-----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, MM6zF434xB+bMnaYwJs9wOfezCGXk3BhTxDC5a0PtCllga5IRqX0hUi+TK0Q0OYo uU9iEmgPngB6TVs703Y9CQ== 0001005150-98-000377.txt : 19980420 0001005150-98-000377.hdr.sgml : 19980420 ACCESSION NUMBER: 0001005150-98-000377 CONFORMED SUBMISSION TYPE: 10-K/A PUBLIC DOCUMENT COUNT: 4 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980417 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: TEL SAVE HOLDINGS INC CENTRAL INDEX KEY: 0000948545 STANDARD INDUSTRIAL CLASSIFICATION: RADIO TELEPHONE COMMUNICATIONS [4812] IRS NUMBER: 232827736 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K/A SEC ACT: SEC FILE NUMBER: 000-26728 FILM NUMBER: 98595881 BUSINESS ADDRESS: STREET 1: 6805 ROUTE 202 CITY: NEW HOPE STATE: PA ZIP: 18938 BUSINESS PHONE: 2158621500 MAIL ADDRESS: STREET 1: 6805 RIYTE 202 CITY: NEW HOPE STATE: PA ZIP: 18938 10-K/A 1 FORM 10-K/A SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K/A Amendment No. 1 Annual Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the Year Ended December 31, 1997 Commission File No. 0 - 26728 TEL-SAVE HOLDINGS, INC. (Exact name of registrant as specified an its charter) DELAWARE 23-2827736 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 6805 ROUTE 202 NEW HOPE, PENNSYLVANIA 18938 (215) 862-1500 (Address, including zip code, and telephone number, including area code, of registrant's principal executive offices) Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of each exchange on which registered ------------------- ----------------------------------------- None Not applicable
Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, PAR VALUE $.01 PER SHARE Indicate by check mark whether the Registrant (1) has filed all documents and reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment of this Form 10-K. [X] The aggregate market value of voting stock held by non-affiliates of the registrant as of March 30, 1998 was approximately $895,030,756 based on the average of the high and low prices of the Common Stock on March 30, 1998 of $22.59 per share as reported on the Nasdaq National Market. As of March 30, 1998, the Registrant had outstanding 64,585,012 shares of its Common Stock, par value $.01 per share. TEL-SAVE HOLDINGS, INC. INDEX TO FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1997
ITEM PAGE NO. NO. - ---- ---- PART I 1. BUSINESS.................................................................................................. 1 2. PROPERTIES............................................................................................... 16 3. LEGAL PROCEEDINGS........................................................................................ 16 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...................................................... 16 PART II 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.................................... 19 6. SELECTED CONSOLIDATED FINANCIAL DATA..................................................................... 20 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.................... 21 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.............................................................. 26 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS AND FINANCIAL DISCLOSURE................................... 42 PART III 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT....................................................... 42 11 EXECUTIVE COMPENSATION................................................................................... 42 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT........................................... 42 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS........................................................... 42 PART IV 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.......................................... 43
i PART I ITEM 1. BUSINESS For the definition of certain terms used in this Form 10-K, see "Glossary." OVERVIEW Tel-Save Holdings, Inc. (the "Company") provides long distance services throughout the United States to small and medium-sized businesses, and to increasing numbers of residential customers as a result of the Company's recent online marketing efforts. The Company's long distance service offerings include outbound service, inbound toll-free 800 service, and dedicated private line services for data. Until 1997, the Company operated primarily as a switchless, nonfacilities-based reseller of AT&T long distance services to small and medium-sized businesses. By purchasing large usage volumes from AT&T pursuant to contract tariffs, the Company has been and continues to be able to procure substantial discounts and offer low cost, high quality long distance services to its customers at rates generally more favorable than those offered directly by AT&T. In order to reduce its dependence on AT&T contract tariffs and increase its growth opportunities, the Company has deployed its own nationwide telecommunications network, One Better Net ("OBN"). OBN features five Company-owned, AT&T (now Lucent Technologies, Inc., hereinafter "Lucent") manufactured 5ESS-2000 switches connected with AT&T digital transmission facilities. OBN's reduced cost structure allows the Company to offer rates competitive with those of non-AT&T resellers while continuing to provide the quality of AT&T (now Lucent) manufactured switches and AT&T-provided transmission facilities and billing services. OBN allows the Company to pursue the non-AT&T based switchless resale market, which represents the majority of the switchless resale long distance market. In February 1997, as part of its efforts to expand its business by taking advantage of online marketing, billing and customer service, the Company entered into a Telecommunications Marketing Agreement (the "AOL Agreement") with America Online, Inc. ("AOL"), under which the Company provides long distance telecommunications services marketed by AOL to the subscribers to AOL's online network. The Company's services were launched on the AOL online network on October 9, 1997 on a limited basis and the general public promotion of the service began at the end of 1997. The AOL Agreement has an initial term of three years and can be extended by AOL on an annual basis thereafter. The Company's strategy for expanding its business is principally to target new retail customers through the Company's online marketing, expanded services to be offered to the Company's online customer base, local service and dial around long distance service. The Company also intends to attract new partitions and support existing partitions, to grow through acquisitions and strategic partnerships and to expand into the college and university market. The Company will approach online customers through the AOL Agreement and similar opportunities, such as the Company's recently announced arrangement with CompuServe Interactive, Inc. ("CompuServe") pursuant to which the Company will provide long distance telecommunications services to be marketed by CompuServe to its online network subscribers. The Company intends to attract new partitions and support existing partitions by, among other things, continuing its current practice of offering advances to new partitions to enable such partitions to pay outstanding balances due to their existing long distance providers in order for such partitions to transfer their end users to the Company's service, and to existing partitions to support their marketing efforts. The Company regularly evaluates potential acquisition candidates and strategic partners with which the Company could achieve its expansion goals. The Company, with the recent completion of the acquisition of Compco, Inc. ("Compco"), intends to leverage the relationships that Compco has as a leading provider of communications software in the college and university marketplace by offering bundled communications services to the college and university market. The Company has also recently gained certification in many states to sell local services, although it does not yet offer such services. Although the Company expects to expand its business through these and other opportunities, in view of the intense competition in this industry and other contingencies, there can be no assurance that the Company will be able to expand its business. Tel-Save, Inc., the Company's predecessor ("Predecessor Corporation") and now its principal operating subsidiary, was incorporated in Pennsylvania in May 1989. The Company was incorporated in Delaware in June 1995. The address of the Company's principal executive offices is 6805 Route 202, New Hope, Pennsylvania 18938, and its telephone number is (215) 1 862-1500. Unless the context otherwise requires, the "Company" or "Tel-Save" includes the Predecessor Corporation and the Company's other subsidiaries. DEVELOPMENT OF THE COMPANY The Company was formed to capitalize on the Federal Communications Commission ("FCC") mandate allowing the resale of AT&T services. The Company initially marketed AT&T's multi-location calling plan ("MLCP"), which provided incremental discounts earned by inclusion of the usage volume of diverse end user locations under a single service plan. The Company was successful in marketing MLCP, but realized that there were significant barriers to growth associated with the product, primarily the lack of reporting from AT&T, product inflexibility and the lack of control over end user accounts. In late 1989, the Company successfully obtained an additional AT&T service plan developed by AT&T and marketed as Software Defined Network Service ("SDN"), an AT&T product designed for larger business customers. SDN provided the Company with higher margins, network controls, advanced features and the ability to rebill its end users through AT&T and AT&T's College and University Systems ("ACUS"), thus enabling the Company to have more control over the end user account. As a result of SDN, the Company began to offer services on a wholesale basis through partitions. The Company thereby outsourced its marketing and end user service expenses to partitions, allowing it to focus on managing the AT&T relationship and to further develop its billing and information systems. In December 1992, the Company obtained the first contract tariff created by AT&T specifically for the Company. The contract tariff provided the Company with significant additional price advantages at stabilized rates and the ability to absorb the traffic of competitors' plans into the contract tariff. The Company subsequently obtained other contract tariffs, which also provide AT&T inbound 800 services and AT&T private line services, in order to diversify its service offerings. This in turn enabled the Company to increase the number of its partitions and end users. Prior to 1997, the Company operated primarily as a "switchless," nonfacilities-based reseller of AT&T long distance services. The Company offered, and continues to offer, its partitions and end users nationwide access to AT&T long distance network services through contract tariffs, including outbound long distance, 800 service and private line service. Outbound long distance service accommodates voice, data and video transmissions. The Company's 800 service is currently provided by reselling AT&T's 800 Service (Readyline, Megacom 800, etc.), which is AT&T's inbound, toll-free (recipient of the call pays the charges) long distance service. The Company's private line service is currently provided by reselling AT&T Private Line Service, which includes dedicated transmission lines connecting pairs of sites. The Company successfully established its position as a switchless reseller of AT&T long distance services as a result of its ability to negotiate with and obtain favorable contract tariffs from AT&T, manage and distribute data, bill accurately and provide partition support. Contract tariff subscriptions do not impose restrictions on the rates the Company may charge its partitions and end users. By purchasing large usage volumes from AT&T pursuant to such contract tariffs, the Company is able to procure substantial volume discounts and offer long distance services to its partitions and end users at rates generally more favorable than those offered directly by AT&T. With its information systems, the Company is able to manage and distribute to partitions information such as data about end user usage and payment history. In order to reduce its dependence on the AT&T contract tariffs and increase its growth opportunities, the Company developed its own network, OBN. Since 1996, the Company has deployed a total of five 5ESS-2000 switches, in Chicago, Dallas, Jacksonville, New York and San Francisco. As of March 30, 1998, the Company has provisioned approximately one million lines (representing approximately 71% of the total lines then using the Company's services) to OBN and most of the Company's new outbound lines are now being provisioned to OBN. OBN enables the Company to offer its end users and partitions more competitive rates than in the past and to improve customer provisioning, as well as to improve reporting to existing and new partitions. RECENT DEVELOPMENTS The Company believes that eventually it must either be, or become part of, a larger organization in order to succeed in the long term. To that end, the Company has been exploring the possibility of being acquired by larger entities that have expressed interest in the Company. The Company has previously disclosed that it has had discussions with potential suitors and that the Company has retained Salomon Smith Barney to advise the Company on any proposed acquisition of the Company. 2 There can be no assurance that any transaction will take place and no prediction can be made as to the price at which an acquisition of the Company, if any, may be consummated or whether any such transaction would be for cash or securities. Moreover, the Company has not made any determination to be acquired, and may remain independent. The Company does not plan to make any further public statements regarding the possible acquisition of the Company until it either has reached a definitive agreement regarding such a transaction, or has determined not to continue to pursue such possibility. At the same time, the Company continues to seek and consider potential acquisitions and strategic partnerships. On February 3, 1998, the Company completed the acquisition of Symetrics Industries, Inc. ("Symetrics"), a Florida corporation, for approximately $25 million in cash, plus assumed liabilities. Symetrics designs, develops and manufactures electronic systems, system components and related software for defense-related products and for telecommunications applications. In the telecommunications field, Symetrics has developed hardware and software to make telephone switching more efficient for small telephone networks, such as in college dormitories and apartments. The equipment routes room-to-room calls itself and sends only billing information back to the service provider's switch, freeing space on the system to handle more calls. The Company intends to dispose of Symetrics' assets related to non-telecommunications businesses, although there can be no assurance that any such transaction will be consummated. The Company has announced that its Board has authorized the repurchase from time to time of up to eight million shares of its Common Stock. It is anticipated that the repurchased shares will be held in treasury for issuance upon exercise of outstanding options and warrants and upon conversion, if any, of convertible notes, and for other general corporate purposes. In connection with the AOL Agreement, the Company issued two warrants to AOL to purchase shares of the Company's Common Stock, including a warrant to purchase 5 million shares at an exercise price of $15.50 per share, which warrant became fully vested on February 22, 1998. On March 31, 1998, AOL exercised this warrant as to 1 million shares of Company Common Stock on a net issuance basis and the Company repurchased from AOL all of the 380,624 shares issued upon such net issuance exercise for $23 1/4 per share. In connection with such repurchase, AOL agreed not to dispose of any shares of the Company's Common Stock acquired by AOL under any of these warrants until March 30, 1999. SALES AND MARKETING Online The Company launched a major new initiative for the marketing and provisioning of its telecommunication services online when, in February 1997, it entered into the AOL Agreement, under which the Company provides long distance telecommunications services that are marketed by AOL to the subscribers of AOL's online network. The AOL Agreement has an initial term of three years and can be extended by AOL on an annual basis thereafter. Under the AOL Agreement, the Company also has certain rights to offer, on a comparable basis, local and wireless telecommunications services when available. The Company's services, which include provision for online sign-up, call detail and reports and credit card payment, were launched on the AOL online network on October 9, 1997 on a limited basis, and general public promotion of the services began at the end of 1997. AOL subscribers who sign-up for the telecommunications services are customers of the Company, as the carrier providing such services. Under the AOL Agreement, AOL provides each month, over the term of the Agreement, certain minimum amounts of online advertising and promotion of the services and provides all of its subscribers with access to a dedicated Company service area online. Effective January 25, 1998, the Company and AOL entered into an amendment (the "AOL Amendment") to the AOL Agreement to provide for the acceleration of some of AOL's online advertising and promotion obligations under the AOL Agreement into a special promotional period (the "Special Promotional Period") during the latter part of the first quarter of 1998, as well as to provide for offline marketing through other media, such as directed mail promotions and print and radio promotions of the services, the costs of which would be borne by the Company. The Company made an initial payment of $100 million to AOL at the signing of the AOL Agreement and agreed to provide marketing payments to AOL based on a percentage of the Company's profits from the services (between 50% and 70% depending on the level of revenues from the services). The AOL Agreement provides that $43 million of the initial $100 million payment will be offset and recoverable by the Company through reduction of such profit-based marketing payments during the initial term of the AOL Agreement or, subject to certain monthly reductions of the amount thereof, directly by AOL upon certain earlier terminations of the AOL Agreement. The $57 million balance of the initial payment is solely recoverable by offset against a percentage of such profit-based marketing payments made after the first five years of the AOL Agreement (when extended beyond the initial term) and by offset against a percentage of AOL's share of the profits from the services after termination or expiration of the AOL Agreement. Any portion of the $43 million not previously repaid or reduced in amount would be added to the $57 million and would be recoverable similarly. Also under the AOL Agreement, the Company issued to AOL at signing two warrants to purchase shares of the Company Common Stock at a premium over the market value of such stock on the issuance date. One warrant is for 5 million shares, at an exercise price of $15.50 per share, one-half of which shares vested on October 9, 1997 when the Company's service was launched on the AOL online network in accordance with the AOL Agreement and the balance of which vested on February 22, 1998, the first anniversary of issuance. See "RECENT DEVELOPMENTS." The other warrant (the "Second Warrant") is for up to 7 million shares, at an exercise price of $14.00 per share, which vest, commencing December 31, 1997, based on the number of subscribers to the services and would vest fully if there are at least 3.5 million such subscribers at any one time. The Company also agreed to issue to AOL an additional warrant to purchase 1 million shares of the Company Common Stock, at market value at the time of issuance, upon each of the first two annual 3 extensions by AOL of the term of the AOL Agreement, which warrants also will vest based on the number of subscribers to the services. Under the AOL Amendment, the Company agreed to pay to AOL an additional bonus fee for each new subscriber (up to an aggregate of 1,000,000 subscribers) to the Company's services under the AOL Agreement who subscribed during the Special Promotional Period or after this Period in response to AOL telemarketing efforts and to direct mail solicitations to AOL subscribers and who continued as a customer of the Company services for at least 30 days. Such bonus payments also would continue as to additional qualifying subscribers who subscribe in response to certain AOL telemarketing efforts. Under the AOL Amendment, the Company guaranteed, with respect to these bonus payments, that it would pay to AOL, as of April 3, 1998, an amount (the "Excess Amount") equal to $10 million reduced by the amount of bonus fees paid to AOL before such date and by an amount based on the number of shares of Company Common Stock that vested under the Second Warrant during the Special Promotional Period. Any Excess Amount would be credited against, and solely recoverable from, any bonus fees subsequently payable to AOL. The Company also entered into a Telecommunications Marketing Agreement, dated as of February 6, 1998 (the "CompuServe Agreement"), with CompuServe, a wholly owned subsidiary of AOL, under which the Company will provide long distance telecommunications services to be marketed by CompuServe to all of the subscribers of CompuServe's online network in substantially the same manner as under the AOL Agreement. The CompuServe Agreement has an initial term of three years that can be extended by CompuServe on an annual basis thereafter and is also subject to earlier termination by CompuServe if the AOL Agreement shall have terminated upon payment of $10 million to the Company. As with the AOL Agreement, the Company also has certain rights under the CompuServe Agreement to offer, on a comparable basis, local and wireless telecommunications services when available. The Company anticipates that the services will be offered generally to CompuServe subscribers in the third quarter of 1998. Under the CompuServe Agreement, which is similar to the AOL Agreement, the Company services will include provision for online sign-up, call detail and reports and credit card payment. CompuServe will provide each month, over the term of the CompuServe Agreement, certain minimum amounts of online and offline advertising and promotion of the Company services and provide all of its subscribers with access to a dedicated Company service area online. CompuServe subscribers who sign up for the telecommunications services will be customers of the Company, as the carrier providing such services. The Company will provide marketing payments to CompuServe based on a percentage of the Company's profits from the services under the CompuServe Agreement (between 50% and 70% depending on the level of revenues from such services). Under the CompuServe Agreement, the Company made an initial payment of $3,500,000 as an advance against profit-sharing payments to be made to CompuServe; the Company will make an additional, non-refundable payment of $3,500,000 (the "Base Payment") on the date that the Company's services first are made generally available to substantially all of the CompuServe subscribers (but, generally, not later than November 1, 1998); and, 18 months after the date such services are first made generally available and if the CompuServe Agreement has not earlier terminated, the Company will make a further advance (the "Midterm Advance") of an amount up to $7,000,000 and based on the then number of subscribers to the CompuServe service. The CompuServe Agreement provides that the initial $3.5 million advance and the Midterm Advance will be offset and recoverable by the Company through reduction of the profit-based marketing payments to be made to CompuServe during the initial term of the CompuServe Agreement or, subject to certain monthly reductions of the amount thereof, directly by CompuServe upon certain earlier terminations of the CompuServe Agreement. The Base Payment is generally not recoverable by the Company. Under the CompuServe Agreement, the Company also agreed to pay to CompuServe a $10 fee for each new subscriber to the Company's services under the CompuServe Agreement who subscribes within the first six months after the date that the Company's services first are made generally available to substantially all of the CompuServe subscribers and who continues as a subscriber for at least 60 days, which fees also are not recoverable by the Company. Under the terms of the AOL Amendment, subscribers to the Company services under the CompuServe Agreement will be counted as subscribers for purposes of vesting under the AOL Supplemental Warrant. In connection with the AOL Agreement, the Company, and AOL jointly developed the online marketing and advertising for the services, and the Company and CompuServe will jointly develop the marketing and advertising under the CompuServe Agreement. The Company provides online customer service as well as inbound calling customer service to the AOL member base in connection with the services and will do so for the Compuserve member base. Customer service representatives for these services are located in the Company's Clearwater, Florida facility. The Company anticipates that it will incur expenses for the promotion of the services under the AOL Agreement and for the start-up and development of the services contemplated in the CompuServe Agreement primarily during the first half of 1998, including expenses for the continued expansion of the Clearwater operation, for software programming and for software and hardware additions to the Company's network, OBN, to expand its capacity for the traffic. The profitability of the AOL and CompuServe Agreements for the Company depends on the Company's ability to continue to develop (and, in the case of CompuServe, to develop) and to maintain online ordering, call detail, billing and customer services for the AOL and CompuServe members, which will require, among other things, the ability to identify and employ sufficient personnel qualified to provide the necessary programming; the ability of the Company and AOL and CompuServe to work together effectively to 4 develop jointly the marketing contemplated by the AOL and CompuServe Agreements; a rapid response rate to online promotions to AOL's and CompuServe's online subscribers, most of whom are expected to be potential residential customers rather than business customers to which Tel-Save has marketed historically; the Company's ability to expand OBN to accommodate increased traffic levels; and, in the case of CompuServe, CompuServe's ability to maintain its subscriber base in light of its recently completed acquisition by AOL. Since the $100 million initial payment under the AOL Agreement and up to $10.5 million of the payments that may be made by the Company under the CompuServe Agreement are recoverable only through the profits from the services under the respective Agreements, to the extent that the respective Agreement is unsuccessful, such respective amounts are subject to potential non-recovery or limited recovery by the Company. The Company currently estimates that between 2% and 6% of AOL's customers will need to sign up for the Company's long distance service in order for the Company to break even on its investment in the AOL Agreement. Partitions Prior to 1997, the Company primarily marketed its services to small and medium-sized business end users (i.e., generally businesses with fewer than 200 employees) throughout the United States through independent long distance and marketing companies known as "partitions." While the Company explored the use of direct marketing in 1997, it has determined (as described below) to continue to market its services to small and medium sized business end users primarily through partitions. Partitions resell and market the Company's products, allowing the Company to minimize its marketing and end user overhead. Partitions offer end users a variety of services and rates. As compensation for their services, partitions generally receive the difference between the amount received from end users and the amount charged by the Company to the partition for providing such services. The Company offers customer service to end users, including end users of certain partitions. Customer service representatives are located in the Company's facilities in Clearwater, Florida and New Hope, Pennsylvania. A substantial number of the Company's partitions have executed partition agreements with the Company pursuant to which the Company agrees to provide services utilizing the AT&T network service or OBN and to arrange for end user billing services at agreed upon prices or discounts. The Company requires that the partitions adhere to certain Company established guidelines in marketing the Company's services and comply with federal and state regulations. These requirements include certain representations by each organization that it is acting as an independent contractor with regard to the resale of the Company's services, and not as a joint venture partner, agent or employee of the Company, along with provisions for the proper completion of forms and other sales procedures. In addition, payments for long distance services made by end users are either paid directly into a lock-box controlled by the Company or are made to the end-user's local exchage carrier ("LEC"), which payments are then forwarded by a third-party billing company to the Company. The Company's partition agreements typically run for three years or for the term of the applicable tariffs, whichever is less. The partitions generally make no minimum use or revenue commitments to the Company under these agreements with respect to the resale of services. The agreements also are generally non-exclusive. If the Company were to lose access to services on the AT&T network or billing services or experience difficulties with OBN, the Company's agreements with partitions could be adversely affected. The Company intends to continue to promote increased marketing activities of certain of its partitions through advances collateralized by assets of such partitions. In return for providing such marketing advances, the Company seeks long-term arrangements with such partitions. In 1997, the Company entered into long term arrangements with several existing and new partitions. One partition, Group Long Distance, Inc., accounted for approximately 13% of the Company's sales in 1997; however, the Company does not expect that any partition will account for 10% or more of the Company's sales in 1998. In the event that any of the partitions, and particularly the partition specifically noted above, were to cease doing business with the Company, the financial condition or results of operations of the Company could be materially adversely affected. The Company believes that the discounts it offers partitions and end users using OBN, together with the functionality and quality of OBN and the accuracy of the billing services used, will enable it to continue to attract current and future partitions to OBN. The Company will continue its policy of advancing funds to most partitions to support their marketing efforts. Historically, partitions of the Company have continued to do business under their partition agreements following changes in the Company's service offerings. Current marketing practices, including the methods and means to convert a customer's long distance telephone service from one carrier to another, have recently been subject to increased regulatory review at both the federal and state levels. See "REGULATION". This increased regulatory review could affect the current business of existing partitions and also could affect possible future acquisitions of new business from new partitions or other resellers. Provisions in the Company's partition agreements mandate compliance by the partitions with applicable state and federal regulations. A partition's failure to comply with applicable state and federal regulations could have an adverse effect on the Company. Such a failure could result in state and 5 federal authorities imposing sanctions on a partition (such as restrictions on the partition's business practices, loss of its right to do business, or fines or forfeitures) that would hinder the partition's ability to resell the Company's services or raise its costs of doing so. Such sanctions also could make it difficult for the Company to engage in an asset sale, merger, or other transaction with the partition, and might impair any loans that the partition has outstanding from the Company. State or federal authorities also might attempt to hold the Company responsible for the partition's misconduct. Because the Company's partitions are independent carriers and marketing companies, the Company is unable to control such partitions' activities. The Company is also unable to predict the extent of its partitions' compliance with applicable regulations or the effect of such increased regulatory review. The Company's partitions that resell AT&T long distance service are under a contractual obligation to the Company to comply with AT&T's guidelines on the use of the AT&T name and logo in connection with their resale of AT&T long distance service. AT&T recently announced that it intends to enforce those guidelines with renewed vigor. A partition's failure to comply with AT&T's guidelines could have an adverse effect not only on the partition but also on the Company, which might be sued by AT&T or be subject to increased rates or loss of service from AT&T. Colleges and Universities In late November 1997, the Company acquired Compco, Inc., a provider of communications software for the college and university marketplace, for $15 million in cash and stock. Compco primarily licenses proprietary communications software to colleges and universities. This software assists the institution in its management of the billing, services and facilities related to its telecommunications network. In addition to the licensing of its telemanagement software, Compco also offers and provides billing services and training to such institutions. Compco's customers include approximately 100 academic institutions in the country. The Company intends to leverage the relationships Compco has with these institutions by offering bundled communications services to the college and university market. Direct Telemarketing In 1996, Tel-Save began to telemarket its long distance service directly to small and medium-sized businesses and, in December 1996, acquired substantially all of the assets, and hired substantially all of the employees, of American Business Alliance, Inc. ("ABA"), a switchless reseller of long distance services and a partition of Tel-Save, which acquisition significantly increased Tel-Save's direct telemarketing capabilities. In the second quarter of 1997, Tel-Save determined to change its business practice and de-emphasize the use of direct telemarketing to solicit customers for Tel-Save as the carrier, and, in October 1997, Tel-Save decided to discontinue its internal telemarketing operations, which were primarily conducted through the ABA business that it had acquired. Both federal and state officials are tightening the rules governing the telemarketing of telecommunications services and the requirements imposed on carriers acquiring customers in that manner. See "REGULATION". Customer complaints of unauthorized conversion or "slamming" are widespread in the long distance industry and are beginning to occur with respect to newly competitive local services. While Tel-Save's discontinuance of its internal telemarketing operations should reduce its exposure to customer complaints and federal or state enforcement actions with respect to telemarketing practices, certain state officials have made inquiries with respect to the marketing of Tel-Save's services and there is the risk of enforcement actions by virtue of its prior telemarketing efforts and its ongoing support of its customer/partitions. Some direct telemarketing is being used in connection with the AOL and CompuServe Agreements. INFORMATION AND BILLING SERVICES The Company has developed and will seek to continue to develop and to improve systems for customer care and billing services, including online sign-up, call detail and billing reports and credit card payments. The Company is currently implementing these technologies in connection with the AOL Agreement. Any delay or difficulties in developing these systems or in hiring personnel could adversely affect the success of this service offering and the offering to AOL subscribers. The Company also utilizes the billing services of AT&T and ACUS, a wholly owned strategic business unit of AT&T, as well as the billing services of the LECs. Detailed call information on the usage of each end user is produced by AT&T (in the case of the switchless resale business) and by the Company (in the case of OBN business). In each case, AT&T or the LEC then processes the information and provides billing information to the Company and bills the end users. In addition, the Company has developed its own information systems in order to have its own billing capacity, although the Company has not provided such direct billing services to end users in the past except in connection with the online billing area under the AOL Agreement. The Company provides to each partition computerized management systems that control order processing, accounts receivable, billing and status information in a streamlined fashion between the Company and its partitions. Furthermore, when applicable, the systems interface with the AT&T Provisioning System and ACUS for order processing and billing services, 6 respectively. Enhancements and additional features are provided as needed. Electronic processing and feature activation are designed to maintain the Company's goal of minimizing overhead. The information functions of the system are designed to provide easy access to all information about an end user, including volume and patterns of use, which will help the Company and partitions identify value-added services that might be well suited for that end user. The Company also expects to use such information to identify emerging end user trends and respond with services to meet end users' changing needs. Such information also allows the Company and its partitions to identify unusual or declining use by an individual end user, which may indicate fraud or that an end user is switching its service to a competitor. Recently released FCC rules, however, may limit the Company's use of such customer proprietary network information. See "REGULATION." ONE BETTER NET ("OBN") In order to reduce its dependence on AT&T contract tariffs and to increase its growth opportunities, the Company developed its own telecommunications network, OBN, which utilizes AT&T (now Lucent) manufactured switches owned by the Company in conjunction with AT&T-provided lines and digital cross-connect equipment (herein referred to as "transmission facilities") and AT&T-provided billing systems that the Company uses pursuant to agreements with AT&T and ACUS. OBN includes five AT&T (now Lucent) 5ESS-2000 switches, which are generally considered the most reliable switches in the telecommunications industry. The Company was one of the first installation sites for AT&T's 5ESS-2000 switching equipment featuring the new Digital Networking Unit--SONET technology, a switching interface designed to increase the reliability of the 5ESS-2000 and to provide much greater capacity in a significantly smaller footprint. OBN allows the Company to offer long distance services directly to its end users and partitions throughout the continental United States at rates that are competitive with or below those offered by the major long distance providers. OBN also allows the Company to control provisioning of end user accounts. The Company's current contract tariffs under which it resells AT&T services require the Company to pay one all-inclusive "bundled" charge to AT&T for the delivery of services, including switching and transmission services and the payment of LEC access fees. As a result of the deployment of OBN, for customers provisioned on OBN, the Company pays "unbundled" charges consisting of charges paid directly to the LECs for access charges and, under AT&T contract tariffs, charges paid to AT&T for use of its network transmission facilities. The Company pays AT&T "bundled" charges for use of its international facilities to handle the international portion of a call on OBN. The total cost per call to the Company for the LEC access fees, the charges for use of AT&T's transmission facilities and the overhead cost for calls using OBN is less than the per call cost incurred by the Company as a switchless reseller paying "bundled" charges to AT&T. LEC access fees represent a substantial portion of the total cost of providing long distance services. As a result of the Telecommunications Act, it is generally expected that the entry over time of competitors into LEC markets will result in lowering of access fees, but there is no assurance that this will occur. To the extent it does occur, the Company, by using OBN, will receive the benefit of any future reduction in LEC access fees, which it would not automatically receive under contract tariffs. See "REGULATION" for a discussion of universal service contributions imposed on carriers, which may offset some or all of the savings from lower access charges. In October 1996, the Company subscribed to a new AT&T contract tariff, which was amended in December 1996 and May 1997 and which permits the Company to continue to resell through mid-1998 AT&T long distance services, including AT&T SDN service and other services, at rates that are more favorable to the Company than prior tariffs. As a result, the Company decided only to provision new end users on OBN and to leave existing end users on AT&T service. The 1996 AT&T contract has enabled the Company to earn higher margins on existing traffic and minimize possible attrition that might result from moving existing end users from the AT&T network to OBN. This has permitted a more gradual introduction of OBN, which has reduced the expense of providing the capacity required in a more rapid phase-in of OBN and lessened the impact of any technical difficulties during the phase-in of OBN. See "AT&T CONTRACT TARIFFS." While the Company expects to continue to offer private line service as a reseller, in 1998 the Company also will begin to offer private line service using OBN to new and existing customers. In order for the Company to provide service over OBN, the Company has installed and operates, and is responsible for the maintenance of, its own switching equipment. The Company also has installed lines to connect its OBN switches to LEC 7 switches and is responsible for maintaining these lines. The Company entered into a contract with GTE with respect to the monitoring, servicing and maintenance of the switching equipment purchased from AT&T (now Lucent). Additional management personnel and information systems are required to support OBN, the costs of which have increased the Company's overhead. Moreover, operation as a switch-based provider subjects the Company to risk of significant interruption in the provision of services on OBN in the event of damage to the Company's facilities (switching equipment or connections to AT&T transmission facilities) such as could be caused by fire or natural disaster. Such interruption could have a material adverse impact on the Company's financial condition and results of operations. The Company began testing new customer calls over OBN in the third quarter of 1996. In the fourth quarter of 1996, the Company began provisioning on a test basis new customer orders on OBN. In early 1997, the Company deployed OBN. Of the over 1.4 million lines using the Company's services, OBN currently provides services to approximately one million lines and most of the Company's new outbound lines are now being provisioned to OBN. The Company has continued to expand the capacity of OBN to meet its increased demands and believes that such capacity may be further expanded at reasonable cost to meet the Company's needs in the foreseeable future, including under the AOL and CompuServe Agreements. Separately, the Company is operating under an interim agreement with AT&T to purchase its Carrier Solutions Platform ("CSP") service, subject to either party's right to terminate such agreement. The Company is negotiating a long term agreement with AT&T for such service. The CSP service provides OBN with significant additional capacity and enables the Company to accommodate large numbers of additional customers on OBN by handling their peak load or overflow traffic. AT&T CONTRACT TARIFFS The Company historically has obtained services from AT&T through contract tariffs and has been able to obtain the services it seeks and to do so at increasingly favorable contract tariff rates. The deployment of OBN decreases the Company's dependence on AT&T contract tariffs or other service arrangements. To the extent the Company will need future service from AT&T, there is no guarantee the Company will be able to obtain favorable contract tariffs or other service arrangements, although the Company has been successful in the past in obtaining such arrangements. In October 1996, the Company subscribed to a new AT&T contract tariff ("Contract Tariff No. 5776"), which was amended in December 1996 and May 1997 and which permits the Company to continue to resell AT&T long distance services, including AT&T-SDN service, through mid-1998 and also includes, through late 2000, other AT&T services (such as international long distance, inbound and outbound services) that will be used in the Company's network, OBN. The rates that the Company pays under Contract Tariff No. 5776 are more favorable to the Company than under previous tariffs. During its term, Contract Tariff No. 5776 enables the Company to minimize possible attrition that might result from moving existing end users from the AT&T network to OBN. Contract Tariff No. 5776 also permitted a more gradual introduction of OBN, which has reduced the expense of providing the capacity required in a more rapid phase-in of OBN and lessened the impact of any technical difficulties during the phase-in of OBN. Contract Tariff No. 5776 commits the Company to purchase $285 million of service from AT&T over its 4 year term, including at least $1 million per month of international service. The Company can terminate Contract Tariff No. 5776 without liability to AT&T effective April 30, 1998 if the Company has generated at least $105 million in usage charges, including at least $15 million in international usage charges; the Company had exceeded these thresholds by the end of 1997. If minimum usage requirements are not met, the Company is obligated to pay shortfall fees to AT&T based on a percentage of the difference between the minimum requirement and the actual billed usage. In addition, if the contract tariffs with AT&T are terminated prior to the end of the contract tariff term, either by the Company or by AT&T for non-payment, the Company may be liable for "termination with liability" or "termination charges" and subject to material monetary 8 penalties. The Company also may discontinue Contract Tariff No. 5776 without liability if, prior to April 30, 1998, the Company and AT&T enter into a new contract tariff or another contract with a revenue commitment of at least $7.5 million per month and a term of at least the difference between 18 months and the number of months that the Company subscribed to the contract tariff, provided that the Company must purchase or pay for AT&T services under the contract tariff of at least $6.7 million per month for the months prior to such termination, including $1 million per month of international usage. The Company is considering terminating Contract Tariff No. 5776 as of April 30, 1998, since, based on its traffic growth to date, the Company has a one-time opportunity to do so without termination liability and the Company believes that it will be able to replace the services thereunder on more favorable terms. Such termination would free the Company from the minimum usage and other financial obligations to AT&T under that contract tariff. It also, however, would require the Company to make other arrangements to obtain critical services for the Company's operation and provision of service to its customers with AT&T or with another carrier, either another large customer of AT&T or another facilities-based carrier. The Company is in the process of negotiating a new Master Carrier Agreement (MCA) with AT&T which would replace all of the Company's existing tariffs with AT&T (including the interim agreement for provision of CSP services) and is expected to include certain minimum usage commitments. The Company has also engaged in discussions with other carriers to explore alternative arrangements. There can be no assurance that the Company will be successful in these negotiations with AT&T or other carriers. Should the Company terminate Contract Tariff No. 5776 and not reach a new agreement with AT&T by such termination, the Company could be forced to move its traffic to other AT&T tariffs at rates significantly higher than the Company is paying today. If the Company concludes an agreement with another carrier, the rates could be higher or lower than the Company is paying today. If the other carrier provides these services to the Company over its own network, end-user customers of the Company who want to keep their service on an AT&T network-based carrier, and partitions who want to remain on an AT&T network-based carrier, may choose to terminate their service with the Company. In that circumstance, the Company may also be obliged to notify customers of a change in underlying facilities-based carrier and the Company's billing arrangements with AT&T and ACUS would have to be replaced. As a nondominant carrier, AT&T is subject to the same regulations as other long distance service providers. AT&T remains subject to Title II of the Communications Act (47 U.S.C. Section 151, et seq.) and is required to offer service under rates, terms and conditions that are just, reasonable and not unreasonably discriminatory. AT&T is also subject to the FCC's complaint process and is required to file tariffs, though under streamlined procedures. In addition, AT&T is also required to give notice to the FCC and to affected customers prior to discontinuing, reducing, or impairing any services. COMPETITION The long distance telecommunications industry is highly competitive and affected by the introduction of new services by, and the market activities of, major industry participants. Competition in the long distance business is based upon pricing, customer service, billing services and perceived quality. The Company competes against various national and regional long distance carriers composed of both facilities-based providers and switchless resellers offering essentially the same services as the Company. Several of the Company's competitors are substantially larger and have greater financial, technical and marketing resources. Although the Company believes it has the human and technical resources to pursue its strategy and compete effectively in this competitive environment, its success will depend upon its continued ability to provide profitably high quality, high value services at prices generally competitive with, or lower than, those charged by its competitors. End users are not obligated to purchase any minimum usage amount and can discontinue service, without penalty, at any time. There can be no assurance that end users will continue to buy their long distance telephone service through the Company or through partitions that purchase service from the Company. In the event that a significant portion of the Company's end users decides to purchase long distance service from another long distance service provider, there can be no assurance that the Company will be able to replace its end user base from other sources. A high level of attrition is inherent in the long distance industry, and the Company's revenues are affected by such attrition. Attrition is attributable to a variety of factors, including termination of customers by the Company for non-payment and the initiatives of existing and new competitors as they engage in, among other things, national advertising campaigns, telemarketing programs and cash payments and other incentives. AT&T and other carriers have announced new price plans aimed at residential customers (the Company's primary target audience under the AOL Agreement) with significantly simplified rate structures, which may have the impact of lowering overall long distance prices. There can be no assurance that AT&T or other carriers will not make similar offerings available to 9 the small to medium-sized businesses that the Company also serves. Additional pricing pressure may come from a new technology, Internet telephony, which uses packet switching to transmit voice communications at a cost today apparently below that of traditional circuit-switched long distance service. While Internet telephony is not yet available in all areas, requires the dialing of additional digits, and produces sound quality inferior to traditional long distance service, it could eventually be perceived as a substitute for traditional long distance service, and put additional downward pricing pressure on long distance rates. Although OBN makes the Company more price competitive, a reduction in long distance prices still may have a material adverse impact on the Company's profitability. One of the Company's principal competitors, AT&T, is also a major supplier of services to the Company. The Company links its switching equipment with transmission facilities and services purchased or leased from AT&T and resells services obtained from AT&T. The Company also utilizes AT&T and ACUS to provide billing services. There can be no assurance that either AT&T or ACUS will continue to offer services to the Company at competitive rates or on attractive terms. The Telecommunications Act of 1996 (the "Telecommunications Act") was intended to introduce more competition to U.S. telecommunications markets. The legislation opens the local services market by requiring LECs to permit interconnection to their networks and establishing, among other things, LEC obligations with respect to access, resale, number portability, dialing parity, access to rights-of-way, and mutual compensation. The legislation also codifies the LECs' equal access and nondiscrimination obligations and preempts most inconsistent state regulation. The Company in the future may take advantage of the opportunities provided by the Telecommunications Act for competition in the local services market by reselling local services. The Telecommunications Act also was intended to increase competition in the market for long distance services by overturning the prohibition in the Consent Decree on RBOC provision of interLATA interexchange telecommunications services. See "INDUSTRY BACKGROUND." Under Section 271 of the Telecommunications Act, RBOCs may provide certain interLATA services immediately, and other interLATA services after state and federal regulators certify that the RBOCs have satisfied certain conditions. No RBOC has yet been certified by both state and federal regulators as having satisfied the conditions for provision of all interLATA services. However, the FCC recently has indicated that it will work more cooperatively with the RBOCs in helping them to satisfy the conditions necessary for certification. Several members of Congress also have expressed dissatisfaction over the slow pace of certification, and legislation is being considered to speed up RBOC entry into the long distance market. In addition, one federal district court has found that the restrictions on RBOC provision of interLATA services are an unconstitutional bill of attainder, but this decision has been stayed and is under appeal. RBOC entry into the long distance market means that the Company will face new competition from well-capitalized, well-known companies. The Telecommunications Act includes certain safeguards against anticompetitive conduct by the RBOCs in the provision of interLATA service. Anticompetitive conduct could result, among other things, from a RBOC's access to all subscribers on its existing network as well as its potentially lower costs related to the termination and origination of calls within its territory. It is impossible to predict whether such safeguards will be adequate to protect against anticompetitive conduct by the RBOCs and the impact that any anticompetitive conduct would have on the Company's business and prospects. Because of the name recognition that the RBOCs have in their existing markets and the established relationships that they have with their existing local service customers, and their ability to take advantage of those relationships, as well as the possibility of interpretations of the Telecommunications Act favorable to the RBOCs, it may be more difficult for other providers of long distance services, such as the Company, to compete to provide long distance services to RBOC customers. At the same time, as a result of the Telecommunications Act, RBOCs have become potential customers for the Company's long distance services. Consolidation and alliances across geographic regions (e.g., Bell Atlantic/Nynex and SBC Communications Inc./Pacific Telesis Group) and in the interexchange market (e.g., WorldCom/MCI domestically and France Telecom/Deutsche Telekom/Sprint internationally) and across industry segments (e.g., WorldCom/MFS/UUNet and AT&T/Teleport) may also intensify competition in the telecommunications market from significantly larger, well-capitalized carriers and materially adversely affect the position of the Company. Such consolidation and alliances are providing some of the Company's competitors with the capacity to offer a wide range of services, including local, long distance, and wireless telephone service, as well as Internet access. The Company, which currently offers only long distance service, may be at a competitive disadvantage because of its inability to offer so-called "one stop shopping." The Company's online marketing of long distance service is spawning imitators that are attempting to copy its major features, including online sign-up and billing and automatic payment through a credit card. The Company cannot predict what effect these competitors will have on its online marketing of long distance service. 10 INDUSTRY BACKGROUND The $82 billion U.S. long distance industry is dominated by the nation's four largest long distance providers, AT&T, MCI, Sprint and WorldCom, which together generated approximately 83% of the aggregate revenues of all U.S. long distance interexchange carriers in 1996. Other long distance companies, some with national capabilities, accounted for the remainder of the market. Based on published FCC estimates, toll service revenues of U.S. long distance interexchange carriers have grown from $38.8 billion in 1984 to $82 billion in 1996. The aggregate market share of all interexchange carriers other than AT&T, MCI and Sprint has grown from 2.6% in 1984 to 22.5% in 1996. During the same period, the market share of AT&T declined from 90.1% to 47.9%. Prior to the Telecommunications Act, the long distance telecommunications industry had been principally shaped by a court decree between AT&T and the United States Department of Justice, known as the Modification of Final Judgment (the "Consent Decree") that in 1984 required the divestiture by AT&T of its 22 Bell operating companies and divided the country into some 200 Local Access and Transport Areas ("LATAs"). The 22 operating companies, which were combined into the RBOCs, were given the right to provide local telephone service, local access service to long distance carriers and intraLATA toll service (service within LATAs), but were prohibited from providing interLATA service (service between LATAs). The right to provide interLATA service was maintained by AT&T and other carriers. To encourage the development of competition in the long distance market, the Consent Decree and the FCC required most LECs to provide all carriers with access to local exchange services that is "equal in type, quality and price" to that provided to AT&T and with the opportunity to be selected by customers as their preferred long distance carrier. These so-called "equal access" and related provisions are intended to prevent preferential treatment of AT&T. Further market opening, access and non-discrimination provisions were built into the Telecommunications Act. Regulatory, legislative, judicial and technological factors have helped to create the foundation for smaller companies to emerge as competitive alternatives to AT&T, MCI, and Sprint for long distance telecommunication services. The FCC requires that AT&T not restrict the resale of its services, and the Consent Decree, the Telecommunications Act and regulatory proceedings have ensured that access to LEC networks is, in most cases, available to all long distance carriers. Long distance companies that have their own transmission facilities and switches, such as AT&T, are referred to as facilities-based carriers. Facilities-based carriers are switch-based carriers, meaning that they have at least one switch to direct their long distance traffic. Nonfacilities-based carriers either (i) depend upon facilities-based carriers for switching and transmission facilities ("switchless resellers") or (ii) install and operate their own switches but depend on facilities-based carriers for transmission facilities ("switch-based resellers"). The relationship between resellers and the major long distance carriers is predicated primarily upon the fact that the pricing strategies and cost structures of the major long distance carriers have resulted historically in their charging higher rates to the small to medium-sized business customer. Small to medium-sized business customers typically are not able to make the volume commitments necessary to negotiate reduced rates under individualized contracts. By committing to large volumes of traffic, the reseller is guaranteeing traffic to the major long distance carrier but the major long distance carrier is relieved of the administrative burden of qualifying and servicing large numbers of medium to small accounts. The successful reseller has lower overhead costs and is able to market efficiently the long distance product, process orders, verify credit and provide customer service to large numbers of accounts. REGULATION The Company's provision of communications services is subject to government regulation. Federal law regulates interstate and international telecommunications, while states have jurisdiction over telecommunications that originate and terminate within the same state. Changes in existing policies or regulations in any state or by the federal government could 11 materially adversely affect the Company's financial condition or results of operations, particularly if those policies make it more difficult for the Company to obtain service from AT&T or other long distance companies at competitive rates, make it more difficult for customers to change carriers or otherwise increase the cost and regulatory burdens of marketing and providing service. There can be no assurance that the regulatory authorities in one or more states or the FCC will not take action having an adverse effect on the business or financial condition or results of operations of the Company. Regulatory action by the FCC or the states also could adversely affect the partitions, or otherwise increase the partitions' cost and regulatory burdens of marketing and providing long distance services. The Company is classified by the FCC as a nondominant carrier. After the recent reclassification of AT&T as nondominant, only the LECs are classified as dominant carriers among domestic carriers. As a consequence, the FCC regulates many of the rates, charges, and services of the LECs to a greater degree than the Company's. Because AT&T is no longer classified as a dominant carrier, certain pricing restrictions that formerly applied to AT&T have been eliminated, which could make it easier for AT&T to compete with the Company for low volume long distance subscribers. The FCC generally does not exercise direct oversight over charges for service of nondominant carriers, although it has the statutory power to do so. Nondominant carriers are required by statute to offer interstate services under rates, terms, and conditions that are just, reasonable and not unreasonably discriminatory. The FCC has the jurisdiction to act upon complaints filed by third parties, or brought on the FCC's own motion, against any common carrier, including nondominant carriers, for failure to comply with its statutory obligations. Nondominant carriers have been required to file tariffs listing the rates, terms and conditions of service, which were filed pursuant to streamlined tariffing procedures. The FCC also has the authority to impose more stringent regulatory requirements on the Company and change its regulatory classification from nondominant to dominant. In the current regulatory atmosphere, the Company believes, however, that the FCC is unlikely to do so. The FCC imposes only minimal reporting, accounting and record-keeping obligations. International nondominant carriers, including the Company, must maintain international tariffs on file with the FCC. The FCC has issued an order requiring non-dominant carriers to withdraw their domestic tariffs, but as of the date hereof, a court has stayed the FCC's order. The Company currently has two tariffs on file with the FCC. Although the tariffs of nondominant carriers, and the rates and charges they specify, are subject to FCC review, they are presumed to be lawful and are seldom contested. The Company is permitted to make tariff filings on a single day's notice and without cost support to justify specific rates. IXCs are also subject to a variety of miscellaneous regulations that, for instance, govern the documentation and verifications necessary to change a subscriber's long distance carrier, limit the use of 800 numbers for pay-per-call services, require disclosure of certain information if operator assisted services are provided and govern interlocking directors and management. The Telecommunications Act grants explicit authority to the FCC to "forbear" from regulating any telecommunications services provider in response to a petition and if the agency determines that enforcement is unnecessary and the public interest will be served. At present, the FCC exercises its regulatory authority to set rates primarily with respect to the rates of dominant carriers, and it has increasingly relaxed its control in this area. Even when AT&T was classified as a dominant carrier, the FCC most recently employed a "price cap" system, which essentially exempted most of AT&T's services, including virtually all of its commercial and 800 services, from traditional rate of return regulation because the FCC believes that these services were subject to adequate competition. Similarly, the FCC is in the process of changing the regulation and pricing of access charges including the local transport component of access charges (i.e., the fee for use of the LEC transmission facilities connecting the LECs' central offices and the IXC's access points). In addition, the LECs have been afforded a degree of pricing flexibility in setting interstate access charges where adequate competition exists. The impact of such repricing and pricing flexibility on IXCs, such as the Company, cannot be determined at this time. The Company is subject to varying levels of regulation in the states in which it is currently authorized to provide intrastate telecommunications services. The vast majority of the states require the Company to apply for certification to provide intrastate telecommunications services, or at least to register or to be found exempt from regulation, before commencing intrastate service. The vast majority of states also require the Company to file and maintain detailed tariffs listing its rates for intrastate service. Many states also impose various reporting requirements and/or require prior approval for transfers of control of certified carriers, corporate reorganizations, acquisitions of telecommunications operations, assignments of carrier assets, including subscriber bases, carrier stock offerings and incurrence by carriers of significant debt obligations. Certificates of authority can generally be conditioned, modified, canceled, terminated or revoked by state regulatory authorities for failure to comply with state law and the rules, regulations and policies of the state regulatory authorities. Fines and other penalties, including the return of all monies received for intrastate traffic from residents of a state, may be imposed for such violations. In certain states, prior regulatory approval may be required for acquisitions of telecommunications operations. Currently, the Company is certificated and tariffed to provide intrastate interLATA service in substantially all states where such authorization can be obtained. The Company's prior direct marketing efforts, the Company's marketing of its AOL and CompuServe-based services and the marketing efforts of the Company's partitions require compliance with relevant federal and state regulations that govern 12 direct sales of telecommunications services. FCC rules prohibit switching a customer from one long distance carrier to another without the customer's consent and specify how that consent can be obtained and must be verified. Most states also have consumer protection laws that further define the framework within which the Company's marketing activities must be conducted. The constraints of federal and state restrictions could impact the success of the Company's direct marketing efforts. Federal and state restrictions on the marketing of telecommunications services are becoming stricter in the wake of widespread consumer complaints throughout the industry about "slamming" (the unauthorized conversion of a customer's preselected telecommunications carrier) and "cramming" (the unauthorized provision of additional telecommunications services). Section 258 of the Telecommunications Act of 1996 authorized strengthened penalties against slamming, and the FCC is expected shortly to issue rules implementing Section 258 and overhauling federal rules on the verification of orders for telecommunications services. Congress is considering additional legislation that would further increase penalties for slamming and cramming. Several states also have been active in combating abusive marketing practices through new legislation and regulation, as well as through enhanced enforcement activities. In addition, to combat slamming, many local exchange carriers have initiated "PIC freeze" programs that, once selected by the customer, then require a customer seeking to change long distance carriers to contact the local carrier directly in lieu of having the long distance carrier contact the local carrier on behalf of the customer. While the Company vigorously supports curbs on abusive marketing practices, such measures, unless carefully designed, can have the incidental effect of entrenching incumbent carriers and hindering the emergence of new competitors, such as the Company. Statutes and regulations designed to protect consumer privacy also may have the incidental effect of hindering the growth of newer telecommunications carriers, such as the Company. The FCC recently released rules to implement Section 222 of the Telecommunications Act of 1996 that severely restrict the use of "customer proprietary network information" (information that a carrier obtains about its customers through their use of the carrier's services). These rules may make it more difficult for the Company to market additional services (such as local and wireless) to its existing customers if and when the Company begins to offer such services. The FCC has announced rules implementing Section 254 of the Telecommunications Act of 1996 that require the Company and other providers of telecommunications services to contribute to the universal service fund, which helps to subsidize the provision of local telecommunications services and other services to low-income consumers, schools, libraries, health care providers, and rural and insular areas that are costly to serve. The Company's required contributions to the universal service fund could increase over time, and some of the Company's potential competitors (such as providers of Internet telephony) are not currently, and in the future may not be, required to contribute to the universal service fund. To the extent that the Company makes additional telecommunications service offerings, the Company may encounter additional regulatory constraints. EMPLOYEES As of December 31, 1997, the Company employed 235 persons, of whom 5 were engaged in marketing and sales, 179 were engaged in partition and end user support, and 51 were engaged in systems development, finance, administration and management. None of the Company's employees is covered by collective bargaining agreements. The Company considers relations with its employees to be good. 13 GLOSSARY ACUS: AT&T College and University Systems, a wholly owned strategic business unit of AT&T Corp. AIN: Advanced Intelligent Network. Consent Decree: A 1984 U.S. Department of Justice decree that, among other things, ordered AT&T to divest its wholly-owned local Bell operating subsidiaries. End users: Customers that utilize long distance telephone services. Equal Access: Connection provided by a LEC permitting a customer to be automatically connected to the IXC of the customer's choice when the customer dials "1." Facilities-based provider: Long distance service providers who own transmission facilities. 5ESS-2000: The switching equipment manufactured by AT&T (now Lucent), which the Company acquired from AT&T (now Lucent). FCC: Federal Communications Commission. Inbound "800" Service: A service that bills long distance telephone charges to the called party. IXC: Interexchange carrier, a long distance carrier providing services between local exchanges. LATA: Local Access and Transport Areas, the approximately 200 geographic areas defined pursuant to the Consent Decree between which the RBOCs are generally prohibited from providing long distance service. LEC: Local Exchange Carrier, a company providing local telephone services. MEGACOM: An outbound long distance service offering by AT&T that requires dedicated access. MEGACOM 800: An inbound 800 service offering provided by AT&T that requires dedicated access. MCI: MCI Communications Corporation. MLCP: AT&T's multi-location calling plan (a discounted long distance program). Network: An integrated system composed of switching equipment and transmission facilities designed to provide for the direction, transport and recording of telecommunications traffic. Nonfacilities-based provider: Long distance service providers that do not own transmission facilities. OBN: One Better Net, the Company's nationwide long distance network. Partition: An independent long distance and marketing company that contracts with the Company to purchase or otherwise provide to end users the long distance services provided by the Company. Private Line: A full-time leased line directly connecting two points. Provisioning: The process of initiating a carrier's service to an end user. PUC: A state regulatory body empowered to establish and enforce rules and regulations governing public utility companies and others, such as the Company in many of its state jurisdictions. RBOC: Regional Bell Operating Company -- Any of seven regional Bell holding companies that the Consent Decree established to serve as parent companies for the Bell operating companies. 14 Readyline: An Inbound 800 service offering provided by AT&T. SDN: The AT&T Software Defined Network. Sprint: Sprint Corporation. Switching Equipment: A computer that directs telecommunication traffic in accordance with programmed instructions. Tariff: The schedule of rates and regulations set by communications common carriers and filed with the appropriate Federal and state regulatory agencies; the published official list of charges, terms and conditions governing provision of a specific communication service or facility, which functions in lieu of or with a contract between the user and the supplier or carrier. 15 ITEM 2. PROPERTIES The Company owns the 24,000 square foot facility in New Hope, Pennsylvania which serves as the Company's headquarters. The Company leases properties in the cities in which OBN switches have been installed. With respect to the Company's customer service operations with respect to the AOL Agreement, the Company owns the 32,000 square foot facility located in Clearwater, Florida. With respect to the Company's Symetrics operations, Symetrics' corporate office and primary engineering and manufacturing facility is a 40,000 square foot building, which it owns, on approximately five acres in Melbourne, Florida. Symetrics uses 40% of this facility for its own business and leases and/or offers for lease the balance of the building for terms typically of one to five years. Rental rates charged by Symetrics are consistent with rates for similar type buildings in the area. The Company also owns the adjoining property to the east which consists of a 50,000 square foot building on a five-acre lot. The Company leases a 14,500 square foot building for $6,360 per month, with 27 months remaining on the term thereof, for the Symetrics commercial contract manufacturing operations. Symetrics' subsidiary leases a 14,428 square foot building for approximately $7,500 per month, with 47 months remaining on the lease. ITEM 3. LEGAL PROCEEDINGS The Company is a party to certain legal actions arising in the ordinary course of business. The Company believes that the ultimate outcome of these actions will not result in any liability that would have a material adverse effect on the Company's financial condition or results of operations. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS (a) The Company's Annual Meeting of Stockholders was held on December 1, 1997 ("Annual Meeting"); (b) Not applicable; (c) At the Annual Meeting, the stockholders of the Company considered and approved the following proposals: (i) At the Annual Meeting, the stockholders approved a proposal to amend the Company's Certificate of Incorporation to increase the number of shares of Common Stock that may be issued by the Company from 100,000,000 to 300,000,000. This proposal received 51,571,254 votes in favor, 4,483,173 votes opposed such proposal and 27,485 votes abstained from such matter. (ii) Election of Directors. The following sets forth the nominees who were elected directors of the Company for the term expiring in the year indicated as well as the number of votes cast for, against or withheld:
VOTES ----- Term (year expires) Name For Against Withheld -------------------------------------------------------------------------------------------------- 2000 Gary W. McCulla 55,981,895 0 100,017 2000 George P. Farley 55,981,952 0 99,960 1999 Harold First 55,981,952 0 99,960
(iii) At the Annual Meeting the stockholders approved the appointment of BDO Seidman LLP as independent certified public accounts of the Company. The appointment received 56,047,874 votes in favor, 6,180 votes in opposition and 27,858 votes abstained from such matter. 16 (iv) At the Annual Meeting the stockholders approved a proposal to approve the grant of an option to purchase 800,000 shares of the Company's Common Stock to Edward B. Meyercord, III. This proposal received 55,776,343 votes in favor, 273,819 votes in opposition and 31,750 votes abstained from such matter. 17 EXECUTIVE OFFICERS OF THE COMPANY The executive officers of the Company are as follows:
NAME AGE POSITION - --------------------------------- --- -------------------------------------------------------------- Daniel Borislow 36 Chairman of the Board, Chief Executive Officer and Director Gary W. McCulla 38 President and Director of Sales and Marketing and Director Emanuel J. DeMaio 38 Chief Operations Officer and Director George P. Farley 59 Chief Financial Officer, Treasurer and Director Edward B. Meyercord, III 32 Executive Vice President, Marketing and Corporate Development Mary Kennon 38 Director of Customer Care and Human Resources Aloysius T. Lawn, IV 39 General Counsel and Secretary Kevin R. Kelly 33 Controller
DANIEL BORISLOW. Mr. Borislow founded the Company and has served as a director and as Chief Executive Officer of the Company since its inception in 1989. Prior to founding the Company, Mr. Borislow formed and managed a cable construction company. GARY W. MCCULLA. Mr. McCulla currently serves as President and Director of Sales and Marketing. In 1991, Mr. McCulla founded GNC and was its President. Until March 1994, GNC was a privately-held independent marketing company and one of the Company's partitions. At that time, the Company acquired certain assets of GNC. EMANUEL J. DEMAIO. Mr. DeMaio joined the Company in February 1992 and currently serves as Chief Operations Officer. Prior to joining the Company, from 1981 through 1992, Mr. DeMaio held various technical and managerial positions with AT&T. GEORGE P. FARLEY. Mr. Farley became Chief Financial Officer and Treasurer of Tel-Save effective October 29, 1997. Mr. Farley is formerly Group Vice President of Finance/Chief Financial Officer of Twin County Grocers, Inc. ("Twin County"), a food distribution company. Prior to joining Twin County in September 1995, Mr. Farley was a partner of BDO Seidman, LLP, where he had served as a partner since 1974. EDWARD B. MEYERCORD, III. Mr. Meyercord joined the Company in September 1996 and currently serves as Executive Vice President, Marketing and Corporate Development. From 1993 until joining the Company, Mr. Meyercord worked in the corporate finance department of Salomon Brothers, where he held various positions, the most recent of which was Vice President. Prior to joining Salomon Brothers, Mr. Meyercord worked in the corporate finance department at Paine Webber Incorporated. MARY KENNON. Ms. Kennon joined the Company in October 1994 and currently serves as Director of Customer Care and Human Resources. Prior to joining the Company, from 1984 through 1994, Ms. Kennon held various managerial positions with AT&T. ALOYSIUS T. LAWN, IV. Mr. Lawn joined the Company in January 1996 and currently serves as General Counsel and Secretary of the Company. Prior to joining the Company, from 1985 through 1995, Mr. Lawn was an attorney in private practice. KEVIN R. KELLY. Mr. Kelly joined the Company in April 1994 and currently serves as Controller. From 1987 to 1994, Mr. Kelly held various managerial positions with a major public accounting firm. Mr. Kelly is a certified public accountant. 18 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS The Company's common stock, $.01 par value per share ("Common Stock"), is traded on the Nasdaq National Market, and high and low quotations listed below are actual sales prices as quoted in the Nasdaq National Market under the symbol "TALK." The price per share in the following table sets forth the high and low price in the Nasdaq National Market for the quarter indicated as reported by Bloomberg L.P.:
Price Range of Common Stock High Low ---- --- 1995 First Quarter (from September 20, 1995) $ 5 21/64 $ 4 27/64 1996 First Quarter 8 7/16 4 5/64 Second Quarter 11 7/8 8 1/4 Third Quarter 14 3/4 9 5/8 Fourth Quarter 14 1/2 10 3/8 1997 First Quarter 20 1/2 12 5/8 Second Quarter 17 1/4 13 9/16 Third Quarter 24 1/16 14 1/4 Fourth Quarter 26 1/16 16 5/16 1998 First Quarter (through March 30, 1998) 30 19 1/4
As of March 30, 1998, there were approximately 299 record holders of Common Stock. The Company has never declared or paid any cash dividends on its capital stock. The Company currently intends to retain any future earnings to finance the growth and development of its business and, therefore, does not anticipate paying any cash dividends in the foreseeable future. RECENT SALES OF UNREGISTERED SECURITIES On November 26, 1997, the Company acquired all of the outstanding shares of Compco for $15,000,000, comprised of a cash payment of $7,500,000 and the issuance to Compco's stockholders of 339,982 shares of the Company's Common Stock. The Company believes that such sale of stock was exempt from registration under Section 4(2) under the Securities Act. On December 10, 1997, the Company sold $200,000,000 aggregate principal amount of 5% Convertible Subordinated Notes due 2004 (the "5% Notes") to Smith Barney Inc., Deutsche Morgan Grenfell Inc. and UBS Securities LLC, who acted as Initial Purchasers in an offering relying on the exemption in ss. 4(2) of the Securities Act of 1933, as amended. Proceeds to the Company were $195,000,000. The 5% Notes are convertible, at the option of the holder thereof, at any time after 90 days following the date of issuance thereof and prior to maturity, into shares of Common Stock at a conversion price of $25.47, subject to adjustment in certain events. 19 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The selected consolidated financial data should be read in conjunction with, and are qualified in their entirety by, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and the Company's Consolidated Financial Statements included elsewhere in this Form 10-K.
YEAR ENDED DECEMBER 31, ----------------------------------------------------------------------------- 1997 1996 1995 1994 1993 ---- ---- ---- ---- ---- (In thousands, except per share amounts) Consolidated Statements of Operations Data: Sales $304,768 $232,424 $180,102 $82,835 $31,940 Cost of sales 355,169 200,597 156,121 70,104 26,715 Gross profit (loss) (50,401) 31,827 23,981 12,731 5,225 Selling, general and administrative expenses 34,650 10,039 6,280 3,442 2,060 Operating income (loss) (85,051) 21,788 17,701 9,289 3,165 Investment and other income, net 50,715 10,585 331 66 108 Income (loss) before income taxes (34,336) 32,373 18,032 9,355 3,273 Provision (benefit) for income taxes(1) (13,391) 12,205 7,213 3,742 1,309 Net income (loss) (1) $(20,945) $ 20,168 $ 10,819 $ 5,613 $ 1,964 Net income (loss) per share - Basic (1) $ (0.33) $ 0.38 $ 0.34 $ 0.20 $ 0.07 Weighted average common shares outstanding-Basic 64,168 52,650 31,422 28,650 28,650 Net income (loss) per share - Diluted(1) $ (0.33) $ 0.35 $ 0.32 $ 0.18 $ 0.07 Weighted average common and common equivalent shares outstanding -Diluted 64,168 57,002 33,605 30,663 29,452 AT DECEMBER 31, ---------------------------------------------------------------------------- 1997 1996 1995 1994 1993 ---- ---- ---- ---- ---- (In thousands) Consolidated Balance Sheets Data: Working capital $634,788 $175,597 $38,171 $12,265 $4,502 Total assets 814,891 257,008 71,388 21,435 6,694 Convertible debt 500,000 -- -- -- -- Total stockholders' equity 222,828 230,720 41,314 14,042 4,687
- ---------- (1) For the years and period ended December 31, 1993, 1994 and September 19, 1995, the Predecessor Corporation elected to report as an S corporation for federal and state income tax purposes. Accordingly, the Predecessor Corporation's stockholders included their respective shares of the Company's taxable income in their individual income tax returns. The pro forma income taxes reflect the taxes that would have been accrued if the Company had elected to report as a C corporation. See Note 12 to the Consolidated Financial Statements. 20 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the Consolidated Financial Statements included elsewhere in this Form 10-K. OVERVIEW In 1997, the Company raised approximately $500 million in connection with two private placements of convertible notes. In addition, as part of its efforts to expand its business into the online market, the Company entered into the AOL Agreement, under which the Company provides long distance telecommunications services to be marketed by AOL. The Company's results of operations for 1997 were negatively impacted by the pre-tax charges of $60.7 million primarily related to the AOL Agreement, $30.0 million primarily related to the restructuring of its sales and marketing efforts and $11.5 million primarily as a result of the Company's change in accounting for customer acquisition costs. These charges were offset by $32 .1 million of other income, net of related costs, associated with the break-up of a proposed merger between the Company and Shared Technologies Fairchild, Inc. ("STF"). RESULTS OF OPERATIONS The following table sets forth for the periods indicated certain financial data as a percentage of sales:
1997 1996 1995 ---- ---- ---- Sales 100.0% 100.0% 100.0% Cost of sales 116.5 86.3 86.7 ----- ----- ----- Gross profit (loss) (16.5) 13.7 13.3 Selling, general and administrative expenses 11.4 4.3 3.5 ----- ----- ----- Operating income (loss) (27.9) 9.4 9.8 Investment and other income, net 16.6 4.5 0.2 ----- ----- ----- Income (loss) before income taxes (11.3) 13.9 10.0 Provision (benefit) for income taxes (4.4) 5.2 4.0(A) ----- ----- ----- Net income (loss) (6.9)% 8.7% 6.0% ===== ===== =====
- ---------- (A) Pro forma tax provisions have been calculated as if the Company's results of operations were taxable as a C corporation (the Company's current tax status) for the year ended December 31, 1995. Prior to September 20, 1995, the Company was an S Corporation with all earnings taxed directly to its shareholders. 21 YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996 Sales. Sales increased by 31.1% to $304.8 million in 1997 from $232.4 million in 1996. The increase in sales resulted primarily from the marketing of the Company's OBN services and the addition of new partitions. One partition, Group Long Distance Inc., accounted for approximately 13% of the Company's sales in 1997. Although the Company expects sales to increase by virtue of the AOL Agreement and, based on its experience to date, to have attracted approximately 1,000,000 lines to its service by June 30, 1998 as a result of its marketing campaign under the AOL Agreement in view of the intense competition in this industry, there can be no assurance that the Company will increase sales on a quarter-to-quarter or year-to-year basis. Cost of Sales. The Company's cost of sales increased by 77.1% to $355.2 million in 1997 from $200.6 million in 1996 as a result of increased sales and charges of $11.5 million primarily as a result of the Company's change in its accounting for customer acquisition costs (Note 3), $60.7 million primarily related to the AOL Agreement (Note 4) and $30.0 million primarily related to the restructuring of its sales and marketing efforts (Note 3). Prior to 1997, network usage costs consisted solely of "bundled" charges from AT&T. Beginning in 1997, the Company also incurred "unbundled" charges, including local access fees, associated with the operation of OBN. Both "bundled" and "unbundled" charges are directly related to calls made by the Company's end users. During 1997, the Company acquired most of the services purchased from AT&T for resale or use in OBN under AT&T Contract Tariff No. 5776, which was entered into in late 1996 and provides rates that are more favorable than under previous tariffs. The Company has the opportunity to terminate this AT&T tariff without termination liability effective as of April 30, 1998 and currently expects it will do so since it believes that it can replace these services at more favorable rates. While the Company is currently negotiating a new master services contract with AT&T, which would replace all of the Company's existing AT&T tariffs with what the Company expects would be lower rate tariffs, there can be no assurance that such agreement can be reached. If the Company terminates Contract Tariff No. 5776 and is unsuccessful in reaching a more favorable agreement with AT&T, it would be required to pay more to obtain these services from AT&T or negotiate an agreement with another carrier (either another large customer of AT&T or another facilities-based carrier) which may be at rates higher or lower than the Company is paying today. OBN and the operation of the Company's own switches and network have to date and will in the future require the Company to incur systems and equipment maintenance, lease and network personnel expenses significantly above the levels historically experienced by the Company as a switchless reseller of AT&T services. However, these per call costs, in combination with "unbundled" charges paid to LECs and AT&T, were, in 1997, and are expected in the future, to be less than the per call cost currently incurred by the Company as a switchless reseller paying "bundled" charges to AT&T. The Company made an initial payment of $100 million to AOL at the signing of the AOL Agreement and issued to AOL at signing two warrants to purchase shares of the Company's Common Stock at a premium over the market value of such stock on the issuance date (See Note 4). Of the prepaid AOL marketing costs, approximately $57.0 million was charged to expense in 1997. The remaining portion of the prepaid AOL marketing costs (approximately $63.6 million at December 31, 1997) will be recognized ratably over the balance of the term of the AOL Agreement, the initial term of which expires on June 30, 2000, as advertising services are received. The AOL warrant for up to 7 million shares will be valued and charged to expense as and when subscribers to the Company's services under the AOL Agreement sign-up and the shares under such warrant vest. The amount of such charges, which could be significant, will be based on the extent to which such AOL warrants vest and the market prices of the Company's Common Stock at the time of vesting and therefore such charges are not currently determinable. Generally, the higher the market price of the Company's Common Stock at the time of vesting, the larger the amount of the charge will be. The Company also anticipates that it may incur up to $100 million in additional AOL marketing expenses in 1998 for such marketing efforts as direct mail, media campaigns and special pricing and other promotions. 22 The Company has traditionally operated primarily as a wholesale reseller of long distance services. With the introduction of the AOL Agreement, the Company has begun to focus on a more retail-oriented business plan. As discussed above, the Company has incurred, and expects to continue to incur, significant upfront expenses for marketing under the AOL Agreement, the revenues from which may not be realized for some period of time after the expenditures. In addition, approximately 15-20% of the orders under the AOL Agreement have required special attention by the Company because of PIC freezes imposed by the regional Bell operating companies. See "ITEM 1--BUSINESS--REGULATION." As the Company focuses more on the retail market in 1998, continuing its activities under the AOL and CompuServe Agreements and venturing into other telecommunications services such as dial-around and local service, with the increased development and promotional expenses, such as special pricing and other promotion and retention devices, entailed in retail marketing and the greater time period between expenditures and resulting revenues, the Company anticipates that its 1998 revenues and income could be adversely affected. Gross Margin. Gross margin decreased to (16.5)% in 1997 from 13.7% in 1996. The decrease in gross margin was primarily due to the charges discussed above. Absent these charges, gross margin increased to 17.0% in 1997 from 13.7% in 1996, due to lower network costs for OBN services which were lower on a per call basis when compared to those paid to AT&T. Price competition continues to intensify for the Company's products, and this trend can be expected to continue to put downward pressure on gross margins. Selling, general and administrative expenses. Selling, general and administrative expenses increased by 245.2% to $34.7 million in 1997 from $10.0 million in 1996. The increase in selling, general and administrative expenses was due primarily to compensation expenses related to the issuance of options to and the purchase of shares of Company Common Stock by executive officers of the Company in connection with the commencement of their employment with the Company, the costs associated with hiring additional personnel to support the Company's continuing growth, the development costs associated with AOL and increased fees for professional services. The Company expects selling, general and administrative expenses to continue to increase as it operates and maintains OBN and as it markets the AOL service offering. The additional selling, general and administrative expenses may be offset by the increased sales and gross profit gained as a result of the implementation of the components of the Company's strategic plan, but increased costs may have an adverse impact on results of operations, and there can be no assurances of such increased sales and profits. The Company granted options to purchase 810,000 shares of Company Common Stock at an exercise price of $17.50 per share to an executive officer and two outside directors. The options granted are subject to the approval of the stockholders and are being submitted for approval at the Company's stockholder meeting scheduled in May of 1998. Approval of the option grants will result in compensation expense equal to the difference between the exercise price and the market value of the Company Common Stock on the date of such approval. Other Income. Other income was $50.7 million in 1997 versus $10.6 million in 1996. Other income consists primarily of fees for customer service and support for the marketing operations of the Company's carrier partitions in 1997 of $8.1 million and investment income earned by the Company. In 1997, other income also includes $32.1 million, net of related costs, associated with the break-up of a proposed merger between the Company and STF. Provision for income taxes. The Company's effective tax rate increased to 39.0% in 1997 from the effective tax rate of 37.7% in 1996 primarily due to an anticipated higher effective state tax rate in 1997. YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995 Sales. Sales increased by 29.1% to $232.4 million in 1996 from $180.1 million in 1995. The increase in sales related primarily to the continued expansion of the Company's distribution network of partitions, as well as increases in the number of orders submitted by the Company's existing partitions. One partition, The Furst Group, Inc., accounted for approximately 11% of the Company's sales in 1996 versus zero in 1995. In addition, significant partition marketing efforts focused on inbound 800 service resulted in sales of $75.3 million for the year ended December 31, 1996 versus $55.6 million for the year ended December 31, 1995. Cost of Sales. The Company's cost of sales, consisting primarily of network usage charges for AT&T long distance services, increased by 28.5% to $200.6 million in 1996 from $156.1 million in 1995 and is directly related to the 29.1% increase in sales. Gross Margin. Gross margin, the gross profit as a percentage of sales, increased to 13.7% for the year ended December 31, 1996 from 13.3% for the year ended December 31, 1995. The increase in gross margin was due to greater discounts obtained from AT&T on network usage partially offset by direct marketing expenses and higher volume discounts granted to certain partitions. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased by 59.9% to $10.0 million in 1996 from $6.3 million in 1995. The increase in selling, general and administrative expenses was due primarily to the costs associated with hiring additional management personnel to support the Company's continuing growth and increased fees for professional services. Other Income. Other income was $10.6 million in 1996 versus $331,000 in 1995. Other income for the year ended December 31, 1996 includes two nonrecurring gains: a $1.4 million gain on the sale of securities of another long distance 23 company and a $1.5 million gain on the sale of short term U.S. Treasury securities. The remainder of other income consists primarily of investment income earned on the Company's cash balances resulting primarily from the unapplied proceeds of the Company's public offering in April and May 1996 and excess cash from operations. Provision for income taxes. The Company's effective tax rate declined to 37.7% in 1996 from the pro forma effective tax rate of 40.0% in 1995 due to the lower effective state tax rate in 1996. LIQUIDITY AND CAPITAL RESOURCES The Company has since September 1995 raised capital primarily through public and private distributions of its securities. In fall 1995 and spring 1996, the Company consummated public offerings of shares of the Company's Common Stock and received net proceeds of $42.8 million and $139.1 million, respectively. In September 1997, the Company privately sold $300 million of 4 1/2% Convertible Subordinated Notes which mature on September 15, 2002 (the "2002 Convertible Notes"). Interest on the 2002 Convertible Notes is due and payable semiannually on March 15 and September 15 of each year. The 2002 Convertible Notes are convertible, at the option of the holder thereof, at any time after December 9, 1997 and prior to maturity, unless previously redeemed, into shares of the Company's Common Stock at a conversion price of $24.61875 per share. The 2002 Convertible Notes are redeemable, in whole or in part, at the Company's option, at any time on or after September 15, 2000 at 101.80% of par prior to September 14, 2001 and 100.90% of par thereafter. In December 1997, the Company privately sold $200 million of 5% Convertible Subordinated Notes which mature on December 15, 2004 (the "2004 Convertible Notes"). Interest on the 2004 Convertible Notes is due and payable semiannually on June 15 and December 15 of each year. The 2004 Convertible Notes are convertible, at the option of the holder thereof, at any time after March 5, 1998 and prior to maturity, unless previously redeemed, into shares of the Company's Common Stock at a conversion price of $25.47 per share. The 2004 Convertible Notes are redeemable, in whole or in part at the Company's option, at any time on or after December 15, 2002 at 101.43% of par prior to December 14, 2003 and 100.71% of par thereafter. During 1996, certain options and warrants to purchase shares of the Company's Common Stock were exercised and the Company repurchased approximately 428,000 shares, which are held as treasury shares, yielding to the Company net proceeds of $7.8 million. During 1997, certain options and warrants to purchase shares of the Company's Common Stock were exercised and the Company repurchased certain Common Stock Warrants, yielding to the Company net proceeds of $16.9 million. In addition, during 1997 the Company repurchased approximately 3.5 million shares of the Company's Common Stock, which are held as treasury shares, for approximately $72.0 million. The tax benefit realized from the options and warrants was approximately $21.3 million in 1996 and $25.7 million in 1997 and is reflected as an adjustment to additional paid-in capital. The Company's working capital was $634.8 million and $175.6 million at December 31, 1997 and December 31, 1996, respectively. The significant increase in working capital is primarily a result of the sale of the 2002 and 2004 Convertibles Notes, discussed above. In the first quarter of 1998, the Company invested $300 million in a tax exempt bond fund, $245 million in government bond funds and incurred $155 million of margin account indebtedness in connection with these investments. While the Investment Company Act of 1940, as amended (the "Investment Company Act"), principally regulates vehicles for pooled investments in securities, such as mutual funds, it also may be deemed to be applicable to companies that are not organized for the purpose of investing or trading in securities but nonetheless have more than a specified percentage of their assets in investment securities. The Company is engaged in the telecommunications business, and the availability of cash and liquid securities is important to the Company's ability to take advantage of opportunities to acquire other telecommunications businesses, assets and technologies from time to time. The Company believes, therefore, that its activities do not and will not subject the Company to regulation under the Investment Company Act. However, if the Company were to be deemed to be an investment company within the meaning of the Investment Company Act, the Company would become subject to certain restrictions relating to the Company's activities, including, but not limited to, restrictions on the conduct of its business, the nature of its investments, the issuance of securities and transactions with affiliates. Therefore, the characterization of the Company as an investment company would have a material adverse effect on the Company. In the Indenture governing the 2002 Convertible Notes, the Company has covenanted that it will not become an investment company within the meaning of the Investment Company Act and that it will take all such actions as are necessary in order to continue not to be deemed an investment company. In light of the Company's cash position, the Company recently notified its bank of its intention to terminate its line of credit. The Company invested $28.9 million in capital equipment during 1997, of which $17.1 million was used for the acquisition of capital equipment and installation costs relating to the deployment of OBN and the remainder of which was primarily used for the acquisition of computer equipment utilized in connection with the offering of the Company's services on AOL. To date, through December 31, 1997, the Company has invested $41.9 million for the acquisition of capital equipment and installation costs relating to the deployment of OBN. The Company generally does not have a significant concentration of credit risk with respect to accounts receivable due to the large number of partitions and end users comprising the Company's customer base and their dispersion across different geographic regions. The Company maintains reserves for potential credit losses and, to date, such losses have been within the Company's expectations. The Company has announced that its Board has authorized the repurchase up to eight million shares of its Common Stock. It is anticipated that the repurchased shares will be held in treasury for issuance upon exercise of outstanding options and warrants and upon conversion, if any, of convertible notes, and for other general corporate purposes. As noted above in connection with the AOL Agreement, the Company issued two warrants to AOL to purchase shares of the Company's Common Stock, including a warrant to purchase 5 million shares at an exercise price of $15.50 per share. AOL is exercising this warrant as to 1 million shares of Company Common Stock on a net issuance basis and the Company is repurchasing from AOL all of the 380,624 shares issued upon such net issuance exercise for $23 1/4 per share. In connection with such purchases, AOL agreed not to dispose of any shares of the Company's Common Stock acquired by AOL under any of these warrants until March 30, 1999. 24 The Company believes that its current cash position, marketable securities and the cash flow expected to be generated from operations, will be sufficient to fund its capital expenditures, working capital and other cash requirements for at least the next twelve months. YEAR 2000 The "Year 2000" issue refers to the potential harm from computer programs that identify dates by the last two digits of the year rather than using the full four digits. As such, dates after January 1, 2000 could be misidentified, and such programs could fail. The Company has examined its computer-based systems and believes that the "Year 2000" problem is not present in such systems. However, the Company is dependent upon computer systems operated by third parties, such as LECs, AT&T, AOL and other vendors. If those systems were to malfunction due to the "Year 2000" problem, the Company's services could fail, as well. Such failures could have a material adverse effect upon the Company's business, results of operations and financial condition. The Company is inquiring of such third parties to determine the effect, if any, of the "Year 2000" problem on the systems upon which the Company is dependent, and to obtain appropriate assurances that no such problem exists. * * * * * Certain of the statements contained herein may be considered forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such statements are identified by the use of forward-looking words or phrases, including, but not limited to, "estimates," "expects," "expected," "anticipates," and "anticipated." These forward-looking statements are based on the Company's current expectations. Although the Company believes that the expectations reflected in such forward-looking statements are reasonable, there can be no assurance that such expectations will prove to have been correct. Forward-looking statements involve risks and uncertainties and the Company's actual results could differ materially from the Company's expectations. Important factors that could cause such actual results to differ materially include, among others, adverse developments in the Company's relationship with AT&T or AOL, increased price competition for long distance services, failure of the marketing of long distance services under the AOL Agreement, attrition in the number of end users, and changes in government policy, regulation and enforcement. The Company undertakes no obligation to update its forward-looking statements. 25 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Independent Certified Public Accountants 27 Consolidated balance sheets as of December 31, 1997 and 1996 28 Consolidated statements of operations for the years ended December 31, 1997, 1996, and 1995 29 Consolidated statements of stockholders' equity for the years ended December 31, 1997, 1996 and 1995 30 Consolidated statements of cash flows for the years ended December 31, 1997, 1996 and 1995 31 Notes to consolidated financial statements 32
26 REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Tel-Save Holdings, Inc. We have audited the accompanying consolidated balance sheets of Tel-Save Holdings, Inc. and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity 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 generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Tel-Save Holdings, Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1997 in conformity with generally accepted accounting principles. BDO Seidman, LLP New York, New York February 5, 1998 27 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT FOR SHARE DATA)
DECEMBER 31, ------------------------------------------- 1997 1996 ---- ---- ASSETS CURRENT: Cash and cash equivalents $316,730 $ 8,023 Marketable securities 212,269 149,237 Accounts receivable, trade net of allowance for uncollectible accounts of $2,419 and $987, respectively 44,587 19,971 Advances to partitions and note receivables 26,110 13,410 Due from broker 21,087 867 Prepaid AOL marketing costs - current 30,857 -- Deferred taxes - current 30,916 -- Prepaid expenses and other current assets 8,495 10,377 -------- -------- Total current assets 691,051 201,885 Property and equipment, net 55,835 30,097 Intangibles, net 10,590 21,102 Prepaid AOL marketing costs 32,722 -- Other assets 24,693 3,924 -------- -------- Total assets $814,891 $257,008 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT: Accounts payable and accrued expenses: Trade and other $ 16,858 $ 19,404 Partitions 7,740 4,398 Interest and other 10,578 1,619 Securities sold short 21,087 867 --------- --------- Total current liabilities 56,263 26,288 Convertible debt 500,000 -- Deferred revenue 35,800 -- --------- --------- Total liabilities 592,063 26,288 --------- --------- Commitments and Contingencies Stockholders' equity Preferred stock, $.01 par value, 5,000,000 shares authorized; no shares outstanding -- -- Common stock - $.01 par value, 300,000,000 shares authorized; 67,249,635 and 62,237,998 issued, respectively 672 622 Additional paid-in capital 291,952 210,616 Retained earnings 3,097 24,042 Treasury stock (72,893) (4,560) -------- -------- Total stockholders' equity 222,828 230,720 -------- -------- Total liabilities and stockholders' equity $814,891 $257,008 ======== ========
See accompanying notes to consolidated financial statements. 28 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
1997 1996 1995 ---- ---- ---- Sales $304,768 $232,424 $180,102 Cost of sales 355,169 200,597 156,121 -------- -------- -------- Gross profit (loss) (50,401) 31,827 23,981 Selling, general and administrative expenses 34,650 10,039 6,280 -------- -------- -------- Operating income (loss) (85,051) 21,788 17,701 Investment and other income, net 50,715 10,585 331 -------- -------- -------- Income (loss) before provision for income taxes (34,336) 32,373 18,032 Provision (benefit) for income taxes (13,391) 12,205 8,997 -------- -------- -------- Net income (loss) $(20,945) $ 20,168 $ 9,035 ======== ======== ======== Net income (loss) per share - Basic $ (.33) $ .38 ======== ======== Weighted average common shares outstanding - Basic 64,168 52,650 ======== ======== Net income (loss) per share - Diluted $ (.33) $ .35 ======== ======== Weighted average common and common equivalent shares outstanding - Diluted 64,168 57,002 ========= ======== Pro forma: Income before provision for income taxes $ 18,032 Pro forma provision for income taxes 7,213 -------- Pro forma net income $ 10,819 ======== Pro forma net income per share - Basic $ .34 ======== Weighted average common share outstanding - Basic 31,422 ======== Pro forma net income per share - Diluted $ .32 ======== Weighted average common and common equivalent shares outstanding - Diluted 33,605 ========
See accompanying notes to consolidated financial statements. 29 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS)
COMMON STOCK ADDITIONAL TREASURY STOCK -------------------------- PAID-IN RETAINED -------------------------- SHARES AMOUNT CAPITAL EARNINGS SHARES AMOUNT TOTAL ----------- ----------- ------------- ----------- ----------- ------------ --------- Balance, January 1, 1995 9,550 $ 95 $ -- $ 13,947 -- $ -- $ 14,042 Net income -- -- -- 9,035 -- -- 9,035 Cash distributions -- -- -- (13,200) -- -- (13,200) Stock redemption -- -- -- (11,400) -- -- (11,400) Reclassification of S Corporation deficit -- -- (5,492) 5,492 -- -- -- Sale of common stock 3,450 35 42,802 -- -- -- 42,837 Three-for-two stock split 6,500 65 (65) -- -- -- --------- ------ --------- -------- ----- -------- --------- Balance, December 31, 1995 19,500 195 37,245 3,874 -- -- 41,314 Net income -- -- -- 20,168 -- -- 20,168 Issuance of warrants to partitions -- -- 1,077 -- -- -- 1,077 Sale of common stock 8,534 85 138,984 -- -- -- 139,069 Exercise of common stock options 1,079 11 4,927 -- -- -- 4,938 Exercise of warrants 2,006 20 7,383 -- -- -- 7,403 Income tax benefit related to exercise of common -- -- 21,311 -- -- -- 21,311 stock options and warrants Acquisition of treasury stock -- -- -- -- (428) (4,560) (4,560) Two-for-one stock split 31,119 311 (311) -- -- -- -- -------- --------- ---------- -------- ----- -------- -------- Balance, December 31, 62,238 622 210,616 24,042 (428) (4,560) 230,720 1996 Net loss -- -- -- (20,945) -- -- (20,945) Issuance of warrants to AOL -- -- 21,200 -- -- -- 21,200 Issuance of common stock for acquired business 141 1 2,217 -- -- -- 2,218 Exercise of common stock warrants 2,662 27 11,977 -- -- -- 12,004 Exercise of common stock options 2,209 22 9,318 -- -- -- 9,340 Purchase of common stock warrants -- -- (4,400) -- -- -- (4,400) Issuance of common stock options for compensation -- -- 13,372 -- -- -- 13,372 Acquisition of -- -- -- -- (3,520) (71,959) (71,959) treasury stock Issuance of treasury stock for acquired business -- -- 1,999 -- 340 3,626 5,625 Income tax benefit related to exercise of common stock options and warrants -- -- 25,653 -- -- -- 25,653 -------- -------- --------- -------- ------- --------- --------- Balance, December 31, 1997 67,250 $672 $291,952 $ 3,097 (3,608) $(72,893) $222,828 ======== ========= ========= ======== ======= ========= =========
See accompanying notes to consolidated financial statements. 30 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
1997 1996 1995 ---- ---- ---- Cash flows from operating activities: Net income (loss) $ (20,945) $ 20,168 $ 9,035 Adjustment to reconcile net income to net cash provided by operating activities: Unrealized loss on securities 1,865 179 234 Provision for bad debts 1,579 38 (28) Depreciation and amortization 5,429 2,462 1,287 Charge for customer acquisition costs 11,550 -- -- Write-off of intangibles 23,032 -- -- Compensation charges 13,372 -- -- AOL marketing costs 58,185 -- -- Deferred credits -- (280) -- Income tax benefit related to exercise of options and warrants 25,653 21,311 -- (Increase) decrease in: Accounts receivable, trade (26,048) (1,065) (2,996) Advances to partitions and note receivables (12,700) (20,797) (1,700) Prepaid AOL marketing costs (100,564) Prepaid expenses and other current assets (38,259) (10,183) 1,400 Other assets (20,769) (3,924) -- Increase (decrease) in: Accounts and partition payables and accrued expenses 9,608 7,978 12,047 Deferred revenue 35,800 -- -- Income taxes payable -- (5,184) 5,184 --------- ------- -------- Net cash (used in) provided by operating activities (33,212) 10,703 24,463 --------- ------- -------- Cash flows from investing activities: Acquisition of intangibles (9,293) (9,800) (1,057) Capital expenditures, net (28,876) (27,679) (2,330) Securities sold short 17,700 (411) 866 Due from broker (20,220) 233 (1,100) Loans to stockholder -- (3,034) (2,075) Repayment of stockholder loans -- 5,109 -- Purchase of marketable securities, net (62,377) (149,238) -- --------- -------- -------- Net cash used in investing activities (103,066) (184,820) (5,696) --------- -------- -------- Cash flows from financing activities: Proceeds from sale of convertible subordinated notes 500,000 -- -- Payments to related parties -- -- (1,725) Payment of note payable to stockholder -- (5,921) (979) Proceeds from sale of common stock -- 139,069 42,837 Proceeds from exercise of options and warrants 21,344 12,341 -- Purchase of common stock warrants (4,400) -- -- Acquisition of treasury stock (71,959) (4,560) -- Distributions to stockholders -- -- (13,200) Stock redemption -- -- (4,500) --------- --------- -------- Net cash provided by financing activities 444,985 140,929 22,433 --------- --------- -------- Net increase (decrease) in cash and cash equivalents 308,707 (33,188) 41,200 Cash and cash equivalents, at beginning of period 8,023 41,211 11 --------- ---------- -------- Cash and cash equivalents, at end of period $316,730 $ 8,023 $ 41,211 ========= ========== ========
See accompanying notes to consolidated financial statements. 31 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1 -- SUMMARY OF ACCOUNTING POLICIES (a) Business Tel-Save Holdings, Inc. (the "Company"), which is incorporated in Delaware, provides long distance services throughout the United States to small and medium-sized businesses, and to increasing numbers of residential customers as a result of the Company's recent online marketing efforts. The Company's long distance service offerings include outbound service, inbound toll-free 800 service and dedicated private line services for data. (b) Reorganization On September 21, 1995, the Company consummated its initial public offering ("IPO") (Note 10(b)). The shares of Tel-Save, Inc., a Pennsylvania corporation (the "Predecessor Corporation"), owned by the two founding stockholders were contributed to the Company as of the date of the IPO. The majority stockholder exchanged all of his shares of the Predecessor Corporation for 21,060,000 shares of the common stock of the Company plus loans of up to $5,000,000. The majority stockholder repaid his outstanding indebtedness, including interest, using a portion of his proceeds from the sale of 1,500,000 shares of common stock in connection with the Company's public offering in April 1996 (Note 10(a)). The minority stockholder exchanged all his shares of the Predecessor Corporation for 7,590,000 shares of the common stock of the Company, $4,500,000 in cash plus a note (the "Cash Flow Note") in the original principal amount of $6,900,000 bearing interest at 10% per annum which was guaranteed by the majority stockholder. The payment and the issuance of the Cash Flow Note to the minority stockholder are accounted for as a distribution of capital. In January 1996, the Company paid the remaining balance of $5,921,000 due under the Cash Flow Note. The transactions described above are collectively referred to as the "Reorganization." (c) Basis of financial statements presentation The consolidated financial statements include the accounts of Tel-Save Holdings, Inc. and its wholly-owned subsidiaries and have been prepared as if the entities had operated as a single consolidated group since their respective dates of incorporation. All intercompany balances and transactions have been eliminated. In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting period. Actual results could differ from those estimates. (d) Recognition of revenue The Company recognizes revenue upon completion of telephone calls by end users. Allowances are provided for estimated uncollectible usage. (e) Cash and cash equivalents The Company considers all temporary cash investments purchased with a maturity of three months or less to be cash equivalents. (f) Marketable securities The Company buys and holds securities principally for the purpose of selling them in the near term and therefore, they are classified as trading securities and carried at market. Unrealized holding gains and losses (determined by specific identification) on investments classified as trading securities are included in earnings. (g) Advances to partitions and note receivables The Company makes advances to partitions to support their marketing activities. The advances are secured by partition assets, including contracts with end users and collections theron. (h) Property and equipment and depreciation Property and equipment are recorded at cost. Depreciation and amortization is calculated using the straight-line method over the estimated useful lives of the assets, as follows: Buildings and building improvement 39 years Switching equipment 15 years Equipment, vehicles and other 5-7 years 32 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) (i) Intangibles and amortization Intangibles include the costs to acquire billing bases of customer accounts, long-distance service contract pricing plans and goodwill arising from business acquisitions. Amortization is computed on a straight-line basis over the estimated useful lives of the intangibles which is 15 years. (j) Deferred revenue Deferred revenue is recorded for a non-refundable prepayment received in connection with an amended telecommunications services agreement with Shared Technologies Fairchild, Inc. ("STF") and is amortized over the five year term of the agreement. This agreement is terminable by either party on thirty days notice. Termination by either party would accelerate recognition of the deferred revenue. (k) Long-lived assets The Company adopted SFAS No. 121, "Accounting For the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of" as of January 1, 1996 and its implementation did not have a material effect on the consolidated financial statements. (l) Income taxes Deferred tax assets and liabilities are recorded for the estimated future tax effects attributable to temporary differences between the basis of assets and liabilities recorded for financial and tax reporting purposes (Note 12). (m) Net income per share During 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 128 ("SFAS No. 128"). "Earnings per Share," which provides for the calculation of "basic" and "diluted" earnings per share. This Statement is effective for financial statements issued for periods ending after December 15, 1997. Basic earnings per share includes no dilution and is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect, in periods in which they have a dilutive effect, the effect of common shares issuable upon exercise of stock options. As required by this Statement, all periods presented have been restated to comply with the provisions of SFAS No. 128. The computation of basic net income per share is based on the weighted average number of common shares outstanding during the period. In 1996 and 1995, diluted earnings per share also includes the effect of 4,352,000 and 2,183,000 common shares, respectively, issuable upon exercise of common stock options and warrants. Net income per share for the year ended December 31, 1995 is based on pro forma net income. All references in the consolidated financial statements with regard to average number of common stock and related per share amounts have been calculated giving retroactive effect to the exchange of shares in the Reorganization and the stock splits. (n) Financial instruments and risk concentration Financial instruments which potentially subject the Company to concentrations of credit risk are cash investments and marketable securities. At December 31, 1997, a large majority of the Company's cash investments and marketable securities were invested in money market funds and commercial paper. The carrying amount of these cash investments approximates the fair value due to their short maturity. The Company believes no significant concentration of credit risk exists with respect to these cash investments and marketable securities. The carrying values of accounts receivable, advances to partitions and note receivables, accounts payable and accrued expenses, and convertible debt approximate fair values. In the first quarter of 1998, the Company invested $300 million in a tax exempt bond fund, $245 million in government bond funds and incurred $155 million of margin account indebtedness in connection with these investments. (o) Securities sold short/financial investments with off-balance sheet risk At December 31, 1997, securities sold short by the Company, which consist of equity securities valued at market, resulted in an obligation to purchase such securities at a future date. Securities sold short may give rise to off-balance sheet market risk. The Company may incur a loss if the market value of these securities subsequently increases. (p) Stock-based Compensation The Company accounts for its stock option awards under the intrinsic value based method of accounting prescribed by Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees." Under the intrinsic value based method, compensation cost is the excess. if any, of the quoted market price of the stock at grant date or other measurement date over the amount an employee must pay to acquire the stock. The Company makes pro forma disclosures of net income and earnings per share as if the fair value based method of accounting had been applied as required by Statement of Financial Accounting Standards ("SFAS") 123, "Accounting for Stock-Based Compensation." (q) New Accounting Pronouncements In June 1997, the FASB issued SFAs No. 130, "Reporting Comprehensive Income," which establishes standards for reporting and display of comprehensive income, its components and accummulated balances, comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributions to owners. Among other disclosures, SFAS 130 requires that all items that are required to be rocognized under current accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominance as other financial statements. SFAS 130 is effective for financial statements for periods beginning after December 15, 1997 and requires comparative information for earlier years to be restated. Because of the recent issuance of this standard, management has been unable to fully evaluate the impact, if any, the standard may have on future financial statement disclosures. Results of operations and financial position, however, will be unaffected by implementation of this standard. In June 1997, the Financial Accounting Standards Board issued SFAS No. 131. Disclosures about Segments of an Enterprise and Related Information, (SFAS 131) which supercedes SFAS No. 14, Financial Reporting for Segments of a Business Enterprise. SFAS 131 establishes standards for the way that public companies report information about operating segments in annual financial statements and requires reporting of selected information about operating segments in interim financial statements issued to the public. It also establishes standards for customers. SFAS 131 defines operating segments as components of a company about which separate financial information is available that is evaluated regularly by the chief operating decision maker in deciding how to allocate resources and is assessing performance. SFAS 131 is effective for financial statements for periods beginning after December 15, 1997 and requires comparative information for earlier years to be restated. Because of the relatively recent issuance of this standard, management has been unable to fully evaluate the impact, if any, it may have on future financial statement disclosures. Results of operations and financial position, however, will be unaffected by implementation of this standard. 33 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) NOTE 2 -- MAJOR PARTITIONS Partitions who provided end user accounts, which in the aggregate account for more than 10% of sales, are as follows:
Number of Total Percentage Partitions Of Sales ----------------------- ----------------------- Year ended December 31, 1997 1 13% Year ended December 31, 1996 1 11% Year ended December 31, 1995 -- --
NOTE 3 -- CUSTOMER ACQUISITION The Company determined in the second quarter of 1997 to de-emphasize the use of direct marketing to solicit customers for the Company as the carrier and to focus the majority of its existing direct marketing resources on customer service and support for the marketing operations of its carrier partitions, on a fee basis. The Company recognized fees of $8.1 million for the year ended December 31, 1997, included in other income, from the services net of related costs of $14.6 million for the year ended December 31, 1997. The Company recorded a one-time charge of $11.5 million as cost of sales in the quarter ended June 30, 1997, primarily as a result of the Company changing its accounting for customer acquisition costs to expense them in the period incurred versus the Company's prior treatment of capitalizing customer acquisition costs and amortizing them over a six month period. In October 1997, the Company decided to discontinue its internal telemarketing operations which were primarily conducted through American Business Alliance (which was acquired by the Company in December 1996), as part of its restructuring of its sales and marketing efforts and wrote-off, as cost of sales, approximately $23.0 million of intangible assets. NOTE 4 -- AOL AGREEMENT In conjunction with the Telecommunications Marketing Agreement (the "AOL Agreement") with America Online, Inc. ("AOL"), the Company paid AOL a total of $100 million and issued two warrants to purchase shares of the Company's stock, one warrant (the "First Warrant") to purchase, at an exercise price of $15.50 per share, up to 5,000,000 shares, which vested as to 2,500,000 shares on October 9, 1997 ("Commercial Launch Date"), when the Company's service was launched on the AOL online network, and as to 2,500,000 shares on February 22, 1998, and one warrant (the "Second Warrant") to purchase, at an exercise price of $14.00 per share, up to 7,000,000 shares, which will vest, commencing December 31, 1997, based on the number of subscribers to the Company's service and would vest fully if there are at least 3.5 million such subscribers at any one time. With respect to the Second Warrant, as vesting occurs, the fair value of the incremental vested portion of the warrant will be changed to expense in the consolidated statement of operations. As of December 31, 1997 the second warrant was vested as to approximately 120,000 shares and $1,200,000 was charged to expense in the 1997 consolidated statement of operations. The initial term of the AOL Agreement runs to June 30, 2000, and the AOL Agreement provides for annual extensions by AOL of its term thereafter. The $100 million cash payment, the $20.0 million value of the First Warrant and $0.6 million of agreement related costs was accounted for as follows: (i) $35.9 million was charged to expense ratably over the period from the signing of the AOL Agreement to December 31, 1997, as payment for certain exclusivity rights for that period; (ii) $13.2 million was treated as production of advertising costs and was charged to expense on October 9, 1997, the Commercial Launch Date; and (iii) $71.5 million, the balance of the cash payment and the value of the First Warrant and AOL Agreement related costs, represents the combined value of advertising and exclusivities which extend over the term of the AOL Agreement and will be recognized ratably after the Commercial Launch Date as advertising services are received. For the year ended December 31, 1997, the Company recognized $57.0 million of expense, related to items discussed above. The AOL Agreement also provides for marketing payments to AOL based on the "pre-tax profit" (as defined in the AOL Agreement) in each calendar quarter from the telecommunications services provided by the Company. AOL's share of the pre-tax profit will vary from 50% to 70%, depending upon the level of revenues from such services. The Company will withhold a portion of AOL's share of the pre-tax profit as a recovery of the initial $100 million cash payment. The Company is permitted to offset up to $4.3 million in each of the 10 quarters ending after December 31, 1997 and to offset 33% of AOL's share of the pre-tax profits for every quarter ending after June 30, 2002 until the entire $100 million cash payment has been recovered. AOL's share of pre-tax profits in excess of the $4.3 million and 33% will be distributed as earned. The AOL Agreement also provides for the grant to AOL of additional warrants to purchase up to an aggregate of 2 million shares if AOL extends its obligations under the AOL Agreement beyond June 30, 2000. The fair value of any such additional warrants that may be granted to AOL will be charged as an expense in the statement of operations. 34 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) NOTE 5 -- PROPERTY AND EQUIPMENT
DECEMBER 31, ----------------------------------------------- 1997 1996 --------------------- ---------------------- (In thousands) Land $ 220 $ 220 Buildings and building improvements 4,259 3,398 Switching equipment 41,915 -- Switching equipment under construction -- 24,861 Equipment, vehicles and other 13,078 2,117 -------- --------- 59,472 30,596 Less: Accumulated depreciation (3,637) (499) -------- --------- $ 55,835 $30,097 ======== =========
NOTE 6 -- INTANGIBLES
YEAR ENDED DECEMBER 31, ----------------------------------------------- 1997 1996 --------------------- ---------------------- (In thousands) Goodwill $10,590 $18,356 Other -- 6,533 ------- ------- 10,590 24,889 Less: Accumulated amortization -- 3,787 ------- ------- $10,590 $21,102 ======= =======
NOTE 7 -- ACQUISITIONS In November 1997 the Company acquired Compco, Inc. ("Compco") a provider of communications software in the college and university marketplace, for a total purchase price of $13,125,000, comprised of a cash payment of $7,500,000 and 339,982 shares of Company common stock. This transaction was accounted for as a purchase with the results of Compco included in the consolidated financial statements from acquisition date. The cost in excess of the net asset acquired (goodwill) was approximately $10,590,000. In February 1998, the Company completed the acquisition of Symetrics Industries, Inc. ("Symetrics"), a Florida corporation for approximately $25 million in cash, plus assumed liabilities. Symetrics designs, develops and manufactures electronic systems, system components and related software for defense-related products and for telecommunication applications. This transaction will be accounted for as a purchase. The Company is in the process of allocating the purchase price among the assets of Symetrics. 35 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) NOTE 8 -- CONVERTIBLE DEBT In September 1997, the Company sold $300 million of 4 1/2% Convertible Subordinated Notes which mature on September 15, 2002 (the "2002 Convertible Notes"). Interest on the 2002 Convertible Notes are due and payable semiannually on March 15 and September 15 of each year. The 2002 Convertible Notes are convertible, at the option of the holder thereof, at any time after December 9, 1997 and prior to maturity, unless previously redeemed, into shares of the Company's Common Stock at a conversion price of $24.61875 per share. The 2002 Convertible Notes are redeemable, in whole or in part, at the Company's option, at any time on or after September 15, 2000 at 101.80% of par prior to September 14, 2001 and 100.90% of par thereafter. In December 1997, the Company sold $200 million of 5% Convertible Subordinated Notes which mature on December 15, 2004 (the "2004 Convertible Notes"). Interest on the 2004 Convertible Notes are due and payable semiannually on June 15 and December 15 of each year. The 2004 Convertible Notes are convertible, at the option of the holder thereof, at any time after March 5, 1998 and prior to maturity, unless previously redeemed, into shares of the Company's Common Stock at a conversion price of $25.47 per share. The 2004 Convertible Notes are redeemable, in whole or in part at the Company's option, at any time on or after December 15, 2002 at 101.43% of par prior to December 14, 2003 and 100.71% of par thereafter. NOTE 9 -- RELATED PARTY TRANSACTIONS At December 31, 1997, executive officers of the Company had outstanding loans from the Company of $4,237,000 which were repaid during the first quarter of 1998. In connection with the Reorganization (Note 1(b)), the Company made distributions of the Company's 1995 taxable income through September 19, 1995 of approximately $13,200,000 in 1995 to its two founding stockholders. NOTE 10 -- STOCKHOLDERS' EQUITY (a) 1996 Public Offering The Company consummated a public offering (the "1996 Offering") of 18,568,000 shares of common stock (adjusted to reflect the most recent stock split, Note 10(c)), including the underwriter's over-allotment, at a price of $8.75 per share in April and May, 1996. Of the 18,568,000 shares offered, 17,068,000 were sold by the Company and 1,500,000 were sold by the majority stockholder. Proceeds of the 1996 Offering to the Company, less underwriting discounts of approximately $9,302,000, were approximately $140,043,000. Expenses for the 1996 Offering were approximately $974,000 resulting in net proceeds to the Company of approximately $139,069,000. The majority stockholder used a portion of his proceeds to repay his outstanding indebtedness, including interest, to the Company. (b) Initial Public Offering In September and October, 1995, the Company consummated its IPO of 10,350,000 shares of common stock (adjusted to reflect stock splits, Note 10(c)), including the underwriter's overallotment option, at a price of $4.59 per share. Proceeds of the offering less underwriting discounts of approximately $3,151,000 were $44,287,000. Expenses for the IPO totaled approximately $1,450,000, resulting in net proceeds to the Company of approximately $42,837,000. In connection with the IPO, the Company issued warrants to purchase 900,000 shares of common stock to the underwriter. The exercise price of the warrants is $5.73 per share of common stock and such warrants expire on September 21, 2000. (c) Stock Splits On January 3, 1997, the Company's Board of Directors approved a two-for-one split of the common stock in the form of a 100% stock dividend. The additional shares resulting from the stock split were distributed on January 31, 1997 to all stockholders of record at the close of business on January 17, 1997. The consolidated balance sheet as of December 31, 1996 and the consolidated statement of stockholders' equity for the year ended December 31, 1996 reflect the recording of the stock split as if it had occurred on December 31, 1996. 36 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) On February 16, 1996, the Company's Board of Directors approved a three-for-two split of the common stock in the form of a 50% stock dividend. The additional shares resulting from the stock split were distributed on March 15, 1996, to all stockholders of record at the close of business on February 29, 1996. The consolidated balance sheet as of December 31, 1995 and the consolidated statement of stockholders' equity for the year ended December 31, 1995 reflect the recording of the stock split as if it had occurred on December 31, 1995. Further, all references in the consolidated financial statements to average number of shares outstanding and related prices, per share amounts, warrant and stock option data have been restated for all periods to reflect the stock splits. (d) Authorized Shares During 1997, the Board of Directors and stockholders approved the increase in the number of authorized shares of the Company's $0.01 par value common stock to 300,000,000 shares. NOTE 11 -- STOCK OPTIONS AND WARRANTS (a) Stock Options The Company has both qualified and non-qualified stock option agreements with most of its key employees. Prior to the Company's Initial Public Offering in September, 1995, the Company granted ten key employees options to purchase shares of the Company's common stock. The exercise price of the options, was based on the fair market value of the Company at the date of grant. The options vest 22 months from the date of issuance and expire five years from the date of grant. All options were vested as of December 31, 1996. In 1995, 1996 and 1997, the Company granted options to purchase a total of 100,000 shares of common stock to each of the two nonemployee directors of the Company. In September 1995, the Company's Board of Directors and stockholders adopted the Company's 1995 Employee Stock Option Plan (the "Option Plan") which provided for the granting of up to 1,950,00 shares of common stock. An amendment to the Option Plan was approved by the Board of Directors and stockholders in April 1996 increasing the authorized number of options which can be granted under the Option Plan to 5,000,000 shares of common stock. As of December 31, 1997, 4,985,000 options had been granted under the Option Plan. In 1996 and 1997 the Company granted certain employees 3,561,000 and 2,741,000, respectively, non-qualified options to purchase shares of the Company's common stock. These options become exercisable from one to three years from the date of the grant. During 1997, The company recognized $13,371,785 of compensation expenses related to the grant of options or the purchase of the Company's stock at prices below the quoted market price at date of grant or purchase date. SFAS No. 123, "Accounting for Stock-Based Compensation," requires the Company to provide pro forma information regarding net income and earnings per share as if compensation cost for the Company's stock options had been determined in accordance with the fair value-based method prescribed in SFAS No. 123. The Company estimates the fair value of each stock option at the grant date by using the Black-Scholes option-pricing model with the following weighted-average assumptions used for grants in 1995, 1996 and 1997, respectively: no dividends paid for all years; expected volatility of 40.4% in 1995 and 1996 and 55.8% in 1997; weighted average risk-free interest rates of 5.8%, 5.7%, and 5.49%, respectively; and expected lives of 1 to 5 years. 37 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Under the accounting provisions of SFAS No. 123, the Company's net income and earnings per share would have been reduced to the pro forma amounts indicated below.
1997 1996 1995 ---- ---- ---- (In thousands, except for per share data) NET INCOME: As reported $ (20,945) $20,168 $10,819 Pro forma (30,942) $16,521 $10,436 BASIC EARNINGS PER SHARE: As reported $ (.33) $ .38 $ .34 Pro forma $ (.48) $ .31 $ .33 DILUTED EARNINGS PER SHARE: As reported $ (.33) $ .35 $ .32 Pro forma $ (.48) $ .29 $ .31
The following tables contain information on stock options for the three year period ended December 31, 1997:
EXERCISE WEIGHTED OPTION PRICE RANGE AVERAGE SHARES PER SHARE EXERCISE PRICE ---------------- ---------------- ---------------- Outstanding, December 31, 1994 2,455,800 $ .32-$1.57 $ .48 Granted 1,950,000 $ 4.58 $ 4.58 ---------------- ---------------- ---------------- Outstanding, December 31, 1995 4,405,800 $ .32-$4.58 $ 2.30 Granted 6,736,000 $ 4.09-$12.00 $ 7.96 Exercised (2,158,000) $ .32-$5.67 $ 2.28 ---------------- ---------------- ---------------- Outstanding, December 31, 1996 8,983,800 $ .32-$12.00 $ 6.54 Granted 2,801,000 $ 5.67-$22.06 $16.02 Exercised (2,208,812) $ .32-$12.78 $ 4.25 Cancelled (690,000) $ 5.67-$13.25 $11.98 ---------------- ---------------- ---------------- Outstanding, December 31, 1997 8,885,988 .32-$22.06 $ 9.26 ================ ================ ================ EXERCISE WEIGHTED OPTION PRICE RANGE AVERAGE EXERCISABLE AT YEAR ENDED DECEMBER 31, SHARES PER SHARE EXERCISE PRICE - ------------------------------------------- ---------------- ---------------- ---------------- 1995 1,515,600 $ .32 $ .32 1996 2,649,800 $ .32-$4.58 $ 2.82 1997 3,866,987 $ .32-$14.50 $ 7.24 WEIGHTED-AVERAGE OPTIONS GRANTED IN FAIR VALUE - ------------------ ---------- 1995 $1.14 1996 $2.39 1997 $6.99
The following table summarizes information about stock options outstanding at December 31, 1997:
RANGE OF EXERCISE PRICE --------------------------------------------------------------------------------------- $.32-$5.00 $5.01-$10.00 $10.01-$15.00 $15.00-$22.06 $.32-$22.06 ------------- ------------- ---------------- --------------- -------------- OUTSTANDING OPTIONS: Number outstanding at December 31, 1997 2,776,988 2,382,000 1,989,500 1,742,500 8,885,988 Weighted-Average remaining contractual life (Years) 1.94 1.69 2.11 3.12 2.18 Weighted-average exercise price $ 3.48 $ 8.52 $ 11.47 $ 17.57 $ 9.26 EXERCISABLE OPTIONS: Number outstanding at December 31, 1997 1,596,988 779,000 1,490,999 - 3,866,987 Weighted-average exercise price $ 2.68 $ 8.66 11.37 - $ 7.23
(b) Warrants 38 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) At December 31, 1996, the Company had warrant agreements with certain partitions and the underwriter for its IPO (Note 10(b)). All warrants were issued with exercise prices equal to or above the market price of the underlying stock at the date of the grant. These warrants are accounted for based on their fair value. At December 31, 1996, 3,712,000 warrants were outstanding with exercise prices ranging from $4.67 to $5.73 and an average weighted exercise price of $5.00 and 600,000 which were currently exercisable at a weighted exercise price of $5.73. The remaining warrants are exercisable over a one to two year period beginning in January 1997. In January 1997, 800,000 of these warrants were purchased by the Company and recorded as a reduction in additional paid-in capital and 2,662,000 warrants were exercised. At December 31, 1997, warrants to purchase 12,250,000 shares were outstanding; these consisted of the 12,000,000 AOL warrants (Note 4) and 250,000 of the warrants issued to the underwriter for the Company's IPO (Note 10(b)). NOTE 12 -- INCOME TAXES On June 1, 1991, the Company, with the consent of its stockholders, elected to be taxed as an S Corporation. As a result of the election, all earnings of the Predecessor Corporation were taxed directly to the stockholders. Accordingly, the statements of operations prior to September 20, 1995 did not include provisions for income taxes. In connection with the Company's IPO, as described in Note 10(b), on September 19, 1995, the Company terminated its S Corporation status. Pro forma tax provisions have been calculated as if the Company's results of operations were taxable as a C Corporation under the Internal Revenue Code for the year ended December 31, 1995. The following summarizes the provision for pro forma income taxes: YEAR ENDED DECEMBER 31, --------------- 1995 ---- (In thousands) Current: Federal $5,574 State and local 1,639 ------- Pro forma provision for income taxes $7,213 ======= 39 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) The provision for pro forma income taxes on adjusted historical income for the year ended December 31, 1995 differs from the amounts computed by applying the applicable Federal statutory rates due to the following: YEAR ENDED DECEMBER 31, ---------------- 1995 ---- (In thousands) Provision for Federal income taxes at the statutory rate $6,311 State and local income taxes, net of Federal benefit 1,082 Other (180) ------- Pro forma provision for income taxes $7,213 ======== As a result of the termination, the Company was required to provide for taxes on income for the period subsequent to September 19, 1995 and for the previously earned and untaxed S Corporation income which has been deferred primarily as a result of reporting on a cash basis. The provision (benefit) for income taxes for the years ended December 31, 1997, 1996 and 1995 consisted of the following:
YEAR ENDED DECEMBER 31, -------------------------------- 1997 1996 1995 ---- ---- ---- (In thousands) Current: Federal $ - $10,995 $4,379 State and local - 1,817 1,809 ------- ------- ------ Total current - 12,812 6,188 ======= ======= ====== Deferred: Federal (11,111) (607) 2,201 State and local (2,280) - 608 ------- ------- ------ Total deferred (13,391) (607) 2,809 ------- ------- ------ $(13,391) $12,205 $8,997 ======= ======= ======
A reconciliation of the Federal statutory rate to the provision (benefit) for income taxes is as follows:
YEAR ENDED DECEMBER 31, -------------------------------------------------------------- 1997 1996 1995 ----------------------- --------------------------- ------------------------- (In thousands) Federal income taxes computed at the statutory rate $(12,018) (35.0)% $11,331 35.0% $6,311 35.0% Increase (decrease): Federal income taxes at the statutory rate from January 1, 1995 to September 19, 1995 - - - - (4,086) (22.7) Federal and state taxes resulting from cash to Accrual basis for tax reporting - - - - 6,399 35.5 State income taxes less Federal benefit (1,482) (4.3) 1,199 3.7 373 2.1 Other 109 .3 (325) (1.0) - - -------- ------ ------- ------ ------- ------ Total provision (benefit) for income taxes $(13,391) (39.0)% $12,205 37.7% $ 8,997 49.9% ======== ====== ======= ====== ======= ====
40 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) Deferred tax (assets) liabilities at December 31, 1997, 1996 and 1995 are comprised of the following elements:
YEAR ENDED DECEMBER 31, ------------------------------------------- 1997 1996 1995 ---- ---- ---- (In thousands) Taxable loss carryforwards $ (21,548) $ (3,705) $ -- Deferred revenue taxable currently (13,897) -- -- Stock based compensation (4,951) -- -- Allowance for uncollectible accounts (2,198) -- -- Federal and state taxes resulting from cash to accrual basis for tax reporting 1,337 2,342 3,130 Amortization of certain intangibles - (85) (227) Other 869 (55) (94) ------------ ------------ ---------- Deferred tax (assets) liabilities $ (40,388) $ (1,503) $ 2,809 ============ ============ ==========
Long-term deferred tax assets of $9,472,000 are included in other assets in the consolidated balance sheet at December 31, 1997. The Company has recorded net deferred tax assets at December 31, 1997 and 1996 primarily representing net operating loss carryforwards and other temporary differences. Management believes that no valuation allowance is required for these assets due to future reversals of existing taxable temporary differences and the exception that the Company will generate taxable income in future years. NOTE 13 -- STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, ------------------------------------------------- 1997 1996 1995 ---- ---- ---- (In thousands) Supplemental disclosure of cash flow information: Cash paid for: Interest $915 $ 47 $ 24 Income taxes $ -- $ 1,090 $ 3,813
During 1997, the Company recorded an asset of $20,000,000 in connection with the issuance of warrants to AOL (Note 4). In connection with the acquisition of Compco in 1997, the Company issued 339,982 shares of Company common stock with a value of $5,625,000 (Note 7). In connection with the acquisition of the assets of ABA in 1996, the Company released ABA of its outstanding obligations to the Company of $10,949,000. During 1996, the Company recorded an intangible of $1,077,000 in connection with the issuance of warrants to certain partitions (Note 11(b)). During 1995, the Company issued the Cash Flow Note in the amount of $6,900,000 to the minority stockholder of the Predecessor Corporation in connection with the IPO and Reorganization (Note 1(b)). NOTE 14 -- QUARTERLY FINANCIAL DATA (UNAUDITED)
FIRST SECOND THIRD FOURTH QUARTER QUARTER QUARTER QUARTER(2) ------- ------- ------- ------- (In thousands, except for per share data) 1997 Sales $71,160 $75,032 $80,314 $78,262 Gross profit (loss) 9,375 (9,264)(1) 2,097 (52,609)(1) Operating income (loss) 6,082 (13,924) (3,243) (73,966) Net income (loss) 5,430 (5,865) 721 (21,231) Net income (loss) per share - Basic 0.09 (0.09) 0.01 (0.32) Net income (loss) per share - Diluted 0.08 (0.09) 0.01 (0.32) 1996 Sales $51,065 $57,015 $60,079 $64,265 Gross profit 6,832 7,387 8,323 9,285 Operating income 4,546 4,882 5,871 6,489 Net income 3,377 4,058 7,032 5,701 Net income per share - Basic 0.09 0.08 0.12 0.10 Net income per share - Diluted 0.08 0.07 0.11 0.09
(1) See Note 3. (2) Includes $32.1 million (pre-tax) of other income associated with the break- up of a proposed merger between the Company and STF. 41 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (CONTINUED) ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS AND FINANCIAL DISCLOSURE Not applicable. PART III ITEM 10 THROUGH 13 Information required by Part III (Items 10 through 13) of this Form 10-K is incorporated by reference to the Company's definitive proxy statement for the Annual Meeting of Stockholders to be held in May, 1998, which will be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year to which this Form 10-K relates. 42 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Annual Report on Form 10-K. 1. Consolidated Financial Statements: The Consolidated Financial Statements filed as part of this Form 10-K are listed in the "Index to Consolidated Financial Statements" in Item 8. 2. Consolidated Financial Statement Schedule: The Consolidated Financial Statement Schedule filed as part of this report is listed in the "Index to S-X Schedule." Schedules other than those listed in the accompanying Index to S-X Schedule are omitted for the reason that they are either not required, not applicable, or the required information is included in the Consolidated Financial Statements or notes thereto. 43 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES INDEX TO S-X SCHEDULE PAGE ---- Report of Independent Certified Public Accountants 55 Schedule II -- Valuation & Qualifying Accounts 56 44 [LOGO] REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of Tel-Save Holdings, Inc. The audits referred to in our report dated February 5, 1998 relating to the consolidated financial statements of Tel-Save Holdings, Inc. and subsidiaries, which is contained in Item 8 of this Form 10-K, included the audits of the financial statement schedule listed in the accompanying index for each of the three years in the period ended December 31, 1997. This financial statement schedule is the responsibility of management. Our responsibility is to express an opinion on this schedule based on our audits. In our opinion, the financial statement Schedule II -- Valuation and Qualifying Accounts, presents fairly, in all material respects, the information set forth therein. BDO Seidman, LLP New York, New York February 5, 1998 45 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS (IN THOUSANDS)
BALANCE AT CHARGED TO BALANCE AT BEGINNING OF COSTS AND OTHER END OF DESCRIPTION PERIOD EXPENSES CHANGES DEDUCTIONS PERIOD ----------- ------ -------- ------- ---------- ------ Year ended December 31, 1997: Reserves and allowances deducted from as- set accounts: Allowance for uncollectible accounts $987 $1,285 $ 147 (a) $-- $2,419 ==== ====== ========== === ====== Year ended December 31, 1996: Reserves and allowances deducted from as- set accounts: Allowance for uncollectible accounts $804 $ 38 $ 145 (a) $-- $ 987 ==== ======= ========== === ====== Year ended December 31, 1995: Reserves and allowances deducted from as- set accounts: Allowance for uncollectible accounts $987 $ (13) $(170)(a) $-- $ 804 ==== ========= ========= === ======
- ---------- (a) Amount represents portion of change in allowance for uncollectible accounts applied against Accounts Payable Partitions. 46 (3) EXHIBITS: EXHIBIT NUMBER DESCRIPTION - ------ ----------- 2.1 Plan of Reorganization between and among Tel-Save Holdings, Inc., a Delaware corporation, Tel-Save, Inc., a Pennsylvania corporation, Daniel Borislow and Paul Rosenberg, and Exhibits Thereto (incorporated by reference to Exhibit 2.1 to the Company's registration statement on Form S-1 (File No. 33-94940)). 3.1 Amended and Restated Certificate of Incorporation of the Company, as amended (incorporated by reference to Exhibit 3.1 to the Company's registration statement on Form S-4 (File No. 333-38943)). 3.2 Bylaws of the Company (incorporated by reference to Exhibit 3.2 to the Company's registration statement on Form S-1 (File No. 33-94940)). 9.1 Voting Trust Agreement between Daniel Borislow and Paul Rosenberg (included as part of Exhibit 2.1). 10.1* Employment Agreement between the Company and Daniel Borislow and related Agreement (incorporated by reference to Exhibit 10.1 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.2 * Employment Agreement between the Company and Emanuel J. DeMaio (incorporated by reference to Exhibit 10.2 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.3 * Employment Agreement between the Company and Gary W. McCulla (incorporated by reference to Exhibit 10.3 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.4 * Employment Agreement between the Company and George P. Farley (incorporated by reference to Exhibit 10 to the Company's report on Form 10-Q for the Quarter ended September 30, 1997). 10.5 * Employment Agreement between the Company and Aloysius T. Lawn, IV (incorporated by reference to Exhibit 10.5 to the Company's registration statement on Form S-1 (File No. 333-2738)). 10.6 * Employment Agreement between the Company and Edward B. Meyercord, III (incorporated by reference to Exhibit 10.6 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996). 10.7 Indemnification Agreement between the Company and Daniel Borislow (incorporated by reference to Exhibit 10.4 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.8 Indemnification Agreement between the Company and Emanuel J. DeMaio (incorporated by reference to Exhibit 10.5 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.9 Indemnification Agreement between the Company and Gary W. McCulla (incorporated by reference to Exhibit 10.6 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.10 Indemnification Agreement between the Company and Joseph M. Morena (incorporated by reference to Exhibit 10.7 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.11 Indemnification Agreement between the Company and Peter K. Morrison (incorporated by reference to Exhibit 10.8 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.12 Indemnification Agreement between the Company and Kevin R. Kelly (incorporated by reference to Exhibit 10.9 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.13 Indemnification Agreement between the Company and Aloysius T. Lawn, IV (incorporated by reference to Exhibit 10.12 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1995). 10.14 Indemnification Agreement between the Company and Edward B. Meyercord, III (incorporated by reference to Exhibit 10.14 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1996). 10.15 Agreement dated as of March 15, 1994 between the Company and Global Network Communications (incorporated by reference to Exhibit 10.10 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.16 AT&T Contract Tariff No. 516 (incorporated by reference to Exhibit 10.11 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.17 AT&T Contract Tariff No. 1715 (incorporated by reference to Exhibit 10.15 to the Company's registration statement on Form S-1 (File No. 333-2738)). 10.18 AT&T Contract Tariff No. 2039 (incorporated by reference to Exhibit 10.16 to the Company's registration statement on Form S-1 (File No. 333-2738)). 10.19 AT&T Contract Tariff No. 2432 (incorporated by reference to Exhibit 10.17 to the Company's registration statement on Form S-1 (File No. 333-2738)). 10.20 AT&T Contract Tariff No. 3628 (incorporated by reference to Exhibit 10.18 to the Company's registration statement on Form S-1 (File No. 333-2738)). 10.21 AT&T Contract Tariff No. 5776 (incorporated by reference to Exhibit 10.21 to the Company's Annual Report on Form 10-K for the year ended December 31, 1996). 47 EXHIBIT NUMBER DESCRIPTION - ------ ----------- 10.22 General Agreement between Tel-Save, Inc. and AT&T Corp. dated June 26, 1995 (incorporated by reference to Exhibit 10.14 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.23* Tel-Save Holdings, Inc. 1995 Employee Stock Option Plan (incorporated by reference to Exhibit 10.15 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.24* Tel-Save Holdings, Inc. Employee Bonus Plan (incorporated by reference to page 13 of the Company's Proxy Statement for the Company's 1996 Annual Meeting of Stockholders dated April 3, 1996). 10.25* Non-Qualified Stock Option Agreement between the Company and Daniel Borislow (incorporated by reference to Exhibit 10.17 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.26* Non-Qualified Stock Option Agreement between the Company and Emanuel J. DeMaio (incorporated by reference to Exhibit 10.18 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.27* Non-Qualified Stock Option Agreement between the Company and Mary Kennon (incorporated by reference to Exhibit 10.19 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.28* Non-Qualified Stock Option Agreement between the Company and Gary W. McCulla (incorporated by reference to Exhibit 10.20 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.29* Non-Qualified Stock Option Agreement between the Company and Peter K. Morrison (incorporated by reference to Exhibit 10.22 to the Company's registration statement on Form S-1 (File No. 33-94940)). 10.30+ Telecommunications Marketing Agreement by and among the Company, Tel-Save, Inc. and America Online, Inc., dated February 22, 1997 (incorporated by reference to Exhibit 10.32 to the Company's Form 10-K for the year ended December 31, 1996). 10.31++ Amendment No 1, dated as of January 25, 1998, to the Telecommunications Marketing Agreement dated as of February 22, 1997 by and among the Company, Tel-Save, Inc. and America Online, Inc. 10.32 Indenture dated as of September 9, 1997 between the Company and First Trust of New York, N.A. (incorporated by reference to Exhibit 4.3 to the Company's registration statement on Form S-3 (File No. 333-39787)). 10.33 Registration Agreement dated as of September 3, 1997 between the Company and Salomon Brothers Inc, Deutsche Morgan Grenfell Inc., Bear, Stearns & Co. Inc., Smith Barney Inc., Robertson Stephens & Company LLC (incorporated by reference to the Company's registration statement on Form S-3 (File No. 333-39787)). 10.34 Indenture dated as of December 10, 1997 between the Company and First Trust of New York, N.A. (incorporated by reference to Exhibit 10.34 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997) 10.35 Registration Agreement dated as of December 10, 1997 between the Company and Smith Barney Inc. (incorporated by reference to Exhibit 10.35 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997) 11.1 Net Income Per Share Calculation. 21.1 Subsidiaries of the Company. 23.1 Consent of BDO Seidman, LLP. (incorporated by reference to Exhibit 23.1 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997) 27 Financial Data Schedule. (incorporated by reference to Exhibit 27 to the Company's Annual Report on Form 10-K for the year ended December 31, 1997) - ---------- * Management contract or compensatory plan or arrangement. + Confidential treatment previously has been granted for a portion of this exhibit. ++ Confidential treatment has been requested for portions of this exhibit. (b) Reports on Form 8-K. The following Current Reports on Form 8-K were filed by the Company during the three months ended December 31, 1997: 1. Current Report on Form 8-K dated December 5, 1997. 2. Current Report on Form 8-K dated November 25, 1997. 3. Current Report on Form 8-K dated November 20, 1997. 4. Current Report on Form 8-K dated October 29, 1997. 5. Current Report on Form 8-K dated October 26, 1997. 48 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: April 16, 1998 TEL-SAVE HOLDINGS, INC. By: /s/ Daniel Borislow --------------------------- Daniel Borislow Chairman of the Board of Directors, Chief Executive Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the registrant in the capacities and on the dates indicated.
SIGNATURE TITLE DATE /s/ Daniel Borislow Chairman of the Board - ----------------------------- of Directors, Chief Executive Officer and April 16, 1998 Daniel Borislow Director (Principal Executive Officer) /s/ Gary W. McCulla President, Director of Sales and April 16, 1998 - ----------------------------- Marketing and Director Gary W. McCulla /s/ Emanuel J. DeMaio Chief Operations Officer and Director April 16, 1998 - ----------------------------- Emanuel J. DeMaio /s/ George P. Farley Chief Financial Officer and Director April 16, 1998 - ----------------------------- (Principal Financial Officer) George P. Farley /s/ Kevin R. Kelly Controller (Principal Accounting Officer) April 16, 1998 - ----------------------------- Kevin R. Kelly /s/ Harold First Director April 16, 1998 - ----------------------------- Harold First /s/ Ronald R. Thoma Director April 16, 1998 - ----------------------------- Ronald R. Thoma
49 EX-10.31 2 EXHIBIT 10.31 "***" indicates text omitted pursuant to a request for confidential treatment. Such material has been filed separately with the Securities and Exchange Commission. AMENDMENT NO. 1 This AMENDMENT NO. 1 (the "Amendment"), dated as of January 25, 1998 (the "Amendment Effective Date"), by and among Tel-Save, Inc. ("TS"), a Pennsylvania corporation, and Tel-Save Holdings, Inc. ("Holdings"), a Delaware corporation, with their principal offices at 6805 Route 202, New Hope, Pennsylvania 18938, on the one hand, and America Online, Inc., a Delaware corporation with its principal offices at 22000 AOL Way, Dulles, Virginia 20166 ("AOL"), on the other hand (each a "party" and, collectively, the "parties"). INTRODUCTION TS, Holdings and AOL are parties to the Telecommunications Marketing Agreement, dated as of February 22, 1997, as heretofore corrected and amended by letter, dated April 23, 1997 (as so corrected and amended to the date hereof, but without giving effect to this Amendment, the "Agreement"). Capitalized terms used in this Amendment without other definition are defined as in the Agreement. The parties have since considered further the marketing and advertising expenditures provided in the Agreement, and, in light of both parties' desire to increase the number of End Users of the Long Distance Telecommunications Services, hereby agree as follows: TERMS 1. The Agreement is amended to provide that references in the Agreement to "this Agreement" or "the Agreement" (including indirect references such as "hereunder," "hereby," "herein" and "hereof") shall be deemed to be references to the Agreement as amended hereby. 2. Section I.A of the Agreement is hereby amended to add the following definitions: "1.A. "Additional Promotion Period" means the period from the Amendment Effective Date through March 31, 1998 (as such period may be shortened as provided herein). "5.A. "Amendment" means the Amendment No. 1 to the Agreement dated as of the Amendment Effective Date. "5.B. "Amendment Effective Date" means January 25, 1998." 3. Section I.A.19 of the Agreement is amended to read in its entirety as follows: "19. "Gross Revenues" for any calendar quarter shall mean the sum of (a) total billings by TS to End Users for the provision of Services during such quarter and (b) if such billings are in a material amount, total billings by TS to any other end users of telecommunications services provided by TS that would meet the definition of "Restricted Services," which such other end users became such as a direct result of marketing by TS that used the AOL Marks or any variation of the AOL name (whether or not such marketing has been approved by AOL or is otherwise in compliance with this Agreement, and without waiver of AOL's rights hereunder with respect to such approval or compliance) ("Other End Users"), less * * * " 4. Section III.A.1 of the Agreement is amended to add "(a)" before "During each" at the beginning of such section and to add the following at the end of such section: "(b) Notwithstanding anything to the contrary in this Agreement, the parties agree that, commencing February 1, 1998 and until the end of the Additional Promotion Period, AOL shall provide TS with additional online promotions and advertisements, including Pop-Up Ads, in form and substance as determined pursuant to the foregoing portion of this Section III.A.1, with an Ad Value of at least * * * per month (or the pro-rata amounts thereof for portions of months) in addition to the Ad Values to be provided pursuant to Section III.A.1(a) (the "Additional Promotions"). Pop-Up Ads during the Additional Promotion Period shall be made available onscreen for at least * * * days (instead of the number required pursuant to Section I.A.31 hereof), and any Pop-Up Ads included by AOL during the Additional Promotion Period in excess of * * * Pop-Up Ads per month and any Pop-Up Ads included by AOL with TS's approval during the remainder of the Introductory Period in excess of * * * per month shall be counted toward AOL's satisfaction of the * * * monthly requirement set forth in Section III.A.1(a) above. Following the expiration of the Additional Promotion Period, AOL shall not be obligated to provide any promotions or advertisements other than those promotions or advertisements that were required of AOL pursuant to the Agreement, but without regard to this Section III.A.1.(b). (c) In the event that AOL has not delivered each of the "AOL Deliverables" (as set forth in Attachment A) in accordance with the terms hereof or has not delivered the Ad Values of promotions and advertisements required by Sections III.A.1(a) and (b) to be provided during the Additional Promotion Period, in each case, on or before February 28, 1998, TS may elect in its sole discretion that the Additional Promotion Period end as of February 28, 1998 so long as TS has provided AOL with written notice of such election by fascimile to the attention of David Colburn (fax no. 703-265-1202) no later than 5:00 p.m. EST on February 28, 1998. In such case: (i) TS will be relieved of any obligation to pay AOL the bounties provided for hereunder with respect to any customers who first signed up for Services subsequent to February 28, 1998, (ii) the additional guaranteed amount to be paid by TS pursuant to this Amendment shall be as adjusted as described below and (iii) AOL will not deliver the additional promotions contemplated hereunder thereafter. (d) Except for those AOL Deliverables noted as "ongoing" obligations on Attachment A ("Ongoing Deliverables"), an AOL Deliverable shall be deemed delivered in the event AOL completes delivery of the AOL Deliverable on or before the due date specified on Attachment A; provided that AOL shall be 2 entitled to a cure period of five (5) business days following such due date within which to complete its delivery. Any Ongoing Deliverable shall be deemed delivered if AOL has commenced delivery of such item and is continuing without default its delivery as of February 28, 1998; provided that AOL shall be entitled to a cure period of five (5) business days following any interruption in delivery of such AOL Deliverable within which to restore its ongoing delivery of such item. Notwithstanding the foregoing, the cure periods with respect to the AOL Deliverable relating to * * * requirements and the AOL Deliverable relating to * * * shall be only one (1) day. AOL shall be entitled to only one (1) cure period with respect to each AOL Deliverable; provided that (i) AOL shall be entitled to two (2) one-day cure periods with respect to the AOL Deliverable relating to * * * and (ii) there shall be no cure period with respect to the AOL Deliverable relating to* * *. (e) In the event that TS fails to deliver any "TS Deliverable" (as set forth in Attachment A), AOL may extend the due date set forth on Attachment A for any AOL Deliverable that (as indicated in Attachment A) depends on receipt of a TS Deliverable specified in Attachment A for a period equal to the number of days by which TS's delivery is overdue. AOL may toll its delivery of any Ongoing Deliverable until TS has delivered the TS Deliverable specified on Attachment A as necessary for the delivery of such AOL Deliverable. In the event that TS has not delivered any TS Deliverable as of February 28, 1998, any AOL Deliverable specified on Attachment A as corresponding to such TS Deliverable shall be deemed delivered by AOL as of such date. Except as otherwise expressly provided herein, (a) either party's failure to deliver its respective deliverables set forth in Attachment A shall not be deemed a breach of the Agreement and (b) following the expiration of the Additional Promotion Period, neither party shall be obligated with respect to any deliverables set forth on Attachment A other than (x) those deliverables that were required of such party pursuant to the Agreement (other than by reason of the Amendment) and (y) the * * * or the * * * program (each, as described herein), if any, that may be provided in the Extended Offline Promotion Period (as defined in Section V.C.1)." (f) Notwithstanding anything to the contrary herein, in connection with any * * * efforts directed to subscribers to the AOL Service that may be provided hereunder, AOL reserves the right to (i) approve all procedures, scripts and other materials used in connection with any such effort, such approval not to be unreasonably withheld, (ii) subject to the proviso at the end of this clause (ii), cease, or otherwise limit the amount, duration or frequency of, any such effort in the event AOL determines in its reasonable discretion that such effort (including, without limitation, any statement or claim made by TS in connection with such effort or the Services (e.g., comments made during a * * *call) is false or inaccurate or misrepresents or mischaracterizes the true nature of the Services or of any party's role in providing the Services and has resulted or is resulting in significant complaints by recipients of such efforts or material disruptions of AOL's relations with existing and potential customers, provided that AOL shall 3 have provided to TS at least five (5) days prior written notice of its intention so to cease or limit such effort, which notice shall include a specific statement of the basis for such action, including reasonable evidence of such basis, and TS shall not have, within five (5) days of such notice, modified the terms of such effort or taken such other actions as shall be reasonably likely, in AOL's discretion, to (x) prevent a continuation or recurrence of the circumstances forming the basis of such notice or (y) remedy material harm to AOL's business arising from such prior occurrence (as the case may be); and (iii) monitor such efforts for quality assurance and for compliance with the terms and conditions hereof. 5. Section III.A.2 of the Agreement is amended to add at the end thereof the following: "Notwithstanding anything to the contrary in this Agreement, the parties agree that any Pop-Up Ads included by AOL with TS's approval subsequent to the Introductory Period and during the Term in excess of * * * shall be counted toward AOL's satisfaction of the * * * monthly requirement set forth in this Section III.A.2. The total Ad Value of all promotions and advertisements to be provided by AOL pursuant to this Section III.A.2 during the period from July 1, 1999, through June 30, 2000, shall be reduced by the amount of the Ad Value of the Additional Promotions provided by AOL pursuant to Section III.A.1 above, such reduction to be applied ratably to the Ad Value to be provided during such period." 6. Section III.A.4(a) of the Agreement is amended to add at the end thereof the following: "Notwithstanding the preceding sentence, during the Additional Promotion Period, AOL shall not deploy Pop-Up Ads having * * * ." 7. Section III.A.4 of the Agreement is amended to add the following new Section III.A.4(d): "(d) Notwithstanding anything to the contrary in this Agreement, the parties agree that AOL may in its sole discretion replace any Pop-Up Ad required hereunder (or otherwise scheduled to be provided by AOL) with * * * (e.g., for purposes of fulfilling requirements of law or court order or issuing announcements regarding AOL members or AOL policies) (each an "Excluded Pop-Up"); provided that AOL delivers the replaced Pop-Up Ad as soon as reasonably possible thereafter (without resulting in simultaneous Pop-Up Ads) * * * ." 8. Section V of the Agreement is amended to add the following new Section V.B.6: "6. TS shall provide AOL biweekly with information with respect to any * * * efforts during the Additional Promotion Period and the Extended Offline Promotion Period (as defined herein) which is reasonably required for (a) measuring TS's efforts hereunder or (b) delivery of the applicable AOL Deliverable (and any other information mutually agreed upon by the parties), but 4 in no event less information than would be required of TS pursuant to Section V.B.4 hereof." 9. Section V of the Agreement is amended to add the following new Section V.C: "C. Additional Promotion Period. 1. In addition to any other payments required hereunder (and in addition to any Warrant Shares due AOL pursuant to the Supplemental Warrant and any amendments thereto), TS shall pay to AOL Bounty Fees (as defined below) as follows: a. TS shall pay to AOL the applicable Bounty Fee for each Qualified End User (as defined below) who subscribes to the Long Distance Telecommunications Services (i) during the Additional Promotion Period or (ii) following the Additional Promotion Period but only insofar as such subscription following the Additional Promotion Period is the result of * * * efforts directed to subscribers to the AOL Service that may be provided hereunder; provided however, that, from and after the total number of Qualified End Users for which TS has paid AOL a Bounty Fee pursuant to this Amendment equals one million (1,000,000), , TS shall not, subsequent to such date, be required to pay any further Bounty Fees with respect to End Users acquired as a result of any such * * * efforts. b. A "Qualified End User" is an End User who remains an End User for at least thirty (30) consecutive days. c. On the first day of each month commencing March 1, 1998, TS shall pay AOL the aggregate amount of such Bounty Fees owing to AOL with respect to the preceding month (or the preceding 35 days, in the case of the first such payment). 2. "Bounty Fee" means (i) with respect to any Qualified End User who subscribed to the Services on or before the Change Time (as defined below), $* * * and (ii) with respect to any Qualified End User who subscribed to the Services after the Change Time, $* * * , provided that the amount of any Bounty Fee payable to any Qualified End User (i) whose subscription is the result of * * * efforts directed to subscribers to the AOL Service and (ii) who subscribes to any Services at any time after the 120th day after the commencement of such * * * efforts will be one-half (1/2) of the amount set forth in clause (i) or (ii), as the case may be. "Change Time" means the time at which an aggregate of * * * persons or entities shall have subscribed to the Services since the Effective Date and become End Users (and regardless of whether such persons or entities shall then be End Users). 3. In addition to any other payments required hereunder (and in addition to any Warrant Shares due AOL pursuant to the Supplemental Warrant and any amendments thereto) and provided that AOL shall have delivered the Ad Values of promotions and advertisements required by Sections III.A.1(a) and (b) 5 to be provided during the Additional Promotion Period, on April 3, 1998, in consideration of the Additional Promotions and any additional promotion or marketing provided by AOL to TS during the Additional Promotion Period, TS shall pay to AOL a guaranteed, non-refundable amount (the "Excess Amount") equal to (i) $10,000,000 (or $3,000,000 in the event that the Additional Promotion Period is terminated as of February 28, 1998 pursuant to Section III.A.1(c) hereof) less (ii) the sum of (x) the aggregate Bounty Fees, if any, paid to AOL by TS prior to April 3, 1998, and (y) the product of (i) the Adjustment Value (as defined below) times (ii) the number of the Warrant Shares, if any, that shall have vested pursuant to the Supplemental Warrant as of March 31, 1998, with respect to the period between the Amendment Effective Date and the end of the Additional Promotion Period. "Holdings Share Price" shall mean the average of the closing prices (as defined in Section 6(d) of the Supplemental Warrant) for one (1) share of Holdings' Common Stock during each of the four (4) consecutive business days prior to April 3, 1998. The "Adjustment Value" shall mean the dollar figure that shall be determined using the schedule set forth in Attachment B. The Excess Amount shall be credited against any subsequent TS obligations to pay Bounty Fees pursuant to the Agreement on or after April 3, 1998 until the full amount of such Excess Amount shall have been so credited and, following payment of the Excess Amount to AOL, TS shall not be required to pay the Bounty Fees otherwise payable to AOL hereunder until such time as the aggregate amount of otherwise payable Bounty Fees equals the Excess Amount. TS shall thereafter commence payment of Bounty Fees to AOL as otherwise provided herein." 10. The following new Section V.D is added to Section V of the Agreement: "D. Offline Marketing Costs. TS shall be responsible for all costs and expenses associated with (a) any * * * efforts by TS or AOL or either party's agents, (b) any * * * efforts by AOL or its agents (including, without limitation, any related * * * efforts) and (c) any * * * efforts by AOL or its agents (specifically including Incentive Payments, as defined below, if any, and specifically excluding any television or print media marketing campaigns) (collectively, the "Offline Marketing Costs"); provided that all Offline Marketing Costs incurred by AOL shall be approved in writing in advance by TS. The Offline Marketing Costs shall not be included in the calculation of Actual Services Costs. Except with respect to the Estimated * * * Costs (as defined below), TS shall pay AOL within thirty (30) days of receipt of a monthly invoice from AOL detailing the Offline Marketing Costs for the preceding month. Subject to TS' right to approve in advance all Offline Marketing Costs, as provided above, TS shall pay AOL in advance with respect to the Offline Marketing Costs for any * * * efforts in an amount equal to AOL's reasonable estimate for the costs of each effort that AOL provides to TS reasonably in advance of the dates payments are due (such estimated costs, the "Estimated * * * Costs"). which Estimated * * * Costs shall be payable on the first day of each month (subject to AOL's having provided the estimate for such month), commencing March 1, 1998, with respect to Estimated * * * Costs for such 6 month. As promptly as reasonably possible after the end of each month, AOL shall provide TS with a statement detailing the Offline Marketing Costs incurred for any * * * efforts in such month and, to the extent the aggregate Costs included on such statement are less than the Estimated * * * Costs previously paid by TS to AOL with respect to such month, AOL shall promptly pay to TS the amount of such difference and, to the extent the aggregate Costs included on such statement are greater than the Estimated * * * Costs previously paid by TS to AOL with respect to such month, TS shall promptly pay to AOL the amount of such difference. The parties will mutually agree on how to allocate any costs and expenses other than the Offline Marketing Costs associated with any further offline marketing and promotional activities occurring during the remainder of the Term, including, without limitation, any joint promotional offers with respect to both the AOL Service and the Long Distance Telecommunications Services." "Incentive Payments" shall mean such payments as TS may elect to fund, at its option, pursuant to incentive programs to be implemented for * * * agents, which programs will be in form and substance to be mutually agreed upon by the parties. 11. The following new Sections V.F.1 and V.F.2 are added to Section V of the Agreement: "1. Substantially concurrently herewith, TS and Holdings are entering into a written agreement with CompuServe Interactive Services, Inc. ("CompuServe") with respect to the exclusive marketing of TS's telecommunications services by CompuServe (the "CompuServe Agreement") on the CompuServe Service (as defined in the CompuServe Agreement). In the event a Change Event occurs, AOL shall pay, or shall cause CompuServe to pay, TS within thirty (30) days of such Change Event an amount (the "Repayment Amount") which shall be calculated in accordance with Attachment E hereto; provided that, with respect to that portion of the Repayment Amount allocable to the Base Payment (the "Base Payment Portion"),, AOL may, at its option, elect, in lieu of paying the Base Payment Portion, to provide TS with an additional amount of promotion and marketing with respect to either the AOL Service or the CompuServe Service (as mutually agreed upon by the parties) (the "Change Event Promotions") with a value, as measured and calculated using the Ad Value, as defined herein, if the parties elect to deliver the Change Event Promotions with respect to the AOL Service, and the "Ad Value" (as defined in the CompuServe Agreement), if the parties elect to deliver such promotions with respect to the CompuServe Service, equal to (a) * * * times (b) the amount of the Base Payment Portion. For purposes of Attachment E: (i) "Credit Amount" shall mean, as of the date of the Change Event, the aggregate amounts theretofore credited to TS pursuant to Sections V.C.1(b) and (c); (ii) "Measurement Date" means the date sixty (60) days subsequent to the Effective Date; and (iii) "Change Event" means * * *. Immediately following the Change Event, the parties shall cause the CompuServe Agreement to be terminated; provided that such termination shall not affect the advertising to be delivered pursuant to Section V.F.1 (in the event AOL elects to deliver such advertising in lieu of paying the Base Payment Portion due to TS in connection with a Change Event). TS hereby expressly 7 acknowledges and agrees that neither the CompuServe online service (however defined in this Agreement or the CompuServe Agreement) nor the end users thereof (including, without limitation, "End Users" as defined in the CompuServe Agreement) are or shall be deemed to be within the scope of this Agreement (including, without limitation, the exclusivity provisions set forth in Section VI.A hereof), (i) by reason of the consummation of AOL's recent acquisition of CompuServe Interactive Services, Inc. (or the fact of such acquisition) or (ii) based on the facts known to TS existing as of the execution date of this Amendment. 3. Unless and until a Change Event shall have occurred, (a) no user of the TS telecommunications services marketed thereunder pursuant to the CompuServe Agreement (the "TS/CS Services") shall for any purposes of this Agreement (excluding any purpose related to the Supplemental Warrant) be, or be deemed to be, an "End User" as defined and used herein, (b) the TS/CS Services shall not be, or be deemed to be, "Services" as defined and used herein, (c) no revenues generated under or by reason of the CompuServe Agreement shall form a part of, or in any respect be included in, "Gross Revenues" as defined and used herein, and (d) TS's exclusivity rights set forth in Section VII.A herein shall not apply in any manner to CompuServe's marketing of the TS/CS Services. 4. From and after the date a Change Event shall have occurred, (a) each user of the TS/CS Services shall for all purposes of this Agreement and the Warrants be, and shall be deemed to be, an "End User" as defined and used herein, (b) the TS/CS Services shall be, and shall be deemed to be, "Services" as defined and used herein, (c) all revenues generated under or by reason of the CompuServe Agreement shall form a part of, and be included in, "Gross Revenues" as defined and used herein, and (d) TS's exclusivity rights set forth in Section VII.A herein shall apply to CompuServe's marketing of the TS/CS Services; provided that, to the extent that the CompuServe Service shall be operated as a separately accessible online service (e.g., subscribers are not required to access the service by first accessing the America Online brand service) (and without acknowledgment or agreement by AOL that such CompuServe Service satisfies the definition of AOL Service set forth Section I.A.9 hereof), AOL agrees that TS shall continue to have the access, linkage, designated area, display and other similar rights within and with respect to such CompuServe and the billing and servicing of any End Users thereon that are provided in the CompuServe Agreement." 5. AOL hereby consents to TS' and Holdings' entering into, and performing under, the CompuServe Agreement and agrees that, in and of itself, such conduct shall not constitute a breach by TS or Holdings of Section VII.A.6 of this Agreement or require the payment of any override pursuant thereto. 8 12. The following clause (iv) is added to the end of Section XI.A.2 of the Agreement: "and (iv) any claim relating to (a) the content of any statement or claim made by TS in connection with the Services or (b) the content of any promotion, advertisement or other marketing (whether offline or online, including * * *) relating to the Services (excluding any content that was submitted by AOL), which content AOL (x) advised TS that it was not reviewing, (y) did not receive from TS or was not otherwise provided a reasonable opportunity to review or (z) reviewed and provided comments, suggestions or input that were not reflected by TS in the content (and the claim is based on the content that was not reflected)." 13. The parties hereby agree to execute an amendment to the Supplemental Warrant (the "Warrant Amendment"), as soon as reasonably practicable following the Amendment Effective Date, which shall provide that each "End User" (as defined in the CompuServe Agreement) acquired through the CompuServe Service shall be included in the calculation of Warrant Shares pursuant to Section 1(a) of the Supplemental Warrant. Until such time as the parties have executed the Warrant Amendment, this paragraph shall serve as a valid amendment to the Supplemental Warrant and shall be fully self-executing in all respects. 14. The parties hereby agree that (a) the number of End Users who subscribed to the Long Distance Telecommunications Services between the Effective Date and December 31, 1997, is a minimum of * * * and (b) the number of End Users who subscribed to the Long Distance Telecommunications Services between December 31, 1997, and January 25, 1998 is * * *. The parties acknowledge that AOL is utilizing the figure of * * * net End Users as of December 31, 1997 for purposes of calculating the number of Warrant Shares due to AOL as of such date; provided that, to the extent the actual number of net End Users from the period between the Effective Date and December 31, 1997 is greater than * * * (the "Excess End Users"), then TS shall continue to be responsible to provide AOL Warrant Shares in consideration of such actual Excess End Users as of December 31, 1998. 15. This Amendment does not, and shall not be construed to, modify any term or condition of the Agreement (including, without limitation, any payment obligations under the Agreement) other than those specific terms and conditions expressly referenced in this Amendment. Except as herein provided, the Agreement shall remain unchanged and in full force and effect. In the event of any inconsistency or discrepancy between the Agreement and this Amendment, the terms and conditions set forth in this Amendment shall control. Neither party shall be bound by, and each party specifically objects to, any term, condition or other provision that is different from or in addition to the provisions of this Amendment and the Agreement (whether or not it would materially alter this Amendment or the Agreement) and which is proffered by the other party in any correspondence or other document, unless the party to be bound thereby specifically agrees to such provision in writing in accordance with the terms of the Agreement. This Amendment may be executed in multiple counterparts, each of which shall be deemed an original, but all of which together shall constitute one and the same document. This 9 Amendment shall be governed by the internal laws of the State of New York, without giving effect to the principles of conflict of laws thereof. 10 EX-11.1 3 EXHIBIT 11.1 EXHIBIT 11.1 TEL-SAVE HOLDINGS, INC. AND SUBSIDIARIES COMPUTATION OF NET INCOME PER SHARE (IN THOUSANDS)
Year Ended December 31, --------------------------------------------- 1997 1996 1995(A) ------------ ------------ ------------ Net income (loss) $(20,945) $20,168 $10,819 ======== ======= ======= BASIC Weighted average common shares - Basic 64,168 52,650 31,422 ======== ======= ======= Net income (loss) per share - Basic $ (0.33) $ 0.38 $ 0.34 ======== ======= ======= DILUTED Weighted average common and common equivalent shares outstanding - Diluted: Weighted average shares 64,168 52,650 31,422 Weighted average equivalent shares -- 4,352 2,183 -------- ------- ------- Weighted average common and common equivalent shares - Diluted 64,168 57,002 33,605 ======= ======= ======= Net income (loss) per share - Diluted $ (0.33) $ 0.35 $ 0.32 ======= ======= =======
- ---------- (A) Pro forma tax provisions have been calculated as if the Company's results of operations were taxable as a C corporation (the Company's current tax status) for the year ended December 31, 1995. Prior to September 20, 1995, the Company was an S corporation with all earnings taxed directly to its shareholders. EX-21.1 4 EXHIBIT 21.1 EXHIBIT 21.1 SUBSIDIARIES OF THE REGISTRANT Name State of Incorporation - ---- ---------------------- Tel-Save, Inc. ................................................Pennsylvania Emergency Transport, Inc. .....................................Delaware Compco, Inc. ..................................................Delaware Symetrics Industries, Inc. ....................................Florida -----END PRIVACY-ENHANCED MESSAGE-----