Globalstar 10-Q 2006
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
For the quarterly period ended September 30, 2006
For the transition period from to
Commission file number 001-33117
(Exact Name of Registrant as Specified in Its Charter)
461 South Milpitas Blvd.
Milpitas, California 95035
(Address of principal executive offices and zip code)
Registrants telephone number, including area code
Indicate by 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 o. No x.
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.
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.
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date. As of December 6, 2006, there were 72,600,186 shares of $0.0001 par value Common Stock outstanding.
TABLE OF CONTENTS
(In thousands, except share data)
See accompanying notes to unaudited interim consolidated financial statements.
(In thousands, except share data)
See accompanying notes to unaudited interim consolidated financial statements.
See accompanying notes to unaudited interim consolidated financial statements.
Note 1: The Company and Summary of Significant Accounting Policies
Nature of Operations
Globalstar, Inc. (Globalstar or the Company) was formed as a Delaware limited liability company in November 2003, and was converted into a Delaware corporation on March 17, 2006.
Globalstar is a leading provider of mobile voice and data communications services via satellite. Globalstars network, originally owned by Globalstar, L.P. (Old Globalstar), was designed, built and launched in the late 1990s by a technology partnership led by Loral Space and Communications (Loral) and QUALCOMM Incorporated (QUALCOMM). On February 15, 2002, Old Globalstar and three of its subsidiaries filed voluntary petitions under Chapter 11 of the United States Bankruptcy Code. In 2004, Thermo Capital Partners L.L.C. (Thermo) became Globalstars principal owner, and Globalstar completed the acquisition of the business and assets of Old Globalstar.
Basis of Presentation
The accompanying unaudited interim consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (GAAP) for interim financial information. These unaudited interim consolidated financial statements include the accounts of Globalstar and its majority owned or otherwise controlled subsidiaries. All significant intercompany transactions and balances have been eliminated in the consolidation. The interim financial information is unaudited. In the opinion of management, such information includes all adjustments, consisting of normal recurring adjustments, that are necessary for a fair presentation of the Companys consolidated financial position, results of operations, and cash flows for the periods presented. The results of operations for the three and nine months ended September 30, 2006 are not necessarily indicative of the results that may be expected for the full year or any future period. Globalstars results of operations are subject to seasonal usage changes. The months of April through October are typically peak months for service revenues and equipment sales. Government customers in North America tend to use Globalstars services during summer months, often in support of relief activities after events such as hurricanes, forest fires and other natural disasters.
The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The Company evaluates its estimates on an ongoing basis, including those related to revenue recognition, allowance for doubtful accounts, inventory valuation, deferred tax assets, property and equipment, warranty obligations and contingencies and litigation. Actual results could differ from these estimates.
These unaudited interim consolidated financial statements should be read in conjunction with the audited consolidated financial statements and related notes included in the Companys Registration Statement on Form S-1. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted. The consolidated balance sheet as of December 31, 2005 was derived from the Companys audited consolidated financial statements for the year ended December 31, 2005, but does not include all disclosures required by GAAP.
Globalstar operates in one segment, providing voice and data communication services via satellite. As a result, all segment-related financial information required by Statement of Financial Accounting Standards No. 131, Disclosures About Segments of an Enterprise and Related Information, or SFAS No. 131, is included in the consolidated financial statements.
The Company utilizes a derivative instrument in the form of an interest rate swap agreement to minimize the risk of variability in its borrowing costs over the term of the borrowing arrangement. The interest rate swap agreement is used to manage risk and is not used for trading or other speculative purposes. Derivative instruments are recorded in the balance sheet as either assets or liabilities, measured at fair value. The interest rate swap agreement did not qualify for hedge accounting treatment. Changes in the fair value of the interest rate swap agreement are recognized as Interest rate derivative gain (loss) over the life of the agreement.
Other income (expense) includes foreign exchange transaction losses of $0.1 million and $1.8 million for the three and nine months ended September 30, 2006, respectively, and $0.2 million and $0.8 million for the three and nine months ended September 30, 2005, respectively.
Recent Accounting Pronouncements
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxesan Interpretation of FASB Statement No. 109 (FIN 48), which clarifies the accounting for uncertainty in income tax positions. This Interpretation requires that the Company recognize in its financial statements the impact of a tax position if that position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective for the Company on January 1, 2007, with the cumulative effect of the change in accounting principle, if any, recorded as an adjustment to opening retained earnings. The Company is currently evaluating the impact of adopting FIN 48 on its financial position, cash flows, and results of operations.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157), which clarifies the definition of fair value, establishes guidelines for measuring fair value, and expands disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements and eliminates inconsistencies in guidance found in various prior accounting pronouncements. SFAS 157 will be effective for the Company on January 1, 2008. The Company is currently evaluating the impact of adopting SFAS 157 on its financial position, cash flows, and results of operations.
In September 2006, the Securities and Exchange Commission (SEC) released Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (SAB 108). SAB 108 provides interpretive guidance on the SECs views on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The provisions of SAB 108 will be effective for the Company for the fiscal year ended December 31, 2006. The Company is currently evaluating the impact of applying SAB 108 but does not believe that the application of SAB 108 will have a material effect on its financial position, cash flows, or results of operations
Also in September 2006, the FASB released Statement of Financial Accounting Standards No. 158, Employers Accounting for Defined Benefit Pension and Other Postretirement Plans, an amendment of FASB Statements No. 87, 88, 106, and 132(R) (SFAS No. 158). Under the new standard, companies must recognize a net liability or asset to report the funded status of their defined benefit pension and other postretirement benefit plans on their balance sheets. The recognition and disclosure provisions of SFAS No. 158 must be adopted by the Company as of December 31, 2006. Additionally, SFAS No. 158 requires companies to measure plan assets and obligations at their year-end balance sheet date. This requirement is not effective until December 31, 2008. The Company is currently reviewing the requirements of SFAS No. 158 to determine the impact on its financial position and results of operations.
Note 2: Basic and Diluted Earnings Per Share
The Company applies the provisions of Statement of Financial Accounting Standard No. 128, Earnings Per Share (SFAS 128) which requires companies to present basic and diluted earnings per share. Basic earnings per share is computed based on the weighted-average number of common shares outstanding during the period. Common Stock equivalents are included in the calculation of diluted earnings per share only when the effect of their inclusion would be dilutive. For the three and nine months ended September 30, 2006, weighted average shares outstanding for diluted earnings per share includes the effects of the 120,000 stock options which the Company agreed to grant to a new board member during the first quarter of 2005 and approximately 230,000 shares of Common Stock that are contingently issuable to the former stockholders of the Globalstar Americas Holding (GAH), Globalstar Americas Telecommunications (GAT), and Astral Technologies Investment Limited (Astral), collectively, the GA Companies (See Note 3).
The following table sets forth the computations of basic and diluted earnings per share (in thousands, except share and per share data):
Note 3: Globalstar Americas Telecommunications, LTD
Effective January 1, 2006, the Company consummated an agreement dated December 30, 2005 to purchase all of the issued and outstanding stock of the GA Companies. The GA Companies owned assets, contract rights, and licenses necessary and sufficient to operate a satellite communications business in Panama, Nicaragua, Honduras, El Salvador, Guatemala, and Belize (collectively, the Territory). The Company believes the purchase of the GA Companies will further enhance Globalstars presence and coverage in Central America and consolidation efforts. The stipulated purchase price for the GA Companies is $5,250,500 payable substantially 100% in Globalstar common stock. At the time of closing of the purchase of the GA Companies, the selling stockholders received 91,986 membership units, which subsequently were converted into the same number of shares of Common Stock of the Company (See Notes 11 and 17). Under the terms of the acquisition agreement, the Company is obligated either to redeem the stock issued to the selling stockholders for $5.2 million in cash or to pay the selling stockholders, in cash or in stock, the difference between $5.2 million and the market value of the stock received at closing. If the Company does not fulfill these conditions of the acquisition agreement, the selling stockholders may rescind the transaction. In accordance with the acquisition agreement, an additional 275,954 shares or approximately $3.9 million in cash could be distributed to the selling stockholders based upon the five day average closing price between November 15, 2006 and November 21, 2006 of $14.27.
The following table summarizes the Companys preliminary allocation of the estimated values of the assets acquired and liabilities assumed in the acquisition (in thousands):
The results of operations of the GA Companies have been included in the Companys unaudited interim consolidated financial statements from January 1, 2006. The Companys pro forma results of operations assuming the transaction had been completed on January 1, 2005 are not material.
Note 4: Property and Equipment
Property and equipment consist of the following (in thousands):
Property and equipment consist of an in-orbit satellite constellation, ground equipment, and support equipment located in various countries around the world. During 2004, the Company began construction of a gateway located in Florida. Construction was completed in July 2005 with a cost of $2.9 million. During 2005, the Company began construction of a gateway located in Alaska. Through December 31, 2005, actual costs incurred were approximately $3.3 million. The Alaska gateway construction was completed by June 30, 2006 for a total cost of $4.8 million.
As of September 30, 2006 and December 31, 2005, capitalized interest included within Spare and second-generation satellites and launch costs was $920,000 and $0, respectively. The amount of interest capitalized during each of the three and nine month periods ended September 30, 2006 was $920,000. No interest was capitalized during 2005.
Note 5: Accrued Expenses
Accrued expenses consist of the following (in thousands):
Other accrued expenses primarily include outsourced logistics services, storage, maintenance, and roaming charges.
Warranty terms extend from 90 days on equipment accessories to one year for fixed and mobile user terminals. Warranties are accounted for in accordance with SFAS No. 5, Accounting for Contingencies, such that an accrual is made when it is estimable and probable that a loss has been incurred based on historical experience. Warranty costs are accrued based on historical trends in warranty charges as a percentage of gross product shipments. A provision for estimated future warranty costs is recorded as cost of sales when products are shipped. The resulting accrual is reviewed regularly and periodically adjusted to reflect changes in warranty cost estimates. The following is a summary of the activity in the warranty reserve account (in thousands):
Note 6: Payables to Affiliates
Payables to affiliates relate to normal purchase transactions and are comprised of the following (in thousands):
Thermo incurs certain general and administrative expenses on behalf of the Company, which are charged to the Company. For the three and nine months ended September 30, 2006, total expenses were approximately $0 and $20,000, respectively. For the three and nine months ended September 30, 2005, total expenses were approximately $0 and $51,000, respectively. For each of the three and nine months ended September 30, 2006 and 2005, the Company also recorded $36,000 and $108,000, respectively, of expenses related to services provided by officers of Thermo which were accounted for as a contribution to capital. The Thermo expense charges are based on actual amounts incurred or upon allocated employee time. Management believes the allocations are reasonable. The balance at September 30, 2006, includes $686,000 that became payable to Thermo as a result of Globalstars conversion from a limited liability company to a corporation.
Note 7: Other Related Party Transactions
During 2005, Globalstar issued separate purchase orders for additional phone equipment and accessories under the terms of previously executed commercial agreements with QUALCOMM that aggregate to a total commitment balance of approximately $158.0 million. Approximately $107.0 million of the $158.0 million consists of a new generation of phones and fixed user terminals, car kits and accessories, which QUALCOMM began delivering in October 2006. The remaining $51.0 million consists of phones and accessories under the original commercial agreement and was 99% fulfilled as of September 30, 2006.
Within the terms of the commercial agreements, the Company paid QUALCOMM approximately 15% to 25% of the total order as advances for inventory. As of September 30, 2006 and December 31, 2005, total advances to QUALCOMM for inventory were $16.9 million, and $13.5 million, respectively. Under the new agreements, Globalstar did not receive any additional discounts from QUALCOMM. The total orders placed with QUALCOMM as of September 30, 2006 and December 31, 2005 were approximately $186.7 million and $182.1 million, with outstanding commitment balances of approximately $109.3 million and $136.0 million, respectively.
Purchases from Affiliates
Total purchases from affiliates are as follows (in thousands):
Revenues from Affiliates
Total usage revenues from affiliates for the three and nine months ended September 30, 2006 were $0.8 million and $1.3 million, respectively. Total usage revenues from affiliates for the three and nine months ended September 30, 2005 were $0.2 million and $0.6 million, respectively. Total equipment revenues from affiliates for the three and nine months ended September 30, 2006 were $1.1 million and $3.4 million, respectively. Total equipment revenues from affiliates for the three and nine months ended September 30, 2005 were $1.5 million and $3.4 million, respectively. Affiliates include Qualcomm and Globalstar Australia PTY Limited, the independent gateway operator in Australia, which is 50% owned by Columbia Ventures Corporation.
Note 8: Pension and Other Employee Benefit Plans
Components of the net periodic benefit cost of the Companys contributory defined benefit pension plan were as follows (in thousands):
Note 9: Income Taxes
Until January 1, 2006, the Company was treated as a partnership for U.S. tax purposes. Generally, taxable income or loss, deductions and credits were passed through to members. The Company did have some corporate subsidiaries that required a tax provision or benefit using the asset and liability method of accounting for income taxes as prescribed by Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS No. 109). Effective January 1, 2006, the Company elected to be taxed as a C corporation in the United States. When an enterprise changes its tax status from non-taxable to taxable, under SFAS No. 109 the effect of recognizing deferred tax assets and liabilities is included in income from continuing operations in the period of change. As a result, the Company recognized a gross deferred tax asset of $204.2 million and a gross deferred tax liability of $0.1 million on January 1, 2006. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. In evaluating the need for a valuation allowance, the Company takes into account various factors including the expected level of future taxable income and available tax planning strategies. The Company determined that it was more likely than not that the entire deferred tax asset would not be recognized; therefore, it established a valuation allowance of $182.7 million, resulting in recognition of a net deferred tax benefit of $21.4 million. The Company will continue to assess the recoverability of its gross deferred tax assets to ensure that, if and when it is more likely than not to be able to utilize more of the deferred tax asset, it will be able to reduce the valuation allowance accordingly.
Prior to January 1, 2006, the Companys foreign corporate subsidiaries calculated their tax expense under SFAS No. 109. Based upon the Canadian subsidiaries results of operations between January 1, 2005 and September 30, 2005 and their expected profitability in the fourth quarters of 2005 and in 2006, the Company concluded, effective September 30, 2005, that it is more likely than not that all of the remaining Canadian net deferred tax assets will be realized. As a result, in accordance with SFAS No. 109, the valuation allowance applied to such net deferred tax assets was reversed in the third quarter of 2005. Reversal of the valuation allowance resulted in a non-cash income tax benefit in the third quarter of 2005 totaling $4.2 million.
For interim reporting purposes, for the three and nine month periods ended September 30, 2006 and 2005, the Company estimated the effective tax rate of the group by analyzing each company and each tax jurisdictions rates to determine the appropriate effective tax rate. The reversal of the allowance on the Canadian deferred assets and the recognition of the deferred tax asset upon a change of tax status were considered discrete events and therefore were not taken into account when determining the estimated tax rate. For the three month period ended September 30, 2006, the effective tax rate was 53%. For the nine month period ended September 30, 2006, the recognition of the $21.4 million net deferred tax benefit upon conversion to a C corporation was greater than the income tax expense incurred during the period, resulting in an overall tax benefit even though the Company was profitable for the period. For the three month period ended September 30, 2005, the effective tax rate after taking into account the reversal of the Canadian valuation allowance (which resulted in a $4.2 million net deferred tax benefit) was greater than the expense incurred during the period providing for an overall tax benefit even though the Company was profitable for the period. For the nine month period ended September 30, 2005, the effective tax rate after taking into account the reversal of the allowance on the deferred tax asset discussed above was 8.1%.
Pro forma net income and pro forma earnings per share for the three and nine months ended September 30, 2005 have been calculated as if the Company had been a C corporation for federal income tax purposes.
Note 10: Comprehensive Income
SFAS No. 130, Reporting Comprehensive Income, establishes standards for reporting and displaying comprehensive income and its components in shareholders equity. Comprehensive income includes all changes in equity during a period from non-owner sources. The change in accumulated other comprehensive income for all periods presented resulted from foreign currency translation adjustments and minimum pension liability adjustment.
The following are the components of comprehensive income (in thousands):
Note 11: Incorporation in 2006
In preparation for meeting its commitments to register Globalstar shares of common stock under the Securities Exchange Act of 1934, Globalstar elected to be taxed as a C corporation effective January 1, 2006. Effective March 17, 2006, Globalstar was converted from a limited liability company into a corporation under Delaware law. On that date, the Companys 61,947,654 issued and outstanding membership units (adjusted for a subsequent six-for-one stock split - see Note 17) were automatically converted into a like number of shares of common stock, its limited liability company agreement was replaced by a certificate of incorporation and bylaws, and its name was changed to Globalstar, Inc. In connection with its conversion into a corporation, the Company established three classes of $0.0001 par value common stock, Series A (300,000,000 shares authorized); Series B (20,000,000 shares authorized); and Series C (480,000,000 shares authorized). All classes of common stock had identical rights and
privileges except with respect to their rights to elect directors. Series A holders were entitled to elect two directors, Series B holders to elect one director, and Series C holders to elect up to five directors. Under the applicable Delaware statute, all assets and liabilities of the limited liability company became the property of and were deemed to be assumed by the corporation. On October 25, 2006, the Company amended and restated its certificate of incorporation to, among other things, create a single class of Common Stock. See Note 17.
Note 12: Globalstar Financing Transaction
As required by the lender under the Companys credit agreement discussed below, the Company executed an agreement with Thermo Funding Company LLC (Thermo Funding Company), an affiliate of Thermo, to provide Globalstar up to an additional $200.0 million of equity via an irrevocable standby stock purchase commitment. The irrevocable standby purchase commitment allows the Company to put up to 12,371,136 shares of its Common Stock to Thermo Funding Company at a predetermined price of approximately $16.17 per share when the Company requires additional liquidity or upon the occurrence of certain other specified events. Thermo Funding Company also may elect to purchase the shares at any time. Minority stockholders of Globalstar as of June 15, 2006 who are accredited investors and who received at least thirty-six shares of Globalstar Common Stock as a result of the Old Globalstar bankruptcy will be provided an opportunity to participate in this financing. As of September 30, 2006, Thermo Funding Company had purchased 927,840 shares of Common Stock for an aggregate purchase price of $15.0 million. On December 5, 2006, Thermo Funding Company elected to purchase an additional 2,000,000 shares of Common Stock for an aggregate purchase price of $32.3 million. See Note 17.
On August 16, 2006, the Company entered into an amended and restated credit agreement with Wachovia Investment Holdings, L.L.C., as administrative agent and swingline lender, and Wachovia Bank, National Association, as issuing lender, which was subsequently amended on September 29, 2006 and October 26, 2006. The amended and restated credit agreement provides for a $50.0 million revolving credit facility and a $100.0 million delayed draw term loan facility. The delayed draw term loan may be drawn after January 1, 2008 and prior to August 16, 2009, but only if the Company has received aggregate net cash proceeds of $200.0 million from sales, after April 24, 2006, of the Companys common stock (including sales pursuant to the irrevocable standby stock purchase agreement) prior to the draw date and if, after giving effect to the delayed draw term loan and thereafter at the end of each quarter while the delayed draw term loan is outstanding, the Companys consolidated senior secured leverage ratio does not exceed 3.5 to 1.0. In addition to the $50.0 million revolving and $100.0 million delayed draw term loan facilities, the amended and restated credit agreement permits the Company to incur additional term loans on an equally and ratably secured, pari passu basis in an aggregate amount of up to $150.0 million (plus the amount of any reduction in the delayed draw term loan facility or prepayment of the delayed draw term loan described above resulting from sales of common stock or any additional term loans) from the lenders under the credit agreement or other banks, financial institutions or investment funds approved by the Company and the administrative agent. The Company has not received any commitments for these additional term loans. These additional term loans may be incurred only if no event of default then exists, if the Company is in pro-forma compliance with all of the financial covenants of the credit agreement, and if, after giving effect thereto, the Companys consolidated total leverage ratio does not exceed 5.5 to 1.0.
All revolving credit loans will mature on June 30, 2010 and all term loans will mature on June 30, 2011. Revolving credit loans will bear interest at LIBOR plus 4.25% to 4.75% or the greater of the prime rate or Federal Funds rate plus 3.25% to 3.75%. The delayed draw term loan will bear interest at LIBOR plus 6.0% or the greater of the prime rate or Federal Funds rate plus 5.0%, and the delayed draw term loan facility bears an annual commitment fee of 2.0% until drawn or terminated. Additional term loans will bear interest at rates to be negotiated. To hedge a portion of the interest rate risk with respect to the delayed draw term loans, the Company entered into a five-year interest rate swap agreement (see Note 16). The loans may be prepaid without penalty at any time. The Companys indebtedness under the agreement is guaranteed by its principal domestic subsidiaries and is secured by a first lien on its and their property. The agreement contains covenants limiting the Companys ability to dispose of assets, change its business, merge, make acquisitions, incur indebtedness or liens, pay dividends, make investments or engage in certain transactions with its affiliates. Additionally, the agreement contains covenants requiring Globalstar to maintain certain financial and operating covenants and restricting capital expenditures.
As of September 30, 2006, $23.3 million was drawn under the $50.0 million revolving credit facility. As of September 30, 2006, the undrawn amounts on the revolving credit facility and delayed draw term loan facility available to the Company were $26.7 million and $100.0 million, respectively. For the nine months ended September 30, 2006, the weighted average annualized interest rate on the outstanding revolving credit loans was 9.96%.
Note 13: Equity Incentive Plan
On July 12, 2006, the Companys board of directors adopted and a majority of the Companys stockholders approved the Globalstar, Inc. 2006 Equity Incentive Plan (Equity Plan), which became effective upon the registration of the Companys common stock under the Securities Act of 1933 in November 2006. The purpose of the Equity Plan is to make available incentives that will assist the Company in attracting, retaining and motivating employees, directors and consultants whose contributions are essential to its success. The Company may provide these incentives through the grant of stock options, stock appreciation rights, restricted stock capitalize purchase rights, restricted stock bonuses, restricted stock units, performance shares or performance units. The Equity Plan is administered by the Compensation Committee of the board of directors. As of September 30, 2006, no grants had been made under the Equity Plan. On November 9, 2006, the Company registered 1.2 million shares of its Common Stock for issuance under the Equity Plan and, on November 10, 2006, the Compensation Committee authorized restricted stock and restricted stock unit awards for an aggregate of approximately 296,000 shares of Common Stock to substantially all the Companys employees.
Note 14: Litigation
From time to time, the Company is involved in various litigation matters involving ordinary and routine claims incidental to its business. Management currently believes that the outcome of these proceedings, either individually or in the aggregate, will not have a material adverse effect on the Companys business, results of operations or financial condition. The Company is involved in certain litigation matters as discussed below.
On May 26, 2005, Loral, filed a motion for an order in its Delaware bankruptcy case under Rule 2004 seeking to compel Globalstar and certain affiliates and individuals to produce documents and appear for oral examination. The matter involved Globalstars management of Government Services, L.L.C. (GSLLC), in which Loral holds a 25 percent minority interest, and alleged breach of fiduciary duty by the directors of GSLLC. On October 17, 2006, Globalstar and Loral agreed to settle this litigation. See Note 17 for further details.
On January 13, 2006, Elsacom N.V., an independent gateway operator whose territories include portions of Central and Eastern Europe and North Africa, served Globalstar with a notice of arbitration pursuant to a dispute resolution provision in its Satellite Services Agreement. The dispute stems from the Companys decision in the fall of 2005 to realign coverage of the two gateways serving Western and Central Europe. Elsacom has not specified the amount of damages that it is seeking. Elsacom asserts that the realignment diminishes its rights under its Satellite Services Agreement. Globalstar disagrees and intends to defend its decision vigorously. The arbitration is scheduled to be held in January 2007.
Note 15: Geographic Information
Revenue by geographic location, presented net of eliminations for intercompany sales, was as follows for the three and nine month periods ended September 30, 2006 and 2005 (in thousands):
Note 16: Interest Rate Derivative
In July 2006, in connection with entering into its credit agreement, which provides for interest at a variable rate (see Note 12), the Company entered into a five-year interest rate swap agreement. The interest rate swap agreement reflected a $100.0 million notional amount at a fixed interest rate of 5.64%. As of September 30, 2006, the fair value of the interest rate swap agreement was $2.9 million which is reflected in the Companys Consolidated Balance Sheet in Other non-current liabilities. The change in fair value for the three months ended September 30, 2006, of approximately $2.9 million, was charged to Interest rate derivative gain (loss) in the accompanying Consolidated Statement of Operations.
Note 17: Subsequent Events
On October 17, 2006, Globalstar and Loral agreed to settle the litigation described under Note 14. Globalstar agreed to pay $0.5 million in cash to Loral to settle the litigation and to acquire from Loral its 25% interest in Globalstars 75% owned subsidiary, GSLLC. The Delaware court approved the settlement on November 22, 2006, and payment was made on December 4, 2006. Globalstar now owns 100% of GSLLC.
On October 25, 2006, the Company filed an amended and restated certificate of incorporation, which among other things, converted each share of the Companys three series of common stock into one share of a single series of Common Stock. Immediately following the filing of the amended and restated certificate of incorporation, a six-for-one stock split (in the form of a five-shares-for-one-share stock dividend), which had been pre-approved by the Companys board of directors, was effected. All references to shares of Common Stock and membership interests and their respective per-unit amounts in these consolidated financial statements and notes to consolidated financial statements have been restated to reflect the effect of this stock split on a retroactive basis as if it had occurred on January 1, 2005. Except where otherwise expressly indicated, the information in these notes also gives effect to the conversion of the Companys three series of common stock into a single series of Common Stock.
On November 7, 2006, the Company completed its initial public offering and sold 7,500,000 shares of its Common Stock. The Company received cash proceeds, net of underwriting fees, of approximately $118.6 million.
On November 30, 2006, the Company and Alcatel Alenia Space France (Alcatel) entered into a definitive contract pursuant to which Alcatel will construct 48 low-earth-orbit satellites in two batches (the first of 25, including a proto-flight model satellite, and the second of 23) for Globalstars second-generation satellite constellation. Under the contract, Alcatel also will provide launch support services and mission operations support services. Globalstar will contract separately with other providers for launch services and launch insurance for the satellites. The total contract price will be approximately 661.0 million (approximately $871.0 million at a conversion rate of 1.00 = $1.3177), subject to reduction by approximately 28.0 million (approximately $36.9 million) if Globalstar elects to accelerate construction and delivery of the second batch of satellites. Of the 661.0 million, approximately 620.0 million ($816.9 million) will be paid for the design, development and manufacture of the satellites and approximately 41.0 million ($54.0 million) will be paid for launch and mission support services. Globalstar also is obligated to pay Alcatel up to $75.0 million in bonus payments depending upon the fulfillment of various conditions, including Globalstars cumulative EBITDA exceeding certain projections, Alcatels achievement of the specified delivery schedule and satisfactory operation of the satellites after delivery. Approximately 146.8 million ($190.0 million) of the purchase price may be paid by Globalstar in dollars at a fixed exchange rate of 1.00 = $1.2940. The approximately 12.4 million ($16.0 million) paid by Globalstar to Alcatel pursuant to an Authorization to Proceed dated October 5, 2006, as amended, will be credited against payments to be made by Globalstar under the contract. Globalstar will establish and maintain an escrow account with a commercial bank to secure its payment obligations under the contract, with the amount of the escrow account being not less than the next two quarterly payments required by the contract. The initial escrow deposit will be 40.0 million. Globalstar and Alcatel were required to enter into an escrow agreement by December 12, 2006, which date subsequently was extended to December 22, 2006. If they fail to do so, the contract terminates. Globalstar must obtain the consent of its lenders to establish the escrow account. Payments under the contract will begin in the fourth quarter of 2006 and will extend into the fourth quarter of 2013 unless Globalstar elects to accelerate the delivery of the second batch of satellites. The contract requires Alcatel to commence delivery of the satellites in the third quarter of 2009, with deliveries continuing until the third quarter of 2013, unless Globalstar elects to accelerate deliveries. If Globalstar elects to accelerate delivery of the second batch of satellites, it is contemplated that all of the satellites will be delivered by the third quarter of 2010.
On December 5, 2006, Thermo Funding Company purchased an additional 2,000,000 shares of the Companys common stock under its irrevocable standby stock purchase agreement for an aggregate purchase price of approximately $32.3 million.
In addition to current and historical information, this Report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our future operations, prospects, potential products, services, developments and business strategies. These statements can, in some cases, be identified by the use of terms such as may, will, should, could, would, intend, expect, plan, anticipate, believe, estimate, predict, project, potential, continue, the negative of such terms or other comparable terminology. Forward-looking statements, such as the statements regarding our ability to develop and expand our business, our ability to manage costs, our ability to exploit and respond to technological innovation, the effects of laws and regulations (including tax laws and regulations) and legal and regulatory changes, the opportunities for strategic business combinations and the effects of consolidation in our industry on us and our competitors, our anticipated future revenues, our anticipated capital spending (including for future satellite procurements and launches), our anticipated financial resources, our expectations about the future operational performance of our satellites (including their projected operational lives), the expected strength of and growth prospects for our existing customers and the markets that we serve, and other statements contained in this report regarding matters that are not historical facts, involve predictions. These and similar statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements or industry results to be materially different from any future results, performance or achievements expressed or implied by the statements. Such risks and uncertainties include, among others, those listed in Part II Item 1A Risk Factors of this Report. We do not intend, and undertake no obligation, to update any of our forward-looking statements after the date of this Report to reflect actual results or future events or circumstances.
This Management Discussion and Analysis of Financial Condition should be read in conjunction with the Management Discussion and Analysis of Financial Condition and information included in our Registration Statement on Form S-1.
We are a leading provider of mobile voice and data communication services via satellite. Our communications platform extends telecommunications beyond the boundaries of terrestrial wireline and wireless telecommunications networks to serve our customers desire for connectivity and reliable service at all times and locations. Using in-orbit satellites and ground stations, which we call gateways, we offer voice and data communications services to government agencies, businesses and other customers in over 120 countries.
In early 2002, Old Globalstar and three of its subsidiaries filed voluntary petitions under Chapter 11 of the United States Bankruptcy Code. We were formed in Delaware in November 2003 for the purpose of acquiring substantially all the assets of Old Globalstar and its subsidiaries. With Bankruptcy Court approval, we acquired Old Globalstars assets and assumed certain of its liabilities in a two-step transaction, with the first step completed on December 5, 2003, and the second step on April 14, 2004 (the Reorganization). On January 1, 2006, we elected to be taxed as a C corporation, and on March 17, 2006, we converted from a Delaware limited liability company to a Delaware corporation.
Material Trends and Uncertainties. Our satellite communications business, by providing critical, reliable mobile communications to our subscribers, serves principally the following markets: government, public safety and disaster relief; recreation and personal; maritime and fishing; business, financial and insurance; natural resources, mining and forestry; oil and gas; construction; utilities; and transportation. Both our industry and our own subscriber base have been growing rapidly as a result of:
· favorable market reaction to new pricing plans with lower service charges;
· awareness of the need for remote and reliable communication services;
· increased demand for reliable communication services by disaster and relief agencies and emergency first responders;
· improved voice and data transmission quality; and
· a general reduction in prices of user equipment.
In addition, our industry as a whole has benefited from the improved financial condition of most industry participants following their financial reorganizations or conversions to private ownership.
Nonetheless, we face a number of challenges and uncertainties, including:
· Constellation life and health. Our current satellite constellation is aging. We plan to launch our eight spare satellites during 2007. Assuming these launches are successful, we believe our current satellite constellation will provide a commercially acceptable quality of service into 2010. However, nine of our satellites have failed in orbit and others have encountered problems that, to date, have been remedied. If the health of our current constellation were to decline more rapidly than we expect and we were unable to offer commercially acceptable service until we can deploy our second-generation constellation, which we expect to do beginning in 2009, our number of subscribers, revenue and cash flow would be negatively impacted.
· Competition and pricing pressures. We face increased competition from both the expansion of terrestrial-based cellular phone systems and from other mobile satellite service providers. For example, Inmarsat plans to commence offering satellite services to handheld devices in the United States around 2008, and several competitors, such as ICO Global Communications Company, have received financing to deploy new satellite constellations. Increased numbers of competitors, and the introduction of new services and products by competitors, increases competition for subscribers and pressures all providers, including us, to reduce prices. Increased competition may result in loss of subscribers, decreased revenue, decreased gross margins, increased cost per gross addition, higher churn rates, and, ultimately, decreased profitability and cash flows.
· Technological changes. It is difficult for us promptly to match major technological innovations by our competitors because substantially modifying or replacing our basic technology, satellites or gateways is time consuming and very expensive. Approximately 43% of our total assets at September 30, 2006 represented fixed assets. Although we believe our current technology and fixed assets are competitive with those of our competitors, and we plan to procure and deploy our second-generation satellite constellation and upgrade our gateways and other ground facilities, we are vulnerable to the unexpected introduction of superior technology by our competitors.
· Capital expenditures. Launching our eight spare satellites to augment our current constellation will cost approximately $110.0 million, of which $65.9 million had been paid or accrued by September 30, 2006. We plan to fund the balance of this cost from the sale of our common stock to Thermo Funding Company pursuant to its irrevocable standby stock purchase agreement described under Liquidity and Capital ResourcesIrrevocable Standby Stock Purchase Agreement. Procuring and deploying our second-generation satellite constellation and upgrading our gateways and other ground facilities will cost $1.0 to $1.2 billion, which we expect will be reflected in capital expenditures through 2014. On November 30, 2006, we entered into a 661.0 million (approximately $871.0 million) contract with Alcatel Alenia Space France (Alcatel) for the construction of our second-generation constellation. See Liquidity and Capital Resources Contractual Obligations and Commitments. We plan to fund approximately $400.0 million of the total $1.0 to $1.2 billion from the proceeds of our initial public offering, the $100.0 million delayed draw term loans under our credit agreement and the remaining proceeds from sales of our common stock under the standby stock purchase agreement. We plan to fund the remaining cost of approximately $600.0 million to $800.0 million from cash generated by our business. If our future revenues or profitability are substantially below our expectations or the conditions requiring Thermo Funding Company to purchase the stock do not occur and Thermo Funding Company does not elect to purchase the stock during the term of the irrevocable standby stock purchase agreement, we will require additional financing, which may be
difficult or expensive to obtain, or we will have to modify our plans. Additionally, because substantially all of these costs will be capitalized, the resulting increase in our non-cash depreciation expense could have a material adverse effect on our future results of operations.
· Introduction of new products. We work continuously with the manufacturers of the products we sell to offer our customers innovative and improved products. Virtually all engineering, research and development costs of these new products are paid by the manufacturers. However, to the extent the costs are reflected in increased inventory costs to us, and we are unable to raise our prices to our subscribers correspondingly, our margins and profitability would be reduced.
· Fluctuations in interest and currency rates. Debt under our credit agreement bears interest at a floating rate. Therefore, increases in interest rates will increase our interest costs. A substantial portion of our revenue (34% in the first nine months of 2006) is denominated in foreign currencies. In addition, the contract for the launch of our spare satellites and a substantial majority of our obligations under the contract for our second-generation constellation are denominated in Euros. Any decline in the relative value of the U.S. dollar may adversely affect our revenues and increase our capital expenditures.
Ancillary Terrestrial Component (ATC). ATC is the integration of a satellite-based service with a terrestrial wireless service resulting in a hybrid mobile satellite services. The ATC network would extend our services to urban areas and inside buildings where satellite services currently are impractical. We believe we are at the forefront of ATC development and are actively working to be among the first market entrants. To that end we are considering a range of options for rollout of our ATC services. We are exploring selective opportunities with a variety of media and communication companies to capture the full potential of our spectrum and ATC license.
Service Revenues. We earn revenues primarily from the sale of satellite communications services to direct customers, resellers and independent gateway operators. These services include mobile and fixed voice and data services and asset tracking and monitoring services. We generated approximately 71% and 65% of our consolidated revenues from the sale of our satellite communication services for the three and nine months ended September 30, 2006, respectively, compared to 55% and 63% for the same periods in 2005. The increase in service revenue as a percentage of total revenue resulted primarily from a continued growth in our core markets in North America and rapidly growing subscriber base, which grew from approximately 184,000 at September 30, 2005 to approximately 256,000 at September 30, 2006.
Subscriber Equipment Sales Revenue. We also sell related voice and data equipment to our customers. We generated approximately 29% and 35% of our consolidated revenues from the sale of our satellite communication equipment for the three and nine months ended September 30, 2006, respectively, compared to 45% and 37% for the same periods in 2005. As a percentage of our revenue, equipment sales decreased in 2006 as compared to 2005 primarily as a result of robust equipment sales in 2005 related to that years active hurricane season.
The table below sets forth amounts and percentages of our revenue by type of service and subscriber equipment sales for the three and nine months ended September 30, 2006 and 2005.
(1) Includes Engineering Services and activation fees
Operating Expenses. Our operating expenses are comprised principally of:
· Cost of services, which are costs directly related to the operation and maintenance of our network, such as satellite tracking and monitoring, gateway monitoring, trouble shooting and sub-system maintenance, and the ordering, billing and provisioning of our services, including customer care and phone activations;
· Cost of subscriber equipment sales, which is the recognition of inventory carrying cost into expense when equipment is sold;
· Marketing, general and administrative expenses, which are the salaries and related costs, including expenses related to our 2006 Equity Incentive Plan and other employee benefits, for employees other than those involved in operations and engineering, and the marketing and administrative costs of operating our business; and
· Depreciation and amortization, which represent the depreciation and amortization of our space and ground facilities, property and equipment, as well as amortization of certain intangible assets.
Our increased sales and number of subscribers have caused increases both in our cost of subscriber equipment and in our marketing, general and administrative expenses. We expect to experience growth in general and administrative costs associated with increased revenue, such as bad debt allowance, human resources and collections, as well as costs associated with being a public company including compliance costs related to the requirements of the Sarbanes-Oxley Act. We anticipate these compliance costs will be approximately $1.0 to $1.5 million in 2007. We expect the rate of growth of these costs to be substantially lower than the growth rate of our revenue. Acquisition of new fixed assets, especially gateways acquired from independent gateway operators and new gateways built by us, has increased our depreciation and amortization expense.
Compensation Expense. On November 10, 2006, the compensation committee of our board of directors authorized restricted stock and restricted stock unit awards for an aggregate of approximately 296,000 shares of Common Stock to substantially all our employees (see Note 13 to the unaudited interim consolidated financial statements). As a result of these awards, we will incur a pre-tax non-cash charge of approximately $1.2 million in the fourth quarter of 2006 and approximately $3.5 million will be amortized over the shares remaining three-year vesting period.
Operating Income. Our operating income grew from an operating income of $12.5 million for the nine months ended September 30, 2005, to operating income of $14.5 million for the nine months ended September 30, 2006. Our operating income grew between 2005 and 2006 due principally to increased revenue which resulted from growth in our number of subscribers from approximately 184,000 to 256,000.
Independent Gateway Acquisition Strategy
Currently 16 of the gateways in our network are owned and operated by unaffiliated companies, which we call independent gateway operators, some of whom operate more than one gateway. Some of these independent gateway operators have been unable to grow their businesses adequately due in part to limited resources. Old Globalstar initially developed the independent gateway strategy to establish operations in multiple territories with reduced demands on its capital. In addition, for political or other reasons, there are territories in which it is impractical for us to operate directly. We sell services to the independent gateway operators on a wholesale basis and they resell them to their customers on a retail basis.
We have acquired, and intend to continue to pursue the acquisition of, independent gateway operators when we believe we can do so on favorable terms. We believe that these acquisitions can enhance our results of operations in three respects. First, we believe that, with our greater financial and technical resources, we can grow our subscriber base and revenue faster than some of the independent gateway operators. Second, we realize greater margin on retail sales to individual subscribers than we do on wholesale sales to independent gateway operators. Third, we believe expanding the territory we serve directly will better position us to market our services directly to multinational customers who require a global communications provider. However, acquisitions of independent gateway operators do require us to commit capital for acquisition of their assets, as well as management resources and working capital to support the gateway operations, and therefore increase our risk in operating in these territories directly rather than through the independent gateway operators. In addition, operating the acquired
gateways increases our marketing, general and administrative expenses. Our credit agreement limits to $25.0 million the aggregate amount we may invest in foreign acquisitions without the consent of our lenders.
In February 2005, we purchased the Venezuela gateway for $1.6 million in cash to be paid over four years. Effective January 1, 2006, we acquired the Central American gateway and other real property assets for $5.2 million, paid, or to be paid, as explained in Note 3 to the unaudited interim consolidated financial statements. See also Liquidity and Capital Resources - Contractual Obligations and Commitments below. Because independent gateway operations vary in size and value, we are unable to predict the timing or cost of further acquisitions.
Our management reviews and analyzes several key performance indicators in order to manage our business and assess the quality of and potential variability of our earnings and cash flows. These key performance indicators include:
· total revenue, which is an indicator of our overall business growth;
· subscriber growth and churn rate, which are both indicators of the satisfaction of our customers;
· average revenue per user, which is an indicator of our ability to obtain effectively long-term, high-value customers;
· operating income, which is an indication of our performance and liquidity;
· EBITDA, which is an indicator of our financial performance; and
· capital expenditures, which are an indicator of future revenue growth potential and cash requirements.
Our results of operations are subject to seasonal usage changes. April through October are typically our peak months for service revenues and equipment sales. Government customers in North America tend to use our services during summer months, often in support of relief activities after events such as hurricanes, forest fires and other natural disasters.
Critical Accounting Policies and Estimates
The preparation of our consolidated financial statements requires us to make estimates and judgments that affect our revenues and expenses for the periods reported and the reported amounts of our assets and liabilities, including contingent assets and liabilities, as of the date of the financial statements. We evaluate our estimates and judgments, including those related to revenue recognition, inventory, long-lived assets, income taxes and pension obligations, on an on-going basis. We base our estimates and judgments on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from our estimates under different assumptions or conditions. We believe the following accounting policies are most important to understanding our financial results and condition and require complex or subjective judgments and estimates.
Customer activation fees are deferred and recognized over four to five year periods, which approximates the estimated average life of the customer relationship. We periodically evaluate the estimated customer relationship life. Historically, changes in the estimated life have not been material to our financial statements.
Monthly access fees billed to retail customers and resellers, representing the minimum monthly charge for each line of service based on its associated rate plan, are billed on the first day of each monthly bill cycle. Airtime minute fees in excess of the monthly access fees are billed in arrears on the first day of each monthly billing cycle. To the extent that billing cycles fall during the course of a given month and a portion of the monthly services has not been delivered at month end, fees are prorated and fees associated with the undelivered portion of a given month are deferred.
We also provide certain engineering services to assist customers in developing new technologies related to our system. The revenues associated with these services are recorded when the services are rendered, and the expenses are recorded when incurred.
Our Liberty Plans were introduced on a limited basis in August 2004 and broadly introduced during the second quarter of 2005. These Plans grew substantially in 2005 and 2006. These Plans require users to pre-pay usage charges for the entire Plan period, generally 12 months, which results in the deferral of certain of our revenues. Under our revenue recognition policy for Liberty Plans, we defer revenue until the earlier of when the minutes are used or when these minutes expire. Any unused minutes are recognized as revenue at the expiration of a Plan. Most of our customers have not used all the minutes that are available to them or have not used them at the pace anticipated, which, with the rapid acceptance of our Liberty Plans, has caused us to defer increasingly large amounts of service revenue. At September 30, 2006, our deferred revenue aggregated approximately $22.5 million. Accordingly, we expect significant revenues from 2005 and 2006 purchases of Liberty Plans to be recognized during the remainder of 2006 and in 2007 as the minutes are used or expire.
We own and operate our satellite constellation and earn a portion of our revenues through the sale of airtime minutes on a wholesale basis to the independent gateway operators. Revenue from services provided to independent gateway operators is recognized based upon airtime minutes used by customers of independent gateway operators and contractual fee arrangements. Where collection is uncertain, revenue is recognized when cash payment is received.
Subscriber equipment revenue represents the sale of fixed and mobile user terminals and accessories. Revenue is recognized upon shipment provided title and risk of loss have passed to the customer, persuasive evidence of an arrangement exists, the fee is fixed and determinable and collection is probable.
In December 2002, the Emerging Issues Task Force (EITF) reached a consensus on EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. EITF Issue No. 00-21 addresses certain aspects of the accounting by a vendor for arrangements under which it will perform multiple revenue-generating activities. In some arrangements, the different revenue-generating activities (deliveries) are sufficiently separable and there exists sufficient evidence of their fair values to account separately for some or all of the deliveries (that is, there are separate units of accounting). In other arrangements, some or all of the deliveries are not independently functional, or there is not sufficient evidence of their fair values to account for them separately. EITF Issue No. 00-21 addresses when and, if so, how an arrangement involving multiple deliverables should be divided into separate units of accounting. EITF Issue No. 00-21 does not change otherwise applicable revenue recognition criteria.
Inventory consists of purchased products, including fixed and mobile user terminals, accessories and gateway spare parts. Inventory acquired on December 5, 2003, through the Old Globalstar bankruptcy proceedings, was stated at fair value at the date of our acquisition. Subsequent inventory transactions are stated at the lower of cost or market. At the end of each quarter, product sales and returns from the previous twelve months are reviewed and any excess and obsolete inventory is written off. Cost is computed using the first-in, first-out (FIFO) method. Inventory allowances for inventories with a lower market value or that are slow moving are recorded in the period of determination.
Globalstar System, Property and Equipment
Our Globalstar System assets include costs for the design, manufacture, test, and launch of a constellation of low earth orbit satellites, including in-orbit spare satellites, which we refer to as the space segment, and primary and backup terrestrial control centers and gateways, which we refer to as the ground segment. Loss from an in-orbit failure of a satellite is recognized as an expense in the period it is determined that the satellite is not recoverable.
The carrying value of the Globalstar System is reviewed for impairment whenever events or changes in circumstances indicate that the recorded value of the space segment and ground segment, taken as a whole, may not be recoverable. We look to current and future undiscounted cash flows, excluding financing costs, as primary indicators of recoverability. If an impairment is determined to exist, any related impairment loss is calculated based on fair value.
Property and equipment acquired by us on December 5, 2003 in the Old Globalstar bankruptcy proceedings was recorded based on our allocation of acquisition cost. Because the acquisition cost of these assets was substantially below their historic cost or replacement cost, current depreciation and amortization costs have been reduced substantially for GAAP purposes, thereby increasing net income or decreasing net loss. As we increase our capital expenditures, especially to procure and launch our second-generation satellite constellation, we expect GAAP depreciation to increase substantially. Depreciation is provided using the straight-line method over the estimated useful lives. For this purpose, we have estimated that our satellites have an estimated useful life of 10 years from commencement of service, or through December 31, 2009. To verify the life of our satellites, we commissioned a report by an independent consultant to assess the health and life of our current constellation. Leasehold improvements are amortized on a straight-line basis over the shorter of the estimated useful life of the improvement or the term of the lease, generally five years. We perform ongoing evaluations of the estimated useful lives of our property and equipment for depreciation purposes. The estimated useful lives are determined and continually evaluated based on the period over which services are expected to be rendered by the asset. Maintenance and repair items are expensed as incurred.
Until January 1, 2006, we were treated as a partnership for U.S. tax purposes. Generally, our taxable income or loss, deductions and credits were passed through to our members. We did have some corporate subsidiaries that required a tax provision or benefit using the asset and liability method of accounting for income taxes as prescribed by Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes (SFAS No. 109). Effective January 1, 2006, we elected to be taxed as a C corporation in the United States. When an enterprise changes its tax status from non-taxable to taxable, under SFAS No. 109 the effect of recognizing deferred tax assets and liabilities is included in income from continuing operations in the period of change. As a result, we recognized a gross deferred tax asset of $204.2 million and a gross deferred tax liability of $0.1 million on January 1, 2006. SFAS No. 109 also requires that deferred tax assets be reduced by a valuation allowance if it is more likely than not that some portion or all of the deferred tax asset will not be realized. In evaluating the need for a valuation allowance, we take into account various factors including the expected level of future taxable income and available tax planning strategies. We determined that it was more likely than not that we would not recognize the entire deferred tax asset; therefore, we established a valuation allowance of $182.7 million, resulting in recognition of a net deferred tax benefit of $21.4 million. We monitor the situation to ensure that, if and when we are more likely than not to be able to utilize more of the deferred tax asset, we will be able to reduce the valuation allowance accordingly.
Spare and Second-Generation Satellites and Launch Costs
Old Globalstar purchased eight additional satellites in 1998 for $148.0 million (including performance incentives of up to $16.0 million) to serve as on-ground spares. Costs of $147.0 million (including a portion of the performance incentives) were previously recognized for these spare satellites. Prior to 2002, Old Globalstar recorded an impairment of these costs, and at December 31, 2002 they were carried at $24.2 million. All eight satellites have been completed and are being readied for launch. Depreciation of these assets will not begin until the satellites are placed in service. As of September 30, 2006 and December 31, 2005, these assets were recorded at $66.6 million and $3.0 million, respectively, of which $0.9 million was based on our allocation of the Reorganization cost on December 5, 2003. As of September 30, 2006 and December 31, 2005, capitalized interest included within spare and second-generation satellites and launch costs was $920,000 and $0, respectively. The amount of interest capitalized during each of the three and nine month periods ended September 30, 2006 was $920,000. No interest was capitalized during 2005. We expect to launch these eight additional satellites during 2007.
We have initiated the process of procuring our second-generation satellite constellation and had incurred costs of approximately $0.8 million as of September 30, 2006. Depreciation of these assets will not begin until the satellites are placed in service. The constellation will have an estimated useful life of 15 years and will be depreciated over that time period. See Liquidity and Capital Resources - Contractual Obligations and Commitments for further details.
We have various company-sponsored retirement plans covering certain current and past U.S.-based employees. Until June 1, 2004, substantially all of Old Globalstars and our employees and retirees who participated and/or met the vesting criteria for the plan were participants in the Retirement Plan of Space Systems/Loral, Inc. (the Loral Plan), a defined benefit pension plan. The accrual of benefits in the Old Globalstar segment of the Loral Plan was curtailed, or frozen, by the administrator of the Loral Plan as of October 23, 2003. Prior to October 23, 2003, benefits for the Loral Plan were generally based upon compensation, length of service with the company and age of the participant. On June 1, 2004, the assets and frozen pension obligations of the segment attributable to our employees were transferred into a new Globalstar Retirement Plan (the Globalstar Plan). The Globalstar Plan remains frozen and participants are not currently accruing benefits beyond those accrued as of October 23, 2003. Our funding policy is to fund the Globalstar Plan in accordance with the Internal Revenue Code and regulations.
We account for our defined benefit pension and life insurance benefit plans in accordance with Statement of Financial Accounting Standards No. 87, Employers Accounting for Pensions and SFAS No. 106, Employers Accounting for Postretirement Benefits Other than Pensions, which require that amounts recognized in financial statements be determined on an actuarial basis. Pension benefits associated with these plans are generally based primarily on each participants years of service, compensation, and age at retirement or termination. Two critical assumptions, the discount rate and the expected return on plan assets, are important elements of expense and liability measurement. We utilize the services of a third party to perform these actuarial calculations.
We determine the discount rate used to measure plan liabilities as of the December 31 measurement date for the U.S. pension plan. The discount rate reflects the current rate at which the associated liabilities could be effectively settled at the end of the year. In estimating this rate, we look at rates of return on fixed-income investments of similar duration to the liabilities in the plan that receive high, investment grade ratings by recognized ratings agencies. Using these methodologies, we determined a discount rate of 5.5% to be appropriate as of December 31, 2005, which is a reduction of 0.25 percentage points from the rate used as of December 31, 2004. An increase of 1.0% in the discount rate would have decreased our plan liabilities as of December 31, 2005 by $1.6 million and a decrease of 1.0% could have increased our plan liabilities by $2.0 million.
A significant element in determining our pension expense in accordance with SFAS No. 87 is the expected return on plan assets, which is based on historical results for similar allocations among asset classes. For the U.S. pension plan, our assumption for the expected return on plan assets was 7.5% for 2005.
The difference between the expected return and the actual return on plan assets is deferred and, under certain circumstances, amortized over future years of service. Therefore, the net deferral of past asset gains (losses) ultimately affects future pension expense. This is also true of changes to actuarial assumptions. As of December 31, 2005, we had net unrecognized pension actuarial losses of $2.6 million. These amounts represent potential future pension and postretirement expenses that would be amortized over average future service periods.
We utilize a derivative instrument in the form of an interest rate swap agreement to minimize our risk from interest rate fluctuations related to our variable rate credit agreement. We use the interest rate swap agreement to manage risk and not for trading or other speculative purposes. At the end of each accounting period, we record the derivative instrument on our balance sheet as either an asset or a liability measured at fair value. The interest rate swap agreement does not qualify for hedge accounting treatment. Changes in the fair value of the interest rate swap agreement are recognized as Interest rate derivative gain (loss) over the life of the agreement.
Results of Operations
Comparison of Results of Operations for the Three Months Ended September 30, 2006 and 2005 (in thousands):
Revenue. Total revenue decreased by $1.9 million, or approximately 5%, to $38.7 million for the three months ended September 30, 2006, from $40.6 million for the three months ended September 30, 2005, due principally to the unusually high subscriber equipment sales in the third quarter of 2005 related to the active hurricane season, which was not repeated in 2006. The decrease in equipment revenue was partially offset by an increase in service revenue. Our average retail revenue per user during the three months ended September 30, 2006 decreased by 7% to $69.40 from $74.88 for the three months ended September 30, 2005. This decline resulted from the rapid acceptance of our Liberty Plans, which were introduced in the second quarter of 2005 and which allow subscribers to pay for a year of service in advance. Liberty Plans reduce current period revenue because revenue is not recognized until minutes are used or expire. Unused minutes are recognized as revenue at the expiration of a Plan. Subscribers generally do not use all of the minutes for which they have paid. Accordingly, we generally expect an increase in our average retail revenue per user in later periods as the minutes related to Liberty Plans sold in prior periods are used or expire. Average monthly subscriber churn dropped to 0.9% for the three months ended September 30, 2006 compared to 1.0% for the three months ended September 30, 2005.
Service Revenue. Service revenue increased $5.4 million, or approximately 24%, to $27.6 million for the three months ended September 30, 2006, from $22.2 million for the three months ended September 30, 2005. This increase was driven by a 39% subscriber growth over the twelve month period from September 30, 2005 to September 30, 2006.
Subscriber Equipment Sales. Subscriber equipment sales decreased by $7.3 million, or approximately 40%, to $11.0 million for the three months ended September 30, 2006, from $18.3 million for the three months ended September 30, 2005. This decrease was due to the high volume of equipment sales in the third quarter of 2005 as a result of an active hurricane season.
Operating Expenses. Total operating expenses decreased $4.6 million, or approximately 13%, to $29.9 million for the three months ended September 30, 2006, from $34.4 million for the three months ended September 30, 2005. This decrease was due primarily to higher cost of subscriber equipment in the third quarter of 2005 consistent with higher equipment sales in the same period.
Cost of Services. Our cost of services increased $1.2 million, or approximately 23%, to $6.7 million for the three months ended September 30, 2006, from $5.5 million for the three months ended September 30, 2005. Our cost of services is comprised primarily of network operating costs, which are generally fixed in nature. The increase for the three months ended September 30, 2006 over the three months ended September 30, 2005 was the result of the timing of certain maintenance costs and the addition of headcount and operating costs related to the acquisition of our Central American gateway.
Cost of Subscriber Equipment Sales. Cost of subscriber equipment sales decreased $5.2 million, or approximately 32%, to $10.9 million for the three months ended September 30, 2006, from $16.1 million for the three months ended September 30, 2005. This decrease was due to higher equipment sales in 2005 related to an active hurricane season as compared to the same period in 2006.
Marketing, General and Administrative. Marketing, general and administrative expenses decreased $1.5 million, or approximately 13%, to $10.5 million for the three months ended September 30, 2006, from $12.1 million for the three months ended September 30, 2005. This decrease was due primarily to commission expenses in the third quarter of 2005 related to increase in sales due to an active hurricane season as compared to the same period in 2006.
Depreciation and Amortization. Depreciation and amortization expense increased $0.9 million, or 120%, to $1.7 million for the three months ended September 30, 2006, from $0.8 million for the three months ended September 30, 2005. This increase was due primarily to the addition of depreciation associated with our Sebring, Florida gateway, which became operational in July 2005, and our gateway in Central America, which was acquired in 2006.
Operating Income. Operating income increased $2.7 million, or approximately 44%, to $8.8 million for the three months ended September 30, 2006, from $6.1 million for the three months ended September 30, 2005. The increase was due to the increased service revenue which grew $5.4 million, or 24%, more than offsetting a decline in our equipment margin. The total of our cost of services and marketing, general and administrative expenses remained relatively flat.
Interest Income. Interest income increased less than $0.1 million for the three months ended September 30, 2006. This increase was due to increased cash balances on hand and higher yields on those balances.
Interest Expense. Interest expense increased by $0.1 million, to $0.15 million for the three months ended September 30, 2006 from $0.05 million for the three months ended September 30, 2005. This increase was due to increased interest expense related to our credit facilities.
Interest Rate Derivative Gain (Loss). For the three months ended September 30, 2006, interest rate derivative gain (loss) consists of a $2.9 million change in the fair value of the interest rate swap agreement. In July 2006, in connection with entering into our credit agreement, which provides for interest at a variable rate, we entered into a five-year interest rate swap agreement to minimize the risk of variability in our borrowing costs over the term of our credit agreement. Derivative instruments are recorded in the balance sheet as either assets or liabilities, measured at fair value. The interest rate swap agreement does not qualify for hedge accounting and the changes in its fair value are recorded as Interest rate derivative gain (loss) over the life of the agreement.
Other Income (Expense). Other income (expense) generally consists of foreign exchange transaction gains and losses. Other expense changed by less than $0.1 million for the third quarter of 2005 as compared to the third quarter of 2006.
Income Tax Expense (Benefit). Income tax expense for the three months ended September 30, 2006 was $3.1 million, an increase of $4.9 million from last year. For the three months ended September 30, 2005, we and our domestic subsidiaries were treated as a partnership for U.S. income tax purposes and, thus, we did not have a tax provision for the domestic entities. Our Canadian subsidiary reported a net deferred tax benefit of $2.1 million as a result of reversing its remaining valuation allowance against its deferred tax assets. On January 1, 2006, we elected to be taxed as a C corporation for U.S. income tax purposes.
Net Income. Our net income decreased $5.2 million to $2.7 million for the three months ended September 30, 2006, from $7.9 million for the three months ended September 30, 2005. This decrease resulted primarily from our income tax expense and interest rate derivative loss described above.
Comparison of Results of Operations for the Nine Months Ended September 30, 2006 and 2005 (in thousands):
Revenue. Total revenue increased by $16.6 million, or approximately 18%, to $107.4 million for the nine months ended September 30, 2006, from $90.9 million for the nine months ended September 30, 2005, due principally to the growth in service revenue related to the additional 72,000 net subscribers we added between September 30, 2005 and September 30, 2006. Our average retail revenue per user during the nine months ended September 30, 2006 decreased by 11% to $61.61 from $69.55 for the nine months ended September 30, 2005. This decline resulted from the rapid acceptance of our Liberty Plans, which were introduced in the second quarter of 2005 and which allow subscribers to pay for a year of service in advance. These pricing Plans were extensively purchased. Liberty Plans reduce current period revenue because revenue is not recognized until minutes are used or expire. Unused minutes are recognized as revenue at the expiration of a Plan. Subscribers generally do not use all of the minutes for which they have paid. Accordingly, we expect an increase in our average retail revenue per user in later periods as the minutes related to Liberty Plans sold in prior periods are used or expire. Average monthly subscriber churn dropped slightly to 1.0% for the nine months ended September 30, 2006 compared to 1.1% in the nine months ended September 30, 2005.