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Deltathree 10-K 2009 Documents found in this filing:UNITED
STATES
SECURITIES
AND EXCHANGE COMMISSION
Washington,
D.C. 20549
FORM
10-K
For
the Fiscal Year Ended December 31, 2008, or
Commission
File Number: 000-28063
deltathree, Inc.>
(Exact
name of registrant as specified in charter)
Registrant's
telephone number, including area code:(212) 500-4850
Securities registered pursuant to
Section 12(b) of the Act: None.
Securities registered pursuant to
Section 12(g) of the Act:>
Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act. Yes o No x
Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act. Yes o No x
Indicate
by a check mark whether the Registrant (1) has filed all 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 o
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 to this Form 10-K. o
Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “accelerated
filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
one):
Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Exchange Act). Yes o No x
The
aggregate market value of the Class A Common Stock held by non-affiliates
of the Registrant based upon the closing bid of the Class A Common
Stock as reported by the OTC Bulletin Board on June 30, 2008 (the last business
day of the Registrant’s most recently completed second fiscal quarter) was
$3,288,254. Solely for purposes of this calculation, shares beneficially owned
by directors and officers of the Registrant and persons owning 5% or more of the
Registrant's Class A Common Stock have been excluded, in that such persons
may be deemed to be affiliates of the Registrant. Such exclusion should not be
deemed a determination or admission by the Registrant that such individuals or
entities are, in fact, affiliates of the Registrant.
As of
April 6, 2009, the Registrant had outstanding 71,932,405 shares of Class A
Common Stock, par value $0.001 per share.
Documents
incorporated by reference: None
DELTATHREE, INC.
2008
ANNUAL REPORT ON FORM 10-K
TABLE OF
CONTENTS
PART
I
The
statements contained in this Annual Report on Form 10-K, or Annual Report, that
are not descriptions of historical facts may be forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. These
forward-looking statements are based on current expectations, estimates,
forecasts and projections about us, our future performance, the industries in
which we operate, our beliefs and our management’s assumptions. In addition,
other written or oral statements that constitute forward-looking statements may
be made by us or on our behalf. Words such as “expects,” “anticipates,”
“targets,” “goals,” “projects,” “intends,” “plans,” “believes,” “seeks,”
“estimates,” variations of such words and similar expressions are intended to
identify such forward-looking statements. These statements are not guarantees of
future performance and involve certain risks, uncertainties and assumptions that
are difficult to assess. Therefore, actual outcomes and results may differ
materially from what is expressed or forecasted in such forward-looking
statements. Please see “Item 1A. Risk Factors” in this Annual Report for
detailed information about the uncertainties and other factors that may cause
actual results to materially differ from the views stated in such
forward-looking statements. All forward-looking statements and risk factors
included in this Annual Report are made as of the date hereof, based on
information available to us as of the date hereof, and we assume no obligation
to update any forward-looking statement or risk factor, whether as a result of
new information, future events, changes in assumptions or
otherwise.
Our
fiscal year ends on December 31 of each calendar year. Each reference to a
fiscal year in this Annual Report refers to the fiscal year ending December 31
of the calendar year indicated. Unless the context requires otherwise,
references to “we,” “us,” “our,” “the Company,” and “deltathree” refer to
deltathree, Inc. and its subsidiaries, collectively.
ITEM 1.
BUSINESS>
Company
Overview
We are a
well-known provider of integrated Voice over Internet Protocol, or VoIP,
telephony services, products, hosted solutions and infrastructure. We were
founded in 1996 to capitalize on the growth of the Internet as a communications
tool by commercially offering Internet Protocol, or IP, telephony services, or
VoIP telephony. VoIP telephony is the real-time transmission of voice
communications in the form of digitized "packets" of information over the
Internet or a private network, similar to the way in which e-mail and other data
is transmitted. While we began as primarily a low-cost alternative source of
wholesale minutes for carriers around the world, we have evolved into a
well-known provider of next generation communication services.
Today we
support tens of thousands of active users around the globe through our two
primary distribution channels: our service provider and reseller channel, and
our direct-to-consumer channel. We offer a broad suite of private label VoIP
products and services as well as a back-office platform for service providers,
resellers and corporate customers, such as VoIP operators and various corporate
enterprises. Based on our customizable VoIP solutions, these customers can offer
private label telecommunications to their own customer bases under their own
brand name, a “white-label” brand (in which no brand name is indicated and
different customers can offer the same product), or the deltathree brand. At the
same time, our direct-to-consumer channel includes our iConnectHere offering
(which provides VoIP products and services directly to consumers
and small businesses online using the same primary platform) and our joip
offering (which serves as the exclusive VoIP service provider embedded in the
Globarange cordless phones of Panasonic Communications).
We have
built a privately-managed, state-of-the-art global telecommunications platform
using IP technology and offer our customers a suite of IP telephony products,
including PC-to-Phone and Broadband Phone products. We provide a robust set of
value-added services and features that enable us to address the challenges that
have traditionally made the provision of telecommunications services difficult,
and we offer our products and services to a global customer base in a fashion
that meets the disparate needs of this diverse customer base. Our operations
management tools include, among others: account provisioning; e-commerce-based
payment processing systems; billing and account management; operations
management; web development; network management; and customer care. We are able
to provide our services at a cost per user that is generally lower than that
charged by traditional service providers because we minimize our network costs
by using efficient packet-switched technology and interconnecting to a wide
variety of termination options, which allows us to benefit from pricing
differences between vendors to the same termination points.
Prior to
1999, we focused on building a privately-managed, global network utilizing IP
technology, and our business primarily consisted of carrying and transmitting
traffic for communications carriers over our network. Beginning in 1999, we
began to diversify our offerings by layering enhanced IP telephony services over
our network. These enhanced services were targeted at consumers and were
primarily accessible through our consumer website. During 2000, we began
offering services on a co-branded or private-label basis to service providers
and other businesses to assist them in diversifying their product offerings to
their customer bases. In 2001, we continued to enhance our unique strengths
through our pioneering work with the Session Initiation Protocol, or SIP, an
Internet Engineering Task Force standard that has been embraced by industry
leaders such as Microsoft and Cisco. These efforts culminated in the launch of
our state-of-the-art SIP infrastructure, and in doing so we became the first
major VoIP service provider to deploy an end-to-end SIP network and services. In
recent years, we have continued our pioneering efforts in SIP and these efforts
have yielded significant new releases. For example, in 2007 we released a next
generation SIP-based PC-to-Phone application, certified many new devices which
function as access points to our services, and added new features and new
calling plans to our offerings.
In 2004,
we announced our first major service provider contract with Verizon
Communications to provide the Verizon VoiceWing VoIP service. In
2007, we entered into an agreement with Market America, a leading on-line
shopping and one-to-one marketing company, pursuant to which Market America
launched its Voitel Home Phone Service powered by our Hosted Consumer VoIP
Solution platform. In addition, we entered into an agreement with RCN
Corporation, a leading provider of video, data, and voice services to
residential, business, and commercial/carrier customers, to power its Starpower
Internet Phone Service. On January 15, 2009, we received notice from
Verizon that no later than May 15, 2009, our service provider contract with
Verizon would be terminated pursuant to the terms of the
agreement. Verizon is not required to pay us any termination
penalties or fees in connection with its termination of the agreement, and
following the termination date we will not receive any more revenue as a result
of this agreement. In addition, on February 5, 2009, we entered into
a Termination, Settlement Agreement and Mutual Release with RCN, pursuant to
which the service agreement between us and RCN was terminated and RCN
transferred to us some of the subscribers to the VoIP service we had been
providing to RCN under the agreement. In addition, RCN paid us a termination fee
of $230,000.
As a
complement to the initiatives we have taken to attempt to organically expand our
businesses, we have also evaluated opportunities for growth through acquisitions
and strategic relationships. In February 2007, we acquired the service provider
and consumer business assets (including the customer bases) of Go2Call.com,
Inc., a privately held U.S.-based VoIP solutions provider. However, in 2008 we
wrote-off approximately $2.0 million in goodwill and approximately $1.6 million
in intangible assets acquired in the Go2Call transaction. Through our joip
offering we attempted to expand into other product and geographic consumer
markets, but in 2008 we recognized only $119,000 in revenues from our
service agreement with Panasonic and we do not expect that this will be a
significant source of revenue in the future. In addition, as discussed below
under “ - Transaction with D4 Holdings”, on February 12, 2009, we consummated a
transaction with D4 Holdings LLC, or D4 Holdings, a Delaware limited liability
company, pursuant to which, among other things, D4 Holdings acquired (i)
39,000,000 shares of our common stock, representing approximately 54.3% of the
total number of issued and outstanding shares of common stock following the
transaction and (ii) a warrant, exercisable for ten years, to purchase up to an
additional 30,000,000 shares of our common stock at an exercise price of $0.04
per share. D4 Holdings is a private investment fund whose ownership
includes owners of ACN, Inc., or ACN, a direct seller of telecommunications
services. As a result of the investment in our company by D4
Holdings, we expect to seek opportunities to provide services to ACN and enter
into other commercial transactions that give us access to ACN’s international
marketing and distribution capabilities. We have
sustained significant operating losses in recent periods, which has led to a
significant reduction in our cash reserves. As a result, in 2008 we
effected a restructuring that helped us reduce our operating costs significantly
and better align our operations with our current business model. As
part of this restructuring, we initiated a series of reductions in force,
which resulted in a decrease in the number of our employees from 148
as of December 31, 2007, to 43 as of December 31, 2008, as discussed below in “
– Employees”. In addition, as discussed below in “ - Properties”, we
subleased our principal executive offices, following which we entered into an
agreement with the landlord pursuant to which we paid a termination fee equal to
$450,000, our lease agreement for the offices was terminated, and the landlord
returned to us the letter of credit in the approximate amount of $1.0 million we
had provided to secure our obligations under the lease. We also
secured the release of letters of credit we had previously provided to
other suppliers. From an operational standpoint, we shifted the focus
of our efforts and resources away from our service provider and consumer
divisions towards our reseller business. Within the reseller business
itself we made a decision to focus on servicing fewer, larger resellers rather
than more, smaller resellers. Finally, we began seeking additional
financing, which culminated in the transaction with D4 Holdings described below
in “ – Transaction with D4 Holdings”.
Going
forward, we expect to:
Transaction
with D4 Holdings
On
February 10, 2009, we entered into a Securities Purchase Agreement with D4
Holdings pursuant to which we issued to D4 Holdings (i) 39,000,000 shares of our
common stock, representing approximately 54.3% of the total number of issued and
outstanding shares of common stock following the transaction, for an aggregate
purchase price of $1,170,000, paid in cash, and (ii) a warrant, exercisable for
ten years, to purchase up to an additional 30,000,000 shares of our common stock
at an exercise price of $0.04 per share. The transaction closed on February 12,
2009.
Upon the
closing of the transaction and pursuant to the terms of the Purchase Agreement,
Noam Bardin resigned as a director and the board of directors appointed Robert
Stevanovski and Anthony Cassara to serve on the board. In addition,
Lior Samuelson resigned as Chairman of the Board and remained a director, and
Robert Stevanovski was appointed to serve as Chairman. Following the
closing of the transaction, our Board of Directors appointed three additional
directors to serve on the Board. The appointments of the three new directors
became effective on March 28, 2009.
In
connection with the transaction, the parties also entered into an Investor
Rights Agreement, pursuant to which we have agreed to file, upon the request of
D4 Holdings, a registration statement covering the resale of any shares of our
common stock held by D4 Holdings (including the shares of common stock
underlying the warrant issued to D4 Holdings). Subject to our ability to suspend
the effectiveness of the registration statement for a limited period of time
under certain circumstances, we are required to maintain the effectiveness of
any such registration statement until the earlier of (i) the date on which all
shares of common stock covered by the registration statement have been sold
thereunder or (ii) the date on which all such shares of common stock can be sold
without registration pursuant to Rule 144 or another similar exemption under the
Securities Act of 1933. Subject to certain limitations, D4 Holdings
will also be entitled to “piggy-back” registration rights on all future
registrations by and any registrations initiated by our other
stockholders.
Industry
Background
VoIP
technology translates voice into data packets, transmits the packets over data
networks such as the Internet or privately managed networks (such as our
network), and reconverts them into voice at the destination. Unlike traditional
telephone networks, VoIP does not use dedicated circuits for each telephone
call; instead, the same VoIP network can be shared by multiple users for voice,
data and video simultaneously. This type of data network is more efficient than
a dedicated circuit network because the data network is not restricted by the
one-call, one-line limitation of a traditional telephone network and, as a
result, greater traffic can be transmitted over this data network. This improved
efficiency creates cost savings that can be passed on to consumers in the form
of lower rates or retained by the VoIP provider. Significant cost savings are
also achieved for international telephone calls carried over data networks
primarily because they bypass the international settlement process, which
represents a significant portion of international long distance tariffs.
Additionally, VoIP allows for features that are not available on traditional
telephony networks - particularly at the consumer level - including voice mail
to email forwarding, find me/follow me, web-based control of call forwarding
preferences, user account review/revision and a host of other features and
functions.
Beyond
cost savings, we believe that VoIP telephony technologies will further the
potential for the Internet to become the preferred medium of communications and
commerce. As a result, VoIP has experienced significant growth in recent years
due to:
As a
result of these growth trends, various service providers, enterprises and
consumers are continuing to procure offerings from VoIP providers such as
deltathree. Specifically, consumers in emerging markets are increasingly using
VoIP-enabled services, such as IP telephones, to realize significant cost
savings on long distance and international calls, while in markets where a
significant number of consumers have access to broadband internet services these
consumers are increasingly viewing VoIP as a viable and more affordable
substitute for their traditional telecommunications provider. As
broadband connectivity has become more available and less expensive around the
world, it is now possible for providers like us to offer voice as well as video
services to businesses and residential consumers.
Our
Products and Services
Products
We have
built a privately-managed, global network using IP technology and offer our
customers a suite of IP telephony products. Our VoIP products
include:
Broadband Phone. Our
Broadband Phone product is a phone replacement solution available to business
and consumer customers over the "last mile" through broadband connections via
cable modem, DSL or fixed wireless. In addition to offering capabilities similar
to those offered by traditional telephony providers and allowing users to use
their existing phone, Broadband Phone enables a user to conveniently operate
features and retrieve voice mail through email, web or a phone interface. For
our potential partners, the turnkey or customizable solution is delivered with
our full back-end infrastructure, including customer service for end users and
service providers, pricing information, fulfillment, billing, provisioning,
local number portability, and fraud services. Additionally, Broadband Phone is
easily integrated (a variety of devices are available to plug directly into a PC
or IP network) so as to allow broadband providers to begin delivering our voice
solution rapidly.
PC-to-Phone. Our PC-to-Phone
offering enables a user to conveniently and inexpensively place a call to a
standard telephone anywhere in the world directly from a personal computer while
remaining on-line.
Services
We
provide a robust set of value-added services that enables us to address the
challenges that have traditionally made the provision of telecommunications
services difficult. These operations management tools include the
following:
The
provision of VoIP telephony products and services through our service provider
and reseller sales channel accounted for 84.7% of our total revenues in 2008,
while the provision of VoIP telephony through our direct-to-consumer channel
accounted for 13.8% of our total revenues in 2008.
Our
Distribution Channels
We
market, support and distribute our products and services to tens of thousands of
active users around the globe through our two primary distribution channels: the
service provider and reseller channel and our direct-to-consumer
channel.
Service
Provider and Reseller Channel
We have
developed high-value solutions for the large number of service providers and
resellers that are focused on providing their customers with VoIP telephony
products and services.
Our
Hosted Consumer VoIP Solution leverages our VoIP experience and delivers to our
service providers, resellers, and various corporate customers a customizable,
private-label suite of VoIP products and services. Using our infrastructure, we
enable these enterprises to offer their customers different combinations of our
basic products and services, accessible through a single account.
Direct-to-Consumer
Channel
Our
direct-to-consumer channel includes our iConnectHere offering, which provides
VoIP products and services directly to consumers and small businesses online,
and our joip offering, which serves as the exclusive VoIP service provider
embedded in the Globarange cordless phones of Panasonic.
Through
iConnectHere, consumer users can:
Our
strategy is to become a leading worldwide provider of VoIP telephony products
and services. The following are key elements of our
strategy:
We sell
and market our products and services through our service provider and reseller
channel and our direct-to-consumer channel. In general, our sales and marketing
activities include:
Service
Provider and Reseller Channel
Direct-to-Consumer
Channel
Our
Infrastructure
Network
In order
to deliver our VoIP products and services, we operate a privately-managed IP
telephony network. By managing our own network, we have the ability to regulate
traffic volumes and to directly control the quality of service from each
originating point of presence, or POP, to the termination point via a variety of
termination options. Our ability to interconnect to a wide variety of
termination options increases the diversity and robustness of our network,
minimizes and eliminates single points of failure, and simultaneously allows us
to benefit from pricing differences between vendors to the same termination
points. In addition, our network allows us to avoid the significant transmission
delays associated with the Internet, which may impede delivery of high quality,
reliable services to our users.
In 2001,
we rolled out our state of the art SIP infrastructure. The SIP protocol is one
of the most advanced VoIP protocols and unlike its predecessors, which were
modeled after traditional telephony protocols, SIP has the ability to scale with
a distributed architecture and at a lower cost. SIP’s superior attributes also
include faster and more cost effective development and lower hardware
requirements, which allows us to incur lower capital expenditure costs. Our SIP
network currently powers all of our offerings. In recent years, we have
continued our pioneering efforts in SIP and these efforts have yielded
significant new releases. For example, in 2007 we released a next generation
SIP-based PC-to-Phone application, certified many new devices which function as
access points to our services, and added new features and new calling plans to
our offerings.
Our
network is built around a high availability backbone that connects New Jersey,
Atlanta, London and Frankfurt. In each of, and between, these locations we
maintain multiple interconnections or peering arrangements with Internet
backbone and voice providers. These points are strategically located to allow
access from our network to and from the Internet with a high level of
performance. While operating as a private extension of the Internet, our
backbone has a high level of security designed to isolate it from security
threats found on the public Internet.
Access to
our network is possible through several products and services. A call can
originate from the PC-to-Phone product using our downloadable software
application “soft-phones,” a Web browser, or Broadband Phone devices. These
calls enter our network from the Internet through our interconnection
points.
Our
network can terminate calls through our POPs and termination providers’ POPs.
Termination decisions are based on a sophisticated routing system that applies
routing rules based on origination point, termination cost and other
factors. These rules are consistently updated to ensure a high level of quality
and economic efficiency. Each termination port is carefully managed with
capacity planning tools and techniques to provide cost-effective service to
customers, along with multiple termination options to ensure the highest
possible levels of redundancy. We are a
party to service agreements with several telecommunications providers, including
competitive local exchange carriers, foreign telephone companies, Internet
backbone providers and others. Pursuant to these agreements, we can transport
VoIP packets to our hubs and terminate calls throughout the world in a cost
effective and efficient manner.
Support
Our NOC
monitors and manages our network from a central location, seven days a week,
24 hours a day. The NOC monitors all aspects of our network, including the
routers, databases, switches, leased lines, Internet connections, gatekeepers
and gateways to ensure that they are functioning at optimal levels. In the event
of a failure of any of these network components, NOC personnel are provided with
a real time, systems-generated notification via an instant messaging system
consisting of pagers, cellular phones, screen pop-ups and e-mail that identifies
the malfunction so that proper measures can be taken to restore service in a
timely fashion. Our NOC utilizes a combination of industry technologies as well
as unique applications developed by us. The NOC serves all of the different
parts of our operations environment, including network nodes, Web servers and
specific applications.
We
provide customer support on various levels to different customers. With respect
to our service provider and reseller customers, we provide customer care and
technical support directly to these customers and they in turn provide their own
support directly to the end users. Customers of iConnectHere and joip receive
technical support and customer care through e-mail support.
Our
services are supported by our on-line interactive customer service and billing
center, which enables an end user to set up an account, receive an account
number and a PIN, pay by credit card for services, find answers to frequently
asked questions and contact customer service representatives. Once a user has
established an account, the user can prepay for additional usage by credit card
as well as access real-time detailed information such as call logs and
transaction records. Through the on-line billing system, a user can personalize
the billing information to select the data most relevant to them. This on-line
interactive customer service and billing center is supported by a human customer
care contact center that provides voice and e-mail support to the
customers.
Suppliers
We
outsource to third-party vendors the provisioning of certain of our local
telecommunications services, including local phone numbers, access to the public
switched telephone network, or PSTN, operator assistance, directory listings and
assistance, E-911 emergency services and local number portability. We also
outsource the provisioning of our consumer premises equipment, such as our
analog telephone adapters, IP Phones and gateways, and certain aspects of our
customer care services. We do not rely on any one specific vendor for providing
these services, except for E-911 emergency services and certain specific
services of customer care. While we believe our relations with our suppliers are
good, we believe that we could replace our suppliers if necessary and that
although our ability to provide services to our customers may be impacted in
such a case we do not expect that this would have a material adverse affect on
our business, financial condition and results of operation.
Proprietary
Rights
We rely
and expect to be able to rely on trademark and trade secret laws,
confidentiality agreements and other contractual arrangements with our
employees, strategic partners and others to protect our proprietary
rights.
We have
registered trademarks, and have filed applications for additional registrations,
for “deltathree”, “deltathree making VoIP work for you”, “the IP Communications
Network”, “iConnectHere.com”, “joip”, “joipy”, “Click It” and other trademarks
in the United States and internationally. In connection with our acquisition of
the Go2Call businesses, we acquired the “Go2Call” trademark and a variety of
trade-marked derivatives of “Go2Call”. These trademarks may not provide adequate
protection against competitive technology and may not be held valid and
enforceable if challenged. We do not own any registered copyrights.
To
further safeguard our intellectual property, we have a policy that requires our
employees and contractors to execute confidentiality and assignment of
inventions agreements when they begin their relationships with us.
Regulation
Regulatory
Environment Overview
The use
of the Internet and private IP networks to provide voice service is a relatively
recent market development. Although the provision of such services is currently
not as regulated as traditional telephony services within the United States, the
Federal Communications Commission, or FCC, has applied some regulation to
certain types of VoIP services and is reviewing whether to apply additional
regulations to VoIP services. In addition, several foreign governments have
adopted or proposed regulations that could restrict or prohibit the provision of
VoIP services. Regulation of Internet telephony providers and services may
materially and adversely affect our business, financial condition, operating
results and future prospects, particularly if increased numbers of governments
impose regulations restricting the use and sale of IP telephony services. In
addition, to the extent we become required to contribute to regulatory funds and
collect and remit regulatory fees, taxes and surcharges this will increases our
costs, which may result in either our increasing the retail price of our service
offerings or reducing our profitability.
Federal
Regulation
Regulatory
Classification of VoIP Services
Although
there are several regulatory proceedings currently pending before federal
authorities, VoIP telephony is lightly regulated compared to more traditional
telecommunications services. On February 12, 2004, the FCC initiated a generic
rulemaking proceeding concerning the provision of voice and other services using
IP technology, including assessing whether VoIP services should be classified as
information services or telecommunications services. The rulemaking is ongoing
and we cannot predict the outcome of this proceeding. In November 2004, the FCC
determined that certain interconnected VoIP services (meaning VoIP services that
can be used to send and receive calls to or from the PSTN), including some
services that are similar to ours, should be considered interstate services
subject to federal rather than state jurisdiction. Although this
ruling was appealed by several states, on March 21, 2007, the United States
Court of Appeals for the Eighth Circuit affirmed the FCC’s
determination.
The FCC’s
generic rulemaking proceeding could result in the FCC determining, for instance,
that certain types of Internet telephony should be regulated like basic
telecommunications services. Thus, Internet telephony would no longer be exempt
from more onerous telecommunications-related regulatory obligations, or other
economic regulations typically imposed on traditional telecommunications
carriers.
VoIP
E-911 Matters
On
June 3, 2005, the FCC released an order and notice of proposed rulemaking
concerning VoIP emergency 911 services. The order set forth two primary
requirements for providers of interconnected VoIP services. The order applies to
our iConnectHere and joip customers, or our “consumer customers”. We do not
believe that we are responsible for compliance with this order in connection
with the services sold to our customers who purchase our services for the
provision of services directly to end users. We cannot predict whether we would
be subject to any third-party litigation in connection with such customers who
resell our services.
First,
the order required us to notify our consumer customers of the differences
between the emergency services available through us and those available through
traditional telephony providers. We also had to receive affirmative
acknowledgment from all of our consumer customers that they understand the
nature of the emergency services available through our service. On
September 27, 2005, the FCC's Enforcement Bureau released an order stating
that the Enforcement Bureau will not pursue enforcement actions against
interconnected VoIP providers, like us, that have received affirmative
acknowledgement from at least 90% of their subscribers. We received affirmative
acknowledgment from more than 95% of our customers that they understand the
nature of the emergency services available through our service, and thus we
believe we are substantially in compliance with the first aspect of the FCC's
June 3 order.
Second,
the order required us to provide enhanced emergency dialing capabilities, or
E-911, to all of our consumer customers by November 28, 2005. Under the
terms of the order, we are required to use the dedicated wireline E-911 network
to transmit customers' 911 calls, callback number and customer-provided location
information to the emergency authority serving the customer's specified
location. On November 7, 2005, the FCC's Enforcement Bureau issued a Public
Notice with respect to that requirement. The Public Notice indicated that
providers who have not fully complied with the enhanced emergency dialing
capabilities requirement are not required to discontinue the provision of
services to existing clients, but that the FCC expects that such providers will
discontinue marketing their services and accepting new customers in areas in
which the providers cannot offer enhanced emergency dialing
capabilities.
Almost
all of our consumer customers currently receive E-911 service in conformity with
the FCC’s order, but (as is the case with customers for other interconnected
VoIP providers) some customers who were receiving service prior to the FCC’s
deadline for compliance with the E-911 regulations may not receive such service.
The FCC permitted service providers to continue to provide service to those
existing customers rather than disconnect those customers. Pursuant to the FCC’s
requirement, after the implementation of the FCC E-911 requirements, we provide
services to customers only where we can provide the FCC required E-911 service.
We may be required to stop serving those customers to whom we cannot provide the
required enhanced emergency dialing capabilities that were being serviced prior
to the issuance of the FCC’s rules at any time.
The FCC
is considering enhancing its VoIP E-911 rules. In June, 2007, the FCC
released a Notice of Proposed Rulemaking to consider whether it should impose
additional obligations on interconnected VoIP
providers. Specifically, the FCC included a proposal that
interconnected VoIP providers be required to automatically determine the
location of their customers for purposes of E-911 rather than require customers
to update their existing location (as is the case under the current
regulations). Moreover, the Notice included a tentative conclusion
that interconnected VoIP providers that allow their service to be used in more
than one location, like us, be required to meet the same customer location
accuracy standards applicable to providers of mobile telecommunications
services. We cannot predict the outcome of this proceeding or its
potential impact on our business.
See
“ - State and Local Regulation” below for a discussion of fees we may collect in
the future in connection with providing E-911.
Communications
Assistance for Law Enforcement Act
The
Communications Assistance for Law Enforcement Act, or CALEA, requires certain
communications service providers to assist law enforcement agencies in
conducting lawfully authorized electronic surveillance. On September 23,
2005, the FCC released an order concluding that CALEA applies to interconnected
VoIP providers. In May 2006 the FCC released an order finding that broadband
Internet access service providers and interconnected VoIP providers are required
to implement the same type of CALEA requirements that have been applied to
wireline telecommunications carriers. These include obligations to (1) ensure
that communications equipment, facilities, and services meet interception
assistance capability requirements and (2) develop system security policies and
procedures to define employee supervision and record retention requirements. As
a result of the steps we have taken, we believe that we comply with the
CALEA.
Universal
Service Fund
The FCC
decided in June 2006 that interconnected VoIP service providers should be
required to contribute to the universal service fund, or USF. The amount of
universal service contribution for interconnected VoIP service providers is
based on a percentage of revenues earned from end-user interstate services. The
FCC developed three alternatives under which an interconnected VoIP service
provider may elect to calculate its universal service contribution: (1) a
safe harbor that assumes 64.9% of the provider’s end user revenues are
interstate; (2) a traffic study to determine an allocation for interstate
end user revenues; or (3) actual interstate and international end user
revenues. If an interconnected VoIP service provider calculates its universal
service contributions based on its actual percentage of interstate calls, the
FCC suggested that its preemption of state regulation of such services may no
longer apply, in which case the interconnected VoIP service provider could be
subject to regulation by each state in which it operates as well as federal
regulation. In addition, the FCC is considering a number of proposals that could
alter the way that the USF is assessed. For instance, the FCC is considering an
assessment based on the use of telephone numbers. Furthermore, some states may
attempt to impose state universal service contribution requirements on
interconnected VoIP providers such as deltathree. At this time, various states –
including Nebraska and New Mexico – claim that they have the right to require
interconnected VoIP providers to contribute to their respective USF funds. The
attempts of the Nebraska and New Mexico authorities to impose state USF
obligations on interconnected VoIP providers are currently subject to
litigation, and we cannot predict how the courts, the FCC, and states may rule
on these matters.
Customer
Proprietary Network Information
On April
2, 2007, the FCC issued an order that tightened existing rules on protection and
use of Customer Proprietary Network Information, or CPNI, and extended coverage
of the CPNI rules to interconnected VoIP service providers. Although the rules
are aimed in large part at preventing the practice of pretexting (in which a
caller impersonates a phone customer to gain access to his or her phone
records), the rules impose greater obligations on us and other companies like us
to protect customer calling and network information and to file formal
certifications with the FCC regarding procedures for protecting this
information. As a result of the steps we have taken, we believe that
we comply with the FCC’s order regarding CPNI.
Access
for People with Disabilities
On June
15, 2007, and effective October 5, 2007, interconnected VoIP providers, like us,
became required to make certain that their equipment and service is accessible
to and usable by individuals with disabilities, if readily achievable, which we
did. In addition, interconnected VoIP providers like us became obligated to
contribute to the Telecommunications Relay Services, or TRS, fund and to offer
711 abbreviated dialing for access to relay services. Following March 31, 2009,
interconnected VoIP providers are required to route such 711 calls to the
appropriate TRS center based upon the registered location provided by such
customers. Although we experienced a delay in providing 711
abbreviated dialing for access to relay services and routing such services to
the appropriate relay center, we are in the final stages of implementing such
requirements and expect to provide such services in the immediate
future.
Regulatory
Fees
On August
6, 2007 and effective November 2007, the FCC adopted an Order concerning the
collection of regulatory fees for Fiscal Year 2007 requiring the collection of
such fees from interconnected VoIP providers like us. Interconnected VoIP
providers pay regulatory fees based on interstate and international revenues.
The Regulatory Fees Order became effective in November 2007.
Local
Number Portability
On
November 8, 2007, the FCC released an Order relating to local number portability
imposing local number portability and related obligations on interconnected VoIP
Providers like us. The Order requires interconnected VoIP providers to
contribute to shared numbering administration costs. Additionally, the Order
mandates that we port telephone numbers within certain timeframes. As
a result of the steps we have taken, we believe that we comply with the FCC’s
order regarding local number portability.
Intercarrier
Compensation
The
FCC is currently seeking comment concerning proposed reforms of the intercarrier
compensation system, which is a set of FCC rules and regulations by which
telecommunications carriers compensate each other for the use of their
respective networks. These rules and regulations affect the prices we pay to our
suppliers for access to the facilities and services that they provide to us,
such as termination of calls by our customers onto the public switched telephone
network. In addition, proceedings have been initiated to determine what
intercarrier compensation charges should apply to the termination of VoIP
traffic. We cannot predict what, if any, intercarrier compensation regulations
the FCC’s order may impose on VoIP providers.
State
and Local Regulation
Some
state and local regulatory authorities believe they retain jurisdiction to
regulate the provision of, and impose taxes, fees and surcharges on, intrastate
Internet and VoIP telephony services, and have attempted to impose such taxes,
fees and surcharges, such as a fee for providing E-911 service. Rulings by the
state commissions on the regulatory considerations affecting Internet and IP
telephony services could affect our operations and revenues, and we cannot
predict whether state commissions will be permitted to regulate the services we
offer in the future.
We are in
the process of examining the applicability of such state and other local taxes
and other fees. We have recently completed an initial study of state and local
taxes and other fees and have accrued approximately $500,000 of estimated taxes
and fees due through the year ended December 31, 2008. We have also
determined that we need to collect and remit sales and excise taxes in certain
states and local jurisdictions and will begin collecting and remitting such
sales and excise taxes in the immediate future. To the extent we
increase the cost of services to our customers to recoup some of the costs of
compliance, this will have the effect of decreasing any price advantage we may
have over traditional telecommunications companies.
In
addition, it is possible that we will be required to collect and remit taxes,
fees and surcharges in other states and local jurisdictions and which such
authorities may take the position that we should have collected. If so, they may
seek to collect those past taxes, fees and surcharges from us and impose fines,
penalties or interest charges on us. Our payment of these past taxes, fees and
surcharges, as well as penalties and interest charges, could have a material
adverse effect on us.
International
Regulation
The
regulatory treatment of Internet and Internet-based voice services, including IP
telephony or VoIP, outside of the United States varies widely from country to
country. A number of countries may prohibit Internet and IP telephony, while
other countries expressly permit but regulate Internet and IP telephony. Some
countries evaluate proposed Internet and IP telephony service on a case-by-case
basis to determine whether any regulation is necessary or whether it should be
regulated as a voice service or as another telecommunications or data service.
Finally, in many countries neither Internet nor IP telephony have been addressed
by legislation or regulatory action as of the date of this filing. Although we
strive to comply with applicable international IP telephony regulations, we
cannot be certain that we are in compliance with all of the relevant regulations
at any given point in time.
In 2002,
the European Commission adopted a set of directives for a new framework (New
Regulatory Framework) for electronic communications regulation that, in part,
attempts to harmonize the regulations that apply to services regardless of the
technology used by the provider. Under the New Regulatory Framework, there is no
distinction in regulation made based upon technology between switched or
packet-based networks. As a result, some types of IP telephony and VoIP services
may be regulated like traditional telephony services while others may remain
free from regulation. The European Commission has published a staff working
paper aimed at clarifying the conditions applicable to providers of IP-based
services. The working paper identifies various issues that may arise in relation
to IP-based services including the regulatory classification of Internet
telephony and VoIP under the New Regulatory Framework. The European Regulators
Group (consisting of regulators from European Union Member States and the
European Commission) has adopted a Common Statement for VoIP regulation. The
European Commission currently is reviewing how IP telephony services fit into
the New Regulatory Framework. Although the European Commission has recommended
that a “light touch” to regulation be taken, we cannot predict what future
actions the European Commission, member states, and courts reviewing the New
Regulatory Framework may take regarding IP telephony and related matters, or
what impact, if any, such actions may have on our business.
Based on
the European Commission's current position, we believe that most providers of IP
telephony would be subjected to no more than minimal regulation such as a
general authorizations or declaration requirements that may be imposed by the
European Union Member States, subject to the European Commission’s current
review of the issue. Several Member States have issued statements or regulations
concerning IP telephony and VoIP while others have issued consultations
requesting industry comments on the applicability of the New Regulatory
Framework to various IP telephony and VoIP services in their respective
countries. However, since the Commission's findings on IP telephony are not
binding on the Member States, we cannot assure you that the services provided
over our network will not be deemed “voice telephony” subject to heightened
regulation by one or more EU Member States. Although Member States are required
to adhere to the New Regulatory Framework, Member States may not take a uniform
approach in regulating a particular Internet-enabled service including IP
telephony. We cannot predict the outcome of these consultations or the manner in
which Member States will implement the New Regulatory Framework with respect to
our particular services.
As we
make our services available in foreign countries, and as we facilitate sales by
our network partners to end users located in foreign countries, such countries
may claim that we are required to qualify to do business in the particular
foreign country. Such countries may also claim that we are subject to
regulation, including requirements to obtain authorization for the provision of
voice telephony or other telecommunications services, or for the operation of
telecommunications networks. It is also possible that such countries
may claim that we are prohibited in all cases from providing our services or
conducting our business in those countries. Failure to qualify as a foreign
corporation in certain jurisdictions, or to comply with foreign laws and
regulations, may adversely affect our business. In addition, we cannot predict
how a regulatory or policy change of a particular country might affect the
provision of our services.
Our
network partners may also currently be, or in the future may become, subject to
requirements to qualify to do business in a particular foreign country, comply
with regulations (including requirements to obtain authorizations for the
provision of voice telephony or other telecommunications services or for the
operation of telecommunications networks) or cease providing services or
conducting their business as conducted in that country. We cannot be certain
that our network partners either are currently in compliance with any such
requirements, will be able to comply with any such requirements, and/or will
continue in compliance with any such requirements.
Other
Regulation Affecting the Internet
The
European Union has also enacted several directives relating to the Internet,
including regulations that address online commerce and data protection.
International governments are adopting and implementing privacy and data
protection regulations that establish certain requirements with respect to,
among other things, the confidentiality, processing and retention of personal
subscriber information. The potential effect, if any, of these data protection
rules on the development of our business remains uncertain.
Competition
We
compete primarily in the market for enhanced VoIP telephony, and specifically in
the VoIP reseller market. This market is highly competitive and there are
numerous competing service providers. We believe that the primary competitive
factors determining our success in the VoIP telephony market are: quality of
service and network capacity; the ability to meet and anticipate customer needs
through multiple service offerings and feature sets; customer services; and
price.
Future competition could come from a
variety of companies both in the Internet and telecommunications industries.
These industries include major companies who have greater resources and larger
subscriber bases than we have, and have been in operation for many years.
In addition, many
companies provide, or are planning to provide, some of the services we offer,
including Net2Phone and MediaRing.
Revenues
and Assets by Geographic Area
For the
year ended December 31, 2008, approximately $11.0 million, or 54.5%, of our
revenue was derived from international customers, and $9.2 million, or
45.5%, was derived
from customers in the United States. Most of our long-lived assets are located
in the United States. For more detailed information concerning our geographic
segments, see Note 16 to our financial statements included elsewhere in this
Annual Report.
Employees
As of
December 31, 2008, we had 43 employees, of which 36 were located in Israel
(ten of whom were part-time employees) and eight were located in the United
States (of which one was a part-time employee). This was a significant reduction
from the number of employees we had as of December 31, 2007, at which time we
had 148 employees, of which 124 were located in Israel (20 of whom were
part-time employees) and 24 were located in New York. This reduction was due to
the restructuring that we implemented in 2008, which included reductions in
force. We consider our relationship with our employees to be good.
None of our employees is covered by collective bargaining
agreements. Customers
In 2008,
one customer accounted for approximately 16.5% of our annual gross revenues; in
the fourth quarter of 2008 this customer accounted for approximately 21.0% of
our gross revenues for that quarter. We have no long-term agreements
with this customer, and we have no assurance that it will continue to purchase
services from us in the future. Any significant decline in our sales
to this customer could have a material adverse effect on our
revenues.
In
addition, during 2008 Verizon accounted for approximately 10.9% of our gross
revenues; in the fourth quarter of 2008 Verizon accounted for approximately 9.7%
of our gross revenues. As discussed above under “Company Overview”,
on January 15, 2009, we received notice from Verizon that no later than May 15,
2009, our service provider contract with Verizon would be terminated pursuant to
the terms of the agreement. Following the termination date we will
not receive any more revenue as a result of this agreement, which could have a
material adverse effect on our financial condition and results of
operations.
Available
Information
Our
Internet address is www.deltathree.com. Through a link at the Investor Relations
section of our website we make available, free of charge, our annual reports on
Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all
amendments to those reports as soon as reasonably practicable after such
materials have been electronically filed with, or furnished to, the
SEC.
ITEM 1A.
RISK
FACTORS>
Our
business, financial condition and results of operations and the trading price of
our common stock could be materially adversely affected by any of the following
risks as well as the other risks highlighted elsewhere in this Annual Report,
particularly the discussions about regulation, competition and intellectual
property. Additional risks and uncertainties not presently known to us or that
we currently deem immaterial also may impair our business
operations.
Risks
Related to our Company
We
have a history of losses and we are uncertain as to our future
profitability.
Except
for the year ended December 31, 2006, in which we reported net income of
approximately $500,000 but a net loss from operations of $52,000, we have a
history of significant, recurring losses since our inception, and we may
continue to incur significant losses for the foreseeable future. We reported net
losses of $9.3 million in 2007 and $11.9 million in 2008. As of
December 31, 2008, our accumulated deficit was approximately $172.6
million. Our revenues may not grow or even continue at their current level.
Going forward, we will need to increase our revenues and/or lower our current
cost structure to reach profitability. If our revenues do not increase and/or if
we are unable to reduce our expenses, we may not be able to reach profitability
again. We cannot assure you that we will be able to reach profitability on a
quarterly or annual basis in the future. These factors raise
substantial doubt about our ability to continue as a going concern.
We
may not be able to expand our revenue.
Our
business strategy is to expand our revenue sources and our distribution channels
in order to include the provision of VoIP telephony to different customer
groups. We can neither assure you that we will be able to accomplish this nor
that this strategy will be profitable. Currently, our revenues are primarily
generated by sales of our VoIP telephony products and services through our
service provider and reseller sales channel and our direct-to-consumer channel.
VoIP telephony from these channels generated 98.5%, 98.3% and 94.6% of our total revenues in
2008, 2007 and 2006, respectively.
We expect
that our revenues for the foreseeable future will be dependent on, among other
factors:
We may
not be able to sustain our current revenues or successfully generate additional
revenues from the sale of our services.
The
global financial crisis may have an impact on our business and financial
condition in ways that we currently cannot predict.
The
continued financial crisis and related turmoil in the global financial system
may have an impact on our business and our financial condition, as well as
increase the risk of uncollectible accounts receivable from our customers.
For example, our ability to seek additional financing may be severely restricted
at a time when we would like, or need, to do so, which could have an impact on
our flexibility to react to changing economic and business
conditions.
We
are substantially dependent upon a few material customers, and any significant
decline in our sales to those customers could have a material adverse effect on
our revenues.
In 2008,
one customer accounted for approximately 16.5% of our annual gross revenues; in
the fourth quarter of 2008 this customer accounted for approximately 21.0% of
our gross revenues for that quarter. We have no long-term agreements
with this customer, and we have no assurance that it will continue to purchase
services from us in the future. Any significant decline in our sales
to this customer could have a material adverse effect on our
revenues. In addition, because we have recently begun focusing on
servicing fewer, larger reseller customers rather than many, smaller reseller
customers, it is probable that our dependence upon a few material customers will
increase in the future.
In
addition, during 2008 Verizon accounted for approximately 10.9% of our gross
revenues; in the fourth quarter of 2008 Verizon accounted for approximately 9.7%
of our gross revenues. As discussed above under “Company Overview”,
on January 15, 2009, we received notice from Verizon that no later than May 15,
2009, our service provider contract with Verizon would be terminated pursuant to
the terms of the agreement. Following the termination date we will
not receive any more revenue as a result of this agreement, which could have a
material adverse effect on our financial condition and results of
operations.
A
continuing decline in telecommunications prices may cause us to lower our prices
to remain competitive, which could prevent our future
profitability.
International
and domestic telecommunications prices have decreased significantly over the
last few years in most of the markets in which we operate, and as a result our
margins have decreased materially. We anticipate that prices will continue to be
reduced in all of the markets in which we do business or expect to do business.
Users who select our services (or our resellers’ or our service provider
customers’ services) to take advantage of the current pricing differential
between traditional telecommunications prices and our (or our customers’) prices
may switch to traditional telecommunications carriers as such pricing
differentials diminish or disappear, and we will be unable to use such pricing
differentials to attract new customers in the future. Such competition or
continued price decreases may require us to lower our prices to remain
competitive, may result in reduced revenue, a loss or decrease of customers and
may prevent our future profitability.
We
believe that we will need additional capital to continue our
operations.
We have
sustained significant operating losses in recent periods, which have led to a
significant reduction in our cash reserves. At this time, we believe
that, unless we are able to increase our revenues, we will not have sufficient
funds to continue our current operations over the foreseeable future if we do
not receive additional financing. There can be no assurance that we
will be able to raise such additional capital on favorable terms or at
all. In addition, as a result of D4 Holdings’ controlling interest in
our company, D4 Holdings will be able to exercise a controlling influence over
future issuances of capital stock or other securities by us and a third party
may be deterred from investing in us.
The
success of our VoIP telephony products and services is dependent on the growth
and public acceptance of VoIP telephony.
The
success of our VoIP telephony products and services is dependent upon future
demand for VoIP telephony systems and services. In order for the VoIP telephony
market to continue to grow, several things need to occur. Telephone and cable
service providers must continue to invest in the deployment of high speed
broadband networks to residential and business customers. VoIP networks must
improve quality of service for real-time communications, managing effects such
as packet jitter, packet loss, and unreliable bandwidth, so that toll-quality
service can be provided. VoIP telephony equipment and services must achieve a
similar level of reliability that users of the public switched telephone network
have come to expect from their telephone service. VoIP telephony service
providers must offer cost and feature benefits to their customers that are
sufficient to cause the customers to switch away from traditional telephony
service providers. If any or all of these factors fail to occur, our business
may not be successful.
Intense
competition could reduce our market share and decrease our revenue.
The
market for VoIP telephony is extremely competitive. Our competitors include
companies in the Internet and telecommunications industries. Many of our
existing competitors and potential competitors have broader portfolios of
services, greater financial, management and operational resources, greater
brand-name recognition, larger subscriber bases and more experience than we
have. In addition, our Internet competitors use the Internet instead of a
private network to transmit traffic, and the operating and capital costs of
these providers may be less than ours.
If we are
unable to provide competitive service offerings, we may lose existing customers
and be unable to attract additional customers. In addition, many of our
competitors enjoy economies of scale that result in a lower cost structure for
transmission and related costs, which cause significant pricing pressures within
the industry. To remain competitive, we must continue to invest significant
resources in research and development, sales and marketing, and customer
support. We may not have sufficient resources to make these investments or to
make the technical advances necessary to be competitive, which, in turn, will
cause our business to suffer.
Fluctuations
in our quarterly financial results may make it difficult for investors to
predict our future performance.
Our
quarterly operating results may fluctuate significantly in the future as a
result of a variety of factors, many of which are outside our control. The
factors generally within our control include:
The
factors outside our control include:
We
believe that quarter-to-quarter comparisons of our historical operating results
may not be a good indication of our future performance, nor would our operating
results for any particular quarter be indicative of our future operating
results.
We
face a risk of failure of computer and communications systems used in our
business.
Our
business depends on the efficient and uninterrupted operation of our computer
and communications systems as well as those that connect to our network. We
maintain communications systems in facilities in New Jersey, Atlanta, London and
Frankfurt. Although we have designed our network to reduce the possibility of
disruptions or other outages, our systems and those that connect to our network
are subject to damage or interruption from natural disasters, power loss,
communications failure, hardware or software malfunction, network failures,
physical or electronic break-ins, sabotage, computer viruses, intentional acts
of terrorism or vandalism and other events that may be or may not be beyond our
control. Any system interruptions that cause our services to be unavailable,
including significant or lengthy telephone network failures or difficulties for
users in communicating through our network or portal, could damage our
reputation and result in a loss of users.
Our
computer systems and operations may be vulnerable to security
breaches.
We
believe that the secure transmission of confidential information over the
Internet, such as credit card numbers, is essential in maintaining user
confidence in our services. Although we have developed systems and processes
that are designed to protect consumer information and prevent fraudulent credit
card transactions and other security breaches, our computer infrastructure is
potentially vulnerable to physical or electronic computer viruses, break-ins and
similar disruptive problems and security breaches that could cause
interruptions, delays or loss of services to our users. We rely on licensed
encryption and authentication technology to effect secure transmission of
confidential information, including credit card numbers. It is possible that
advances in computer capabilities or new technologies could result in a
compromise or breach of the technology we use to protect user transaction data.
A party that is able to circumvent our security systems could misappropriate
proprietary information or cause interruptions in our operations. Security
breaches also could damage our reputation and expose us to a risk of loss,
litigation and possible liability. Although we have experienced no security
breaches to date of which we are aware, we cannot guarantee you that our
security measures will prevent security breaches.
Operating
internationally exposes us to additional and unpredictable risks.
We
operate in many international markets. In addition to the uncertainty regarding
our ability to generate revenue from foreign operations, there are certain risks
inherent in doing business on an international basis, including:
We
need to retain key personnel to support our products and ongoing
operations.
The
marketing and operations of our VoIP products and services will continue to
place a significant strain on our limited personnel, management, and other
resources. Our future success depends upon the continued services of our
executive officers and other key employees whom we rely upon to run our
operations; this is particularly true following the significant reduction in the
number of employees that occurred as a result of the reductions in force during
2008. Except for Mr. Effi Baruch, our interim Chief Executive Officer and
President, and Senior Vice President of Technology and Operations, none of our
officers or key employees is subject to an employment agreement for any specific
term. The loss of the services of any of these officers or key employees could
impact our ability to run our operations and delay the development and
introduction of, and negatively impact our ability to sell, our products, either
of which could adversely affect our financial results. We currently do not
maintain key person life insurance policies on any of our
employees.
Our
ability to provide our service is dependent in part upon third-party facilities
and equipment, the failure of which could cause delays or interruptions of our
service, damage our reputation, cause us to lose customers and limit our
growth.
Our
success depends on our ability to provide quality and reliable service, which is
in part dependent upon the proper functioning of facilities and equipment owned
and operated by third parties and is, therefore, beyond our control. Unlike
traditional wireline telephone service or wireless service, our service requires
our customers to have an operative broadband Internet connection and an
electrical power supply, which are provided by the customer's Internet service
provider and electric utility company, respectively, and not by us. The quality
of some broadband Internet connections may be too poor for customers to use our
services properly. In addition, if there is any interruption to a customer's
broadband Internet service or electrical power supply, that customer will be
unable to make or receive calls, including emergency calls, using our service.
We also outsource several of our network functions to third-party providers. For
example, we outsource the maintenance of our regional data connection points,
which are the facilities at which our network interconnects with the public
switched telephone network. If our third-party service providers fail to
maintain these facilities properly, or fail to respond quickly to problems, our
customers may experience service interruptions. Our customers have experienced
such interruptions in the past and may experience interruptions in the future.
In addition, our E-911 service is currently dependent upon a third-party
provider. Interruptions in service from this vendor could cause failures in our
customers' access to E-911 services. Furthermore, we outsource certain aspects
of our customer care services. Interruptions in our service caused by
third-party facilities or service providers have in the past caused and may in
the future cause us to lose customers, or cause us to offer substantial customer
credits, which could adversely affect our revenue and profitability. If
interruptions adversely affect the perceived reliability of our service, we may
have difficulty attracting new customers and our brand, reputation and growth
will be negatively impacted.
Third
parties might infringe upon our proprietary technology.
We cannot
assure you that the steps we have taken to protect our intellectual property
rights will prevent misappropriation of our proprietary technology. To protect
our rights to our intellectual property, we rely on a combination of trademarks
and trade secret protection, confidentiality agreements and other contractual
arrangements with our employees, affiliates, strategic partners and others. We
may be unable to detect the unauthorized use of, or take appropriate steps to
enforce, our intellectual property rights. Effective trademark and trade secret
protection may not be available in every country in which we offer or intend to
offer our services. Failure to adequately protect our intellectual property
could materially harm our brand, devalue our proprietary content and affect our
ability to compete effectively. Further, defending our intellectual property
rights could result in significant financial expenses and managerial
resources.
Third parties may claim that our
services infringe upon their intellectual property rights.>
Third
parties may assert claims that we have violated a patent or infringed a
copyright, trademark or other proprietary right belonging to them and subject us
to expensive and disruptive litigation. For example, a complaint was
filed in the United States District Court for the Eastern District of
Texas-Tyler Division by Centre One alleging, inter alia, that we and
Verizon are offering for sale a VoIP service that infringes a patent held by
Centre One. In addition, we incorporate licensed third-party
technology in some of our products and services. In these license agreements,
the licensors have agreed to indemnify us with respect to any claim by a third
party that the licensed software infringes any patent or other proprietary right
so long as we have not made changes to the licensed software. We cannot assure
you that these provisions will be adequate to protect us from infringement
claims. Any infringement claims and lawsuits, even if not meritorious, could be
expensive and time consuming to defend; divert management’s attention and
resources; require us to redesign our products, if feasible; require us to
pay royalties or enter into licensing agreements in order to obtain the right to
use necessary technologies; and/or may materially disrupt the conduct of our
business.
Risks
Related to our Industry
Government
regulation and legal uncertainties relating to IP telephony could harm our
business.
Historically,
voice communications services have been provided by regulated telecommunications
common carriers. We offer voice communications to the public for international
and domestic calls using IP telephony, and we do not operate as a licensed
telecommunications common carrier in many jurisdictions based on specific
regulatory classifications and recent regulatory decisions. However, the growth
of IP telephony has led to close examination of its regulatory treatment in many
jurisdictions making the legal status of our services uncertain and subject to
change as a result of future regulatory action, judicial decisions or
legislation in any of the jurisdictions in which we operate. Established
regulated telecommunications carriers have sought and may continue to seek
regulatory actions to restrict the ability of companies such as ours to provide
services or to increase the cost of providing such services.
Application
of new regulatory restrictions or requirements to us could increase our costs of
doing business and prevent us from delivering our services through our current
arrangements. In such event, we would consider a variety of alternative
arrangements for providing our services, including obtaining appropriate
regulatory authorizations for our local network partners or ourselves, changing
our service arrangements for a particular country or limiting our service
offerings. Such regulations could limit our service offerings, raise our costs
and restrict our pricing flexibility, and potentially limit our ability to
compete effectively. Furthermore, regulations and laws that affect the growth of
the Internet could hinder our ability to provide our services over the
Internet.
Our
international operations are also subject to regulatory risks, including the
risk that regulations in some jurisdictions will prohibit us from providing our
services cost-effectively or at all, which could limit our growth. Currently,
there are several countries where regulations prohibit us from offering service.
We cannot assure you that these conditions will not have a material effect on
our revenues and growth in the future. In addition, because customers can use
our services almost anywhere that a broadband Internet connection is available,
including countries where providing VoIP services is illegal, the governments of
those countries may attempt to assert jurisdiction over us, which could expose
us to significant liability and regulation.
We
may not be able to keep pace with rapid technological changes in the
communications industry.
Our
industry is subject to rapid technological change, and we cannot predict the
effect of technological changes on our business. We expect that new services and
technologies will emerge in the market in which we compete. These new services
and technologies may be superior to the services and technologies that we use
and/or may render our services and technologies obsolete.
To be
successful, we must adapt to our rapidly changing market by continually
improving and expanding the scope of services we offer and by developing new
services and technologies to meet customer needs. Our success will depend, in
part, on our ability to license leading technologies and respond to
technological advances and emerging industry standards on a cost-effective and
timely basis. We will need to spend significant amounts of capital to enhance
and expand our services to keep pace with changing technologies.
The
success of our business is affected by customers' unimpeded access to broadband
service. Providers of broadband services may be able to block our services,
which could adversely affect our revenue and growth.
A portion
of our customers must have broadband access to the Internet in order to use our
service. Some providers of broadband access have taken measures that affect
their customers' ability to use our service, such as degrading the quality of
the data packets we transmit over their lines, giving those packets low
priority, giving other packets higher priority than ours, blocking our packets
entirely or attempting to charge their customers more for also using our
services. It is not clear whether suppliers of broadband access services have a
legal obligation to allow their customers to access and use our service without
interference. As a
result of recent decisions by the U.S. Supreme Court and the FCC, providers of
broadband services are subject to relatively light regulation by the FCC.
Consequently, federal and state regulators might not prohibit broadband
providers from limiting their customers' access to VoIP or otherwise
discriminating against VoIP providers. Interference with our service or higher
charges for using our service could cause us to lose existing customers, impair
our ability to attract new customers, and harm our revenue and
growth.
We are
not currently accepting customers in areas where we cannot provide E-911 service
in conformity with the FCC’s rules. This has adversely impacted the ability of
iConnectHere to accept new customers and may also have an adverse effect on our
sales to customers who resell our service.
Various
U.S. state and local fees, taxes and surcharges may increase our costs and our
customers' cost of using our services.
Some
state and local regulatory authorities claim that they retain jurisdiction to
regulate the provision of, and impose taxes, fees and surcharges on, intrastate
Internet and VoIP telephony services, and have attempted to impose such taxes,
fees and surcharges, such as a fee for providing E-911 service. Rulings by the
state commissions on the regulatory considerations affecting Internet and IP
telephony services could affect our operations and revenues, and we cannot
predict whether state commissions will be permitted to regulate the services we
offer in the future.
We have
recently completed an initial study of state and local taxes and other fees and
have accrued approximately $500,000 of estimated taxes and fees due through the
year ended December 31, 2008. We have also determined that we need to
collect and remit sales and excise taxes in certain states and local
jurisdictions and will begin collecting and remitting such sales and excise
taxes in the immediate future. To the extent we increase the cost of
services to our customers to recoup some of the costs of compliance, this will
have the effect of decreasing any price advantage we may have over traditional
telecommunications companies.
In
addition, it is possible that we will be required to collect and remit taxes,
fees and surcharges in other states and local jurisdictions, and which such
authorities may take the position that we should have collected. If so, they may
seek to collect those past taxes, fees and surcharges from us and impose fines,
penalties or interest charges on us. Our payment of these past taxes, fees and
surcharges, as well as penalties and interest charges, could have a material
adverse effect on us.
There
may be risks associated with our ability to comply with funding requirements of
the USF and similar state or federal funds as well as other FCC-mandated funding
requirements or that our customers will cancel service due to the impact of
these or other price increases to their service.
We
began contributing to the USF during the fourth fiscal quarter of 2006 and began
charging our customers a USF surcharge fee. In addition, we are
required to collect and remit other FCC-related fees, such as the TRS fund and
contributions towards local number portability. We have recently
completed an initial study of FCC-related fees that are due and have accrued
approximately $200,000 of estimated fees due through December 31, 2008. The
impact of this price increase on our customers or our inability to recoup the
costs or liabilities in remitting such fees could have a material adverse effect
on our financial position, results of operations and cash flows, or could cause
some customers to cancel our service due to the loss of any price advantage we
may have over traditional telecommunications companies..
Future
legislation or regulation of our service offerings may increase our costs, which
may result in either our increasing the retail price of our service offerings or
reducing our profitability.
The FCC
has several ongoing proceedings that could negatively impact
us. Specifically, the FCC may reform the system of payments between
companies that connect telephone companies. Such reforms may increase
the charges we pay to other companies for handling our calls. The FCC
may adopt more stringent E-911 obligations. This could result in us
having to deploy new technologies or engage a third party to provide services in
compliance with the new regulations, increasing our costs. The FCC
may determine that some or all of our offerings are properly classified as
“telecommunications” services subjecting our offerings to state and federal
regulations, thereby increasing our compliance costs. The U.S.
Congress, state legislatures, state regulatory commissions and foreign
regulatory commissions could attempt to impose additional obligations on us at
any time. We cannot predict the outcome of the pending FCC
proceedings or what actions such other governmental and regulatory bodies may
take that may affect us.
Risks Related to our Relationship
with D4 Holdings
D4
Holdings controls a majority of our common stock and has the ability to exercise
control over all matters submitted to a stockholder vote.
D4
Holdings owns approximately 54.3% of the issued and outstanding shares of our
common stock and, in the event it exercises in full the warrant that we issued
to it to purchase up to an additional 30,000,000 shares of our common stock at
an exercise price of $0.04 per share, it will own approximately 67.7% of the
issued and outstanding shares of our common stock. As long as D4
Holdings continues to beneficially own more than 50% of the voting power of our
company, D4 Holdings will be able to exercise a controlling influence over
decisions affecting us, including:
In
addition, this concentration of ownership may discourage, delay or prevent a
change in control of our company, which could deprive our stockholders of an
opportunity to receive a premium for their common stock as part of a sale of our
company or result in strategic decisions that could negatively impact the value
and liquidity of our outstanding stock. D4 Holdings also has sufficient voting
power to amend our organizational documents. Furthermore, conflicts of interest
could arise in the future between us and D4 Holdings concerning, among other
things, potential competitive business activities or business opportunities. D4
Holdings is not restricted from competitive activities or investments. We cannot
provide assurance that the interests of D4 Holdings will coincide with the
interests of other holders of our common stock. Also, four of our
seven directors are affiliated with D4 Holdings. As a result, the ability of any
of our other stockholders to influence the management of our company is limited,
which could have an adverse effect on the market price of our
stock.
The
ownership of D4 Holdings includes owners of ACN, and we may engage in commercial
transactions with ACN in the future.
D4
Holdings is a private investment fund whose ownership includes owners of ACN.
Several of the members of our board of directors currently serve as officers
and/or directors of ACN. Because ACN is a direct seller of telecommunications
services, we may seek to engage in commercial transactions to provide services
to ACN in the future. Although we expect that the terms of any such
transactions will be established based upon negotiations between employees of
ACN and us and, when appropriate, subject to the approval of the independent
directors on our board or a committee of disinterested directors, there can be
no assurance the terms of any such transactions will be as favorable to us as
might otherwise be obtained in arm’s length negotiations.
As
a result of D4 Holding’s controlling interest in deltathree a third party may be
deterred from attempting to acquire our company.
D4
Holding’s controlling interest in deltathree could delay, deter or prevent a
third party from attempting to acquire control of us. This may have the effect
of discouraging a third party from making a tender offer or otherwise attempting
to obtain control of us, even though such a change in ownership would be
economically beneficial to us and our stockholders.
Our
stockholders may suffer dilution in the future in the event that D4 Holdings
exercises its warrant.
On
February 12, 2009, we issued to D4 Holdings 39,000,000 shares of our common
stock for an aggregate purchase price of $1,170,000 and a warrant, exercisable
for up to ten years, to purchase up to an additional 30,000,000 shares of our
common stock for a purchase price of $0.04 per share. In the event
that D4 Holdings exercises the warrant, in full or in part, our existing
stockholders may experience significant and immediate dilution.
Our
ability to utilize our historical net operating losses is substantially limited
as a result of our transaction with D4 Holdings.
As of
December 31, 2008, we had net operating loss carryforwards, or NOLs, generated
in the U.S. of approximately $80.0 million. Our issuance of common stock to D4
Holdings in February 2009 may constitute an “ownership change” as defined in
Section 382 of the Internal Revenue Code, which may result in a loss of a
substantial amount of the NOLs we have accrued and our ability to offset income
that we may generate in the future. Our ability to use our remaining
NOLs could be additionally reduced if we experience any further “ownership
change,” as defined under Section 382.
Risks
Related to our Common Stock
Volatility
of our stock price could adversely affect our stockholders.
From the
time that trading commenced in our common stock in November 1999, the
market price of our common stock has been highly volatile and may continue to be
volatile and could be subject to wide fluctuations in response to factors such
as:
All of
these factors are, in whole or part, beyond our control and may materially
adversely affect the market price of our common stock regardless of our
performance.
Investors
may not be able to resell their shares of our common stock following periods of
volatility because of the market's adverse reaction to such volatility. In
addition, the market price for shares of telecommunications, Internet-related
and technology companies has dramatically decreased. We cannot assure you that
our common stock will trade at the same levels of other telecommunications or
Internet stocks.
Our
common stock is quoted on the OTC Bulletin Board, which may increase the
volatility of our stock and make it harder to sell shares of our
stock.
Our
common stock is quoted on the OTC Bulletin Board, which tends to be a highly
illiquid market. There is a greater chance of market volatility for
securities that trade on the OTC Bulletin Board (as opposed to a national
exchange or quotation system), as a result of which stockholders may experience
wide fluctuations and a depressed price in the market price of our securities.
Thus, stockholders may be required to either sell our securities at a market
price which is lower than their purchase price or to hold our securities for a
longer period of time than they planned. Because our common stock
falls under the definition of “penny stock,” trading in our common stock may be
limited because broker-dealers are required to provide their customers with
disclosure documents prior to allowing them to participate in transactions
involving our common stock. These rules impose additional sales practice
requirements on broker-dealers that sell low-priced securities to persons other
than established customers and institutional accredited investors; and require
the delivery of a disclosure schedule explaining the nature and risks of the
penny stock market. As a result, the ability or willingness of broker-dealers to
sell or make a market in our common stock might decline, and stockholders could
find it more difficult to sell their stock.
Risks
Related to our Israel Operations
We
may be negatively impacted by changes in political, military and/or economic
conditions.
Since the
establishment of the State of Israel in 1948, a number of armed conflicts have
taken place between Israel and its Arab neighbors and a state of hostility,
varying from time to time in intensity and degree, has led to security and
economic problems for Israel. A peace agreement between Israel and Egypt was
signed in 1979 and a peace agreement between Israel and Jordan was signed in
1994. However, as of the date hereof Israel has not entered into any peace
agreement with Syria or Lebanon.
Despite
peace related developments, certain countries, companies and organizations
continue to participate in a boycott of Israeli firms. We do not believe that
the boycott has had a material adverse effect on us, but there can be no
assurance that restrictive laws, policies or practices directed towards Israel
or Israeli-based businesses will not have an adverse impact on our business or
financial condition in the future.
Our costs
of operations have at times been affected by changes in the cost of our
operations in Israel resulting from changes in the value of the Israeli shekel
relative to the U.S. dollar. Recently, the weakening of the dollar relative to
the shekel has significantly increased the costs of our Israeli operations,
stated in U. S. dollars.
Israel’s
economy has been subject to numerous destabilizing factors, including a period
of rampant inflation in the early- to mid-l980s, low foreign exchange reserves,
fluctuations in world commodity prices and military conflicts. The Israeli
Government has, for these and other reasons, intervened in the economy by
utilizing, among other means, fiscal and monetary policies, import duties,
foreign currency restrictions and control of wages, prices and exchange rates.
The Israeli Government has periodically changed its policies in all these areas.
Although we derive most of our revenues outside of Israel, a substantial portion
of our expenses are incurred in Israel and are affected by economic conditions
in the country.
All of
these factors are, in whole or part, beyond our control and may materially
adversely affect on our business, financial condition and operating results, or
market price of our common stock regardless of our performance.
We
may be negatively impacted by employees being called for army
service.
Generally,
all male adult citizens and permanent residents of Israel under the age of 41
are, unless exempt, obligated to perform up to 36 days of military reserve
duty annually. Additionally, all such residents are subject to being called to
active duty at any time under emergency circumstances. Furthermore, some of our
officers and employees are currently obligated to perform annual reserve duty.
While we have operated effectively under these requirements since we began
operations, no assessment can be made as to the full impact of such requirements
on our workforce or business if conditions should change, and no prediction can
be made as to the effect on us of any expansion of such
obligations.
Until
July 15, 2008, we
leased our executive offices on the 31st and
32nd
floors at 75 Broad Street, New York, New York. The term of the lease was until
July 2010. In October 2003 we entered into a sub-lease agreement with eMarketer,
Inc., or eMarketer, to sub-lease our office space on the 32nd
floor. The term of the sublease was until July 2010.
As of
July 15, 2008, eMarketer subleased from us our offices located on the 31st floor,
and effective August 1, 2010, eMarketer was to be substituted in place of us as
the tenant under the lease between us and the landlord. On November
20, 2008, upon receipt of a termination fee equal to $450,000 payable by us and
a letter of credit provided by eMarketer in the amount of $850,000 to the
landlord, the landlord substituted eMarketer for us as the tenant under the
lease and returned to us the original letter of credit in the approximate amount
of $1.0 million we had provided to secure our obligations under the
lease.
We are
currently renting office space at 419 Lafayette Street, New York, N.Y. on an
interim basis while we seek long-term facilities.
We lease
a 1,290 square meter office, which houses our research and development
facilities, in Jerusalem, Israel, at an annual cost of approximately
$265,900; in 2008, we also received approximately $31,200 from a subtenant that
was subleasing part of our office space. The term of our lease extends
through December 2014. We have an option to terminate the lease, effective
December 31, 2009, by providing written notice thereof prior to June 1, 2009,
and paying a termination fee equal to approximately $40,000.
On
December 5, 2008, a complaint for patent infringement was filed in the United
States District Court for the Eastern District of Texas (Tyler Division) by
Centre One naming us, Verizon Communications Inc., Vonage Holdings Corp. and
Vonage America Inc. as defendants. The complaint alleges, inter alia, that we and
Verizon are offering for sale “a VoIP service, including, but not limited to, a
service under the name Verizon VoiceWing” that infringes United States Patent
No. 7,068,668, or Patent ’668, entitled “Method and Apparatus for
Interfacing a Public Switched Telephone Network and an Internet Protocol Network
for Multi-Media Communication.”
On
February 23, 2009, defendants Vonage Holdings and Vonage America filed a motion
to transfer the action from the United States District Court for the Eastern
District of Texas (Tyler Division) to the United States District Court for the
District of New Jersey. The transfer motion argued that none of the
parties have meaningful contacts with the Eastern District of Texas and that
most of the defendants’ evidence and fact witnesses are located in or near New
Jersey. On March 6, 2009, we filed an Answer and Counterclaim, in
which we denied that we have infringed Patent ’668 and sought declaratory
judgments that: we have not infringed Patent ’668; any alleged infringement
would not be actionable due to one or more of our affirmative defenses; and
Patent ’668 is invalid and unenforceable due to inequitable conduct and a
failure to meet the requirements of patentability. Also on March 6,
we joined the Vonage defendants in moving to transfer the action to the United
States District Court for the District of New Jersey. The transfer motions
remain pending.
On April
7, 2009, the court held a status conference and assigned May 6, 2010, and
December 6, 2010, as the dates for the pretrial hearing to interpret the
construction of Centre One’s claims and the commencement of the trial,
respectively.
Our
initial examination of the allegations set forth in the Complaint lead us to
firmly believe that we do not infringe any valid claim of Patent ’668. We are
continuing our examination into the allegations set forth in the complaint and
the validity of Patent ’668, and cannot predict with any degree of certainty the
results of our examination and/or the outcome of the suit or determine the
extent of any potential liability or damages.
We, as
well as certain of our former officers and directors, were named as
co-defendants in a number of purported securities class actions in the United
States District Court for the Southern District of New York, arising out of our
initial public offering, or IPO, in November 1999. In addition, a
number of other issuers and underwriters of public offerings of such issuers
(including the underwriters of our IPO) were named as defendants in such class
action suits in connection with such public offerings. The case is currently
being litigated against a small number of focus issuers (which does not include
us) selected by the district court. A confidential global settlement is
presently being negotiated between the plaintiffs, issuers, underwriters and
insurers, which ultimately will be subject to the approval of the district
court. If the settlement does not occur, and litigation against us recommences,
we believe that we have meritorious defenses to the claims us and we intend to
defend the case vigorously. We are not a party to any other material pending
legal proceedings, other than ordinary routine litigation incidental to the
business, to which we are a party or of which any of our property is the
subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY
HOLDERS
No
matters were submitted to a vote of security holders during the fourth quarter
of the year ended December 31, 2008.
PART
II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED
STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Market
Information
Our
common stock is currently listed on the OTC Bulletin Board under the symbol
“DDDC.OB”. The listing of our common stock was transferred from The Nasdaq
National Market (where it had traded since November 22, 1999) to The Nasdaq
Capital Market on September 17, 2002, and from The Nasdaq Capital Market to the
OTC Bulletin Board on March 28, 2008.
The
following table sets forth the high and low sales prices of our common stock for
such time as our common stock was traded on the Nasdaq Capital Market and the
high and low bid prices for such time as our shares have been listed on the OTC
Bulletin Board for the periods indicated:
Holders
As of
April 6, 2009, we had 163 holders of record of the 71,932,405 outstanding shares
of our common stock. This does not reflect persons or entities that hold their
stock in nominee or "street" name through various brokerage firms.
Dividend
Policy
We have
never declared or paid any cash dividends on our capital stock, and do not
anticipate paying any cash dividends on our capital stock in the foreseeable
future. We currently intend to retain future earnings, if any, to finance our
operations and to expand our business. Any future determination to pay cash
dividends will be at the discretion of our board of directors and will be
dependent upon our financial condition, operating results, capital requirements
and other factors that our board of directors considers
appropriate.
Purchases
of Equity Securities by the Issuer and Affiliated Purchasers
None.
ITEM 6. SELECTED FINANCIAL DATA
You
should read the selected consolidated financial data together with our
consolidated financial statements and related notes and the section of this
Annual Report entitled “Management's Discussion and Analysis of Financial
Condition and Results of Operations.” Brightman Almagor & Co., a member
firm of Deloitte Touche Tohmatsu, independent certified public accountants, have
audited our historical financial statements since inception. The selected
financial data for each of the years in the three-year period ended December 31,
2008, and as of December 31, 2007 and 2008 is derived from our audited financial
statements that have been included in this Annual Report. The selected financial
data as of December 31, 2004, 2005 and 2006 and for the years ended December 31,
2004 and 2005 is derived from consolidated financial statements that have not
been included in this Annual Report.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The
following discussion of our financial condition and results of operations should
be read together with our consolidated financial statements and the related
notes thereto included elsewhere in this Annual Report. This discussion contains
certain forward-looking statements that involve substantial risks and
uncertainties. When used in this report, words such as “anticipate,” “believe,”
“estimate,” “expect,” “target,” “goal,” “project,” “intend,” “plan,” “believe,”
“seek,” variations of such words and similar expressions as they relate to our
management or us are intended to identify such forward-looking statements. Our
actual results, performance or achievements could differ materially from those
expressed in, or implied by, these forward-looking statements. Factors that
might cause such a difference include, but are not limited to, those discussed
in “Risk Factors.” Historical operating results are not necessarily indicative
of the trends in operating results for any future period.
Overview
We are a
well-known provider of integrated Voice over Internet Protocol, or VoIP,
telephony services, products, hosted solutions and infrastructure. We were
founded in 1996 to capitalize on the growth of the Internet as a communications
tool by commercially offering Internet Protocol, or IP, telephony services, or
VoIP telephony. VoIP telephony is the real-time transmission of voice
communications in the form of digitized "packets" of information over the
Internet or a private network, similar to the way in which e-mail and other data
is transmitted. While we began as primarily a low-cost alternative source of
wholesale minutes for carriers around the world, we have evolved into a
well-known provider of next generation communication services.
Today we
support tens of thousands of active users around the globe through our two
primary distribution channels: our service provider and reseller channel, and
our direct-to-consumer channel. We offer a broad suite of private label VoIP
products and services as well as a back-office platform for service providers,
resellers and corporate customers, such as VoIP operators and various corporate
enterprises. Based on our customizable VoIP solutions, these customers can offer
private label telecommunications to their own customer bases under their own
brand name, a “white-label” brand (in which no brand name is indicated and
different customers can offer the same product), or the deltathree brand. At the
same time, our direct-to-consumer channel includes our iConnectHere offering
(which provides VoIP products and services directly to consumers
and small businesses online using the same primary platform) and our joip
offering (which serves as the exclusive VoIP service provider embedded in the
Globarange cordless phones of Panasonic Communications).
We have
built a privately-managed, state-of-the-art global telecommunications platform
using IP technology and offer our customers a suite of IP telephony products,
including PC-to-Phone and Broadband Phone products. We provide a robust set of
value-added services and features that enable us to address the challenges that
have traditionally made the provision of telecommunications services difficult,
and we offer our products and services to a global customer base in a fashion
that meets the disparate needs of this diverse customer base. Our operations
management tools include, among others: account provisioning; e-commerce-based
payment processing systems; billing and account management; operations
management; web development; network management; and customer care. We are able
to provide our services at a cost per user that is generally lower than that
charged by traditional service providers because we minimize our network costs
by using efficient packet-switched technology and interconnecting to a wide
variety of termination options, which allows us to benefit from pricing
differences between vendors to the same termination points.
Prior to
1999, we focused on building a privately-managed, global network utilizing IP
technology, and our business primarily consisted of carrying and transmitting
traffic for communications carriers over our network. Beginning in 1999, we
began to diversify our offerings by layering enhanced IP telephony services over
our network. These enhanced services were targeted at consumers and were
primarily accessible through our consumer website. During 2000, we began
offering services on a co-branded or private-label basis to service providers
and other businesses to assist them in diversifying their product offerings to
their customer bases. In 2001, we continued to enhance our unique strengths
through our pioneering work with the Session Initiation Protocol, or SIP, an
Internet Engineering Task Force standard that has been embraced by industry
leaders such as Microsoft and Cisco. These efforts culminated in the launch of
our state-of-the-art SIP infrastructure, and in doing so we became the first
major VoIP service provider to deploy an end-to-end SIP network and services. In
recent years, we have continued our pioneering efforts in SIP and these efforts
have yielded significant new releases. For example, in 2007 we released a next
generation SIP-based PC-to-Phone application, certified many new devices which
function as access points to our services, and added new features and new
calling plans to our offerings.
In 2004,
we announced our first major service provider contract with Verizon
Communications to provide the Verizon VoiceWing VoIP service. In
2007, we entered into an agreement with Market America, a leading on-line
shopping and one-to-one marketing company, pursuant to which Market America
launched its Voitel Home Phone Service powered by our Hosted Consumer VoIP
Solution platform. In addition, we entered into an agreement with RCN
Corporation, a leading provider of video, data, and voice services to
residential, business, and commercial/carrier customers, to power its Starpower
Internet Phone Service. On January 15, 2009, we received notice from
Verizon that no later than May 15, 2009, our service provider contract with
Verizon would be terminated pursuant to the terms of the
agreement. Verizon is not required to pay us any termination
penalties or fees in connection with its termination of the agreement, and
following the termination date we will not receive any more revenues as a result
of this agreement. In addition, on February 5, 2009, we entered into
a Termination, Settlement Agreement and Mutual Release with RCN, pursuant to
which the service agreement between us and RCN was terminated and RCN
transferred to us some of the subscribers to the VoIP service we had been
providing to RCN under the agreement. In addition, RCN paid us a termination fee
of $230,000.
As a
complement to the initiatives we have taken to attempt to organically expand our
businesses, we have also evaluated opportunities for growth through acquisitions
and strategic collaborations. In February 2007, we acquired the service provider
and consumer business assets (including the customer bases) of Go2Call.com,
Inc., a privately held U.S.-based VoIP solutions provider. However, in 2008
we wrote-off approximately $2.0 million in goodwill and approximately $1.6
million in intangible assets acquired in the Go2Call transaction. Through our
joip offering we attempted to expand into other product and geographic consumer
markets, but in 2008 we recognized only $119,000 in revenues from our
service agreement with Panasonic and we do not expect that this will be a
significant source of revenue in the future. In addition, as discussed above, on
February 12, 2009, we consummated a transaction with D4 Holdings LLC, or D4
Holdings, a Delaware limited liability company, pursuant to which, among other
things, D4 Holdings acquired (i) 39,000,000 shares of our common stock,
representing approximately 54.3% of the total number of issued and outstanding
shares of common stock following the transaction and (ii) a warrant, exercisable
for ten years, to purchase up to an additional 30,000,000 shares of our common
stock at an exercise price of $0.04 per share. D4 Holdings is a
private investment fund whose ownership includes owners of ACN, Inc., or
ACN, a direct seller of telecommunications services. As a result
of the investment in our company by D4 Holdings, we expect to seek opportunities
to provide services to ACN and enter into other commercial transactions that
give us access to ACN’s international marketing and distribution
capabilities. We have
sustained significant operating losses in recent periods, which has led to a
significant reduction in our cash reserves. As a result, in 2008 we
effected a restructuring that helped us reduce our operating costs significantly
and better align our operations with our current business model. As
part of this restructuring, we initiated a series of reductions in force,
which resulted in a decrease in the number of our employees from 148
as of December 31, 2007, to 43 as of December 31, 2008. In addition,
we subleased our principal executive offices, following which we entered into an
agreement with the landlord pursuant to which we paid a termination fee equal to
$450,000, our lease agreement for the offices was terminated, and the landlord
returned to us the letter of credit in the approximate amount of $1.0 million we
had provided to secure our obligations under the lease. We also
secured the release of letters of credit we had previously provided to
other suppliers. From an operational standpoint, we shifted the focus
of our efforts and resources away from our service provider and consumer
divisions towards our reseller business. Finally, we began seeking additional
financing, which culminated in the transaction with D4 Holdings described
above.
Trends
in Our Industry and Business
A number
of factors in our industry and business have a significant effect on our results
of operations and are important to an understanding of our financial statements.
These trends include:
Overall Economic Factors: Our
operations and earnings are affected by local, regional and global events or
conditions that affect supply and demand for telecommunications products and
services. These events or conditions are generally not predictable and include,
among other things, general economic growth rates and the occurrence of economic
recessions; changes in demographics, including population growth rates; and
consumer preferences. Our strategy and execution focus is predicated on an
assumption that these factors will continue to promote strong desire for the
utilization of telephony products and services and that the cost and feature
advantages of VoIP alternatives will not be negatively impacted by unforeseen
changes in these factors.
Industry: The
telecommunications industry is highly competitive. In recent years we have seen
new sources of supply for our underlying infrastructure that have reduced our
overall costs of operation, including both advances in telecommunications
technology and advances in technology relating to telecommunications usage, and
have enjoyed the benefits of competition among these suppliers for a relatively
limited amount of viable customers. A key component of our competitive position,
particularly given the number and range of competing communications products, is
our ability to manage operating expenses successfully, which requires continuous
management focus on reducing unit costs and improving efficiency.
Consumer Demand: There is
significant competition within the traditional telecommunications marketplaces
(landline and wireless) and also with other emergent “next generation”
telecommunications providers, including IP telecommunications providers, in
supplying the overall telecommunications needs of businesses and individual
consumers, and several of the larger traditional telecommunications companies
have announced intentions to merge, which will create even larger competitors.
We compete with other telecommunications firms in the sale and purchase of
various products and services in many national and international markets and
employ all methods of competition that are lawful and appropriate for such
purposes. A key component of our competitive position, particularly given the
commodity-based nature of many of our products, is our ability to sell to a
growing demand base for alternative communications products, in both the
developed and developing global marketplace.
Within
the developed global marketplace, our ability to sell broadband VoIP telephony
products and services is directly linked to the significant growth rate of
broadband adoption, and we expect this trend to continue. We benefit from this
trend because our service requires a broadband Internet connection and our
potential addressable market increases as broadband adoption
increases.
Within
the developing areas of the world, our ability to sell alternative telephony
products and services is linked to both the increasing baseline economic trends
within these countries as well as the growing desire for individuals and
businesses to communicate and do business outside of their own countries. We
expect these trends to continue, and benefit from them because both the ability
to afford long distance calls and the desire to make them increase as a
result.
Political Factors: Our
operations and earnings have been, and may in the future be, affected from time
to time in varying degree by political instability and by other political
developments and laws and regulations, such as: telecommunications regulations;
war, terrorism and other international conflicts; restrictions on production,
imports and exports; price controls; tax increases and retroactive tax claims;
expropriation of property; and cancellation of contract rights. Both the
likelihood of such occurrences and their overall effect upon us vary greatly
from country to country and are not predictable. At the same time, VoIP is
becoming legal in more countries as governments seek to increase competition,
and this affects us in a positive manner as service providers and resellers seek
to meet their customers’ telecommunications needs with newly available
solutions. Both the likelihood of VoIP legalization and its overall effect upon
us vary greatly from country to country and are not predictable.
Regulatory Factors:
Our business has developed in an environment largely free from
regulation. However, the United States and other countries have begun to examine
how VoIP services should be regulated and to begin instituting such regulation,
and a number of initiatives could have an impact on our business. These
initiatives include the assertion of state regulatory and taxing authorities
over us, FCC rulemaking regarding emergency calling services, CALEA, CPNI,
access to relay services for people with disabilities, and proposed reforms for
the inter-carrier compensation system. Complying with regulatory developments
will impact our business by increasing our operating expenses, including legal
fees, requiring us to make significant capital expenditures or increasing the
taxes and regulatory fees we pay. We may impose additional fees on our customers
in response to these increased expenses. This would have the effect of
increasing our revenues per customer, but not our profitability, and increasing
the cost of our services to our customers, which would have the effect of
decreasing any price advantage we may have over traditional telecommunications
companies.
We have
recently completed an initial study of FCC-related fees that are due and have
accrued approximately $200,000 of estimated fees due through December 31,
2008. In addition, we have recently completed an initial study of
state and local taxes and other fees and have accrued approximately $500,000 of
estimated taxes and fees due through December 31, 2008. We have also
determined that we need to collect and remit such FCC-related fees and sales and
excise taxes in certain states and local jurisdictions and will begin collecting
and remitting such FCC-related fees and sales and excise taxes in the immediate
future.
Project Factors: In addition
to the factors cited above, the advancement, cost and results of particular
projects depend on the outcome of: negotiations with potential partners,
governments, suppliers, customers or others; changes in operating conditions or
costs; and the occurrence of unforeseen technical difficulties or enhancements.
The likelihood of these items occurring and its overall positive or negative
effect upon us vary greatly from project to project and are not
predictable.
Risk Factors: See “Item 1A.
Risk Factors” for a discussion of the impact of market risks, financial risks
and other uncertainties.
Revenues
Our
revenues are derived mainly from resellers, service providers, and end-users of
our VoIP telephony products and services, including PC-to-Phone, and Broadband
Phone. All revenues are recognized at the time the services are performed. The
provision of VoIP telephony products and services through our service provider
and reseller sales efforts (including sales of our Hosted Consumer VoIP
Solution) accounted for 84.7% and 85.2% of our total revenues in 2008 and 2007,
respectively, while the provision of VoIP telephony (primarily PC-to-Phone)
through iConnectHere accounted for 13.8% and 13.4% of our total revenues in 2008
and 2007, respectively.
Costs
and Operating Expenses
Costs and
operating expenses consist of the following: cost of revenues; research and
development expenses; selling and marketing expenses; general and administrative
expenses; non-cash stock compensation; write-down of intangible assets; and
depreciation and amortization.
Cost of
revenues consist primarily of access, termination and transmission costs paid to
carriers that we incur when providing services and fixed costs associated with
leased transmission lines. The term of our contracts for leased transmission
lines is generally one year or less, and either party can terminate with prior
notice.
Research
and development expenses consist primarily of costs associated with establishing
our network and the initial testing of our services and compensation expenses of
software developers involved in new product development and software
maintenance. In the future, these expenses may fluctuate as a percentage of
revenue depending on the project undertaken during the reporting period. Since
our inception, we have expensed all research and development costs in each of
the periods in which they were incurred.
Selling
and marketing expenses consist primarily of expenses associated with our direct
sales force incurred to attract potential service provider, reseller, and
corporate customers and advertising and promotional expenses incurred to attract
potential consumer users of iConnectHere.
General
and administrative expenses consist primarily of compensation and benefits for
management, finance and administrative personnel, occupancy costs and legal and
accounting fees, as well as the expenses associated with being a public company,
including the costs of directors' and officers' insurance.
Depreciation
and amortization consists of the depreciation calculated on our fixed assets for
the fiscal year ended December 31, 2008, and the amortization of the intangible
assets acquired by us in the purchase of certain assets of Go2Call.
We have
not recorded any income tax benefit for net losses and credits incurred for any
period from inception to December 31, 2008. The utilization of these
losses and credits depends on our ability to generate taxable income in the
future. Because of the uncertainty of our generating taxable income going
forward, we have recorded a full valuation allowance with respect to these
deferred assets.
Net
Operating Losses
As of December 31, 2008, we had NOLs
generated in the U.S. of approximately $80.0 million. Our issuance of common
stock to D4 Holdings in February 2009 may constitute an “ownership change” as
defined in Section 382 of the Internal Revenue Code, which may result in a loss
of a substantial amount of the NOLs we have accrued and our ability to offset
income that we may generate in the future. Our ability to use our
remaining NOLs could be additionally reduced if we experience any further
“ownership change,” as defined under Section
382.
Critical
Accounting Policies
The SEC
defines critical accounting policies as those that are, in management's view,
most important to the portrayal of a company's financial condition and results
of operations and most demanding on their calls on judgment, often as a result
of the need to make estimates about the effect of matters that are inherently
uncertain and may change in subsequent periods. We believe our most critical
accounting policies relate to:
Use of
estimates: Our consolidated financial statements are prepared
in conformity with accounting principles generally accepted in the United
States, which require management to make estimates and assumptions that affect
the amounts reported and disclosed in the consolidated financial statements and
the accompanying notes. Actual results could differ materially from these
estimates.
On an
ongoing basis, we evaluate our estimates, including the following:
We base
our estimates on historical experience, available market information,
appropriate valuation methodologies and various other assumptions that we
believe to be reasonable, the results of which form the basis for making
judgments about the carrying values of assets and liabilities.
Revenue recognition and deferred
revenue: We
record revenue from Internet telephony services based on minutes (or fractions
thereof) of customer usage. We record revenue from related services based on
completion of the specific activities associated with the services. We record
payments received in advance for prepaid services and services to be supplied
under contractual agreements as deferred revenue until such related services are
provided. We estimate the allowance for doubtful accounts by reviewing the
status of significant past due receivables and analyzing historical bad debt
trends and we then reduce accounts receivables by such allowance for doubtful
accounts to expected net realizable value.
Long-lived assets: We assess
the impairment of long-lived assets whenever events or changes in circumstances
indicate that the carrying value may not be recoverable. Factors we consider
important which could trigger an impairment review include the
following:
We
determine the recoverability of long-lived assets based on an estimate of
undiscounted future cash flows resulting from the use of the asset and its
eventual disposition. Such estimation process is highly subjective and involves
significant management judgment. Determination of impairment loss from
long-lived assets to be disposed of is reported at the lower of carrying amount
or fair value less costs to sell.
Results
of Operations
The
following table sets forth the statement of operations data presented as a
percentage of revenues for the periods indicated:
Comparison
of 2007 and 2008
Revenues
Revenues
overall decreased approximately $9.3 million or 31.5% to approximately $20.2
million in 2008 from approximately $29.5 million in 2007. All of our
revenue channels were affected. Revenues from VoIP telephony through our service
provider and reseller sales efforts (both pre-paid and post-paid) decreased
approximately $8.0 million or 31.9% from approximately $25.1 million in 2007 to
approximately $17.1 million in 2008. In addition, revenues from VoIP
telephony (primarily PC-to-Phone) through iConnectHere decreased approximately
$1.0 million or 27% from approximately $3.8 million in 2007 to approximately
$2.8 million in 2008.
Our
revenue decrease can be attributed to a number of factors, the most important
being an increasingly competitive VoIP market causing market rates to
decline. Some of the other factors included the
following:
As a
result, the number of minutes on our network utilized by our resellers and
end-users dropped by approximately 17% from 380 million in 2007 to 315 million
in 2008.
Furthermore,
our reseller revenues, which made up approximately 66% of our overall revenues
in both 2007 and 2008, were adversely affected by regulatory problems in key
destinations. In addition, the introduction of several competitors offering
lower prices than ours to our biggest markets further adversely affected our
revenues. Revenues generated by resellers we acquired in the Go2Call acquisition
amounted to approximately $1.1 million or 7% of our reseller revenues in 2008,
down by $1.9 million or 62% from $3.0 million for 2007.
Revenues
from our Hosted Consumer VoIP Solution division decreased by approximately $2.0
million or 36% from $5.6 million in 2007 to $3.6 million in 2008, largely due to
the expiration of our service agreements with SBC Communications and Bezek
International, together with the expiration of our development agreement with
Panasonic.
In
addition, during 2008 Verizon accounted for approximately 10.9% of our gross
revenues; in the fourth quarter of 2008 Verizon accounted for approximately 9.7%
of our gross revenues. As discussed above under “Item 1. Company Overview”, on
January 15, 2009, we received notice from Verizon that no later than May 15,
2009, our service provider contract with Verizon would be terminated pursuant to
the terms of the agreement. Following the termination date we will
not receive any more revenue as a result of this agreement, which could have a
material adverse effect on our financial condition and results of
operations.
Costs
and Operating Expenses
Loss
from Operations
Loss from
operations increased by $2.3 million or 24% from $9.6 million in 2007 to $11.9
million in 2008, due primarily to the decrease in revenues, increase in costs
and operating expenses (including selling and marketing expenses) and a one-time
amortization charge.
Interest
Income, Net
We
recorded interest expense of $0.01 million in 2008 compared to interest earned
of $0.4 million in 2007. This was due to both the drop in our overall
cash and cash equivalents of approximately $6.5 million and the drop in our
overall interest rate achieved on our investments.
Income
Taxes, Net
We paid
net income taxes of $28,000 in 2008 compared to $126,000 in 2007.
Net
Loss
Net Loss
increased by $2.6 million or 28% from $9.3 million in 2007 to $11.9 million in
2008, due to the foregoing factors.
Comparison
of 2006 and 2007
Revenues
Revenues
overall decreased approximately $8.5 million or 22.4% to approximately $29.5
million in 2007 from approximately $38.0 million in 2006. All of our
revenue channels were affected. Revenues from VoIP telephony through our service
provider and reseller sales efforts (both pre-paid and post-paid) decreased
approximately $6.2 million or 19.8% from approximately $31.3 million in 2006 to
approximately $25.1 million in 2007. In addition, revenues from VoIP
telephony (primarily PC-to-Phone) through iConnectHere decreased approximately
$1.8 million or 31.6% from approximately $5.7 million in 2006 to approximately
$3.8 million in 2007. Revenues generated by our Hosted Consumer VoIP Solution
division decreased by approximately $0.9 million or 13.8% from $6.5 million in
2006 to approximately $5.6 million in 2007.
Our
revenue decrease can be attributed to a number of factors, the most important
being an increasingly competitive VoIP market causing market rates to decline.
We made a decision not to change our existing policy regarding retaining certain
margin rates and thus did not significantly lower our rates. As a result, the
number of minutes on our network utilized by our resellers and end-users
dropped by approximately 29% from 538 million in 2006 to 380 million in
2007.
Furthermore,
our reseller revenues, which made up approximately 65% of our overall revenues
in both 2006 and 2007, were adversely affected by regulatory problems in key
destinations. In addition, the introduction of several competitors offering
lower prices than ours to our biggest markets further adversely affected our
revenues. Revenues generated by resellers we acquired in the Go2Call acquisition
amounted to approximately $3.0 million or 15.4% of our reseller revenues in
2007.
Revenues
generated by iConnectHere declined by approximately $1.8 million or 33.3% from
$5.7 million in 2006 to $3.8 million in 2007. This resulted in part from a
decision we made to invest our time and resources in other areas.
Revenues
from our Hosted Consumer VoIP Solution division decreased by approximately $0.9
million or 13.8%from $6.5 million in 2006 to $5.6 million in 2007, largely due
to the expiration of our agreement with SBC.
No
customer accounted for ten percent or more of our sales during
2007.
Costs
and Operating Expenses
Loss
from Operations
Loss from
operations increased by $9.5 million or 9,500% from $0.1 million in 2006 to $9.6
million in 2007, due primarily to the decrease in revenues, increase in costs
and operating expenses (including selling and marketing expenses) and a one time
amortization charge.
Interest
Income, Net
We earned
interest income of $0.4 million in 2007 compared to $0.6 million in 2006 due
primarily to interest earned on the remaining proceeds from our
IPO.
Income
Taxes, Net
We paid
net income taxes of $126,000 in 2007 compared to $61,000 in 2006.
Net
Income/Loss
Net
income decreased by $9.8 million or 1,960% from $0.5 million in 2006 to a loss
of $9.3 million in 2007, due to the foregoing factors.
Liquidity
and Capital Resources
Since our
inception in June 1996, we have incurred significant operating and net
losses due in large part to the start-up and development of our operations and
our recent losses from operations. For the year ended December 31, 2008,
our net loss from operations increased by $2.3 million or 24.0% from $9.6
million in 2007 to $11.9 million in 2008. To date, we have an
accumulated deficit of approximately $172.6 million.
As of
December 31, 2008, we had cash and cash equivalents of approximately $1.8
million and restricted cash and short-term investments of approximately $0.3
million. or a total of cash, cash equivalents and restricted cash of $2.1
million, a decrease of $6.5 million from December 31, 2007. In
addition, we had negative working capital of approximately $0.7 million, down
from $4.5 million in 2007 or a net change of ($5.2) million. The
decrease in cash, restricted cash, and short and long term investments was
primarily caused by the net cash used in operating activities of approximately
$6.2 million. During 2008, our average monthly cash burn was approximately
$0.53 million (including cash used in our operations and cash used in to pay
capital leases). In the first quarter of 2008 our average monthly
cash burn was approximately $0.8 million, or approximately $2.4 million for the
quarter, following which we were able to decrease our cash burn as a result of
the steps we took during the restructuring. Looking forward, we
estimate that the average monthly cash burn rate for the first quarter of 2009
will be approximately $0.1 million on a monthly basis without one-time
items.
Cash used
in or provided by operating activities is net income adjusted for certain
non-cash items and changes in assets and liabilities. We had negative cash flow
from operating activities of approximately $6.2 million during 2008 compared
with negative cash flow from operating activities of approximately
$5.1 million during 2007. The decrease in our cash generated
from operating activities was primarily driven by our net loss of $11.9 million
plus changes in working capital of approximately $1.7 million, depreciation and
amortization of approximately $1.5 million and write-offs for the Go2call
intangible asset of approximately $3.6 million.
Net cash
used in investing activities is generally driven by our annual capital
expenditures and changes in our short and long term investments. In
2008, we spent $0.3 million on capital expenditures and decreased our
investments by $6.7 million, for a net decrease of $6.4 million. In 2007, we
spent $0.7 million on capital expenditures, reduced our investments by $6.2
million and used approximately $2.5 million in cash to purchase the assets of
Go2Call, for a net use of cash of $3.0 million.
Financing
cash flows consist primarily of payments of capital leases and of proceeds from
exercise of employee options. During 2008 we paid $0.1 million for capital lease
and $0.01 million during 2007. During 2007 our employees exercised options of
$0.03 million. No options were exercised during 2008 due to the drop in the
market price of our common stock.
As
discussed above under “Business – Transaction with D4 Holdings”, on February 12,
2009, we consummated the transaction with D4 Holdings pursuant to which we
issued to D4 Holdings (i) 39,000,000 shares of our common stock, representing
approximately 54.3% of the total number of issued and outstanding shares of
common stock following the transaction, for an aggregate purchase price of
$1,170,000, paid in cash, and (ii) a warrant, exercisable for ten years, to
purchase up to an additional 30,000,000 shares of our common stock at an
exercise price of $0.04 per share.
We
obtained our funding from our utilization of the remaining proceeds from our
IPO, offset by positive or negative cash flow from our operations, and most
recently from the sale of shares of our common stock to D4 Holdings. These
proceeds are maintained as cash, restricted cash, and short and long term
investments. We have sustained significant operating losses in recent periods,
which has led to a significant reduction in our cash
reserves. In 2008 we initiated a restructuring plan that helped
us cut operating costs significantly and better align our operations
with our current business model, but there are no assurances that these
reductions in costs will be sufficient to return us to positive cash
flow. Based on current trends in our operations we believe that we
will not have sufficient funds to meet our working capital requirements,
including operating losses, and capital expenditure requirements for the next
fiscal year future if we do not receive additional financing. There
can be no assurance that we will be able to raise such additional capital on
favorable terms or at all. If additional funds are raised through the
issuance of equity securities, our existing stockholders will experience
significant further dilution. As a result of the foregoing factors, there is
substantial doubt about our ability to continue as a going
concern. Contractual
Obligations and Commercial Commitments
The
following table sets forth our future contractual obligations and commercial
commitments in total, for each of the next five years and
thereafter:
Off-Balance
Sheet Arrangements
None.
Certain
Factors That May Affect Future Results of Operations
The SEC
encourages companies to disclose forward-looking information so that investors
can better understand a company's future prospects and make informed investment
decisions. This Annual Report contains such "forward-looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995, as
amended.
Words
such as "may," "anticipate," "estimate," "expects," "projects," "intends,"
"plans," "believes" and words and terms of similar substance used in connection
with any discussion of future operating or financial performance, identify
forward-looking statements. All forward-looking statements are management's
present expectations of future events and are subject to a number of risks and
uncertainties that could cause actual results to differ materially and adversely
from those described in the forward-looking statements. These risks include, but
are not limited to, those set forth under the heading "Risk Factors" contained
in Item 1A of this Annual Report.
In light
of these assumptions, risks and uncertainties, the results and events discussed
in the forward-looking statements contained in this Annual Report or in any
document incorporated by reference might not occur. Stockholders are cautioned
not to place undue reliance on the forward-looking statements, which speak only
as of the date of this Annual Report. We are not under any obligation, and we
expressly disclaim any obligation, to update or alter any forward-looking
statements, whether as a result of new information, future events or otherwise.
All subsequent forward-looking statements attributable to deltathree or to any
person acting on our behalf are expressly qualified in their entirety by the
cautionary statements contained or referred to in this section.
The
Company's Consolidated Financial Statements required by this Item are set forth
in Item 15 beginning on page 40 of this Annual Report.
ITEM 9.
CHANGES IN AND DISAGREEMENTS
WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
(a)
Evaluation of Disclosure
Controls and Procedures. Each of our principal executive officer and
principal financial officer, after evaluating the effectiveness of our
disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e)
and 15d-15(e)) and internal control over financial reporting (as defined in
Exchange Act Rules 13a-15(f) and 15d-15(f)) as of the end of the period covered
by this Annual Report, has concluded that, based on such evaluation, and as a
result of the material weaknesses described below, our disclosure controls and
procedures were not adequate and effective to ensure that material information
required to be disclosed by us in the reports that we file and submit under the
Exchange Act is recorded, processed, summarized and reported within the time
periods specified in the SEC’s rules and forms.
(b) Management’s Report on Internal
Control over Financial Reporting. Management is responsible
for establishing and maintaining adequate internal control over financial
reporting of the Company. We maintain internal control over financial reporting
designed to provide reasonable assurance regarding the reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles.
Because of its inherent
limitations, internal control over financial reporting may not prevent or detect
misstatements. Also, projections of any evaluation of effectiveness to future
periods are subject to the risk that controls may become inadequate because of
changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate. Therefore, internal control over financial reporting
determined to be effective provides only reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements
for external purposes in accordance with generally accepted accounting
principles.
Under the
supervision and with the participation of our Chief Executive Officer and Chief
Financial Officer, management has evaluated internal control over financial
reporting by the Company using the framework for effective internal control
established in Internal Control—Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission. Management assessed the
effectiveness of our internal control over financial reporting as of
December 31, 2008. During the course of this assessment, management
identified material weaknesses relating primarily to:
Based on
management's assessment, management concluded that internal controls over
financial reporting were not effective, as of December 31, 2008, due to the
material weaknesses described above. In discussion with our outside auditors we
are currently actively attempting to determine how we will remediate these
material weaknesses and prevent their reoccurrence, although we have not yet
identified a specific course of action. This Annual Report does not include an
attestation report of our registered public accounting firm regarding internal
control over financial reporting. Management's report was not subject to
attestation by our registered public accounting firm pursuant to temporary rules
of the SEC that permit us to provide only management's report in this Annual
Report.
(c) Changes in Internal
Controls. As discussed above under “Item 1. Employees”, in
2008 we effected a series of reductions in force that caused the number of our
employees to drop from 148 as of December 31, 2007, to 43 as of December 31,
2008. As a result of this sharp decline our ability to ensure a proper
segregation of duties amongst different employees was severely
curtailed. This had a material effect on our internal controls over
financial reporting, and resulted in the material weaknesses set forth
above.
None.
PART
III
Directors
Our
Amended and Restated Certificate of Incorporation provides that a director shall
hold office until the annual meeting for the year in which his or her term
expires except in the case of elections to fill vacancies or newly created
directorships. Each director is elected for a one-year term. Set forth below are
the name, age and the positions and offices held by each of our current
directors, his principal occupation and business experience during at least the
past five years and the names of other publicly-held companies of which he
serves as a director.
Upon the
closing of the transaction with D4 Holdings and pursuant to the terms of the
Purchase Agreement, Noam Bardin resigned as a director and the board of
directors appointed Robert Stevanovski and Anthony Cassara to serve on the
board. In addition, Lior Samuelson resigned as Chairman of the Board
and remained a director, and Robert Stevanovski was appointed to serve as
Chairman. Following the closing of the private placement, our Board
of Directors appointed Gregory Provenzano, Lyle Patrick and David Stevanovski to
serve on the Board, effective on March 28, 2009.
Benjamin
Broder and J. Lyle Patrick qualify as “independent” as defined in Rule
4200(a)(15) of the Nasdaq listing standards.
Executive
Officers and Key Employees
Set forth
below is a brief description of the present and past business experience of each
of the persons who currently serve as our executive officers or key employees.
Board
of Directors and Committees of the Board
Our
Amended and Restated Certificate of Incorporation provides that the number of
members of our Board of Directors shall be not less than three and not more than
thirteen. There are currently seven directors on the Board. At each annual
meeting of stockholders, directors are elected to hold office for a term of one
year and until their respective successors are elected and
qualified.
The Board
had five regular meetings and four special meetings during the fiscal year ended
December 31, 2008. During the fiscal year ended December 31, 2008, each member
of the Board participated in at least 75% of all Board and applicable committee
meetings held during the period for which he was a director. None of our other
directors attended our 2008 Annual Stockholder Meeting with the exception of Mr.
Gonen, who at the time of the meeting served as a member of the Board of
Directors. The Board has established an Audit Committee and a Compensation
Committee, but dissolved the Nominating and Governance Committee as of September
11, 2006. The functions of the remaining committees and their current members
are set forth below.
Due to a
decrease in the number of members of the Board after our 2006 Annual
Stockholders Meeting, our Board members determined that it is efficient and
important for each member to actively participate in all matters that were
previously the responsibility of the Nominating and Governance Committee. As
such, each of our Board members participates in, among other matters, the
following nominating and governance-related matters:
Furthermore,
our Board adopted a nominating and governance policy that was based on the
former Nominating and Governance Committee Charter. This policy outlines our
Board’s goals, responsibilities, and procedures related to nominating and
governance matters. In this regard, our
Board may consider candidates recommended by stockholders as well as from other
sources such as other directors or officers, third party search firms or other
appropriate sources. For all potential candidates, the Board may consider all
factors it deems relevant, such as a candidate’s personal integrity and sound
judgment, business and professional skills and experience, independence,
knowledge of the industry in which we operate, possible conflicts of interest,
diversity, the extent to which the candidate would fill a present need in the
Board, and concern for the long-term interests of our stockholders. In general,
persons recommended by stockholders will be considered on the same basis as
candidates from other sources. If a stockholder wishes to nominate a candidate
to be considered for election as a director at our 2009 Annual Meeting of
Stockholders using the procedures set forth in the Company's Amended and
Restated By-laws, it must follow the procedures described under "Nomination of
Directors" in our Amended and Restated By-laws. If a stockholder wishes simply
to propose a candidate for consideration as a nominee by our Board, it should
submit any pertinent information regarding the candidate to the Chairman of the
Board by mail care of our Secretary at 419 Lafayette Street, New York, New York
10003.
The
Compensation Committee is responsible for:
As part
of these responsibilities, the Compensation Committee determines the
compensation of our Chief Executive Officer, and conducts its decision making
process with respect to this issue without the presence of the Chief Executive
Officer. The Compensation Committee had three meetings during 2008. Benjamin
Broder is currently the sole current member of the Compensation
Committee. The Compensation Committee has a charter, a copy of which
is available to our stockholders at the Corporate Governance section of our
website located at www.deltathree.com.
The Audit
Committee is responsible for:
During
the course of the 2008 fiscal year, Noam Bardin and (until his resignation from
the board on November 2, 2008) Ilan Biran and (until such time as he was
appointed Chairman of the Board) Lior Samuelson served on the Audit Committee.
Following the resignation of Noam Bardin on February 12, 2009, there were no
members of the Audit Committee. Mr. Patrick was appointed by the Board to serve
as the Chairman and, until such time as we are able to appoint additional
independent directors, the sole member of the Audit Committee
effective March 28, 2009, the effective time of his appointment to the
board. The Board of Directors has determined that Mr. Patrick meets
the requirements of the applicable Securities and Exchange Commission rules for
membership on the Audit Committee, including Rule 10A-3(b) under the Exchange
Act, is “independent” as defined in Rule 4200(a)(15) of the Nasdaq listing
standards, and qualifies as an “audit committee financial expert” as defined in
Item 407 of Regulation S-K. The Audit Committee had four
meetings during 2008. The Audit Committee has a charter, a copy of
which is available to our stockholders at the Corporate Governance section of
our website located at www.deltathree.com.
Section
16(a) Beneficial Ownership Reporting Compliance
Section
16(a) of the Exchange Act requires that the Company’s directors, executive
officers and persons who own more than 10% of the outstanding common stock of
the Company file initial reports of ownership and reports of changes in
ownership in such common stock with the SEC. Officers, directors and
stockholders who own more than 10% of the outstanding common stock are required
by the SEC to furnish the Company with copies of all Section 16(a) reports they
file.
To our
knowledge, based solely upon our review of the copies of such reports furnished
to us, we believe that all of our directors, officers and holders of more than
10% of any class of our equity securities have complied with the applicable
Section 16(a) reporting requirements, except that one report of change in
beneficial ownership, covering one transaction, was not filed by each of Ilan
Biran (a former member of our Board of Directors), Benjamin Broder and Noam
Bardin (a former member of our Board of Directors).
Code
of Conduct and Ethics
On March
25, 2004, we adopted a Corporate Code of Conduct and Ethics applicable to all
employees and directors of deltathree, including our principal executive
officer, principal financial and accounting officer and controller. There were
no changes made to the Corporate Code of Conduct and Ethics during 2008. The
text of the Corporate Code of Conduct and Ethics is posted on the Corporate
Governance section of our website at www.deltathree.com and will be made
available to stockholders without charge, upon request, in writing to the
Secretary at 419 Lafayette Street, New York, New York 10003. We intend to post
on our website any amendments to, or waivers from, our Code of Conduct and
Ethics that apply to our principal executive officer, principal financial and
accounting officer and controller. We have all of our new employees certify that
they have read and understand our Corporate Code of Conduct and Ethics, and,
periodically, we also ask our existing employees to certify that they have
reviewed our Corporate Code of Conduct and Ethics.
ITEM 11.
EXECUTIVE
COMPENSATION>
Summary
Compensation Table
The
following table shows the total compensation accrued during the fiscal years
ended December 31, 2007 and 2008 to (1) all individuals who served as our Chief
Executive Officer during any part of 2008 and (2) our two next most highly
compensated executive officers whose total compensation exceeded $100,000 during
the fiscal year ended December 31, 2008. These executive officers are referred
to in this Annual Report as our “named executive officers”.
Employment
Agreement with Mr. Effi Baruch
We
currently have an employment agreement with Mr. Baruch, our interim Chief
Executive Officer and President, and Senior Vice President of Operations and
Technology. The agreement became effective on December 9, 2008, and
was amended as of March 17, 2009, and will continue indefinitely
thereafter. Mr. Baruch receives a base salary of $186,000 per year,
which is adjusted as of January 15 each year (beginning 2010) by the percentage
change in the Cost of Price Index during the preceding year. Mr. Baruch is
entitled to receive an annual bonus under our then-applicable bonus plan equal
to up to three (3) months’ salary based on performance criteria that shall be
jointly agreed upon by him and the Board of Directors. Mr. Baruch is
also entitled to an award of non-qualified stock options under our Amended and
Restated 2004 Stock Incentive Plan, as set forth in the option agreement to be
entered into between him and us. In the event of termination of the
agreement, the terminating party is required to provide the other party 90 days’
written notice unless the Company terminates the agreement for cause, in which
case the Company is required to provide such written notice required by
applicable law.
Employment
Agreement with Mr. Lior Samuelson
We were a
party to an employment agreement with Mr. Samuelson, our former Chairman of the
Board, from February 1, 2008, until February 12, 2009, at which time Mr.
Samuelson resigned as Chairman pursuant to the terms of the transaction with D4
Holdings described above under “Business – Transaction with D4
Holdings”. Under the terms of the agreement, Mr. Samuelson received a
salary of $125,000 per year. Mr. Samuelson also received an award of
non-qualified stock options to purchase 300,000 shares of our common stock under
our Amended and Restated 2004 Stock Incentive Plan. The options have
an exercise price of $0.39 per share, and terminate on February 1,
2018. Immediately upon the consummation of the transactions with D4
Holdings, which constituted a change of control under Mr. Samuelson’s employment
agreement, all unvested options became vested and immediately
exercisable.
Outstanding
Equity Awards at Fiscal Year-End
The
following table shows certain information with respect to stock options and
unvested stock awards outstanding as of December 31, 2008, for each of the named
executive officers.
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