TMCnet News
MAGICJACK VOCALTEC LTD - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our unaudited condensed consolidated financial statements as of September 30, 2014 and for the three and nine month periods ended September 30, 2014 and 2013, as well as our Annual Report on Form 10-K for the year ended December 31, 2013. This Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements, the accuracy of which involves risk and uncertainties. We use words such as "anticipates," "believes," "plans," "expects," "future," "intends," "estimates," "projects," and similar expressions to identify forward-looking statements. Readers should not place undue reliance on these forward-looking statements, which apply only as of the date of this report. Our actual results could differ materially from those anticipated in these forward-looking statements for many reasons. Factors that might cause or contribute to such differences include, but are not limited to those discussed under the section titled "Risk Factors" of our Form 10-K for the year ended December 31, 2013 filed on March 12, 2014. Overview 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 and provide users with complete phone service for home, enterprise and while traveling. We charge our customers highly competitive rates for the right (the "access right") to access our servers, and our customers then continue to have the ability to obtain free telephone services. We also provide 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. Our 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. We own 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. We also wholesale telephone services to VoIP providers and telecommunications carriers. Our strategy since 2007 has been to vertically integrate our technology, design and suppliers, and we have 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, we 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 public switch telephone network. 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 for 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 our servers in order to make and receive telephone calls for free. In July 2014, the Company introduced the magicJack GO which includes a twelve month right to access our servers. Basis of Presentation Our consolidated financial statements are prepared in conformity with United States generally accepted accounting principles ("GAAP") for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, our consolidated financial statements do not include all of the information and footnotes required by GAAP for complete financial statements that are included in our Annual Report on Form 10-K for the year ended December 31, 2013. The balance sheet at December 31, 2013 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements. Management believes, however, that all adjustments of a normal, recurring nature considered necessary for a fair presentation have been included. Our consolidated financial statements are the basis for the discussion and analysis of our results of operations, liquidity and capital resources. References to authoritative accounting literature in this report, where applicable, are based on the Accounting Standards Codification ("ASC"). Our functional and reporting currency is the United States Dollar ("U.S. Dollar"), which is the currency of the primary economic environment in which our 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 our consolidated financial statements in the period they occur. 24 -------------------------------------------------------------------------------- We prepare our consolidated financial statements on the basis of being a single reporting entity. Approximately 90% of our revenues in the three and nine months ended September 30, 2014 and 2013 were derived from sales to customers located in the United States. Basis of Consolidation Our 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 may have been made to prior period financial statement amounts to conform to the current presentation. The results for the three and nine months ended September 30, 2014 may not be indicative of the results for the entire year ending December 31, 2014. The interim unaudited consolidated financial statements should be read in conjunction with our financial statements and Management's Discussion and Analysis of Financial Condition and Results of Operations included in this report and in our Annual Report on Form 10-K for the year ended December 31, 2013 filed on March 12, 2014. 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 our 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 Net 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. Revenue is recorded net of sales returns and allowances. magicJack Devices Revenue We recognize 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 our software to access our 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 We offer some of our direct sales customers a 30-day free trial before they have to pay for their magicJack device. We do not record or recognize revenue until the 30-day trial period has expired and a customer's credit card has been charged. 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. We estimate potential returns under these arrangements at point of sale and re-estimate potential returns on a quarterly basis. For the three months and nine months ended September 30, 2014 and 2013, our estimates of returns and actual returns from initial stocking orders have not been materially different. 25 --------------------------------------------------------------------------------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 telecommunications carriers or providers for origination of their calls to 800-numbers, access fees charged to other telecommunications 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 telecommunications 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 carry-forwards 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, 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 make adjustments if available evidence indicates that it is more-likely-than-not a change in the carrying amounts is required. We decreased the valuation allowance by $0.3 million during the three and nine months ended September 30, 2014, due to the utilization of previously reserved net-operating-loss carry-forwards in our 2013 U.S. tax filings. We assess our income tax positions and record tax benefits for all years subject to examination based upon our evaluation of the facts, circumstances and information available at the reporting date. For those tax positions that we estimate there is a 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 that we estimate there is a 50% or less likelihood that a tax benefit will be sustained, no tax benefit has been recognized in the financial statements. We revised our liability for uncertain tax positions by a net decrease of ($157) thousand and a net increase of $128 thousand in the three months and nine months ended September 30, 2014, respectively. We record our income tax expense for interim financial statements by using an estimated annual effective income tax rate based on our expected annual results after elimination of nontaxable items. The tax benefits of net operating loss carry-forwards expected to be realized through 2014 and certain other deferred tax assets were recognized for financial reporting purposes at December 31, 2013. At September 30, 2014, the estimated annual effective income tax rate is expected to approximate 26.7%, excluding discrete tax items, which includes federal, foreign, and state and local taxes. This rate may fluctuate due to changes in our jurisdictional income and due to the timing of other discrete period transactions during the remainder of the year. In October 2014, we received notice from the IRS that it was going to audit the Company's 2012 and 2013 tax returns. The audit is in its early stages and we are not able to determine any potential liability as this time. 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. We account 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 statement of operations. 26 --------------------------------------------------------------------------------RESULTS OF OPERATIONS The following table presents our consolidated results of operations for the periods indicated (in thousands). The condensed 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. Three Months Ended 2014 Nine Months Ended 2014 September 30, Compared to September 30, Compared to 2014 2013 2013 2014 2013 2013 Net Revenues Sale of magicJack devices $ 3,107 $ 13,214 $ (10,107 ) (76.5 )% $ 21,586 $ 39,407 $ (17,821 ) (45.2 )% Access right renewals 16,834 14,609 2,225 15.2 48,378 42,278 6,100 14.4 Shipping and handling 356 1,085 (729 ) (67.2 ) 1,868 3,003 (1,135 ) (37.8 ) magicJack-related products 1,442 2,012 (570 ) (28.3 ) 5,870 6,596 (726 ) (11.0 ) Prepaid minutes 2,502 3,152 (650 ) (20.6 ) 7,978 9,594 (1,616 ) (16.8 ) Access and wholesale charges 1,572 1,381 191 13.8 4,919 4,418 501 11.3 Other - 80 (80 ) (100.0 ) 7 16 (9 ) (56.3 ) Total Net Revenue 25,813 35,533 (9,720 ) (27.4 ) 90,606 105,312 (14,706 ) (14.0 ) Cost of Revenues Cost of magicJack devices 1,725 4,172 (2,447 ) (58.7 ) 9,373 10,183 (810 ) (8.0 ) Shipping and handling 603 795 (192 ) (24.2 ) 1,551 1,976 (425 ) (21.5 ) Credit card processing fees 530 692 (162 ) (23.4 ) 1,980 2,044 (64 ) (3.1 ) Network and carrier charges 4,734 5,214 (480 ) (9.2 ) 15,306 16,510 (1,204 ) (7.3 ) Other 1,885 1,261 624 49.5 5,681 4,620 1,061 23.0 Total Cost of Revenues 9,477 12,134 (2,657 ) (21.9 ) 33,891 35,333 (1,442 ) (4.1 ) Gross Profit 16,336 23,399 (7,063 ) (30.2 ) 56,715 69,979 (13,264 ) (19.0 ) Operating expenses: Marketing 6,244 2,866 3,378 117.9 15,230 8,437 6,793 80.5 General and administrative 9,402 6,892 2,510 36.4 26,721 20,386 6,335 31.1 Research and development 1,494 990 504 50.9 4,613 3,626 987 27.2 Total operating expenses 17,140 10,748 6,392 59.5 46,564 32,449 14,115 43.5 Operating (loss) income (804 ) 12,651 (13,455 ) (106.4 ) 10,151 37,530 (27,379 ) (73.0 ) Other income (expense): Gains on investments - - - * 37 722 (685 ) * Interest and dividend income 13 45 (32 ) * 108 275 (167 ) * Interest expense (34 ) (65 ) 31 * (154 ) (242 ) 88 * Fair value loss on common equity put options - - - * - (1,047 ) 1,047 * Other income, net 1 15 (14 ) * 4 16 (12 ) * Total other expense (20 ) (5 ) (15 ) * (5 ) (276 ) 271 * (Loss) income before income taxes (824 ) 12,646 (13,470 ) (106.5 ) 10,146 37,254 (27,108 ) (72.8 ) Income tax (benefit) expense (823 ) 3,743 (4,566 ) * 2,559 12,257 (9,698 ) * Net (loss) income $ (1 ) $ 8,903 $ (8,904 ) (100.0 ) $ 7,587 $ 24,997 $ (17,410 ) (69.6 ) * - Not meaningful. Components of Net Revenues Our net revenues are comprised of the following sources: · Sales of the magicJack devices - represents 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; 27-------------------------------------------------------------------------------- · Access right renewals - represents 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 month 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 - represents 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 - represents revenues recognized from the 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 - represents 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 telecommunications 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 - represents primarily revenues generated by ancillary revenue sources. Components of Cost of Revenues Our cost of revenues is comprised of the following components: · Cost of magicJack devices - represents 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 and is charged to expense over the period associated with the initial six or twelve months access right period; · Shipping and handling - represents 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 directly to customers. These costs are expensed as incurred; · Credit card processing fees - represents 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 directly to customers through our website. These fees are expensed as incurred; · Network and carrier charges - represents facilities charges to establish and maintain our network as well as network usage fee charges from other telecommunications 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 - 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. 28--------------------------------------------------------------------------------THREE MONTHS ENDED SEPTEMBER 30, 2014 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2013 Net Revenues Total net revenue was $25.8 million and $35.5 million for the three months ended September 30, 2014 and 2013, respectively, representing a decrease of $9.7 million, or 27.4%. The decrease in the components of net revenues was primarily attributable to the following: · $10.1 million decrease in revenues from the sale of magicJack devices and related products primarily reflecting lower price points and lower unit sales volumes; · $0.7 million decrease in shipping and handling revenue reflecting the lower sales volumes; · $0.6 million decrease in magicJack related product revenue reflecting lower volumes; and · $0.7 million decrease in revenues from prepaid minutes resulting from lower usage levels. These decreases in components of net revenue were partially offset by a $2.2 million increase in access right renewal revenues reflecting higher average renewal rates, a higher number of devices on renewal and the impact of e-mail marketing to expiring customers. In addition, access and wholesale charges increased $0.2 million reflecting increased network access fees resulting from increased network usage. For the three months ended September 30, 2014 and 2013, sales of the magicJack devices through retail outlets represented approximately 64% and 62%, respectively, of sales of all magicJack devices sold. For the same periods, direct sales represented approximately 36% and 38%, respectively, of magicJack devices sold. For the three months ended September 30, 2014 and 2013, no retailer accounted for more than 10% of the Company's total net revenue. Cost of Revenues Total cost of revenues was $9.5 million and $12.1 million for the three months ended September 30, 2014 and 2013, respectively, representing a decrease of approximately $2.7 million, or 21.9%. This decrease in cost of revenues was primarily attributable to: (i) a $2.4 million decrease in the cost of magicJack devices resulting primarily from lower device sales volumes partially offset by higher per unit costs reflecting shorter amortization periods on the new devices, (ii) a $0.4 million combined decrease in shipping and handling costs and credit card processing fees as a result of lower sales volumes, and (iii) a $0.5 million decrease in network and carrier charges as a result of better negotiated rates with other carriers. These decreases in cost of revenues were partially offset by a $0.6 million increase in overhead allocation primarily reflecting higher personnel related costs. Operating Expenses Total operating expenses were $17.1 million and $10.7 million for three months ended September 30, 2014 and 2013, respectively, representing an increase of $6.4 million, or 59.5%. This increase in operating expenses is attributable to: (i) a $3.4 million increase in marketing expense reflecting increased media buys and marketing related spends related to the Company's brand refresh and new advertising campaigns as well as higher personnel related costs reflecting the ramp up of staff and other payroll related allocations; (ii) a $2.5 million increase in G&A expense due to several factors including higher legal fees related to legal and tax matters, an impairment charge associated with a non-compete agreement with the Company's founder, increases in customer service related costs reflecting our commitment to investing in the customer experience, as well as smaller increases in occupancy costs and insurance expense; (iii) a $0.5 million increase in R&D expenses related to the costs of new products and increased personnel related costs primarily related to allocated costs associated with new positions and stock based compensation costs. Other Expense Total other expense was $20 thousand and $5 thousand for the three months ended September 30, 2014 and 2013, respectively, representing an increase of $15 thousand. This increase in other expense was primarily due to a decrease in other income of $14 thousand for the three months ended September 30, 2014 vs. the three months ended September 30, 2013. 29 --------------------------------------------------------------------------------Income Taxes Total income tax (benefit) / expense was $(0.8) million and $3.7 million for the three months ended September 30, 2014 and 2013, respectively. The principal components of our income taxes for the three months ended September 30, 2014 and 2013 are the following (in thousands): Three Months Ended September 30, 2014 2013 (Loss) income before income taxes $ (824 ) $ 12,646 Income tax (benefit) expense (823 ) 3,743 Effective income tax rate (99.88 )% 29.60 % In the fourth quarter of 2013, we released $40.5 million of our valuation allowance against certain deferred tax assets related primarily to foreign net operating loss carry-forwards and deferred revenue that are expected to be realized in 2014, 2015 and 2016. These benefits are expected to reduce income taxes payable as realized and will not affect our effective tax rate. The effective income tax rate for the three months ended September 30, 2014 is a higher benefit than the federal statutory rate of 35% due, in part, to the inclusion of discrete tax items which includes the effect of a decrease in the Company's uncertain tax position of $157 thousand and a decrease to the valuation allowance for net operating losses previously included in the allowance of $282 thousand, in addition to the effect of an overall reduction to the 2014 estimated income tax rate. The 2014 estimated annual effective tax rate is expected to approximate 26.7%, but may fluctuate during the year due to changes in our jurisdictional income and due to the timing of other discrete period transactions. Net (loss) income As a result of the foregoing items, net (loss) / income decreased to $(1) thousand in the three months ended September 30, 2014, as compared to $8.9 million in the three months ended September 30, 2013. Net (loss) income per diluted share decreased to $(0.00) per ordinary share for the three months ended September 30, 2014, as compared to $0.48 per ordinary share in the prior year comparable period primarily as a result of decreased profitability, offset in part by a decrease of approximately 0.7 million (or 4%) in the weighted average number of diluted ordinary shares outstanding in the three months ended September 30, 2014 as compared to the prior year comparable period. NINE MONTHS ENDED SEPTEMBER 30, 2014 COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 2013 Net Revenues Total net revenue was $90.6 million and $105.3 million for the nine months ended September 30, 2014 and 2013, respectively, representing a decrease of $14.7 million, or 14.0%. The decrease in the components of net revenues was primarily attributable to the following: · $17.8 million decrease in revenues from the sale of magicJack devices primarily reflecting lower price points and sales volumes; · $1.1 million decrease in shipping and handling revenue reflecting the lower sales volumes; · $0.7 million decrease in magicJack related product revenue reflecting lower volumes; and · $1.6 million decrease in revenues from prepaid minutes resulting from lower usage levels. These decreases in components of net revenue were partially offset by a $6 million increase in access right renewal revenues reflecting higher average renewal rates, a higher number of devices on renewal and the impact of e-mail marketing to expiring customers. In addition, access and wholesale charges increased $0.5 million reflecting increased network access fees resulting from increased network usage. For the nine months ended September 30, 2014 and 2013, sales of the magicJack devices through retail outlets represented approximately 71% of sales of all magicJack devices sold. For the same periods, direct sales represented approximately 29% of magicJack devices sold. For the nine months ended September 30, 2014 and 2013, no retailer accounted for more than 10% of the Company's total net revenue. Cost of Revenues Total cost of revenues was $33.9 million and $35.3 million for the nine months ended September 30, 2014 and 2013, respectively, representing a decrease of approximately $1.4 million, or 4.1%. This decrease in cost of revenues was primarily attributable to: (i) a $0.8 million decrease in the cost of magicJack devices resulting primarily from lower device sales volumes partially offset by higher per unit costs reflecting shorter amortization periods on the new devices as well as higher broker commissions due to a $1.1 million one-time first quarter 2013 favorable settlement with a retail sales broker, (ii) a $0.5 million combined decrease in shipping and handling costs and credit card processing fees as a result of lower sales volumes partially offset by higher fees, and (iii) a $1.2 million decrease in network and carrier charges as a result of better negotiated rates with other carriers, the net favorable settlement of certain billing disputes and the continued implementation of a 2011 Federal Communications Commission ("FCC") ruling which favorably impacted the rating and pricing of some of our network traffic. 30 --------------------------------------------------------------------------------These decreases in cost of revenues were partially offset primarily by an increase in overhead allocation reflecting higher personnel related costs. Operating Expenses Total operating expenses were $46.6 million and $32.4 million for the nine months ended September 30, 2014 and 2013, respectively, representing an increase of $14.1 million, or 43.5%. This increase in operating expenses is attributable to: (i) a $6.8 million increase in marketing expense reflecting increased media buys and marketing related spends related to the Company's brand refresh and new advertising campaigns as well as higher personnel related costs reflecting the ramp up of staff and other payroll related allocations; (ii) a $6.3 million increase in G&A expense due to several factors including higher legal and professional fees related to legal and tax matters, amortization expense and an impairment charge associated with a non-compete agreement with the Company's founder, increases in customer service related costs reflecting our commitment to investing in the customer experience, as well as smaller increases in occupancy costs and insurance expense; (iii) a $1 million increase in R&D expenses related to new products costs and increased personnel related costs primarily related to allocated costs associated with new positions and stock based compensation costs. Other Expense Total other expense was $5 thousand for the nine months ended September 30, 2014 versus total other expense of $0.3 million for the nine months ended September 30, 2013, representing an increase of $0.3 million. This increase in other income was primarily due to a fair value loss on common equity put options of approximately $1.0 million in 2013 when 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 purchased. There was no such loss in 2014 as we did not repurchase shares during the nine months ended September 30, 2014. This was partially offset in part by a decrease in gains on investments of $0.7 million and a reduction of interest and dividend income of $0.2 million. During the nine months ended September 30, 2014, we sold the last of our investments in marketable equity securities realizing a gain on the sale of approximately $37 thousand. Income Taxes Total income tax expense was $2.6 million and $12.3 million for the nine months ended September 30, 2014 and 2013, respectively. The principal components of our income taxes for the nine months ended September 30, 2014 and 2013 are the following (in thousands): Nine Months Ended September 30, 2014 2013 Income before income taxes $ 10,146 $ 37,254 Income tax expense 2,559 12,257 Effective income tax rate 25.22 % 32.90 % At December 31, 2013, we released $40.5 million of our valuation allowance against certain deferred tax assets related primarily to foreign net operating loss carry-forwards and deferred revenue that are expected to be realized in 2014, 2015 and 2016. These benefits are expected to reduce income taxes payable as realized and will not affect our effective tax rate. The effective income tax rate for the nine months ended September 30, 2014 is lower than the federal statutory rate due, in part, to the net impact of increases in the effective rate for items that are not deductible for income tax purposes and state income tax expense, offset by a lower statutory tax rate on our Israeli operations, which is 26.5%. The 2014 estimated annual effective tax rate is expected to approximate 26.7%, but may fluctuate during the year due to changes in our jurisdictional income and due to the timing of other discrete period transactions. 31 --------------------------------------------------------------------------------Net income As a result of the foregoing items, net income decreased to $7.6 million in the nine months ended September 30, 2014, as compared to $25 million in the nine months ended September 30, 2013. Net income per diluted share decreased to $0.43 per ordinary share for the nine months ended September 30, 2014, as compared to $1.34 per ordinary share in the prior year comparable period as a result of decreased profitability, offset in part by a decrease of approximately 0.8 million (or 4%) in the weighted average number of diluted ordinary shares outstanding in the nine months ended September 30, 2014 as compared to the prior year comparable period due to our share repurchase program. BUSINESS TRENDS Renewal revenues have remained strong during the three and nine months ended September 30, 2014. We are encouraged by the loyalty of our existing customer base and we continue to undertake efforts to improve our customer renewal rates. Direct and retail device sales declined during the three and nine months ended September 30, 2014. We are repositioning the device with the launch of the magicJack GO and the accompanying increased promotion of the magicAPP companion service. We believe that there will continue to be solid consumer demand for our low priced, unlimited phone service, whether through our magicJack device, our magicAPP, or a combination of both. Furthermore, we are working with Telefonica to expand distribution of our product into Latin American markets where we believe that there is significant potential for growth. With the launch of the magicJack GO and the strategic shift of more fully integrating the device with the APP, we are focused during the remaining quarter of 2014 and beyond on driving sales growth through monetizing the magicAPP and integrating the full range of our product offerings including the sale of international prepaid minutes. The following factors could materially adversely affect our growth strategy to integrate the device with the APP and monetize the magicAPP: if we experience any further delays in the implementation of technical developments needed to position the magicAPP for monetization; the fact that we have not previously generated any material revenues from the magicAPP as it has been a free service to date; and the redeveloped magicAPP will, when launched, compete with other large, well-capitalized global companies in the telecom APP industry who are introducing low priced consumer offers into the marketplace on an ongoing basis. We cannot assure that the features we offer for monetization of the magicAPP will, when introduced, be attractive to consumers at the price points we offer, or at all. LIQUIDITY AND CAPITAL RESOURCES Our primary sources of liquidity are cash generated from operations and cash on hand and investments. As of September 30, 2014, we had cash and cash equivalents of $75.2 million, marketable securities of $0.4 million and accounts receivables of $3.1 million. Our accounts payable at September 30, 2014 was $7.0 million. During the nine months ended September 30, 2014, we generated positive operating cash flows of $23.5 million, as compared to $28.8 million for the nine months ended September 30, 2013. The $5.3 million decrease was primarily due to lower sales of magicJack devices in the nine months ended September 30, 2014, combined with higher operating costs offset in part by increased revenues from access right renewals. Net income was $7.6 million for the nine months ended September 30, 2014 as compared to $25 million for the nine months ended September 30, 2013. We currently believe that available funds and cash flows generated by operations will be sufficient to fund our working capital and capital expenditure requirements for at least the next twelve months. If we decide to make future acquisitions, we may require new sources of funding, including additional debt, equity financing or some combination thereof. There can be no assurances that we will be able to secure additional sources of funding or that such additional sources of funding will be available to us on acceptable terms. Cash Flow - Operating Activities Net cash provided by operating activities was $23.5 million and $28.8 million for the nine months ended September 30, 2014 and 2013, respectively. During the nine months ended September 30, 2014, net cash provided by operating activities was primarily attributable to: (i) $7.6 million of net income, (ii) $11.3 million in non-cash items consisting of $5.7 million of stock-based compensation expense, $3.8 million of depreciation and amortization expense, $2.5 million for impairment of intangible assets, and $0.4 million in an increase in the uncertain tax position partially offset by a $1.1 million decrease in the deferred income tax provision, (iii) a $2.3 million decrease in deferred costs, (iv) a $1.2 million decrease in inventory levels, (v) a $0.5 million decrease in accounts receivable, and (vi) a $2.8 million increase in accounts payable. These items were partially offset by: (i) a $0.7 million decrease in accrued expenses, (ii) a $1 million decrease in deferred revenue, and (iii) $0.4 million increase in prepaid and other current assets including prepaid income taxes. During the nine months ended September 30, 2013, net cash provided by operating activities was primarily attributable to: (i) a $25.0 million net income; (ii) $1.9 million in non-cash items consisting primarily of $3.5 million for depreciation and amortization expense, $1.6 million in share-based issuances primarily related to expense recognized for ordinary share options and restricted stock units issued to our CEO and CFO, and a $0.3 million combined net loss on common equity put options and investments, offset in part by a $3.8 million net recovery related to billing adjustments as a result of settlements with carriers; (iii) a $5.6 million decrease in accounts receivable, and (iv) a $0.8 million decrease in inventory. These items were partially offset by: (i) a $2.1 million decrease in accounts payable and accrued liabilities, and (ii) a $2.3 million decrease in deferred revenues. 32 --------------------------------------------------------------------------------Cash Flow - Investing Activities Net cash provided by investing activities was $7.2 million and $12.4 million for the nine months ended September 30, 2014, and 2013, respectively. Net cash provided by investing activities during the nine months ended September 30, 2014 was primarily attributable to $9.1 million of proceeds from sale of investments, offset in part by $1.9 million used to purchase equipment and leasehold improvements primarily due to upgrades to our data storage facility and new warehouse and distribution center. Net cash provided by investing activities during the nine months ended September 30, 2013 was primarily attributable to $12.6 million of proceeds from sale of investments, offset in part by $0.1 million used to purchase certain intangible assets and $0.1 million used to purchase equipment. Cash Flow -Financing Activities Net cash used in financing activities was $1.5 million and $7.2 million for the nine months ended September 30, 2014 and 2013, respectively. Net cash used in financing activities during the nine months ended September 30, 2014 consisted primarily of a $1.5 million annual payment in connection with an agreement entered into during June 2011 for the purchase of certain intangible assets. Net cash used in financing activities during the nine months ended September 30, 2013 consisted of: (i) $5.7 million in cash used to purchase ordinary shares as part of our stock repurchase program, and (ii) $1.5 million annual payment in connection with an agreement entered during June 2011 for the purchase of certain intangible assets. Stock Repurchase Program Our Board of Directors authorized a stock repurchase program to enable us to purchase our ordinary shares at such times as management deems appropriate up to a maximum cumulative repurchase authority of $100.0 million. The primary objective of our stock repurchase program is to improve stockholders' returns. We expended $91.3 million under our repurchase program through September 30, 2014. At September 30, 2014, there was $8.7 million remaining authorized to purchase ordinary shares pursuant to the stock repurchase program. All shares purchased and not yet retired, are recorded as treasury stock. We have bought call option contracts and have sold put option contracts in connection with our share repurchase program in order to attempt to lower the average price paid for ordinary shares we purchase. There were no outstanding put option contracts at September 30, 2014. We did not repurchase any ordinary shares under our stock repurchase program during the nine months ended September 30, 2014. Taking into consideration the proceeds received from the sale of put option contracts exercised, put option contracts that expired unexercised and the purchase price of call option contracts exercised during the nine months ended September 30, 2013, we expended approximately $3.3 million purchasing 190,000 shares of outstanding ordinary shares at an average price of $17.27 during the nine months ended September 30, 2013. Other Liabilities As of September 30, 2014, we had outstanding indebtedness in connection with an agreement entered into during June 2011 for the purchase of certain intangible assets, and secured only by such intangible assets, under which we are required to make a final non-interest bearing future annual payment of $1.5 million on May 31, 2015. The liability for such payments has been discounted at a rate of 10% to a net present value of $1.4 million at September 30, 2014. Refer to Note 8, "Other Liabilities," in the Notes to our unaudited condensed consolidated financial statements included in Item 1 for further details. 33-------------------------------------------------------------------------------- |