGREGATED OPTION EXERCISES IN THE LAST FISCAL YEAR AND FISCAL YEAR-ENDED OPTION VALUES -- HER STOCK OPTION PLAN The following table provides information on the number of options held by Mr. Loeber under the HER Stock Option Plan at December 31, 1997, and the value of all unexercised options held by Mr. Loeber as of that date.
NUMBER OF SECURITIES VALUE OF UNEXERCISED UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS OPTIONS AT FY-END(#) AT FY-END($)(1) NAME EXERCISABLE/UNEXERCISABLE(1) EXERCISABLE/UNEXERCISABLE(2) ---- ---------------------------- ---------------------------- Jan Loeber.................................... 3,208/1,604 $1,417,551/$708,775
- - - - --------------- (1) No options were exercised during the year ended December 31, 1997. (2) Based on $525.00 per share value of common stock as of December 31, 1997 less the exercise price. HER STOCK OPTION PLAN In the fourth quarter of 1997, HER established a stock option plan (the "New Plan") to replace the GTS-Hermes Plan for the purpose of incentivizing HER key employees. The aggregate number of shares of HER stock subject to the New Plan is approximately 13% of the total shares of HER stock issued and outstanding including options. During 1997, HER issued 10,166 options in replacement of those outstanding under a stock option plan maintained by HER's parent, GTS-Hermes, Inc., a wholly owned subsidiary of the Company, as well as additional options to certain employees. The issuance of these options will result in a non-cash charge of $3.7 million of which $2.6 million is expected to be recorded during the fourth quarter and the remaining $1.1 million will be recognized principally ratably over fiscal 1998. The GTS-Hermes Plan is intended to be terminated. EMPLOYMENT AGREEMENTS GTS has executed employment agreements (together, the "Employment Agreements") with all the Named Executive Officers. The agreements with Messrs. Thames, and Marks include a three-year term of employment commencing on February 1, 1997 and April 1, 1996, respectively. Mr. D'Avanzo's employment agreement has a three-year term commencing on March 1, 1997. The agreements with Mr. Toth and Mr. Loeber include a two-year term of employment commencing on April 1, 1996 and January 3, 1995, respectively. All the Employment Agreements, except for Mr. Thames' and Mr. D'Avanzo's agreements, provide for the automatic renewal of the term for additional one-year periods after the initial term unless written notice of intent to terminate is provided by either party within a stated period of between 120 days and six months prior to the renewal date. Mr. Thames' agreement provides for an automatic renewal each year for a new three-year period. Mr. D'Avanzo's agreement terminates on March 1, 2000, unless either GTS or Mr. D'Avanzo requests an extension 180 days prior to such termination and the parties agree upon an extension. The salary of each Named Executive Officer is reviewed yearly and may be increased at the sole discretion of the Board of Directors. In addition to salary, each Named Executive Officer is eligible for a performance-based annual bonus, to participate in the Stock Option Plan (with the exception of Mr. Loeber whose employment agreement provides him with an option grant under the HER Stock Option Plan), to receive standard health and insurance benefits that are provided to executives of GTS, to receive certain other fringe benefits and to be reimbursed for all reasonable expenditures incurred in the execution of each Named 113 119 Executive Officer's respective duties. In addition, Mr. Loeber's employment agreement provides him with 30,000 shares of restricted stock that vest in an amount of one-third each year for three years beginning on January 2, 1997. The Employment Agreements provide for severance payments in the event of (a) termination without cause, as defined, or (b) resignation for good reason, as defined, following a change of control event, as defined. Mr. Thames would be eligible for severance payments of base salary for the greater of 24 months or the remaining term of his agreement. Severance arrangements with other named officers are for a period of six to eighteen months of base salary. If the Named Executive Officer is terminated for cause or if he voluntarily terminates his employment other than for good reason after a change of control event, he shall not be entitled to any salary, bonus or severance payments (other than accrued salary). Each Employment Agreement includes noncompetition and nonsolicitation clauses that are effective during the term of employment and for a period of from four months to one year thereafter. In addition, the Employment Agreements include an unlimited covenant of confidentiality and nondisclosure. Any dispute arising under an employment agreement must be resolved through arbitration, except that each agreement also provides for specific performance and for a court injunction in the event of a breach by the Named Executive Officer. 114 120 CERTAIN RELATED PARTY TRANSACTIONS Alan B. Slifka, the Chairman of the Board of Directors, owns an interest in an office building in New York in which GTS leased office space until the corporate headquarters were moved to McLean, Virginia on March 1, 1995. Until April 1, 1998, GTS retained a small office space in New York City that it leased from Mr. Slifka on a monthly basis, and the annual expense for 1997 was $30,690. Mr. Slifka also has a consulting agreement with GTS pursuant to which he is paid consulting fees of $100,000 per year. Halcyon/Alan B. Slifka Management Company LLC (formerly Alan B. Slifka and Company), a company principally owned by Mr. Slifka, holds 225,000 stock options to purchase Common Stock that were granted in 1991 pursuant to a stock option agreement that is not subject to any stock option plan. The options have an exercise price of $0.533 per share and are fully vested. Any of the stock options that remain unexercised after November 30, 2001 shall lapse and become void. Generally, in the event that Mr. Slifka ceases to be an employee or nonemployee director of GTS, any of such unexercised stock options shall lapse thirty days after such termination. The shares of Common Stock underlying such options have been registered under a registration statement that has been declared effective by the Commission. In addition, Joel Schatz, a director of GTS, and Ms. Sandler, the wife of Morris A. Sandler, a former director of GTS were granted in 1991 stock options to purchase Common Stock pursuant to stock option agreements that are not subject to any stock option plan. Mr. Schatz holds 50,250 of such stock options to purchase Common Stock with an exercise price of $0.533 per share. Mr. Schatz's options are fully vested and any unexercised options he holds after November 4, 2001 shall lapse and become void. Generally, in the event that Mr. Schatz ceases to be an employee or nonemployee director of GTS any of his unexercised stock options shall lapse thirty days after such termination. The stock options held by the spouse of Mr. Sandler were granted to Mr. Sandler in November 1991 and, with the approval of the Board, were immediately assigned to his spouse, whom the stand-alone stock option agreement names as the optionee. Pursuant to such stock option agreement, the spouse of Mr. Sandler was granted 225,000 stock options to purchase Common Stock at an exercise price of $.533 per share. The options are fully vested and any unexercised options held after November 4, 2001 shall lapse and become void. Generally, in the event that Mr. Sandler ceases to be an employee or nonemployee director of GTS, any of such unexercised stock options shall lapse thirty days after such termination. The shares of Common Stock underlying such options have been registered under a registration statement that has been declared effective by the Commission. Bernard McFadden, Director, has a consulting agreement with GTS pursuant to which he is paid $100,000 in consulting fees each year. In August and September 1997, affiliates of George Soros and Mr. Slifka purchased 319,149 and 57,015 shares of Common Stock, respectively, at a price of $15.67 per share in the Company's private stock offering. In addition, affiliates of Mr. Slifka purchased $2.9 million of Convertible Bonds in September 1997. Pursuant to the terms of the indenture related to the Convertible Bonds, the Convertible Bonds will be convertible into such shares of Common Stock as is equal to the principal amount of such Convertible Bonds divided by the applicable conversion price, which conversion price shall be equal to the public offering price of the Common Stock in the Offerings. See "Principal and Selling Stockholders." Affiliates of Soros Fund Management purchased $40 million of notes from GTS in 1996, which notes bore interest at 10% per annum, in partial consideration of which (i) W. James Peet was appointed to the Board of Directors and (ii) the affiliates received warrants to purchase 4,444,443 shares of Common Stock. Together with their prior equity interests in GTS, these affiliates currently hold, on a fully diluted basis (excluding shares underlying stock options), in excess of 20.3% of the Company's Common Stock. In accordance with the terms of the warrant agreement, the exercise price of the warrants was reduced from $10.27 per share to $9.33 per share as the outstanding debt had not been repaid prior to December 31, 1996. In February 1998, the Company repaid the $40 million of notes, plus accrued interest, using part of the proceeds of an offering of senior notes and IPO completed at that time. In addition, these affiliates collect a monitoring fee of $40,000 per month. Under certain agreements, these affiliates have the right to co-invest with GTS in all of its new ventures throughout Asia, excluding countries in the former Soviet Union, and pursuant to this right, one of these affiliates holds a 25% interest in GTS China Investments LLC. See "Business -- Asia." 115 121 The Company has agreed to register within 45 days after the consummation of the Stock Offerings pursuant to a shelf registration statement all of the Affiliate Shares owned by the affiliates of Mr. Slifka and the affiliates of Mr. Soros that are not sold in the Stock Offerings in consideration of such shareholders' undertaking to be bound by the Restrictions. Under the Restrictions, holders of Affiliate Shares will be prevented from selling any such shares during the first six months after the closing date of the Offerings and will be able to sell (i) 50% of such shares after the six month anniversary of the closing date of the Offerings, (ii) 75% of such shares after the nine month anniversary of the closing date of the Offerings and (iii) 100% of such shares after the twelve month anniversary of the closing date of the Offerings. In connection with this agreement, the Company also has agreed to permit certain of the Soros affiliates to resell, immediately after the closing date of the Stock Offerings, up to 100,000 of any shares that they are unable to resell in the Stock Offerings as a result of any cut-back that may be imposed by the underwriters (subject to a waiver by the underwriters in the Company's IPO of the lockup agreement entered into by such affiliates to the extent of such 100,000 shares). Affiliates of Capital Research International purchased $30 million of notes from GTS in 1996, which notes bore interest at 10% per annum, in partial consideration of which it received warrants to purchase 3,333,333 shares of Common Stock. In accordance with the terms of the warrant agreement, the exercise price of the warrants was reduced from $10.27 per share to $9.33 per share as the outstanding debt had not been repaid prior to December 31, 1996. In February 1998, the Company repaid the $30 million of notes, plus accrued interest, using part of the proceeds of an offering of senior notes completed at that time. Affiliates of Capital Research International exercised their warrants on June 3, 1998 under a cashless exercise procedure and will receive approximately 2.5 million shares in accordance therewith. Jean Salmona, a director of GTS, is the Chairman and Chief Executive Officer of CESIA. CESIA also provides consultancy services for CDI and for HER. The Company paid $37,500 in 1997 to CESIA for consulting services related to CDI. In addition, HER paid $405,893 in 1997 to CESIA for consulting services. Further, the Company paid $5,843 to CESIA in 1997, pursuant to the purchase agreement with CESIA related to the CDI business. Pursuant to a 1995 purchase agreement, the Company received its interest in GTS-Vox Limited, the intermediate holding company of TCM, in exchange for a note in the principal amount of $693,380 issued to the sellers and certain additional consideration to its partners payable in the form of either cash or Common Stock based upon its financial performance. The Company paid the note in 1996. On January 17, 1997, the agreement was amended such that the consideration would only be in the form of the issuance of Common Stock and as such, GTS is obligated under these arrangements to issue up to a maximum of 1,121,640 shares of Common Stock. In the first quarter of 1997, pursuant to this agreement the Company issued 504,600 common shares, which was valued at the Company's current fair market value of $13.33 per share. In addition, the Company was credited 37,480 shares of Common Stock under the amended agreement, for purposes of applying against the 1,121,640 maximum number of shares of Common Stock, for the Company's payment of its note to the sellers in 1996. Common Stock issued pursuant to the agreement must be held for a minimum holding period. In certain circumstances, if GTS's partners are unable to sell their shares of Common Stock, GTS is obligated to assist in locating a purchaser for the Common Stock, and, if unable to do so, to repurchase these shares. GTS's repurchase obligations are at the following prices: (i) if shares of Common Stock are then being publicly traded, at the average trading price of such shares for the 10 trading days preceding such repurchase or (ii) if shares of Common Stock are not then publicly traded, at the price shares of Common Stock were most recently offered to individual investors in a private placement, or, if no such private placement has occurred within the three months preceding the repurchase of such shares, at a price determined by an independent financial institution to be agreed upon by GTS and the seller. As a result of their receipt of shares of Common Stock in 1997, the sellers became shareholders of GTS. Affiliates of Baring International Investment Management Limited ("Barings"), which affiliates consist primarily of investment funds and trusts, are shareholders of the Company. In April 1996, GTS entered into an agreement with First NIS Regional Fund SICAF, an affiliate of Barings, to organize GTS Ukrainian TeleSystems, L.L.C. (the "LLC"), a Delaware limited liability company 60% owned by GTS, which in turn entered into a stock purchase agreement to acquire 49% of all the ownership interests in Bancomsvyaz, a 116 122 Ukrainian limited liability company. See "Business -- Russia and the CIS." Such acquisition closed in May 1996. By contractual arrangement, Barings designates one member of the board of directors of Bancomsvyaz. Barings funded $4.5 million to be applied towards the LLC's purchase of the interest in Bancomsvyaz and for the LLC's $1.5 million contribution to the registered capital of Bancomsvyaz. Prior to March 1, 1999, Barings may exercise an option to convert its initial investment into 438,311 shares of Common Stock at an exercise price of $10.27. In June 1997 the agreement was amended, such that Barings funded an additional $4.1 million to be applied toward Bancomsvyaz's capital expenditure and operating capital requirements. On September 30, 2000, Barings may exercise an option to convert such additional investment into 275,000 Shares of Common Stock at an exercise price of $15.00. In connection with the contemplated restructuring of Bancomsvyaz, the Company is currently negotiating with Barings to restructure the capital and ownership of the LLC. See "Business -- Russia and the CIS -- Bancomsvyaz." Under such restructuring, Barings would exercise its option to convert its existing LLC investment into 713,311 Shares of Common Stock and would make an additional investment of $5.75 million to be applied toward Bancomsvyaz's capital expenditure and operating capital requirements. Barings would have no put right in connection with such additional investment. Upon consummation of the restructuring, which the Company expects to occur by the end of the second quarter of 1998, GTS would own 75% of the LLC and Barings would own 25%. 117 123 PRINCIPAL AND SELLING STOCKHOLDERS The following table sets forth certain information regarding ownership of the Common Stock and rights to acquire Common Stock by (i) stockholders that manage or own, either beneficially or of record, five percent or more of the Common Stock of the Company and (ii) each of the Selling Stockholders. Information in the table below regarding shares offered is based on an assumed price per share of $38.25 (the closing sale price per share on the Nasdaq National Market on June 8, 1998). For the purposes of this table, a person or group of persons is deemed to have "beneficial ownership" of any shares which such has the right to acquire within 60 days after such date, but such shares are not deemed to be outstanding for the purpose of computing the percentage ownership of any other person.
SHARES BENEFICIALLY OWNED SHARES BENEFICIALLY OWNED AFTER THE STOCK PRIOR TO THE STOCK OFFERINGS NUMBER OF OFFERINGS ----------------------------- SHARES -------------------- NUMBER OF BEING NUMBER OF NAME OF BENEFICIAL OWNER SHARES(1)(2) PERCENT(1) OFFERED SHARES PERCENT ------------------------ -------------- ------------ --------- ---------- ------- George Soros affiliates....... 10,837,791(3) 19.2% 835,669(4) 10,002,123 16.9% c/o Soros Fund Management 888 Seventh Avenue, 31st Floor New York, NY 10106 Alan B. Slifka and affiliates.................. 5,643,331(5) 10.8% 943,463(6) 4,699,866 8.5% c/o Halcyon/Alan B. Slifka Management Company LLC 477 Madison Avenue, 8th Floor New York, NY 10022 Capital Research International............... 5,347,620(7) 9.7% 741,251(8)(9) 4,606,369 7.9% c/o Capital Research International 25 Bedford Street London WC2E England Emerging Markets Management... 2,767,046(10) 5.3% 2,161,059 605,987 1.1% 1001 19th Street North, 16th Floor Arlington, VA 22209 American International Underwriters Overseas, Ltd......................... 555,555 1.1% 86,778 468,777 * Banca Del Ceresio............. 22,500 * 17,572 4,928 * Bancroft Central Europe, L.P. ....................... 510,639 * 132,936 377,703 * Baring Chrysalis Fund......... 408,628 * 212,197 196,431 * Bonarco Ltd................... 9,000 * 7,029 1,971 * Caisse Centrale Des Banques Populaires.................. 159,575 * 124,627 34,947 * Citibank (Switzerland) Zurich...................... 1,581,069 3.0% 390,916 1,190,153 2.2% Creditanstalt-Bankverein...... 363,638 * 15,490 348,148 * Eastrosed & Company........... 750,000 1.4% 585,749 164,251 * EXE Asia Co., Ltd............. 37,500 * 29,287 8,213 * Heisen & Co. (Morgan Stanley Offshore, Morgan Stanley Institutional).............. 750,000 1.4% 585,749 164,251 * Heisen & Co. (Morgan Stanley Emerging Markets Fund)...... 321,428 * 251,034 70,393 * Hirokazu Hasegawa............. 37,500 * 14,644 22,856 * Kingdon Associates, L.P....... 150,000 * 117,150 32,850 *
118 124
SHARES BENEFICIALLY OWNED SHARES BENEFICIALLY OWNED AFTER THE STOCK PRIOR TO THE STOCK OFFERINGS NUMBER OF OFFERINGS ----------------------------- SHARES -------------------- NUMBER OF BEING NUMBER OF NAME OF BENEFICIAL OWNER SHARES(1)(2) PERCENT(1) OFFERED SHARES PERCENT ------------------------ -------------- ------------ --------- ---------- ------- Kingdon Partners, L.P......... 150,000 * 117,150 32,850 * M. Kingdon Offshore, N.V...... 450,000 * 117,150 332,850 * Majid Harirchi................ 1,500 * 390 1,110 * Permal Emerging Growth IV Ltd......................... 166,667 * 130,166 36,500 * Permal Private Equity Holdings, L.P............... 25,884 * 20,215 5,669 * Piedmont Harbor -- Piedmont Associates L.P. ............ 75,000 * 29,287 45,713 * Private Equity Holdings, L.P......................... 29,671 * 23,173 6,498 * Scottish Eastern Investment Trust plc................... 132,541 * 103,515 29,027 * Sperry Futures Fund, LTD...... 63,830 * 49,851 13,979 *
- - - - --------------- * Less than 1% (1) The percentage of ownership is based upon 59,817,916 shares, comprised of 52,040,140 shares of Common Stock issued and outstanding, and warrants to purchase 7,777,776 shares of Common Stock. Excluded from the calculation are: 5,159,972 shares of Common Stock issued to employees under the Third Amended and Restated 1992 Stock Option Plan of the Company (the "Stock Option Plan"), of which 2,016,031 are vested at March 31, 1998; 759,000 options to purchase shares of Common Stock issued to employees prior to the adoption of the Stock Option Plan and options issued pursuant to the Global TeleSystems Group, Inc. Non-Employee Directors' Stock Option Plan (the "Directors' Plan") and the SFMT, Inc. Equity Compensation Plan (the "Equity Compensation Plan"); and an option to convert a debt put right to 713,311 shares of Common Stock. (2) Includes shares of Common Stock issuable upon the exercise of stock options and stock warrants within 60 days of March 31, 1998. (3) Comprised of 3,074,199 shares of Common Stock held by the Soros Foundation-Hungary; 1,125,000 shares of Common Stock held by the Soros Charitable Foundation; 319,149 shares of Common Stock held by Soros Humanitarian Foundation; 1,125,000 shares and warrants to purchase 3,333,333 shares of Common Stock held by Soros Foundation (The Open Society Institute); 500,000 and 250,001 shares of Common Stock held by Winston Partners II LDC and Winston Partners II LLC, respectively; warrants to purchase 370,371, 185,184 and 555,555 shares of Common Stock held by Winston Partners II LDC, Winston Partners II LLC and Chatterjee Fund Management, respectively, all of which are affiliates of George Soros. Information in the above entry excludes 9,000 and 13,500 shares of, and options for the purchase of, Common Stock held by Stewart J. Paperin and W. James Peet, respectively, over which the George Soros affiliates disclaim ownership. The Company has agreed to register all of the shares presented in the above table (other than shares sold in the Stock Offerings) pursuant to a shelf registration statement in consideration of the Soros affiliates' undertaking not to sell such shares thereunder for specified periods of time after the consummation of the Stock Offerings. See "Shares Eligible for Future Sale." (4) The entry in the table reflects the sale by Soros Foundation (The Open Society Institute) of 113,411 shares, Soros Charitable Foundation of 340,233 shares, Soros Humanitarian Foundation of 249,255 shares, Winston Partners II LDC of 87,628 shares and Winston Partners II LLC of 45,142 shares. See "Certain Related Party Transactions" and "Shares Eligible for Future Sale." (5) Includes 2,788,784 shares of Common Stock owned by Mr. Slifka, shares of Common Stock held in trust for a minor child and options to purchase 225,000 shares of Common Stock; 2,563,041 shares of Common Stock owned by various Halcyon Partnerships which are managed by Halcyon/Alan B. Slifka Management Company LLC, of which Mr. Slifka is the Managing Principal and over which Mr. Slifka disclaims beneficial ownership; 67,500 shares of Common Stock held by GTS 1995 Partners, LP; 4,500 119 125 shares of Common Stock held by Kevah Konner, a Principal of Halcyon/Alan B. Slifka Management Company LLC; 19,656 shares of Common Stock held by John M. Bader, a Principal of Halcyon/ Alan B. Slifka Management Company LLC; 49,500 shares of Common Stock owned by Randolph Slifka, Mr. Slifka's son, over all of which Mr. Slifka disclaims beneficial ownership; 145,000 shares of Common Stock issuable upon the conversion of Convertible Bonds held by various Halcyon Partnerships which are managed by Halcyon/Alan B. Slifka Management Company LLC, over which Mr. Slifka disclaims beneficial ownership; and 4,350 and 1,000 shares of Common Stock issuable upon the conversion of Convertible Bonds held by Mr. Bader and Mr. Konner, respectively, over which Mr. Slifka disclaims beneficial ownership. Furthermore, the Company has agreed to register all of the shares presented in the above table (other than shares sold in the Stock Offerings) pursuant to a shelf registration statement in consideration of the Slifka affiliates' undertaking not to sell such shares thereunder for specified periods of time after the consummation of the Stock Offerings. See "Shares Eligible for Future Sale." (6) The entry in the table reflects the sale by Halcyon Arbitrage, L.P. of 295,360 shares, Halcyon Distressed Securities, L.P. of 248,936 shares, Halcyon SFMT 1994, L.P. of 90,597 shares, Halcyon Special Situations, L.P. of 140,622 shares, Halcyon/Slifka Balanced Multi-Manager Fund, L.P. of 149,864 shares, John M. Bader of 15,351 shares and Kevah Konner of 2,733 shares. See "Certain Related Party Transactions" and "Shares Eligible for Future Sale." (7) Includes 2,014,287 shares of Common Stock and warrants to purchase 3,333,333 shares of Common Stock held by funds managed by affiliates of Capital Research International. (8) The entry in the table reflects the sale by New Europe East Investment Fund of 524,307 shares and Capital International Emerging Markets Fund of 216,944 shares. (9) The sale of these shares is subject to the conditions that (a) other stockholders with greater than 1% beneficial ownership of shares also sign lock-up agreements and (b) the Stock Offerings be consummated by August 31, 1998. (10) Shares of Common Stock held by funds managed by Emerging Markets Management. The sale of these shares is conditional upon the Stock Offerings being consummated by July 7, 1998. 120 126 DESCRIPTION OF CERTAIN INDEBTEDNESS NEW CONVERTIBLE BONDS DUE 2010 Concurrently with the offering hereby, the Company will issue $400.0 million of convertible senior subordinated notes ("New Convertible Bonds"). The New Convertible Bonds will have a 12-year maturity and will be unsecured senior subordinated obligations of the Company. In the event of a change of control of the Company, holders of the New Convertible Bonds will have the right to require GTS to purchase such holder's New Convertible Bonds at a price equal to 100% of the principal amount plus accrued interest. The New Convertible Bonds will bear interest payable semiannually at a rate of % per annum. Each New Convertible Bond will be convertible into such number of shares of Common Stock as is equal to the principal amount of such New Convertible Bond divided by $ . The Company, at its option, may elect to redeem all or a portion of the New Convertible Bonds commencing on , 2001, at redemption prices beginning at % of principal amount for the twelve-month period commencing , 2001 declining to par at and thereafter. The consummation of the Stock Offerings is not conditioned upon the consummation of the New Convertible Bond Offering, and there can be no assurance that the New Convertible Bond Offering will be consummated. SENIOR NOTES DUE 2005 Concurrently with the IPO, the Company offered $105 million of 9 7/8% Notes. The 9 7/8% Notes were issued pursuant to an indenture (the "9 7/8% Notes Indenture") between the Company and The Bank of New York as trustee, dated February 10, 1998. The 9 7/8% Notes mature in 2005 and bear interest, payable semi-annually, at 9 7/8% per annum. The 9 7/8% Notes Indenture does not provide for a sinking fund. The 9 7/8% Notes are subject to redemption at any time on or after February 15, 2002, at the option of the Company, in whole or in part, in integral multiples of $1,000 principal amount at declining redemption prices set forth in the 9 7/8% Notes Indenture. Notwithstanding the foregoing, during the first three years after the date of the 9 7/8% Notes Indenture, the Company will be permitted to redeem up to 33 1/3% of the aggregate principal amount of the 9 7/8% Notes with the net proceeds of any Public Equity Offerings (as defined in the 9 7/8% Notes Indenture) or Strategic Equity Investments (as defined in the 9 7/8% Notes Indenture) at 109.875% of the principal amount thereof. The Company placed net proceeds of $19.6 million from the offering of the 9 7/8% Notes representing funds that, together with the proceeds from the investment thereof, are sufficient to pay the first four scheduled interest payments (but not additional interest) on the 9 7/8% Notes, into an escrow account (the "Escrow Account") to be held by the Trustee for the benefit of the holders of the 9 7/8% Notes. The Company granted to the Trustee for the benefit of the holders of the 9 7/8% Notes, a first priority and exclusive security interest in the Escrow Account and the proceeds thereof. Funds will be disbursed from the Escrow Account for interest payments (but not additional interest) on the 9 7/8% Notes. Pending such disbursement, all funds contained in the Escrow Account are invested in Cash Equivalents (as defined in the 9 7/8% Notes Indenture). Upon a Change of Control (as defined in the 9 7/8% Notes Indenture) of the Company, or in the event of Asset Sales (as defined in the 9 7/8% Notes Indenture) in certain circumstances, the Company is required by the terms of the 9 7/8% Notes Indenture to make an offer to purchase the outstanding 9 7/8% Notes at a purchase price equal to 101% and 100%, respectively, of the principal amount thereof. The indebtedness of the Company evidenced by the 9 7/8% Notes ranks pari passu in right of payment with all other existing and future unsubordinated indebtedness of the Company and senior in right of payment to all existing and future obligations of the Company expressly subordinated in right of payment to the 9 7/8% Notes. The 9 7/8% Notes Indenture contains a number of covenants restricting the operations of the Company and its Restricted Group Members (as defined in the 9 7/8% Notes Indenture), including those restricting: the incurrence of indebtedness; the making of restricted payments (in the form of the declaration or payment of certain dividends or distributions, the purchase, redemption or other acquisition of any capital stock of the Company, the voluntary prepayment of pari passu or subordinated indebtedness and the making of certain investments, loans and advances) unless no Default or Event of Default (each, as defined in the 9 7/8% Notes 121 127 Indenture) exists, its leverage ratio does not exceed 6.0 to 1.0 and such restricted payments do not exceed the Basket (as defined in the 9 7/8% Notes Indenture); transactions with stockholders and affiliates; the incurrence of liens; sale-leaseback transactions; issuances and sales of capital stock of subsidiaries; the incurrence of guarantees by subsidiaries; dividend and other payment restrictions affecting subsidiaries; consolidation, merger or sale of substantially all of the Company's assets; and requiring the purchase of 9 7/8% Notes, at the option of the holder, upon the occurrence of a Change of Control and certain Asset Sales. The events of default under the 9 7/8% Notes Indenture include provisions that are typical of senior debt financings, including a cross-acceleration to a default by the Company or any Restricted Group Member on any indebtedness that has an aggregate principal amount in excess of certain levels. Upon the occurrence of such an event of default, the trustee or the holders of not less than 25% in principal amount at maturity of the outstanding 9 7/8% Notes may immediately accelerate the maturity of all the Notes as provided in the 9 7/8% Notes Indenture. CONVERTIBLE BONDS The Company sold approximately $144.8 million bonds ("Convertible Bonds") in the Convertible Bond Offering in July 1997. The Convertible Bonds have a three year maturity and are unsecured, senior subordinated obligations of the Company. The Convertible Bonds bear interest payable semiannually at a stated rate of 8.75% until maturity on June 30, 2000. The Company has granted to the holders of the Convertible Bonds certain rights with respect to the registration of the shares of Common Stock issuable upon conversion of the Convertible Bonds. Each Convertible Bond is convertible into such number of shares of Common Stock as is equal to the principal amount of such Convertible Bond divided by $20.00. Outstanding Convertible Bonds are, subject to certain conditions, redeemable at the option of the Company on or after the second anniversary of a Complying Public Equity Offering, at the principal amount thereof plus accrued interest, if any. At maturity the Convertible Bonds will be redeemed at their principal amount plus accrued interest. The IPO constituted a Complying Public Equity Offering under the terms of the Convertible Bonds. As a result, 7,239,350 shares of Common Stock became issuable upon conversion of the Convertible Bonds. As of March 31, 1998, 317,500 shares have been issued upon conversion of $6,350,000 aggregate principal amount of Convertible Bonds. HER NOTES HER sold $265 million aggregate principal amount of 11 1/2% Senior Notes due 2007 ("HER Notes") in August, 1997. The HER Notes have a ten year maturity and are unsecured, senior obligations of HER. HER placed approximately $56.6 million of the net proceeds in escrow for the first two years' interest payments on the HER Notes. The HER Notes were issued pursuant to an indenture containing certain covenants for the benefit of the holders of HER Notes, including, among other things, covenants limiting the incurrence of indebtedness, restricted payments, liens, payment restrictions affecting certain subsidiaries and joint ventures, transactions with affiliates, assets sales and mergers. The HER Notes are redeemable in whole or part, at the option of HER at any time on or after August 15, 2002 at a price ranging from 105.75 percent to 100.0 percent of the principal amount. A portion of the HER Notes are also redeemable at any time or from time to time prior to August 15, 2000 at a redemption price equal to 111.5% of the principal amount of the HER Notes so redeemed, plus accrued and unpaid interest thereon, if any, to the date of redemption with the net cash proceeds of one or more public equity offerings or strategic equity investments resulting in aggregate gross cash proceeds to HER of at least $75 million. In the event of a change of control of HER, holders of the HER Notes have the right to require HER to purchase such holder's HER Notes at a price equal to 101% of the aggregate principal amount. 122 128 DESCRIPTION OF CAPITAL STOCK The Company's authorized capital stock consists of 135,000,000 shares of Common Stock, par value $0.10 per share, of which 52,040,140 shares were issued and outstanding as of March 31, 1998, and 10,000,000 shares of preferred stock, par value $0.0001 per share (the "Preferred Stock"), none of which is outstanding. The following summary of the rights, privileges, restrictions and conditions of each of the classes of shares issued by the Company does not purport to be complete and is subject to the detailed provisions of, and qualified in its entirety by reference to, the Certificate of Incorporation and By-laws, and to the applicable provisions of the General Corporation Law of the State of Delaware (the "DGCL"). COMMON STOCK Holders of Common Stock are entitled to one vote for one share held of record on all matters upon which shareholders have the right to vote. There are no cumulative voting rights. All issued and outstanding shares of Common Stock are, and the Offered Shares, when issued and paid for, will be, validly issued, fully paid and non-assessable. Holders of Common Stock are entitled to such dividends as may be declared from time to time by the Board of Directors out of funds legally available for that purpose. See "Dividend Policy." Upon dissolution, holders of Common Stock are entitled to share pro rata in the assets of the Company remaining after payment in full of all of its liabilities and obligations, including payment of the liquidation preference, if any, of any Preferred Stock then outstanding. PREFERRED STOCK The Board of Directors may authorize the issuance of one or more series of Preferred Stock having such rights, including voting, conversion and redemption rights, and such preferences, including dividend and liquidation preferences, as the Board may determine, without further action by the stockholders of the Company. The issuance of Preferred Stock by the Board of Directors could adversely affect the rights of holders of Common Stock. For example, the issuance of Preferred Stock could result in a series of securities outstanding that would have preferences over the Common Stock with respect to dividends and in liquidation and that could, upon conversion or otherwise, enjoy all the rights appurtenant to the Common Stock. As of the date of the Offerings, the Company has authorized 200,000 shares of Series A Junior Participating Preferred Stock, par value $.0001 per share (the "Series A Preferred Stock"). No other series of Preferred Stock has been authorized. There are no issued and outstanding shares of Series A Preferred Stock and no such shares are being offered hereby. A Right (as defined below) to purchase shares of Series A Preferred Stock, however, is attached to each share of Common Stock pursuant to the Rights Agreement discussed below. The Company has authorized 200,000 shares of Series A Preferred Stock initially for issuance upon exercise of such Rights. The Units (as defined herein) of Series A Preferred Stock that may be acquired upon exercise of the Rights will be nonredeemable and subordinate to any other shares of preferred stock that may be issued by the Company. Each Unit of Series A Preferred Stock will have a minimum preferential quarterly dividend of $.01 per Unit or any higher per share dividend declared on the Common Stock. In the event of liquidation, the holder of a Unit of Series A Preferred Stock will receive a preferred liquidation payment equal to the greater of $.01 per Unit and the per share amount paid in respect of a share of Common Stock. Each Unit of Series A Preferred Stock will have one vote, voting together with the Common Stock. The holders of Units of Series A Preferred Stock, voting as a separate class, shall be entitled to elect two directors if dividends on the Series A Preferred Stock are in arrears for six fiscal quarters. In the event of any merger, consolidation or other transaction in which shares of Common Stock are exchanged, each Unit of Series A Preferred Stock will be entitled to receive the per share amount paid in respect of each share of Common Stock. The rights of holders of the Series A Preferred Stock to dividends, liquidation and voting, and in the event of mergers and consolidations, are protected by customary antidilution provisions. Because of the nature of the Series A Preferred Stock's dividend, liquidation and voting rights, the economic value of one Unit of Series A Preferred Stock that may be acquired upon the exercise of each Right is expected to approximate the economic value of one share of Common Stock. 123 129 PRIOR PURCHASE AGREEMENTS The Company and certain investors ("Prior Shareholders") have previously entered into stock purchase agreements on (i) April 23, 1993 (the "1993 Stock Purchase Agreement"), (ii) April 22, 1994 and June 17, 1994 (collectively, the "1994 Stock Purchase Agreements"), (iii) a series of dates in 1995 (the "1995 Stock Purchase Agreements"), (iv) a series of dates in 1996 (the "1996 Stock Purchase Agreements"), (v) a series of dates in 1997 (the "1997 Stock Purchase Agreements" and, together with the 1993 Stock Purchase Agreement, the 1994 Stock Purchase Agreements, the 1995 Stock Purchase Agreements and the 1996 Stock Purchase Agreements, the "Prior Purchase Agreements"). The Prior Purchase Agreements contain, among other things, certain registration and other rights granted by the Company with respect to such Common Stock described below. Registration Rights. Pursuant to the terms of the Prior Purchase Agreements, Prior Shareholders holding an aggregate of 29,623,784 shares of Common Stock are entitled to certain demand registration rights with respect to the Common Stock held by them ("Demand Registration Rights") following the consummation of the IPO. In addition to the Demand Registration Rights, Prior Shareholders are, subject to certain limitations, entitled to register shares of Common Stock in connection with a registration statement prepared by the Company to register its equity securities. Holders who purchased pursuant to the 1993 Stock Purchase Agreement may also register their shares of Common Stock in connection with a registered sale of Common Stock by a Major Shareholder (as that term is defined in the 1993 Stock Purchase Agreement). All of the registration rights of the Prior Shareholders are subject to certain conditions and limitations described in the Prior Purchase Agreements. Rights of First Refusal and Tag-Along Rights. Under the Prior Purchase Agreements, Prior Shareholders have certain rights of first refusal to purchase pro rata any issue of New Securities (as that term is defined in the Prior Purchase Agreements) which the Company thereafter may from time to time propose to issue and sell, other than in connection with certain types of transactions and to certain types of excluded purchasers. Termination of such rights will occur upon the earlier of the closing of an initial public offering pursuant to an effective registration statement under the Act or, as to any Prior Shareholder, when such Prior Shareholder no longer owns all the shares it originally purchased. The Prior Purchase Agreements further provide that, in the case of a sale by the Major Shareholders as a group of all their Major Shareholders' Shares (as those terms are defined in the Prior Purchase Agreements), holders under the Prior Purchase Agreements may elect to participate in that sale as well. SECTION 145 OF DGCL AND CERTAIN CHARTER PROVISIONS Section 145 of the DGCL provides that a corporation may indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding whether civil, criminal or investigative (other than an action by or in the right of the corporation) by reason of the fact that he is or was a director, officer, employee or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by him in connection with such action, suit or proceeding if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his conduct was unlawful. Section 145 further provides that a corporation similarly may indemnify any such person serving in any such capacity who was or is a party or is threatened to be made a party to any threatened, pending or completed action or suit by or in the right of the corporation to procure a judgment in its favor, against expenses (including attorneys' fees) actually and reasonably incurred in connection with the defense or settlement of such action or suit if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation and except that no indemnification shall be made in respect of any claim, issue or matter as to which such person shall have been adjudged to be liable to the corporation unless and only to the extent that the Delaware Court of Chancery or such other court in which such action or suit was brought shall determine upon application that, despite the adjudication of liability but in view of all 124 130 the circumstances of the case, such person is fairly and reasonably entitled to indemnity for such expenses which the Court of Chancery or such other court shall deem proper. Section 102(b)(7) of the DGCL permits a corporation to include in its certificate of incorporation a provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director (i) for any breach of the director's duty of loyalty to the corporation or its stockholders, (ii) for acts or omission not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) under Section 174 of the DGCL (relating to unlawful payment of dividends and unlawful stock purchase and redemption) or (iv) for any transaction from which the director derived an improper personal benefit. The Company's Certificate of Incorporation provides that the Company's Directors shall not be liable to the Company or its stockholders for monetary damages for breach of fiduciary duty as a director provided, however, that such exculpation from liabilities is not permitted with respect to liability arising from items described in clauses (i) through (iv) in the preceding paragraph. The Certificate and the Company's By-Laws further provide that the Company shall indemnify its directors and officers to the fullest extent permitted by the DGCL. The directors and officers of the Company are covered under directors' and officers' liability insurance policies maintained by the Company. CERTAIN CHARTER AND BY-LAW PROVISIONS Shareholders' rights and related matters are governed by the DGCL, the Certificate of Incorporation and By-laws. Certain provisions of the Certificate of Incorporation and the By-laws, which are summarized below, may discourage or make more difficult a takeover attempt that a shareholder might consider in its best interest, although certain of such provisions in the By-laws are subject to final approval by the Company's Board of Directors. Such provisions may also adversely affect prevailing market prices for the Common Stock. See "Risk Factors -- Anti-takeover Provisions." Classified Board of Directors and Related Provisions. The Certificate of Incorporation provides that the Board of Directors of the Company be divided into three classes of directors serving staggered three-year terms. The classes of directors (designated Class I, Class II and Class III) shall be, as nearly as possible, equal in number. Accordingly, one-third of the Company's Board of Directors will be elected each year. The terms of the Initial Class I directors terminated at the May 20, 1998 annual meeting of stockholders and such directors were re-elected to a three-year term terminating on the date of the 2001 annual meeting of stockholders; the term of the initial Class II directors shall terminate on the date of the 1999 annual meeting of stockholders; and the term of the initial Class III directors shall terminate on the date of the 2000 annual meeting of stockholders. At each annual meeting of stockholders beginning in 1998, successors to the class of directors whose term expires at that annual meeting shall be elected for a three-year term. The classified board provision may prevent a party who acquires control of a majority of the outstanding voting stock of the Company from obtaining control of the Board of Directors until the second annual shareholders meeting following the date such party obtains the controlling interest. Subject to the rights of the holders of any series of Preferred Stock or any other class of capital stock of the Company (other than the Common Stock) then outstanding, directors may only be removed for cause by a majority vote of the holders of capital stock of the Company issued and outstanding and entitled to vote generally in the election of directors, voting together as a single class. No Shareholder Action by Written Consent; Special Meetings. The Certificate of Incorporation prohibits shareholders from taking action by written consent in lieu of an annual or special meeting, and thus shareholders may take action at an annual or special meeting called in accordance with the By-laws. The Certificate of Incorporation and By-laws provide that special meetings of shareholders may only be called only by the Chairman of the Board of Directors, the Chief Executive Officer or a majority of the Board of Directors. Special meetings may not be called by the shareholders, except as permitted by the Shareholder Rights By-law described below. 125 131 Amendments to the Certificate of Incorporation. The provisions of the Certificate of Incorporation described above may not be amended, altered, changed or repealed without the affirmative vote of the holders of at least 75% of the shares of capital stock of the Company issued and outstanding and entitled to vote. SECTION 203 OF DELAWARE GENERAL CORPORATION LAW AND CERTAIN PROVISIONS OF THE CERTIFICATE OF INCORPORATION Section 203 of the DGCL prohibits certain transactions between a Delaware corporation and an "interested stockholder", which is defined as a person who, together with any affiliates or associates of such person, beneficially owns, directly or indirectly, 15% or more of the outstanding voting shares of a Delaware corporation. This provision prohibits certain business combinations (defined broadly to include mergers, consolidations, sales or other dispositions of assets having an aggregate value in excess of 10% of the consolidated assets of the corporation, and certain transactions that would increase the interested stockholder's proportionate share ownership in the corporation) between an interested stockholder and a corporation for a period of three years after the date the interested stockholder becomes an interested stockholder, unless (i) the business combination is approved by the corporation's board of directors prior to the date the interested stockholder becomes an interested stockholder, (ii) the interested stockholder acquired at least 85% of the voting stock of the corporation (other than stock held by directors who are also officers or by certain employee stock plans) in the transaction in which it becomes an interested stockholder or (iii) the business combination is approved by a majority of the board of directors and by the affirmative vote of 66 2/3% of the outstanding voting stock that is not owned by the interested stockholder. In addition, the Company's Certificate of Incorporation grants the Board of Directors of the Company the authority to issue up to 10,000,000 shares of preferred stock in one or more series and to determine the rights, voting powers, dividend rate, conversion rights, redemption price, liquidation preference and other terms of such preferred stock without any further vote or action by the stockholders. The foregoing provisions of Section 203 of the DGCL and the Company's Certificate of Incorporation, and any issuance of preferred stock with voting or conversion rights, may adversely affect the voting power of the holders of Common Stock and may have the effect of delaying or preventing a change of control of the Company or adversely affect the market price of the Company's Common Stock. SHAREHOLDER RIGHTS AGREEMENT AND SHAREHOLDER RIGHTS BY-LAW Shareholder Rights Plan. The Company has entered into a Rights Agreement (the "Rights Agreement"). In connection with the Rights Agreement, the Board of Directors of the Company declared a distribution of one right (a "Right") for each outstanding share of Common Stock, each share of Common Stock offered hereby and each share of Common Stock issued (including shares distributed from treasury) by the Company thereafter and prior to the Distribution Date (as defined below). Each Right will entitle the registered holder, subject to the terms of the Rights Agreement, to purchase from the Company one one-thousandth of a share (a "Unit") of Series A Preferred Stock at a purchase price of $75 per Unit, subject to adjustment. Initially, the Rights will attach to all certificates representing shares of outstanding Common Stock, and no separate Rights Certificates will be distributed. The Rights will separate from the Common Stock and the "Distribution Date" will occur upon the earlier of (i) 10 days following a public announcement (the date of such announcement being the "Stock Acquisition Date") that a person or group of affiliated or associated persons (other than the Company, any subsidiary of the Company or any employee benefit plan of the Company or such subsidiary) (an "Acquiring Person") has acquired, obtained the right to acquire, or otherwise obtained beneficial ownership of 15% or more of the then outstanding shares of Common Stock and (ii) 10 business days (or such later date as may be determined by action of the Board of Directors prior to such time as any person becomes an Acquiring Person) following the commencement of a tender offer or exchange offer that would result in a person or group beneficially owning 15% or more of the then outstanding shares of Common Stock. George Soros and his affiliates and Alan B. Slifka and his affiliates are excluded from the definition of "Acquiring Person" under the Rights Agreement unless such persons increase the aggregate percentage of their ownership interest in the Company to 20%. 126 132 Until the Distribution Date, (i) the Rights will be evidenced by Common Stock certificates and will be transferred with and only with such Common Stock certificates, (ii) new Common Stock certificates issued after date of consummation of the Offerings (also including shares distributed from treasury) will contain a notation incorporating the Rights Agreement by reference and (iii) the surrender for transfer of any certificates representing outstanding Common Stock will also constitute the transfer of the Rights associated with the Common Stock represented by such certificates. The Rights will not be exercisable until the Distribution Date and will expire at the close of business on the tenth anniversary of the Rights Agreement unless earlier redeemed by the Company as described below. In the event that (i) the Company is the surviving corporation in a merger with an Acquiring Person and shares of Common Stock shall remain outstanding, (ii) a Person becomes an Acquiring Persons, (iii) an Acquiring Person engages in one or more "self-dealing" transactions as set forth in the Rights Agreement or (iv) during such time as there is an Acquiring Person, an event occurs which results in such Acquiring Person's ownership interest being increased by more than 1% (e.g., by means of a recapitalization), then, in each such case, each holder of a Right (other than such Acquiring Person) will thereafter have the right to receive, upon exercise, Units of Series A Preferred Stock (or, in certain circumstances, Common Stock, cash, property or other securities of the Company) having a value equal to two times the exercise price of the Right. The exercise price is the Purchase Price multiplied by the number of Units of Series A Preferred Stock issuable upon exercise of a Right prior to the events described in this paragraph. In the event that, at any time following the Stock Acquisition Date, (i) the Company is acquired in a merger or other business combination transaction and the Company is not the surviving corporation (other than a merger described in the preceding paragraph), (ii) any Person consolidates or merges with the Company and all or part of the Common Stock is converted or exchanged for securities, cash or property of any other Person or (iii) 50% or more of the Company's assets or earning power is sold or transferred, each holder of a Right (other than an Acquiring Person) shall thereafter have the right to receive, upon exercise, common stock of the ultimate parent of the Acquiring Person having a value equal to two times the exercise price of the Right. The Purchase Price payable, and the number of Units of Series A Preferred Stock issuable, upon exercise of the Rights are subject to adjustment from time to time to prevent dilution (i) in the event of a stock dividend on, or a subdivision, combination or reclassification of, the Series A Preferred Stock, (ii) if holders of the Series A Preferred Stock are granted certain rights or warrants to subscribe for Series A Preferred Stock or convertible securities at less than the current market price of the Series A Preferred Stock or (iii) upon the distribution to the holder of the Series A Preferred Stock of evidences of indebtedness, cash or assets (excluding regular quarterly cash dividends) or of subscription rights or warrants (other than those referred to above). At any time until ten business days following the Stock Acquisition Date, either (i) 75% of the Company's Board of Directors or (ii) a majority of the Company's Board of Directors and a majority of the Continuing Directors (as defined below), may redeem the Rights in whole, but not in part, at a nominal price. Immediately upon the action of a majority of the Company's Board of Directors ordering the redemption of the Rights, the Rights will terminate and the only right of the holders of Rights will be to receive such redemption price. As used in the Rights Agreement, a Continuing Director means any person (other than an Acquiring Person or an affiliate or associate of an Acquiring Person or a representative of an Acquiring Person or of any such affiliate or associate) who was a director prior to the date of the Rights Agreement and any person (other than an Acquiring Person or an affiliate or associate of an Acquiring Person or a representative of an Acquiring Person or of any such affiliate or associate) nominated for selection or elected to the Board of Directors pursuant to the approval of a majority of the Continuing Directors. At its option, either (i) 75% of the Company's Board of Directors or (ii) a majority of the Company's Board of Directors and a majority of the Continuing Directors, may exchange each Right for (i) one Unit of Series A Preferred Stock or (ii) such number of Units of Series A Preferred Stock as will equal the spread between the market price of each Unit to be issued and the purchase price of such Unit set forth in the Rights Agreement. 127 133 Any of the provisions of the Rights Agreement may be amended without the approval of either (i) 75% of the Company's Board of Directors or (ii) a majority of the Company's Board of Directors and a majority of Continuing Directors in order to cure any ambiguity, defect or inconsistency, to make changes which do not adversely affect the interests of holders of Rights (excluding the interests of any Acquiring Person), or to shorten or lengthen any time period under the Rights Agreement; provided, however, that no amendment to adjust the time period governing redemption shall be made at such time as the Rights are not redeemable. Shareholder Rights By-Law. If a fully financed tender offer is made publicly to purchase all the Company's outstanding shares of Common Stock for cash or Marketable Securities (as defined below) at a price that is at least 40 percent greater than the average closing price of such shares on the principal exchange on which such shares are listed during the 30 days prior to the date on which such offer is first published or sent to security holders (the "Offer Date") and the Board of Directors opposes such offer, the holders of more than 50% of the outstanding shares of Common Stock may, at any time subsequent to the date that is nine calendar months after the Offer Date, call a special meeting of the stockholders, notwithstanding the provisions described in "-- Certain Charter and By-Law Provisions -- No Shareholder Action by Written Consent; Special Meetings," at which meeting stockholders may be asked to vote upon a proposal to request that the Board of Directors amend the Rights Agreement to exempt such offer from the terms of the Rights Agreement; provided, however, if prior to the expiration of such nine-month period, the Board of Directors determines that it is in the best interests of the shareholders to undertake efforts to sell the Company, such period shall be extended as long as the Board of Directors continues its efforts to solicit, evaluate and negotiate alternative bids to acquire the Company. If the proposal to amend the Rights Agreement is approved by a vote of 70% of the votes cast for or against such proposal at such meeting of stockholders at which a quorum is present, the Board of Directors shall amend the Rights Agreement to exempt such offer from its terms no later than 60 days after the date of such stockholders' meeting. "Marketable Securities" means any securities that are traded on a nationally recognized exchange and, in the opinion of an independent investment bank, provide sufficient value and liquidity so that they would be treated as substantially equivalent to cash consideration. 128 134 SHARES ELIGIBLE FOR FUTURE SALE As of March 31, 1998, after giving effect to the Stock Offerings, there would have been 54,654,640 shares of Common Stock outstanding, (i) assuming no exercise of the Underwriters' over-allotment options and (ii) excluding (w) 10,488,807 shares for which outstanding warrants and vested options are exercisable, (x) 713,311 shares reserved for issuance upon exercise of a put right (y) the 6,921,850 shares into which the Convertible Bonds are convertible and (z) the shares into which the New Convertible Bonds are convertible. Of the 54,654,640 shares, (i) the 12,765,000 shares sold in the IPO and the 10,458,000 shares registered in the Stock Offerings will be freely tradable without restriction under the Securities Act (except that any shares held by "affiliates" of the Company may generally be resold only in compliance with applicable provisions of Rule 144, as described below) and (ii) 16,974,029 additional shares may be resold under Rule 144 without restriction under the Securities Act and any additional 18,136,552 shares may be resold under Rule 144 subject to the volume and manner limitations therein (in each case, subject to the lock-up agreements described below). In addition, the shares into which the New Convertible Bonds are convertible will be freely tradable without restriction under the Securities Act. In addition, the Company has caused to become effective, (i) a registration statement on Form S-1 covering the resale of the Convertible Bonds and the shares of Common Stock into which the Convertible Bonds are convertible and (ii) two registration statements on Form S-8 covering the resale of shares of Common Stock issued to employees, officers and directors of the Company pursuant to employee benefit plans. Holders of approximately 29,623,784 shares of Common Stock and warrants to purchase 7,777,776 shares of Common Stock, and an affiliate of the Company with an option with respect to 438,311 shares of Common Stock, have certain demand and piggy-back registration rights for shares that are not being sold in the Stock Offerings. The Company has agreed to register within 45 days after consummation of the Offerings pursuant to a shelf registration statement all of the Affiliate Shares owned by Mr. Slifka and his affiliates and the affiliates of Mr. Soros that are not sold in the Stock Offerings (the "Affiliate Shares") in consideration of such shareholders' undertaking to be bound by the Restrictions on their ability to resell such Affiliate Shares under such shelf registration statement for specified periods after the consummation of the Offerings. It is the Company's belief, after consultation with its financial advisors, that this agreement relating to the Affiliate Shares will contribute toward assuring the market of an orderly manner for such Affiliate Shares to be sold over a period of time. Under the Restrictions, holders of Affiliate Shares will be prevented from selling any such shares during the first six months after the closing date of the Offerings and will be able to sell (i) 50% of such shares after the six month anniversary of the closing date of the Offerings, (ii) 75% of such shares after the nine month anniversary of the closing date of the Offerings and (iii) 100% of such shares after the twelve month anniversary of the closing date of the Offerings. In connection with this agreement, the Company also has agreed to permit certain of the Soros affiliates to resell, immediately after the closing date of the Stock Offerings, up to 100,000 of any shares that they are unable to resell in the Stock Offerings as a result of any cut-back that may be imposed by the underwriters (subject to a waiver by the underwriters in the IPO of the lockup agreement entered into by such affiliates to the extent of such 100,000 shares). The Company and its directors, executive officers and certain stockholders have agreed, subject to certain exceptions, not to (i) grant any option to purchase or otherwise transfer or dispose of any Common Stock or securities convertible into or exercisable or exchangeable for Common Stock or (ii) enter into any swap or other agreement or transaction that transfers, in whole or in part, the economic consequences of ownership of the Common Stock without the prior written consent of Merrill Lynch, on behalf of the Underwriters for a period of 90 days after the date of this Prospectus. See "Underwriting." In general, under Rule 144 as currently in effect, a person (or persons whose shares of the Company are required to be aggregated) who has been deemed to have owned shares of an issuer for at least one year, including an "affiliate," is entitled to sell, within any three-month period, a number of shares that does not exceed the greater of 1% of the then outstanding number of shares of such class or the average weekly trading volume in composite trading in all national securities exchanges during the four calendar weeks preceding the 129 135 filing of the required notice of such sale. A person (or persons whose shares of the Company are required to be aggregated) who is not deemed an affiliate of an issuer at the time of the sale and for at least three months prior to the sale and who has owned shares for at least two years is entitled to sell such shares under Rule 144 without regard to the volume limitations described above. Affiliates continue to be subject to such limitations. As defined in Rule 144, an "affiliate" of an issuer is a person that directly or indirectly, through one or more intermediaries, controls or is controlled by, or is under common control with, such issuer. CERTAIN UNITED STATES FEDERAL TAX CONSEQUENCES TO NON-U.S. STOCKHOLDERS The following is a summary of the principal United States federal income and estate tax considerations with respect to the ownership and disposition of shares of Common Stock by "Non-U.S. Holders." This summary is based on the Internal Revenue Code of 1986, as amended (the "Code"), existing and proposed Treasury regulations thereunder and administrative and judicial interpretations thereof (all as currently in effect and all of which are subject to change, possibly with retroactive effect). This summary does not address all United States federal income and estate tax consequences that may be relevant to a non-U.S. Holder in light of its particular circumstances or to certain Non-U.S. Holders that may be subject to special treatment under United States federal income tax laws, such as banks, insurance companies, tax-exempt entities and certain United States expatriates. Furthermore, the following discussion does not discuss any aspects of foreign, state or local taxation. As used herein, the term "Non-U.S. Holder" means a holder of Common Stock that for U.S. federal income tax purposes is not (i) a citizen or individual resident of the United States; (ii) a corporation or partnership created or organized in or under the laws of the United States or any political subdivision thereof; (iii) an estate the income of which is subject to United States federal income tax regardless of its source; or (iv) a trust if both: (A) a court within the United States is able to exercise primary supervision over the administration of the trust and (B) one or more United States persons have the authority to control all substantial decisions of the trust. EACH PROSPECTIVE NON-U.S. HOLDER IS URGED TO CONSULT ITS OWN TAX ADVISER WITH RESPECT TO THE UNITED STATES FEDERAL INCOME AND ESTATE TAX CONSEQUENCES OF OWNING AND DISPOSING OF SHARES OF COMMON STOCK, AS WELL AS ANY TAX CONSEQUENCES ARISING UNDER THE LAWS OF ANY STATE, LOCAL OR OTHER TAXING JURISDICTION. DIVIDENDS Dividends that are paid by a U.S. corporation to a Non-U.S. Holder and that are not effectively connected with a trade or business carried on by such Non-U.S. Holder in the United States (or, if one or more of certain tax treaties apply, are attributable to a permanent establishment in the United States maintained by the Non-U.S. Holder) generally are subject to a 30% U.S. withholding tax. An exemption from such withholding exists with respect to dividends paid to Non-U.S. Holders by a U.S. corporation (an "80/20 company") if at least 80% of the gross income derived by such corporation (either directly or through certain of its subsidiaries) during the applicable testing period is "active foreign business income," as defined in section 861 of the Code. Under the provisions of the Code applicable to 80/20 companies, the proportion of an 80/20 company's dividends equal to such company's total gross income from foreign sources over its total gross income is exempt from U.S. withholding tax. At present, the Company believes that it qualifies as an 80/20 company. However, the 80% active foreign business income test is applied on a periodic basis, and operations and business plans of the Company may change in subsequent taxable years. Therefore, no assurances can be made regarding the Company's future status as an 80/20 company. If, for any period or periods, the Company fails to satisfy the requirements applicable to an 80/20 company, then, for payments made prior to January 1, 2000, the withholding agent generally would be required to withhold tax from all distributions paid on the Common Stock regardless of the Company's earnings and profits. For payments made after January 1, 2000, a withholding agent may elect not to withhold on a distribution to the extent it is not paid out of current or accumulated earnings and profits, based on the Company's reasonable estimate of the extent to which the distribution will be out of such earnings and profits. Holders could, however, apply for refunds if such Common Stock's share of the Company's earnings and profits is less than the amount of the 130 136 distributions. Additionally, the rate of withholding may be reduced to the extent provided by a tax treaty between the United States and the country of which the Non-U.S. Holder is a resident for tax purposes. In order to claim the benefit of an applicable tax treaty rate, a Non-United States Holder may have to file with the Company or its dividend paying agent an exemption or reduced treaty rate certificate or letter in accordance with the terms of such treaty. Under United States Treasury regulations currently in effect, for purposes of determining whether tax is to be withheld at a 30% rate or at a reduced rate as specified by an income tax treaty, the Company ordinarily will presume that dividends paid to the address in a foreign country are paid to a resident of such country absent knowledge that such presumption is not warranted (the "address rule"). However, on October 6, 1997, the U.S. Treasury Department issued final regulations on withholding of income tax payments to foreign persons, effective January 1, 2000, which will abolish the address rule. Effective January 1, 2000, a Non-United States Holder seeking a reduced rate of withholding under an income tax treaty would generally be required to provide to the Company a valid Internal Revenue Service Form W-8 certifying that such Non-United States Holder is entitled to benefits under an income tax treaty. The final regulations also provide special rules for determining whether, for purposes of assessing the applicability of an income tax treaty, dividends paid to a Non-United States Holder that is an entity should be treated as being paid to the entity itself or to the persons holding an interest in that entity. A Non-United States Holder who is eligible for a reduced withholding rate may obtain a refund of any excess amounts withheld by filing an appropriate claim for a refund with the Internal Revenue Service. In the case of dividends that are effectively connected with the Non-United States Holder's conduct of a trade or business with the United States or, if an income tax treaty applies, attributable to a United States permanent establishment of the Non-United States Holder, the Non-United States Holder will generally be subject to regular U.S. income tax in the same manner as if the Non-United States Holder were a United States resident. A Non-United States corporation receiving effectively connected dividends also may be subject to an additional "branch profits tax" which is imposed, under certain circumstances, at a rate of 30% (or such lower rate as may be specified by an applicable treaty) of the Non-United States corporation's "effectively connected earnings and profits," subject to certain adjustments. GAIN ON DISPOSITION OF COMMON STOCK A Non-United States Holder generally will not be subject to U.S. Federal income tax with respect to gain realized on a sale or other disposition of Common Stock unless (i) the gain is effectively connected with a trade or business of such Non-United States Holder in the U.S., (ii) in the case of certain Non-United States Holders who are non-resident alien individuals and hold the Common Stock as a capital asset, such individuals are present in the U.S. for 183 or more days in the taxable year of the disposition and either (a) such individuals have a "tax home" (as defined for United States Federal income tax purposes) in the U.S., or (b) the gain is attributable to an office or other fixed place of business maintained by such individuals in the U.S. (iii) the Non-United States Holder is subject to tax, pursuant to the provisions of U.S. tax law applicable to certain U.S. expatriates whose loss of U.S. citizenship has as one of its principal purposes the avoidance of U.S. taxes, or (iv) under certain circumstances if the Company is or has been during certain time periods a "United States real property holding corporation" within the meaning of Section 897(c)(2) of the Code and, assuming that the Common Stock is regularly traded on an established securities market for tax purposes, the Non-United States Holder held, directly or indirectly, at any time within the five-year period preceding such disposition more than 5% of the outstanding Common Stock. The Company is not, and does not anticipate becoming, a United States real property holding corporation. INFORMATION REPORTING REQUIREMENTS AND BACKUP WITHHOLDING Under the United States Treasury regulations, the Company must report annually to the Internal Revenue Service and to each Non-United States Holder the amount of dividends paid to such holder and any tax withheld with respect to such dividends. These information reporting requirements apply regardless of whether withholding is required because the dividends were effectively connected with a trade or business in the United States of the Non-United States Holder or withholding was reduced or eliminated by an applicable income tax treaty. Copies of the information returns reporting such dividends and withholding may also be 131 137 made available to the tax authorities in the country in which the Non-United States Holder is a resident under the provisions of an applicable income tax treaty or agreement. United States backup withholding (which generally is a withholding tax imposed at the rate of 31% on certain payments to persons that fail to furnish certain information under the United States information reporting requirements) generally will not apply to (i) dividends paid to Non-United States Holders that are subject to the 30% withholding discussed above (or that are not so subject because a tax treaty applies that reduces or eliminates such 30% withholding) or (ii) under current law, dividends paid to a Non-United States Holder at an address outside of the United States. However, under final United States Treasury regulations, effective as of January 1, 2000, a Non-United States Holder will generally be subject to United States withholding tax at a 31% rate, unless certain certification procedures (or, in the case of payments made outside the United States with respect to an offshore account, certain documentary evidence procedures) are satisfied, directly or through a foreign intermediary. Backup withholding and information reporting generally will apply to dividends paid to addresses inside the United States on shares of Common Stock to beneficial owners that are not "exempt recipients" and that fail to provide in the manner required certain identifying information. The payment of the proceeds of the disposition of Common Stock to or through the U.S. office of a broker is subject to information reporting unless the disposing holder, under penalty of perjury, certifies its Non-United States status or otherwise establishes an exemption. Generally, U.S. information reporting and backup withholding will not apply to a payment of disposition proceeds if the payment is made outside the U.S. through a Non-United States office of a Non-United Sates broker. However, information reporting requirements (but probably, prior to January 1, 2000, not backup withholding) will apply to a payment of disposition proceeds outside the U.S. if (A) the payment is made through an office outside the U.S. of a broker that is either (i) a U.S. person, (ii) a foreign person which derives 50% or more of its gross income for certain periods from the conduct of a trade or business in the U.S., (iii) a "controlled foreign corporation" for U.S. Federal income tax purposes, or (iv) effective January 1, 2000, but probably not prior to such date, a foreign broker that is (1) a foreign partnership, one or more of whose partners are U.S. persons who, in the aggregate hold more than 50% of the income or capital interest in the partnership at any time during its tax year, or (2) a foreign partnership engaged at any time during its tax year in the conduct of a trade or business in the United States, and (B) the broker fails to maintain documentary evidence that the holder is a Non-United States Holder and that certain conditions are met, or that the holder otherwise is entitled to an exemption. Backup withholding is not an additional tax. Rather the tax liability of persons subject to backup withholding will be reduced by the amount of tax withheld. If withholding results in an overpayment of taxes, a refund may be obtained, provided that the required information is furnished to the Internal Revenue Service. FEDERAL ESTATE TAX An individual Non-United States Holder who is treated as the owner of or has made certain lifetime transfers of an interest in the Common Stock will be required to include the value thereof in his gross estate for U.S. Federal estate tax purposes, and may be subject to U.S. Federal estate tax unless an applicable estate tax treaty provides otherwise. Estates of non-resident aliens are generally allowed a statutory credit which generally has the effect of offsetting the U.S. Federal estate tax imposed on the first $60,000 of the taxable estate. THE FOREGOING DISCUSSION IS INCLUDED FOR GENERAL INFORMATION ONLY. ACCORDINGLY, EACH PROSPECTIVE PURCHASER IS URGED TO CONSULT HIS TAX ADVISOR WITH RESPECT TO THE UNITED STATES FEDERAL INCOME TAX AND FEDERAL ESTATE TAX CONSEQUENCES OF THE OWNERSHIP AND DISPOSITION OF COMMON STOCK, INCLUDING THE APPLICATION AND EFFECT OF THE LAWS OF ANY STATE, LOCAL, FOREIGN, OR OTHER TAX JURISDICTION. 132 138 UNDERWRITING Subject to the terms and conditions set forth in a U.S. purchase agreement (the "U.S. Purchase Agreement") among the Company, the Selling Stockholders and each of the underwriters named below (the "U.S. Underwriters") and concurrently with the sale of 4,183,200 shares of Common Stock to the International Managers (as defined below), the Company and the Selling Stockholders severally have agreed to sell to each of the U.S. Underwriters, and each of the U.S. Underwriters for whom Merrill Lynch, Pierce, Fenner & Smith Incorporated ("Merrill Lynch"), Donaldson, Lufkin & Jenrette Securities Corporation, Bear, Stearns & Co. Inc., BT Alex. Brown Incorporated, Lehman Brothers Inc., Prudential Securities Incorporated and Arnhold and S. Bleichroeder, Inc. are acting as representatives (the "U.S. Representatives"), has severally agreed to purchase from the Company and the Selling Stockholders, the number of shares of Common Stock set forth opposite its name below.
NUMBER U.S. UNDERWRITERS OF SHARES ----------------- --------- Merrill Lynch, Pierce, Fenner & Smith....................... Incorporated Donaldson, Lufkin & Jenrette Securities Corporation......... Bear, Stearns & Co. Inc. ................................... BT Alex. Brown Incorporated................................. Lehman Brothers Inc. ....................................... Prudential Securities Incorporated ......................... Arnhold and S. Bleichroeder, Inc. .......................... --------- Total......................................... 6,274,800 =========
The Company and the Selling Stockholders have also entered into an international purchase agreement (the "International Purchase Agreement" and, together with the U.S. Purchase Agreement, the "Purchase Agreements") with certain underwriters outside the United States and Canada (the "International Managers" and, together with the U.S. Underwriters, the "Underwriters") for whom Merrill Lynch International and Donaldson, Lufkin & Jenrette International are acting as representatives (the "International Representatives"). Subject to the terms and conditions set forth in the International Purchase Agreement, and concurrently with the sale of 6,274,800 shares of Common Stock to the U.S. Underwriters pursuant to the U.S. Purchase Agreement, the Company and the Selling Stockholders severally have agreed to sell to the International Managers, and the International Managers severally have agreed to purchase, an aggregate of 4,183,200 shares of Common Stock. The public offering price per share and the underwriting discount per share of Common Stock are identical under the U.S. Purchase Agreement and the International Purchase Agreement. In each Purchase Agreement, the several U.S. Underwriters and the several International Managers, respectively have agreed, subject to the terms and conditions set forth in such Purchase Agreement, to purchase all the shares of Common Stock offered hereby, if any are purchased. In the event of default by an Underwriter, the Purchase Agreement provides that, in certain circumstances, purchase commitments of the nondefaulting Underwriters may be increased or the Purchase Agreement may be terminated. The sale of Common Stock to the U.S. Underwriters is conditioned upon the sale of shares of Common Stock to the International Managers, and vice versa. The U.S. Underwriters and the International Managers have entered into an intersyndicate agreement (the "Intersyndicate Agreement") that provides for the coordination of their activities. Pursuant to the Intersyndicate Agreement, the U.S. Underwriters and the International Managers are permitted to sell shares of Common Stock to each other for purposes of resale at the public offering price set forth on the cover page of this Prospectus, less an amount not greater than the selling concession. Under the terms of the Intersyndicate Agreement, the U.S. Underwriters and any dealer to whom they sell shares of Common Stock will not offer to sell or sell shares of Common Stock to persons who are non-U.S. or non-Canadian persons or to persons they believe intend to resell to persons who are non-U.S. or non-Canadian persons, and the International Managers 133 139 and any dealer to whom they sell shares of Common Stock will not offer to sell or sell shares of Common Stock to U.S. persons or Canadian persons or to persons they believe intend to resell to U.S. persons or Canadian persons, except, in each case, for transactions pursuant to the Intersyndicate Agreement. The U.S. Representatives have advised the Company and the Selling Stockholders that the U.S. Underwriters propose initially to offer the shares of Common Stock to the public at the public offering price set forth on the cover page of this Prospectus, and to certain dealers at such price less a concession not in excess of $ per share of Common Stock. The U.S. Underwriters may allow, and such dealers may reallow, a discount not in excess of $ per share of Common Stock on sales to certain other dealers. After the Stock Offerings, the public offering price, concession and discount may be changed. The Company, its directors, executive officers and certain stockholders have agreed, subject to certain exceptions, not to directly or indirectly (i) offer, pledge, sell, contract to sell, sell any option or contract to purchase, purchase any option or contract to sell, grant any option, right or warrant for the sale of, or otherwise dispose of or transfer any Common Stock or any securities convertible into or exchangeable or exercisable for any shares of Common Stock or request the filing of any registration statement under the Securities Act, with respect to any of the foregoing or (ii) enter into any swap or any other agreement or any transaction that transfers, in whole or in part, directly or indirectly, the economic consequence of ownership of Common Stock, whether any such swap transaction is to be settled by delivery of the Common Stock or other securities, in cash or otherwise without the prior written consent of Merrill Lynch, on behalf of the Underwriters, for a period of 90 days after the date of this Prospectus. In addition, except to the extent otherwise provided in this Prospectus with respect to the Affiliate Shares, certain stockholders have agreed not to make any demand for or exercise any rights with respect to the registration of Common Stock and have waived all rights (including demand and "piggyback" registration rights) to register securities owned by them for such 90 day period and rights to purchase additional shares of Common Stock in connection with the Offerings. See "Shares Eligible for Future Sale." The Company and the Selling Stockholders have granted an option to the U.S. Underwriters, exercisable for 30 days after the date of this Prospectus, to purchase up to an aggregate of 941,220 additional shares of Common Stock at the public offering price set forth on the cover page of this Prospectus, less the underwriting discount. The Company will determine, prior to the pricing of the Common Stock offered hereby, the number of Shares of Common Stock subject to such over-allotment option to be sold by the Company and the Selling Stockholders, respectively. The U.S. Underwriters may exercise this option only to cover over-allotments, if any, made on the sale of the Common Stock offered hereby. To the extent that the U.S. Underwriters exercise this option, each U.S. Underwriter will be obligated, subject to certain conditions, to purchase a number of additional shares of Common Stock proportionate to such U.S. Underwriter's initial amount reflected in the foregoing table. The Company and the Selling Stockholders have also granted an option to the International Managers, exercisable for 30 days after the date of this Prospectus, to purchase up to an additional 627,480 shares of Common Stock to cover over-allotments, if any, on terms similar to those granted to U.S. Underwriters. The Company and the Selling Stockholders have agreed to indemnify the several U.S. Underwriters and the International Managers against certain liabilities, including liabilities under the Securities Act of 1933, as amended, or to contribute to payments the Underwriters may be required to make in respect thereof. Until the distribution of the Common Stock is completed, rules of the Securities and Exchange Commission may limit the ability of the U.S. Underwriters and certain selling group members to bid for and purchase the Common Stock. As an exception to these rules, the Representatives are permitted to engage in certain transactions that stabilize the price of the Common Stock. Such transactions consist of bids or purchases for the purpose of pegging, fixing or maintaining the price of the Common Stock. In connection with the Offerings, certain Underwriters or their respective affiliates and selling group members (if any) who are qualified market makers on the Nasdaq National Market may engage in "passive market making" in the Common Stock on the Nasdaq National Market in accordance with Rule 103 under Regulation M. Rule 103 permits, upon the satisfaction of certain conditions, underwriters and selling group members participating in a distribution that are also Nasdaq National Market market makers in the security 134 140 being distributed to engage in limited market making transactions during the period when Rule 103 under Regulation M would otherwise prohibit such activity. Rule 103 prohibits underwriters and selling group members engaged in passive market making generally from entering a bid or effecting a purchase at a price that exceeds the highest bid for those securities displayed on the Nasdaq National Market by a market maker that is not participating in the distribution. Under Rule 103, each underwriter or selling group member engaged in passive market making is subject to a daily net purchase limitation equal to 30% of such entity's average daily trading volume during the two full consecutive calendar months immediately preceding the date of the filing of the registration statement under the Securities Act pertaining to the security to be distributed. If the Underwriters create a short position in the Common Stock in connection with the Stock Offerings, (i.e., if they sell more shares of Common Stock than are set forth on the cover page of this Prospectus), the U.S. Representatives may reduce that short position by purchasing Common Stock in the open market. The U.S. Representatives may also elect to reduce any short position by exercising all or part of the over-allotment option described above. The U.S. Representatives may also impose a penalty bid on certain Underwriters and selling group members. This means that if the U.S. Representatives purchase shares of Common Stock in the open market to reduce the Underwriters' short position or to stabilize the price of the Common Stock, they may reclaim the amount of the selling concession from the Underwriters and selling group members who sold those shares as part of the Offering. In general, purchases of a security for the purpose of stabilization or to reduce a short position could cause the price of the security to be higher than it might be in the absence of such purchases. The imposition of a penalty bid might also have an effect on the price of a security to the extent that it were to discourage resales of the security before the distribution is completed. Neither the Company nor any of the Underwriters makes any representation or prediction, however, as to the direction or magnitude of any effect that the transactions described above may have on the price of the Common Stock. In addition, neither the Company nor any of the Underwriters makes any representation that the U.S. Representatives will engage in such transaction or that such transactions, once commenced, will not be discontinued without notice. The Common Stock is quoted on the Nasdaq National Market and the EASDAQ Market Authority under the symbol "GTSG". Certain of the Underwriters have been engaged from time to time, and may in the future be engaged, to perform financial advisory and other investment banking services to the Company and its affiliates. In connection with rendering such services in the past, such Underwriters have received customary compensation, including reimbursement of related expenses. LEGAL MATTERS The validity of the Offered Securities offered hereby will be passed upon for the Company by Shearman & Sterling, New York, New York. Certain legal matters will be passed upon for the Underwriters by Cahill Gordon & Reindel (a partnership including a professional corporation), New York, New York. 135 141 EXPERTS The consolidated financial statements of Global TeleSystems Group, Inc. as of December 31, 1996 and 1997, and for each of the three years in the period ended December 31, 1997 appearing in this Prospectus and Registration Statement, have been audited by Ernst & Young, LLP, independent auditors, as set forth in their report appearing elsewhere herein and are included in reliance upon such report given upon the authority of such firm as experts in accounting and auditing. The financial statements of EDN Sovintel as of December 31, 1997 and 1996, and for each of the three years in the period ended December 31, 1997, appearing in this Prospectus and Registration Statement, have been audited by Ernst & Young (CIS) Ltd., independent auditors, as set forth in their report appearing elsewhere herein and are included in reliance upon such report given upon the authority of such firm as experts in accounting and auditing. 136 142 INDEX TO FINANCIAL STATEMENTS GLOBAL TELESYSTEMS GROUP, INC.
PAGE ---- YEAR END FINANCIAL STATEMENTS Report of Ernst & Young LLP, Independent Auditors......... F-2 Consolidated Balance Sheets as of December 31, 1996 and 1997................................................... F-3 Consolidated Statements of Operations for the years ended December 31, 1995, 1996, and 1997............................................... F-4 Consolidated Statements of Cash Flows for the years ended December 31, 1995, 1996, and 1997............................................... F-5 Consolidated Statements of Shareholders' Equity for the years ended December 31, 1995, 1996, and 1997......................................... F-6 Notes to Consolidated Financial Statements................ F-7 FIRST QUARTER FINANCIAL STATEMENTS Consolidated Balance Sheets as of December 31, 1997 and March 31, 1998......................................... F-27 Consolidated Statements of Operations for the Three Months ended March 31, 1997 and 1998.......................... F-28 Consolidated Statements of Cash Flows for the Three Months Ended March 31, 1997 and 1998.......................... F-29 Notes to Consolidated Financial Statements................ F-30 EDN SOVINTEL YEAR END FINANCIAL STATEMENTS Report of Ernst & Young (CIS) Limited, Independent Auditors............................................... F-33 Balance Sheets as of December 31, 1997 and 1996........... F-34 Statements of Income and Retained Earnings for the years ended December 31, 1997, 1996, and 1995................ F-35 Statements of Cash Flows for the years ended December 31, 1997, 1996, and 1995................................... F-36 Notes to Financial Statements............................. F-37 FIRST QUARTER FINANCIAL STATEMENTS Balance Sheets as of December 31, 1997 and March 31, 1998................................................... F-45 Statements of Operations for the Three Months ended March 31, 1997 and 1998...................................... F-46 Statements of Cash Flows for the Three Months ended March 31, 1997 and 1998...................................... F-47 Notes to Financial Statements............................. F-48
F-1 143 REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS The Board of Directors Global TeleSystems Group, Inc. We have audited the accompanying consolidated balance sheets of Global TeleSystems Group, Inc. as of December 31, 1996 and 1997, and the related consolidated statements of operations, cash flows, and shareholders' equity for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Global TeleSystems Group, Inc. at December 31, 1996 and 1997, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1997, in conformity with generally accepted accounting principles. Ernst & Young LLP Vienna, Virginia February 26, 1998 F-2 144 GLOBAL TELESYSTEMS GROUP, INC. CONSOLIDATED BALANCE SHEETS ASSETS
DECEMBER 31, ---------------------- 1996 1997 --------- --------- (IN THOUSANDS, EXCEPT SHARE DATA) CURRENT ASSETS Cash and cash equivalents................................. $ 57,874 $ 318,766 Accounts receivable, net.................................. 8,920 17,079 Restricted cash........................................... 13,627 30,486 Prepaid expenses.......................................... 2,537 14,101 Other assets.............................................. 2,396 6,707 --------- --------- TOTAL CURRENT ASSETS.............................. 85,354 387,139 Property and equipment, net................................. 35,463 236,897 Investments in and advances to ventures..................... 104,459 76,730 Goodwill and intangible assets, net of accumulated amortization of $3,916 and $10,184 at December 31, 1996 and 1997, respectively.................................... 9,548 43,284 Restricted cash............................................. 2,554 36,411 --------- --------- TOTAL ASSETS...................................... $ 237,378 $ 780,461 ========= ========= LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable and accrued expenses..................... $ 15,211 $ 61,984 Debt maturing within one year............................. 16,261 6,390 Current portion of capital lease obligations.............. -- 21,490 Related party debt maturing within one year............... 4,947 5,708 Other current liabilities................................. 2,040 6,301 --------- --------- TOTAL CURRENT LIABILITIES......................... 38,459 101,873 Long-term debt, less current portion........................ 5,260 408,330 Long-term portion of capital lease obligations.............. -- 117,645 Related party long-term debt, less current portion.......... 59,079 79,796 Taxes and other non-current liabilities..................... 14,664 14,595 --------- --------- TOTAL LIABILITIES................................. 117,462 722,239 COMMITMENTS AND CONTINGENCIES Minority interest......................................... 1,915 18,766 Common stock, subject to repurchase (325,000 shares and 797,100 shares outstanding at December 31, 1996 and 1997, respectively)............................................. 4,333 12,489 SHAREHOLDERS' EQUITY Preferred stock, $0.0001 par value (10,000,000 shares authorized; none issued and outstanding)............... -- -- Common stock, $0.10 par value (135,000,000, shares authorized; 34,589,106, and 37,606,814 shares issued and outstanding, net of 116,639 and 195,528 shares of treasury stock at December 31, 1996 and 1997, respectively).......................................... 3,459 3,761 Additional paid-in capital................................ 238,268 274,359 Cumulative translation adjustment......................... (2,161) (8,269) Accumulated deficit....................................... (125,898) (242,884) --------- --------- TOTAL SHAREHOLDERS' EQUITY........................ 113,668 26,967 --------- --------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........ $ 237,378 $ 780,461 ========= =========
The accompanying notes are an integral part of these financial statements. F-3 145 GLOBAL TELESYSTEMS GROUP, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31, --------------------------------------- 1995 1996 1997 ---------- ---------- ----------- (IN THOUSANDS, EXCEPT PER SHARE DATA) REVENUES, NET: Telecommunication and other services.................... $ 5,979 $ 19,210 $ 41,300 Equipment sales......................................... 2,433 4,907 5,798 -------- -------- --------- 8,412 24,117 47,098 -------- -------- --------- OPERATING COSTS AND EXPENSES Cost of revenues: Telecommunication and other services................. 8,150 14,741 37,206 Equipment sales...................................... 246 4,200 5,513 Selling, general and administrative..................... 37,291 47,940 68,425 Depreciation and amortization........................... 3,491 4,165 6,227 Non-income taxes........................................ 234 850 2,085 -------- -------- --------- 49,412 71,896 119,456 Write-off of venture-related assets..................... -- -- 1,673 Equity in losses of ventures............................ 7,871 10,150 14,599 -------- -------- --------- Loss from operations...................................... (48,871) (57,929) (88,630) OTHER INCOME/(EXPENSE): Other non-operating income.............................. 10,270 -- -- Interest income......................................... 2,177 3,569 11,361 Interest expense........................................ (728) (11,122) (39,086) Foreign currency losses................................. (685) (1,176) (1,826) -------- -------- --------- 11,034 (8,729) (29,551) -------- -------- --------- Net loss before income taxes and minority interest........ (37,837) (66,658) (118,181) Income taxes.............................................. 2,565 1,360 2,482 -------- -------- --------- Net loss before minority interest......................... (40,402) (68,018) (120,663) Minority interest......................................... 2 27 3,677 -------- -------- --------- Net loss.................................................. $(40,400) $(67,991) $(116,986) ======== ======== ========= Net loss per share........................................ $ (1.70) $ (2.33) $ (3.26) ======== ======== ========= Weighted average common shares outstanding................ 23,707 29,157 35,833 ======== ======== =========
The accompanying notes are an integral part of these financial statements. F-4 146 GLOBAL TELESYSTEMS GROUP, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, --------------------------------- 1995 1996 1997 -------- -------- --------- (IN THOUSANDS) OPERATING ACTIVITIES Net loss................................................ $(40,400) $(67,991) $(116,986) ADJUSTMENTS TO RECONCILE NET LOSS TO NET CASH USED IN OPERATING ACTIVITIES: Depreciation and amortization........................... 3,721 7,444 14,843 Amortization of discount on note payable................ -- 3,598 5,023 Equity in losses of ventures, net of dividends received............................................. 7,871 11,123 17,474 Deferred interest....................................... -- 6,583 12,970 Write-off of venture related assets..................... -- -- 1,673 Non-cash compensation................................... -- -- 4,571 Minority interest....................................... (2) (27) (3,677) Other................................................... 2,577 1,342 2,985 Changes in assets and liabilities, excluding effects of acquisitions and ventures: Accounts receivable.................................. (1,557) (6,996) (10,900) Prepaid expenses..................................... (438) (605) (7,522) Accounts payable and accrued expenses................ 12,820 (1,694) 34,925 Other changes in assets and liabilities.............. 9,474 8,207 (3,984) -------- -------- --------- NET CASH USED IN OPERATING ACTIVITIES........... (5,934) (39,016) (48,605) INVESTING ACTIVITIES Investments in and advances to ventures, net of repayments............................. (45,102) (54,932) 5,943 Purchases of property and equipment..................... (24,324) (12,195) (45,148) Restricted cash......................................... (2,543) (13,138) (62,924) Acquisitions, net of cash acquired...................... (1,871) -- 1,050 Goodwill and other intangibles.......................... (6,181) (487) (2,196) Other investing activities.............................. 2,069 (125) (149) -------- -------- --------- NET CASH USED IN INVESTING ACTIVITIES........... (77,952) (80,877) (103,424) FINANCING ACTIVITIES Proceeds from debt...................................... 23,325 63,599 409,817 Payment of debt issue costs............................. (779) (2,777) (24,927) Net proceeds from issuance of common stock.............. 42,175 107,775 36,432 Other financing activities.............................. (750) -- (536) -------- -------- --------- NET CASH PROVIDED BY FINANCING ACTIVITIES....... 63,971 168,597 420,786 Effect of exchange rate changes on cash and cash equivalents............................................. (676) 126 (7,865) -------- -------- --------- Net (decrease) increase in cash and cash equivalents...... (20,591) 48,830 260,892 Cash and cash equivalents at beginning of year............ 29,635 9,044 57,874 -------- -------- --------- CASH AND CASH EQUIVALENTS AT END OF YEAR.................. $ 9,044 $ 57,874 $ 318,766 ======== ======== =========
The accompanying notes are an integral part of these financial statements. F-5 147 GLOBAL TELESYSTEMS GROUP, INC. CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY FOR THE YEARS ENDED DECEMBER 31, 1995, 1996, AND 1997
COMMON STOCK ADDITIONAL CUMULATIVE TOTAL --------------- PAID-IN TRANSLATION ACCUMULATED SHAREHOLDERS' SHARES AMOUNT CAPITAL ADJUSTMENT DEFICIT EQUITY ------ ------ ---------- ----------- ----------- ------------- (IN THOUSANDS) BALANCE AT DECEMBER 31, 1994.................... 20,781 $2,078 $ 70,359 $ (246) $ (17,507) $ 54,684 Proceeds from the sale of common stock, net of expenses of $3,680.......................... 5,091 509 41,629 -- -- 42,138 Translation adjustment........................ -- -- -- (1,289) -- (1,289) Net loss...................................... -- -- -- -- (40,400) (40,400) Other......................................... 333 33 156 -- -- 189 ------ ------ -------- ------- --------- --------- BALANCE AT DECEMBER 31, 1995.................... 26,205 2,620 112,144 (1,535) (57,907) 55,322 Proceeds from the sale of common stock, net of expenses of $3,567.......................... 8,349 835 106,909 -- -- 107,744 Issuance of 7,223 warrants in connection with debt financing.............................. -- -- 20,184 -- -- 20,184 Translation adjustment........................ -- -- -- (626) -- (626) Net loss...................................... -- -- -- -- (67,991) (67,991) Other......................................... 35 4 (969) -- -- (965) ------ ------ -------- ------- --------- --------- BALANCE AT DECEMBER 31, 1996.................... 34,589 3,459 238,268 (2,161) (125,898) 113,668 Proceeds from the sale of common stock, net of expenses of $2,777.......................... 2,503 250 36,182 -- -- 36,432 Translation adjustment........................ -- -- -- (6,108) -- (6,108) Net loss...................................... -- -- -- -- (116,986) (116,986) Other......................................... 515 52 (91) -- -- (39) ------ ------ -------- ------- --------- --------- BALANCE AT DECEMBER 31, 1997.................... 37,607 $3,761 $274,359 $(8,269) $(242,884) $ 26,967 ====== ====== ======== ======= ========= =========
The accompanying notes are an integral part of these financial statements. F-6 148 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1: NATURE OF BUSINESS OPERATIONS Global TeleSystems Group, Inc. ("GTS" or "the Company"), is a provider of a broad range of telecommunications services to businesses, other telecommunications service providers and consumers through its operation of voice and data networks, international gateways, local access and cellular networks and the provision of various value-added services in the Commonwealth of Independent States ("CIS"), primarily Russia, Central Europe, and India and China ("Asia"). The Company, through two of its ventures, is also building a new infrastructure for transporting international voice, data and video traffic for other carriers throughout Western Europe and for worldwide international voice, data and video traffic that either originates or terminates in, or transits through, Western Europe. See further discussion of the Company's business operations within Note 3, "Investments In and Advances to Ventures," and Note 14, "Segment Information and Certain Geographical Data." Certain of the Company's ventures are in the early stages of operations in the telecommunications industry. The Company's businesses are developing rapidly; some are in countries with an emerging economy, which by nature have an uncertain economic, political and regulatory environment. The general risks of operating businesses in the CIS and other developing countries include the possibility for rapid change in government policies, economic conditions, the tax regime and foreign currency regulations. The ultimate recoverability of the Company's investments in and advances to ventures is dependent on many factors including, but not limited to, the economies of the countries in which it does business; the ability of the Company to maintain the necessary telecommunications licenses; and the ability of the Company to obtain sufficient financing to continue to meet its capital and operational commitments. On December 1, 1997, the Company filed an amendment to its Certificate of Incorporation to effect an increase in the authorized common shares from 60,000,000 to 135,000,000; a 3 for 2 common share stock split, 1 1/2 common shares for every common share issued and outstanding; and an increase in the par value of its authorized common shares from $0.0001 to $0.10 on a post-split basis. Accordingly, the Company has presented share and per share data for issued and outstanding shares as well as options and warrants on a restated basis to give effect to the increase in authorized common shares, the stock split and the increase in par value for its capital stock. Subsequent to year end, the Company completed an initial public offering of 12.8 million shares of common stock at $20 per common share (the "Stock Offering"). The Company also issued aggregate principal amount $105.0 million of 9.875% senior notes due 2005 (the "Notes Offering" and together with the Stock Offering, the "Offerings"). See Note 15, "Subsequent Events." NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION Wholly-owned subsidiaries and majority-owned ventures where the Company has unilateral operating and financial control are consolidated. Those ventures where the Company exercises significant influence, but does not exercise unilateral operating and financial control are accounted for by the equity method. The Company has certain majority-owned ventures that are accounted for by the equity method as a result of minority shareholder rights, super majority voting conditions or other governmentally imposed uncertainties so severe that they prevent the Company from obtaining unilateral control of the venture. If the Company has little ability to exercise significant influence over a venture, the venture is accounted for by the cost method. All significant intercompany accounts and transactions are eliminated upon consolidation. The Company recognizes profits and losses in accordance with its underlying ownership percentage or allocation percentage as specified in the agreements with its partners; however, the Company recognizes 100% of the losses in ventures where the Company bears all of the financial risk. When such ventures become F-7 149 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) profitable, the Company recognizes 100% of the profits until such time as the excess losses previously recognized have been recovered. RECLASSIFICATIONS Certain reclassifications have been made to the 1995 and 1996 consolidated financial statements in order to conform to the 1997 presentation. CASH AND CASH EQUIVALENTS The Company considers all highly liquid investments with a maturity of three months or less at the time of purchase to be cash equivalents. The Company had $16.2 million and $66.9 million of restricted cash at December 31, 1996 and 1997, respectively. The restricted cash is primarily related to cash held in escrow for interest payments associated with the Company's debt obligations. PROPERTY AND EQUIPMENT Property and equipment is stated at cost. Depreciation, which includes the amortization of assets recorded under capital leases, is calculated on a straight-line basis over the lesser of the estimated lives, ranging from five to ten years for telecommunications equipment and three to five years for furniture, fixtures and equipment and other property, or their contractual term. Construction in process reflects amounts incurred for the configuration and build-out of telecommunications equipment and telecommunications equipment not yet placed into service. Maintenance and repairs are charged to expense as incurred. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 34, "Capitalization of Interest Costs," the Company intends to capitalize material interest costs associated with the construction of capital assets for business operations and amortize the costs over the assets' useful lives. The Company has not capitalized any interest costs through December 31, 1997. GOODWILL AND INTANGIBLE ASSETS Goodwill represents the excess of acquisition costs over the fair market value of the net assets of acquired businesses and is being amortized on a straight-line basis over their estimated useful lives ranging from three to ten years. Intangible assets, principally telecommunications service contracts, licenses and deferred financing costs, are amortized on a straight-line basis over the lesser of their estimated useful lives, generally three to fifteen years, or their contractual term. In accordance with Accounting Principles Board ("APB") Opinion No. 17, "Intangible Assets," the Company continues to evaluate the amortization period to determine whether events or circumstances warrant revised amortization periods. Additionally, the Company considers whether the carrying value of such assets should be reduced based on the future benefits of its intangible assets. LONG-LIVED ASSETS In accordance with SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," long-lived assets to be held and used by the Company are reviewed to determine whether any events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. For long-lived assets to be held and used, the Company bases its evaluation on such impairment indicators as the nature of the assets, the future economic benefit of the assets, any historical or future profitability measurements, as well as other external market conditions or factors that may be present. If such impairment indicators are present or other factors exist that indicate that the carrying amount of the asset may not be recoverable, the Company determines whether an impairment has occurred through the use of an undiscounted cash flows analysis of assets at the lowest level for which identifiable cash flows exist. If an F-8 150 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) impairment has occurred, the Company recognizes a loss for the difference between the carrying amount and the estimated value of the asset. The fair value of the asset is measured using quoted market prices or, in the absence of quoted market prices, fair value is based on an estimate of discounted cash flow analysis. During the year ended December 31, 1996, the Company's analyses indicated that there was not an impairment of its long-lived assets. During the year ended December 31, 1997, the Company's analyses indicated that there was an impairment of its long-lived assets. Accordingly, the Company recorded a write-down of long-lived assets associated with its investments in the Asia and Central Europe regions (see Note 3, "Investments in and Advances to Ventures"). INCOME TAXES The Company uses the liability method of accounting for income taxes. Deferred income taxes result from temporary differences between the tax basis of assets and liabilities and the basis as reported in the consolidated financial statements. The Company does not provide for deferred taxes on the undistributed earnings of its foreign companies, as such earnings are intended to be permanently reinvested in those operations. FOREIGN CURRENCY TRANSLATION The Company follows a translation policy in accordance with SFAS No. 52, "Foreign Currency Translation." In most instances, the local currency is considered the functional currency for the Company's subsidiaries and ventures, except for operations in the CIS, where the U.S. dollar has been designated as the functional currency. Assets and liabilities of these subsidiaries and ventures are translated at the rates of exchange at the balance sheet date. Income and expense accounts are translated at average monthly rates of exchange. The resultant translation adjustments are included in the cumulative translation adjustment, a separate component of shareholders' equity. Gains and losses from foreign currency transactions of these subsidiaries and ventures are included in the operations of the subsidiary or venture. For those ventures operating in the CIS, the temporal method for translating assets and liabilities is used. Accordingly, monetary assets and liabilities are translated at current exchange rates while non-monetary assets and liabilities are translated at their historical rates. Income and expense accounts are translated at average monthly rates of exchange. The resultant translation adjustments are included in the operations of the subsidiaries and ventures. REVENUE RECOGNITION The Company records as revenue the amount of telecommunications services rendered, as measured primarily by the minutes of traffic processed, after deducting an estimate of the traffic that will be neither billed nor collected. Revenue from service or consulting contracts is accounted for when the services are provided. Equipment sales revenue is generally recognized upon shipment of the equipment. Billings received in advance of service being performed are deferred and recognized as revenue as the service is performed. NET LOSS PER SHARE During 1997, the Company adopted SFAS No. 128, "Earnings Per Share," which requires the Company to present basic and fully diluted earnings per share for all years presented. The Company's net loss per share calculation (basic and fully diluted) is based upon the weighted average common shares issued. There are no reconciling items in the numerator or denominator of the Company's net loss per share calculation. Employee stock options, warrants, and convertible debt instruments have been excluded from the net loss per share calculation because their effect would be anti-dilutive (see Note 5, "Debt Obligations," Note 6, Shareholders' Equity and Note 7, "Stock Option Plans"). F-9 151 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) FAIR VALUE OF FINANCIAL INSTRUMENTS The Company believes that the carrying amount of its financial instruments reported in the balance sheets approximates their fair value. OFF BALANCE SHEET RISK AND CONCENTRATION OF CREDIT RISK Financial instruments that potentially subject the Company to concentration of credit risk consist primarily of cash and cash equivalents and accounts and notes receivable. The Company maintains most of its cash and cash equivalents in one high-quality U.S. financial institution. The Company extends credit to various customers and establishes an allowance for doubtful accounts for specific customers that it determines to have significant credit risk. The Company provides allowances for potential credit losses when necessary. The Company does not currently hedge against foreign currency fluctuations, although the Company may implement such practices in the future. Under current practices, the Company's results of operations could be adversely affected by fluctuations in foreign currency exchange rates. STOCK BASED COMPENSATION SFAS No. 123, "Accounting for Stock-Based Compensation," establishes a fair value method of accounting for employee stock options and similar equity instruments. The fair value method requires compensation cost to be measured at the grant date based on the value of the award and is recognized over the service period. SFAS No. 123 allows companies to either account for stock-based compensation under the new provisions of SFAS No. 123 or under the provisions of APB No. 25, "Accounting for Stock Issued to Employees." The Company has elected to account for its stock-based compensation in accordance with the provisions of APB No. 25 and presents pro forma disclosures of net loss as if the fair value method had been adopted. USES OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS The preparation of these consolidated financial statements, in conformity with generally accepted accounting principles, requires management to make estimates and assumptions that affect amounts in the financial statements and accompanying notes and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. NEW ACCOUNTING STANDARDS The Financial Accounting Standards Board has issued two new standards which become effective for reporting periods beginning after December 15, 1997. SFAS No. 130, "Reporting Comprehensive Income," requires additional disclosures with respect to certain changes in assets and liabilities that previously were not required to be reported as results of operations for the period. The Company will begin making the additional disclosures required by SFAS No. 130 in the first quarter of 1998. SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," requires financial and descriptive information with respect to "operating segments" of an entity based on the way management disaggregates the entity for making internal operating decisions. The Company will begin making the disclosures required by SFAS No. 131 with financial statements for the period ending December 31, 1998. NOTE 3: INVESTMENTS IN AND ADVANCES TO VENTURES The Company has various investments in ventures that are accounted for by the equity method. The Company's ownership percentages in its equity method investments range from 49% to 80%. The Company has no investments in ventures that are accounted for by the cost method. F-10 152 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The components of the Company's investments in and advances to ventures are as follows:
DECEMBER 31, ------------------- 1996 1997 -------- ------- (IN THOUSANDS) Equity in net assets acquired............................... $ 41,105 $31,183 Excess of investment cost over equity in net assets acquired net of amortization of $4,347 and $4,851 at December 31, 1996 and 1997, respectively............................... 11,288 7,582 Accumulated (losses) earnings recognized.................... (13,840) 14,659 Dividends................................................... (973) (3,848) Cash advances and other..................................... 66,879 27,154 -------- ------- Total investments in and advances to ventures..... $104,459 $76,730 ======== =======
In applying the equity method of accounting, the Company's policy is to amortize the excess of investment cost over equity in net assets acquired based upon an assignment of the excess to the fair value of the venture's identifiable tangible and intangible assets, with any unassigned amounts designated as goodwill. The Company then amortizes the allocated costs in accordance with its policies defined in Note 2, "Summary of Significant Accounting Policies." The Company has financed the operating and investing cash flow requirements of several of its ventures in the form of cash advances. The Company anticipates that these ventures will generate sufficient cash inflows for the repayment of the cash advances as their businesses mature. Also, due to the long-term nature of the anticipated repayment period and the potential risk associated with the repatriation of the cash advances, the Company has aggregated its investments in and cash advances to the ventures. The Company's share of the ventures' foreign currency translation adjustments is reflected in the investment accounts. INVESTMENT RECOVERABILITY The Company periodically evaluates the recoverability of its equity investments, in accordance with APB No. 18, "The Equity Method of Accounting for Investments in Common Stock," and if circumstances arise where a loss in value is considered to be other than temporary, the Company will record a write-down of excess investment cost. The Company's recoverability analysis is based on the projected undiscounted cash flows of the operating ventures, which is the lowest level of cash flow information available. As of December 31, 1997, the Company recorded a write-off of approximately $5.4 million, which represented the net balance of certain investments in and advances to ventures located in Asia (primarily Beijing Tianmu and V-Tech) and Central Europe (Eurohivo) which were stated in excess of their net realizable value. The entire net balance of these investments in and advances to ventures was written-off based on the fact that these ventures project overall negative cash flows for the foreseeable future. The ventures projected future operations deteriorated during 1997 as a result of problems dealing with one of its partners, the inability of the F-11 153 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) ventures to develop markets for its services, and technical problems. The components of the charge, which was classified as equity in losses of ventures, were as follows: Equity in net assets acquired............................... $ 17,093 Excess of investment cost over equity in net assets acquired.................................................. 593 Accumulated (losses) earnings recognized.................... (23,253) Dividends................................................... -- Cash advances and other..................................... 10,921 -------- Net write-off as of December 31, 1997....................... $ 5,354 ========
Prior to the write-off detailed above, the Company included approximately $14.4 million in its accumulated losses (of the $14.4 million, approximately $13.5 million related to the write-off of advances to several Chinese owned operating telecommunications companies to which the Company provides technical and financial assistance and $0.9 million related to the write-off of inventories, receivables, and other assets) which represented the Company's share of asset write-offs recorded by certain of the Company's equity method investments in Asia during the year ended December 31, 1997. Such write-offs, for the same reasons mentioned in the previous paragraph, were recorded by the Company's equity method investments pursuant to SFAS No. 121 and are included in the $(23.3) million accumulated (losses) detailed above. Additionally, during the year ended December 31, 1997 the Company recorded a charge of $1.7 million in order to write off certain holding company assets associated with the ventures located in Asia and Central Europe. This charge has been included as a separate line item in the Company's statement of operations. HERMES EUROPE RAILTEL B.V. ("HER") RECAPITALIZATION During the year ended December 31, 1997, HER recapitalized its equity structure and amended its existing shareholder agreement. In connection with the HER recapitalization the Company contributed approximately $51.8 million and converted existing note receivables of approximately $28.4 million in exchange for an additional 29% equity interest in HER. As a result of the recapitalization and amended shareholder agreement, the Company obtained unilateral control over HER. As such, HER has been consolidated into the Company's financial statements effective July 6, 1997, the effective date of the recapitalization. The Company recognized approximately $8.7 million of goodwill in connection with the recapitalization. As a result of the Company's loss recognition policy, the consolidation of HER would not have a material impact on the Company's historical financial position or operating results and thus no pro forma information is disclosed herein. As of December 31, 1997, the consolidation of HER resulted in reductions of $72.9 million, $10.0 million, and $4.6 million in the equity in net assets acquired, excess of investment cost over equity in net assets acquired, and cash advances and other, respectively. Additionally, as of December 31, 1997 the consolidation of HER had a $21.4 million favorable impact on the accumulated (losses) earnings recognized. F-12 154 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) CHANGES IN THE INVESTMENTS IN AND ADVANCES TO VENTURES The changes in the investments in and advances to ventures are as follows:
DECEMBER 31, -------------------- 1996 1997 -------- -------- (IN THOUSANDS) Balance, at beginning of period............................. $ 56,153 $104,459 Equity in net assets acquired............................... 22,441 80,054 Excess of investment cost over equity in net assets acquired.................................................. 5,288 10,187 Dividends................................................... (973) (2,875) Cash advances (repayments) and other........................ 31,700 (24,171) Effect of consolidating equity method company............... -- (76,325) -------- -------- 58,456 (13,130) Equity ownership in losses.................................. (3,122) (5,552) Excess losses recognized over amount attributable to ownership interest.................................................. (4,451) (10,610) Amortization of excess of investment cost over equity in net assets acquired........................................... (2,577) (3,313) Loss in value that is other than temporary.................. -- (5,354) Effect of consolidating equity method company............... -- 10,230 -------- -------- (10,150) (14,599) -------- -------- Balance, at end of period................................... $104,459 $ 76,730 ======== ========
As of December 31, 1997, the significant investments accounted for under the equity method and the percentage interest owned consist of the following:
EQUITY OWNED SUBSIDIARIES OWNERSHIP % ------------------------- ----------- EDN Sovintel................................................ 50% Sovam Teleport.............................................. 67% GTS Ukrainian TeleSystems, L.L.C. (holds a 49% interest in Bancomsvyaz).............................................. 60% GTS-Vox Limited (holds a 95% interest in TeleCommunications of Moscow)................................................ 52.64% TeleRoss Ventures -- 13 joint ventures in various regions in the CIS................................................... 50% Vostok Ventures -- 12 joint ventures in various regions in the CIS................................................... 50-70% PrimTelefone................................................ 50% GTS Monaco Access S.A.M..................................... 50%
In connection with a purchase of a venture during 1995, the Company is required to pay additional consideration through 1998, in shares of the Company's common stock, based on the actual earnings of the venture. The Company's maximum obligation pursuant to this agreement is to issue 1,121,640 shares of common stock. The Company will recognize any additional consideration paid under this agreement as goodwill. During the first quarter of 1998, the Company will issue additional shares based on the venture's 1997 earnings (see Note 15, "Subsequent Events"). During 1996 and 1997, the Company, in connection with a venture investment, entered into two financing agreements with a shareholder of the Company for a total of approximately $8.6 million. Subject to certain conditions, the shareholder has the right to require the repayment of this amount in cash or by exchange for 713,311 shares of the Company's common stock. Subsequent to the Stock Offering, repayment of this financing is due on demand and must be in exchange for the Company's common stock. This amount has been included in "Other financing agreements" (see Note 5, "Debt Obligations"). F-13 155 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Subsequent to year end, the Company purchased the remaining interest in Sovam Teleport, one of its equity method investments in the CIS. The following tables present condensed financial information of the Company's ventures that are accounted for by the equity method of accounting as of December 31, 1996 and 1997. YEAR ENDED DECEMBER 31, 1996
MAJORITY OWNED 50% OR LESS TOTAL EQUITY EQUITY METHOD ENTITIES VENTURES OWNED VENTURES METHOD VENTURES ---------------------- -------------- -------------- --------------- (IN THOUSANDS) Revenue.......................................... $36,202 $107,270 $143,472 Gross margin..................................... 17,109 45,937 63,046 Net income (loss)................................ 3,240 (8,460) (5,220) Equity in net losses............................. (1,091) (6,482) (7,573) Current assets................................... 27,293 50,689 77,982 Total assets..................................... 48,174 146,483 194,657 Current liabilities.............................. 19,416 68,474 87,890 Total liabilities................................ 24,987 102,332 127,319 Net assets....................................... 23,187 44,151 67,338 Ownership interest in equity in net assets....... 14,912 19,513 34,425
YEAR ENDED DECEMBER 31, 1997
MAJORITY OWNED 50% OR LESS TOTAL EQUITY EQUITY METHOD ENTITIES VENTURES OWNED VENTURES METHOD VENTURES ---------------------- -------------- -------------- --------------- (IN THOUSANDS) Revenue.......................................... $47,986 $178,174 $226,160 Gross margin..................................... 29,292 69,136 98,428 Net (loss) income................................ (10,370) 14,700 4,330 Equity in net (losses) earnings.................. (11,538) 5,131 (6,407) Current assets................................... 20,841 59,959 80,800 Total assets..................................... 35,090 176,117 211,207 Current liabilities.............................. 18,719 68,503 87,222 Total liabilities................................ 27,653 102,758 130,411 Net assets....................................... 7,438 73,359 80,797 Ownership interest in equity in net assets....... 9,541 45,638 55,179
F-14 156 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 4: SUPPLEMENTAL BALANCE SHEET INFORMATION
DECEMBER 31, ------------------- 1996 1997 ------- -------- (IN THOUSANDS) Accounts Receivable Consists Of: Trade accounts receivable................................. $ 6,769 $ 15,725 Value added taxes receivable.............................. 1,971 3,350 Other receivables......................................... 962 2,089 ------- -------- 9,702 21,164 Less: allowance for doubtful accounts................... 782 4,085 ------- -------- Total accounts receivable, net...................... $ 8,920 $ 17,079 ======= ======== Property And Equipment Consists Of: Telecommunications equipment.............................. $28,302 $231,996 Furniture, fixtures and equipment......................... 5,877 9,760 Other property............................................ 837 3,470 Construction in process................................... 7,009 7,799 ------- -------- 42,025 253,025 Less: accumulated depreciation.......................... 6,562 16,128 ------- -------- Total property and equipment, net................... $35,463 $236,897 ======= ======== Accounts Payable And Accrued Expenses Consists Of: Accounts payable.......................................... $ 6,761 $ 25,005 Interest payable.......................................... 213 17,483 Accrued compensation...................................... 3,151 6,165 Other accrued expenses.................................... 5,086 13,331 ------- -------- Total accounts payable and accrued expenses......... $15,211 $ 61,984 ======= ========
NOTE 5: DEBT OBLIGATIONS Company debt consists of:
DECEMBER 31, ------------------- 1996 1997 ------- -------- (IN THOUSANDS) Senior notes of HER, due August 15, 2007 at 11.5% interest payable semiannually...................................... $ -- $265,000 Senior subordinated convertible bonds, due June 30, 2000 at an effective interest rate of 15%, and a stated rate of 8.75%-9.75% payable semiannually.......................... -- 144,787 Related party debt obligations, with principal payments beginning April 1, 1998 and maturing on March 31, 2001 at 10% interest, net of unamortized discount for warrants to purchase 7,778 common shares.............................. 59,079 72,233 Other financing agreements.................................. 26,468 18,204 ------- -------- 85,547 500,224 Less: debt maturing within one year....................... 21,208 12,098 ------- -------- Total long-term debt.............................. $64,339 $488,126 ======= ========
In the third quarter of 1997, HER issued $265.0 million aggregate principal amount of senior notes due August 15, 2007 (the "Senior Notes"). The Senior Notes are general unsecured obligations of the subsidiary with interest payable semiannually at a rate of 11.5%. Approximately $56.6 million of the net proceeds of the offering of the Senior Notes is being held in escrow for the first four semiannual interest payments commencing in 1998. HER may redeem the Senior Notes, in whole or in part, any time on or after August 15, F-15 157 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) 2002 at specific redemption prices. HER may also redeem a portion of the Senior Notes at a price equal to 111.5% of the principal amount prior to August 15, 2000 with net cash proceeds of a public equity offering of HER with gross proceeds of at least $75 million or in certain other circumstances specified in the indenture for the Senior Notes, provided, however, that at least two-thirds of the principal amount of the Senior Notes originally issued remain outstanding after each such redemption. In July 1997, the Company issued $144.8 million aggregate principal amount of senior subordinated convertible bonds (the "Bonds") due June 30, 2000. The Bonds constitute direct, unsecured senior subordinated indebtedness after existing debt of $82.7 million. Upon completion of a complying public equity offering as defined in the Bond agreement (an "Offering") or in certain other circumstances as defined in the Bond agreement, the Bonds may be converted at the option of the holders from time to time, in whole or in part, prior to the close of business on June 30, 2000, into shares of the Company's common stock, par value $0.10 per share. The Bonds will be convertible into such number of shares of the Company's common stock as is equal to the principal amount of such Bonds divided by the applicable conversion price as defined in the Bond Agreement. The Bonds bear interest payable semiannually at a stated rate of 8.75% for the first year, 9.25% for the second year and 9.75% for the final year. In the event of an Offering, the interest rate will remain at the interest rate prevailing at the time of the Offering until maturity. In the event that an Offering has not occurred by the maturity date, the Bonds will be redeemed at 121% of their principal amount. As a result of the redemption feature, interest expense is being accrued and accreted at a 15% annual rate. (Subsequent to year end, the Company completed the Stock Offering at $20.00 per common share which will result in the Bonds being convertible into approximately 7.2 million shares of the Company's common stock. In addition, due to the completion of the Stock Offering, the interest rate will remain at 8.75% until maturity (see Note 15, "Subsequent Events").) In 1996, the Company entered into long-term obligations ("Debt Obligations"), totaling $70.0 million, with lenders (the "Lenders"). The Lenders are affiliated with and are considered related parties to the Company, as a result of their ownership of the Company's common stock (see Note 12, "Related Party Transactions"). The Debt Obligations require principal payments beginning in the third year, to maturity in the fifth year. The Debt Obligations bear an interest rate of 10.0% and require interest payments beginning in the first fiscal quarter subsequent to the date of issuance. At the Company's discretion, the initial interest accrued until the first principal payment can be deferred until maturity. Upon commencement of principal payments, the Company is obligated to make concurrent interest payments. Further, in connection with the Debt Obligations, the Company issued warrants to purchase 7,777,776 common shares, valued at $20.7 million. In accordance with the terms of the warrant agreement, the exercise price of the warrants was reduced from $10.27 per share to $9.33 per share, as the outstanding debt had not been repaid prior to December 31, 1996. The warrants may be exercised up to six years after the date of the relevant agreements. The Company is subject to certain restrictive covenants pursuant to these Debt Obligations, including restrictions on the payment of dividends and indebtedness to affiliated ventures. As of December 31, 1997, the Debt Obligations have been classified within "Related party long-term debt, less current portion" on the balance sheet. Subsequent to year end the Company repaid the Debt Obligations by using a portion of the proceeds from the Offerings (see Note 15, "Subsequent Events"). Certain of the Company's consolidated ventures maintain credit facilities for their local operations. Borrowings under such credit facilities bear interest at prevailing negotiated market rates. Aggregate maturities of long-term debt, as of December 31, 1997, are as follows: 1998 -- $12.1 million, 1999 -- $1.1 million, 2000 -- $149.4 million, 2001 -- $0.2 million and $349.5 million thereafter. The Company paid interest of $0.7 million, $0.2 million and $2.0 million in 1995, 1996 and 1997, respectively. The Company incurred interest expense of $39.1 million in 1997 and would have recorded $33.1 million in additional interest expense in 1997 had the Senior Notes and Bonds been outstanding on January 1, 1997. F-16 158 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 6: SHAREHOLDERS' EQUITY COMMON STOCK The following table summarizes the Company's equity private placements for the periods ending:
SHARES ISSUED SHARE PRICE NET PROCEEDS ------------- ----------- ------------ (IN THOUSANDS, EXCEPT SHARE DATA) December 31, 1995.................................. 5,090,876 $ 9.00 $42,138 December 31, 1996.................................. 8,348,532 13.33 107,744 December 31, 1997.................................. 2,502,686 15.67 36,432
During 1995, the Company issued 400,000 shares of common stock to an independent third party in connection with the purchase of an interest in a venture within the CIS region. At the discretion of the holder of these shares, the Company is obligated to repurchase these shares at the prevailing fair market value of the Company's common stock on the date of repurchase. During 1995, the Company repurchased 75,000 shares at $10.00 per share and the repurchased shares became treasury stock. In March 1997, the Company repurchased 32,500 shares at $13.33 per share, and these shares became treasury stock. The Company will be required to repurchase the remaining shares over the next three years. During 1997, the Company issued 504,600 shares of common stock pursuant to a purchase agreement with a seller for a portion of their interest in a venture within the CIS region. Pursuant to the purchase agreement, the Company is obligated to assist the seller in locating a purchaser for the common stock, and if unable to do so, to repurchase the issued common stock. The Company has accreted the value of the outstanding common stock subject to repurchase (325,000 shares at December 31, 1996 and 797,100 shares at December 31, 1997), to the fair value of the Company's common stock as of December 31, 1996 and 1997 ($13.33 and $15.67 per share, respectively). During 1996, the Company entered into the Debt Obligations totaling $70.0 million with the Lenders. In connection with the Debt Obligations, the Company issued warrants to purchase 7,777,776 common shares at $10.27 per share. The exercise price of the warrants was automatically reduced to $9.33 per share as of December 31, 1996, because the Debt Obligations remained outstanding. The warrants expire during the first and second quarters of 2002. The Company does not intend to pay dividends on common stock in the foreseeable future. In addition, certain of the Company's financing agreements include covenant restrictions precluding the payment of dividends by the Company. The Company has reserved 15,572,260 shares of common stock for issuance upon conversion of the exercise of outstanding and future stock options, warrants and similar rights. PREFERRED STOCK As of December 31, 1996 and 1997, there were 10,000,000 shares of $0.0001 par value preferred stock authorized, with rights and preferences to be determined by the Board of Directors. As of December 31, 1996 and 1997, no shares of preferred stock had been issued. NOTE 7: STOCK OPTION PLANS The Company applies the provisions of APB No. 25 in accounting for its stock option incentive plans. The effect of applying SFAS No. 123 on the net loss as reported is not representative of the effects on reported net loss for future years due to the vesting period of the stock options and the fair value of additional stock options in future years. Had compensation expense been determined in accordance with the methodology of SFAS No. 123, the Company's net loss for the years ended December 31, 1995, 1996 and 1997 would have been approximately $40.9 million, $69.4 million and $123.4 million, respectively. The fair value of options F-17 159 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) granted during 1995 and 1996 are estimated as $2.19 and $2.93 per common share, respectively, on the date of grant using the minimum value option pricing model with the following assumptions: dividend yield 0%, risk free interest rate of 5.50% for 1995 and 6.13% for 1996, and an expected life of five years. The fair value of options granted during 1997 are estimated as $7.35 per common share, on the date of grant using the Black Scholes option valuation model with the following assumptions: dividend yield 0%, risk free interest rate of 5.74%, an expected life of five years, and an expected volatility of .50. The Company determined its volatility factor with the assistance of an investment banker, based on peer group public companies. The Company maintains the 1992 Stock Option Plan, the Non-Employee Directors Stock Option Plan and the GTS Equity Compensation Plan (the "Option Plans"). As of December 31, 1997, the maximum number of shares of common stock available for grant under the Option Plans was 8,836,534. All options granted under the Option Plans are at exercise prices that were at least equal to the fair market value of common stock at the date of grant. Generally, all options granted under the Option Plans vest over a three-year period from the date of grant and expire ten years from the date of grant. Additional information with respect to stock option activity is summarized as follows:
YEAR ENDED DECEMBER 31, ------------------------------------------------------------------ 1995 1996 1997 -------------------- -------------------- -------------------- WEIGHTED WEIGHTED WEIGHTED AVERAGE AVERAGE AVERAGE EXERCISE EXERCISE EXERCISE SHARES PRICE SHARES PRICE SHARES PRICE --------- -------- --------- -------- --------- -------- Outstanding at beginning of year...................... 2,431,800 $3.65 3,422,399 $ 5.56 4,869,360 $ 7.31 Options granted............. 1,210,800 9.04 1,612,962 11.10 2,215,296 14.53 Options exercised........... (28,001) 4.46 (56,498) 6.70 (89,312) 6.34 Options canceled or expired................... (192,200) 3.57 (109,503) 8.73 (433,173) 7.38 --------- --------- --------- Outstanding at end of year...................... 3,422,399 5.56 4,869,360 7.31 6,562,171 9.75 ========= ========= ========= Options exercisable at year end....................... 995,617 $3.59 1,992,236 $ 4.65 2,962,110 $ 6.06
The following table summarizes information about stock options outstanding:
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ----------------------------------------- ---------------------- WEIGHTED AVERAGE WEIGHTED WEIGHTED REMAINING AVERAGE AVERAGE RANGE OF EXERCISE PRICE NUMBER CONTRACTUAL LIFE EXERCISE NUMBER EXERCISE AT DECEMBER 31, 1997: OUTSTANDING (IN YEARS) PRICE EXERCISABLE PRICE ----------------------- ----------- ---------------- -------- ----------- -------- $1.42 to $2.75....................... 1,446,000 6 $ 2.69 1,371,000 $ 2.68 $4.67 to $9.00....................... 1,270,650 7 7.88 986,679 7.66 $10.00 to $15.67..................... 3,845,521 8 13.03 604,431 11.13 --------- --------- 6,562,171 7 $ 9.75 2,962,110 $ 6.06 ========= =========
In addition, prior to the establishment of the Option Plans, certain options were granted in 1991 to certain key employees and former employees to purchase 1,172,250 shares of the Company's common stock at an exercise price of $0.53 per share. All options were granted at an exercise price equal to the fair value of the underlying common stock at the date of grant. The options vested in equal increments over a three-year period. During 1993, 603,000 of the options were canceled and in 1994, 50,250 options were exercised, leaving 519,000 fully vested options outstanding at December 31, 1995, 1996 and 1997. F-18 160 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) During 1996, the Company implemented the GTS 1996 Top Talent Retention Program (the "Program"), which granted options to certain employees under the 1992 Stock Option Plan. The Program was offered to 28 employees, who had an aggregate of 339,524 options, and provided for an altered vesting period based on certain revenue levels achieved and certain stock price levels maintained. If these performance-based achievements are not attained, the options vest in April 2001. As of December 31, 1997 no performance levels were met. In the fourth quarter of 1997, HER implemented a stock option plan for its key officers and employees (the "HER Plan"). The ownership dilution caused by the HER Plan is not expected to be significant. As a result of issuing options under the HER Plan, HER will incur a non-cash charge of approximately $3.7 million, of which $2.6 million was recorded during the fourth quarter and the remaining $1.1 million will be recognized in 1998. NOTE 8: EMPLOYEE BENEFIT PLAN The Company has a 401(k) retirement savings plan (the "Savings Plan") covering all U.S. citizen employees. The Savings Plan qualifies under section 401(k) of the Internal Revenue Code and as such, participants may defer pretax income in accordance with federal income tax limitations. The Company provides a 50% matching contribution on the first 5% contributed by the employee. The Company may also, at its discretion, make non-matching contributions. Both matching and non-matching contributions by the Company vest 100% after three years of service. The Company's expense under the Savings Plan was approximately $0.1 million, $0.2 million and $0.2 million for the years ended December 31, 1995, 1996 and 1997, respectively. The Company made no discretionary (non-matching) contributions for the years ended December 31, 1995, 1996 or 1997. HER established a pension plan in 1995 that covers all HER employees upon twenty-five years of age and at least one year of service. HER has entered into an insurance arrangement (an annuity contract) whereby an insurance provider has undertaken a legal obligation to provide specific benefits to participants in return for a fixed premium. As such, HER does not bear significant financial risk for its pension plan. HER's expense under the pension plan was $0.05 million, $0.4 million and $0.7 million for the years ended December 31, 1995, 1996 and 1997, respectively. NOTE 9: OTHER NON-OPERATING INCOME Favorably affecting the 1995 results was the non-recurring $10.3 million gain the Company recognized as a result of its cash settlement of certain claims with a third party in 1995. NOTE 10: INCOME TAXES The components of loss before income taxes and minority interest were as follows:
YEAR ENDED DECEMBER 31, --------------------------------- 1995 1996 1997 -------- -------- --------- (IN THOUSANDS) Pretax loss: Domestic........................................ $(22,398) $(41,554) $ (64,920) Foreign......................................... (15,437) (25,077) (53,261) -------- -------- --------- $(37,835) $(66,631) $(118,181) ======== ======== =========
For the years ended December 31, 1995, 1996 and 1997, the Company recorded $2.6 million, $1.4 million and $2.5 million, respectively, in income tax expense that related exclusively to its current provision for foreign taxes. F-19 161 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The reconciliation of the U.S. statutory federal tax rate of 34.0% to the Company's effective tax rate is as follows:
YEAR ENDED DECEMBER 31, ------------------------------------------------------------ 1995 1996 1997 ------------------ ------------------ ------------------ AMOUNT PERCENT AMOUNT PERCENT AMOUNT PERCENT -------- ------- -------- ------- -------- ------- (IN THOUSANDS) Taxes at U.S. statutory rates...................... $(12,865) 34.0% $(22,655) 34.0% $(40,181) 34.0% Foreign operating losses generating no tax benefit.................... 6,550 (17.3) 8,526 (12.8) 18,108 (15.3) Domestic operating losses generating no tax benefit.................... 6,315 (16.7) 14,129 (21.2) 22,073 (18.7) Other -- net................. 2,565 (6.8) 1,360 (2.1) 2,482 (2.1) -------- ----- -------- ----- -------- ----- $ 2,565 (6.8)% $ 1,360 (2.1)% $ 2,482 (2.1)% ======== ===== ======== ===== ======== =====
Deferred tax assets and liabilities are recorded based on temporary differences between earnings as reported in the financial statements and earnings for income tax purposes. The following table summarizes major components of the Company's deferred tax assets and liabilities:
DECEMBER 31, -------------------- 1996 1997 -------- -------- (IN THOUSANDS) Deferred Tax Assets: Net operating loss carryforwards.......................... $ 20,720 $ 38,029 Other deferred tax assets................................. 1,326 3,912 -------- -------- Total deferred tax asset.................................... 22,046 41,941 Deferred Tax Liability...................................... 1,161 2,292 -------- -------- Net deferred tax asset...................................... 20,885 39,649 Less: valuation allowance................................. (20,885) (39,649) -------- -------- Total............................................. $ -- $ -- ======== ========
As of December 31, 1997, the Company had net operating loss carryforwards for U.S. federal income tax purposes of approximately $110 million expiring in fiscal years 2003 through 2012. Because of the "change in ownership" provisions of the Tax Reform Act of 1986, the utilization of the Company's net operating loss carry-forwards will be subject to an annual limitation. The Company's investment in EDN Sovintel is treated for U.S. tax purposes as a partnership and, therefore, the Company's share of EDN Sovintel's income or loss flows through to the Company's consolidated federal income tax return on a current basis. Undistributed earnings of the Company's other foreign investments are considered to be indefinitely reinvested and, accordingly, no provision for U.S. federal and state income taxes, or foreign withholding taxes has been made. Upon distribution of those earnings, the Company would be subject to foreign withholding taxes and U.S. income taxes (subject to reduction for foreign tax credits). Certain of the Company's foreign ventures have foreign tax loss carryforwards in excess of $60 million. The Company's financial statements do not reflect any provision for benefits that might be associated with such loss carryforwards. F-20 162 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 11: COMMITMENTS AND CONTINGENCIES LEASES The Company has various lease agreements for office space, equipment and fiber. The obligations extend through 2018. Most of the leases contain renewal options of one to twelve years. Assets under capital leases are included in the consolidated balance sheets as follows:
DECEMBER 31, ----------------- 1996 1997 ----- -------- (IN THOUSANDS) Telecommunications equipment................................ $ -- $150,787 Less: accumulated amortization.............................. -- 482 ----- -------- $ -- $150,305 ===== ========
Rental expense aggregated $2.0 million, $2.2 million, and $3.1 million for the years ended December 31, 1995, 1996 and 1997, respectively. Future minimum payments, by year and in the aggregate, under the capital leases and other non-cancellable operating leases with initial or remaining terms in excess of one year as of December 31, 1997 were as follows:
CAPITAL LEASES OPERATING LEASES -------------- ---------------- (IN THOUSANDS) December 31, 1998....................................... $ 26,679 $ 3,311 1999...................................... 14,217 2,982 2000...................................... 15,300 1,604 2001...................................... 16,465 1,143 2002...................................... 16,630 933 Thereafter.............................................. 152,016 1,155 -------- ------- Total minimum lease payments............................ 241,307 $11,128 ======= Less amount representing interest....................... 102,172 -------- Present value of net minimum lease payments............. 139,135 Less current portion of capital lease obligations....... 21,490 -------- Long-term portion of capital lease obligations.......... $117,645 ========
OTHER COMMITMENTS AND CONTINGENCIES In September 1997, the Company purchased the remaining interest in one of its subsidiaries, which owns interests in cellular ventures within the CIS region, for $5.2 million, which was paid in October 1997. Furthermore, the Company is required to pay additional consideration of a minimum of $2.4 million when certain revenue levels are met, certain other events occur or, if neither has occurred, on April 1, 1999. The purchase price and consideration have been allocated to net assets based on the fair value at the date of acquisition. The excess of the purchase price over the fair value of the net assets acquired was $5.9 million, which has been recorded as goodwill and is being amortized on a straight-line basis over five years. The Company's consolidated and non-consolidated ventures have future purchase commitments amounting to $2.7 million and $1.1 million, respectively, as of December 31, 1997. F-21 163 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) In the ordinary course of business, the Company has issued financial guarantees on debt and equities for the benefit of certain of its non-consolidated ventures. The total amount guaranteed at December 31, 1997 was approximately $29.0 million. MAJOR CUSTOMERS In 1995, the Company had one major customer, a foreign governmental agency in Central Europe, representing $2.7 million, or 32.1%, of total revenue. In 1996, the Company had two major customers, a foreign governmental agency in Central Europe and a customer in the CIS, representing $3.8 million, or 15.8%, of total revenue and $2.6 million, or 10.8%, of total revenue, respectively. There were no major customers in 1997. TAX MATTERS The taxation system in Russia ("Russian Taxes") is evolving as the central government transforms itself from a command to a market oriented economy. The Russian Federation has introduced and continues to introduce new tax and royalty laws and related regulations. These laws and regulations are not always clearly written and their interpretation is subject to the opinions of the local tax inspectors, Central Bank officials and the Ministry of Finance. Instances of inconsistent opinions between local, regional and federal tax authorities and between the Central Bank and Ministry of Finance are not unusual. The Company's policy is to accrue for contingencies in the accounting period in which a liability is deemed probable and the amount is reasonably determinable. In this regard, because of the uncertainties associated with the Russian Taxes, the Company's Russian Taxes may be in excess of the estimated amount expensed to date and accrued at December 31, 1996 and 1997. It is the opinion of management that the ultimate resolution of the Company's Russian Tax liability, to the extent not previously provided for, will not have a material effect on the financial condition of the Company. However, depending on the amount and timing of an unfavorable resolution of this contingency, it is possible that the Company's future results of operations or cash flows could be materially affected in a particular period. In various foreign jurisdictions, the Company is obligated to pay value added taxes ("VAT") on the purchase or importation of assets, and for certain other transactions. In many instances, VAT can be offset against VAT the Company collects and otherwise would remit to the tax authorities, or may be refundable. Because the law in some jurisdictions is unclear, the local tax authorities could assert that the Company is obligated to pay additional amounts of VAT. In the opinion of management, any additional VAT the Company may be obligated to pay would not be material. OTHER MATTERS In the ordinary course of business, the Company may be party to various legal and tax proceedings, and subject to claims, certain of which relate to the developing markets and evolving fiscal and regulatory environments in which the Company operates. In the opinion of management, the Company's liability, if any, in all pending litigation, other legal proceeding or other matter other than what is discussed above, will not have a material effect upon the financial condition, results of operations or liquidity of the Company. NOTE 12: RELATED PARTY TRANSACTIONS As discussed within Note 5, "Debt Obligations," the Company entered into the Debt Obligations during 1996 with the Lenders. The Lenders are shareholders of the Company. As part of these transactions, the Company provided one of the Lenders with the opportunity, at its discretion, to co-invest with the Company in all of the Company's new ventures within the Asia region. The Company repaid the Debt Obligations subsequent to year end (see Note 15, "Subsequent Events"). F-22 164 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) During 1996 and 1997, the Company, in connection with a venture investment, entered into two financing agreements with a shareholder of the Company for a total of approximately $8.6 million. Subject to certain conditions, the shareholder has the right to require the repayment of this amount in cash or 713,311 shares of the Company's common stock. Subsequent to the Stock Offering, repayment of this financing must be in exchange for the Company's common stock. This amount has been included in "Other financing agreements" (see Note 5, "Debt Obligations"). During 1997, the Company issued 504,600 shares of common stock pursuant to a purchase agreement with a seller for a portion of their interest in a venture within the CIS region. As a result of the issuance of the common shares, the seller became a shareholder of the Company (see Note 3, "Investments in and Advances to Ventures," and Note 6, "Shareholders' Equity"). The Company has entered into certain consulting agreements with directors of the Company and paid $0.2 million, $0.2 million and $0.4 million in 1995, 1996, and 1997, respectively, pursuant to those agreements. The Company had notes receivable due from employees aggregating $0.1 million and less than $0.1 million as of December 31, 1996 and 1997, respectively, with no single amount due from any individual in excess of $0.1 million. The Company derived revenue from affiliates of $3.3 million and $4.4 million in 1996 and 1997, respectively. There was no significant revenue earned from affiliate sales in 1995. NOTE 13: SUPPLEMENTAL CASH FLOW INFORMATION The following table summarizes non-cash investing and financing activities for the Company:
YEAR ENDED DECEMBER 31, ------------------ 1996 1997 ------ -------- (IN THOUSANDS) Purchase of additional interest in Western Europe region subsidiary with conversion of debt to equity.............. $ -- $ 9,139 Line of credit issued as payment on note payable and reclassification of restricted cash....................... -- 7,887 Conversion of a note payable to stock as additional consideration in relation to purchase of interest in a CIS region subsidiary......................................... 4,497 4,250 Note payable issued for additional capital infusion in CIS region subsidiary......................................... 4,500 4,125 Capitalization of leases.................................... -- 139,136
No significant non-cash investing activities were incurred for the year ended December 31, 1995. NOTE 14: SEGMENT INFORMATION AND CERTAIN GEOGRAPHICAL DATA The Company operates predominantly in a single industry segment, the telecommunications industry. The industry consists of a wide range of telecommunications services to international business customers, including long distance voice and data services and electronic messaging services. The following tables present F-23 165 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) consolidated financial information by geographic area for 1995, 1996 and 1997. Transfers between geographic areas were not considered material for disclosure purposes.
CORPORATE WESTERN CENTRAL OFFICE & EUROPE CIS EUROPE ASIA ELIMINATIONS TOTAL -------- -------- -------- -------- ------------ --------- (IN THOUSANDS) Year Ended December 31, 1995 Total revenue................................... $ 179 $ 3,838 $ 4,361 $ 140 $ (106) $ 8,412 Gross margin.................................... (318) (949) 1,380 9 (106) 16 Operating loss.................................. (5,469) (16,681) (6,312) (4,831) (15,578) (48,871) Net loss........................................ (5,452) (19,415) (7,091) (4,771) (3,671) (40,400) Identifiable assets............................. 5,898 73,816 15,639 9,167 11,101 115,621 Liabilities..................................... 11,766 78,440 26,834 13,936 (75,950) 55,026 Net (liabilities)/assets........................ (5,868) (4,624) (11,195) (4,769) 87,051 60,595
CORPORATE WESTERN CENTRAL OFFICE & EUROPE CIS EUROPE ASIA ELIMINATIONS TOTAL -------- -------- -------- -------- ------------ --------- (IN THOUSANDS) Year Ended December 31, 1996 Total revenue................................... $ -- $ 12,696 $ 9,355 $ 1,561 $ 505 $ 24,117 Gross margin.................................... -- 811 3,292 652 421 5,176 Operating loss.................................. (10,679) (14,608) (4,651) (5,057) (22,934) (57,929) Net loss........................................ (10,700) (15,572) (5,295) (4,951) (31,473) (67,991) Identifiable assets............................. 19,607 96,773 17,339 14,973 88,686 237,378 Liabilities..................................... 35,728 116,961 33,826 24,753 (93,806) 117,462 Net (liabilities)/assets........................ (16,121) (20,188) (16,487) (9,780) 182,492 119,916
CORPORATE WESTERN CENTRAL OFFICE & EUROPE CIS EUROPE ASIA ELIMINATIONS TOTAL -------- -------- -------- -------- ------------ --------- (IN THOUSANDS) Year Ended December 31, 1997 Total revenue................................... $ 5,373 $ 27,045 $ 13,513 $ 1,016 $ 151 $ 47,098 Gross margin.................................... (4,599) 3,940 4,985 (99) 152 4,379 Operating loss.................................. (25,926) (7,088) (5,076) (28,066) (22,474) (88,630) Net loss........................................ (29,064) (9,505) (6,882) (28,043) (43,492) (116,986) Identifiable assets............................. 505,593 99,926 23,840 (6,544) 157,646 780,461 Liabilities..................................... 451,171 62,862 40,465 19,161 148,580 722,239 Net (liabilities)/assets........................ 54,422 37,064 (16,625) (25,705) 9,066 58,222
NOTE 15: SUBSEQUENT EVENTS THE OFFERINGS In February 1998, the Company completed the Stock Offering in which the Company raised $255.3 million in gross proceeds, including $33.3 million attributable to the sale of shares resulting from the exercise by the underwriters of an over-allotment option, from the sale of 12.8 million shares of common stock at an issue price of $20.00 per share. The Stock Offering resulted in the Company's common stock being listed in the United States on the National Association of Securities Dealers Automated Quotation Market and internationally on the European Association of Securities Dealers Automated Quotation Market. Also in February 1998, the Company completed the Notes Offering and issued $105.0 million aggregate principal amount of senior notes, due February 15, 2005. Interest at 9.875% on the Notes will be payable in cash semiannually on February 15 and August 15 of each year, commencing August 15, 1998. Net proceeds from the Offerings were approximately $336.7 million. Approximately $19.6 million of the net proceeds of the Notes Offering is being held in escrow for the first four semiannual interest payments commencing in 1998. F-24 166 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Approximately $85.2 million of the net proceeds of the Offerings has been used to repay the related party Debt Obligations (see Note 5, "Debt Obligations") of $70.0 million plus accrued interest that were due March 31, 2001. In addition, approximately $13.2 million in unamortized discount and debt issuance costs on the Debt Obligations was written off at the time of repayment. The remaining net proceeds from the Offerings will primarily be used to provide working capital for existing ventures, particularly in Russia and the CIS, to expand the Company's operations and for general corporate purposes, including strategic acquisitions. As a result of the completion of the Stock Offering, the interest rate for the Bonds will remain at 8.75% until maturity (see Note 5, "Debt Obligations") and the 6.25% additional interest that was previously accrued, $4.2 million, has been reflected as an increase to additional paid-in capital. The Bonds are convertible into approximately 7.2 million common shares at a conversion price of $20.00 per share. The following unaudited pro forma condensed balance sheet and results of operations of the Company give effect to the Offerings as though the transactions had occurred on December 31, 1997. The pro forma shares and per share data have been calculated assuming the Stock Offering occurred on January 1, 1997. The pro forma results are presented for informational purposes only and do not purport to be indicative of the results of operations which actually would have been obtained if the transactions had occurred in such periods, or which may exist or be obtained in the future.
AS ADJUSTED FOR THE CONDENSED BALANCE SHEET (UNAUDITED) REPORTED ADJUSTMENTS OFFERINGS ----------------------------------- --------- ----------- ----------- (IN THOUSANDS) Cash and cash equivalents................................... $ 318,766 $ 232,875 $ 551,641 Other assets................................................ 461,695 23,064 484,759 --------- --------- ---------- Total Assets........................................ $ 780,461 $ 255,939 $1,036,400 ========= ========= ========== Long-term debt, less current portion........................ $ 408,330 $ 105,000 $ 513,330 Related party debt.......................................... 85,504 (72,140) 13,364 Other liabilities........................................... 228,405 (4,171) 224,234 --------- --------- ---------- Total Liabilities................................... 722,239 28,689 750,928 Minority interest........................................... 18,766 -- 18,766 Common stock subject to repurchase.......................... 12,489 (12,489) -- Common stock and additional paid-in capital................. 278,120 252,952 531,072 Cumulative translation adjustment........................... (8,269) -- (8,269) Accumulated deficit......................................... (242,884) (13,213) (256,097) --------- --------- ---------- Total Shareholders' Equity.......................... 26,967 239,739 266,706 --------- --------- ---------- Total Liabilities and Shareholders' Equity.......... $ 780,461 $ 255,939 $1,036,400 ========= ========= ==========
AS ADJUSTED FOR THE LOSS CONDENSED STATEMENT OF OPERATIONS (UNAUDITED) REPORTED ADJUSTMENTS OFFERINGS PER SHARE --------------------------------------------- --------- ----------- ----------- --------- (IN THOUSANDS, EXCEPT SHARE DATA) Loss before extraordinary item.............................. $(116,986) $ -- $(116,986) $(2.41) Extraordinary item.......................................... -- (13,213) (13,213) (0.27) --------- -------- --------- ------ Net loss............................................ $(116,986) $(13,213) $(130,199) $(2.68) ========= ======== ========= ====== Weighted average common shares outstanding.................. 35,833 12,765 48,598
OTHER SUBSEQUENT EVENT TRANSACTIONS Pursuant to a purchase agreement that the Company has with a venture's partner in the CIS region (see Note 3, "Investments in and Advances to Ventures," Note 6, "Shareholders' Equity," and Note 12, "Related Party Transactions") the Company is obligated to pay additional consideration, via shares of common stock, F-25 167 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) based on the subsidiary's earnings performance. Based on the 1997 results, the Company is obligated to issue 336,630 shares of common stock during the first quarter of 1998. Subsequent to December 31, 1997, HER entered into contractual commitments to lease fiber pairs, including facilities and maintenance and utilizing the partial routes for laying fiber optic cable. Based on the contract provisions, these commitments are currently estimated to aggregate approximately $12.9 million. The commitments have expected lease terms of ten to twenty-one years with options for renewal rights of one and one-half to five additional years. The Company entered into a rights agreement (the "Rights Agreement") on February 2, 1998, and accordingly, the Company authorized the distribution of one right (a "Right") for each common share outstanding from February 2, 1998 through the distribution date (the "Distribution Date"). Each Right entitles the registered holder, subject to the terms of the Rights Agreement, to purchase from the Company one one-thousandth of a share (a "Unit") of Series A Preferred Stock at an exercise price of $75 per Unit, subject to adjustment. The Distribution Date, as defined in further detail within the Rights Agreement, is triggered when a person acquires 15% of the outstanding common stock of the Company, or a tender or exchange offer is commenced for 15% of such outstanding stock, except in the case of two related party shareholders in which case the acquisition threshold that applies is 20% of such outstanding stock. Under certain circumstances thereafter, certain Rightholders may have the right to purchase common stock of the Company, or of an Acquiring Person, as defined in the Rights Agreement, having a value equal to two times the exercise price of the Rights. In addition, the Rights are redeemable or exchangeable under certain circumstances. NOTE 16: EVENTS OCCURRING SUBSEQUENT TO DATE OF AUDIT REPORT In March 1998, the Company purchased an additional 10% interest in HER from an existing shareholder of HER for ECU 13.5 million (approximately $14.6 million). As a result of the purchase, the Company owns approximately 89% of HER. F-26 168 GLOBAL TELESYSTEMS GROUP, INC. CONDENSED, CONSOLIDATED BALANCE SHEETS (UNAUDITED)
DECEMBER 31, MARCH 31, 1997 1998 ------------ ---------- (IN THOUSANDS, EXCEPT SHARE DATA) ASSETS CURRENT ASSETS Cash and cash equivalents................................. $ 318,766 $ 507,895 Accounts receivable, net.................................. 17,079 23,078 Restricted cash........................................... 30,486 41,344 Prepaid expenses.......................................... 14,101 15,492 Other assets.............................................. 6,707 8,113 --------- ---------- TOTAL CURRENT ASSETS.............................. 387,139 595,922 Property and equipment, net................................. 236,897 270,641 Investments in and advances to ventures..................... 76,730 88,083 Goodwill and intangible assets, net......................... 43,284 58,055 Restricted cash............................................. 36,411 35,849 --------- ---------- TOTAL ASSETS...................................... $ 780,461 $1,048,550 ========= ========== LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable and accrued expenses..................... $ 61,984 $ 62,750 Debt maturing within one year............................. 6,390 8,882 Current portion of capital lease obligations.............. 21,490 19,250 Related party debt maturing within one year............... 5,708 10,023 Other current liabilities................................. 6,301 20,510 --------- ---------- TOTAL CURRENT LIABILITIES......................... 101,873 121,415 Long-term debt, less current portion........................ 408,330 506,336 Long-term portion of capital lease obligations.............. 117,645 136,988 Related party long-term debt, less current portion.......... 79,796 3,530 Taxes and other non-current liabilities..................... 14,595 12,970 --------- ---------- TOTAL LIABILITIES................................. 722,239 781,239 COMMITMENTS AND CONTINGENCIES Minority interest........................................... 18,766 12,470 Common stock, subject to repurchase (797,100 outstanding at December 31, 1997)........................................ 12,489 -- SHAREHOLDERS' EQUITY Preferred stock, $0.0001 par value (10,000,000 shares authorized; none issued and outstanding)............... -- -- Common stock, $0.10 par value (135,000,000 shares authorized; 37,606,814 and 52,040,140 shares issued and outstanding, net of 195,528 and 195,528 shares of treasury stock at December 31, 1997 and March 31, 1998, respectively).......................................... 3,761 5,204 Additional paid-in capital................................ 274,359 539,911 Accumulated other comprehensive loss...................... (8,269) (10,213) Accumulated deficit....................................... (242,884) (280,061) --------- ---------- TOTAL SHAREHOLDERS' EQUITY........................ 26,967 254,841 --------- ---------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........ $ 780,461 $1,048,550 ========= ==========
F-27 169 GLOBAL TELESYSTEMS GROUP, INC. CONDENSED, CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
THREE MONTHS THREE MONTHS ENDED MARCH 31, ENDED MARCH 31, 1997 1998 ----------------- ----------------- (IN THOUSANDS, EXCEPT PER SHARE DATA) REVENUES, NET: Telecommunication and other services...................... $ 7,957 $ 20,792 Equipment sales........................................... 430 2,025 -------- -------- 8,387 22,817 OPERATING COSTS AND EXPENSES: Cost of revenues: Telecommunication and other services................... 5,550 17,467 Equipment sales........................................ 874 1,556 Selling, general and administrative....................... 11,488 19,749 Depreciation and amortization............................. 1,246 2,195 Non-income taxes.......................................... 287 742 -------- -------- 19,445 41,709 Equity in losses (earnings) of ventures................... 3,420 (3,412) -------- -------- LOSS FROM OPERATIONS........................................ (14,478) (15,480) OTHER INCOME (EXPENSE): Interest income........................................... 1,296 7,066 Interest expense.......................................... (3,668) (16,466) Foreign currency losses................................... (494) (1,394) -------- -------- (2,866) (10,794) -------- -------- Net loss before income taxes, minority interest and extraordinary loss........................................ (17,344) (26,274) Income taxes................................................ 365 552 -------- -------- Net loss before minority interest and extraordinary loss.... (17,709) (26,826) Minority interest........................................... (24) 2,353 -------- -------- Net loss before extraordinary loss.......................... (17,733) (24,473) Extraordinary loss -- extinguishment of debt................ -- (12,704) -------- -------- NET LOSS.................................................... $(17,733) $(37,177) ======== ======== Loss per share before extraordinary loss.................... $ (0.51) $ (0.54) Extraordinary loss per share................................ -- (0.28) -------- -------- Net loss per share.......................................... $ (0.51) $ (0.82) ======== ======== Weighted average common shares outstanding.................. 34,758 45,549 ======== ========
F-28 170 GLOBAL TELESYSTEMS GROUP, INC. CONDENSED, CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
THREE MONTHS THREE MONTHS ENDED MARCH 31, ENDED MARCH 31, 1997 1998 --------------- --------------- (IN THOUSANDS) OPERATING ACTIVITIES Net loss.................................................... $(17,733) $(37,177) ADJUSTMENTS TO RECONCILE NET LOSS TO NET CASH USED IN OPERATING ACTIVITIES: Extraordinary loss........................................ -- 12,704 Depreciation and amortization............................. 2,124 7,150 Amortization of discount on note payable.................. 1,157 477 Equity in losses (earnings) of ventures, net of dividends received............................................... 3,420 (3,412) Deferred interest......................................... 1,806 1,636 Minority interest......................................... 24 (6,561) Other..................................................... 255 (237) Changes in assets and liabilities, excluding effects of acquisitions and ventures: Accounts receivable.................................... (2,259) (2,162) Prepaid expenses....................................... (803) (1,161) Accounts payable and accrued expenses.................. (1,848) (774) Other changes in assets and liabilities................ 500 2,130 -------- -------- NET CASH USED IN OPERATING ACTIVITIES............. (13,357) (27,387) INVESTING ACTIVITIES Investments in and advances to ventures, net of repayments............................................. (10,420) 2,370 Purchases of property and equipment....................... (1,589) (14,389) Restricted cash........................................... 238 (10,357) Goodwill and other intangibles............................ 208 (14,634) -------- -------- NET CASH USED IN INVESTING ACTIVITIES............. (11,563) (37,010) FINANCING ACTIVITIES Proceeds from debt........................................ -- 105,300 Repayments of debt........................................ (175) (91,355) Payment of debt issue costs............................... -- (3,957) Net proceeds from issuance of common stock................ -- 235,620 Other financing activities................................ (394) 7,199 -------- -------- NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES...................................... (569) 252,807 Effect of exchange rate changes on cash and cash equivalents............................................... (1,692) 719 -------- -------- Net (decrease) increase in cash and cash equivalents........ (27,181) 189,129 Cash and cash equivalents at beginning of period............ 57,874 318,766 -------- -------- CASH AND CASH EQUIVALENTS AT END OF PERIOD.................. $ 30,693 $507,895 ======== ========
F-29 171 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONDENSED, CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. FINANCIAL PRESENTATION AND DISCLOSURES The financial statements of Global TeleSystems Group, Inc. (the "Company") included herein are unaudited and have been prepared in accordance with generally accepted accounting principles for interim financial reporting and Securities and Exchange Commission regulations. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. Material intercompany affiliate account transactions have been eliminated; however, other adjustments may have been required had an audit been performed. In the opinion of management, the financial statements reflect all adjustments of a normal and recurring nature necessary to present fairly the Company's financial position, results of operations and cash flows for the interim periods. These financial statements should be read in conjunction with the Company's 1997 audited consolidated financial statements and the notes related thereto. The results of operations for the three months ended March 31, 1998 may not be indicative of the operating results for the full year. The Company's operations are carried out through alliances with strategic local partners in the form of venture arrangements. Wholly-owned subsidiaries and majority-owned ventures where the Company has unilateral operating and financial control are consolidated within the Company's financial results and operations. Those ventures where the Company exercises significant influence, but does not exercise unilateral operating and financial control, are accounted for by the equity method. The Company has certain majority-owned investments that are accounted for by the equity method as a result of minority shareholder rights, super-majority voting conditions or other governmentally imposed uncertainties so severe that they prevent the Company from obtaining unilateral control of the venture. If the Company has little ability to exercise significant influence over the ventures, those ventures are accounted for by the cost method. All significant intercompany accounts and transactions are eliminated upon consolidation. The Company recognizes profits and losses in accordance with its underlying ownership percentage or allocation percentage as specified in the agreements with its partners; however, the Company recognizes 100% of the losses in ventures where the Company bears all of the financial risk. When such ventures become profitable, the Company recognizes 100% of the profits until such time as the excess losses previously recorded have been recovered. 2. POLICIES AND PROCEDURES On January 1, 1998, the Company adopted Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and display of comprehensive income and its components in a full set of general purpose financial statements. Comprehensive income is defined as the change in equity of a business enterprise during a period from nonowner sources. Comprehensive loss was $19.4 million and $39.1 million for the three months ended March 31, 1997 and 1998, respectively, and was comprised of net loss of $17.7 million and $37.2 million and foreign currency translation adjustments of $1.7 million and $1.9 million for the three months ended March 31, 1997 and 1998, respectively. During 1997, the Company adopted SFAS No. 128, "Earnings Per Share," which requires the Company to present basic and diluted earnings per share for all periods presented. The Company's net loss per share calculation (basic and diluted) is based upon the weighted average common shares issued. There are no reconciling items in the numerator or denominator of the Company's net loss per share calculation. Employee stock options, warrants, and convertible debt instruments have been excluded from the net loss per share calculation because their effect would be anti-dilutive. F-30 172 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONDENSED, CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) Certain reclassifications have been made to the March 1997 condensed, consolidated financial statements in order to conform to the 1998 presentation. 3. SHAREHOLDERS' EQUITY In February 1998, the Company completed an initial public offering of 12.8 million shares of common stock at $20.00 per common share (the "Stock Offering"). The Stock Offering resulted in the Company's common stock being listed in the United States on the National Association of Securities Dealers Automated Quotation Market and internationally on the European Association of Securities Dealers Automated Quotation Market. Net proceeds from the Stock Offering were approximately $235.6 million. As a result of the Stock Offering, the Company no longer has a significant obligation to repurchase or assist the seller in locating a purchaser for the 797,100 shares of common stock subject to repurchase that were outstanding at December 31, 1997. Therefore, all amounts outstanding have been reclassified as additional paid-in capital as of March 31, 1998. 4. DEBT OBLIGATIONS In February 1998, the Company issued aggregate principal amount $105.0 million of 9.875% senior notes due in 2005 (the "Notes Offering" and together with the Stock Offering, the "Offerings"). Net proceeds from the Notes Offering were approximately $100.5 million. Approximately $19.6 million of the net proceeds was placed in escrow for the first four semiannual interest payments, commencing August 15, 1998. As a result of the completion of the Stock Offering, the interest rate on the $144.8 million aggregate principal amount of senior subordinated convertible bonds issued in July 1997 (the "Bonds") will remain at 8.75% until maturity and the approximately $5.1 million of the 6.25% additional interest that was previously accrued through the date of the Stock Offering has been reflected as an increase to additional paid-in capital. Upon completion of the Stock Offering, the Bonds became convertible into 7.2 million common shares at a conversion price of $20.00 per share. In March 1998, $6.4 million of the outstanding Bonds was converted into 0.3 million shares of the Company's common stock. In 1996, the Company entered into long-term obligations ("Debt Obligations" ) totaling $70.0 million with lenders that are affiliated with and are considered related parties to the Company as a result of their ownership of the Company's common stock. In February 1998, approximately $85.2 million of the net proceeds of the Offerings was used to repay the Debt Obligations of $70.0 million plus accrued interest that were due March 31, 2001. In addition, the unamortized discount costs and debt issuance costs on the Debt Obligations were written off at the time of repayment, resulting in the Company recording an extraordinary loss of $12.7 million. 5. OTHER TRANSACTIONS In March 1998, the Company purchased an additional 10.3% interest in Hermes Europe Railtel B.V. ("HER") from an existing shareholder of HER for ECU 13.5 million (approximately $14.6 million). As a result of the purchase, the Company owns approximately 89.4% of HER. The purchase price has been allocated to the net assets based on the fair value at the date of acquisition. The excess purchase price over the fair value of the net assets acquired was $10.2 million, which has been recorded as goodwill and is being amortized on a straight-line basis over five years. Pursuant to a purchase agreement that the Company has with a venture's partner, the Company was obligated to issue 336,630 shares of common stock to the partner, based on the venture's 1997 earnings performance. These shares were issued to the partner in April 1998 and the obligation of $13.5 million, based on the share price of the common stock on the date of issuance, has been reflected in "Other current liabilities" on the balance sheet as of March 31, 1998. F-31 173 GLOBAL TELESYSTEMS GROUP, INC. NOTES TO CONDENSED, CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) In February 1998, the Company acquired the remaining 33% interest in Sovam Teleport from its minority partner and as a result in 1998 Sovam is accounted for by the consolidation as opposed to the equity method of accounting. The Company paid a nominal amount for the additional interest. 6. SUPPLEMENTAL CASH FLOW INFORMATION The following table summarizes non-cash investing and financing activities for the Company:
THREE MONTHS ENDED MARCH 31, 1998 ------------------ (IN THOUSANDS) Capitalization of leases.................................... $26,864 Accrual for additional consideration in relation to purchase of a venture.............................................. 13,549 Reclassification of common stock subject to repurchase...... 12,489 Conversion of the Bonds into common stock................... 6,350 Reclassification of accrued interest on the Bonds........... 5,052
No significant non-cash activities were incurred for the three months ended March 31, 1997. 7. SUBSEQUENT EVENTS In April 1998, $16.3 million of the Bonds were converted into 0.8 million common shares of the Company's common stock. Subsequent to March 31, 1998, HER entered into contractual commitments to lease fiber pairs, including facilities and maintenance and utilize the partial routes for laying fiber optic cable. Based on the contract provisions, these commitments are currently estimated to aggregate approximately $22.5 million. The commitments have expected lease terms of ten to twenty-one years with options for renewal rights of one and one-half to five additional years. F-32 174 REPORT OF INDEPENDENT AUDITORS The Board of Directors and Shareholders EDN Sovintel We have audited the accompanying balance sheets of EDN Sovintel as of December 31, 1997 and 1996, and the related statements of income and retained earnings, and cash flows for each of the three years in the period ended December 31, 1997. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of EDN Sovintel at December 31, 1997 and 1996, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1997, in conformity with accounting principles generally accepted in the United States of America. We have also audited the financial statements of the Company at December 31, 1997 and 1996 and for each of the three years ended December 31, 1997, not presented herewith, prepared in compliance with the regulations for bookkeeping and accounting for income tax and statutory reporting purposes in the Russian Federation on which we expect to report separately for the 1997 audited financial statements and have reported separately for the 1996 and 1995 financial statements. The significant differences between the accounting principles applied in preparing the statutory financial statements and accounting principles generally accepted in the United States of America are summarized in Note 2. Ernst & Young (CIS) Ltd. Moscow, Russia February 16, 1998 F-33 175 EDN SOVINTEL BALANCE SHEETS ASSETS
DECEMBER 31, ------------------ 1997 1996 ------- ------- (IN THOUSANDS OF US DOLLARS) Current assets: Cash and cash equivalents................................. $ 5,620 $ 3,606 Cash deposit with related party........................... 485 476 Accounts receivable, net of allowances.................... 16,223 15,329 Due from affiliates....................................... 1,586 1,879 Inventories............................................... 1,697 1,749 Prepaid expenses and other assets......................... 1,630 1,171 VAT receivable, net....................................... 3,688 1,157 Deferred income taxes..................................... 186 ------- ------- Total current assets.............................. 31,115 25,367 Property and equipment, net................................. 38,709 27,709 Deferred expenses........................................... 945 1,080 ------- ------- Total assets...................................... $70,769 $54,156 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities: Note due shareholder...................................... $ 39 $ 5,700 Trade payables............................................ 5,725 8,382 Accrued liabilities and other payables.................... 3,194 1,661 Taxes accrued or payable.................................. 1,088 555 Amounts due to shareholder and affiliates................. 10,104 5,703 Amount due to partner in commercial venture............... 1,350 1,350 ------- ------- Total current liabilities......................... 21,500 23,351 Commitments and contingencies Shareholders' equity: Capital contributions..................................... 2,000 2,000 Retained earnings......................................... 47,269 28,805 ------- ------- Total shareholders' equity........................ 49,269 30,805 ------- ------- Total liabilities and shareholders' equity........ $70,769 $54,156 ======= =======
See accompanying notes. F-34 176 EDN SOVINTEL STATEMENTS OF INCOME AND RETAINED EARNINGS
YEARS ENDED DECEMBER 31 ------------------------------ 1997 1996 1995 -------- ------- ------- (IN THOUSANDS OF US DOLLARS) Revenues, net: Service revenues.......................................... $105,288 $63,488 $29,920 Installation revenues..................................... 5,241 9,312 12,981 Product sales............................................. 3,433 2,240 1,391 -------- ------- ------- 113,962 75,040 44,292 Cost of revenues: Service costs............................................. 67,174 37,884 18,545 Cost of installation...................................... 2,621 4,656 6,491 Cost of products.......................................... 2,834 1,370 1,211 -------- ------- ------- 72,629 43,910 26,247 -------- ------- ------- Gross profit................................................ 41,333 31,130 18,045 Selling, general and administrative expenses................ 17,020 10,291 7,145 Interest expense............................................ 503 638 703 Interest income............................................. (392) (87) (59) Other (income) loss......................................... (57) 120 (98) Foreign exchange loss on net monetary items................. 131 252 112 -------- ------- ------- Income before taxes......................................... 24,128 19,916 10,242 Income taxes................................................ 5,664 5,154 2,594 -------- ------- ------- Net income.................................................. 18,464 14,762 7,648 Retained earnings, beginning of year........................ 28,805 14,043 6,395 -------- ------- ------- Retained earnings, end of year.............................. $ 47,269 $28,805 $14,043 ======== ======= =======
See accompanying notes. F-35 177 EDN SOVINTEL STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31 ------------------------------- 1997 1996 1995 -------- -------- ------- (IN THOUSANDS OF US DOLLARS) OPERATING ACTIVITIES Net income................................................ $ 18,464 $ 14,762 $ 7,648 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation........................................... 5,312 3,638 2,448 Provision for deferred income taxes.................... (186) Provision for doubtful accounts........................ 345 678 132 Write-off of accounts receivable....................... (602) (147) (492) Write-down of network equipment and inventories........ 100 196 Foreign exchange loss.................................. 131 252 112 Changes in operating assets and liabilities: Accounts receivable.................................... (637) (8,460) (2,759) Due from affiliates.................................... 293 (683) (1,011) Inventories............................................ 52 (911) (309) Prepaid expenses and other assets...................... (538) (1,108) 599 VAT receivable, net.................................... (2,609) 54 (906) Trade payables......................................... (2,491) (193) 2,983 Accrued liabilities and other payables................. 1,533 310 1,233 Taxes accrued or payable............................... 570 326 229 Amounts due to shareholder and affiliates.............. 4,401 3,039 2,165 -------- -------- ------- Net cash provided by operating activities......... 24,038 11,657 12,268 INVESTING ACTIVITIES -- purchases of and advances for property and equipment.................................... (16,177) (9,863) (9,259) FINANCING ACTIVITIES Borrowings from shareholder............................... 10,760 11,300 11,888 Repayments to shareholder................................. (16,421) (11,100) (9,271) Repayments of long-term debt.............................. (694) (3,979) Cash deposited with related party......................... (41) (476) -------- -------- ------- Net cash used in financing activities....................... (5,702) (970) (1,362) Effect of exchange rate changes on cash and cash equivalents............................................... (145) (312) -------- -------- ------- Net increase in cash and cash equivalents................... 2,014 512 1,647 Cash and cash equivalents at beginning of year.............. 3,606 3,094 1,447 -------- -------- ------- Cash and cash equivalents at end of year.................... $ 5,620 $ 3,606 $ 3,094 ======== ======== =======
See accompanying notes. F-36 178 EDN SOVINTEL NOTES TO FINANCIAL STATEMENTS (US DOLLAR AMOUNTS IN TABLES EXPRESSED IN THOUSANDS) 1. DESCRIPTION OF BUSINESS EDN Sovintel (the "Company") was created in August 1990 to design, construct, and operate a telecommunications network in Moscow. This network provides worldwide communications services, principally to major hotels, business offices and mobile communication companies. Telecommunications services are subject to local licensing. The Company's license for international, intercity and local calls was most recently renewed on November 4, 1996 and is valid until May 1, 2000. The Company received a license for leased lines on September 20, 1996 valid for 5 years. The Company began operating in December 1991, providing services under long-term contracts payable in US dollars. The Company initially registered as a Soviet-American joint venture. The venture re-registered as a Russian limited liability partnership in November 1992. The Company is 50% owned by Open Joint Stock Company "Rostelecom", an intercity and long-distance carrier which is 38% owned by Svyazinvest, and 50% owned by Sovinet, a US general partnership, owned by two wholly-owned Global TeleSystems Group, Inc. ("GTS") subsidiaries. 2. BASIS OF PRESENTATION The Company maintains its records and prepares its financial statements in Russian roubles in accordance with the requirements of Russian accounting and tax legislation. The accompanying financial statements differ from the financial statements used for statutory purposes in Russia in that they reflect certain adjustments, not recorded on the Company's books, which are appropriate to present the financial position, results of operations and cash flows in accordance with generally accepted accounting principles in the United States of America ("US GAAP"). The principal adjustments are related to certain accrued revenue and expenses, foreign currency translation, deferred taxation, and depreciation and valuation of property and equipment. 3. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES USE OF ESTIMATES The preparation of financial statements, in conformity with US GAAP, requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. FOREIGN CURRENCY TRANSLATION The Company's functional currency is the US dollar because the majority of its revenues, costs, property and equipment purchased, and debt and trade liabilities are either priced, incurred, payable or otherwise measured in US dollars. Accordingly, transactions and balances not already measured in US dollars (primarily Russian roubles) have been remeasured into US dollars in accordance with the relevant provisions of US Financial Accounting Standard ("FAS") No. 52, "Foreign Currency Translation". Under FAS No. 52, revenues, costs, capital and non-monetary assets and liabilities are translated at historical exchange rates prevailing on the transaction dates. Monetary assets and liabilities are translated at exchange rates prevailing on the balance sheet date. Exchange gains and losses arising from remeasurement of monetary assets and liabilities that are not denominated in US dollars are credited or charged to operations. The rouble is not a convertible currency outside the territory of Russia. Official exchange rates are determined daily by the Central Bank of Russia ("CBR") and are generally considered to be a reasonable approximation of market rates. The translation of rouble denominated assets and liabilities into US dollars for the purpose of these financial statements does not indicate that the Company could realize or settle in F-37 179 EDN SOVINTEL NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) US dollars the reported values of the assets and liabilities. Likewise, it does not indicate that the Company could return or distribute the reported US dollar values of capital and retained earnings to its shareholders. The exchange rates at December 31, 1997, 1996 and 1995 for one US dollar were RUR 5,960, RUR 5,560 and RUR 4,640 respectively. At February 16, 1998, the CBR rate had changed to RUR 6,050. The effect of this devaluation of the rouble on monetary assets and liabilities has not been determined. On January 1, 1998, the CBR introduced a new rouble to replace existing roubles. The new rouble has been redenominated so that one new rouble is equivalent to one thousand old roubles. The old rouble will continue in circulation until December 31, 1998 and will be accepted as legal tender until December 31, 2002. All rouble amounts reflected in these financial statements are stated in old roubles. CASH AND CASH EQUIVALENTS Cash and cash equivalents consist of cash on hand and in the bank. ACCOUNTS RECEIVABLE Accounts receivable are shown at their net realizable value which approximates fair value. Accounts receivable are shown in the balance sheet net of an allowance for uncollectible accounts of $643,000 and $900,000 at December 31, 1997 and 1996, respectively. INVENTORIES Inventories consist of telecommunications equipment held for resale and are stated at the lower of cost or market. Cost is computed on a weighted average basis. PROPERTY AND EQUIPMENT Property and equipment are recorded at their historical cost. Depreciation is provided on the straight-line method over the following estimated useful lives: Network equipment........................................... 10 years Other property and equipment................................ 3-5 years
There is no depreciation charge for construction-in-progress. Depreciation commences upon completion of the related project. DEFERRED EXPENSES Deferred expenses represent the Company's interest in the historical cost of network equipment owned by MTU Inform, a partner in a commercial venture (Note 8). These expenses are amortized over the equipment's useful life of 10 years. REVENUE RECOGNITION AND TAXES ON REVENUE Revenues from telecommunication traffic are recognized in the period in which the traffic occurs. Revenues from product sales, connection fees, and other services are recognized in the period in which the products are shipped, connections made, and services rendered. Taxes on certain revenues were charged at rates ranging from 1.5% to 4.0% over the three years ended December 31, 1997, 1996 and 1995 and amounted to $4,458,000, $2,792,000 and $1,166,000, respectively, and are charged to selling general and administrative expenses. F-38 180 EDN SOVINTEL NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) ADVERTISING The Company expenses the cost of advertising as incurred. Advertising expenses for the years ended December 31, 1997, 1996 and 1995 were $671,000, $512,000 and $395,000, respectively, and are included in selling, general and administrative expenses. INVESTMENT INCENTIVE DEDUCTIONS Russian legislation allows for certain additional tax deductions related to new asset investments. These deductions are accounted for as a reduction to current income taxes in the year in which they arise. INCOME TAXES The Company computes and records income taxes in accordance with FAS No. 109, "Accounting for Income Taxes". GOVERNMENT PENSION FUNDS The Company contributes to the Russian Federation state pension fund, social fund, medical insurance fund, unemployment fund and transport fund on behalf of all its Russian employees. Contributions were 40.5%, 40.5% and 41.0% from base payroll for 1997, 1996 and 1995, respectively. FAIR VALUE OF FINANCIAL INSTRUMENTS The fair value of financial instruments included in current assets and liabilities is considered to be the carrying value. NEW ACCOUNTING PRONOUNCEMENTS In 1997, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of." SFAS 121 requires recognition of impairment of long-lived assets in the event the net book value of such assets exceeds the future undiscounted cash flows attributable to such assets. The adoption of SFAS No. 121 had no impact on the Company's financial position or results of operations. In June 1997, SFAS No. 130, "Reporting Comprehensive Income", was issued. SFAS No. 130 establishes standards for the reporting and display of comprehensive income and its components in a full set of general-purpose financial statements and is effective for fiscal years beginning after December 15, 1997. The Company will adopt SFAS No. 130 in fiscal 1998. SFAS No. 130 expands or modifies disclosures and, accordingly, will have no impact on the Company's reported financial position, results of operations or cash flows. RECLASSIFICATIONS Certain 1996 and 1995 comparative figures have been reclassified to conform to the presentation adopted in the current year. F-39 181 EDN SOVINTEL NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) 4. PROPERTY AND EQUIPMENT Property and equipment consists of the following at December 31:
1997 1996 -------- ------- Network equipment........................................... $ 43,876 $31,251 Other property and equipment................................ 4,527 3,108 -------- ------- 48,403 34,359 Accumulated depreciation.................................... (14,557) (9,380) Construction-in-progress.................................... 4,409 1,796 Network equipment and advances for network equipment not yet in service................................................ 454 934 -------- ------- Net book value.............................................. $ 38,709 $27,709 ======== =======
Total depreciation expense on property and equipment for 1997, 1996 and 1995 was $5,177,000, $3,503,000 and $2,253,000, respectively. 5. INCOME TAXES The Russian Federation was the only tax jurisdiction in which the Company's income was taxed. The income tax expense reported in the accompanying statements of income and retained earnings for the years ended December 31, 1997, 1996 and 1995 represents the provision for current and deferred taxes. Significant components of the provision for income taxes for the years ended December 31 are as follows:
1997 1996 1995 ------ ------ ------ Current tax expense...................................... $5,850 $5,154 $2,594 Deferred tax benefit..................................... (186) ------ ------ ------ Provision for income taxes............................... $5,664 $5,154 $2,594 ====== ====== ======
F-40 182 EDN SOVINTEL NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) The following is a reconciliation of the tax basis and book basis of the taxable income reported in the Russian statutory financial statements to the income before taxes reported in the accompanying financial statements presented in accordance with US GAAP for the years ended December 31:
1997 1996 1995 ------- ------- ------- Taxable income reported for Russian tax purposes...... $16,184 $14,726 $ 7,411 Investment incentive deductions..................... 12,337 9,030 7,220 Tax loss carry-forwards utilized.................... 97 113 Net permanent difference related to revenues and (2,455) expenses incurred in the ordinary course of business which are not assessable or deductible for Russian tax purposes......................... (1,174) (2,595) ------- ------- ------- Russian income before taxes........................... 26,163 22,695 12,036 Adjustments to present financial statements in accordance with US GAAP: Reversal of excess depreciation due to statutory (2,101) revaluations..................................... (1,497) (293) Depreciation rate differences....................... (279) (424) (236) Allowances for uncollectible accounts............... 35 369 (132) Inventory write-downs............................... (100) (249) Accrual of deductible expenses...................... (3,234) (2,437) (1,339) Accrual of revenue.................................. 2,704 1,093 19 Foreign exchange differences........................ 236 280 1,425 Other............................................... 604 (63) (989) ------- ------- ------- Income before taxes under US GAAP..................... $24,128 $19,916 $10,242 ======= ======= =======
A reconciliation between the statutory rate and the effective income tax rate is as follows for the years ended December 31:
1997 1996 1995 ------- ------- ------- Income tax expense computed on financial income before taxes at statutory tax rate of 35%.................. $ 8,445 $ 6,970 $ 3,585 Tax effect of permanent differences: Investment incentive deductions..................... (4,318) (3,161) (2,594) Tax loss carryforwards utilized..................... (34) (40) Other permanent differences......................... 859 411 805 Adjustments made to compute income before taxes for US GAAP financial reporting...................... 1,142 813 555 Increase (decrease) in the valuation allowance for deferred tax assets................................. (430) 161 243 ------- ------- ------- Income tax expense reported in the financial statements.......................................... $ 5,664 $ 5,154 $ 2,594 ======= ======= =======
F-41 183 EDN SOVINTEL NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) The deferred tax balances are calculated by applying the statutory tax rates in effect at the respective balance sheet dates to the temporary differences between the tax basis of assets and liabilities and the amount reported in the accompanying financial statements, and consist of the following at December 31:
1997 1996 1995 ------ ------- ----- Deferred tax assets (liabilities): Depreciation........................................... $ 398 $ 300 $ 151 Inventory write-downs and allowances................... 235 235 147 Accrual of expenses.................................... 1,132 898 469 Accrual of revenue..................................... (946) (383) (7) Allowance for uncollectible accounts................... (13) 129 ------ ------- ----- Deferred tax assets...................................... 806 1,050 889 Valuation allowance for deferred tax assets.............. (620) (1,050) (889) ------ ------- ----- Net deferred tax assets........................ $ 186 $ -- $ -- ====== ======= =====
For financial reporting purposes, a valuation allowance has been recognised to reflect management's estimate of the deferred tax assets that are less likely than not to be realized. The Company paid Russian profits tax of $4,302,000, $5,849,000 and $2,660,000 in 1997, 1996 and 1995, respectively. 6. NOTE DUE TO SHAREHOLDER AND LONG-TERM DEBT In October 1995, the Company entered into a $5,000,000 credit facility with Sovinet, one of the Company's shareholders. It was subsequently increased to $7,000,000. In January 1997, this facility was repaid and on January 16, 1997, a new six-month facility was established with GTS Finance, Inc. for $7,000,000 which was then extended to December 19, 1997. The loan was repaid prior to December 31, 1997 except for withholding taxes on interest. The loan carried interest at a rate equal to the then current six month LIBOR rate (5.6%) plus 5.0 percent per annum. As of December 31, 1997, 1996 and 1995, the outstanding borrowings under this agreement were $39,000, $5,700,000 and $5,500,000, respectively. The Company believes that the carrying value of the above loans approximates fair values. The Company paid interest of $697,000, $542,000 and $576,000 in 1997, 1996 and 1995, respectively. 7. SHAREHOLDERS' EQUITY The Company's capital structure as specified in the charter capital document is as follows as of December 31:
1997 1996 ---------- ---------- Registered capital in Russian roubles: Rostelecom................................................ 600,000 600,000 Sovinet................................................... 600,000 600,000 ---------- ---------- 1,200,000 1,200,000 ========== ========== Historical value of the Company's capital in US dollars..... $ 2,000 $ 2,000 ========== ==========
As a Russian limited liability company, the Company has no capital stock; rather, it has only contributed and locally registered capital in accordance with its charter. As such, no earnings per share data are presented in these financial statements. F-42 184 EDN SOVINTEL NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) Retained earnings available for distribution at December 31, 1997 amounted to 256 billion roubles or approximately $42,953,000 at applicable year-end exchange rates. 8. RELATED PARTY TRANSACTIONS Transactions and balances with Rostelecom (one of the Company's shareholders) and its affiliates were as follows, as of and for the years ended December 31:
1997 1996 1995 ------- ------ ------ Sales................................................... $ 2,310 $1,525 $ 62 Telecommunication lease and traffic costs............... 11,183 4,586 1,506 Amounts due to shareholder and affiliates............... 4,184 656 460 Cash deposit with related party......................... 485 476
At the request of Rostelecom, a shareholder, the Company placed a deposit of 2.65 billion roubles in August 1996 with a Russian bank related to this shareholder. The bank deposit agreement states a deposit term of one year, which was rolled over for an additional year during 1997. The deposit earns interest quarterly at a rate of 15% per annum plus any devaluation losses against the US dollar up to a maximum of 4.8% per quarter. Management is aware that the deposited amount collateralizes certain obligations of the shareholder. Transactions and balances with Sovinet (one of the Company's shareholders), GTS and affiliates were as follows, as of and for the years ended December 31:
1997 1996 1995 ------ ------ ------ Sales.................................................... $4,974 $3,115 $1,041 Management service fees and reimbursements of expenses of expatriate staff....................................... 1,318 927 2,062 Balances due under credit facility....................... 39 5,700 5,500 Interest expense......................................... 503 626 461 Amounts due from affiliates.............................. 1,586 1,879 1,196 Amounts due to shareholder and affiliates................ 5,919 5,047 2,204
Transactions and balances with MTU Inform, an entity with which the Company entered into a commercial agreement to co-develop and operate a "258" phone exchange were as follows, as of and for the years ended December 31:
1997 1996 1995 ------- ------- ------- Telecommunication settlement and rent expense....... $19,003 $15,889 $10,491 Balances in trade payables.......................... 1,237 2,184 Balances in accounts receivable..................... 487 Amount due to partner in commercial venture......... 1,350 1,350 1,350 Balances in prepaid expenses and other assets....... 800
The Company also has an interest in the cost of the related network equipment owned by MTU Inform, which is reflected in the balance sheet, net of related amortization, as deferred expenses. In 1997 the Company prepaid $800 of 1998 rent to MTU-Inform for additional office space to be occupied during 1998. 9. CONCENTRATIONS OF CREDIT RISK AND MAJOR CUSTOMERS Financial instruments that potentially subject the Company to concentration of credit risk consist primarily of temporary cash deposits and trade accounts receivables. The Company deposits its available cash with several Russian financial institutions. The Company's sales and accounts receivable are made to and due F-43 185 EDN SOVINTEL NOTES TO FINANCIAL STATEMENTS -- (CONTINUED) from a variety of international and Russian business customers. As of December 31, 1997, two customers accounted for 16% and 11% of revenues and 11% and 7% of accounts receivable, respectively. As of December 31, 1996, these same two customers accounted for 17% and 16% of revenues and 25% and 10% of accounts receivable, respectively. As of December 31, 1995, these two customers accounted for 1% and 14% of revenues and 10% and 11% of accounts receivable, respectively. The Company has no other significant concentrations of credit risk. 10. COMMITMENTS The Company has several cancelable operating leases for office and warehouse space and telecommunications lines with terms ranging from one to five years. Total rent expense for 1997, 1996 and 1995 was $2,794,000, $2,137,000 and $1,234,000, respectively. 11. CONTINGENCIES Legislation and regulations regarding taxation, foreign currency transactions and licensing of foreign currency loans in the Russian Federation continues to evolve as the central government manages the transformation from a command to a market-oriented economy. The various legislation and regulations are not always clearly written and their interpretation is subject to the opinions of the tax inspectors, Central Bank officials and the Ministry of Finance. Instances of inconsistent opinions between local, regional and national tax authorities and between the Central Bank and Ministry of Finance are not unusual. The Company believes that it has paid or accrued all taxes that are applicable. Where practice concerning the provision of taxes is unclear, the Company has accrued tax liabilities based on management's best estimate. The Company's policy is to accrue contingencies in the accounting period in which a loss is deemed probable and the amount is reasonably determinable. Because of the uncertainties associated with the Russian tax and legal systems, the ultimate amount of taxes, penalties and interest, if any, assessed may be in excess of the amount expensed to date and accrued at December 31, 1997. It is the opinion of the Company's management that any material amounts are either not probable, not reasonably determinable, or both. The Company's operations and financial position will continue to be affected by Russian political developments, including the application of existing and future legislation and tax regulations. The Company does not believe that these contingencies, as related to its operations, are any more significant than those of similar enterprises in Russia. F-44 186 EDN SOVINTEL CONDENSED BALANCE SHEETS (UNAUDITED)
DECEMBER 31, MARCH 31, 1997 1998 ------------ ------------ (IN THOUSANDS) ASSETS Current assets Cash and cash equivalents................................. $ 5,620 $ 6,956 Accounts receivable, less allowance for doubtful accounts of $643 and $800 at December 31, 1997 and March 31, 1998................................................... 16,223 19,766 Restricted cash........................................... 485 474 Due from affiliated companies............................. 1,586 2,267 Inventory................................................. 1,697 1,697 Deferred tax asset........................................ 186 186 Prepaid expenses and other assets......................... 5,318 7,303 ------- ------- Total current assets.............................. 31,115 38,649 Property and equipment, net of accumulated depreciation of $14,557 and $16,026 at December 31, 1997 and March 31, 1998...................................................... 38,709 40,741 Deferred expenses........................................... 945 912 ======= ======= TOTAL ASSETS...................................... $70,769 $80,302 ======= ======= LIABILITIES AND SHAREHOLDERS' EQUITY Current liabilities Accounts payable.......................................... $ 5,725 $ 6,543 Accrued expenses.......................................... 3,194 2,969 Due to affiliated companies............................... 10,104 12,478 Note payable to shareholder............................... 39 -- Taxes and other liabilities............................... 2,438 4,698 ------- ------- TOTAL LIABILITIES................................. 21,500 26,688 Commitments and contingencies SHAREHOLDERS' EQUITY Contributed capital......................................... 2,000 2,000 Retained earnings........................................... 47,269 51,614 ------- ------- TOTAL SHAREHOLDERS' EQUITY........................ 49,269 53,614 ------- ------- TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........ $70,769 $80,302 ======= =======
The accompanying notes are an integral part of these financial statements. F-45 187 EDN SOVINTEL CONDENSED STATEMENTS OF OPERATIONS (UNAUDITED)
THREE MONTHS ENDED MARCH 31, ------------------ 1997 1998 ------- ------- (IN THOUSANDS) REVENUES, NET:.............................................. $25,162 $32,404 COST OF REVENUES:........................................... 14,763 21,957 ------- ------- Gross margin................................................ 10,399 10,447 OPERATING EXPENSES: Selling, general and administrative....................... 2,696 3,027 Depreciation and amortization............................. 160 177 Non-income taxes.......................................... 999 1,442 ------- ------- Total operating expenses.......................... 3,855 4,646 Income from operations...................................... 6,544 5,801 OTHER (EXPENSE) INCOME: Interest income........................................... 55 37 Interest expense.......................................... (159) -- Foreign currency losses................................... (38) (220) ------- ------- (142) (183) Net income before taxes..................................... 6,402 5,618 Income taxes................................................ 1,708 1,273 ------- ------- Net income.................................................. $ 4,694 $ 4,345 ======= =======
The accompanying notes are an integral part of these financial statements. F-46 188 EDN SOVINTEL CONDENSED STATEMENTS OF CASH FLOWS
THREE MONTHS ENDED MARCH 31, ------------------------- 1997 1998 ------------ --------- (IN THOUSANDS) OPERATING ACTIVITIES Net income.................................................. $ 4,694 $ 4,345 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization............................. 1,113 1,501 Provision for doubtful accounts........................... 152 157 Changes in assets and liabilities: Accounts receivable.................................... (4,616) (3,700) Inventory.............................................. 293 -- Prepaid expenses and other assets...................... (600) (1,985) Accounts payable and accrued expenses.................. 1,686 2,853 ------- ------- Net cash provided by operating activities................... 2,722 3,171 INVESTING ACTIVITIES Purchases of property and equipment....................... (3,541) (3,500) Restricted cash........................................... (31) 11 ------- ------- Net cash used in investing activities....................... (3,572) (3,489) FINANCING ACTIVITIES Borrowing on (repayment of) shareholder note, net......... 204 (39) Due to affiliated companies, net.......................... (961) 1,693 ------- ------- Net cash (used in) provided by financing activities......... (757) 1,654 ------- ------- Net (decrease) increase in cash and cash equivalents........ (1,607) 1,336 Cash and cash equivalents at beginning of period............ 3,606 5,620 ------- ------- Cash and cash equivalents at end of period.................. $ 1,999 $ 6,956 ======= =======
The accompanying notes are an integral part of these financial statements. F-47 189 EDN SOVINTEL NOTES TO CONDENSED FINANCIAL STATEMENTS (UNAUDITED) 1. FINANCIAL PRESENTATION AND DISCLOSURES In the opinion of management, the accompanying unaudited condensed financial statements of EDN Sovintel (the "Company") contain all adjustments (consisting only of normal recurring accruals) necessary to present fairly the Company's financial position as of December 31, 1997 and March 31, 1998, and the results of operations and cash flows for the periods indicated. The Company was established as a competitive local exchange carrier (CLEC) in August 1990. Through the design, construction, and operation of a telecommunications network in Moscow, the Company provides its customers, principally major hotels, business offices and mobile communications companies, with an alternative to the local telephone company for worldwide communications services. Telecommunications services are subject to local licensing. The Company's license for international, intercity and local calls was most recently renewed on November 4, 1996 and is valid until May 1, 2000. The Company received a license for leased lines on September 20, 1996 valid for 5 years. The Company began operating in December 1991, providing services under long-term contracts payable in US dollars. The Company initially registered as a Soviet-American joint venture. The venture re-registered as a Russian limited liability partnership in November 1992. The Company is 50% owned by Open Joint Stock Company "Rostelecom," an intercity and long-distance carrier which is 38% owned by Svyazinvest, and 50% owned by Sovinet, a US general partnership, owned by two wholly-owned Global TeleSystems Group, Inc. ("GTS") subsidiaries. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted. Material accruals have been recorded; however, other adjustments may have been required had an audit been performed. It is suggested that these financial statements be read in conjunction with the Company's 1997 audited financial statements and the notes related thereto. The results of operations for the three months ended March 31, 1998 may not be indicative of the operating results for the full year. The Company maintains its records and prepares its financial statements in Russian roubles in accordance with the requirements of Russian accounting and tax legislation. The accompanying financial statements differ from the financial statements used for statutory purposes in Russia in that they reflect certain adjustments, not recorded on the Company's statutory books, which are appropriate to present the financial position, results of operations and cash flows in accordance with generally accepted accounting principles in the United States of America ("US GAAP"). The principal adjustments are related to certain accrued revenue and expenses, foreign currency translation, deferred taxation, and depreciation and valuation of property and equipment. The preparation of financial statements, in conformity with US GAAP, requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. 2. POLICIES AND PROCEDURES On January 1, 1998, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and display of comprehensive income and its components in a full set of general purpose financial statements. Comprehensive income is defined as the change in equity of a business enterprise during a period from nonowner sources. For the three months ended March 31, 1997 and 1998, comprehensive income for the Company is equal to net income. F-48 190 EDN SOVINTEL NOTES TO CONDENSED FINANCIAL STATEMENTS -- (CONTINUED) (UNAUDITED) 3. CONTINGENCIES Legislation and regulations regarding taxation, foreign currency transactions and licensing of foreign currency loans in the Russian Federation continues to evolve as the central government manages the transformation from a command to a market-oriented economy. The various legislation and regulations are not always clearly written and their interpretation is subject to the opinions of the tax inspectors, Central Bank officials and the Ministry of Finance. Instances of inconsistent opinions between local, regional and national tax authorities and between the Central Bank and Ministry of Finance are not unusual. The Company believes that it has paid or accrued all taxes that are applicable. Where practice concerning the provision of taxes is unclear, the Company has accrued tax liabilities based on management's best estimate. The Company's policy is to accrue contingencies in the accounting period in which a loss is deemed probable and the amount is reasonably determinable. Because of the uncertainties associated with the Russian tax and legal systems, the ultimate amount of taxes, penalties and interest, if any, assessed may be in excess of the amount expensed to date and accrued at December 31, 1997 and March 31, 1998. The Company's operations and financial position will continue to be affected by Russian political developments, including the application of existing and future legislation and tax regulations. The Company does not believe that these contingencies, as related to its operations, are any more significant than those of similar enterprises in Russia. F-49 191 EXHIBIT A GLOSSARY OF TELECOMMUNICATIONS INDUSTRY TERMS Accounting Rate Mechanism (ARM) -- The current system of bilateral settlement agreements between PTOs under which tariffs for cross-border pan-European-switched voice traffic are determined. Add-drop multiplexer (ADM) -- A multiplexer which controls cross connect between individual circuits by software, permitting dynamic cross connect of individual 64 kbps circuits within an E-1 line. AMPS -- Advanced Mobile Phone System; the cellular mobile telephone system based on analog technology that is now used in U.S. systems. Each AMPS cell can handle 832 simultaneous conversations. Asynchronous Transfer Mode (ATM) -- A switching and transmission technology that is one of general class of packet technologies that relay traffic by way of an address contained within the first five bits of a switching and transmission of mixed voice, data, and video at varying rates. The ATM format can be used by many different information systems, including LANs. Bps -- Bits per second; the basic measuring unit of speed in a digital transmission system; the number of bits that a transmission facility can convey between a sending location and a receiving location in one second. Backbone -- The through-portions of a transmission network, as opposed to spurs which branch off the through-portions. Bandwidth -- The information-carrying capability of a transmission medium is measured by its bandwidth, which is the relative range of frequencies that can be passed without distortion by such medium. Bandwidth is measured in Hertz, but may also be expressed as the number of bits that can be transmitted per second. Capacity -- Refers to transmission. Carrier -- A provider of communications transmission services by fiber, wire, or radio. CCIT -- International Telegraph and Telephone Consultative Committee. Closed User Group -- A group of customers with some affiliation with one another and which are treated for regulatory purposes as not being the public. Competitive Local Telecommunications Provider -- A company that provides its customers with an alternative to the local telephone company for local transport of private line, special access and transport of switched access telecommunications services. Competitive Local Telecommunications Providers are also referred to in the industry as alternative local telecommunications service providers (ALTS), Competitive Access Providers (CAPs) and Competitive Local Exchange Carriers (CLECs). Dark Fiber -- Fiber that lacks the requisite electronic and optronic equipment necessary to use the fiber for transmission. Dedicated -- Refers to telecommunications lines dedicated to or reserved for use by particular customers along predetermined routes (in contrast to telecommunications lines within the local telephone company's public switched network). Digital -- Describes a method of storing, processing and transmitting information through the use of distinct electronic or optical pulses that represent the binary digits 0 and 1. Digital transmission/switching technologies employ a sequence of discrete, distinct pulses to represent information, as opposed to the continuously variable analog signal. E1 -- Data transmission rate of approximately 2 Mbps. E3 -- Data transmission rate of approximately 34 Mbps. Electrosviaz -- regional telephone company. A-1 192 Enhanced Network Services -- Telecommunications services providing digital connectivity, primarily for data applications, via frame relay, ATM, or digital interexchange private line facilities. Enhanced network services also include applications on such networks, including Internet access and other Internet services. ERMES -- A standard for a pan-European radio message system sponsored by the EC. Eutelsat -- European Telecommunications Satellite Organization; an international satellite organization in which members of the European Union hold an 88% combined investment. Frame Relay -- A wide area transport technology that organizes data into units called frames instead of providing fixed bandwidth as with private lines. A high-speed, data-packet switching service used to transmit data between computers. Frame Relay supports data units of variable lengths at access speeds ranging from 56 kilobits per second to 1.5 megabits per second. This service is well-suited for connecting local area networks, but is not presently well-suited for voice and video applications due to the variable delays which can occur. Frame Relay was designed to operate at high speeds on modern fiber optic networks. Gbps -- Gigabits per second, which is a measurement of speed for digital signal transmission expressed in billions of bits per second. Gateway -- A network element interconnecting two otherwise incompatible networks, network nodes, subnetworks or devices; performs a protocol conversion operation across a wide spectrum of communications functions. GSM -- Global System for Mobile Communications, formerly known as Groupe Speciale Mobile. GSM began as a pan-European standard for digital cellular systems. The name was changed to reflect the fact that the standard has been adopted by several countries in Asia. Hertz -- The unit for measuring the frequency with which an electromagnetic signal cycles through the zero-value state between lowest and highest states. One Hz (Hertz) equals one cycle per second. kHz (kilohertz) stands for thousands of Hertz; MHz (megahertz) stands for millions of Hertz. Inmarsat -- The International Maritime Satellite service, which provides mobile communications to ships at sea, aircraft in flight and vehicles on the road. Intelsat -- International Telecommunications Satellite Organization; a worldwide consortium of national satellite communications organizations. Interconnect -- Connection of a telecommunications device of service to the PSTN. Interconnection -- Connection of a piece of telephone equipment to the telephone network, or a data terminal to a data communications network. Also refers to the connection of one communications network to another so that users of one network can communicate with users of another network. International Simple Resale -- Refers to the wholesale purchase of IPLCs from facilities-based carriers and the reselling of such capacity to customers for switched telephone service. IPLC -- International Private Leased Circuits. ISDN (Integrated Services Digital Network) -- ISDN is an internationally agreed standard which, through special equipment, allows two-way, simultaneous voice and data transmission in digital formats over the same transmission line. ISDN permits video conferencing over a single line, for example, and also supports a multitude of value-added switched service applications. ISDN's combined voice and data networking capabilities reduce costs for end users and result in more efficient use of available facilities. ISDN combines standards for highly flexible customer to network signaling with both voice and data within a common facility. ITU -- International Telecommunications Union; a United Nations treaty organization whose purpose is to accredit international telecommunications standards. ITU signatories can turn ITU-approved standards into law through international treaties such as the treaties governing use of the radio spectrum for international satellite telecommunications and broadcasting. A-2 193 Kbps -- Kilobits per second, which is a measurement of speed for digital signal transmission expressed in thousands of bits per second. Local Area Network (LAN) -- The interconnection of computers for the purpose of sharing files, programs and peripheral devices such as printers and high-speed modems. LANs may include dedicated computers or file servers that provide a centralized source of shared files and programs. LANs are generally confined to a single customer's premises and may be extended or interconnected to other locations through the use of bridges and routers. Local Loop -- The local loop is that portion of the local telephone network that connects the customer's premises to the local exchange provider's central office or switching center. This includes all the facilities starting from the customer premise interface which connects to the inside wiring and equipment at the customer premise to a terminating point within the switching wire center. Mbps -- Megabits per second, which is a measurement of speed for digital signal transmission expressed in millions of bits per second. MGTS -- Moscow city telephone network. Multiplexing -- The use of some means to inter-leave narrow-band or slow-speed data from multiple sources in order to make use of a wide-band or high-speed channel. NMT -- Acronym for Nordic Mobile Telephone System, a cellular standard widely used in Northern Europe. Nodes -- Locations within the network housing electronic equipment and/or switches which serve as intermediate connection points to send and receive transmission signals. PBX/PABX (private branch exchange/private automatic branch exchange) -- A customer operated switch on customer premises, typically used by large businesses with multiple telephone lines. Plesiochronous Digital Hierarchy (PDH) -- A method of controlling the timing between transmission and switching systems that is not synchronized but rather relies on highly accurate clocks to minimize the slip rates between switching nodes. POCSAG (Postal Office Code Standard Advisory Group) -- A lower-cost paging technology which can be transmitted on ERMES frequency. Points of Presence (POPs) -- Locations where a carrier has installed transmission equipment in a service area that serves as, or relays calls to, a network switching center of that carrier. PSTN -- Public switched telecommunications network. PTT/PTO -- Postal, Telegraph and Telephone agency/Public Telephony Operators; a government authority or agency that operates the public telecommunications network, and sets standards and policies. PTTs/PTOs are agencies in charge of telecommunications services in many countries, under direct supervision of the national government. Redundant Electronics -- Describes a telecommunications facility using two separate electronic devices to transmit the telecommunications signal so that if one device malfunctions, the signal may continue without interruption. Regeneration/amplifier -- Devices which automatically re-transmit or boost signals on an out-bound circuit. Route Kilometers -- The number of kilometers along which fiber optic cables are installed. Route Mile -- The number of miles along which fiber optic cables are installed. SDH -- Synchronous Digital Hierarchy; the international standard for ultra-high-speed broadband fiber-optic, digital transmission networks that use equipment from many different manufacturers and carry a variety A-3 194 of services. The basic communications channel of SDH is a 155.52 Mbps transmission channel that is multiplexed upward. STM-1 -- Data transmission rate of approximately 155 Mbps. STM-4 -- Data transmission rate of approximately 622 Mbps. STM-16 -- Data transmission of approximately 2,488 Mbps. STM-64 -- Data transmission rate of approximately 9,952 Mbps. Switch -- A mechanical or electronic device that opens or closes circuits or selects the paths or circuits to be used for the transmission of information. Switching is a process of linking different circuits to create a temporary transmission path between users. Synchronous Digital Hierarchy (SDH) -- SDH is a set of standards for optical communications transmission systems that define optical rates and formats, signal characteristics, performance, management and maintenance information to be embedded within the signals and the multiplexing techniques to be employed in optical communications transmission systems. SDH facilitates the interoperability of dissimilar vendors' equipment and benefits customers by minimizing the equipment necessary for telecommunications applications. SDH also improves the reliability of the local loop connecting customers' premises to the local exchange provider, historically one of the weakest links in the service delivery. TCP/IP -- Transmission Control Protocol/Internet Protocol; an "open" standard operating and interface protocol for federal government local area networks that use devices from multiple vendors. TCP/IP, first developed by the U.S. Defense Department, has been adopted by some academic and business institutions who deal regularly with the federal government. Trunk -- A telephone circuit with a switch at both ends. A trunk may connect two central office switches, or two PBXs, or a PBX and a central office switch. VSAT -- Very Small Aperture Terminal; a satellite communications technology that employs frequencies in the Ku band or C band and very small receiving dishes. VSAT systems employ satellite transponders; the receiving dishes may be leased or owned by the VSAT user. Wavelength Division Multiplexing (WDM) -- A multiplexing technique allowing multiple different signals to be carried simultaneously on a fiber by allocating resources according to frequency on non-overlapping frequency bands. X.25 -- A CCITT standard governing the interface between data terminals and data circuit termination equipment for terminals on packet-switched data networks. A-4 195 EXHIBIT B SUPPLEMENTAL EASDAQ INFORMATION APPROVAL BY THE BELGIAN COMMISSION FOR BANKING AND FINANCE This Prospectus will be submitted for approval by the Belgian Banking and Finance Commission ("Commissie voor bet Banken Financiewezen/Commission Bancaire et Financiere") ("BFC") in accordance with Article 29ter. sec. 1. par.1 of Royal Decree No. 185 of July 9, 1935 and Article 11 of the Royal Decree of 31 October, 1991 on the publication of prospectuses in connection with public issues of securities. The approval of this Prospectus by the BFC does not imply any judgement as to the appropriateness of the quality of this Offering or the Offer Shares nor of the situation of the Company. On December 22, 1997, an application was made for the admission of the Common Stock to trading on EASDAQ under the symbol "GTSG." Admission to EASDAQ is subject to certain adequacy and liquidity requirements determined by the EASDAQ Market Authority. Companies applying for admission to trading on EASDAQ are required to publish relevant financial and other information regularly and to keep the public informed of all events likely to affect the market price of their securities. Price sensitive information is made available to investors in Europe through the EASDAQ Reuters Regulatory Company Reporting System and international information vendors. The documents referred to above will also be made available to Belgian investors upon prior written request addressed to the principal executive office of the Company. PERSONS RESPONSIBLE FOR THE PROSPECTUS AND DECLARATION The Company, represented by Mr. William H. Seippel, Chief Financial Officer, takes responsibility for the contents of this Prospectus. The Company, having made all reasonable inquiries, accepts responsibility for, and confirms that this Prospectus contains all information with regard to the Company and the Common Stock that is material in the context of the offering and sale of the Common Stock, that the information contained in this Prospectus is true and correct in all material respects and is not misleading, that the opinions and intentions of the Company expressed herein are honestly held and that there are no other facts the omission of which makes this Prospectus as a whole or any of such information or the expression of any such opinions or intentions materially misleading. Global TeleSystems Group, Inc. by William H. Seippel Chief Financial Officer THE CLEARING SYSTEMS INTERSETTLE Transactions executed on EASDAQ will be settled by delivery through INTERSETTLE. INTERSETTLE holds securities for its direct participants, which include banks, securities brokers and dealers, other professional intermediaries and foreign depositories, and facilitates the clearance and settlement of securities transactions between INTERSETTLE participants through electronic book-entry changes in the accounts of INTERSETTLE participants. Book-entry settlement is mandatory for all financial instruments traded on EASDAQ. Physical certificates cannot be used to settle a market transaction. Investors must hold a securities account with a financial institution which directly or indirectly has access to INTERSETTLE's clearing and settlement system. INTERSETTLE conducts a real-time gross payment system in connection with its clearance operation, payments being made simultaneously with the book-entry transfers between securities accounts. B-1 196 DTC DTC is a limited-purpose trust company organized under the laws of the State of New York, a member of the Federal Reserve System, a "clearing corporation" within the meaning of the New York Uniform Commercial Code, and a "clearing agency" registered pursuant to the provisions of Section 17A of the Securities Exchange Act of 1934. DTC was created to hold securities of its participants and to facilitate the clearance and settlement of securities transactions among its participants in such securities through electronic book-entry changes in accounts of the participants, thereby eliminating the need for physical movement of securities certificates. DTC participants include securities brokers and dealers, banks, trust companies, clearing corporations and certain other organization, some of whom (and/or their representatives) own DTC. Access to the DTC book-entry system is also available to others, such as banks, brokers, dealers and trust companies that clear through or maintain a custodial relationship with a participant, either directly or indirectly. DTC agrees with and represents to its participants that it will administer its book-entry system in accordance with its rules and by-laws and requirements of law. TRANSFERS BETWEEN INTERSETTLE AND DTC PARTICIPANTS Common Stock will be held through DTC. Common Stock held directly or indirectly by INTERSETTLE participants will be registered on the books of DTC in the name of the nominee company of Brown Brothers Harriman, acting as custodian for INTERSETTLE. Transfers of Common Stock will be effected in the following manner: (i) transfers of Common Stock between INTERSETTLE participants will be effected in accordance with procedures established for this purpose by INTERSETTLE; (ii) transfer of Common Stock between DTC participants will be effected in accordance with procedures established for the purpose by DTC; and (iii) transfers of Common Stock between INTERSETTLE participants and DTC participants will be effected by an increase or a reduction of the quantity of Common Stock held in INTERSETTLE's account at Brown Brothers Harriman and a corresponding reduction or increase of the quantity of Common Stock held by the other relevant DTC participant or participants. Investors should inquire with the financial intermediary with whom the investor has opened a securities account for the purpose of holding and trading Common Stock, as to the cost of such trading as well as the terms and conditions on which the financial service of the Common Stock will be delivered by such financial intermediary. The Common Stock has the following identification number: CUSIP 379 36 U104, ISIN US379 36 U1043 The clearing costs, if any, will be at the cost of the investors. Investors are requested to inform themselves about such costs. POSSIBILITY OF SHARE REPURCHASES The Company is not prohibited by its Certificate of Incorporation, By-laws or Delaware General Corporation Law from repurchasing or otherwise acquiring outstanding shares of Common Stock and, accordingly, the Company may exercise its right to repurchase Common Stock. AUTHORIZATION OF INCREASE IN AUTHORIZED CAPITAL OF THE COMPANY; AUTHORIZATION OF THE ISSUANCE OF COMMON STOCK IN THE STOCK OFFERINGS Effective December 1, 1997, the Board of Directors and stockholders of the Company approved amendments to the Certificate of Incorporation which (i) increased the authorized number of shares of capital stock to 145,000,000 (of which 135,000,000 shares are Common Stock and 10,000,000 shares are preferred stock) and (ii) effected a 3-for-2 stock split of all then-outstanding shares of the Company's Common Stock. B-2 197 In addition, the Board of Directors of the Company has adopted a resolution approving the offering and issuance of 11,100,000 shares of Common Stock in the Stock Offerings. TAXATION OF BELGIAN INVESTORS The following generally summarizes the material Belgian tax consequences of the sequisition, ownership and disposition of Common Stock. It is based on the tax laws applicable in Belgium and France as in effect at the date of this Prospectus, and is subject to changes in Belgium and French law, including changes that could have retroactive effect. The following summary does not take into account or discuss the tax laws of any country other than Belgium and France nor does it take into account the individual circumstances of each investor. The summary uses the term "Eligible Belgian Holders" to refer to beneficial owners of Common Stock who hold directly less than 10% of the share capital of the Company and whose ownership of such Common Stock is not attributable to a permanent establishment or a fixed base in France, are considered residents of Belgium for purposes of the income tax convention between Belgium and France dated March 10, 1964 (the "Belgian-French Treaty") and are fully entitled to benefits under the Belgian-French Treaty. There are currently no procedures available for Holders of Common Stock that are not U.S. residents to claim or receive from the French tax authorities any tax treaty benefits in respect of dividends (including payment of avoir fiscal and availability of a reduced withholding tax rate) that a Holder may be entitled to receive pursuant to the Belgian-French Treaty. Prospective Belgian Investors in Common Stock are advised to consult their own tax advisers as to the Belgian and other tax consequences of the acquisition, ownership and disposition of Common Stock. TAXATION OF DIVIDENDS ON COMMON STOCK French tax considerations Dividends paid to non-residents of France generally are subject to French withholding tax at a 25% rate and are not eligible for the benefit of the avoir fiscal (a tax credit available to French residents equal to 50% of the amount of dividends received from French companies such as the Company). However, under the Belgian-French Treaty, Eligible Belgian Holders can claim the benefit of a reduced withholding tax rate on dividends of 15%. An individual Eligible Belgian Holder generally will also be entitled to receive a payment of the avoir fiscal, after deduction of withholding tax of 15%. This payment will not be made available to such individual Eligible Belgian Holder until after the close of the calendar year in which the dividend was paid and only upon receipt by the French tax authorities of a claim made by the individual Eligible Belgian Holder for such payment in accordance with the procedure set forth below. A Belgian company that is an Eligible Belgian Holder under the Belgian-French Treaty (a "Belgian Resident Company") will not benefit from the refund of the avoir fiscal but will be entitled to obtain from the French tax authorities a refund of any precompte paid in cash in respect of such dividends less the 15% French withholding tax. Amounts distributed as dividends by French companies out of profits which have been taxed at the ordinary corporate income tax rate or which have been earned and taxed more than five years before the distribution and which give rise to the avoir fiscal are subject to a "precompte" or prepayment by such companies. The precompte is paid by the distributing company to the French tax authorities and is equal to one-half of the nominal dividend distributed. Dividends paid to an individual Eligible Belgian Holder will be subject to the reduced withholding tax rate of 15% at the time the dividend is paid if (i) such holder duly completes and provides the French tax authorities with French Treasury Form 5200 RFI Belgique (the "Form") duly certified by the Belgian tax authorities before the date of payment of the relevant dividend, or (ii) if completion of the Form is not possible prior to the payment of dividends, such holder duly completes and provides the French tax authorities with a simplified certificate (the "Certificate") duly certified by the Belgian tax authorities stating that (a) such holder is a Belgian resident as defined pursuant to the provisions of the Belgian-French Treaty, B-3 198 (b) such holder's ownership of the Common Stock is not effectively connected with a permanent establishment or fixed base in France, and (c) such holder meets all the requirements of the Belgian-French Treaty for obtaining the benefit of the reduced rate of withholding tax and the right to payment of the French avoir fiscal. For example, the Company pays a dividend of 100, an individual Eligible Belgian Holder will initially receive 85, but will be entitled to an additional payment of 42.50, consisting of the avoir fiscal of 50, less a 15% withholding tax on that amount (equal to 7.5). Dividends paid to an individual Eligible Belgian Holder that has not filed a completed Form or Certificate before the dividend payment date will be subject to French withholding tax at the rate of 25%. Such a holder may claim a refund of the excess withholding tax and the avoir fiscal by completing and providing the French tax authorities with the Form before December 31st of the calendar year following the year during which the dividend is paid. Dividends paid to a Belgian Resident Company will be subject to the reduced withholding tax rate of 15% at the time the dividend is paid if such holder duly completes and provides the French tax authorities with French Treasury 5207 RF2 Belgique form before the date of payment of the relevant dividend duly certified by the Belgian tax authorities. Dividends paid to such Belgian Resident Company that has not filed a completed form before the dividend payment date will be subject to French withholding tax at the rate of 25%. Such a holder may claim a refund of the excess withholding tax by completing and providing the French tax authorities with such 5207 RF2 Belgique form before December 31st of the calendar year following the year during which the dividend is paid. The claim for refund of the precompte is made on the form RF 5207 RF2 Belgique referred to above. Belgian withholding tax Dividends distributed on Common Stock are subject in Belgium to a withholding tax at the rate of 25%, when paid or attributed through a professional intermediary in Belgium. However, no dividend withholding tax is due if the Eligible Belgian Holder is a company subject to Belgian corporate income tax. In a case where dividends are paid outside Belgium without any intervention of a paying agent in Belgium, no dividend withholding tax is, in principle, due. However, where the Eligible Belgian Holder is a Belgian resident entity subject to the legal entities tax (e.g. a pension fund), the Holder itself has to pay the dividend withholding tax at the rate of 25%. In certain cases the above-mentioned 25% rate of dividend withholding tax will be reduced to 15%. The reduced rate applies in particular to (i) dividends distributed on shares publicly issued after January 1, 1994 and (ii) dividends distributed on shares that have been privately issued after January 1, 1994 in exchange for cash contributions, provided the shares are registered or bearer shares placed in open custody to a financial institution in Belgium as of the date of their issuance. This reduced rate should in principle also apply to dividends on shares issued by the Company. The Company may however irrevocably reject the application of the reduced withholding tax rate. Income tax for Belgian resident individuals In the hands of an Eligible Belgian Holder who is an individual holding Common Stock as a private investment, the Belgian dividend withholding tax is a final tax and the dividends need not be reported in the individual's annual income tax return. If no withholding tax has been levied (i.e. in case of payment or attribution outside Belgium), the individual has to report the dividends in his tax return. Such Holder will be taxed at the separate rate of 25%, to be increased with a municipal surcharge (varying, as a rule, from 6% to 9%). In the hands of an individual Eligible Belgian Holder whose holding of Common Stock is effectively connected with a business, the dividends are taxable at the ordinary rates for business income (i.e. varying from 25% to 55% to be increased with the municipal surcharge and a crisis contribution of 3% of the tax due). Any Belgium withholding tax is creditable against the final income tax due, provided that the Holder has the full ownership of the Common Stock at the time of payment of the dividends. B-4 199 Income tax for Belgian Resident Companies Dividends received by Belgian Resident Companies are, in principle, subject to corporate income tax at the rate of 40.17% (i.e. the standard rate of 39% increased by the additional tax of 3% of the corporate income tax due). However, provided that the dividends benefit from the so-called "dividend-received deduction", only 5% of the dividends received will be taxable. In order to benefit from the deduction, the Company must not fall within one of the categories which are expressly excluded from the "dividend received deduction" (e.g. tax haven companies) and the beneficiary should hold, at the time of payment of the dividends, a participation of at least 5% in the Company or a participation which has a acquisition value of at least BEF 50 million. Any Belgian dividend withholding tax can, in principle, be credited against the company's final income tax, provided that the company has the full ownership of the shares at the time of payment or attribution of the dividends and provided that the dividend distribution does not entail a reduction in value or capital loss on the Shares. Income tax for Belgian resident entities subject to the Belgian legal entities tax (pension funds, etc.) The Belgian dividend withholding tax is a final tax. CAPITAL GAINS TAXATION French tax considerations In general, a Belgian holder who is a resident of Belgium under the Belgian-French Treaty will not be subject to French tax on any capital gain derived from the sale or exchange of Common Stock, unless the gain is attributable to a permanent establishment or fixed place of business maintained by the holder in France. Belgian tax considerations Individual Eligible Belgian Holders holding the Common Stock as a private investment and entities subject to legal entities tax are not subject to the Belgian capital gains taxation on the disposal of the Common Stock. Individual Eligible Belgian Holders may, however, be subject to a 33% tax (to be increased with the municipal surcharge and the crisis contribution) if the capital gain is deemed to be "speculative." Individual Eligible Belgian Holders whose holding of Common Stock is effectively connected with a business are taxable at the ordinary rates on any capital gains realized on the disposal of Common Stock. Belgian resident companies are not subject to capital gains taxation provided that the dividends received on the shares qualify for the "dividend received deduction" (except for the minimum holding requirement). FRENCH ESTATE AND GIFT TAX Under the estate tax convention between Belgium and France, a transfer of Common Stock by reason of the death of an individual Eligible Belgian Holder entitled to benefits under that convention will not be subject to French inheritance tax, unless the decedent was domiciled in France at the time of his or her death. FRENCH WEALTH TAX The French wealth tax (impot de solidare sur la fortune) does not apply to an Eligible Belgian Holder. BELGIAN INDIRECT TAXES Stamp tax on securities transactions In principle, a stamp tax is levied upon the subscription of shares of Common Stock and the purchase and sale in Belgium of Common Stock through a professional intermediary. The rate applicable to subscriptions of B-5 200 new shares of Common Stock is 0.35% but there is a limit of BEF 10,000 per transaction. The rate applicable for secondary sales and purchases in Belgium of Common Stock through a professional intermediary is 0.17% but there is a limit of BEF 10,000 per transaction. An exemption is available to professional intermediaries (e.g. credit institutions), insurance companies, pension funds and collective investment vehicles who are acting for their own account. A non-resident holder of Common Stock who is acting for his own account will also be entitled to an exemption from this stamp tax, provided that he delivers to the issuer or the professional intermediary in Belgium, as the case may be, an affidavit confirming his non-resident status in Belgium. Tax on delivery of bearer securities A tax is levied upon the physical delivery of Common Stock pursuant to their subscription or their acquisition for consideration through a professional intermediary. This tax is also due upon the delivery of Common Stock pursuant to a withdrawal of these Common Stock from "open custody." The tax is due, at the rate of 0.2%, on the sums payable by the subscriber or the acquiror in case of subscription or acquisition or the sales value of the Common Stock, as estimated by the custodian in case of withdrawal from "open custody." However, an exemption is available for deliveries to recognized professional intermediaries (such as credit institutions) acting for their own account. An exemption is also available for delivery of Common Stock, which are held in "open custody", to a non-resident. B-6 201 [MAP OF CIS] 202 ====================================================== NO DEALER, SALESPERSON OR OTHER INDIVIDUAL HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR MAKE ANY REPRESENTATIONS NOT CONTAINED IN THIS PROSPECTUS IN CONNECTION WITH THE OFFERING COVERED BY THIS PROSPECTUS. IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR THE UNDERWRITERS. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO BUY, THE SECURITIES IN ANY JURISDICTION WHERE, OR TO ANY PERSON TO WHOM, IT IS UNLAWFUL TO MAKE SUCH OFFER OR SOLICITATION. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE AN IMPLICATION THAT THERE HAS NOT BEEN ANY CHANGE IN THE FACTS SET FORTH IN THIS PROSPECTUS OR IN THE AFFAIRS OF THE COMPANY SINCE THE DATE HEREOF. ----------------- TABLE OF CONTENTS
PAGE ---- Prospectus Summary..................... 1 Risk Factors........................... 11 Use of Proceeds........................ 29 Price Range of Common Stock............ 29 Dividend Policy........................ 29 Dilution............................... 30 Capitalization......................... 31 Selected Historical Consolidated Financial Data....................... 32 Supplemental Information -- Selected Historical Financial Data -- Combined Equity Investments................... 33 Management's Discussion and Analysis of Financial Condition and Results of Operations........................... 34 Business............................... 48 Management............................. 100 Executive Compensation and Other Information.......................... 103 Certain Related Party Transactions..... 114 Principal and Selling Stockholders..... 117 Description of Certain Indebtedness.... 120 Description of Capital Stock........... 122 Shares Eligible for Future Sale........ 128 Certain U.S. Federal Tax Consequences to Non-U.S. Stockholders............. 129 Underwriting........................... 132 Legal Matters.......................... 134 Experts................................ 135 Index to Financial Statements.......... F-1 Exhibit A -- Glossary of Telecommunications Industry Terms.... A-1 Exhibit B -- Supplemental EASDAQ Information.......................... B-1
====================================================== ====================================================== 10,458,000 SHARES [GLOBAL TELESYSTEMS GROUP, INC. LOGO] GLOBAL TELESYSTEMS GROUP, INC. COMMON STOCK ------------------- PROSPECTUS ------------------- MERRILL LYNCH & CO. DONALDSON, LUFKIN & JENRETTE SECURITIES CORPORATION BEAR, STEARNS & CO. INC. BT ALEX. BROWN LEHMAN BROTHERS PRUDENTIAL SECURITIES INCORPORATED ARNHOLD AND S. BLEICHROEDER, INC. , 1998 ====================================================== 203 INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT BECOMES EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE SECURITIES IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE UNLAWFUL PRIOR TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF ANY SUCH STATE. SUBJECT TO COMPLETION PRELIMINARY PROSPECTUS DATED JUNE 12, 1998 PROSPECTUS 10,458,000 SHARES GLOBAL TELESYSTEMS GROUP, INC. COMMON STOCK [GLOBAL TELESYSTEMS GROUP, INC. LOGO] --------------------- Of the 10,458,000 shares of Common Stock, par value $.10 per share (the "Common Stock"), offered hereby (the "Offered Securities"), 2,614,500 shares are being offered by Global TeleSystems Group, Inc. (the "Company") and 7,843,500 shares are being offered by certain of the Company's stockholders (the "Selling Stockholders"). The Company will not receive any of the proceeds from the sale of shares of the Selling Stockholders. See "Principal and Selling Stockholders" and "Underwriting." Of the 10,458,000 shares of Common Stock offered hereby, 4,183,200 shares are being offered outside the United States and Canada (the "International Offering") and 6,274,800 shares are being offered in the United States and Canada (the "U.S. Offering" and, together with the International Offering, the "Stock Offerings"). The initial offering price per share and the underwriting discount per share are identical for both Stock Offerings. See "Underwriting." The Company has also filed a registration statement with respect to the offering of $350,000,000 of its % Convertible Senior Subordinated Debentures due 2010 (the "New Convertible Bonds"), and such offering (the "New Convertible Bond Offering" and, together with the Stock Offerings, the "Offerings") is being made by a separate prospectus. The consummation of the New Convertible Bond Offering is not conditioned upon the consummation of the Stock Offerings, and there can be no assurance that the New Convertible Bond Offering will be consummated. The Common Stock is quoted on the Nasdaq National Market and the European Association of Securities Dealers Automated Quotation ("EASDAQ") Market authority under the symbol "GTSG." On June 8, 1998, the last reported sale price of the Common Stock on the Nasdaq National Market was $38.25 per share. SEE "RISK FACTORS" BEGINNING ON PAGE 11 FOR A DISCUSSION OF CERTAIN FACTORS THAT SHOULD BE CONSIDERED BY PROSPECTIVE PURCHASERS OF THE COMMON STOCK OFFERED HEREBY. --------------------- THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION, NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
========================================================================================================================= PRICE TO UNDERWRITING PROCEEDS TO PROCEEDS TO PUBLIC DISCOUNT(1) COMPANY(2) SELLING STOCKHOLDERS - - - - ------------------------------------------------------------------------------------------------------------------------- Per share.............. $ $ $ $ - - - - ------------------------------------------------------------------------------------------------------------------------- Total(3)............... $ $ $ $ =========================================================================================================================
(1) The Company and the Selling Stockholders have agreed to indemnify the several Underwriters (as defined herein) against certain liabilities, including liabilities under the Securities Act of 1933, as amended (the "Securities Act"). See "Underwriting." (2) Before deducting expenses payable by the Company estimated at $1,494,780. (3) The Company and the Selling Stockholders have granted to the International Managers (as defined herein) and the U.S. Underwriters (as defined herein) options, exercisable within 30 days of the date hereof, to purchase up to an additional 627,480 and 941,220 shares of Common Stock, respectively, solely to cover over-allotments, if any. If such options are exercised in full, the total Price to Public, Underwriting Discount and Proceeds to the Company and the Selling Stockholders will be $ , $ and $ , respectively. See "Underwriting." --------------------- GLOBAL COORDINATOR MERRILL LYNCH & CO. --------------------- The shares of Common Stock are offered by the several Underwriters, subject to prior sale, when, as and if issued to and accepted by them, subject to approval of certain legal matters by counsel for the Underwriters and certain other conditions. The Underwriters reserve the right to withdraw, cancel or modify such offer and to reject orders in whole or in part. It is expected that delivery of the shares of Common Stock will be made in New York, New York on or about , 1998. --------------------- MERRILL LYNCH INTERNATIONAL --------------------- DONALDSON, LUFKIN & JENRETTE GOLDMAN SACHS INTERNATIONAL INTERNATIONAL --------------------- CIBC WOOD GUNDY OPPENHEIMER ING BARINGS MFK RENAISSANCE --------------------- The date of this Prospectus is , 1998. 204 UNDERWRITING Subject to the terms and conditions set forth in an international purchase agreement (the "International Purchase Agreement") among the Company, the Selling Stockholders and each of the underwriters named below (the "International Managers") and concurrently with the sale of 6,274,800 shares of Common Stock to the U.S. Underwriters (as defined below), the Company and the Selling Stockholders severally have agreed to sell to each of the International Managers, and each of the International Managers for whom Merrill Lynch International ("Merrill Lynch"), Donaldson, Lufkin & Jenrette International, Goldman Sachs International, CIBC Oppenheimer International Limited, Baring Brothers Limited (as agent for ING Bank N.V.) and Renaissance Advisory Limited are acting as representatives (the "International Representatives"), has severally agreed to purchase from the Company and the Selling Stockholders, the number of shares of Common Stock set forth opposite its name below.
NUMBER INTERNATIONAL MANAGERS OF SHARES ---------------------- --------- Merrill Lynch International................................. Donaldson, Lufkin & Jenrette International ................. Goldman Sachs International................................. CIBC Oppenheimer International Limited...................... Baring Brothers Limited (as agent for ING Bank N.V.)........ Renaissance Advisory Limited................................ --------- Total.......................................... 4,183,200 =========
The Company and the Selling Stockholders have also entered into a U.S. purchase agreement (the "U.S. purchase agreement" and, together with the International Purchase Agreement, the "Purchase Agreements") with certain underwriters in the United States and Canada (the "U.S. Underwriters" and, together with the International Managers, the "Underwriters") for whom Merrill Lynch, Pierce, Fenner & Smith Incorporated and Donaldson, Lufkin & Jenrette Securities Corporation, are acting as representatives (the "U.S. Representatives"). Subject to the terms and conditions set forth in the U.S. Purchase Agreement, and concurrently with the sale of 4,183,200 shares of Common Stock to the International Managers pursuant to the International Purchase Agreement, the Company and the Selling Stockholders severally have agreed to sell to the U.S. Underwriters, and the U.S. Underwriters severally have agreed to purchase, an aggregate of 6,274,800 shares of Common Stock. The public offering price per share and the underwriting discount per share of Common Stock are identical under the International Purchase Agreement and the U.S. Purchase Agreement. In each Purchase Agreement, the several International Managers and the several U.S. Underwriters, respectively have agreed, subject to the terms and conditions set forth in such Purchase Agreement, to purchase all the shares of Common Stock offered hereby, if any are purchased. In the event of default by an Underwriter, the Purchase Agreement provides that, in certain circumstances, purchase commitments of the nondefaulting Underwriters may be increased or the Purchase Agreement may be terminated. The sale of Common Stock to the U.S. Underwriters is conditioned upon the sale of shares of Common Stock to the International Managers, and vice versa. The International Managers and the U.S. Underwriters have entered into an intersyndicate agreement (the "Intersyndicate Agreement") that provides for the coordination of their activities. Pursuant to the Intersyndicate Agreement, the International Managers and the U.S. Underwriters are permitted to sell shares of Common Stock to each other for purposes of resale at the public offering price set forth on the cover page of this Prospectus, less an amount not greater than the selling concession. Under the terms of the Intersyndicate Agreement, the U.S. Underwriters and any dealer to whom they sell shares of Common Stock will not offer to sell or sell shares of Common Stock to persons who are non-U.S. or non-Canadian persons or to persons they believe intend to resell to persons who are non-U.S. or non-Canadian persons, and the International Managers and any dealer to whom they sell shares of Common Stock will not offer to sell or sell shares of Common Stock to U.S. persons or Canadian persons or to persons they believe intend to resell to U.S. persons or Canadian persons, except, in each case, for transactions pursuant to the Intersyndicate Agreement. 132 205 The International Representatives have advised the Company that the International Managers propose initially to offer the shares of Common Stock to the public at the public offering price set forth on the cover page of this Prospectus, and to certain dealers at such price less a concession not in excess of $ per share of Common Stock. The International Managers may allow, and such dealers may allow, a discount not in excess of $ per share of Common Stock on sales to certain other dealers. After the Stock Offerings, the public offering price, concession and discount may be changed. The Company, its directors, executive officers and certain stockholders have agreed, subject to certain exceptions, not to directly or indirectly (i) offer, pledge, sell, contract to sell, sell any option or contract to purchase, purchase any option or contract to sell, grant any option, right or warrant for the sale of, or otherwise dispose of or transfer any Common Stock or any securities convertible into or exchangeable or exercisable for any shares of Common Stock, or request the filing of any registration statement under the Securities Act, with respect to any of the foregoing or (ii) enter into any swap or any other agreement or any transaction that transfers, in whole or in part, directly or indirectly, the economic consequence of ownership of Common Stock, whether any such swap transaction is to be settled by delivery of the Common Stock or other securities, in cash or otherwise without the prior written consent of Merrill Lynch, on behalf of the Underwriters, for a period of 90 days after the date of this Prospectus. In addition, except to the extent otherwise provided in this Prospectus with respect to the Affiliate Shares, certain stockholders have agreed not to make any demand for or exercise any rights with respect to the registration of Common Stock and have waived all rights (including demand and "piggyback" registration rights) to register securities owned by them for such 90 day period and rights to purchase additional shares of Common Stock in connection with the Offerings. See "Shares Eligible for Future Sale." The Company and the Selling Stockholders have granted an option to the International Managers, exercisable for 30 days after the date of this Prospectus, to purchase up to an aggregate of 627,480 additional shares of Common Stock at the public offering price set forth on the cover page of this Prospectus, less the underwriting discount. The Company will determine, prior to the pricing of the Common Stock offered hereby, the number of shares of Common Stock subject to such over-allotment option to be sold by the Company and the Selling Stockholders, respectively. The International Managers may exercise this option only to cover over-allotments, if any, made on the sale of the Common Stock offered hereby. To the extent that the International Managers exercise this option, each International Manager will be obligated, subject to certain conditions, to purchase a number of additional shares of Common Stock proportionate to such International Manager's initial amount reflected in the foregoing table. The Company and the Selling Stockholders have also granted an option to the U.S. Underwriters, exercisable for 30 days after the date of this Prospectus, to purchase up to an additional 941,220 shares of Common Stock to cover over-allotments, if any, on terms similar to those granted to International Managers. The Company and the Selling Stockholders have agreed to indemnify the International Managers and the U.S. Underwriters against certain liabilities, including liabilities under the Securities Act of 1933, as amended, or to contribute to payments the Underwriters may be required to make in respect thereof. Until the distribution of the Common Stock is completed, rules of the Securities and Exchange Commission may limit the ability of the U.S. Underwriters and certain selling group members to bid for and purchase the Common Stock. As an exception to these rules, the U.S. Representatives are permitted to engage in certain transactions that stabilize the price of the Common Stock. Such transactions consist of bids or purchases for the purpose of pegging, fixing or maintaining the price of the Common Stock. In connection with the Offerings, certain Underwriters or their respective affiliates and selling group members (if any) who are qualified market makers on the Nasdaq National Market may engage in "passive market making" in the Common Stock on the Nasdaq National Market in accordance with Rule 103 under Regulation M. Rule 103 permits, upon the satisfaction of certain conditions, underwriters and selling group members participating in a distribution that are also Nasdaq National Market market makers in the security being distributed to engage in limited market making transactions during the period when Rule 103 under Regulation M would otherwise prohibit such activity. Rule 103 prohibits underwriters and selling group members engaged in passive market making generally from entering a bid or effecting a purchase at a price 133 206 that exceeds the highest bid for those securities displayed on the Nasdaq National Market by a market maker that is not participating in the distribution. Under Rule 103, each underwriter or selling group member engaged in passive market making is subject to a daily net purchase limitation equal to 30% of such entity's average daily trading volume during the two full consecutive calendar months immediately preceding the date of the filing of the registration statement under the Securities Act pertaining to the security to be distributed. If the Underwriters create a short position in the Common Stock in connection with the Stock Offerings, (i.e., if they sell more shares of Common Stock than are set forth on the cover page of this Prospectus), the U.S. Representatives may reduce that short position by purchasing Common Stock in the open market. The U.S. Representatives may also elect to reduce any short position by exercising all or part of the over-allotment option described above. The U.S. Representatives may also impose a penalty bid on certain Underwriters and selling group members. This means that if the Representatives purchase shares of Common Stock in the open market to reduce the Underwriters' short position or to stabilize the price of the Common Stock, they may reclaim the amount of the selling concession from the Underwriters and selling group members who sold those shares as part of the Offering. In general, purchases of a security for the purpose of stabilization or to reduce a short position could cause the price of the security to be higher than it might be in the absence of such purchases. The imposition of a penalty bid might also have an effect on the price of a security to the extent that it were to discourage resales of the security before the distribution is completed. Neither the Company nor any of the U.S. Underwriters makes any representation or prediction, however, as to the direction or magnitude of any effect that the transactions described above may have on the price of the Common Stock. In addition, neither the Company nor any of the Underwriters makes any representation that the Representatives will engage in such transaction or that such transactions, once commenced, will not be discontinued without notice. Each International Manager agrees that (a) it has not offered or sold and, for a period of six months following consummation of the Stock Offerings, will not offer or sell any shares of Common Stock to persons in the United Kingdom except to persons whose ordinary activities involve them in acquiring, holding, managing or disposing of investments (as principal or agent) for the purposes of their businesses or otherwise in circumstances which do not constitute an offer to the public in the United Kingdom within the meaning of the Public Offers of Securities Regulations 1995, (b) it has complied with and will comply with all applicable provisions of the Public Offers of Securities Regulations 1995 and the Financial Services Act 1986 with respect to anything done by it in relation to the Common Stock in, from, or otherwise involving the United Kingdom and (c) it has only issued or passed on and will only issue or pass on in the United Kingdom any document received by it in connection with the issue or sale of the Common Stock to a person who is of a kind described in Article 11(3) of the Financial Services Act 1986 (Investment Advertisements) (Exemptions) Order 1996 or to a person to whom the document may otherwise lawfully be issued or passed on. The Common Stock is quoted on the Nasdaq National Market and the EASDAQ Market Authority under the symbol "GTSG." Certain of the Underwriters have been engaged from time to time, and may in the future be engaged, to perform financial advisory and other investment banking services to the Company and its affiliates. In connection with rendering such services in the past, such Underwriters have received customary compensation, including reimbursement of related expenses. LEGAL MATTERS The validity of the shares of Common Stock offered hereby will be passed upon for the Company by Shearman & Sterling, New York, New York. Certain legal matters will be passed upon for the Underwriters by Cahill Gordon & Reindel (a partnership including a professional corporation), New York, New York. 134 207 EXPERTS The consolidated financial statements of Global TeleSystems Group, Inc. as of December 31, 1996 and 1997, and for each of the three years in the period ended December 31, 1997, appearing in this Prospectus and Registration Statement, have been audited by Ernst & Young, LLP, independent auditors, as set forth in their report appearing elsewhere herein and are included in reliance upon such report given upon the authority of such firm as experts in accounting and auditing. 135 208 EXECUTIVE OFFICE OF THE COMPANY GLOBAL TELESYSTEMS GROUP, INC. 1751 Pinnacle Drive McLean, Virginia 22102 INDEPENDENT AUDITORS ERNST & YOUNG, LLP 1225 Connecticut Ave., NW Washington, D.C. 20036 LEGAL ADVISERS to the Company SHEARMAN & STERLING 599 Lexington Avenue New York, New York 10022-6069 as to CIS law COUDERT BROTHERS 1627 I Street, N.W. Washington, D.C. 20006 to the Underwriters CAHILL GORDON & REINDEL 80 Pine Street New York, New York 10005 REGISTRAR AND PRINCIPAL PAYING AND TRANSFER AGENT THE BANK OF NEW YORK One Wall Street New York, New York 10286 209 ====================================================== NO DEALER, SALESPERSON OR OTHER INDIVIDUAL HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR MAKE ANY REPRESENTATIONS NOT CONTAINED IN THIS PROSPECTUS IN CONNECTION WITH THE OFFERING COVERED BY THIS PROSPECTUS. IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR THE UNDERWRITERS. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL, OR A SOLICITATION OF AN OFFER TO BUY, THE COMMON STOCK IN ANY JURISDICTION WHERE, OR TO ANY PERSON TO WHOM, IT IS UNLAWFUL TO MAKE SUCH OFFER OR SOLICITATION. NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE AN IMPLICATION THAT THERE HAS NOT BEEN ANY CHANGE IN THE FACTS SET FORTH IN THIS PROSPECTUS OR IN THE AFFAIRS OF THE COMPANY SINCE THE DATE HEREOF. ----------------- TABLE OF CONTENTS
PAGE ---- Prospectus Summary..................... 1 Risk Factors........................... 11 Use of Proceeds........................ 29 Price Range of Common Stock............ 29 Dividend Policy........................ 29 Dilution............................... 30 Capitalization......................... 31 Selected Historical Consolidated Financial Data....................... 32 Supplemental Information -- Selected Historical Financial Data -- Combined Equity Investments................... 33 Management's Discussion and Analysis of Financial Condition and Results of Operations........................... 34 Business............................... 48 Management............................. 100 Executive Compensation and Other Information.......................... 103 Certain Related Party Transactions..... 114 Principal and Selling Stockholders..... 117 Description of Certain Indebtedness.... 120 Description of Capital Stock........... 122 Shares Eligible for Future Sale........ 128 Certain United States Federal Tax Consequences to Non-U.S. Stockholders......................... 129 Underwriting........................... 132 Legal Matters.......................... 134 Experts................................ 135 Index to Financial Statements.......... F-1 Exhibit A -- Glossary of Telecommunications Industry Terms.... A-1 Exhibit B -- Supplemental EASDAQ Information.......................... B-1
====================================================== ====================================================== 10,458,000 SHARES [GLOBAL TELESYSTEMS GROUP, INC. LOGO] GLOBAL TELESYSTEMS GROUP, INC. COMMON STOCK ----------------- PROSPECTUS ----------------- MERRILL LYNCH INTERNATIONAL DONALDSON, LUFKIN & JENRETTE INTERNATIONAL GOLDMAN SACHS INTERNATIONAL CIBC WOOD GUNDY OPPENHEIMER ING BARINGS MFK RENAISSANCE , 1998 ====================================================== 210 PART II INFORMATION NOT REQUIRED IN PROSPECTUS ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION The following table sets forth the estimated expenses, other than underwriting discounts and commissions, to be borne by the Company in connection with the offering of the securities being hereby registered.
ITEM ---- SEC Registration Fee........................................ $169,625 NASD Filing Fee............................................. 30,500 Nasdaq National Market Listing Fee.......................... Blue Sky Fees and Expenses.................................. 5,000 Transfer Agent and Registrar Fees........................... Accounting Fees and Expenses................................ Legal Fees and Expenses..................................... 200,000 Printing Expenses........................................... Miscellaneous............................................... -------- TOTAL............................................. $ ========
ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS Section 145 of the Delaware General Corporation Law ("DGCL") provides that a corporation may indemnify any person who was or is a party or is threatened to be made a party to any threatened, pending or completed action, suit or proceeding whether civil, criminal or investigative (other than an action by or in the right of the corporation) by reason of the fact that he is or was a director, officer, employee or agent of the corporation, or is or was serving at the request of the corporation as a director, officer, employee or agent of another corporation, partnership, joint venture, trust or other enterprise, against expenses (including attorneys' fees), judgments, fines and amounts paid in settlement actually and reasonably incurred by him in connection with such action, suit or proceeding if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his conduct was unlawful. Section 145 further provides that a corporation similarly may indemnify any such person serving in any such capacity who was or is a party or is threatened to be made a party to any threatened, pending or completed action or suit by or in the right of the corporation to procure a judgment in its favor, against expenses (including attorneys' fees) actually and reasonably incurred in connection with the defense or settlement of such action or suit if he acted in good faith and in a manner he reasonably believed to be in or not opposed to the best interests of the corporation and except that no indemnification shall be made in respect of any claim, issue or matter as to which such person shall have been adjudged to be liable to the corporation unless and only to the extent that the Delaware Court of Chancery or such other court in which such action or suit was brought shall determine upon application that, despite the adjudication of liability but in view of all the circumstances of the case, such person is fairly and reasonably entitled to indemnity for such expenses which the Court of Chancery or such other court shall deem proper. Section 102(b)(7) of the DGCL permits a corporation to include in its certificate of incorporation a provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director (i) for any breach of the director's duty of loyalty to the corporation or its stockholders, (ii) for acts or omission not in good faith or which involve intentional misconduct or a knowing violation of law, (iii) under Section 174 of the DGCL (relating to unlawful payment of dividends and unlawful stock purchase and redemption) or (iv) for any transaction from which the director derived an improper personal benefit. The Company's Certificate of Incorporation (the "Certificate") provides that the Company's Directors shall not be liable to the Company or its stockholders for monetary damages for breach of fiduciary duty as a director provided, however, that such exculpation from liabilities is not permitted with respect to liability II-1 211 arising from items described in clauses (i) through (iv) in the preceding paragraph. The Certificate and the Company's By-Laws further provide that the Company shall indemnify its directors and officers to the fullest extent permitted by the DGCL. The directors and officers of the Company are covered under directors' and officers' liability insurance policies maintained by the Company. ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES The foregoing reflects a 3-for-2 common stock split and an increase in the par value per share of common stock to $0.10 effective December 1997. Within the past three years the Company issued securities which were not registered under the Securities Act of 1933, as amended (the "Securities Act") as follows: On March 13, 1995, the Company issued 400,000 shares of common stock, par value $0.10 per share, pursuant to a stock purchase agreement. The shares were issued to CIBV Liquidating B.V., a closed company with limited liability organized under the laws of the Netherlands in exchange for the Company's interest in PrimTelefone. No underwriter or underwriting discount was involved in the offering. Exemption from registration was claimed under Section 4(2) of the Securities Act regarding transactions by an issuer not involving any public offering. On June 21, 1995, the Company issued 5,090,876 shares of common stock, par value $0.10 per share, at a purchase price of $9.00 per share, for an aggregate offering price of $45.8 million, pursuant to a stock purchase agreement. In addition to (i) certain investment funds and (ii) certain individual private investors, these shares were issued to certain members of management and various entities affiliated with certain members of management. No underwriter or underwriting discount was involved in the offering. Exemption from registration was claimed under Section 4(2) of the Securities Act regarding transactions by an issuer not involving any public offering. On January 19, 1996, and June 6, 1996, the Company granted affiliates of George Soros an aggregate of 4,444,443 warrants, each warrant to purchase one share of common stock, par value $0.10 per share, at an exercise price of $10.27 per share. The exercise price of the warrants was automatically reduced to $9.33 per share as of December 31, 1996 because the debt obligations remained outstanding. The warrants were issued in connection with the Company's issuance for cash of $40 million of notes to affiliates of George Soros, which notes bear interest at a rate of 10% per annum and mature on March 3, 2001. No underwriter or underwriting discount was involved in the offering. Exemption from registration was claimed under Section 4(2) of the Securities Act regarding transactions by an issuer not involving any public offering. On February 2, 1996, the Company granted affiliates of Capital Research International an aggregate of 3,333,333 warrants, each warrant to purchase one share of common stock, par value $0.10 per share, at an exercise price of $10.27 per share. The exercise price of the warrants was automatically reduced to $9.33 per share as of December 31, 1996 because the debt obligations remained outstanding. The warrants were issued in connection with the Company's issuance for cash of $30 million of notes to affiliates of Capital Research International, which notes bear interest at a rate of 10% per annum and mature on March 31, 2001. No underwriter or underwriting discount was involved in the offering. Exemption from registration was claimed under Section 4(2) of the Securities Act regarding transactions by an issuer not involving any public offering. On July 23, 1996, July 31, 1996, August 8, 1996, August 22, 1996 and September 12, 1996 the Company issued an aggregate of 8,348,532 shares of common stock, par value $0.10 per share, at a purchase price of $13.33 per share, for an aggregate offering price of $111 million, pursuant to a stock purchase agreement. In addition to (i) certain investment funds and (ii) certain individual private investors, these shares were issued to certain members of management and various entities affiliated with certain members of management. Exemption from registration was claimed under Section 4(2) of the Securities Act regarding transactions by an issuer not involving any public offering. II-2 212 On July 14, 1997 and July 31, 1997, the Company issued an aggregate $141,295,000 of its Senior Subordinated Convertible Bonds due 2000, convertible into the common stock, par value $0.10 per share, at a purchase price of 100%, pursuant to a subscription agreement. UBS Securities LLC, Donaldson, Lufkin & Jenrette Securities Corporation and Merrill Lynch & Co. acted as managers in the offering and the aggregate discount was $5,651,800. The securities were sold to a limited number of qualified institutional buyers as defined in Rule 144A under the Securities Act and to non-U.S. persons outside the United States. Exemption from registration was claimed under Rule 144A and Regulation S of the Securities Act. On August 15, 1997, August 29, 1997 and September 5, 1997, the Company issued an aggregate 2,502,686 shares of common stock, par value $0.10 per share, at a purchase price of $15.67 per share, for an aggregate offering price of $39.2 million, pursuant to a stock purchase agreement. In addition to (i) certain investment funds and (ii) certain individual private investors, these shares were issued to certain members of management and various entities affiliated with certain members of management. Exemption from registration was claimed under Section 4(2) of the Securities Act regarding transactions by an issuer not involving any public offering. On August 29, 1997, the Company issued $3.5 million of its Senior Subordinated Convertible Bonds due 2000, convertible into the common stock, par value $0.10 per share, at a purchase price of 100%. In addition to (i) certain investment funds and (ii) certain individual private investors, these shares were issued to certain members of management and various entities affiliated with certain members of management. Exemption from registration was claimed under Section 4(2) of the Securities Act regarding transactions by an issuer not involving any public offering. ITEM 16. EXHIBITS (a) Exhibits: The following is a list of exhibits filed as a part of this registration statement.
1.1*** -- Form of U.S. Purchase Agreement with respect to Stock Offerings 1.2*** -- Form of International Purchase Agreement with respect to Stock Offerings 1.3*** -- Form of New Convertible Bond Purchase Agreement with respect to Convertible Senior Debentures 3.1** -- Certificate of Incorporation of SFMT, Inc. 3.2** -- Certificate of Correction to the Certificate of Incorporation of SFMT, Inc., filed with the Delaware Secretary of State on October 8, 1993 3.3** -- Certificate of Ownership and Merger Merging San Francisco/Moscow Teleport, Inc. into SFMT, Inc., filed with the Delaware Secretary of State on November 3, 1993 3.4** -- Certificate of Amendment to the Certificate of Incorporation of SFMT, Inc., filed with the Delaware Secretary of State on January 12, 1995 3.5** -- Certificate of Amendment to the Certificate of Incorporation of SFMT, Inc., filed with the Delaware Secretary of State on February 22, 1995 3.6** -- Certificate of Amendment to the Certificate of Incorporation of Global TeleSystems Group, Inc., filed with the Delaware Secretary of State on October 16, 1996 3.7** -- By-laws of SFMT, Inc. 3.8** -- Certificate of Amendment to the Certificate of Incorporation of Global TeleSystems Group, Inc., filed with the Delaware Secretary of State on December 1, 1997 3.9** -- Form of Amended and Restated By-laws of Global TeleSystems Group, Inc. (supersedes By-laws of SFMT, Inc. filed as Exhibit 3.7) 3.10+ -- Certificate of Amendment to the Certificate of Incorporation of Global TeleSystems Group, Inc. filed with the Delaware Secretary of State on January 29, 1998 3.11+ -- Certificate of Amendment to the Certificate of Incorporation of Global TeleSystems Group, Inc. filed with the Delaware Secretary of State on February 9, 1998 3.12+ -- Certificate of Designation of the Series A Preferred Stock of the Company 4.1** -- Form of Specimen Stock Certificate for Common Stock of the Registrant
II-3 213 4.2** -- Indenture dated as of July 14, 1997 between the Company and The Bank of New York (including the form of Senior Subordinated Convertible Bond due 2000 as an exhibit thereto) 4.3** -- Registration Rights Agreement, dated as of July 14, 1997, between Global TeleSystems Group, Inc. and UBS Securities LLC. 4.4** -- Indenture dated as of August 19, 1997 between Hermes Europe Railtel B.V. and The Bank of New York (including the form of 11 1/2% Senior Note due 2007 as an exhibit thereto) 4.5** -- Registration Rights Agreement dated as of August 19, 1997 between Hermes Europe Railtel B.V. and Donaldson, Lufkin & Jenrette Securities Corporation, UBS Securities LLC, and Lehman Brothers, Inc. 4.6** -- Form of Rights Agreement between Global TeleSystems Group, Inc. and The Bank of New York, as Rights Agent 4.7+ -- Indenture dated as of February 10, 1998 between Global TeleSystems Group, Inc. and The Bank of New York (including the form of 9 7/8% Senior Notes due 2005 as an exhibit thereto) 4.8*** -- Indenture dated as of , 1998 between Global TeleSystems Group, Inc. and The Bank of New York relating to the Company's Convertible Senior Debentures due 2010 5.1*** -- Opinion of Shearman & Sterling respecting the Securities registered hereby 10.1** -- Senior Note Purchase Agreement, dated as of January 19, 1996, among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P. 10.1(a)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated June 6, 1996 10.1(b)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated June 6, 1996 10.1(c)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated July 23, 1996 10.1(d)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated September 16, 1996 10.1(e)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated July 11, 1997 10.1(f)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated July 29, 1997 10.1(g)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated September 29, 1997 10.2** -- Registration Rights Letter Agreement, dated as of January 19, 1996, among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P. 10.3** -- Warrant Agreement, dated as of January 19, 1996, among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P. 10.4** -- Joint Venture Letter Agreement, dated January 19, 1996, among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P. 10.5 -- Intentionally Omitted 10.6** -- Registration Rights Letter Agreement, dated June 6, 1996, among the Company, The Open Society Institute, Winston Partners II LDC and Winston Partners II LLC
II-4 214 10.7** -- Warrant Agreement, dated as of June 6, 1996, between Global TeleSystems Group, Inc., The Open Society Institute, Winston Partners II LDC and Winston Partners II LLC 10.8** -- Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc. 10.8(a)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated June 6, 1996 (see Exhibit No. 10.1(b)) 10.8(b)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated June 6, 1996 10.8(c)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated July 25, 1996 10.8(d)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated September 10, 1996 10.8(e)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated September 16, 1996 10.8(f)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated December 30, 1996 10.8(g)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated May 13, 1997 10.8(h)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated June 20, 1997 10.8(i)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated July 11, 1997 10.8(j)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated July 21, 1997 10.8(k)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated August 14, 1997 10.8(l)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated September 29, 1997 10.9** -- Registration Rights Letter Agreement, dated as February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc. 10.10** -- Warrant Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc. 10.11 -- Intentionally Omitted 10.12** -- Registration Rights Letter Agreement, dated as February 2, 1996, between Global TeleSystems Group, Inc. and Capital International Emerging Markets Funds 10.13** -- Warrant Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Capital International Emerging Markets Funds 10.14+ -- Restated and Amended Global TeleSystems Group, Inc. Non-Employee Directors' Stock Option Plan 10.15** -- GTS-Hermes, Inc. 1994 Stock Option Plan 10.16** -- Restricted Stock Grant letter, dated as of January 1, 1995
II-5 215 10.17 -- Employment Agreement dated as of January 1995 between SFMT, Inc. and Jan Loeber 10.18** -- Employment Agreement dated as of April 1996 between GTS Group, Inc. and Louis Toth 10.19** -- Employment Agreement dated as of April 1996 between GTS Group, Inc. and Gerald W. Thames 10.20** -- Employment Agreement dated as of April 1996 between GTS Group, Inc. and Raymond J. Marks 10.21** -- Employment Agreement dated as of April 1996 between GTS Group, Inc. and Henry Radzikowski 10.22** -- SFMT, Inc. Equity Compensation Plan 10.23** -- Form of Non-Statutory Stock Option Agreement 10.24+ -- Third Amended and Restated 1992 Stock Option Plan of Global TeleSystems Group Inc. dated as of September 25, 1997 10.25** -- GTS-Hermes 1994 Stock Option Grant, Non-Qualified Stock Option Grant 10.26** -- Agreement on the Creation and Functions of the Joint Venture of EDN Sovintel, dated June 18, 1990 10.27** -- Stock Purchase Agreement among Global Telesystems Group, Inc, Kompaniya "Invest-Project," Swinton Limited, GTS-Vox Limited, and MTU-Inform, dated September 6, 1995 10.28** -- Certificate of Registration of Revised and Amended Foundation Document in the State Registration of Commercial Organizations, dated May 30, 1996 10.29** -- Agreement on the Creation and Functions of the Joint Venture Sovam Teleport, dated May 26, 1992 10.30** -- Amended and Restated Joint Venture Agreement between GTS Cellular, Tricor B.V., Gerard Essing, Ivan Laska, and Erik Jennes, dated July 6, 1995 10.31** -- Amended and Restated Shareholders' Agreement between HIT Rail B.V., GTS-Hermes, Inc., Nationale Maatschappu Der Belgische Spoorwegen, Teleport B.V., AB Swed Carrier, and Hermes Europe Railtel B.V., dated July, 1997 10.31(a)** -- Shareholders' Agreement among the Hermes Europe Railtel B.V., GTS-Hermes Inc., HIT Rail B.V., SNCB/NMBS and AB Swed Carrier (incorporated by reference to Exhibit 10.1 to the Hermes Europe Railtel B.V.'s Registration Statement on Form S-4 (File No. 333-37719) filed on December 11, 1997) (supersedes the Amended and Restated Shareholders' Agreement incorporated by reference as Exhibit 10.31 to this Registration Statement) 10.32** -- Company Agreement between The Societe National de Financement, GTS S.A.M. and The Principality of Monaco, dated September 27, 1995 10.33** -- Joint Venture Agreement between SFMT-Hungaro Inc. and Montana Holding Vagyonkezelo Kft., dated December 23, 1993 10.34** -- Joint Venture and Shareholders' Agreement among Gerard Aircraft Sales and Leasing Company, SFMT-Hungaro Inc., and Microsystem Telecom Rt., dated August 5, 1994 10.35** -- Agreement on the Establishment of Limited Liability Company between SFMT-Czech, Inc. and B&H s.r.o., dated July 12, 1994 10.36** -- Formation of the Equity Joint Venture between GTS and SSTIC, dated April 12, 1995 10.37** -- Contract to Establish the Sino-foreign Cooperative Joint Venture Beijing Tianmu Satellite Communications Technology Co., Ltd, amended, by and between China International Travel Service Telecom Co., Ltd. and American China Investment Corporation, dated March 27, 1996 10.38** -- Joint Venture Contract between GTS TransPacific Ventures Limited and Shanghai Intelligence Engineering, Inc., dated March 28, 1996 10.39** -- Agreement between Global TeleSystems Group, Inc. and Cesia S.A., dated June 21, 1997 10.40** -- Consulting Agreement between SFMT, Inc. and Alan B. Slifka, dated March 1, 1994 10.41** -- Consulting Agreement between Global TeleSystems Group, Inc. and Bernard J. McFadden, dated August 15, 1996
II-6 216 10.42** -- Consulting Agreement between CESIA S.A. and Hermes Europe Railtel B.V., dated June 20, 1997 21.1+ -- List of Subsidiaries of the Registrant 23.1*** -- Consent of Shearman & Sterling (included in its opinion delivered under Exhibit No. 5.1) 23.2++ -- Consent of Ernst & Young (CIS) Ltd. 23.3++ -- Consent of Ernst & Young LLP 24.1++ -- Powers of Attorney 27.1+ -- Financial Data Schedule extracted from 12/31/97 audited financial statements 27.2++ -- Financial Data Schedule extracted from 3/31/98 unaudited financial statements
- - - - --------------- * Filed herewith. ** Incorporated by reference to the corresponding exhibit to the Company's Registration Statement on Form S-1 (File No. 333-36555) filed on September 26, 1997. *** To be filed by amendment. + Incorporated by reference to the corresponding exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1997. ++ Previously filed. (b) Financial Statements and Schedules: (1) Financial Statements The financial statements filed as part of this Registration Statement are listed in the Index to Financial Statements on page F-1. (2) Schedules The Company has furnished Schedule II -- Valuation and Qualifying Accounts on page S-1 of the Registration Statement. The other financial statement schedules of the Company have been omitted because the information required to be set forth therein is not applicable or is shown in the Financial Statements or Notes thereto. ITEM 17. UNDERTAKINGS Insofar as indemnification for liabilities arising under the Securities Act of 1933 may be permitted to directors, officers and controlling persons of the registrant pursuant to the provisions described under "Item 14 -- Indemnification of Directors and Officers" hereof, or otherwise, the registrant has been advised that in the opinion of the Securities and Exchange Commission such indemnification is against public policy as expressed in the Act and is, therefore, unenforceable. In the event that a claim for indemnification against such liabilities (other than the payment by the registrant of expenses incurred or paid by a director, officer or controlling person of the registrant in the successful defense of any action, suit or proceeding) is asserted by such director, officer or controlling person in connection with the securities being registered, the registrant will, unless in the opinion of its counsel the matter has been settled by controlling precedent, submit to a court of appropriate jurisdiction the question whether such indemnification by it is against public policy as expressed in the Act and will be governed by the final adjudication of such issue. The undersigned registrant hereby undertakes that: (1) For purposes of determining any liability under the Securities Act of 1933, the information omitted from the forms of prospectus filed as part of this registration statement in reliance upon Rule 430A and contained in forms of prospectus filed by the registrant pursuant to Rule 424(b)(1) or (4) or 497(h) under the Securities Act shall be deemed to be part of this registration statement as of the time it was declared effective. (2) For the purpose of determining any liability under the Securities Act of 1933, each post-effective amendment that contains a form of prospectus shall be deemed to be a new registration II-7 217 statement relating to the securities offered therein, and the offering of such securities at that time shall be deemed to be the initial bona fide offering thereof. The undersigned registrant hereby undertakes to provide to the underwriters at the closing specified in the underwriting agreements certificates in such denominations and registered in such names as required by the underwriters to permit prompt delivery to each purchaser. II-8 218 SIGNATURES Pursuant to the requirements of the Securities Act of 1933, as amended, the registrant certifies that it has duly caused this Amendment to the Registration Statement to be signed on its behalf by the undersigned, thereunto duly authorized, in the City of McLean, Commonwealth of Virginia, on this 11th day of June, 1998. GLOBAL TELESYSTEMS GROUP, INC. By: /s/ WILLIAM H. SEIPPEL ---------------------------------- Name: William H. Seippel Title: Executive Vice President and Chief Financial Officer Pursuant to the requirements of the Securities Act of 1933, this Amendment to the Registration Statement has been signed below by the following persons in the capacities indicated on the 11th day of June, 1998.
SIGNATURE TITLE DATE --------- ----- ---- /s/ GERALD W. THAMES* President, Chief Executive Officer June 11, 1998 - - - - ----------------------------------------------------- and Director (principal Gerald W. Thames executive officer) /s/ WILLIAM H. SEIPPEL Executive Vice President of June 11, 1998 - - - - ----------------------------------------------------- Finance and Chief Financial William H. Seippel Officer (principal financial and accounting officer) /s/ ALAN B. SLIFKA* Chairman of the Board of Directors June 11, 1998 - - - - ----------------------------------------------------- Alan B. Slifka /s/ MICHAEL GREELEY* Director June 11, 1998 - - - - ----------------------------------------------------- Michael Greeley /s/ BERNARD MCFADDEN* Director June 11, 1998 - - - - ----------------------------------------------------- Bernard McFadden /s/ STEWART J. PAPERIN* Director June 11, 1998 - - - - ----------------------------------------------------- Stewart J. Paperin Director June 11, 1998 - - - - ----------------------------------------------------- W. James Peet /s/ JEAN SALMONA* Director June 11, 1998 - - - - ----------------------------------------------------- Jean Salmona /s/ JOEL SCHATZ* Director June 11, 1998 - - - - ----------------------------------------------------- Joel Schatz /s/ ADAM SOLOMON* Director June 11, 1998 - - - - ----------------------------------------------------- Adam Solomon
II-9 219
SIGNATURE TITLE DATE --------- ----- ---- /s/ DAVID DEY* Director June 11, 1998 - - - - ----------------------------------------------------- David Dey Director June 11, 1998 - - - - ----------------------------------------------------- Roger W. Hale /s/ ROBERT J. AMMAN* Director June 11, 1998 - - - - ----------------------------------------------------- Robert J. Amman *By: /s/ WILLIAM H. SEIPPEL ------------------------------------------------- William H. Seippel Attorney-in-fact
II-10 220 REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS The Board of Directors Global TeleSystems Group, Inc. We have audited the consolidated financial statements of Global TeleSystems Group, Inc. as of December 31, 1996 and 1997, and for each of the three years in the period ended December 31, 1997, and have issued our report thereon dated February 26, 1998 (included elsewhere in this Registration Statement). Our audits also included the financial statement schedules listed in Item 16(b) of this Registration Statement. These schedules are the responsibility of the Company's management. Our responsibility is to express an opinion based on our audits. In our opinion, the financial statement schedules referred to above, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein. ERNST & YOUNG LLP Vienna, Virginia February 26, 1998 S-1 221 SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS
======================================================================================================== COL. A COL. B COL. C COL. D COL. E - - - - -------------------------------------------------------------------------------------------------------- ADDITIONS ----------------------- BALANCE AT CHARGED TO CHARGED TO BALANCE AT BEGINNING COSTS AND OTHER END DESCRIPTION OF PERIOD EXPENSES ACCOUNTS DEDUCTIONS OF PERIOD - - - - -------------------------------------------------------------------------------------------------------- Allowance for doubtful accounts at 12/31/95.............................. 0 30 30 Allowance for doubtful accounts at 12/31/96.............................. 30 752 782 Allowance for doubtful accounts at 12/31/97.............................. 782 3,303 4,085 Allowance for doubtful accounts at 3/31/98............................... 4,085 515 1,458 3,142
S-2 222 EXHIBIT INDEX
EXHIBIT NUMBER DESCRIPTION ------- ----------- 1.1*** -- Form of U.S. Purchase Agreement with respect to Stock Offerings................................................... 1.2*** -- Form of International Purchase Agreement with respect to Stock Offerings............................................. 1.3*** -- Form of New Convertible Bond Purchase Agreement with respect to Convertible Senior Debentures............................ 3.1** -- Certificate of Incorporation of SFMT, Inc. ................. 3.2** -- Certificate of Correction to the Certificate of Incorporation of SFMT, Inc., filed with the Delaware Secretary of State on October 8, 1993....................... 3.3** -- Certificate of Ownership and Merger Merging San Francisco/Moscow Teleport, Inc. into SFMT, Inc., filed with the Delaware Secretary of State on November 3, 1993......... 3.4** -- Certificate of Amendment to the Certificate of Incorporation of SFMT, Inc., filed with the Delaware Secretary of State on January 12, 1995 ........................................... 3.5** -- Certificate of Amendment to the Certificate of Incorporation of SFMT, Inc., filed with the Delaware Secretary of State on February 22, 1995 .......................................... 3.6** -- Certificate of Amendment to the Certificate of Incorporation of Global TeleSystems Group, Inc., filed with the Delaware Secretary of State on October 16, 1996...................... 3.7** -- By-laws of SFMT, Inc. ...................................... 3.8** -- Certificate of Amendment to the Certificate of Incorporation of Global TeleSystems Group, Inc., filed with the Delaware Secretary of State on December 1, 1997...................... 3.9** -- Form of Amended and Restated By-laws of Global TeleSystems Group, Inc. (supersedes By-laws of SFMT, Inc. filed as Exhibit 3.7)................................................ 3.10+ -- Certificate of Amendment to the Certificate of Incorporation of Global TeleSystems Group, Inc. filed with the Delaware Secretary of State on January 29, 1998...................... 3.11+ -- Certificate of Amendment to the Certificate of Incorporation of Global TeleSystems Group, Inc. filed with the Delaware Secretary of State on February 9, 1998...................... 3.12+ -- Certificate of Designation of the Series A Preferred Stock of the Company.............................................. 4.1** -- Form of Specimen Stock Certificate for Common Stock of the Registrant ................................................. 4.2** -- Indenture dated as of July 14, 1997 between the Company and The Bank of New York (including the form of Senior Subordinated Convertible Bond due 2000 as an exhibit thereto) ................................................... 4.3** -- Registration Rights Agreement, dated as of July 14, 1997, between Global TeleSystems Group, Inc. and UBS Securities LLC. ....................................................... 4.4** -- Indenture dated as of August 19, 1997 between Hermes Europe Railtel B.V. and The Bank of New York (including the form of 11 1/2% Senior Note due 2007 as an exhibit thereto) ........ 4.5** -- Registration Rights Agreement dated as of August 19, 1997 between Hermes Europe Railtel B.V. and Donaldson, Lufkin & Jenrette Securities Corporation, UBS Securities LLC, and Lehman Brothers, Inc. ...................................... 4.6** -- Form of Rights Agreement between Global TeleSystems Group, Inc. and The Bank of New York, as Rights Agent.............. 4.7+ -- Indenture dated as of February 10, 1998 between Global TeleSystems Group, Inc. and The Bank of New York (including the form of 9 7/8% Senior Notes due 2005 as an exhibit thereto).................................................... 4.8*** -- Indenture dated as of , 1998 between Global TeleSystems Group, Inc. and The Bank of New York relating to the Company's Convertible Senior Debentures due 2010........ 5.1*** -- Opinion of Shearman & Sterling respecting the Securities registered hereby...........................................
223
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.1** -- Senior Note Purchase Agreement, dated as of January 19, 1996, among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P. ............. 10.1(a)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated June 6, 1996.......................................... 10.1(b)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated June 6, 1996.......................................... 10.1(c)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated July 23, 1996......................................... 10.1(d)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated September 16, 1996 ................................... 10.1(e)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated July 11, 1997......................................... 10.1(f)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated July 29, 1997......................................... 10.1(g)** -- Amendment to Senior Note Purchase Agreement dated January 19, 1996 among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P., dated September 29, 1997.................................... 10.2** -- Registration Rights Letter Agreement, dated as of January 19, 1996, among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P. ..... 10.3** -- Warrant Agreement, dated as of January 19, 1996, among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P. ....................... 10.4** -- Joint Venture Letter Agreement, dated January 19, 1996, among Global TeleSystems Group, Inc., The Open Society Institute and Chatterjee Fund Management, L.P. ............. 10.5 -- Intentionally Omitted 10.6** -- Registration Rights Letter Agreement, dated June 6, 1996, among the Company, The Open Society Institute, Winston Partners II LDC and Winston Partners II LLC................. 10.7** -- Warrant Agreement, dated as of June 6, 1996, between Global TeleSystems Group, Inc., The Open Society Institute, Winston Partners II LDC and Winston Partners II LLC................. 10.8** -- Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc. .................................. 10.8(a)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated June 6, 1996 (see Exhibit No. 10.1(b))........................................ 10.8(b)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated June 6, 1996...... 10.8(c)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated July 25, 1996..... 10.8(d)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated September 10, 1996........................................................ 10.8(e)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated September 16, 1996........................................................
224
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.8(f)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated December 30, 1996........................................................ 10.8(g)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated May 13, 1997...... 10.8(h)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated June 20, 1997..... 10.8(i)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated July 11, 1997..... 10.8(j)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated July 21, 1997..... 10.8(k)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated August 14, 1997... 10.8(l)** -- Amendment to Senior Note Purchase Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc., dated September 29, 1997........................................................ 10.9** -- Registration Rights Letter Agreement, dated as February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc. .................................. 10.10** -- Warrant Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Emerging Markets Growth Fund, Inc. ................................................. 10.11 -- Intentionally Omitted 10.12** -- Registration Rights Letter Agreement, dated as February 2, 1996, between Global TeleSystems Group, Inc. and Capital International Emerging Markets Funds........................ 10.13** -- Warrant Agreement, dated as of February 2, 1996, between Global TeleSystems Group, Inc. and Capital International Emerging Markets Funds...................................... 10.14+ -- Global TeleSystems Group, Inc. Non-Employee Directors' Stock Option Plan................................................. 10.15** -- Restated and Amended GTS-Hermes, Inc. 1994 Stock Option Plan........................................................ 10.16** -- Restricted Stock Grant letter, dated as of January 1, 1995........................................................ 10.17** -- Employment Agreement dated as of January 1995 between SFMT, Inc. and Jan Loeber......................................... 10.18** -- Employment Agreement dated as of April 1996 between GTS Group, Inc. and Louis Toth.................................. 10.19** -- Employment Agreement dated as of April 1996 between GTS Group, Inc. and Gerald W. Thames............................ 10.20** -- Employment Agreement dated as of April 1996 between GTS Group, Inc. and Raymond J. Marks............................ 10.21** -- Employment Agreement dated as of April 1996 between GTS Group, Inc. and Henry Radzikowski........................... 10.22** -- SFMT, Inc. Equity Compensation Plan......................... 10.23** -- Form of Non-Statutory Stock Option Agreement................ 10.24+ -- Third Amended and Restated 1992 Stock Option Plan of Global TeleSystems Group Inc. dated as of September 25, 1997....... 10.25** -- GTS-Hermes 1994 Stock Option Grant, Non-Qualified Stock Option Grant................................................ 10.26** -- Agreement on the Creation and Functions of the Joint Venture of EDN Sovintel, dated June 18, 1990........................ 10.27** -- Stock Purchase Agreement among Global Telesystems Group, Inc, Kompaniya "Invest-Project," Swinton Limited, GTS-Vox Limited, and MTU-Inform, dated September 6, 1995............ 10.28** -- Certificate of Registration of Revised and Amended Foundation Document in the State Registration of Commercial Organizations, dated May 30, 1996...........................
225
EXHIBIT NUMBER DESCRIPTION ------- ----------- 10.29** -- Agreement on the Creation and Functions of the Joint Venture Sovam Teleport, dated May 26, 1992.......................... 10.30** -- Amended and Restated Joint Venture Agreement between GTS Cellular, Tricor B.V., Gerard Essing, Ivan Laska, and Erik Jennes, dated July 6, 1995.................................. 10.31** -- Amended and Restated Shareholders' Agreement between HIT Rail B.V., GTS-Hermes, Inc., Nationale Maatschappij Der Belgische Spoorwegen, Teleport B.V., AB Swed Carrier, and Hermes Europe Railtel B.V., dated July, 1997................ 10.31(a)** -- Shareholders' Agreement among the Hermes Europe Railtel, B.V., GTS-Hermes Inc., HIT Rail B.V., SNCB/NMBS and AB Swed Carrier (incorporated by reference to Exhibit 10.1 to the Hermes Europe Railtel B.V.'s Registration Statement on Form S-4 (File No. 333-37719) filed on December 11, 1997) (supersedes the Amended and Restated Shareholders' Agreement incorporated by reference as Exhibit 10.31 to this Registration Statement)..................................... 10.32** -- Company Agreement between The Societe National de Financement, GTS S.A.M. and The Principality of Monaco, dated September 27, 1995.................................... 10.33** -- Joint Venture Agreement between SFMT-Hungaro Inc. and Montana Holding Vagyonkezelo Kft., dated December 23, 1993........................................................ 10.34** -- Joint Venture and Shareholders' Agreement among Gerard Aircraft Sales and Leasing Company, SFMT-Hungaro Inc., and Microsystem Telecom Rt., dated August 5, 1994............... 10.35** -- Agreement on the Establishment of Limited Liability Company between SFMT-Czech, Inc. and B&H s.r.o., dated July 12, 1994........................................................ 10.36** -- Formation of the Equity Joint Venture between GTS and SSTIC, dated April 12, 1995........................................ 10.37** -- Contract to Establish the Sino-foreign Cooperative Joint Venture Beijing Tianmu Satellite Communications Technology Co., Ltd, amended, by and between China International Travel Service Telecom Co., Ltd. and American China Investment Corporation, dated March 27, 1996........................... 10.38** -- Joint Venture Contract between GTS TransPacific Ventures Limited and Shanghai Intelligence Engineering, Inc., dated March 28, 1996.............................................. 10.39** -- Agreement between Global TeleSystems Group, Inc. and Cesia S.A., dated June 21, 1997................................... 10.40** -- Consulting Agreement between SFMT, Inc. and Alan B. Slifka, dated March 1, 1994......................................... 10.41** -- Consulting Agreement between Global TeleSystems Group, Inc. and Bernard J. McFadden, dated August 15, 1996.............. 10.42** -- Consulting Agreement between CESIA S.A. and Hermes Europe Railtel B.V., dated June 20, 1997........................... 21.1+ -- List of Subsidiaries of the Registrant ..................... 23.1*** -- Consent of Shearman & Sterling (included in its opinion delivered under Exhibit No. 5.1) ........................... 23.2++ -- Consent of Ernst & Young (CIS) Ltd. ........................ 23.3++ -- Consent of Ernst & Young LLP................................ 24.1++ -- Powers of Attorney.......................................... 27.1+ -- Financial Data Schedule extracted from 12/31/97 audited financial statements........................................ 27.2++ -- Financial Data Schedule extracted from 3/31/98 unaudited financial statements........................................
- - - - --------------- * Filed herewith. ** Incorporated by reference to the corresponding exhibit to the Company's Registration Statement on Form S-1 (File No. 333-36555) filed on September 26, 1997. *** To be filed by amendment. + Incorporated by reference to the corresponding exhibit to the Company's Annual Report on Form 10-K for the year ended December 31, 1997. ++ Previously filed. -----END PRIVACY-ENHANCED MESSAGE-----