-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, NY5AVnnKr0OnaJBbe9G7+vZM8cABxLCeJkrSE3JkSQRYtVhBCfKPxlG0Ypa706fc w5RlguY8zqIE+svueFanWA== 0001047469-98-014032.txt : 19980408 0001047469-98-014032.hdr.sgml : 19980408 ACCESSION NUMBER: 0001047469-98-014032 CONFORMED SUBMISSION TYPE: 10-K/A PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 19971231 FILED AS OF DATE: 19980407 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: STAR TELECOMMUNICATIONS INC CENTRAL INDEX KEY: 0001026486 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE COMMUNICATIONS (NO RADIO TELEPHONE) [4813] IRS NUMBER: 770362681 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K/A SEC ACT: SEC FILE NUMBER: 000-22581 FILM NUMBER: 98589113 BUSINESS ADDRESS: STREET 1: 223 EAST DE LA GUERRA STREET STREET 2: STE 202 CITY: SANTA BARBARA STATE: CA ZIP: 93101 BUSINESS PHONE: 8058991962 MAIL ADDRESS: STREET 1: 223 EAST DE LA GUERRA STREET CITY: SANTA BARBARA STATE: CA ZIP: 93101 10-K/A 1 10-K/A - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-K/A (AMENDMENT NO. 1) (MARK ONE) /X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER 000-22581 ------------------------ STAR TELECOMMUNICATIONS, INC. (Exact name of registrant as specified in its charter) DELAWARE 77-0362681 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 223 EAST DE LA GUERRA STREET, 93101 SANTA BARBARA, CALIFORNIA (Zip code) (Address of principal executive offices)
(805) 899-1962 (Registrant's telephone no., including area code) Securities registered pursuant to Section 12(b) of the Act: Common Stock, par value $0.001 per share Name of each exchange on which registered: Nasdaq National Market Securities registered pursuant to Section 12(g) of the Act: None Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES _X_ NO ____ Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. / / The aggregate market value of the Common Stock of the Registrant held by non-affiliates of the Registrant on March 16, 1998, based on the average bid and asked prices for the Common Stock as reported by Nasdaq was approximately $438,892,650. The number of shares of the Registrant's Common Stock outstanding as of March 16, 1998 was approximately 35,804,000 shares. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- The undersigned Registrant hereby amends the following items of its Annual Report on Form 10-K for the fiscal year ended December 31, 1997, as set forth below: PART I ITEM 1. BUSINESS. THIS ANNUAL REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997 (THE "FORM 10-K") CONTAINS "FORWARD-LOOKING STATEMENTS," AS DEFINED UNDER SECTION 27A OF THE SECURITIES ACT OF 1933, AS AMENDED (THE "SECURITIES ACT") AND SECTION 21E OF THE SECURITIES EXCHANGE ACT OF 1934, AS AMENDED (THE "EXCHANGE ACT"). FORWARD-LOOKING STATEMENTS ARE STATEMENTS OTHER THAN HISTORICAL INFORMATION OR STATEMENTS OF CURRENT CONDITION AND RELATE TO FUTURE EVENTS OR THE FUTURE FINANCIAL PERFORMANCE OF THE COMPANY. SOME FORWARD-LOOKING STATEMENTS MAY BE IDENTIFIED BY USE OF SUCH TERMS AS "BELIEVES," "ANTICIPATES," "INTENDS" OR "EXPECTS." THE COMPANY'S ACTUAL RESULTS MAY DIFFER SIGNIFICANTLY FROM THE RESULTS DISCUSSED IN THE FORWARD-LOOKING STATEMENTS. THE COMPANY UNDERTAKES NO OBLIGATION TO PUBLICLY UPDATE OR REVISE ANY FORWARD-LOOKING STATEMENTS, WHETHER AS A RESULT OF NEW INFORMATION, FUTURE EVENTS OR OTHERWISE. UNLESS OTHERWISE INDICATED, THE INFORMATION IN THIS FORM 10-K GIVES EFFECT TO A 2.05-FOR-1 STOCK SPLIT PAYABLE IN THE FORM OF A STOCK DIVIDEND TO THE HOLDERS OF ALL SHARES OF COMMON STOCK OUTSTANDING ON FEBRUARY 20, 1998 WITH THE PAYMENT OF 1.05 SHARES FOR EACH SUCH OUTSTANDING SHARE OF COMMON STOCK (THE "STOCK SPLIT"). OVERVIEW STAR Telecommunications, Inc. ("STAR" or the "Company") is an emerging multinational carrier focused primarily on the international long distance market. The Company offers highly reliable, low-cost switched voice services on a wholesale basis, primarily to U.S.-based long distance carriers. STAR provides international long distance service to approximately 220 foreign countries through a flexible network comprised of various foreign termination relationships, international gateway switches, leased and owned transmission facilities and resale arrangements with long distance providers. The Company has grown its revenues rapidly by capitalizing on the deregulation of international telecommunications markets, combining sophisticated information systems with flexible routing and leveraging management's industry expertise. STAR has increased its revenues from $46.3 million in 1995 to $376.2 million in 1997. INDUSTRY BACKGROUND The international long distance telecommunications services industry consists of all transmissions of voice and data that originate in one country and terminate in another. This industry is undergoing a period of fundamental change which has resulted in substantial growth in international telecommunications traffic. According to industry sources, worldwide gross revenues for providers of international telephone service were over $60 billion in 1996 and the volume of international traffic on the public telephone network is expected to grow at a compound annual growth rate of approximately 13% from 1996 through the year 2000. From the standpoint of U.S.-based long distance providers, the industry can be divided into two major segments: the U.S. international market, consisting of all international calls billed in the U.S., and the overseas market, consisting of all international calls billed in countries other than the U.S. The U.S. international market has experienced substantial growth in recent years, with gross revenues from international long distance services rising from approximately $8.5 billion in 1990 to approximately $14.9 billion in 1996, according to Federal Communications Commission ("FCC") data. The Company believes that a number of trends in the international telecommunications market will continue to drive growth in international traffic, including: - continuing deregulation and privatization of telecommunications markets; - pressure to reduce international outbound long distance rates paid by end users driven by increased competition in newly deregulated global markets; - the dramatic increase in the availability of telephones and the number of access lines in service around the world; - the increasing globalization of commerce, trade and travel; 2 - the proliferation of communications devices such as faxes, cellular telephones, pagers and data communications devices; - increasing demand for data transmission services, including the Internet; and - the increased utilization of high quality digital undersea cable and resulting expansion of bandwidth availability. THE DEVELOPMENT OF THE U.S. AND OVERSEAS MARKETS The 1984 deregulation of the U.S. telecommunications industry enabled the emergence of a number of new long distance companies in the U.S. Today, there are over 500 U.S. long distance companies, most of which are small or medium-sized companies. In order to be successful, these small and medium-sized companies need to offer their customers a full range of services, including international long distance. However, most of these carriers do not have the critical mass to receive volume discounts on international traffic from the larger facilities-based carriers such as AT&T Corp. ("AT&T"), MCI Communications Corp. ("MCI") and Sprint Corporation ("Sprint"). In addition, these small and medium-sized companies generally have only limited capital resources to invest in international facilities. New international carriers such as STAR emerged to take advantage of this demand for less expensive international bandwidth. These emerging multinational carriers acted as aggregators of international traffic for smaller carriers, taking advantage of larger volumes to obtain volume discounts on international routes (resale traffic), or investing in facilities when volume on particular routes justify such investments. Over time, as these emerging international carriers became established and created high quality networks, they began to carry overflow traffic from the larger long distance providers seeking lower rates on certain routes. Deregulation and privatization have also allowed new long distance providers to emerge in foreign markets. By eroding the traditional monopolies held by single national providers, many of which are wholly or partially government owned, such as Post Telegraph & Telephone operators ("PTTs"), deregulation is providing U.S.-based providers the opportunity to negotiate more favorable agreements with PTTs and emerging foreign providers. In addition, deregulation in certain foreign countries is enabling U.S.-based providers to establish local switching and transmission facilities in order to terminate their own traffic and begin to carry international long distance traffic originated in that country. STAR believes that growth of traffic originated in markets outside of the U.S. will be higher than the growth in traffic originated within the U.S. due to recent deregulation in many foreign markets, relative economic growth rates and increasing access to telecommunications facilities in emerging markets. INTERNATIONAL SWITCHED LONG DISTANCE SERVICES International switched long distance services are provided through switching and transmission facilities that automatically route calls to circuits based upon a predetermined set of routing criteria. The call typically originates on a local exchange carrier's network and is transported to the caller's domestic long distance carrier. The domestic long distance provider then carries the call to an international gateway switch. An international long distance provider picks up the call at its gateway and sends it directly or through one or more other long distance providers to a corresponding gateway switch operated in the country of destination. Once the traffic reaches the country of destination, it is then routed to the party being called though that country's domestic telephone network. International long distance providers can generally be categorized by their ownership and use of switches and transmission facilities. The largest U.S. carriers, such as AT&T, MCI and Sprint, primarily utilize owned transmission facilities and generally use other long distance providers to carry their overflow traffic. Since only very large carriers have transmission facilities that cover the over 200 countries to which major long distance providers generally offer service, a significantly larger group of long distance providers own and operate their own switches but either rely solely on resale agreements with other long distance carriers to terminate their traffic or use a combination of resale agreements and owned facilities in order to terminate their traffic as shown below: 3 [THIRD PARTY RESALE GRAPHIC] OPERATING AGREEMENTS. Under traditional operating agreements, international long distance traffic is exchanged under bilateral agreements between international long distance providers in two countries. Operating agreements provide for the termination of traffic in, and return traffic to, the international long distance providers' respective countries at a standard "accounting rate" with that international provider. Under a traditional operating agreement, the international long distance provider that originates more traffic compensates the long distance provider in the other country by paying a net amount based on the difference between minutes sent and minutes received and the settlement rate, which is generally one-half of the accounting rate. Under a typical operating agreement both carriers jointly own the transmission facilities between two countries. A carrier gains ownership rights in a digital fiber optic cable by purchasing direct ownership in a particular cable prior to the time the cable is placed in service, acquiring an "Indefeasible Right of Use" ("IRU") in a previously installed cable, or by leasing or obtaining capacity from another long distance provider that either has direct ownership or IRUs in the cable. In situations where a long distance provider has sufficiently high traffic volume, routing calls across directly owned or IRU cable is generally more cost-effective on a per call basis than the use of short-term variable capacity arrangements with other long distance providers or leased cable. However, direct ownership and acquisition of IRUs require a company to make an initial investment of its capital based on anticipated usage. TRANSIT ARRANGEMENTS. In addition to utilizing an operating agreement to terminate traffic delivered from one country directly to another, an international long distance provider may enter into transit arrangements pursuant to which a long distance provider in an intermediate country carries the traffic to a country of destination. Such transit arrangements involve agreement among the providers in all the countries involved and are generally used for overflow traffic or where a direct circuit is unavailable or not volume justified. RESALE ARRANGEMENTS. Resale arrangements typically involve the wholesale purchase and sale of transmission and termination services between two long distance providers on a variable, per minute basis. The resale of capacity, which was first permitted in the U.S. market in the 1980s enabled the emergence of new international long distance providers that rely at least in part on capacity acquired on a wholesale basis from other long distance providers. International long distance calls may be routed through a facilities-based carrier with excess capacity, or through multiple long distance resellers between the originating long distance provider and the facilities-based carrier that ultimately terminates the traffic. Resale arrangements set per minute prices for different routes, which may be guaranteed for a set time period or subject to fluctuation following notice. The resale market for international capacity is constantly changing, as new long distance resellers emerge and existing providers respond to fluctuating costs and competitive 4 pressures. In order to be able to effectively manage costs when utilizing resale arrangements, long distance providers need timely access to changing market data and must quickly react to changes in costs through pricing adjustments or routing decisions. ALTERNATIVE TERMINATION ARRANGEMENTS. As the international telecommunications market has become deregulated, service providers have developed alternative arrangements to reduce their termination costs by, for example, routing traffic via third countries to obtain lower settlement rates or using international private line facilities to bypass the settlement rates applicable to traffic routed over the public switched telephone network ("PSTN"). These arrangements include International Simple Resale ("ISR"), traffic refiling and the acquisition of transmission and switching facilities in foreign countries so as to self-correspond. Refiling of traffic takes advantage of disparities in settlement rates between different countries. An originating operator typically refiles traffic by sending it first to a third country that enjoys lower settlement rates with the destination country where upon it is forwarded or refiled to the destination country thereby resulting in a lower overall termination cost. The difference between transit and refiling is that, with respect to transit, the operator in the destination country typically has a direct relationship with the originating operator and is aware of the arrangement, while with refiling, the operator in the destination country typically is not aware that it is terminating refiled traffic originated in another country. While the United States has taken no position with respect to whether refile comports with international regulation, refile is illegal in many countries. With ISR, a long distance provider completely bypasses the settlement system by connecting an international private line ("IPL") to the PSTN on one or both ends. While ISR currently is only sanctioned by U.S. and other regulatory authorities on some routes, ISR services are increasing and are expected to expand significantly as deregulation of the international telecommunications market continues. In addition, new market access agreements, such as the World Trade Organization ("WTO") Basic Telecommunications Agreement (the "WTO Agreement"), have made it possible for many international service providers to establish their own transmission and switching facilities in certain foreign countries, enabling them to self-correspond and directly terminate traffic. See "--Government Regulation." The highly competitive and rapidly changing international telecommunications market has created a significant opportunity for carriers that can offer high quality, low cost international long distance service. Deregulation, privatization, the expansion of the resale market and other trends influencing the international telecommunications market are driving decreased termination costs, a proliferation of routing options, and increased competition. Successful companies among both the emerging and established international long distance companies will need to aggregate enough traffic to lower costs of both facilities-based or resale opportunities, maintain systems which enable analysis of multiple routing options, invest in facilities and switches and remain flexible enough to locate and route traffic through the most advantageous routes. THE STAR APPROACH STAR is an emerging multinational carrier focused primarily on the international long distance market. The Company offers highly reliable, low-cost switched voice services on a wholesale basis, primarily to U.S.-based long distance carriers. STAR provides international long distance service to approximately 220 foreign countries through a flexible network comprised of various foreign termination relationships, international gateway switches, leased and owned transmission facilities and resale arrangements with long distance providers. The Company has grown its revenues rapidly by capitalizing on the deregulation of international telecommunications markets, combining sophisticated information systems with flexible routing and leveraging management's industry expertise. STAR markets its services to large global carriers seeking lower rates and high quality overflow capacity, as well as to small and medium-sized long distance companies that do not have the critical mass to invest in their own international transmission facilities or to obtain volume discounts from the larger facilities-based carriers. During the fourth quarter of 1997, the Company provided switched international 5 long distance services to 105 customers and currently provides these services to nine of the top forty global carriers. The Company has also recently focused on building a customer base overseas, particularly in Europe, and has opened offices in Dusseldorf, Frankfurt, Hamburg and Munich, Germany and London, England. In addition, STAR has begun to market its international long distance services directly to certain commercial customers in the U.S. and overseas. STRATEGY The Company's objective is to be a leading provider of highly reliable, low-cost switched international long distance services on a wholesale basis to U.S. and foreign-based telecommunications companies, as well as on a retail basis to commercial customers. Key elements of the Company's strategy include the following: EXPAND SWITCHING AND TRANSMISSION FACILITIES. The Company is continuing to pursue a flexible approach to expanding and enhancing its network facilities by investing in both switching and transmission facilities where traffic volumes justify such investments. The Company has expanded its international gateway switching facilities through the addition of a facility in Dallas and plans to put into service in 1998 switches in Atlanta, Chicago, Miami and Seattle; Dusseldorf, Frankfurt, Hamburg and Munich, Germany; Paris, France; and Tokyo, Japan. The Company's international gateway switch in London, England went into service in April 1997 and four switches in Germany are expected to be operational in the second quarter of 1998. In addition, the Company is planning to install a network of switches in selected other European and Asian cities. CAPITALIZE ON PROJECTED INTERNATIONAL LONG DISTANCE GROWTH. The Company believes that the international long distance market provides attractive opportunities due to its higher revenue and profit per minute, and greater projected growth rate as compared to the domestic long distance market. The Company targets international markets with high volumes of traffic, relatively high rates per minute and prospects for deregulation and privatization. The Company believes that the ongoing trend toward deregulation and privatization will create new opportunities for the Company in international markets. Although the Company has focused to date primarily on providing services for U.S.-based long distance providers, the Company also intends to expand the international long distance services it offers to foreign-based long distance providers. LEVERAGE TRAFFIC VOLUME TO REDUCE COSTS. The Company continues to focus on building its volume of international long distance traffic. Higher traffic volumes strengthen the Company's negotiating position with vendors, customers and potential foreign partners, which allows the Company to lower its costs of service. In addition, higher traffic volumes on particular routes allow the Company to lower its cost of services on these routes by transitioning from acquiring capacity on a variable cost per minute basis to fixed cost arrangements such as longer-term capacity agreements with major carriers, long-term leases and ownership of facilities. LEVERAGE INFORMATION SYSTEMS AND SWITCHING CAPABILITIES. The Company leverages its sophisticated information systems to analyze its routing alternatives, and select the most cost-effective routing from among the Company owned facilities, network of resale arrangements with other long distance providers, operating agreements and alternative termination relationships. The Company has invested significant resources in the development of software to track specific usage information by customer and revenue and cost information on specific routes on a daily basis. The Company's information systems are critical components in managing its customer and vendor relationships, routing traffic to the most cost-effective alternative, and targeting its marketing efforts. MAINTAIN HIGH QUALITY. The Company believes that reliability, call completion rates, voice quality, rapid set up time and a high level of customer and technical support are key factors evaluated by U.S. and foreign-based telecommunications companies and large corporate customers in selecting a carrier for their 6 international traffic. The Company's state-of-the-art switching equipment is fully compliant with international C-7 and domestic SS-7 signaling standards. STAR strives to provide a consistently high level of customer and technical support and has technical support personnel at its switching facilities 24 hours per day, seven days per week to assist its customers and to continually monitor network operations. EXPAND INTO COMMERCIAL MARKET. The Company plans to expand into niche commercial markets in the U.S. and in other deregulating countries where it believes it can leverage its international network and where the customer base has a significant international calling pattern. The Company recently acquired L.D. Services, Inc. ("LDS") and intends to acquire United Digital Network, Inc. ("UDN"). The Company is using the LDS telemarketing sales force to target small commercial customers in ethnic markets to increase traffic to Mexico and Latin America. Additionally, STAR intends to use UDN's network of independent sales agents to target medium-sized commercial customers with a demand for international calling services at competitive rates. Finally, the Company plans to use its direct sales forces to target larger commercial customers, concentrating at first on potential customers in Los Angeles and New York. With respect to the offering of commercial services abroad, the Company initially intends to focus on Germany, the U.K. and selected European cities where competition for commercial customers is less mature. GROWTH THROUGH ACQUISITIONS. The Company actively pursues opportunities to enhance its business through strategic and synergistic acquisitions. These acquisitions may focus on entering new territories, enlarging the Company's presence in an existing territory, adding capacity or expanding into new market segments, such as the commercial market. In addition to expanding its revenue base, the Company plans to realize operating efficiencies by integrating newly-acquired operations into the Company's billing, tracking and other systems. On November 30, 1997, the Company acquired LDS, a long distance provider focusing on small commercial customers throughout the United States, for approximately 849,000 shares of Common Stock. On March 10, 1998, the Company acquired T-One Corp. ("T-One"), an international wholesale long distance provider, for 1,353,000 shares of Common Stock. On November 19, 1997, the Company entered into an agreement to acquire UDN, a commercial long distance provider. The acquisition of UDN is subject to approval by UDN's stockholders and to various regulatory approvals. Assuming the receipt of all necessary approvals, STAR expects to consummate the UDN acquisition in the second quarter of 1998 for approximately 800,000 shares of Common Stock. Each of these transactions has been, or will be, accounted for as a pooling of interests. NETWORK The Company provides international long distance services to approximately 220 foreign countries through a flexible, switched-based network consisting of resale arrangements with other long distance providers, various foreign termination relationships, international gateway switches and leased and owned transmission facilities. The Company's network employs state-of-the-art digital switching and transmission technologies and is supported by comprehensive monitoring and technical support personnel. The Company's switching facilities are staffed 24 hours per day, seven days per week. TERMINATION ARRANGEMENTS The Company seeks to retain flexibility and maximize its termination opportunities by utilizing a continuously changing mix of routing alternatives, including resale arrangements, operating agreements and other advantageous termination arrangements. This diversified approach is intended to enable the Company to take advantage of the rapidly evolving international telecommunications market in order to provide low-cost international long distance service to its customers. STAR utilizes resale arrangements to provide it with multiple options for routing traffic through its switches to each destination country. Traffic under resale arrangements typically terminates pursuant to a third party's correspondent relationships. The Company purchased capacity from 57 vendors in 1997. A substantial portion of this capacity is obtained on a variable, per minute and short-term basis, subjecting the Company to the possibility of unanticipated price increases and service cancellations. The Company's 7 contracts with its vendors provide that rates may fluctuate, with rate change notice periods varying from five days to one year, with certain of the Company's longer term arrangements requiring STAR to make minimum usage commitments in order to achieve additional volume discounts. As a result of deregulation and competition in the international telecommunications market, the pricing of termination services varies by carrier depending on such factors as call traffic and time of day. Since the Company does not typically enter into long-term contracts with these providers, pricing can change significantly over short periods of time. The Company's proprietary information systems enable the Company to track the pricing variations in the international telecommunications market on a daily basis, allowing the Company's management to locate and reroute traffic to the most cost-effective alternatives. See "Risk Factors--Operating Results Subject to Significant Fluctuations." The Company currently has operating agreements with carriers in a number of countries and is in the process of negotiating additional operating agreements for other countries. The Company has been and will continue to be selective in entering into operating agreements. The Company also has agreements with international providers of long distance services for termination of traffic that the Company routes over its network to such countries. The Company currently has such termination arrangements with several carriers in a number of countries, and STAR is in the process of expanding its coverage of such countries and entering into similar arrangements in additional countries. The FCC or foreign regulatory agencies may take the view that certain of the Company's termination arrangements do not comply with current rules and policies applicable to international settlements, such as current ISR rules. To the extent that the revenue generated under such arrangements becomes a significant portion of overall revenue, the loss of such arrangements, whether as a result of regulatory actions or otherwise, could have a material adverse effect on the Company's business, operating results and financial condition. In addition, the FCC could impose sanctions on the Company, including forfeitures, if certain of the Company's arrangements are found to be inconsistent with FCC rules. See "--Government Regulation," "Risk Factors--Risks of International Telecommunications Business," and "--Potential Adverse Effects of Government Regulation." SWITCHES AND TRANSMISSION FACILITIES International long distance traffic to and from the U.S. is generally transmitted through an international gateway switching facility across undersea digital fiber optic cable or via satellite to a termination point. International gateway switches are digital computerized routing facilities that receive calls, route calls through transmission lines to their destination and record information about the source, destination and duration of calls. STAR's global network facilities include both international gateway switches and undersea digital fiber optic cable. The Company currently operates international gateway switches in New York, Los Angeles, Dallas and London, England. In 1998, the Company plans to put into service international gateway switches in Atlanta, Chicago, Miami and Seattle; Dusseldorf, Frankfurt, Hamburg and Munich, Germany; Paris, France; and Tokyo, Japan. The Company considers any of its switches to be international gateway switches if the Company can route international calls across such switch. STAR's switching facilities are linked to a proprietary reporting system, which the Company believes provides it with a competitive advantage by permitting management on a real-time basis to determine the most cost-effective termination alternatives, monitor customer usage and manage gross margins by route. The Company has installed multiple redundancies into its switching facilities to decrease the risk of a network failure. For example, the Company employs both battery and generator power back-up and has installed hardware that automatically shifts the system to auxiliary power during a power outage, rather than relying on manual override. STAR is in the process of adding a network control center in its Los Angeles facility, which is expected to be completed in 1998. The Company currently holds ownership positions in a number of digital undersea fiber optic cables, and has recently added capacity on the TPC-5 undersea fiber optic cable system and has entered into 8 commitments to acquire transmission capacity on three additional undersea fiber optic cable systems, Gemini, AC-1 and China-US. The Company plans to increase its investment in direct and IRU ownership of cable in situations where the Company enters into operating agreements and in other situations in which it determines that such an investment would enhance operating efficiency or reduce transmission costs. Through its acquisitions of T-One and UDN, STAR has acquired, or will acquire, additional switching and transmission facilities. By acquiring T-One, the Company has added a switch located in the same building as the Company's New York international gateway switch and has added a number of operating agreements to countries in Africa and the Middle East, among other locations. In addition, T-One owns capacity on certain cable and satellite systems. Upon consummation of the acquisition of UDN, the Company will acquire a switch located in the same building as the Company's Dallas switch. The Company plans to integrate these facilities into its existing network. SALES AND MARKETING The Company markets its services on a wholesale basis to other telecommunications companies through its experienced direct sales force and marketing/account management team who leverage the long-term industry relationships of the Company's senior management. The Company reaches its customers primarily through domestic and international trade shows and through relationships gained from years of experience in the telecommunications industry. The Company had 20 direct sales and marketing employees and over 145 telemarketing representatives as of March 1, 1998. In the wholesale market, the Company's sales and marketing employees utilize the extensive, customer specific usage reports and network utilization data generated by the Company's sophisticated information systems to effectively negotiate agreements with customers and prospective customers and to rapidly respond to changing market conditions. The Company believes that it has been able to compete more effectively as a result of the personalized service and ongoing senior management-level attention that is given to each customer. In connection with the Company's expansion into the commercial market, the Company expects to target small commercial customers through LDS' existing telemarketing operation, deliver services to medium-sized commercial customers through UDN's network of independent sales agents and utilize a direct sales force to approach larger commercial accounts. Establishment of a sales force capable of effectively expanding the Company's services into the commercial market can be expected to require substantial efforts and management and financial resources and may increase the Company's operating costs. See "Risk Factors--Risks Associated with Growth of Telecommunications Network and Customer Base." INFORMATION AND BILLING SYSTEMS The Company's operations use advanced information systems including call data collection and call data storage linked to a proprietary reporting system. The Company also maintains redundant billing systems for rapid and accurate customer billing. STAR's switching facilities are linked to a proprietary reporting system, which the Company believes provides it with a competitive advantage by permitting management on a real-time basis to determine the most cost-effective termination alternatives, monitor customer usage and manage gross margins by route. The Company's systems also enable it to ensure accurate and timely billing and to reduce routing errors. As the Company's systems were designed for the wholesale marketplace, the Company is currently in the process of modifying its systems in anticipation of its entrance into the commercial marketplace. 9 The Company's proprietary reporting software compiles call, price and cost data into a variety of reports which the Company can use to re-program its routes on a real-time basis. The Company's reporting software can generate the following reports as needed: - customer usage, detailing usage by country and by time period within country, in order to track sales and rapidly respond to any loss of traffic from a particular customer; - country usage, subtotaled by vendor or customer, which assists the Company with route and network planning; - vendor rates, through an audit report that allows management to determine at a glance which vendors have the lowest rates for a particular country in a particular time period; - vendor usage by minute, enabling the Company to verify and audit vendor bills; - dollarized vendor usage to calculate the monetary value of minutes passed to the Company's vendors, which assists with calculating operating margin when used in connection with the customer reports; - loss reports used to rapidly highlight routing alternatives that are operating at a loss as well as identifying routes experiencing substantial overflow; and - LATA (Domestic Call Area) reporting by originating and terminating LATA, allowing for accurate Local Exchange charge audits, and protecting from Local Exchange overcharging. STAR has built multiple redundancies into its billing and call data collections systems. Nine call collector computers receive call information in real-time, immediately duplicating data, sending one copy to billing, while the other copy is used for customer service internally and for traffic analysis. STAR maintains two independent and redundant billing systems in order to both verify billing internally and to ensure that bills are sent out on a timely basis. All of the call data, and resulting billing data, are continuously backed up on tape drives and redundant storage devices, and are regularly transported to an off-site safe location. COMPETITION The international telecommunications industry is intensely competitive and subject to rapid change. The Company's competitors in the international wholesale switched long distance market include large, facilities-based multinational corporations and PTTs, smaller facilities-based providers in the U.S. and overseas that have emerged as a result of deregulation, switched-based resellers of international long distance services and international joint ventures and alliances among such companies. International wholesale switched long distance providers compete on the basis of price, customer service, transmission quality, breadth of service offerings and value-added services. The Company also competes abroad with a number of dominant telecommunications operators that previously held various monopolies established by law over the telecommunications traffic in their countries. See "Risk Factors--Significant Competition." Additionally, the telecommunications industry is in a period of rapid technological evolution, marked by the introduction of competitive new product and service offerings, such as the utilization of the Internet for international voice and data communications. The Company is unable to predict which of many possible future product and service offerings will be important to maintain its competitive position or what expenditures will be required to develop and provide such products and services. The Company believes that it competes favorably on the basis of price, transmission quality and customer service. The number of the Company's competitors is likely to increase as a result of the new competitive opportunities created by the WTO Agreement. Further, under the terms of the WTO Agreement, the United States and the other 68 countries participating in the Agreement have committed to open their telecommunications markets to competition, and foreign ownership and adopt measures to protect against anticompetitive behavior, effective starting on February 5, 1998. As a result, the Company believes that competition will continue to 10 increase, placing downward pressure on prices. Such pressure could adversely affect the Company's gross margins if the Company is not able to reduce its costs commensurate with such price reductions. COMPETITION FROM DOMESTIC AND INTERNATIONAL COMPANIES AND ALLIANCES. A majority of the U.S.-based international telecommunications services revenue is currently generated by AT&T, MCI and Sprint. The Company also competes with WorldCom, Inc. ("WorldCom"), Pacific Gateway Exchange, Inc. and other U.S.-based and foreign long distance providers, including the Regional Bell Operating Companies ("RBOCs"), which presently have FCC authority to resell and terminate international telecommunication services. Many of these companies have considerably greater financial and other resources and more extensive domestic and international communications networks than the Company. The Company's business would be materially adversely affected to the extent that a significant number of such customers limit or cease doing business with the Company for competitive or other reasons. Consolidation in the telecommunications industry could not only create even larger competitors with greater financial and other resources, but could also adversely affect the Company by reducing the number of potential customers for the Company's services. EXPANSION INTO COMMERCIAL MARKET. With the acquisition of LDS, STAR began providing long distance service to the commercial market, a market that is subject to intense competition from a number of well capitalized companies. The commercial market is also characterized by the lack of customer loyalty, with commercial customers regularly changing service providers. There can be no assurance that STAR will be able to compete successfully in the commercial market. GOVERNMENT REGULATION The Company's U.S. interstate and international telecommunications service offerings generally are subject to the regulatory jurisdiction of the FCC. Certain telecommunication services offered by the Company in the U.S. may also be subject to the jurisdiction of state regulatory authorities, commonly known as public utility commissions ("PUCs"). The Company's telecommunications service offerings outside the U.S. are also generally subject to regulation by national regulatory authorities. In addition, U.S. and foreign regulatory authorities may affect the Company's international service offerings as a result of the termination or transit arrangements associated therewith. U.S. or foreign regulatory authorities may take actions or adopt regulatory requirements which could adversely affect the Company. See "Risk Factors--Potential Adverse Effect of Government Regulation." U.S. REGULATION The Company's business is subject to various U.S. and foreign laws, regulations, agency actions and court decisions. The Company's U.S. international telecommunications service offerings are subject to regulation by the FCC. The FCC requires international carriers to obtain authorization under Section 214 of the Communications Act of 1934, as amended (the "Communications Act") prior to acquiring international facilities by purchase or lease, or providing international service to the public. Prior FCC approval is also required to transfer control of a certificated carrier. The Company is also subject to FCC policies and rules that regulate the manner in which international telecommunication services may be provided, including, for instance, the circumstances under which a carrier may provide international switched services using IPL facilities and under which it may route traffic through third countries to or from its final destination. The Communications Act and the FCC's rules and policies also impose certain other obligations on carriers providing international telecommunication services. These include the obligation to file at the FCC and to maintain tariffs containing the rates, terms and conditions applicable to their services; to file certain reports regarding international traffic and facilities; to file certain contracts with correspondent carriers; to disclose affiliations with foreign carriers and significant foreign ownership interests; to pay certain regulatory fees based, among other things, upon the carrier's revenues and ownership of international transmission capacity. 11 INTERNATIONAL SERVICES. FCC rules require the Company to obtain prior FCC authorization to acquire and operate international communication circuits in satellites and undersea fiber optic cables; similar FCC authority is required for the Company to resell such capacity. The Company holds both facilities-based and resale international authorizations, including a "global" authorization that provides broad authority to offer switched and private line international services. The Company has filed tariffs for international services with the FCC. FCC INTERNATIONAL PRIVATE LINE RESALE POLICY. The FCC's IPL resale policy limits the conditions under which a carrier may connect IPLs to the PSTN at one or both ends to provide switched services, commonly known as ISR. A carrier generally may only offer ISR services to a foreign country if the FCC has found (a) the country is a member of the WTO and at least 50% of the U.S. billed and settled traffic to that country is settled at or below the benchmark settlement rate adopted by the FCC in IB Docket No. 96-261; or (b) the country is not a WTO member, but it offers U.S. carriers equivalent opportunities to engage in ISR and at least 50% of the U.S. billed and settled traffic is settled at or below the applicable benchmark. Settled traffic refers to traffic subject to an accounting rate agreement between U.S. and foreign carriers. An accounting rate is a per minute wholesale charge negotiated by international carriers for terminating traffic in either direction. Each carrier is paid a settlement rate for terminating traffic on its own network which ordinarily is one-half of the accounting rate. The Company's FCC authority currently permit it to provide ISR service to Canada, the U.K., Sweden, New Zealand, Australia and the Netherlands. The FCC is currently reviewing U.S. carrier applications to provide ISR to Belgium, Chile, Denmark, Finland, France, Germany, Hong Kong, Norway and Luxembourg, among other routes, and upon grant of any such ISR application to a given country, the FCC's rules also would permit the Company to provide ISR service to that country. Certain of the Company's termination arrangements with foreign operators involve IPL arrangements which may be inconsistent with the foregoing FCC IPL resale policy and the Company's existing ISR authorization. If the FCC were to determine, by its own actions or in response to the filing of a third party that any of the Company's IPL arrangements violate its ISR policy or the Company's ISR authorization, the FCC could order the Company to terminate any non-conforming arrangements. In addition, the Company could be subject to a monetary forfeiture and to other penalties, including the revocation of the Company's FCC authorizations to operate as an international carrier. Any such FCC action could have a material adverse effect upon the Company's business, operating results and financial condition. FCC INTERNATIONAL SETTLEMENTS POLICY. The FCC's International Settlement Policy ("ISP") places limits on the arrangements which U.S. international carriers may enter into with foreign carriers for exchanging public switched telecommunications traffic, which the FCC terms International Message Telephone Service ("IMTS"). The policy does not apply to ISR services. The ISP is primarily intended to deter dominant foreign carriers from discriminating amongst competing U.S. carriers by, for example, favoring the foreign carrier's U.S. affiliate. Absent FCC consent, the ISP requires that U.S. carriers receive an equal share of the accounting rate (i.e., that settlement rates be equivalent) and receive inbound traffic in proportion to the volume of U.S. outbound traffic which they generate. The ISP and other FCC policies also prohibit a U.S. carrier from offering or accepting a "special concession" from a foreign carrier where the foreign carrier possess sufficient market power on the foreign end of the route to affect competition adversely in the U.S. market. A "special concession" is defined by the FCC as an exclusive arrangement involving services, facilities or functions on the foreign end of a U.S. international route which are necessary for providing basic telecommunications which are not offered to similarly situated U.S. carriers authorized to serve that route. U.S. international carriers wishing to establish settlement arrangements for IMTS which do not comply with the ISP must obtain a waiver of the FCC's rules or a declaratory ruling from the FCC under the FCC's "flexibility" policy that the non-standard arrangement is in the public interest. FCC policy provides that a request by a U.S. international carrier to establish a non-standard settlement arrangement with a foreign carrier in a WTO member country is presumptively in the public interest, and that said presumption generally may be overcome only by a demonstration that the foreign carrier is not subject to competition in its home market from more than one facilities-based international 12 carrier. Notwithstanding the FCC's ISP waiver and flexibility policies, it is possible that the FCC could find that certain of the Company's arrangements with foreign operators were or are inconsistent with the ISP and that the Company has not requested prior FCC authority therefore. If the FCC were to determine by its own actions or in response to the filing of a third party that the Company has violated the ISP, the FCC could order the Company to terminate any non-conforming arrangement. In addition, the Company could be subject to a monetary forfeiture and to other penalties, including revocation of the Company's FCC authorizations to operate as an international carrier. Any such FCC action could have a material adverse effect upon the Company's business, operating results and financial condition. The FCC's policies also require U.S. international carriers providing IMTS to negotiate and adopt settlement rates with foreign correspondents for IMTS which are at or below certain benchmark rates beginning January 1, 1999 for high income countries. U.S. international carriers must establish IMTS settlement rates at or below the benchmark rate with any foreign affiliate beginning April 1, 1998. The Company expects that any IMTS operating agreement which it has or may have with a foreign affiliate will satisfy the foregoing benchmarks requirement. The Company currently has IMTS operating agreements with certain foreign correspondents which provide for settlement rates above the FCC's prescribed benchmarks. The Company will negotiate in good faith to establish IMTS settlement rates with its foreign correspondents which satisfy the FCC's benchmarks but there can be no assurance that such negotiations will succeed. The FCC's order adopting the foregoing settlement benchmarks and the timetable therefor is currently being reconsidered by the FCC. Several foreign telecommunications carriers also have petitioned the U.S. Court of Appeals to vacate the FCC's benchmarks order arguing that, among other things, the FCC lacks the jurisdiction to prescribe the settlement rates which foreign carriers may collect from U.S. carriers. However, subject to FCC reconsideration and action by the Court of Appeals, if the Company is unable to negotiate benchmark settlement rates with certain foreign correspondents, the FCC may intervene on its own action or in response to a filing by a third party. The Company is unable to predict the form which such intervention may take but it could disrupt the Company's arrangement for transmitting traffic to certain countries require the Company to suspend direct service to certain countries or require the Company to make alternative termination arrangements with certain countries, all of which could have a material adverse effect on the Company's business, operating results and financial condition. FCC POLICIES ON TRANSIT AND REFILE. International switched telecommunication traffic is frequently routed indirectly via one or more third countries to its final destination. When such arrangements are mutually agreed, they are commonly based on a transit agreement under which settlement payments are made to all parties. In other cases, traffic may be sent to a third country and then forwarded or refiled for delivery to its final destination without the knowledge or consent of the destination carrier. The Company uses both transit and refile arrangements to terminate its international traffic. The FCC routinely approves transit arrangements by U.S. international carriers. The FCC's rules also permit carriers to use ISR facilities in many cases to route traffic via a third country for refile through the public switched network. However, the extent to which U.S. carriers may enter into refile arrangements consistent with the ISP is currently under review by the FCC. In 1997, the FCC stated that above-cost accounting rates had led an increasing amount of international traffic to migrate to least cost routes through the use of practices such as hubbing, refile and reorigination. The FCC stated that such practices are an economically rational response to inflated settlement rates. Notwithstanding the FCC's past rules, policies and statements regarding the scope of permissible transit and refile arrangements, the FCC could find by its own actions or in response to the filing of a third party, that certain of the Company's transit or refile arrangements violate the ISP or other FCC policies. In that event, the FCC could order the Company to terminate any non-conforming transit or refile arrangements. In addition, the Company could be subject to a monetary forfeiture and to other penalties, including revocation of the Company's FCC authorizations to operate as an international carrier. Any such FCC action could have a material adverse effect on the Company's business, operating results and financial condition. 13 REPORTING REQUIREMENTS. International telecommunication carriers also are required by the FCC's rules timely to file certain reports regarding international traffic and revenues, the ownership and use of international facilities and their affiliates with foreign carriers. The FCC considers a U.S. carrier to be affiliated with a foreign carrier if it has a 25% interest in the capital stock of the carrier or it controls the foreign carrier or is under common ownership or control. The FCC requires these reports so that, among other things, it may monitor the development of industry competition and the potential for a dominant foreign carrier to discriminate amongst U.S. carriers. The Company generally has filed said traffic, facilities and foreign affiliation reports. The FCC's rules require international telecommunication carriers to file at the FCC copies of their contracts with other carriers, including operating agreements, within 30 days of execution. The Company has filed copies of its operating agreements with the FCC. Competitive U.S. international carriers do not routinely file other carrier-to-carrier contracts with the FCC and, consistent with industry practice, the Company has not filed certain other carrier contracts. Notwithstanding the foregoing FCC filings by the Company, the FCC by its own action or in response to the filing of a third party could determine that the Company has failed to meet certain of the foregoing filing and reporting requirements or that certain Company filings are deficient. In that event, the Company could be directed to remedy any asserted non-compliance; the Company could also be subject to a monetary forfeiture and to other penalties, and, although the Company believes that it would be largely unprecedented in such circumstances, and hence unlikely, the FCC could revoke the Company's authorizations to operate as an international carrier. Any such FCC action could have a material adverse affect on the Company's business, results and financial condition. REGULATORY FEES. The Communications Act and FCC rules and policies impose certain fees upon carriers providing interstate and international telecommunication services. These fees are levied, among other things, to defray the FCC's operating expenses, to underwrite universal telecommunication service (e.g., by subsidizing certain services used by schools and libraries, such as Internet access, and by other telecommunications users in areas of the U.S. where service costs are significantly above average), to fund the Telecommunications Relay Service ("TRS"), which provides special options for hearing-impaired users, and to support the administration of telephone numbering plans. Carriers that provide domestic interstate services must pay an annual regulatory fee based on their interstate revenues; the fee is currently 0.12% of revenue. The bulk of the Company's revenue, which is derived from international services, is not subject to this fee. Carriers that provide domestic interstate services to end users must pay a universal telecommunications service fee each month based upon the total estimated demand for U.S. universal service funding. If applicable, each carrier's share is approximately four percent of the carrier's annual end user revenues. The Company generally offers its services only to other carriers which in turn provide services to end-users. Such carrier-to-carrier revenues are not subject to universal service fees, and thus the Company generally is not liable to pay universal service fees. Carriers that only offer international service (i.e., service between the United States and a foreign country or service between two foreign carriers) also are not subject to the universal service fee. However, if an international carrier has an affiliate that provides domestic interstate services, then the carrier's international revenues are subject to said fee. Until its acquisition of LDS, the Company did not offer domestic interstate services. As a result of the operations of LDS, any revenue the Company receives from end users for international services may be subject to universal service fees. U.S. interstate and international carriers must pay a percentage of their total revenue each year to support the North American Numbering Plan Administrator. For the 1998 filing year, the contribution rate is less than .003 percent of net telecommunications revenue. U.S. carriers must pay a certain percentage of their domestic interstate revenues to support the TRS Fund. For the 1998 filing year, the contribution rate is less than .04 percent of gross domestic interstate revenue. The Company has routinely paid the foregoing regulatory fees and, with regard to the annual regulatory fees owed by interstate carriers, the Company is currently owed approximately $20,000 by the FCC due to the inadvertent overpayment of said fee for a prior year. The foregoing regulatory fees typically change annually. The Company cannot predict the future regulatory fees for which it may be liable. Said fees could rise significantly for the Company and amount to four percent or more of the 14 Company's gross international and interstate revenues if the Company is no longer exempt from paying universal service fees as a result of an affiliate's provision of domestic interstate services, or because the Company provides service directly to end users, or because amendments to the Communications Act repeal the universal service fee exemption for carriers which only offer international service or services provided to connecting carriers. Because the international telecommunication services business is highly competitive, an increase in the regulatory fees which the Company must pay could impair its market position and have a material adverse effect on the Company's business, operating results and financial condition. RECENT AND POTENTIAL FCC ACTIONS. Recent FCC rulemaking orders and other actions have lowered the entry barriers for new facilities-based and resale international carriers by streamlining the processing of new applications and granting non-dominant carriers greater flexibility in establishing non-standard settlement arrangements with non-dominant foreign carriers, including the non-dominant U.S. affiliates of such carriers. In addition, the FCC's rules implementing the WTO Agreement presume that competition will be advanced by the U.S. entry of facilities-based and resale carriers from WTO member countries, thus further increasing the number of potential competitors in the U.S. market and the number of carriers which may also offer end-to-end services. The FCC is reviewing the proposed merger of WorldCom and MCI, and is expected soon to review the proposed merger of LCI International, Inc. and Qwest Communications International Inc. FCC approval and consummation of these mergers would increase concentration in the international telecommunications service industry and the potential market power of the Company's competitors. The FCC also recently has sought to reduce the foreign termination costs of U.S. international carriers by prescribing maximum or benchmark settlement rates which foreign carriers may charge U.S. carriers for terminating switched telecommunications traffic and, if the FCC's benchmarks order survives judicial review, the FCC's action may reduce the Company's settlement costs, although the costs of other U.S. international carriers also may be reduced in a similar fashion. The FCC has not stated how it will enforce the new settlement benchmarks if U.S. carriers are unsuccessful in negotiating settlement rates at or below the prescribed benchmarks, but any future FCC intervention could disrupt the Company's transmission arrangements to certain countries or require the Company to modify its existing arrangements; other U.S. international carriers might be similarly affected. The 1996 amendment to the Communications Act permits the FCC to forbear enforcement of the tariff provisions in the Act, which apply to all interstate and international carriers, and the U.S. Court of Appeals is currently reviewing an FCC order directing all domestic interstate carriers to detariff their offerings. Subject to the Court's decision, the FCC may forbear its current tariff rules for U.S. international carriers, such as the Company, or order such carriers to detariff their services. In that event, the Company would have greater flexibility in pricing its service offerings and to compete, although any such FCC action likely would grant other non-dominant international carriers equivalent freedom. The FCC routinely reviews the contribution rate for various levels of regulatory fees, including the rate for fees levied to support universal service, which fees may be increased in the future for various reasons, including the need to support the universal service programs mandated by the Communications Act, the total costs for which are still under review by the FCC. The FCC also is reviewing the extent to which international carriers may refile traffic using international private line facilities or otherwise. Future FCC actions regarding refile could affect the Company by, for example, requiring it to discontinue certain termination arrangements which it now has or to implement alternative routing arrangements for certain countries; on the other hand, the FCC may further liberalize its existing rules and policies regarding refile in which case the Company is likely to be well positioned to expand certain refile operations even though new opportunities may become available to its competitors. The Company can not predict the net effect of these or other possible future FCC actions on its business, operating results and financial condition, although the net effect could be material. STATE REGULATION STATE. The intrastate long distance telecommunications operations of STAR and its subsidiaries are subject to various state laws and regulations, including prior certification, notification, registration and/or 15 tariff requirements. In certain states, prior regulatory approval is required for changes in control of telecommunications services. The vast majority of states require STAR and its subsidiaries to apply for certification to provide intrastate telecommunications services, or at a minimum to register or to be found to be exempt from regulation, prior to commencing sale of intrastate services. Additionally, the vast majority of states require STAR or its subsidiaries to file and maintain detailed tariffs setting forth rates charged by STAR to its end-users for intrastate services. Many states also impose various reporting requirements and/or require prior approval for transfers of control of certificated carriers and assignments of carrier assets, including customer bases, carrier stock offerings, and incurrence by carriers of significant debt. Certificates of authority can generally be conditioned, modified, canceled, terminated or revoked by state regulatory authorities for failure to comply with state laws and/or rules, regulations and policies of the state regulatory authorities. Fines and other penalties, including, for example, the return of all monies received for intrastate traffic from residents of a state in which a violation has occurred may be imposed. STAR, along with its regulated subsidiaries, believes it has made the filings and taken the actions it believes are necessary to provide the intrastate services it currently provides to end users throughout the U.S. STAR and/or its subsidiaries are qualified to do business as foreign corporations, and have received certification to provide intrastate telecommunications services in all states where certification is required, and have received approval for changes of control where such approvals are necessary. The Company and its subsidiaries are required to make periodic filings in order to maintain certificated status and remain qualified as foreign corporations. In early 1997, the FCC instituted significant changes to the current incumbent local exchange carrier access charge structure. These changes were meant, in part, to bring access charges closer to their actual costs. While there has been a general trend towards access charge reductions, new primary interexchange carrier charges (PICCs) were authorized by the FCC to be imposed on interexchange carriers serving presubscribed access charges closer to their actual costs. PICCs are a flat-rated, per presubscribed line, per month access charge imposed upon all facilities-based carriers (although they may be passed through to resellers). Facilities-based carriers were assessed interstate PICCs effective January 1, 1998. Intrastate PICCs have also been adopted in the five state Ameritech region (Michigan, Wisconsin, Illinois, Indiana, and Ohio), and may be adopted elsewhere. At the same time, the Company may pursue underlying carriers for pass throughs of any access charge reductions they may realize from incumbent local exchange carriers. ACTIONS AGAINST LDS. In 1997, prior to the Company's acquisition of LDS, LDS settled disputes with the California Public Utilities Commission (the "California PUC") and with the District Attorney of Monterey, California regarding LDS' alleged unauthorized switching of long distance customers (the "Settlements"). As part of the Settlements, LDS was subject to fines and restrictions on its business operations in California. In addition, the FCC has received numerous informal complaints against LDS regarding the alleged unauthorized switching of long distance customers, which complaints currently remain under review. Following the Company's acquisition of LDS and in order to comply with the Settlements, STAR has imposed strict restrictions on certain former LDS employees, restricting these employees with respect to California intrastate telecommunications operations. Additionally, the Company has taken a number of steps to reduce the risk of a repeat occurrence regarding the alleged unauthorized switching of commercial customers in California. There can, however, be no assurance that LDS or STAR will not be subject to further regulatory review by the California PUC or the FCC. FOREIGN REGULATION UNITED KINGDOM. In the U.K., telecommunications services offered by the Company and through its affiliate, STAR Europe Ltd., ("STAR Europe") are subject to regulation by various U.K. regulatory agencies. The U.K. generally permits competition in all sectors of the telecommunications market, subject to licensing requirements and license conditions. The Company has been granted a license to provide 16 international services on a resale basis and STAR Europe has been granted a license to provide international services over its own facilities, which licenses are subject to a number of restrictions. Implementation of these licenses have permitted the Company to engage in cost-effective routing of traffic between the U.S. and the U.K. and beyond. GERMANY. In Germany, telecommunications services offered by the Company through its affiliate, STAR Telecommunications Deutschland GmbH ("STAR Germany"), are subject to regulation by the Regulierungsbehorde fur Telekommunikation und Post (which is under the jurisdiction of the Ministry of Economy). Germany permits the competitive provision of international facilities-based and resale services. STAR Germany was granted a license for the provision of voice telephony on the basis of self-operated telecommunications networks on December 4, 1997. Under this license, STAR Germany is presently installing telecommunications switching facilities in Dusseldorf, Frankfurt, Hamburg and Munich and is leasing connection transmission facilities between these switches and additional facilities. The network of STAR Germany will be used primarily for routing international telecommunications traffic between the U.S., the U.K., Germany and beyond. There can be no assurance that future changes in regulation of the services provided by STAR Germany will not have a material adverse effect on the Company's business, operating results and financial condition. OTHER COUNTRIES. The Company plans to initiate a variety of services in certain European countries including France and Belgium. These services will include value-added services to closed user groups and other voice services as regulatory liberalization in those countries permits. These and other countries have announced plans or adopted laws to permit varying levels of competition in the telecommunications market. Under the terms of the WTO Agreement, each of the signatories has committed to opening its telecommunications market to competition, foreign ownership and to adopt measures to protect against anticompetitive behavior, effective starting on January 1, 1998. Although the Company plans to obtain authority to provide service under current and future laws of those countries, or, where permitted, provide service without government authorization, there can be no assurance that foreign laws will be adopted and implemented providing the Company with effective practical opportunities to compete in these countries. Moreover, there can be no assurance of the nature and pace of liberalization in any of these markets. The Company's inability to take advantage of such liberalization could have a material adverse affect on the Company's ability to expand its services as planned. EMPLOYEES As of March 1, 1998, the Company employed 454 full-time employees. The Company is not subject to any collective bargaining agreement and it believes that its relationships with its employees are good. RISK FACTORS IN EVALUATING THE COMPANY, ITS BUSINESS, OPERATIONS AND FINANCIAL POSITION, THE FOLLOWING RISK FACTORS SHOULD BE CONSIDERED CAREFULLY, IN ADDITION TO THE OTHER INFORMATION CONTAINED IN THIS FORM 10-K. THE FOLLOWING FACTORS, AMONG OTHERS, COULD AFFECT THE COMPANY'S ACTUAL FUTURE OPERATING RESULTS AND COULD CAUSE SUCH RESULTS TO DIFFER FROM THE RESULTS DISCUSSED IN ANY FORWARD-LOOKING STATEMENTS MADE BY OR ON BEHALF OF THE COMPANY. OPERATING RESULTS SUBJECT TO SIGNIFICANT FLUCTUATIONS The Company's quarterly operating results are difficult to forecast with any degree of accuracy because a number of factors subject these results to significant fluctuations. As a result, the Company believes that period-to-period comparisons of its operating results are not necessarily meaningful and should not be relied upon as indications of future performance. 17 FACTORS INFLUENCING OPERATING RESULTS, INCLUDING REVENUES, COSTS AND MARGINS. The Company's revenues, costs and expenses have fluctuated significantly in the past and are likely to continue to fluctuate significantly in the future as a result of numerous factors. The Company's revenues in any given period can vary due to factors such as call volume fluctuations, particularly in regions with relatively high per-minute rates; the addition or loss of major customers, whether through competition, merger, consolidation or otherwise; the loss of economically beneficial routing options for the termination of the Company's traffic; financial difficulties of major customers; pricing pressure resulting from increased competition; and technical difficulties with or failures of portions of the Company's network that impact the Company's ability to provide service to or bill its customers. The Company's cost of services and operating expenses in any given period can vary due to factors such as fluctuations in rates charged by carriers to terminate the Company's traffic; increases in bad debt expense and reserves; the timing of capital expenditures, and other costs associated with acquiring or obtaining other rights to switching and other transmission facilities; changes in the Company's sales incentive plans; and costs associated with changes in staffing levels of sales, marketing, technical support and administrative personnel. In addition, the Company's operating results can vary due to factors such as changes in routing due to variations in the quality of vendor transmission capability; loss of favorable routing options; the amount of, and the accounting policy for, return traffic under operating agreements; actions by domestic or foreign regulatory entities; the level, timing and pace of the Company's expansion in international and commercial markets; and general domestic and international economic and political conditions. Further, a substantial portion of transmission capacity used by the Company is obtained on a variable, per minute and short term basis, subjecting the Company to the possibility of unanticipated price increases and service cancellations. Since the Company does not generally have long term arrangements for the purchase or resale of long distance services, and since rates fluctuate significantly over short periods of time, the Company's gross margins are subject to significant fluctuations over short periods of time. The Company's gross margins also may be negatively impacted in the longer term by competitive pricing pressures. EXAMPLES OF FACTORS AFFECTING OPERATING RESULTS. The Company has in the past encountered significant difficulties in the collection of accounts receivable from certain of its customers. For example, in the fourth quarter of 1996 and the first quarter of 1997, Hi-Rim Communications, Inc. ("Hi-Rim"), formerly one of the Company's major customers and Cherry Communications, Inc. ("CCI"), the Company's largest customer in 1996 experienced financial difficulties and were unable to pay in full, on a timely basis, outstanding accounts receivable. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." In early 1997, the Company implemented more stringent credit policies and monitoring systems. There can be no assurance, however, that if the Company experiences similar difficulties in the collection of future accounts receivable from its customers, the Company's financial condition and results of operations would not be materially adversely affected. ABILITY TO CONTINUE AND MANAGE GROWTH; COMMERCIAL MARKET The Company has increased revenues from $46.3 million in 1995 to $376.2 million in 1997, with revenues increasing in each of the last ten quarters. Such growth should not be considered indicative of future revenue growth or operating results. If revenue levels fall below expectations, net income is likely to be disproportionately adversely affected because a proportionately smaller amount of the Company's operating expenses varies with its revenues. This effect is likely to increase as a greater percentage of the Company's cost of services are associated with owned and leased facilities. There can be no assurance that the Company will be able to achieve or maintain profitability on a quarterly or annual basis in the future. It is likely that in some future quarter the Company's operating results will be below the expectations of public market analysts and investors. In such event, the price of the Company's Common Stock would likely be materially adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." 18 As part of the Company's significant revenue growth, it has expanded, and plans to continue to expand, the number of its employees and the geographic scope of its operations. Additionally, an important component of the Company's strategy is to grow and expand through acquisition. These factors have resulted, and will continue to result, in increased responsibilities for management personnel and have placed, and will continue to place, increased demands upon the Company's operating and financial systems, which may lead to unanticipated costs and divert management's attention from day-to-day operations. The Company may also be required to attract, train and retain additional highly qualified management, technical, sales and marketing and customer support personnel. The process of locating such personnel with the combination of skills and attributes required to implement the Company's strategy is often lengthy. The inability to attract and retain additional qualified personnel could materially and adversely affect the Company. The Company expects that its expansion into foreign countries will lead to increased financial and administrative demands, such as increased operational complexity associated with expanded network facilities, administrative burdens associated with managing an increasing number of foreign subsidiaries and relationships with foreign partners and expanded treasury functions to manage foreign currency risks. The Company's accounting systems and policies have been developed as the Company has experienced significant growth. There can be no assurance that the Company's personnel, systems, procedures and controls will be adequate to support the Company's future operations. See "--Dependence on Key Personnel," "Business--Employees" and "Directors and Executive Officers of the Registrant." With the acquisition of LDS, STAR began providing service to the commercial market, which is more labor intensive than the wholesale market, and as a result has higher overhead costs. The Company also may be required to update and improve its billing systems and procedures and/or hire new management personnel to handle the demands of the commercial market. There can be no assurance that the Company will be able to effectively manage the costs of and risks associated with its expansion into the commercial market. RISKS INHERENT IN ACQUISITION STRATEGY An important component to the Company's strategy is to grow and expand through acquisitions. This growth strategy is dependent on the continued availability of suitable acquisition candidates and subjects the Company to a number of risks. The Company has recently completed two acquisitions, LDS on November 30, 1997, and T-One on March 10, 1998. Additionally, on November 19, 1997, the Company entered into an agreement to acquire UDN. The acquisition of UDN is subject to approval of UDN's stockholders and to various regulatory approvals, and the Company may not complete this acquisition. These acquisitions have placed significant demands on the Company's financial and management resources, as the process for integrating acquired operations presents a significant challenge to the Company's management and may lead to unanticipated costs or a diversion of management's attention from day-to-day operations. There can be no assurance that the Company will be able to successfully integrate these acquisitions or any other acquisitions made by the Company in the future into Company operations. Integrating acquisitions may require integration of financial and call routing systems, network and other physical facilities and personnel. Difficulties in integrating these and other acquisitions can cause system degradation, added costs and loss of personnel or customers. Additionally, the Company may incur unknown liabilities despite management's efforts to investigate the operations of the acquired business. The impact of these risks, and other risks arising as a result of STAR's acquisition strategy, could adversely affect the Company's operating results. RISKS ASSOCIATED WITH GROWTH OF TELECOMMUNICATIONS NETWORK AND CUSTOMER BASE Historically, the Company has relied primarily on leased transmission capacity for the delivery of its telecommunications services. The Company's telecommunications expenses have in the past primarily been variable, based upon minutes of use, consisting largely of payments to other long distance carriers, 19 customer/carrier interconnect charges, leased fiber circuit charges and switch facility costs. During 1997, however, the Company made considerable capital expenditures in order to expand its network, and intends to continue to do so in the future. See "Business--Network." Although the Company's strategy is to seek to establish significant traffic volumes prior to investing in fixed-cost facilities, the development of such facilities entails significant costs and prior planning, which are based in part on the Company's expectations concerning future revenue growth and market developments. As the Company expands its network and the volume of its network traffic, its cost of revenues will increasingly consist of fixed costs arising from the ownership and maintenance of its switches and undersea fiber optic cables. While the Company believes that in the long-term these investments will allow it to reduce its cost of service and to enhance its service offerings, in the short-term, costs increases and a decrease in the Company's operating margins may occur. If the Company's traffic volume were to decrease, or fail to increase to the extent expected or necessary to make efficient use of its network, the Company's costs as a percentage of revenues could increase significantly, which could have a material adverse effect on the Company's business, financial condition or results of operations. In addition, the Company's business depends in part on its ability to obtain transmission facilities on a cost-effective basis. Because undersea fiber optic cables typically take several years to plan and construct, carriers generally make investments well in advance, based on a forecast of anticipated traffic. Therefore, the Company's operations are subject to the risk that it will not adequately anticipate the amount of traffic over its network, and may not procure sufficient cable capacity or network equipment in order to ensure the cost-effective transmission of customer traffic. Although the Company participates in the planning of undersea fiber optic transmission facilities, it does not control the construction of such facilities and must seek access to such facilities through partial ownership positions. If ownership positions are not available, the Company must seek access to such facilities through lease arrangements on negotiated terms that may vary with industry and market conditions. There can be no assurance that the Company will be able to continue to obtain sufficient transmission facilities or access to undersea fiber optic cable on economically viable terms. The failure of the Company to obtain telecommunications facilities that are sufficient to support its network traffic in a manner that ensures the reliability and quality of its telecommunications services may have a material adverse effect on its business, financial condition or results of operations. RISKS OF INTERNATIONAL TELECOMMUNICATIONS BUSINESS The Company has to date generated a substantial majority of its revenues by providing international telecommunications services to its customers on a wholesale basis. The international nature of the Company's operations involves certain risks, such as changes in U.S. and foreign government regulations and telecommunications standards, dependence on foreign partners, tariffs, taxes and other trade barriers, the potential for nationalization and economic downturns and political instability in foreign countries. In addition, the Company's business could be adversely affected by a reversal in the current trend toward deregulation of telecommunications carriers. The Company will be increasingly subject to these risks to the extent that the Company proceeds with the planned expansion of its international operations. RISK OF DEPENDENCE ON FOREIGN PARTNERS. The Company will increasingly rely on foreign partners to terminate its traffic in foreign countries and to assist in installing transmission facilities and network switches, complying with local regulations, obtaining required licenses, and assisting with customer and vendor relationships. The Company may have limited recourse if its foreign partners do not perform under their contractual arrangements with the Company. The Company's arrangements with foreign partners may expose the Company to significant legal, regulatory or economic risks. RISKS ASSOCIATED WITH FOREIGN GOVERNMENT CONTROL AND HIGHLY REGULATED MARKETS. Governments of many countries exercise substantial influence over various aspects of the telecommunications market. In some cases, the government owns or controls companies that are or may become competitors of the Company or companies (such as national telephone companies) upon which the Company and its foreign partners may depend for required interconnections to local telephone networks and other services. 20 Accordingly, government actions in the future could have a material adverse effect on the Company's operations. In highly regulated countries in which the Company is not dealing directly with the dominant local exchange carrier, the dominant carrier may have the ability to terminate service to the Company or its foreign partner and, if this occurs, the Company may have limited or no recourse. In countries where competition is not yet fully established and the Company is dealing with an alternative operator, foreign laws may prohibit or impede new operators from offering services in these markets. RISKS ASSOCIATED WITH FOREIGN CURRENCY FLUCTUATIONS. The Company's revenues and cost of long distance services are sensitive to foreign currency fluctuations. The Company expects that an increasing portion of the Company's net revenue and expenses will be denominated in currencies other than U.S. dollars, and changes in exchange rates may have a significant effect on the Company's results of operations. Although the Company utilizes hedging instruments to reduce the risk of foreign currency fluctuations, the Company will not be fully protected from these risks and the instruments themselves involve a degree of risk. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." FOREIGN CORRUPT PRACTICES ACT. The Company is also subject to the Foreign Corrupt Practices Act ("FCPA"), which generally prohibits U.S. companies and their intermediaries from bribing foreign officials for the purpose of obtaining or keeping business. The Company may be exposed to liability under the FCPA as a result of past or future actions taken without the Company's knowledge by agents, strategic partners and other intermediaries. Such liability could have a material adverse effect on the Company's business, operating results and financial condition. POTENTIAL ADVERSE EFFECTS OF GOVERNMENT REGULATION The Company's business is subject to various U.S. and foreign laws, regulations, agency actions and court decisions. The Company's U.S. international telecommunications service offerings are subject to regulation by the FCC. The FCC requires international carriers to obtain authorizations under Section 214 of the Communications Act prior to acquiring international facilities by purchase or lease, or providing international service to the public. Prior FCC approval is also required to transfer control of a certificated carrier. The Company must file reports and contracts with the FCC and must pay regulatory fees, which are subject to change. The Company is also subject to the FCC policies and rules discussed below. The FCC could determine, by its own actions or in response to a third party's filing, that certain of the Company's services, termination arrangements, agreements with foreign carriers, transit or refile arrangements or reports do not or did not comply with FCC policies and rules. If this occurred, the FCC could order the Company to terminate noncompliant arrangements, fine the Company or revoke the Company's authorizations. Any of these actions could have a material adverse effect on the Company's business, operating results and financial condition. FCC INTERNATIONAL PRIVATE LINE RESALE POLICY. The FCC's IPL resale policy limits the conditions under which a carrier may connect IPLs to the PSTN at one or both ends to provide switched services, commonly known as ISR. A carrier generally may only offer ISR services to a foreign country if the FCC has found (a) the country is a member of the WTO and at least 50% of the U.S. billed and settled traffic to that country is settled at or below the FCC's benchmark settlement rate or (b) the country is not a WTO member, but it offers U.S. carriers equivalent opportunities to engage in ISR and at least 50% of the U.S. billed and settled traffic is settled at or below the applicable benchmark. The Company's FCC authority currently permits it to provide ISR service to Canada, the U.K., Sweden, New Zealand, Australia and the Netherlands. The FCC is currently reviewing U.S. carrier applications to provide ISR to Belgium, Chile, Denmark, Finland, France, Germany, Hong Kong, Norway and Luxembourg, among other routes. Upon grant of any such ISR application to a given country, the FCC's rules also would permit the Company to provide ISR service to that country. Certain of the Company's termination arrangements with foreign 21 operators may be inconsistent with the FCC's IPL resale policy and the Company's existing ISR authorization. FCC INTERNATIONAL SETTLEMENTS POLICY. The FCC's ISP limits the arrangements which U.S. international carriers may enter into with foreign carriers for exchanging public switched telecommunications traffic, which the FCC terms International Message Telephone Service. This policy does not apply to ISR services. The ISP requires that U.S. carriers receive an equal share of the accounting rate and receive inbound traffic in proportion to the volume of U.S. outbound traffic which they generate. The ISP and other FCC policies also prohibit a U.S. carrier and a foreign carrier which possesses sufficient market power on the foreign end of the route to affect competition adversely in the U.S. market from entering into exclusive arrangement involving services, facilities or functions on the foreign end of a U.S. international route which are necessary for providing basic telecommunications and which are not offered to similarly situated U.S. carriers. It is possible that the FCC could find that certain of the Company's arrangements with foreign operators are inconsistent with the ISP. FCC POLICIES ON TRANSIT AND REFILE. The Company uses both transit and refile arrangements to terminate its international traffic. The FCC routinely approves transit arrangements by U.S. international carriers. The FCC's rules also permit carriers in many cases to use ISR facilities to route traffic via a third country for refile through the PSTN. The extent to which U.S. carriers may enter into refile arrangements consistent with the ISP is currently under review by the FCC. Certain of the Company's transit or refile arrangements may violate the ISP or other FCC policies. RECENT AND POTENTIAL FCC ACTIONS. Regulatory action that may be taken in the future by the FCC may intensify the competition which the Company faces, impose additional operating costs upon the Company, disrupt certain of the Company's transmission arrangements or otherwise require the Company to modify its operations. Future FCC action may also provide the Company additional competitive flexibility by, for example, eliminating or substantially reducing the tariff requirements applicable to the Company's interstate and international telecommunications services. The FCC is encouraging new market entrants by implementing the WTO Agreement and through other actions. The FCC may approve pending mergers which could produce more effective competitors in the Company's markets. The FCC may increase regulatory fees charged to the Company and its competitors by eliminating the exemption for carriers which provide only international services or through other actions, which could raise the Company's costs of service without assurance that the Company and its competitors could pass fee increases through to their customers. See "Business--Government Regulation." STATE. The intrastate long distance telecommunications operations of STAR and its subsidiaries are subject to various state laws and regulations, including prior certification, notification, registration and/or tariff requirements. The vast majority of states require that STAR and its subsidiaries apply for certification to provide intrastate telecommunications services. Certificates of authority can generally be conditioned, modified or revoked by state regulatory authorities for failure to comply with state laws and regulations. Fines and other penalties, including revocation of a certificate of authority, may be imposed. In 1997, prior to the Company's acquisition of LDS, LDS settled disputes with the California PUC and with the District Attorney of Monterey, California regarding LDS' alleged unauthorized switching of long distance customers. As part of the Settlements, LDS was subject to fines and restrictions on its business operations in California. In addition, the FCC has received numerous informal complaints against LDS regarding the alleged unauthorized switching of long distance customers, which complaints currently remain under review. Following the Company's acquisition of LDS and in order to comply with the Settlements, STAR has imposed strict restrictions on certain former LDS employees, restricting these employees with respect to California intrastate telecommunications operations. Additionally, the Company has taken a number of steps to reduce the risk of a repeat occurrence regarding the alleged unauthorized switching of commercial 22 customers in California. If the Company inadvertently fails to comply with such guidelines or if such guidelines are determined to be inadequate to comply with the Settlements, the Company may be subject to penalties or revocation of its certificate of authority. See "Business--Government Regulation--Actions Against LDS." FOREIGN REGULATIONS. The Company is also subject to regulation in foreign countries, such as the U.K. and Germany, in connection with certain of its business activities. For example, the Company's use of transit, ISR or other routing arrangements may be affected by laws or regulations in either the transited or terminating foreign jurisdiction. Foreign countries, either independently or jointly as members of the International Telecommunications Union ("ITU"), or other supra-national organizations such as the European Union or the WTO, may have adopted or may adopt laws or regulatory requirements regarding such services for which compliance would be difficult or expensive, that could force the Company to choose less cost-effective routing alternatives and that could adversely affect the Company's business, operating results and financial condition. To the extent that it seeks to provide telecommunications services in other non-U.S. markets, the Company is subject to the developing laws and regulations governing the competitive provision of telecommunications services in those markets. The Company currently plans to provide a limited range of services in Mexico, Belgium and France, as permitted by regulatory conditions in those markets, and to expand its operations as these markets implement scheduled liberalization to permit competition in the full range of telecommunications services in the next several years. The nature, extent and timing of the opportunity for the Company to compete in these markets will be determined, in part, by the actions taken by the governments in these countries to implement competition and the response of incumbent carriers to these efforts. There can be no assurance that the regulatory regime in these countries will provide the Company with practical opportunities to compete in the near future, or at all, or that the Company will be able to take advantage of any such liberalization in a timely manner. See "Business--Government Regulation." REGULATION OF CUSTOMERS. The Company's customers are also subject to actions taken by domestic or foreign regulatory authorities that may affect the ability of customers to deliver traffic to the Company. Regulatory sanctions have been imposed on certain of the Company's customers in the past. While such sanctions have not adversely impacted the volume of traffic received by the Company from such customers to date, future regulatory actions could materially adversely affect the volume of traffic received from a major customer, which could have a material adverse effect on the Company's business, financial condition and results of operations. RISKS OF NETWORK FAILURE Any system or network failure that causes interruptions in the Company's operations could have a material adverse effect on its business, financial condition or results of operations. The Company's operations are dependent on its ability to successfully expand its network and integrate new and emerging technologies and equipment into its network, which are likely to increase the risk of system failure and to cause strain upon the network. The Company's operations also are dependent on the Company's protection of its hardware and other equipment from damage from natural disasters such as fires, floods, hurricanes and earthquakes, other catastrophic events such as civil unrest, terrorism and war and other sources of power loss and telecommunications failures. Although the Company has taken a number of steps to prevent its network from being affected by natural disasters, fire and the like, such as building redundant systems for power supply to the switching equipment, there can be no assurance that any such systems will prevent the Company's switches from becoming disabled in the event of an earthquake, power outage or otherwise. The failure of the Company's network, or a significant decrease in telephone traffic resulting from effects of a natural or man-made disaster, could have a material adverse effect on the Company's relationship with its customers and the Company's business, operating results and financial condition. See "Business--Network." 23 DEPENDENCE ON KEY PERSONNEL The Company's success depends to a significant degree upon the efforts of senior management personnel and a group of employees with longstanding industry relationships and technical knowledge of the Company's operations, in particular, Christopher E. Edgecomb, the Company's Chief Executive Officer. The Company maintains and is the beneficiary under a key person life insurance policy in the amount of $10.0 million with respect to Mr. Edgecomb. The Company believes that its future success will depend in large part upon its continuing ability to attract and retain highly skilled personnel. Competition for qualified, high-level telecommunications personnel is intense and there can be no assurance that the Company will be successful in attracting and retaining such personnel. The loss of the services of one or more of the Company's key individuals, or the failure to attract and retain other key personnel, could materially adversely affect the Company's business, operating results and financial condition. See "Directors and Executive Officers of the Registrant." SIGNIFICANT COMPETITION The international telecommunications industry is intensely competitive and subject to rapid change. The Company's competitors in the international wholesale switched long distance market include large, facilities-based multinational corporations and smaller facilities-based providers in the U.S. and overseas that have emerged as a result of deregulation, switch-based resellers of international long distance services and international joint ventures and alliances among such companies. The Company also competes abroad with a number of dominant telecommunications operators that previously held various monopolies established by law over the telecommunications traffic in their countries. International wholesale switched service providers compete on the basis of price, customer service, transmission quality, breadth of service offerings and value-added services. Additionally, the telecommunications industry is in a period of rapid technological evolution, marked by the introduction of competitive product and service offerings, such as the utilization of the Internet for international voice and data communications. The Company is unable to predict which technological development will challenge its competitive position or the amount of expenditures that will be required to respond to a rapidly changing technological environment. Further, the number of the Company's competitors is likely to increase as a result of the competitive opportunities created by a new Basic Telecommunications Agreement concluded by members of the WTO in April 1997. Under the terms of the WTO Agreement, starting February 5, 1998, the United States and over 65 countries have committed to open their telecommunications markets to competition, foreign ownership and adopt measures to protect against anticompetitive behavior. As a result, the Company believes that competition will continue to increase, placing downward pressure on prices. Such pressure could adversely affect the Company's gross margins if the Company is not able to reduce its costs commensurate with such price reductions. COMPETITION FROM DOMESTIC AND INTERNATIONAL COMPANIES. A majority of the U.S.-based international telecommunications services revenue is currently generated by AT&T, MCI and Sprint. The Company also competes with WorldCom, Pacific Gateway Exchange, Inc. and other U.S.-based and foreign long distance providers, including the RBOCs, which presently have FCC authority to resell and terminate international telecommunication services. Many of these competitors have considerably greater financial and other resources and more extensive domestic and international communications networks than the Company. The Company's business would be materially adversely affected to the extent that a significant number of such customers limit or cease doing business with the Company for competitive or other reasons. Consolidation in the telecommunications industry could not only create even larger competitors with greater financial and other resources, but could also adversely affect the Company by reducing the number of potential customers for the Company's services. EXPANSION INTO COMMERCIAL MARKET. With the acquisition of LDS, STAR began providing long distance service to the commercial market, a market that is subject to intense competition from a number of well capitalized companies. The commercial market is also characterized by the lack of customer loyalty, 24 with commercial customers regularly changing service providers. There can be no assurance that STAR will be able to compete successfully in the commercial market. See "Business--Strategy--Expansion into Commercial Market." CUSTOMER CONCENTRATION While the list of the Company's most significant customers varies from quarter to quarter, the Company's five largest customers accounted for approximately 30% of its revenues in 1997. The Company could lose a significant customer for many reasons, including the entrance into the market of significant new competitors with lower rates than the Company, downward pressure on the overall costs of transmitting international calls, transmission quality problems, changes in U.S. or foreign regulations or unexpected increases in the Company's cost structure as a result of expenses related to installing a global network or otherwise. NEED FOR ADDITIONAL CAPITAL TO FINANCE GROWTH AND CAPITAL REQUIREMENTS The Company believes that it must continue to enhance and expand its network and build out its telecommunications network infrastructure in order to maintain its competitive position and continue to meet the increasing demands for service quality, capacity and competitive pricing. The Company's ability to grow depends, in part, on its ability to expand its operations through the ownership and leasing of network capacity, which requires significant capital expenditures, that are often incurred prior to the Company's receipt of the related revenue. The Company believes that, based upon its present business plan, the proceeds from the Offering, as defined, together with the Company's existing cash resources and expected cash flow from operating activities, will be sufficient to meet its currently anticipated working capital and capital expenditure requirements for at least twelve months. If the Company's growth exceeds current expectations, if the Company obtains one or more attractive opportunities to purchase the business or assets of another company, or if the Company's cash flow from operations after the end of such period is insufficient to meet its working capital and capital expenditure requirements, the Company will need to raise additional capital from equity or debt sources. There can be no assurance that the Company will be able to raise such capital on favorable terms or at all. If the Company is unable to obtain such additional capital, the Company may be required to reduce the scope of its anticipated expansion, which could have a material adverse effect on the Company's business, financial condition or results of operations. VOLATILITY OF STOCK PRICE The market price of the shares of Common Stock has risen since the Company's initial public offering in June 1997 and is trading at a high multiple of the Company's earnings. The market price for such shares has been highly volatile and may be significantly affected by factors such as actual or anticipated fluctuations in the Company's operating results, the announcement of potential acquisitions by the Company, changes in federal and international regulations, activities of the largest domestic providers, industry consolidation and mergers, conditions and trends in the international telecommunications market, adoption of new accounting standards affecting the telecommunications industry, changes in recommendations and estimates by securities analysts, general market conditions and other factors. In addition, the stock market has from time to time experienced significant price and volume fluctuations that have particularly affected the market prices for the shares of emerging growth companies like the Company. These broad market fluctuations may adversely affect the market price of the Company's Common Stock. YEAR 2000 COMPUTER PROGRAM FAILURE A significant percentage of the software that runs most of the computers in the United States relies on two-digit date codes to perform computations and decision-making functions. Commencing on January 1, 25 2000, these computer programs may fail from an inability to interpret date codes properly, misinterpreting "00" as the year 1900 rather than 2000. The Company believes that the Company's billing, credit and call tracking systems are Year 2000 compliant and do not use programs with the two-digit date code flaw. At the same time, a number of the computers of the Company's customers and vendors that interface with the Company's systems may run on programs that have Year 2000 problems and may disrupt the Company's billing, credit and tracking systems. Failure of any of the computer programs integral to the Company's key customers and vendors could adversely affect the Company's business, operating results and financial condition. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." FORWARD-LOOKING STATEMENTS Certain statements contained in this Form 10-K, including without limitation, statements containing the words "believes," "anticipates," "intends," "expects" and words of similar import, constitute "forward-looking statements" within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. Such forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors include, among others, the following: general economic and business conditions, both nationally and in the regions in which the Company operates; industry capacity; existing government regulations and changes in, or the failure to comply with, government regulations; competition; changes in business strategy or development plans; the ability of the Company to manage growth; the availability and terms of capital to fund the expansion of the Company's business, including the acquisition of additional businesses; and other factors referenced in this Form 10-K. GIVEN THESE UNCERTAINTIES, THE STOCKHOLDERS OF THE COMPANY ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON SUCH FORWARD-LOOKING STATEMENTS. 26 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS. The Company's Common Stock has been traded on the Nasdaq National Market since June 12, 1997. The following table sets forth, for the fiscal periods indicated, the quarterly high and low sales prices for the Common Stock, as reported by Nasdaq and as adjusted to reflect the Stock Split that occurred on March 31, 1998.
HIGH LOW --------- --------- FISCAL YEAR ENDED DECEMBER 31, 1997 - ----------------------------------------------------------------------------------------------- Second Quarter (from June 12, 1997)............................................................ 7 3/8 4 41/64 Third Quarter.................................................................................. 11 53/64 6 7/32 Fourth Quarter................................................................................. 17 11/16 9 33/64 FISCAL YEAR ENDING DECEMBER 31, 1998 - ----------------------------------------------------------------------------------------------- First Quarter (through March 27, 1998)......................................................... 26 3/32 14 33/64
The last reported sale price of the Common Stock on the Nasdaq National Market on March 27, 1998 was $26.09 per share. As of March 16, 1998, there were 155 holders of record of the Company's Common Stock. The Company has never paid cash dividends on its Common Stock and has no intention of paying cash dividends in the foreseeable future. The Company anticipates that all future earnings, if any, generated from operations will be retained by the Company to develop and expand its business. Any future determination with respect to the payment of dividends will be at the discretion of the Board of Directors and will depend upon, among other things, the Company's operating results, financial condition and capital requirements, the terms of then-existing indebtedness, general business conditions and such other factors as the Board of Directors deems relevant. In addition, the Company's existing revolving credit facility prohibits the payment of cash dividends without the lender's consent. Since inception, the Company has issued and sold the following unregistered securities, which amounts have been adjusted to reflect the Stock Split: 1. On March 10, 1998, the Registrant issued 1,353,000 shares of its Common Stock in exchange for all of the outstanding capital stock of T-One Corp. in a transaction valued at $25,080,000. 2. On November 30, 1997, the Registrant issued 849,298 shares of Common Stock in exchange for all of the outstanding capital stock of LD Services, Inc. in a transaction valued at approximately $13,930,569. 3. As of March 31, 1997, the Registrant had issued 18,450,000 shares of Common Stock pursuant to direct issuances to employees in consideration for services and advances provided by such employees for an aggregate purchase price of approximately $1,103,000. 4. On February 23, 1996, the Registrant issued and sold 2,049,979 shares of Common Stock to a group of six investors for an aggregate purchase price of $1,500,000.00. 5. On July 12, 1996, the Registrant issued and sold 1,874,532 shares of Common Stock to Gotel Investments Ltd. for an aggregate purchase price of $4,068,651.00. 6. On July 25, 1996, the Registrant issued and sold 2,802,446 shares of Series A Preferred Stock to a group of twenty-two investors for an aggregate purchase price of $7,500,003.51. 7. Since inception from time to time, as of February 28, 1998, the Registrant has granted to employees, directors and consultants options to purchase an aggregate of approximately 27 4,798,000 shares of Common Stock pursuant to stock option agreements and the Registrant's stock option plans. The sales and issuances described above were deemed to be exempt from registration under the Securities Act in reliance upon Section 4(2) thereof, as transactions by an issuer not involving any public offering, or in reliance upon the exemption from registration provided by Rule 701 promulgated under the Securities Act. In addition, the recipients of securities in each such transaction represented their intentions to acquire the securities for investment only and not with a view to or for sale in connection with any distribution thereof and appropriate legends were affixed to the share certificates issued in such transactions. All recipients had adequate access, through their relationships with the Registrant, to information about the Registrant. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. THE FOLLOWING DISCUSSION OF THE FINANCIAL CONDITION AND RESULTS OF OPERATIONS OF THE COMPANY SHOULD BE READ IN CONJUNCTION WITH "SELECTED CONSOLIDATED FINANCIAL DATA" AND THE CONSOLIDATED FINANCIAL STATEMENTS AND THE NOTES THERETO CONTAINED ELSEWHERE IN THIS FORM 10-K. THIS DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS, AS DEFINED IN SECTION 27A OF THE SECURITIES ACT AND SECTION 21E OF THE EXCHANGE ACT, THAT INVOLVE RISKS AND UNCERTAINTIES. STAR'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THE FORWARD- LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS, INCLUDING, BUT NOT LIMITED TO THOSE DISCUSSED IN "RISK FACTORS" AND ELSEWHERE IN THIS FORM 10-K. SEE "RISK FACTORS --FORWARD-LOOKING STATEMENTS." OVERVIEW The Company is an emerging multinational carrier focused primarily on the international long distance market. The Company offers highly reliable, low-cost switched voice services on a wholesale basis, primarily to U.S.-based long distance carriers. STAR provides international long distance service to approximately 220 countries through its flexible network comprised of various foreign termination relationships, international gateway switches, leased and owned transmission facilities and resale arrangements with other long distance providers. The Company installed its first international gateway switch in Los Angeles in June 1995 and initially recognized wholesale revenues in August 1995. A significant portion of the Company's revenues in 1994 and 1995 were generated by the commercial operations of LDS. REVENUES. Most of the Company's revenues are generated by the sale of international long distance services on a wholesale basis to other, primarily domestic, long distance providers. The Company records revenues from the sale of long distance services at the time of customer usage. The Company's agreements with its wholesale customers are short-term in duration and the rates charged to customers are subject to change from time to time, generally with five days notice to the customer. COSTS OF SERVICES. The Company has pursued a strategy of attracting customers and building calling volume and revenue by offering favorable rates compared to other long distance providers. The Company continues to lower its costs of services by (i) expanding the Company's owned network facilities, (ii) continuing to utilize the Company's sophisticated information systems to route calls over the most cost-effective routes and (iii) leveraging the Company's traffic volumes and information systems to negotiate lower variable usage-based costs with domestic and foreign providers of transmission capacity. 28 Costs of services include those costs associated with the transmission and termination of international long distance services. Currently, a majority of transmission capacity used by the Company is obtained on a variable, per minute basis. As a result, some of the Company's current costs of services is variable. The Company's contracts with its vendors provide that rates may fluctuate, with rate change notice periods varying from five days to one year, with certain of the Company's longer term arrangements requiring the Company to meet minimum usage commitments in order to avoid penalties. Such variability and the short- term nature of many of the contracts subject the Company to the possibility of unanticipated cost increases and the loss of cost-effective routing alternatives. Included in the Company's costs of services are accruals for rate and minute disputes and unreconciled billing differences between the Company and its vendors. Each quarter management reviews the costs of services accrual and adjusts the balance for resolved items. Costs of services also include fixed costs associated with the leasing of network facilities. The Company intends to begin providing international long distance services to commercial customers in certain European countries in the second half of 1998. STAR began providing long distance service to commercial markets in the U.S. with its acquisition of LDS in November 1997. STAR believes that traffic from commercial customers has the potential to generate higher gross margins than wholesale traffic. STAR also expects, however, that an expansion into this market will also increase the risk of bad debt exposure and lead to higher overhead costs. Information related to wholesale and commercial revenues and operations will be reported in future Exchange Act filings made by STAR in accordance with Financial Accounting Standards Board Statement No. 131. Prices in the international long distance market have declined in recent years and, as competition continues to increase, STAR believes that prices are likely to continue to decline. Additionally, STAR believes that the increasing trend of deregulation of international long distance telecommunications will result in greater competition, which could adversely affect STAR's revenue per minute and gross margin. STAR believes, however, that the effect of such decreases in prices will be offset by increased calling volumes and decreased costs. OPERATING EXPENSES. Selling, general and administrative expenses consist primarily of personnel costs, depreciation and amortization, tradeshow and travel expenses and commissions and consulting fees, as well as an accrual for bad debt expense. These expenses have been increasing over the past year, which is consistent with STAR's recent growth, accelerated expansion into Europe, and investment in systems and facilities. The Company expects this trend to continue, and to include, among other things, a significant increase in depreciation and amortization. Management believes that additional selling, general and administrative expenses will be necessary to support the expansion of the Company's network facilities, its sales and marketing efforts and STAR's expansion into commercial markets. FOREIGN EXCHANGE. The Company's revenues and cost of long distance services are sensitive to foreign currency fluctuations. The Company expects that an increasing portion of the Company's revenues and expenses will be denominated in currencies other than U.S. dollars, and changes in exchange rates may have a significant effect on the Company's results of operations. FACTORS AFFECTING FUTURE OPERATING RESULTS. The Company's quarterly operating results are difficult to forecast with any degree of accuracy because a number of factors subject these results to significant fluctuations. As a result, STAR believes that period-to-period comparisons of its operating results are not necessarily meaningful and should not be relied upon as indications of future performance. The Company's revenues, costs and expenses have fluctuated significantly in the past and are likely to continue to fluctuate significantly in the future as a result of numerous factors. The Company's revenues in any given period can vary due to factors such as call volume fluctuations, particularly in regions with relatively high per-minute rates; the addition or loss of major customers, whether through competition, merger, consolidation or otherwise; the loss of economically beneficial routing options for the termination of STAR's traffic; financial difficulties of major customers; pricing pressure resulting from increased 29 competition; and technical difficulties with or failures of portions of STAR's network that impact STAR's ability to provide service to or bill its customers. STAR's cost of services and operating expenses in any given period can vary due to factors such as fluctuations in rates charged by carriers to terminate STAR's traffic; increases in bad debt expense and reserves; the timing of capital expenditures, and other costs associated with acquiring or obtaining other rights to switching and other transmission facilities; changes in STAR's sales incentive plans; and costs associated with changes in staffing levels of sales, marketing, technical support and administrative personnel. In addition, STAR's operating results can vary due to factors such as changes in routing due to variations in the quality of vendor transmission capability; loss of favorable routing options; the amount of, and the accounting policy for, return traffic under operating agreements; actions by domestic or foreign regulatory entities; the level, timing and pace of STAR's expansion in international and commercial markets; and general domestic and international economic and political conditions. Further, a substantial portion of transmission capacity used by the Company is obtained on a variable, per minute and short term basis, subjecting the Company to the possibility of unanticipated price increases and service cancellations. Since STAR does not generally have long term arrangements for the purchase or resale of long distance services, and since rates fluctuate significantly over short periods of time, STAR's gross margins are subject to significant fluctuations over short periods of time. The Company's gross margins also may be negatively impacted in the longer term by competitive pricing pressures. RECENT ACQUISITIONS AND DEVELOPMENTS The Company has recently acquired or entered into agreements to acquire the following companies and has taken the following actions: - L.D. SERVICES, INC. On November 30, 1997, the Company acquired LDS, certain non-operating entities and majority ownership in another entity for approximately 849,000 shares of Common Stock in a transaction accounted for as a pooling of interests. The Company's audited financial statements have been restated to include LDS' historical performance for all relevant periods. The commercial business of LDS has historically had higher gross margins and higher selling, general and administrative expenses and operating costs than the Company's wholesale operations. As the Company integrates and expands the commercial accounts of LDS, such increase in operations may affect the Company's future operating margins. In 1997, LDS settled disputes with the California PUC and with the District Attorney of Monterey, California. The resulting payments and restrictions on LDS' activities adversely affected its 1997 operating results. See "Business--Government Regulation--Actions Against LDS." - T-ONE CORP. On March 10, 1998, the Company acquired T-One for 1,353,000 shares of Common Stock in a transaction accounted for as a pooling of interests. Consistent with applicable accounting standards, as of the date of this Prospectus, the Company's audited financial statements have not been restated to include T-One's historical performance. For the fiscal year ended December 31, 1997, T-One had revenues of $30.4 million, gross profit of $1.8 million, selling, general and administrative expenses of $1.5 million and net income of $0.2 million. See Note 14 of Notes to Consolidated Financial Statements. - UNITED DIGITAL NETWORK, INC. On November 19, 1997, the Company entered into an agreement to acquire UDN in a transaction to be accounted for as a pooling of interests. The acquisition of UDN is subject to approval by UDN's stockholders and to various regulatory approvals. Assuming the receipt of all necessary approvals, management expects to consummate the UDN acquisition in the second quarter of 1998 for approximately 800,000 shares of Common Stock. In connection with the UDN acquisition, STAR has loaned an aggregate of $4.5 million to UDN. The Company's financial statements have not been restated to reflect the acquisition of UDN. Based solely on information provided by UDN to STAR, which has not been independently verified by STAR, for the nine month period ended January 31, 1998, UDN had revenues of $23.9 million and a net loss of 30 $6.5 million. STAR believes that, because UDN operates in the commercial market, its higher gross margins and operating costs will have an impact on the Company's margins upon consummation of the merger and on a going-forward basis once STAR's operating results are restated to include UDN's historical performance. UDN's Common Stock trades on the Vancouver Stock Exchange under the symbol UDN. - On March 24, 1998, the Company filed a Registration Statement on Form S-1 (Registration No. 333-48559) registering 6,670,000 shares of Common Stock to be sold by the Company (the "Offering"). The Company also granted the Underwriters a 30-day option to purchase up to 1,050,000 additional shares of Common Stock solely to cover over-allotments, if any. The Company intends to use the proceeds from the Offering for capital expenditures, working capital and general corporate purposes. - STOCK SPLIT. On March 31, 1998, the Company will give effect to the Stock Split with payment to the holders of the shares of Common Stock outstanding on February 20, 1998 a stock dividend equal to 1.05 shares of Common Stock for each such outstanding share. RESULTS OF OPERATIONS The following table sets forth certain selected items in the Company's statements of operations as a percentage of total revenues for the periods indicated:
YEARS ENDED DECEMBER 31, ------------------------------- 1995 1996 1997 --------- --------- --------- Revenues.......................................................................... 100.0% 100.0% 100.0% Costs of services................................................................. 68.9 86.4 86.5 --------- --------- --------- Gross profit...................................................................... 31.1 13.6 13.5 Operating expenses: Selling, general and administrative expenses.................................... 21.8 14.4 9.4 Depreciation and amortization................................................... 0.4 0.5 1.1 --------- --------- --------- Total operating expenses........................................................ 22.2 14.9 10.6 Income (loss) from operations..................................................... 8.9 (1.3) 2.9 --------- --------- --------- Income (loss) before provision for income taxes................................... 8.7 (1.5) 2.3 Provision for income taxes........................................................ 0.1 0.3 0.8 --------- --------- --------- Net income (loss)................................................................. 8.6% (1.8)% 1.5% --------- --------- --------- --------- --------- ---------
YEARS ENDED DECEMBER 31, 1997 AND 1996 REVENUES. Revenues increased 58.1% to $376.2 million in 1997 from $238.0 million in 1996. Wholesale revenues increased to $348.7 million from $208.1 million, with minutes of use increasing to 863.3 million minutes in 1997, as compared to 479.7 million minutes of use in the prior year. This increase reflects an increase in the number of wholesale customers from 84 in 1996 to 105 at the end of 1997, as well as an increase in usage by existing customers. The average rate per minute of usage for wholesale customers declined from $0.43 cents per minute in 1996 to $0.40 cents per minute in 1997, reflecting the change in country mix to include a larger proportion of lower rate per minute countries as well as lower prices on competitive routes. Taking into account the acquisition of T-One, on a pro forma basis, revenues in 1997 would have been $406.6 million, an increase of 56.1% from $260.4 million in 1996. Commercial revenues decreased to $27.5 million in 1997 from $29.9 million in 1996 reflecting the termination of the LDS customer base in California due to the 1997 settlement entered into by LDS with 31 each of the California PUC and the District Attorney of Monterey, California. See "Business--Governmental Regulation--Actions Against LDS." GROSS PROFIT. Gross profit increased 57.3% to $51.0 million in 1997 from $32.4 million in 1996. Wholesale gross profit increased to $39.8 million in 1997 from $19.7 million for 1996 and wholesale gross margin increased to 11.4% from 9.4%, respectively. Wholesale gross profit expanded during 1997 as traffic was increasingly routed over the Company's proprietary international network. Commercial gross profit decreased 11.8% to $11.2 million in 1997 from $12.7 million in 1996 and commercial gross margin declined to 40.7% from 42.6% over such periods, reflecting declining prices in the competitive long distance market. As STAR migrates the LDS commercial customer base onto the Company's network, LDS' cost of commercial long distance services is expected to decline. Taking into account the acquisition of T-One, on a pro forma basis, gross profit in 1997 would have been $52.8 million, an increase of 56.4% over gross profit of $33.7 million in 1996. SELLING, GENERAL AND ADMINISTRATIVE. In 1997, selling, general and administrative expenses increased 3.1% to $35.4 million, from $34.3 million in 1996. Wholesale selling, general and administrative expenses increased to $26.0 million in 1997 from $24.1 million in 1996, but decreased as a percentage of wholesale revenues to 7.5% from 11.6% over the comparable periods. Total expenses increased year to year in absolute dollars as STAR expanded its proprietary international network and employee base. Included in the 1996 selling, general and administrative expense was $11.6 million in reserves and write-offs against deposits and accounts receivable related to bad debts from two customers. Commercial selling, general and administrative expenses decreased to $9.4 million in 1997 from $10.2 million in 1996 and remained flat as a percentage of commercial revenues at approximately 34.1%. The Company expects selling, general and administrative expenses to expand in absolute dollars and as a percentage of revenues in fiscal year 1998, as the Company expands its network and employee base and in connection with the Company's entry into the commercial market. DEPRECIATION. Depreciation increased to $4.2 million for 1997 from $1.2 million for 1996, and increased as a percentage of revenues to 1.1% from 0.5% in the prior period. Depreciation increased as a result of STAR's continuing expansion of its proprietary international network which includes purchases of switches, submarine cable and leasehold improvements associated with switch sites. STAR expects depreciation expense to increase as the Company continues to expand its global telecommunications network. OTHER INCOME (EXPENSE). Other expense, net, increased to $2.6 million in 1997 from $552,000 in 1996. This increase is primarily due to interest expense of $1.6 million incurred under various capital leases and bank lines of credit and a legal settlement and associated expenses of $1.7 million. The legal settlement relates to the dispute settled by LDS with the California PUC and the District Attorney of Monterey County. See "Business--Governmental Regulation--Actions Against LDS." Interest income earned on short-term investments increased to $492,000 in 1997 from $110,000 in 1996 due to interest earned on the proceeds of the Company's June 1997 initial public offering. PROVISION FOR INCOME TAXES. The provision for income taxes increased to $2.9 million in 1997 from $592,000 in 1996, primarily due to the increase in profitability of the Company. YEARS ENDED DECEMBER 31, 1996 AND 1995 REVENUES. Revenues increased 414.2% to $238.0 million in 1996 from $46.3 million 1995. Wholesale revenues increased to $208.1 million in 1996 from $16.1 million in 1995, with minutes of use increasing to 479.7 million in 1996, as compared to 38.1 million minutes of use in the prior year. The increase in wholesale revenue resulted from STAR's commencement of operations as an international long distance carrier, an increase in the number of customers as compared to the prior year and an increase in minutes of wholesale traffic from new and existing customers. The increase in traffic is also attributable to an increase in the number of routes with favorable rates that STAR was able to offer to customers. 32 Commercial revenues decreased to $29.9 million in 1996 from $30.2 million in 1995 due to a decrease in the rate per minute charged, which was partially offset by an increase in the number of minutes sold. Taking into account the acquisition of T-One, on a pro forma basis revenues would have been $260.4 million in 1996, an increase of 341.9% from $58.9 million in 1995. GROSS PROFIT. Gross profit increased 125.3% to $32.4 million for 1996 from $14.4 million in 1995. Wholesale gross profit increased to $19.7 million in 1996 from $1.8 million for 1995. Wholesale gross margin decreased to 9.4% in 1996 from 11.0% in 1995, reflecting the change from STAR's prior consulting business to operating as an international long distance carrier. Gross profit was positively impacted during 1996 by the negotiation of lower rates on routes with significant traffic, and negatively impacted by increases in traffic on routes with lower margins. Commercial gross profit increased to $12.7 million in 1996 from $12.6 million in 1995 with gross margin increasing to 42.6% from 41.8%, respectively. The gross profit from commercial services expanded as costs associated with the local exchange carriers declined. Taking into account the acquisition of T-One, on a pro forma basis, gross profit in 1996 would have been $33.7 million, an increase of 130.0% from $14.7 million in 1995. SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative expenses increased 240.4% to $34.3 million in 1996 from $10.1 million in 1995. Wholesale selling, general and administrative expenses increased to $24.1 million in 1996 from $2.1 million in 1995, and decreased as a percentage of revenues to 11.6% from 12.8% in the prior period. Selling, general and administrative expenses increased between periods as STAR increased its employee base and incurred payroll, employee benefits, commission and related expenses. STAR also established a reserve for doubtful accounts to reflect its significantly higher revenue levels and invested in sales and marketing activities, including tradeshows and travel. Hi-Rim and CCI, two of STAR's major customers in 1996, informed STAR that they were experiencing financial difficulties and would be unable to pay in full outstanding accounts receivable. As a result, the full amount of the approximately $10.8 million owed to STAR by Hi-Rim and CCI as of December 31, 1996 which was not subsequently collected or for which no offsetting value was received, was written off or reserved in 1996. In addition, STAR wrote-off $820,000 of intangible assets relating to CCI. Commercial selling, general and administrative expenses increased to $10.2 million in 1996 from $8.0 million in 1995 reflecting higher operating costs. DEPRECIATION. Depreciation increased to $1.2 million for 1996 from $186,000 for 1995, an increase as a percentage of revenues to 0.5% from 0.4% in the prior period. Depreciation increased as a result of STAR's purchase of switches and of the operating equipment and leasehold improvements associated with its Los Angeles and New York switching facilities. Depreciation expense will increase as STAR expands its ownership of switching and transmission facilities through purchase or use of capital leases. OTHER INCOME (EXPENSE). Other expense, net, increased to $552,000 in 1996 from $75,000 in 1995. This increase is primarily due to a $100,000 legal settlement in the second quarter of 1996 as well as $601,000 in interest expense incurred under various bank and stockholder lines of credit. This increase was offset by $110,000 in interest income on short-term investments and cash equivalents primarily from funds raised in private placements of equity securities during the first three quarters of 1996. PROVISION FOR INCOME TAXES. Through December 31, 1995, STAR had elected to be taxed as an S-Corporation for both federal and state income tax purposes and thus was only subject to 1.5% tax on taxable income for state purposes. LDS was an S-Corporation through the date of the merger on November 30, 1997. The pro forma provision for income taxes, assumes that both STAR and LDS were C-Corporations for all periods presented. During 1996, the historical provision for income taxes increased to $592,000 as a result of the reserve of $2.9 million of the net deferred tax asset. 33 LIQUIDITY AND CAPITAL RESOURCES As of December 31, 1997, STAR had cash and cash equivalents of approximately $1.5 million, short-term investments of $18.6 million and a working capital surplus of $15.8 million. In June 1997, the Company completed an initial public offering of 9.4 million shares of Common Stock of which approximately 8.1 million shares were sold by the Company and approximately 1.3 million shares were sold by certain selling stockholders. The net proceeds to the Company (after deducting underwriting discounts and offering expenses) from the sale of such shares of Common Stock were approximately $30.9 million. As of December 31, 1997, the Company had used the proceeds from the offering to repay indebtedness of $14.2 million, to purchase switching and transmission related equipment and to finance the Company's operations in the U.K. As of December 31, 1997, STAR had no funds outstanding on its $25 million revolving line of credit, which bears interest at a rate of the bank's cost of funds plus 175 basis points and expires on July 1, 1999. However, the line of credit is reduced by outstanding letters of credit in the amount of $4.9 million. STAR generated net cash from operating activities of $10.1 million in 1997, primarily from net income plus depreciation and amortization, while using $3.4 million in 1996. The Company's investing activities used cash of approximately $29.6 million during 1997 primarily resulting from capital expenditures and the investment of the proceeds from the initial public offering in marketable securities, while using $9.8 million in 1996. The Company's financing activities provided cash of approximately $19.3 million during 1997 primarily from the sale of Common Stock and borrowings under lines of credit, offset by repayments under various lines of credit, while providing $14.7 million in 1996. STAR had capital lease obligations of $13.6 million, and $0.8 million in term loans, relating to its switching facilities and operating equipment. STAR anticipates making capital expenditures of approximately $80.0 million over the next 12 months to expand its global network. STAR believes that the proceeds from the Offering and cash generated from operations, as well as funding under its bank line of credit, will satisfy STAR's current liquidity needs. Nevertheless, as the Company continues to expand its network facilities and pursues its strategy of growth through acquisition, the Company's liquidity needs may increase, perhaps significantly, which could require the Company to seek such additional financing or the expansion of its borrowing capacity under current or new lines of credit. As appropriate, STAR will use capital lease financing or raise additional debt or equity capital to finance new projects or acquisitions. The Company had foreign currency contracts outstanding at December 31, 1997 in the notional amount of $6.3 million. See Note 2 of Notes to Consolidated Financial Statements. YEAR 2000 COMPLIANCE. The Company has made a concerted effort to insure that the software components of its information and billing systems are Year 2000 compliant. As such, management believes that, after January 1, 2000, the Company will be able to continue to accurately track and bill calls. At the same time, it is likely that the operations of a number of the Company's customers and vendors rely on software that is not Year 2000 compliant. 34 Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report on Form 10-K/A to be signed on its behalf by the undersigned, thereunto duly authorized in the City of Santa Barbara, State of California, on the 7th day of April, 1998. STAR TELECOMMUNICATIONS, INC. By: /s/ KELLY D. ENOS ----------------------------------------- Kelly D. Enos Chief Financial Officer
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