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DELTATHREE INC - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS(Edgar Glimpses Via Acquire Media NewsEdge) 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" and other risks referenced from time to time in our filings with the SEC. Historical operating results are not necessarily indicative of the trends in operating results for any future period. Overview We are a global provider of integrated video and 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 an international provider of next generation communication services. Today we support tens of thousands of active users around the globe through our service provider and reseller channel and our direct-to-consumer channel. We have built a privately-managed, state-of-the-art global telecommunications platform using IP technology and we offer a broad suite of private label VoIP products and services as well as a back-office platform. 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. Based on our customizable VoIP solutions, these customers can offer private label video and voice-over-IP services 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 joip Mobile application (which is a cellular phone application providing low cost mobile calls over 3G cellular networks as well as WiFi networks) and our iConnectHere offering (which provides VoIP products and services directly to consumers and small businesses online using the same primary platform). 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. In 2009 we began the process of expanding the suite of our communications offerings into the global video phone services market. In the third quarter of 2009 we entered into an agreement with ACN Pacific Pty Ltd., a wholly-owned subsidiary of ACN, Inc., or ACN, pursuant to which we provide digital video and voice-over-IP services in Australia and New Zealand to ACN Pacific. In December 2010 we entered into an agreement with ACN Korea, a wholly-owned subsidiary of ACN, pursuant to which we provide digital video and voice-over-IP servicesin Korea. In 2010 we continued to update our network by adding a video mail feature to our video phone applications and launching our joip mobile application in July 2010. Following the launch of the mobile application, in October 2010 we entered into a sales agency agreement with ACN pursuant to which ACN sells a private label version of joip Mobile under the ACN Mobile World brand in the United States and Canada. In addition, we offer the joip Mobile application on a white-label basis to other customers. Finally, we entered into affiliate agreements with different third parties pursuant to which such third parties refer potential subscribers to our joip Mobile application. In April 2011 we entered into an introducer agreement with ACN Europe B.V., a wholly-owned subsidiary of ACN, pursuant to which ACN Europe refers potential customers in different countries in Europe to a private label version of joip Mobile sold under the ACN Mobile World brand. In November 2011 we entered into a service agreement with Momentis U.S. Corp., a multi-level marketing company, pursuant to which Momentis refers potential customers in North America to a co-branded offering of joip Mobile and other consumer VoIP products and services. 26 As a complement to the initiatives we have taken to attempt to organically expand our businesses, we have also evaluated opportunities for growth through strategic relationships. In February 2009 we consummated a transaction with D4 Holdings pursuant to which we sold to D4 Holdings an aggregate of 39,000,000 shares of our common stock and a warrant to purchase up to an additional 30,000,000 shares of our common stock. D4 Holdings is a private investment fund whose ownership includes owners of ACN, a direct seller of telecommunications services. As a result of the transactions with D4 Holdings, we expect to continue 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. From an operational standpoint, in 2012 we continued to focus our near-term strategy and market initiatives on growing our service provider and digital next generation communications offerings while still supporting our core VoIP reseller and direct-to-consumer business segments. Going forward, we expect to: • actively market our products and services to those entities that wish to offer white-label digital next generation communications offerings; • pursue a targeted strategy of identifying and evaluating appropriate strategic collaborations, such as potentially engaging in commercial transactions with ACN, that we hope will continue to expand and diversify our customer base; • market and sell our direct-to-consumer products and services through affiliates and our affiliate program; and • support and maintain our current reseller base, as we expect our revenue from this key channel will continue to represent a significant percentage of our total revenue in the foreseeable future. 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 emerging next generation telecommunications providers, including IP telecommunications providers, in supplying the overall telecommunications needs of businesses and individual consumers. 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 video and voice-over-IP 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. 27 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, social unrest (including the recent social unrest in the Middle East) and by other political developments and laws and regulations, such as: telecommunications regulations; war, civil war, armed conflict, 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 helps us 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 arenot 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, the imposition of law-enforcement obligations like the Communications Assistance for Law Enforcement Act, referred to as "CALEA", marketing restrictions and data protection rules for Customer Proprietary Network Information, referred to as "CPNI", access to relay services for people with disabilities, local number portability, proposed reforms for the inter-carrier compensation system, and an ongoing generic rulemaking considering the classification of interconnected VoIP services under federal law. 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. 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 risks and uncertainties that we face. Revenues Our revenues are derived mainly from resellers, service providers, and direct consumers of our video and voice-over-IP products and services. Revenue is recognized from these products and services as follows: · postpaid minutes: revenue from the sale of minutes on a postpaid basis (primarily sold to our wholesale resellers) is recognized at the time such minutes are used; · prepaid minutes: prepayments for communications services and the sale of minutes are deferred and recognized as revenue at the time communications services are provided and at the time the minutes are utilized, service charges are levied or remaining balances expire. We conduct evaluations of outstanding prepaid balances that do not have expiration dates or service fees associated with them to determine, based on terms and condition of agreements and historical data, whether such balances are likely to be utilized. If we determine that balances are unlikely to be used, the deferred revenue liability is reduced accordingly and other revenue is recognized. The outstanding prepaid balances likely to be utilized are reconciled to our deferred revenue account and deferred revenue is increased or decreased accordingly to properly reflect our estimated liability; · monthly recurring charges: revenue from fees such as set monthly recurring charges based on the level of service or calling plans that the subscriber subscribes for is recognized as the applicable service is provided; and · other revenues: these revenues include, but are not limited to, prepaid balances with no services fees or expiration dates that are unlikely to be utilized. The following sets forth our revenues per segment for each of the years ended December 31, 2012 and 2011: Year Ended December 31, Segment 2012 2011 ($ in thousands) Reseller $ 7,913 $ 6,570 Direct-to-consumer 4,206 2,450 Service provider 1,147 1,378 Other 418 137 Total Revenues $ 13,684 $ 10,535 The provision of video and voice-over-IP products and services through our service provider and reseller channel accounted for approximately 75.4% and 66.2% of our total revenues in 2011 and 2012, respectively, while the provision of VoIP telephony through our direct-to-consumer channel accounted for approximately 23.3% and 30.7% of our total revenues in 2011 and 2012, respectively. 28 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; and depreciation and amortization. Cost of revenues consist primarily of network, 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. 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 to our direct-to-consumer divisions. General and administrative expenses consist primarily of compensation and benefits for management, finance and administrative personnel, insurance premiums, occupancy costs, legal and accounting fees and other professional fees. Additionally, we incur expenses associated with our 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, 2012. We have not recorded any income tax benefit for net losses and credits incurred for any period from inception to December 31, 2012. 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 thesedeferred assets. Net Operating Losses As of December 31, 2012, we had net operating losses, or NOLs, generated in the U.S. of approximately $21.9 million and our Subsidiary had NOLs of approximately $4.5 million. Our issuance of common stock to D4 Holdings in February 2009 constituted an "ownership change" as defined in Section 382 of the Internal Revenue Code. As a result, under Section 382 our ability to utilize NOLs generated in the U.S. prior to February 2009 (equal to approximately $156 million) to offset any income we may generate in the future will be limited to approximately $600,000 per year from February 2009. The NOLs began to expire in 2011 and will continue to expire at various dates until 2029 if not utilized. Our ability to utilize 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 those related to allowances for doubtful accounts receivable, the amortization of deferred revenue associated with customer accounts, the useful lives of property and equipment and the value of common stock, common stock options, and restricted stock for the purpose of determining stock-based compensation. We base our estimates on historical experience, available market information, appropriate valuation methodologies, including the Black Scholes option model and on 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. 29 Revenue recognition and deferred revenue: We record revenue from VoIP 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: • significant decrease in the market price of a long-lived asset; • significant adverse change in the extent or manner in which a long-lived asset is being used or in its physical condition; • significant adverse change in legal factors or in the business climate that could affect the value of a long-lived asset, including an adverse action or assessment by a regulator; • accumulation of costs significantly in excess of the amount originally expected for the acquisition of the long-lived asset; • current period operating or cash flow loss combined with a history of operating or cash flow losses or a projection or forecast that demonstrates continuing losses associated with the use of a long-lived asset; and • current expectation that, more likely than not, a long-lived asset will be sold or otherwise disposed of significantly before the end of its previously estimated useful life. 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. Restructured Long-term debt. We regard the restructured long-term debt to D4 Holdings under the criteria of, and have accounted for the restructured long-term debt as, a troubled debt restructuring in accordance with ASC Subtopic 470-60, "Debt - Troubled Debt Restructurings by Debtors", or ASC 470-60, which requires that the gross future cash flows of principal and interest be reflected in the balance sheet. The long-term debt is secured by substantially all ofour assets. Results of Operations The following table sets forth the statement of operations data presented as a percentage of revenues for the periods indicated: Year Ended December 31, 2010 2011 2012 Revenues: Total revenues 100.0 % 100.0 % 100 % Costs and operating expenses: Cost of revenues 79.0 69.2 64.4 Research and development expenses 10.4 14.2 8.7 Selling and marketing expenses 6.7 18.8 14.8 General and administrative expenses 16.4 11.5 10.3 Accrual for (recovery of) contingency 1.2 (0.1 ) - Accrual for commercial rent tax - 2.8 - Depreciation and amortization 2.4 1.7 1.1 Total costs and operating expenses 116.1 117.8 99.3 (Loss) income from operations (16.1 ) (17.8 ) 0.7 Capital gain - - - Other non-operating income - - - Interest expense, net (1.1 ) (11.7 ) (12.1 ) Income taxes (0.2 ) (0.0 ) (0.0 ) Net income (loss) (17.4 )% (29.5 )% (11.4 )% Year Ended December 31, 2012 Compared to Year Ended December 31, 2011 Revenues Revenues overall for 2012 increased by approximately $3.2 million, or 30.5%, to approximately $13.7 million from approximately $10.5 million in 2011. Revenues increased although during this period the number of minutes carried by our network decreased by approximately 8.5% from approximately 364 million minutes in 2011 to approximately 333 million minutes in 2012. This was due to a change in the relative mix of the destinations of the calls placed over our network, with a lower percentage of calls being made during 2012 to destinations for which we charge significantly higher rates than during 2011. 30 Revenues generated by our reseller division increased by approximately $1.3 million, or 19.7%, to approximately $7.9 million for 2012 from approximately $6.6 million in 2011. This was primarily due to the resumption of business with our largest reseller during the fourth quarter of 2011 after such reseller had temporarily suspended operations at the beginning of February 2011. In 2011, this customer generated revenues of approximately $1.6 million, which accounted for approximately 15.6% of our annual gross revenues, and in 2012 this customer generated revenues of approximately $5.4 million, which accounted for approximately 39.5% of our annual gross revenues. This increase was offset by a sharp decline in the revenues generated by our second largest reseller, primarily due to a decline in rates we charge for specific destinations of more than 50% over a one-year period. In order be able to continue providing this reseller with competitive prices we were required to lower our prices to those provided by the rest of the market. In 2011, this customer generated revenues of approximately $2.9 million, which accounted for approximately 27.8% of our annual gross revenues and in 2012 this customer generated revenues of approximately $1.3 million, which accounted for approximately 9.3% of our annual gross revenues. Our two largest resellers accounted for approximately $6.9 million, or approximately 84.5%, of the revenue generated from our reseller division in 2012, which represented approximately 48.8% of our total revenue for 2012. By comparison, in 2011 our two largest resellers accounted for approximately $4.6 million, or approximately 69.7%, of the revenue generated from our reseller division, or approximately 43.4% of our total revenue for 2011. Revenues generated by our service provider division decreased by approximately $231,000 or 16.8%, to $1.1 million for 2012 from $1.4 million in 2011. This was primarily due to a decline in revenues generated from our service agreement with ACN Pacific offset by an increase generated by our service agreement with ACN Korea. Sales to direct consumers sharply increased by approximately $1.7 million, or 68%, to approximately $4.2 million in 2012 from approximately $2.5 million in 2011. Revenues generated through our iConnectHere offering declined by approximately $275,000 from approximately $835,000 for 2011 to approximately $560,000 for 2012. This was offset by the revenues generated by our joip Mobile offering, which increased from approximately $1.5 million for 2011 to approximately $3.6 million for 2012, primarily as a result of the sales agency agreement we entered into with ACN and the introducer agreement we entered into with ACN Europe and the sales agreement with Momentis during the fourth quarter of 2011. Costs and Operating Expenses Cost of revenues. Cost of revenues increased by approximately $1.5 million, or 20.5%, from approximately $7.3 million in 2011 to approximately $8.8 million in 2012. Our network rent cost decreased slightly by approximately $120,000, from approximately $1.2 million in 2011 to approximately $1.0 million in 2012, while our termination costs increased by 30.3% from $5.6 million in 2011 to $7.3 million in 2012. The main cause of the increase in cost of revenues was the resumption of the operations of our largest reseller in the fourth quarterof 2011. Research and development expenses. Research and development expenses decreased by approximately $300,000, or 20%, to $1.2 million in 2012 from $1.5 million in 2011. The main reason for the decrease was the reduction in force and resulting reduction in salary expenses. Selling and marketing expenses. Selling and marketing expenses remained constant at approximately $2.0 million for each of 2011 and 2012. Due to an increase in sales of joip Mobile by ACN, ACN Europe and Momentis we recorded higher commissions for 2012, however this was offset by the reduction in force of members of our sales department and other related expenses during 2011. General and administrative expenses. General and administrative expenses increased by approximately $198,000, or 16.3%, to $1.4 million in 2012 from $1.2 million in 2011. During 2011 we recorded a reversal of an accrual of $706,000 for expected legal expenses and a reversal of an accrual for tax liability of $158,000. Excluding these onetime expenses, our general and administrative expenses decreased by approximately $666,000 during 2012, primarily due to a reduction in expenses for professional services and other steps to minimize our expenses, such as office and rent expenses. Accrual for contingency. As discussed above under Item 3 - "Legal Proceedings", on August 31, 2010, the DHS seized approximately $176,000 held in our bank accounts in connection with its investigation into the activities of certain of our resellers. In accordance with FASB Statement 5, "Loss Contingencies" [ASC 450-20], we accounted for the seizure as a loss contingency that is probable of occurrence and recognized a loss in the entire amount seized, and recognized the return of $52,804 to us as a reversal of the loss recognized. Accrual for commercial rent tax. During 2011 we recorded $300,000 as a provision for commercial rent tax. As discussed above under Item 3 - "Legal Proceedings", on July 5, 2011, we received a notice from the New York City Department of Finance, or the Department, which claimed that we had not paid commercial rent tax, required under the New York City Administrative Code from June 1998 through May 2008 for the two offices that we had leased during that time. The notice stated that we are obligated to pay the outstanding tax amounts, as well as significant interest and penalties that were assessed on the unpaid amounts as well as for the failure to file the applicable tax returns. 31 Depreciation and amortization. Depreciation and amortization decreased by $31,000, or 17.2%, from $180,000 in 2011 to $149,000 in 2012 due to a decline in the value of our fixed assets during this period. Income (loss) from Operations We reported income from operations of approximately $88,000 in 2012 compared to a loss from operations of approximately $1.9 million in 2011. Interest Expense, Net We recorded interest expense of approximately $1.7 million in 2012 compared to $1.2 million in 2011. This was due primarily to interest accrued to be paid to D4 Holdings under our loan agreements with D4 Holdings in an amount equal to $551,000, and the expense recorded for the warrant we issued to D4 Holdings in connection with the Second Loan Agreement and the warrant and Convertible Note we issued to D4 Holdings in connection with the Third Loan Agreement in an aggregate amount equal to $905,000. Income Taxes, Net We recorded net income taxes of $11,000 in each of 2012 and 2011. Net Loss Net loss decreased by approximately $1.5 million, or 48.4%, from approximately $3.1 million in 2011 to $1.6 million in 2012, due to the foregoing factors. Year Ended December 31, 2011 Compared to Year Ended December 31, 2010 Revenues Revenues overall for 2011 decreased by approximately $3.7 million, or 26%, to approximately $10.5 million from approximately $14.2 million in 2010. Revenues declined even though during this period the number of minutes carried by our network increased by approximately 15% from approximately 312 million minutes in 2010 to approximately 358 million minutes in 2011. This was due to a change in the relative mix of the destinations of the calls placed over our network, with a higher percentage of calls being made during 2011 to destinations for which we charge significantly lower rates than during 2011. This was caused, in large part, by the temporary cessation of services to our then-largest reseller beginning in February 2011, for which we terminated a large number of calls to higher-rate destinations. In September 2011, this reseller resumed operations and conducting business with our company, and has become a material customer of the company again beginning the fourth quarter of 2011. Revenues generated by our reseller division decreased by approximately $4.7 million, or 42%, to $6.6 million for 2011 from $11.3 million in 2010. This was primarily due to our then-largest reseller temporarily suspending its operations and conducting business with our company beginning in February 2011 due to the recent unrest in the Middle East and ongoing instability and operating difficulties caused by such unrest. In 2010, this customer generated revenues of approximately $6.9 million, which accounted for approximately 48% of our annual gross revenues and in 2011 this customer generated revenues of approximately $1.6 million, which accounted for approximately 15% of our annual gross revenues. At the time this reseller suspended its operations it owed us approximately $196,000 for services we had rendered, and we recorded a provision of the entire outstanding amount for losses on accounts receivable. In September 2011, this reseller paid us $50,000 towards the outstanding amount, and we reduced the provision for losses on accounts receivable for the three months ended September 30, 2011, by such amount. In the fourth quarter of 2011 this reseller paid us an additional $146,000 towards the outstanding amount and we reversed the provision entirely. This decrease in revenues was partially offset by an increase of approximately $1.0 million in revenues generated by our largest reseller during 2011. Our two largest resellers accounted for approximately $4.6 million, or approximately 70%, of the revenue generated from our reseller division in 2011, which represented approximately 43% of our total revenue for 2011. By comparison, in 2010 our two largest resellers accounted for approximately $8.7 million, or approximately 78%, of the revenue generated from our reseller division, or approximately 61% of our total revenue for 2010. Revenues generated by our service provider division remained constant at approximately $1.4 million for each of 2011 and 2010. Although revenues decreased due to the expiration of our service agreements with Market America in 2010, the termination of our agreement with Ojo Service, LLC in July 2011 and a decline in revenues generated from our agreement with Velocity Services, Inc, this was offset by increased revenues generated by our service agreements with ACN Pacific and ACN Korea. 32 Sales to direct consumers sharply increased by approximately $1.2 million, or 92%, to approximately $2.5 million in 2011 from approximately $1.3 million in 2010. Revenues generated through our iConnectHere offering declined by approximately $337,000 from approximately $1.2 million for 2010 to approximately $900,000 for 2011. This was offset by the revenues generated by our joip Mobile offering, which increased from 0 for 2010 to approximately $1.4 million for 2011, primarily as a result of the sales agency agreement we entered into with ACN and the introducer agreement we entered into with ACN Europe. In addition, during the fourth quarter of 2011 we entered into a sales agreement with Momentis pursuant to which Momentis refers potential customers in North America to a co-branded offering of joip Mobile and other consumer VoIP products and services. Costs and Operating Expenses Cost of revenues. Cost of revenues decreased by approximately $3.9 million, or 34.8%, from $11.2 million in 2010 to $7.3 million in 2011. Our network rent cost remained constant at approximately $1.2 million in 2010 and 2011, while our termination costs decreased by 39.8% from $9.3 million in 2010 to $5.6 million in 2011. The main cause of the decrease in cost of revenues was the suspension of the operations of our then-largest reseller in the first quarter of 2011. Research and development expenses. Research and development expenses remained constant at approximately $1.5 million for each of 2010 and 2011. Selling and marketing expenses. Selling and marketing expenses increased by approximately $1.0 million, or 100%, to $2.0 million in 2011 from $1.0 million in 2010. The main reason for the increase was commissions accrued to be paid to ACN in connection with the ACN Mobile World offering. General and administrative expenses. General and administrative expenses decreased by approximately $1.1 million, or 47.8%, to $1.2 million in 2011 from $2.3 million in 2010. This was due primarily to a reversal of an accrual of $706,000 for expected legal expenses and the reversal of an accrual for tax liability of $158,000. Excluding these onetime expenses, our general and administrative expenses decreased by approximately $245,000 during 2011, primarily due to a reduction in expenses for professional services. Accrual for contingency. As discussed above under Item 3 - "Legal Proceedings", on August 31, 2010, the DHS seized approximately $176,000 held in our bank accounts in connection with its investigation into the activities of certain of our resellers. In accordance with FASB Statement 5, "Loss Contingencies" [ASC 450-20], we accounted for the seizure as a loss contingency that is probable of occurrence and recognized a loss in the entire amount seized, and recognized the return of $52,804 to us as a reversal of the loss recognized. Accrual for commercial rent tax. During 2011 we recorded $300,000 as a provision for commercial rent tax. As discussed above under Item 3 - "Legal Proceedings", on July 5, 2011, we received a notice from the New York City Department of Finance, or the Department, which claimed that we had not paid commercial rent tax, required under the New York City Administrative Code from June 1998 through May 2008 for the two offices that we had leased during that time. The notice stated that we are obligated to pay the outstanding tax amounts, as well as significant interest and penalties that were assessed on the unpaid amounts as well as for the failure to file the applicable tax returns. Depreciation and amortization. Depreciation and amortization decreased by $165,000, or 47.8%, from $345,000 in 2010 to $180,000 in 2011 due to a decline in the value of our fixed assets during this period. Loss from Operations Loss from operations decreased by approximately $449,000, or 19.5%, from $2.3 million in 2010 to $1.9 million in 2011, due to the factors set forth above. Interest Expense, Net We recorded interest expense of approximately $1.2 million in 2011 compared to $162,000 in 2010. This was due primarily to interest accrued to be paid to D4 Holdings under our loan agreements with D4 Holdings in an amount equal to $281,000, and the expense recorded for the warrant we issued to D4 Holdings in connection with the Second Loan Agreement and the warrant and Convertible Note we issued to D4 Holdings in connection with the Third Loan Agreement in an aggregate amount equal to $768,000. Income Taxes, Net We recorded net income taxes of $11,000 in 2011 compared to $29,000 in 2010. Net Loss Net loss increased by approximately $615,000, or 24.6%, from approximately $2.5 million in 2010 to $3.1 million in 2011, due to the foregoing factors. 33 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 losses from operations. For the year ended December 31, 2012, we reported income from operations of approximately $88,000, as opposed to a loss from operations of approximately $1.9 million in 2011. To date, we have an accumulated deficit of approximately $183 million. As of December 31, 2012, we had cash and cash equivalents of approximately $362,000 and restricted cash and short-term investments of approximately $56,000, or a total of cash, cash equivalents and restricted cash of $418,000, a decrease of approximately $148,000 from December 31, 2011. The decrease in cash, restricted cash, and short and long term investments was primarily caused by the net cash used in operating activities during the year ended December 31, 2012, of approximately $90,000. Our average monthly cash burn during 2012 was approximately $12,000, and during the three months ended December 31, 2012,was approximately $47,000. 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 $90,000 during 2012 compared with negative cash flow from operating activities of approximately $2.1 million during 2011. The decrease in our cash used in operating activities was primarily driven by a decrease in our net loss of $1.5 million, accrual for commercial rent tax of $300,000, an accrual reversal of $706,000 for expected legal expenses and a reversal of an accrual for tax liability of $158,000, offset by an increase in other current liabilities of $135,000. Net cash used in investing activities is generally driven by our capital expenditures and changes in our short and long-term investments. In 2012 and 2011 we expensed approximately $58,000 and $117,000, respectively, for the purchase of new equipment. In addition, during the year ended December 31, 2012, restricted cash equal to $131,000 that was underlying the letter of credit previously provided by us to the landlord of our subsidiary's office in Jerusalem was released, since such letter of credit is no longer required under the extension of the lease that we executed during this period. Net cash used in or provided by financing activities is generally driven by drawing down amounts available under lines of credit available to us, issuing shares of our capital stock and receiving cash that we had previously pledged or otherwise deposited as security for our lenders and creditors. For the year ended December 31, 2012, we did not draw down any amounts under our loan agreements with D4 Holdings. Financing cash flows have historically consisted primarily of payments of capital leases and proceeds from the exercise of options we have granted to our employees and directors. As discussed above under "Item 1. Business - Transactions with D4 Holdings", in February 2009 we consummated a transaction with D4 Holdings pursuant to which we sold to D4 Holdings an aggregate of 39,000,000 shares of our common stock and a warrant to purchase up to an additional 30,000,000 shares of our common stock for an aggregate purchase price of $1.2 million. In addition, on March 1, 2010, we and our subsidiaries entered into the First Loan Agreement with D4 Holdings pursuant to which D4 Holdings agreed to provide us and our subsidiaries a line of credit in a principal amount of $1,200,000. On August 10, 2010, we and our subsidiaries entered into the Second Loan Agreement with D4 Holdings, pursuant to which D4 Holdings agreed to provide us and subsidiaries an additional line of credit in a principal amount of $1,000,000. In connection with the Second Loan Agreement, we issued D4 Holdings a warrant to purchase up to 4,000,000 shares of our common stock at an exercise price of $0.1312 per share. We have drawn down all amounts available to be borrowed under the two lines of credit. On March 2, 2011, we and our subsidiaries entered into the Third Loan Agreement with D4 Holdings, pursuant to which D4 Holdings agreed to provide us and its subsidiaries an additional line of credit in a principal amount of $1,600,000. Pursuant to the terms of the Convertible Note issued by us in connection with the Third Loan Agreement, D4 Holdings may elect to convert all or any portion of the outstanding principal amount under the Convertible Note into that number of shares of the our common stock determined by dividing such principal amount by $0.08 (as may be adjusted under the terms of the Convertible Note). Simultaneous with our entering into the Third Loan Agreement, D4 Holdings and we entered into an amendment of the First Loan Agreement, pursuant to which (among other things) the maturity date for repayment of principal under the First Loan Agreement was extended from March 1, 2011, to March 1, 2012, and then subsequently extended by oral agreement of the parties to July 1, 2012, and then subsequently orally extended again to January 2, 2014, pending the parties' finalizing and entering into a formal amendment. In connection with the Third Loan Agreement, we issued D4 Holdings a warrant to purchase up to 1,000,000 shares of our common stock at an exercise price of $0.096 per share. We have drawn down the aggregate principal amount available under the Third Loan Agreement, the principal amount of which can be converted by D4 Holdings into an aggregate of 20,000,000 shares of our common stock. On September 12, 2011, we and our subsidiaries entered into the Fourth Loan Agreement with D4 Holdings, pursuant to which D4 Holdings agreed to provide us and our subsidiaries an additional line of credit in a principal amount of $300,000. As of December 31, 2012, the Company had drawn down the aggregate amount of $200,000 from D4 Holdings pursuant to notices ofborrowing under the Fourth Loan Agreement. 34 On November 13, 2012, we and our subsidiaries entered into the Third Amendment to Loan and Security Agreements, or the "Third Amendment", and the Amendment to Warrant Agreements, or the "Warrants Amendment", with D4 Holdings. Pursuant to the Third Amendment and the Warrants Amendment: · the maturity date for repayment of principal and interest under the First Loan Agreement was extended to January 2, 2014; · the maturity date for repayment of principal and interest under the Second Loan Agreement was extended to January 2, 2015; · the maturity date for repayment of principal and interest under each of the Third and Fourth Loan Agreements was extended to January 2, 2016; · all interest outstanding under each of the loan agreements was added to the principal amount outstanding under the respective loan agreement and the promissory notes issued pursuant to each respective loan agreement was increased by such amount; and · the exercise price under each of the Warrant Agreements entered into by us and D4 Holdings as of February 12, 2009, August 10, 2010, and March 2, 2011 was amended to $0.02 per share. In connection with the extension of the maturity dates under the Third Amendment, we issued to D4 Holdings a Warrant, exercisable for ten years, to purchase up to 10,000,000 shares of our common stock at an exercise price of $0.02 per share. Pursuant to ASC 470-60, we regard the long-term debt as a troubled debt and accordingly present the amount as $3.6 million on the balance sheet in our consolidated financial statements, net of current portion, included in this annual report. We intend to service our related party debt, which is repayable over the next three years, from cash generated from operations. However, if such funds are insufficient we may seek additional equity funding. The long-term debt is secured by substantially all of our assets. There were no options exercised by our employees or directors during the year ended December 31, 2012. During 2011 we paid approximately $7,000 for capital leases. As discussed above under "Item 3. - Legal Proceedings", on August 31, 2010, the DHS seized approximately $176,000 held in our bank accounts in connection with its investigation into the activities of certain of our resellers. We are opposing this seizure, and on October 12, 2010, we filed a petition with the DHS for the return of the money. On February 4, 2011, our petition was denied, and on February 22, 2011, we presented an offer of compromise. On November 1, 2011, we were notified by the DHS that our offer of compromise had been denied. In March 2012, we signed a Stipulation of Settlement with the CBP pursuant to which, amongst other things, we agreed to a forfeiture of the seized funds and the CBP agreed to return $52,804 to us following completion of the forfeiture proceedings. Our inability to access these funds has had a material impact on our cash position and liquidity. On July 5, 2011, we received a notice from the New York City Department of Finance that claimed that we had not paid commercial rent tax required under the New York City Administrative Code from June 1998 through May 2008 for the two offices that we had leased during that time. The notice stated that we are obligated to pay the outstanding tax amounts, as well as significant interest and penalties that were assessed on the unpaid amounts as well as for the failure to file the applicable tax returns. We engaged outside counsel, which began discussions with the Department of Finance, and contested the assessment and simultaneously attempted to negotiate a significant reduction in the amounts to be paid. Our appeal was rejected in July 2012 by an examiner in the Department of Finance, and we have subsequently engaged and begun discussions with a manager in the Department of Finance and submitted additional supporting materials. The final outcome of this assessment and our negotiations with the New York City Department of Finance cannot be determined at this time. In the event that we are required to pay all or most of the amounts claimed by the New York City Department of Finance this would have a material adverse effect on our financial condition and liquidity. During 2011 we recorded $300,000 as a provision for commercial rent tax. We experience fluctuations in our cash cycle, as we generally make payments to our termination suppliers more frequently (often on a weekly basis) than we receive payments from our customers (often on a monthly basis). In the event one of our customers did not pay us, we would experience a direct loss of the amounts we had already paid to our termination suppliers. We maintain our free cash in accounts with major banks located in the United States, and generally do not invest such cash in short or long-term investments. As a way to try to offset our declining cash position we generally seek to extend payment terms to our suppliers other than our termination providers. We have historically obtained our funding from our utilization of the remaining proceeds from our initial public offering, 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 in February 2009 and borrowings under our loan agreements with 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 have led to a significant reduction in our cash reserves. On April 3, 2012, we entered into an amendment to our sales agency agreement with ACN and our introducer agreement with ACN Europe. Pursuant to the terms of the amendment, beginning April 1, 2012, we are required to pay all current commissions on a timely basis as required under the agreements and a late fee in the amount of one percent per month of any past-due, unpaid commissions (which, as of December 31, 2012, was equal to approximately $812,000. In addition, beginning July 15, 2012, we are required to pay down any unpaid past due amounts in an amount equal to at least $15,000 per month through June 15, 2013, and at least $25,000 per month thereafter until such time as the unpaid balance is paid in full, and are required to pay in full any unpaid, past due amounts upon 30 days' notice. In July 2012 we began making the $15,000 monthly payment. In addition, in the event of certain insolvency-related events defined in the agreements, all unpaid amounts will become immediately due and payable effective immediately prior to such event. 35 As of December 31, 2012, we had negative working capital equal to approximately $2.3 million as well as negative stockholders' equity equal to approximately $5.6 million. We believe it is probable that we will continue to experience losses and increased negative working capital and negative stockholders' equity in the near future and will not be able to return to positive cash flow before we require additional cash (in addition to any further amounts we may borrow from D4 Holdings under the Fourth Loan Agreement) in the near term. We may experience difficulties accessing the equity and debt markets and raising additional capital, and 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. Because of our significant losses to date and our limited tangible assets, we do not fit traditional credit lending criteria, which could make it difficult for us to obtain loans or to access the capital markets. If we issue additional equity or convertible debt securities to raise funds, the ownership percentage of our existing stockholders would be reduced and they may experience significant dilution. New investors may demand rights, preferences or privileges senior to those of existing holders of our common stock. Due to the limited availability of additional loan advances under the Fourth Loan Agreement, we believe that, unless we are able to increase revenues and generate additional cash, our current cash and cash equivalents will not satisfy our current projected cash requirements beyond the foreseeable future. As a result, there is substantial doubt about our ability to continue as a going concern. In addition, unless we are able to increase revenues and generate additional cash, based on currently projected cash flows we believe that we may be unable to pay future scheduled interest and/or principal payments under the various loan agreements with D4 Holdings as these obligations become due. In the event that were to occur, if D4 Holdings is not willing to waive compliance or otherwise modify our obligations such that we are able to avoid defaulting on such obligations, D4 Holdings could accelerate the maturity of our debts due to it. Further, because D4 Holdings has a lien on all of our assets to secure our obligations under the loan agreements, D4 Holdings could take actions under the loan agreements and seek to take possession of or sell our assets to satisfy our obligations thereunder. Any of these actions would likely have an immediate material adverse effect on our business, financial condition or results of operations. Due to our ongoing losses and reduction in cash, we initiated restructuring activities beginning in the second quarter of 2011 in an effort to cut operating costs significantly and better align our operations with our current business model. In accordance with the restructuring, we instituted a reduction in force and decreased the number of full time employees from approximately 53 to 32, reduced the salaries of all remaining employees by five percent, and decreased non-material expenses as well as payments to be made to vendors and other third parties. As of December 31, 2012, the Company had 23 full time employees. In view of our current cash resources, nondiscretionary expenses, debt and near term debt service obligations, we may begin to explore all strategic alternatives available to us, including, but not limited to, a sale or merger of our company, a sale of our assets, recapitalization, partnership, debt or equity financing, voluntary deregistration of our securities, financial reorganization, liquidation and/or ceasing operations. In the event that we require but are unable to secure additional funding, we may determine that it is in our best interests to voluntarily seek relief under Chapter 11 of the U.S. Bankruptcy Code. Seeking relief under the U.S. Bankruptcy Code, even if we are able to emerge quickly from Chapter 11 protection, could have a material adverse effect on the relationships between us and our existing and potential customers, employees, and others. Further, if we were unable to implement a successful plan of reorganization, we might be forced to liquidate under Chapter 7 of the U.S. Bankruptcy Code. There can be no assurance that exploration of strategic alternatives will result in our pursuing any particular transaction or, if we pursue any such transaction, that it will be completed. 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: Payments due by period (in thousands of dollars) Less than 1 More than 5 Contractual obligations Total year 1-3 years 3-5 years years Real estate leases 794 159 318 318 - Auto leases 171 102 69 - - Unpaid commission to ACN 812 240 572 - -Re-payment of Long-term loan 4,551 - 2,503 2,047 - Total 6,328 501 3,462 2,365 - 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 ReformAct of 1995, as amended. 36 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. |