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MAGICJACK VOCALTEC LTD - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
[March 12, 2014]

MAGICJACK VOCALTEC LTD - 10-K - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS


(Edgar Glimpses Via Acquire Media NewsEdge) THE FOLLOWING DISCUSSION OF THE COMPANY'S FINANCIAL CONDITION AND RESULTS OF OPERATIONS SHOULD BE READ IN CONJUNCTION WITH ITS CONSOLIDATED FINANCIAL STATEMENTS AND RELATED NOTES INCLUDED ELSEWHERE IN THIS ANNUAL REPORT ON FORM 10-K. THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS MAY DIFFER SIGNIFICANTLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS. FACTORS THAT MIGHT CAUSE FUTURE RESULTS TO DIFFER SIGNIFICANTLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED BELOW AND ELSEWHERE IN THIS ANNUAL REPORT, PARTICULARLY THOSE DESCRIBED ABOVE UNDER ITEM 1A, RISK FACTORS.



magicJack VocalTec Ltd. and its Subsidiaries (the "Company") is a cloud communications leader that is the inventor of the magicJack devices and other magicJack products and services. magicJacks weigh about one ounce and plug into the USB port on a computer or into a power adapter and high speed Internet source, providing users with complete phone service for home, enterprise and while traveling. The Company charges highly competitive rates for the right (the "access right") to access its servers, and the Company's customers then continue to have the ability to obtain free telephone services. The Company also provides additional products and services, which include voice apps on smart phones, as well as the magicJack PLUS, which is an updated magicJack device that has its own CPU and can connect a regular phone directly to the user's broadband modem/router and function as a standalone phone without using a computer. The Company's products and services allow users to make and/or receive free telephone calls to and from anywhere in the world where the customer has broadband access to the Internet, and allow customers to make free calls back to the United States and Canada from anywhere legally permitted in the world.

magicJack VocalTec is a vertically integrated group of companies. The Company owns a micro-processor chip design company, an appserver and session border controller company, a wholesale provider of VoIP services, a softphone company, and the developer and provider of the magicJack product line. The Company also wholesales telephone service to VoIP providers and telecommunication carriers.


The Company's strategy since 2007 has been to vertically integrate its technology, design and suppliers, and the Company has completed four acquisitions between 2007 and 2010, including a merger with the company that invented VoIP, in order to implement this strategy.

During September 2011, the Company began promoting the magicJack APP that can be used to make or receive telephone calls between two computers or between the customer's computer and a PSTN. The customer can use a headphone or a computer's speakers and microphone to make and receive telephone calls. In September 2011, the magicJack APP also became available for the iPhone, iPad and iPod Touch. In August 2012, the magicJack APP became available to Android phones. In June 2013, we introduced the New magicJack PLUS. This new device has superior voice quality, expanded memory and enhanced processing power. The New magicJack PLUS includes a six-month right to access the Company's servers in order to make and receive telephone calls for free.

Basis of Presentation The Company's consolidated financial statements are prepared in conformity with U.S. GAAP, and are the basis for the discussion and analysis of its results of operations, liquidity and capital resource. References to authoritative accounting literature in this report, where applicable, are based on the Accounting Standards Codification ("ASC"). The Company's functional and reporting currency is the United States Dollar ("U.S. Dollar"), which is the currency of the primary economic environment in which its consolidated operations are conducted. Transactions and balances originally denominated in dollars are presented at their original amounts. Transactions and balances in currencies other than dollars, including Israeli New Shekel ("NIS"), are re-measured in dollars and any gains or losses are recognized in the Company's consolidated financial statements in the period they occur.

The Company prepares its consolidated financial statements on the basis of being a single reporting entity. Approximately 90% of our revenues in the years ended December 31, 2013, 2012 and 2011 were derived from sales to customers located in the United States. The majority of our revenues were generated from sales of the magicJack product line and from the software access right that accompanies these products, which were $124.7 million, $131.9 million and $87.9 million the years ended December 31, 2013, 2012 and 2011, respectively. The Company also provides its customers the ability to make prepaid calls using a magicJack device or magicJack APP by purchasing prepaid minutes. Revenues generated from the usage of prepaid minutes were $12.6 million, $15.5 million and $11.6 million for years ended December 31, 2013, 2012 and 2011, respectively. In February 2012, the Company made an operational change which allowed it to identify the point in time when prepaid minutes expire under the terms of service and approximately $3.0 million attributable to prepaid minutes that expired between February 2008 and February 2012 were recognized as revenue during the quarter ended March 31, 2012 since such amounts were considered earned. As a result, the Company's diluted earnings per ordinary share for the year ended December 31, 2012 were increased by approximately $0.15 per ordinary share.

37 --------------------------------------------------------------------------------Basis of Consolidation The Company's consolidated financial statements include the accounts of magicJack VocalTec and its wholly-owned subsidiaries, YMax Corporation, YMax Communications Corp., magicJack Holdings Corporation, magicJack, LP, SJ Labs, Inc., Tiger Jet Network, Inc., VocalTec Communications LLC ("VocalTec US", formerly Stratus Telecommunications, LLC), and Predictive Marketing, LLC and B Kruse and Associates, LLC (collectively, "Dialmaxx"). All intercompany balances and transactions have been eliminated in consolidation. Certain reclassifications have been made to prior period financial statement amounts to conform to the current presentation.

Use of Estimates The preparation of 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 revenue and expenses during the reporting period. Such estimates and judgments are revised periodically as required. Actual results could differ from those estimates.

Significant estimates include allowances for billing adjustments and doubtful accounts, the recoverability of long-lived assets and goodwill, income taxes, income tax valuation allowance, uncertain tax liabilities, the value of ordinary shares issued in business combinations or underlying the Company's ordinary share options, the expected forfeitures of ordinary share options and estimates of likely outcomes related to certain contingent liabilities.

We evaluate our estimates on an ongoing basis. Our estimates and assumptions are based on factors such as historical experience, trends within the Company and the telecommunications industry, general economic conditions and on various other assumptions that we believe to be reasonable under the circumstances. The results of such assumptions form the basis for making judgments about the carrying values of assets and liabilities that are not readily available. Actual results may differ from our estimates and assumptions as a result of varying market and economic conditions, and may result in lower revenues and lower operating income.

CRITICAL ACCOUNTING POLICIES We have identified below our critical accounting policies. These policies are both the most important to the portrayal of our financial condition and results of operations and require our management's most difficult, subjective and complex judgments and estimates. Actual results may differ from these estimates under different assumptions or conditions.

REVENUE RECOGNITION Revenues consists of revenue from sales of the magicJack devices to retailers, wholesalers or directly to customers, access rights fees, fees charged for shipping the magicJack devices, usage of prepaid minutes, access charges to other carriers and other miscellaneous charges for telecommunication usage, sales of telecommunications hardware, software and related services. Revenue is recorded net of sales returns and allowances.

magicJack Devices Revenue The Company recognizes revenues from sales and shipping of direct sales of the magicJack devices over the period associated with the initial access right period. Customers may purchase access rights for continued use of the Company's software to access its servers for additional years either when the original purchase is made, or at any time thereafter. The revenue associated with the access right for additional years is deferred and recognized ratably over the extended access right period.

Sales Return Policy The Company offers some of our direct sales customers a 30-day free trial before they have to pay for their magicJack device. The Company does not record or recognize revenue until the 30-day trial period has expired and a customer's credit card has been charged.

38 -------------------------------------------------------------------------------- Returns from retailers are accepted on an authorized basis for devices deemed defective. We may offer certain retailers the limited right to return any unsold merchandise from their initial stocking orders. The Company estimates potential returns under these arrangements at point of sale based and re-estimates potential returns on a quarterly basis. For the year ended December 31, 2011, 2012 and 2013, our estimates of returns and actual returns from initial stocking orders have not been materially different.

Prepaid Minutes and Access and Wholesale Charges Revenue from prepaid minutes and access and wholesale charges are recognized as minutes are used. These revenues are generated from the usage of prepaid minutes, fees charged to telecommunication carriers or providers for origination of their calls to 800-numbers, access fees charged to other telecommunication carriers or providers on a per-minute basis for Interexchange Carriers ("IXC") calls terminated to our end-users. Revenues from access fee charges to other telecommunication carriers are recorded based on rates set forth in the respective state and federal tariffs or negotiated contract rates, less a provision for billing adjustments.

INCOME TAXES We recognize deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax basis of assets and liabilities and their book basis using enacted tax rates. Any changes in enacted rates or tax laws are included in the provision for income taxes in the year of enactment. Our net deferred tax assets consist of primarily foreign net operating loss carryforwards and timing differences between recognition of income for book and tax purposes. We record a valuation allowance to reduce the net deferred tax assets to the amount that it estimates is more-likely-than-not to be realized. At December 31, 2012, we released $10.9 million of valuation allowance. Further, at December 31, 2013, based on a number of factors, including cumulative profitability over the preceding three years and expected future results, we released $40.5 million of the valuation allowance recorded against net deferred tax assets. We determined that a valuation allowance of $17.6 million at December 31, 2013 was necessary to reduce the net deferred tax assets to the amount that will more-likely-than-not be realized. We periodically review the composition of our net deferred tax assets and related valuation allowances and will continue to make adjustments if available evidence indicates that it is more-likely-than-not a change in the carrying amounts is required.

We assess our income tax positions and record tax benefits for all years subject to examination based upon its evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where there is greater than 50% likelihood that a tax benefit will be sustained, we have recorded the largest amount of tax benefit that may potentially be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions where there is 50% or less likelihood that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. In 2013, we recorded a provision for uncertain tax positions of $3.9 million, As of December 31, 2013 and 2012, the liability for uncertain tax positions totaled $4.2 million and $0.4 million, respectively.

SHARE-BASED COMPENSATION Share-based compensation generally consists of option grants or ordinary share and restricted stock units awards to directors, officers, employees or consultants. The Company accounts for share-based compensation in accordance with ASC Topic 718, "Compensation - Stock Compensation" ("ASC 718"). ASC 718 requires companies to estimate the fair value of equity-based payment awards on the date of grant based on the fair value of the award. The value of the portion of the award that is ultimately expected to vest is recognized as an expense over the requisite service periods in our consolidated income statements.

39 --------------------------------------------------------------------------------RESULTS OF OPERATIONS The following table presents the Company's consolidated results of operations for the periods indicated (in thousands, except per share information). The consolidated statements of operations below have been expanded to show the composition of our net revenues and cost of revenues items to enable a more meaningful discussion of our operations. The components of our operating revenue and cost of revenues as presented in the following table are described below the table.

Year ended 2013 2012 December 31, Compared to Compared to 2013 2012 2011 2012 2011 Net Revenues Sale of magicJack devices $ 54,491 $ 73,813 $ 44,552 $ (19,322 ) (26.2 ) % $ 29,261 65.7 % Access right renewals 57,038 43,853 36,546 13,185 30.1 7,307 20.0 Shipping and handling 4,399 5,596 2,158 (1,197 ) (21.4 ) 3,438 159.3 magicJack-related products 8,754 8,626 4,596 128 1.5 4,030 87.7 Prepaid minutes 12,578 15,500 11,634 (2,922 ) (18.9 ) 3,866 33.2 Access and wholesale charges 6,210 9,124 3,607 (2,914 ) (31.9 ) 5,517 153.0 Other 22 1,850 7,357 (1,828 ) (98.8 ) (5,507 ) (74.9 ) Total Net Revenue 143,492 158,362 110,450 (14,870 ) (9.4 ) 47,912 43.4 Cost of Revenues Cost of magicJack devices sold 15,341 23,792 12,944 (8,451 ) (35.5 ) 10,848 83.8 Shipping and handling 2,452 2,539 2,499 (87 ) (3.4 ) 40 1.6 Credit card processing fees 2,706 3,204 2,424 (498 ) (15.5 ) 780 32.2 Network and carrier charges 22,141 27,948 27,847 (5,807 ) (20.8 ) 101 0.4 Other 6,454 3,842 5,467 2,612 68.0 (1,625 ) (29.7 ) Total Cost of Revenues 49,094 61,325 51,181 (12,231 ) (19.9 ) 10,144 19.8 Gross Profit 94,398 97,037 59,269 (2,639 ) (2.7 ) 37,768 63.7 Operating expenses: Advertising 14,293 23,181 32,148 (8,888 ) (38.3 ) (8,967 ) (27.9 ) General and administrative 26,998 27,697 29,050 (699 ) (2.5 ) (1,353 ) (4.7 ) Research and development 5,661 2,594 2,716 3,067 118.2 (122 ) (4.5 ) Total operating expenses 46,952 53,472 63,914 (6,520 ) (12.2 ) (10,442 ) (16.3 ) Operating income (loss) 47,446 43,565 (4,645 ) 3,881 8.9 48,210 1,037.9 Other income (expense): Gains (losses) on investments 722 (738 ) 649 1,460 * (1,387 ) * Interest and dividend income 318 783 1,271 (465 ) * (488 ) * Interest expense (307 ) (411 ) (277 ) 104 (25.2 ) (134 ) 48.4 Fair value (loss)/gain on common equity put options (1,047 ) 3,650 2,192 (4,697 ) * 1,458 * Other income, net 16 41 35 (25 ) * 6 * Total other (expense) income (298 ) 3,325 3,870 (3,623 ) (109.0 ) (545 ) (14.1 ) Income (loss) before income taxes 47,148 46,890 (775 ) 258 * 47,665 * Income tax (benefit) expense (23,163 ) (8,961 ) 61 (14,202 ) * (9,022 ) * Net income (loss) 70,311 55,851 (836 ) 14,460 * 56,687 * Dividends on redeemable ordinary shares - - (955 ) - * 955 Net income (loss) attributable to * ordinary shareholders $ 70,311 $ 55,851 $ (1,791 ) $ 14,460 * $ 57,642 * Income (loss) per ordinary share: Basic $ 3.81 $ 2.80 $ (0.08 ) $ 1.01 * $ 2.88 * Diluted $ 3.81 $ 2.73 $ (0.08 ) $ 1.08 * $ 2.81 * * - Not meaningful.

40--------------------------------------------------------------------------------Components of Net Revenues Our net revenues are comprised of the following sources: · Sales of the magicJack devices - represent revenues recognized from sales of the magicJack devices to retailers, wholesalers, or direct to customers, net of returns, over the period associated with the initial six or twelve months access right period. These revenues are recorded net of sales allowance, chargebacks, retailer discounts and advertising allowances; · Access right renewals - represent revenues from customers purchasing rights to access our servers beyond the initial access right period included with a magicJack device or magicJack service. The extended access right ranges from one to five years. These fees charged to customers are initially deferred and recognized as revenue ratably over the extended access right period; · Shipping and handling - represent charges for shipping and handling fees for magicJack devices shipped directly to customers. The fees are initially deferred and recognized as revenues over the initial six or twelve months access right period associated with the magicJack device; · magicJack-related products - represent revenues recognized from sale of other items related to the magicJack devices and access right renewals we offer our customers, including: (i) porting fees charged to customers to port their existing phone number to a magicJack device or service, (ii) fees charged for customers to select a custom, vanity or Canadian phone number, (iii) fees charged to customers to change their existing number, and (iv) insurance covering the replacement of a damaged or lost device; · Prepaid minutes - represents revenues recognized primarily from the usage and expiration of international prepaid minutes, net of chargebacks; · Access and wholesale charges - represent revenues generated from: (i) access fees charged to other telecommunication carriers or providers for Inter-exchange Carriers ("IXC") calls terminated to our end-users, and (ii) fees charged to telecommunication carriers or providers for origination of calls to their 800-numbers. These revenues are recorded based on rates set forth in the respective state and federal tariffs or negotiated contract rates, less provisions for billing adjustments; and · Other revenues - represent primarily revenues from items we stopped selling, which included the sale of telecommunications hardware, proprietary software and related services, as well as other ancillary revenue sources. We stopped selling the aforementioned items in late 2012 as we discontinued efforts to acquire new customers for such products.

Components of Cost of Revenues Our cost of revenues is comprised of the following components: · Cost of magicJack devices sold - represent the costs of components and manufacturing of the magicJack devices, as well as broker commissions, production, packaging and other inventory-related costs. The cost of components and manufacturing of the magicJack devices is recognized from sales of the magicJack devices to retailers, wholesalers, or direct to customers over the period associated with the initial six or twelve months access right period.

· Shipping and handling - represent freight, postage and other transportation costs related to: (i) transportation of the magicJack devices from the manufacturer to our warehouse and distribution center, and (ii) freight, shipping and handling fees incurred to ship the magicJack devices to retailers and direct customers. These costs are expensed as incurred; · Credit card processing fees - represent transaction and other fees incurred as a result of accepting credit card payments for sales of magicJack devices, access right renewals, shipping and handling charges, magicJack related products and prepaid minutes sold direct to customers through our website.

These fees are expensed as incurred; · Network and carrier charges - represent facilities charges to establish and maintain our network as well as network usage fee charges from other telecommunication carriers. These rates or charges are based upon commercial agreements or applicable state and/or federal tariffs. These charges are expensed as incurred; and · Other cost of revenues - represents allocation of personnel-related costs, amortization and depreciation expense related to assets employed in generating our revenues, as well as costs from sources we ceased selling. These sources included the sale of telecommunications hardware, proprietary software and related services. We stopped selling these items in late 2012 as we discontinued efforts to acquire new customers for such products.

41--------------------------------------------------------------------------------YEAR ENDED DECEMBER 31, 2013 COMPARED TO YEAR ENDED DECEMBER 31, 2012 Net Revenues Total net revenue was $143.5 million and $158.4 million for the years ended December 31, 2013 and 2012, respectively, representing a decrease of $14.9 million, or (9.4%). The decreases in the components of net revenues were primarily attributable to the following: · a $19.3 million decrease in revenues recognized for the sale of magicJack devices, primarily as a result of: (i) the reduction in revenues recognized on sales of the magicJack PLUS due to the introduction of the New magicJack PLUS in June 2013, (ii) lower average unit prices of magicJack PLUS units as a result of holiday promotions, offset in part by the revenues from sales of the New magicJack PLUS being recognized over six months as opposed to twelve months for prior devices, and (iii) a lower proportionate number of magicJack devices being sold directly to consumers at retail prices as opposed to the number of units sold to retailers and distributors at wholesale prices; · a $2.9 million decrease in revenues from prepaid minutes primarily as a result of the Company making an operational change in February 2012 which allowed it to identify the point in time when prepaid minutes expire under the terms of service, resulting in approximately $3.0 million attributable to prepaid minutes that expired between February 2008 and February 2012 being recognized as revenue in 2012; · a $2.9 million decrease in revenues from access and wholesale charges; · a $1.8 million decrease in non-core other revenues as a result of the Company no longer selling telecommunications hardware and the Company's proprietary software in late 2012 as it discontinued efforts to acquire new customers for such products; and · a $1.2 million decrease in shipping and handling revenues primarily as a result of the reduction in unit sales mentioned above, offset in part by the recognition of shipping and handling revenues related to the New magicJack PLUS over six months as opposed to twelve months for prior devices.

These decreases in components of net revenue were partially offset by a $13.2 million increase in renewal revenues as a result of an increase in customers on a renewal period and the impact of price increases effective in early 2012; In the years ended December 31, 2013 and 2012, sales of the magicJack devices through retail outlets represented approximately 70% and 59%, respectively, of sales of all magicJack devices sold. For the same periods, direct sales represented approximately 30% and 41%, respectively, of magicJack devices sold.

For years ended December 31, 2013 and 2012, no retailer accounted for more than 10% of our total net revenues.

Cost of Revenues Total cost of revenues was $49.1 million and $61.3 million for the years ended December 31, 2013 and 2012, respectively, representing a decrease of $12.2 million, or 19.9%. This decrease in cost of revenues was primarily attributable to: · a $9.0 million combined decrease in costs related to the magicJack devices, shipping and handling and credit card processing fees driven by: (i) lower sales of the magicJack and magicJack PLUS as the Company only sold the magicJack through certain retailers since the launch of the magicJack PLUS in September 2011 and lower sales of the magicJack PLUS in the 12 months preceding December 2013, offset in part by costs related to the Company starting to sell the New magicJack PLUS in June 2013, and (ii) certain inventory write-downs in 2012; and · a $5.8 million reduction in network and carrier charges as we stopped selling to certain high-cost wholesalers and continued effort to negotiate better rates with other carriers.

These decreases in cost of revenues were partially offset by $2.6 million increase in cost of other revenues primarily due to: (i) higher personnel-related costs attributable to a higher percentage allocation of costs to cost of revenues, (ii) higher amortization expense due to certain intangible assets purchased in mid 2012, offset in part by reduced costs of non-core other revenues as a result of no longer selling telecommunications hardware and our proprietary software in late 2012.

42 --------------------------------------------------------------------------------Operating Expenses Total operating expenses were $47.0 million and $53.5 million for the years ended December 31, 2013 and 2012, respectively, representing a decrease of $6.5 million, or 12.2%. This decrease in operating expenses was primarily due to: · an $8.9 million decrease in advertising-related expense driven by a reduction in long-form advertising for most of 2013 as the Company prepared to launch the New magicJack PLUS and its new advertising campaign and reduced sponsorship-related expenses, offset in part by costs associated with the brand refresh and new advertising campaign; · a $0.7 million decrease in general & administrative expenses primarily due to lower employee bonus expense and reduced legal expenses driven by litigation and other disputes that ended in late 2012 and 2013, offset in part by professional fees, severance payments and other costs in part as a result of the Company reaching certain agreement with its founder and former chief executive officer, as well as other tax-related projects; and · a $3.1 million increase in research and development costs due to higher professional fees and personnel-related costs allocated to research and development as a result of work related to the New magicJack PLUS and magicJack APP.

The Company's combined advertising-related expenses decreased by approximately 38.3% for the year ended December 31, 2013 as compared to December 31, 2012 primarily due to less advertising efforts as the Company geared up to launch the New magicJack PLUS and its new advertising campaign and brand refresh. Advertising-related expenses have varied, and may continue to vary from quarter to quarter.

The Company believes it will be able to reduce legal expenses related to litigation and certain tax-related projects in future periods as certain open legal cases and projects are resolved.

Other (Expense) Income Total other (expense) income was $(0.3) million and $3.3 million for the years ended December 31, 2013 and 2012, respectively, representing a decrease of approximately $3.6 million. This decrease in other income was primarily due to changes in the item discussed below.

Fair Value (Loss) Gain on Common Equity Put Options Fair value (loss) gain on common equity put options for years ended December 31, 2013 and 2012 was ($1.0) million and $3.7 million, respectively. We sold common equity put option contracts in connection with our share repurchase program in order to attempt to lower the average share price paid for ordinary shares we purchase. We do not expect to sell common equity put options in connection with our share repurchase program in the future.

Income Taxes Total income benefit was $23.2 million and $9.0 million for the years ended December 31, 2013 and 2012, respectively. The principal components of the Company's income taxes for the years ended December 31, 2013 and 2012 are the following (in thousands): Year Ended December 31, 2013 2012 Income before taxes $ 47,148 $ 46,890 Income tax benefit (23,163 ) (8,961 ) Effective income tax rate (49.13 )% (19.11 )% The Company recorded an income tax benefit of $23.2 million and $9.0 million for the years ended December 31, 2013 and 2012, respectively, primarily related to the release of $40.5 million and $10.9 million of our valuation allowance in those years. Prior to 2012, we provided a full valuation allowance related to our net deferred tax assets as we then believed the objective and verifiable evidence of our historical pre-tax losses outweighed the existing positive evidence regarding our ability to realize our deferred tax assets. During 2012, we reassessed the need for a valuation allowance against our net deferred tax assets and concluded that it was more-likely-than-not that we would be able to recover certain deferred tax assets by generating taxable income, and again reevaluated our position in the fourth quarter of 2013, and accordingly, we released additional amounts of our valuation allowance. As of December 31, 2013, we determined that a valuation allowance of $17.6 million was required to reduce certain deferred tax assets to their net recoverable amounts. Going forward, we expect that our income tax expense will increase in the future. The actual amount of the income tax expense in the future will be affected by various factors, including our future profitability and, potentially, the realization of previously unrecognized deferred tax assets recovered from future taxable income. We will continue to review our deferred tax valuation allowance on a quarterly basis. Refer to Note 14, "Income Taxes," in the Notes to our Consolidated Financial Statements included in Item 8 herein for further details, as well as a reconciliation of the statutory tax rate to our effective tax rate.

43 --------------------------------------------------------------------------------Net Income Attributable to Ordinary Shareholders and Income Per Share As a result of the foregoing items, net income attributable to ordinary shareholders increased to $70.3 million in 2013 as compared to $55.9 million in 2012. Income per diluted share attributable to ordinary shareholders increased to $3.81 per ordinary share in 2013 as compared to $2.73 per ordinary share in 2012 primarily as a result of the aforementioned additional amounts of our valuation allowance, as well as a decrease of approximately 1.5 million (or 7.6%) in the weighted average number of ordinary shares outstanding in 2013 as compared to 2012 primarily due to the Company's share repurchase program.

YEAR ENDED DECEMBER 31, 2012 COMPARED TO YEAR ENDED DECEMBER 31, 2011 Net Revenues Total net revenue was $158.4 million and $110.5 million for the years ended December 31, 2012 and 2011, respectively, representing an increase of $47.9 million, or 43.4%. The increases in the components of net revenues were primarily attributable to the following: · a $29.3 million combined increase in revenues recognized for the sale of magicJack devices, primarily as a result of: (i) the recognition of revenues on sales of the magicJack PLUS, which started in September 2011, (ii) higher average unit prices of magicJack PLUS units, and (iii) a higher proportionate number of magicJack PLUS units being sold directly to consumers at retail prices as opposed to the number of units sold to retailers and distributors at wholesale prices; · a $7.3 million increase in renewal revenues primarily as a result of the impact of price increases effective in early 2012; · a $4.0 million increase in the sale of magicJack-related products, primarily driven by the increase in porting fees; · a $3.9 million increase in revenues from prepaid minutes primarily as a result of the Company making an operational change in February 2012 which allowed it to identify the point in time when prepaid minutes expire under the terms of service, resulting in approximately $3.0 million attributable to prepaid minutes that expired between February 2008 and February 2012 being recognized as revenue; · a $3.4 million increase in shipping and handling revenues primarily as a result of the Company commencing to sell the magicJack PLUS in September 2011; and · a $5.5 million increase in revenues from access and wholesale charges.

These increases in components of net revenue were partially offset by a $5.5 million decrease in non-core other revenues as a result of reduced sales of telecommunications hardware and the Company's proprietary software as it discontinued efforts to acquire new customers for such products in order to focus on internal matters.

In the years ended December 31, 2012 and 2011, sales of the magicJack and magicJack PLUS units through retail outlets represented approximately 59% and 57%, respectively, of sales of all magicJack units sold. For the same periods, direct sales represented approximately 41% and 43%, respectively, of magicJack units sold.

For years ended December 31, 2012 and 2011, no retailer accounted for more than 10% of the Company's total net revenues.

Cost of Revenues Total cost of revenues was $61.3 million and $51.2 million for the years ended December 31, 2012 and 2011, respectively, representing an increase of $10.1 million, or 19.8%. This increase in cost of revenues was primarily attributable to: (i) $9.1 million increase driven by a higher number of magicJack PLUS units sold with a higher unit cost, (ii) shipping and handling cost and credit card processing fees primarily as a result of an increase in direct sales of the magicJack PLUS units in 2012, and (iii) a $2.6 million increase in write-offs of obsolete raw materials inventory.

The increases in cost of revenues were partially offset by $1.6 million primarily due to: (i) a decrease in VocalTec US and Israel costs as a result of a lower hardware cost as we discontinued efforts to acquire new customers for such products, and (ii) a reduction in depreciation expense resulting from a change in estimated useful lives of certain servers effective January 1, 2012, offset in part by higher amortization expense as a result of certain intangible assets being purchased in 2012.

Operating Expenses Total operating expenses were $53.5 million and $63.9 million for the years ended December 31, 2012 and 2011, respectively, representing a decrease of $10.4 million, or 16.3%. This decrease in operating expenses was primarily due to: (i) a $9.0 million decrease in advertising-related expense driven by a reduction in long-form advertising and sponsorship-related expenses, (ii) a $1.4 million decrease in general and administrative expenses resulting from a $2.2 million decrease in legal expenses as a result of fewer legal cases, offset in part by higher personnel related costs primarily as a result of higher bonuses to employees and outside consultants in 2012 because of successful 2012 results.

44 -------------------------------------------------------------------------------- The Company's combined advertising-related expenses decreased by approximately 27.9% for the year ended December 31, 2012 as compared to December 31, 2011 because the legacy value of its short and long-form advertising did not require continued reinforcement.

Other Income Total other income was $3.3 million and $3.9 million for the years ended December 31, 2012 and 2011, respectively, representing a decrease of approximately $0.6 million. This decrease in other income was due to changes in the item discussed below.

Fair Value Gain on Common Equity Put Options Fair value gain on common equity put options for years ended December 31, 2012 and 2011 was $3.7 million and $2.2 million, respectively. The Company sold common equity put option contracts in connection with its share repurchase program in order to attempt to lower the average share price paid for ordinary shares purchased.

Income Taxes Total income tax (benefit) expense was $(9.0) million and $61 thousand for the years ended December 31, 2012 and 2011, respectively. The principal components of the Company's income taxes for the years ended December 31, 2012 and 2011 are the following (in thousands): Year Ended December 31, 2012 2011 Income (loss) before taxes $ 46,890 $ (775 ) Income tax (benefit) expense (8,961 ) 61 Effective income tax rate (19.11 )% (7.88 )% The Company has had low income taxes because of the offset of operating loss carryovers from earlier years of operation against income (loss) before income taxes. The Company recorded an income tax benefit of $9.0 million for the year ended December 31, 2012, primarily related to the release of $10.9 million of its valuation allowance in the fourth quarter of 2012. As of December 31, 2011, the Company provided a full valuation allowance related to its net deferred tax assets as it then believed the objective and verifiable evidence of its historical pre-tax losses outweighed the existing positive evidence regarding its ability to realize its deferred tax assets. During the fourth quarter of 2012, the Company reassessed the need for a valuation allowance against its net deferred tax assets and concluded that it was more-likely-than-not that the Company would be able to recover certain deferred tax assets by generating taxable income. Accordingly, the Company released a portion of its valuation allowance in the fourth quarter of 2012. Going forward, the Company expects that its effective tax rate will increase in the future. The actual amount of the effective tax rate in the future will be affected by various factors, including its future profitability and the realization of previously unrecognized deferred tax assets recovered from future taxable income. The Company reviews its deferred tax valuation allowance on a quarterly basis. Refer to Note 14, "Income Taxes," in the Notes to the Consolidated Financial Statements included in Item 8 herein for further details, as well as a reconciliation of the statutory tax rate to the Company's effective tax rate.

Net Income (Loss) Attributable to Ordinary Shareholders and Income (Loss) Per Share As a result of the foregoing items, net income (loss) attributable to ordinary shareholders increased to $55.9 million in 2012 as compared to ($1.8) million in 2011. Income (loss) per diluted share attributable to ordinary shareholders increased to $2.73 per ordinary share in 2012 as compared to ($0.08) per ordinary share in 2011 as a result of increased profitability in 2012 and a decrease of approximately 3.3 million (or 14%) in the weighted average number of ordinary shares outstanding in 2012 as compared to 2011 due to the Company's share repurchase program.

45--------------------------------------------------------------------------------LIQUIDITY AND CAPITAL RESOURCES The Company's primary sources of liquidity are cash generated from operations and cash on hand and investments. As of December 31, 2013, the Company had cash and cash equivalents of $46.0 million, available-for-sale marketable securities of $8.8 million and accounts receivables of $3.6 million. Accounts payable at December 31, 2013 was $3.0 million.

During the year ended December 31, 2013, the Company generated positive operating cash flows of $35.3 million, as compared to $65.3 million for year ended December 31, 2012. The $30.0 million decrease was primarily attributable to less magicJack devices sold and cash used to make estimated tax payments in 2013. Net income was $70.3 million for the year ended December 31, 2013 as compared to a $55.9 million for the year ended December 31, 2012. The Company currently believes that available funds and cash flows generated by operations will be sufficient to fund its working capital and capital expenditure requirements for at least the next twelve months. If the Company decides to make future acquisitions, it may require new sources of funding, including additional debt, equity financing or some combination thereof. There can be no assurances that the Company will be able to secure additional sources of funding or that such additional sources of funding will be available on acceptable terms.

Cash Flow - Operating Activities Net cash provided by operating activities was $35.3 million, $65.3 million and $25.3 million for the years ended December 31, 2013, 2012 and 2011, respectively.

During the year ended December 31, 2013, net cash provided by operating activities was primarily attributable to $70.3 million net income, offset primarily by: (i) $15.0 million in non-cash items consisting of a $29.0 million deferred income tax benefit, offset in part by $4.9 million depreciation and amortization expense, $3.9 million increase in uncertain tax positions, $2.8 million in share-based compensation related primarily to ordinary share options and restricted stock units issued to executives, $1.8 million provision for billing adjustments, and $1.0 million fair value loss on common equity put options, (ii) $11.4 million increase in deposits and other current assets as a result of the Company making estimated federal and state income tax payments, (iii) $10.7 million decrease in deferred revenues as a result of less sales of magicJack devices, and (iv) $2.5 million decrease in accrued expenses and other current liabilities primarily attributable to common equity put options outstanding at December 31, 2012 being assigned to us in early 2013.

During the year ended December 31, 2012, net cash provided by operating activities was primarily attributable to: (i) $55.9 million net income, (ii) $2.4 million in non-cash items consisting of a $8.9 million provision for billing adjustments as a result of the aforementioned FCC Order of November 18, 2011, $3.3 million for depreciation and amortization expense, $3.2 million in share-based compensation related primarily to bonuses paid in ordinary shares of the Company, and $0.7 million loss on investments, offset in part by $10.9 million deferred income tax benefit and $3.7 million fair value gains on common equity put options, (iii) $7.4 million increase in deferred revenues attributable to strong sales of access right renewals, (iv) a $3.7 million increase in accrued expenses and other current liabilities, which include outstanding common equity put option contracts sold in connection to our share repurchase program, and (v) a $3.3 million decrease in inventories as a result of the Company writing off approximately $3.5 million in excess components considered obsolete due to starting to manufacture a new product. These items were partially offset by a $3.2 million decrease in accounts payable.

During the year ended December 31, 2011, net cash provided by operating activities was primarily attributable to: (i) $20.6 million in non-cash expenses primarily as a result of a $16.2 million provision for billing adjustments as a result of the aforementioned FCC Order of November 18, 2011, $4.2 million for depreciation and amortization expense and $2.4 million in share-based compensation related primarily to bonuses paid in ordinary shares of the Company, (ii) a $25.6 million increase in deferred revenues attributable primarily to strong initial sales of the magicJack PLUS and access right renewals, and (iii) a $4.3 million increase in accounts payable primarily due to timing of payments to our vendors. These items were partially offset by: (i) a $14.9 million increase in accounts receivable primarily due to the strong sales of the magicJack PLUS to retailers in late 2011 and low collections associated with access fees charged to other carriers, (ii) a $5.7 million increase in inventories as a result of the Company building up inventory for the magicJack PLUS, which we started selling in September 2011, (iii) a $2.1 million decrease in accrued expenses and other current liabilities as a result of the 2010 bonuses being paid out in early 2011, and (iv) a $1.9 million increase in deferred costs.

Cash Flow - Investing Activities Net cash provided by (used in) investing activities was $12.0 million, ($4.7) million, and ($9.0) million for the years ended December 31, 2013, 2012 and 2011, respectively.

Net cash provided by investing activities during the year ended December 31, 2013 was primarily attributable to $12.3 million net proceeds from the sale of investments, partially offset by $0.2 million used for purchases of property and equipment, and $0.1 million used for acquisition of certain intangible assets.

46 -------------------------------------------------------------------------------- Net cash used in investing activities during the year ended December 31, 2012 was primarily attributable to: (i) $5.7 million used to purchase certain intangible assets and (ii) $0.2 million for purchases of property and equipment.

These items were partially offset by $1.3 million net proceeds from sale of investments.

Net cash used in investing activities during the year ended December 31, 2011 was primarily attributable to: (i) $6.5 million net purchase of investments, (ii) $1.5 million primarily due to the first of five installment payments for the purchase of certain intangible assets, and (iii) $1.0 million for purchases of property and equipment, primarily comprised of servers.

Cash Flow -Financing Activities Net cash used in financing activities was $20.2 million, $54.6 million and $32.0 million for the years ended December 31, 2013, 2012 and 2011, respectively.

Net cash used in financing activities for the year ended December 31, 2013 consisted of: (i) $18.7 million in cash used to purchase treasury stock in a privately negotiated repurchase agreements with the independent trustees of two irrevocable trusts previously created by the Company's founder, Mr. Daniel Borislow, as well as through the Company's share repurchase program and (ii) payment of $1.5 million for the third of five installment payments for the purchase of certain intangible assets in 2011.

Net cash used in financing activities during the year ended December 31, 2012 primarily consisted of: (i) $66.5 million in cash used to purchase treasury stock as part of the Company's share repurchase program and (ii) payment of $1.5 million for the second of five installment payments for the purchase of certain intangible assets in 2011. These items were partially offset by: (i) $12.2 million in premiums received from the sale of common equity put options in connection with the share repurchase program, and (ii) $1.2 million in cash received from the exercise of ordinary share options.

Net cash used in financing activities during the year ended December 31, 2011 primarily consisted of: (i) $28.2 million in cash used to purchase treasury stock as part of the Company's share repurchase program and (ii) $8.7 million paid for the redemption of 566,668 redeemable ordinary shares from an affiliate of an unrelated multinational entertainment products and services retailer in an arm's length transaction as described in Note 11, "Redeemable Ordinary Shares," in Item 8 herein. These items were partially offset by: (i) $3.1 million in premiums received from the sale of common equity put options in connection with the share repurchase program, and (ii) $1.8 million in cash received from the exercise of ordinary share options. Refer to the section below for additional information on the Company's share repurchase program.

Stock Repurchase Program The Company's Board of Directors authorized a stock repurchase program to enable it to purchase its ordinary shares at such times as management deems appropriate up to a maximum cumulative repurchase authority of $100.0 million as of December 31, 2013. The objective of the Company's stock repurchase program is to improve stockholders' returns. The Company expended $91.3 million under its repurchase program through December 31, 2013, and there was $8.7 million authorized to purchase ordinary shares pursuant to the stock repurchase program. All shares purchased, not yet retired, are recorded as treasury shares. The Company repurchased 6,143,731 ordinary shares under this program through December 31 2013.

The Company has bought call option contracts and has sold put option contracts in connection with its share repurchase program in order to attempt to lower the average share price paid for ordinary shares it purchased. There were no outstanding put option contracts at December 31, 2013, and the Company does not expect to buy call options or sell common equity put options in the future as part of its share repurchase program. Taking into consideration the proceeds received from the sale of put option contracts exercised, put option contracts that expired unexercised and purchase price of call option contracts exercised during the year ended December 31, 2013, 2012 and 2011, the Company expended approximately (i) $3.3 million purchasing 190,000 shares of outstanding ordinary shares at an average price of $17.27 during the year ended December 31, 2013, (ii) $55.9 million purchasing 2,989,949 shares of outstanding ordinary shares at an average price of $18.69 during the year ended December 31, 2012, and (iii) $32.2 million purchasing 2,963,782 shares of outstanding ordinary shares at an average price of $10.85 during the year ended December 31, 2011.

Other Liabilities As of December 31, 2013, the Company had outstanding indebtedness in connection with an agreement entered during June 2011 for the purchase of certain intangible assets, and secured only by such intangible assets, under which it is required to make two non-interest bearing future annual payments of $1.5 million beginning May 31, 2014. The liability for such payments has been discounted at a rate of 10% to a net present value of $2.8 million and $3.9 million at December 31, 2013 and 2012, respectively. Refer to Note 9, "Other Liabilities," in the Notes to our Consolidated Financial Statements included in Item 8 herein for further details.

47--------------------------------------------------------------------------------RECENT ACCOUNTING PRONOUNCEMENTS In February 2013, the Financial Accounting Standards Board issued ASU No.

2013-02, Reporting Amounts Reclassified Out of Accumulated Other Comprehensive Income ("ASU 2013-02"). ASU 2013-02 requires an entity to present, either on the face of the statement where net income is presented or in the notes to the financial statements, significant amounts reclassified out of accumulated other comprehensive income (loss) by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period. Amounts that are not required to be reclassified in their entirety to net income must be cross-referenced to other disclosures that provide additional detail. This guidance was effective on a prospective basis for the annual and interim reporting periods for the Company beginning January 1, 2013. The Company's adoption of this standard did not have a significant impact on its consolidated financial statements. The Company's accumulated other comprehensive loss is comprised of one item pertaining to the Company's unrealized gains and losses on marketable securities. Reclassification of the gains or losses occurs when the specific investments are sold.

CONTRACTUAL OBLIGATIONS AND OFF-BALANCE SHEET ARRANGEMENTS Contractual Obligations The impact that the Company's aggregate contractual obligations as of December 31, 2013 are expected to have on its liquidity and cash flow in future periods is as follows (in thousands): Payments Due by Period Less Than 1 More Than 5 Total Year 1-3 Years 3-5 Years Years Intangible assets purchased $ 3,000 $ 1,500 $ 1,500 $ - $ - Operating lease obligations $ 2,152 $ 445 $ 828 $ 632 $ 247 Accrued severance pay * $ 340 $ - $ - $ - $ 340 Uncertain tax positions $ 4,247 $ - $ - $ - $ 4,247 Total contractual obligations $ 9,739 $ 1,945 $ 2,328 $ 632 $ 4,834 * As of December 31, 2013, we had $0.2 million in severance pay funds in reserve to settle such liabilities.

Off-Balance Sheet Arrangements The Company had no off-balance sheet arrangements as of December 31, 2013.

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