-----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, O3lYSp0XbQRzSoLA8N3szQ6OzbzmmXkhstMkpO/OAjL+Av1R0ikwZZDuHiQYPqaj gh2I11fcQtU7cPrmuCT/5Q== 0000950144-99-013256.txt : 19991117 0000950144-99-013256.hdr.sgml : 19991117 ACCESSION NUMBER: 0000950144-99-013256 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 19990930 FILED AS OF DATE: 19991115 FILER: COMPANY DATA: COMPANY CONFORMED NAME: WORLD ACCESS INC /NEW/ CENTRAL INDEX KEY: 0001071645 STANDARD INDUSTRIAL CLASSIFICATION: COMMUNICATIONS EQUIPMENT, NEC [3669] IRS NUMBER: 582398004 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: SEC FILE NUMBER: 000-29782 FILM NUMBER: 99755105 BUSINESS ADDRESS: STREET 1: 945 EAST PACES FERRY ROAD STREET 2: SUITE 2200 CITY: ATLANTA STATE: GA ZIP: 30326 BUSINESS PHONE: 4042312025 MAIL ADDRESS: STREET 1: 945 EAST PACES FERRY ROAD STREET 2: SUITE 2200 CITY: ATLANTA STATE: GA ZIP: 30326 FORMER COMPANY: FORMER CONFORMED NAME: WAXS INC DATE OF NAME CHANGE: 19981006 10-Q 1 WORLD ACCESS, INC. 1 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------------- FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE THREE MONTHS ENDED SEPTEMBER 30, 1999. 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 0-29782 WORLD ACCESS, INC. (Exact name of Registrant as specified in its Charter) DELAWARE 58-2398004 (State of Incorporation) (I.R.S. Employer Identification No.) 945 E. PACES FERRY ROAD, SUITE 2200, 30326 ATLANTA, GEORGIA (Zip Code) (Address of principal executive offices)
(404) 231-2025 (Registrant's telephone number) Securities registered pursuant to Section 12(b) of the Act: NONE Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, PAR VALUE $.01 PER SHARE 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 [ ] The number of shares outstanding of the Registrant's common stock, par value $.01 per share, at November 15, 1999 was 45,265,221. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 2 PART I FINANCIAL INFORMATION ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS WORLD ACCESS, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (IN THOUSANDS)
SEPTEMBER 30, DECEMBER 31, 1999 1998 ------------- ------------ (UNAUDITED) ASSETS Current Assets Cash and equivalents...................................... $ 107,841 $ 55,176 Accounts receivable....................................... 123,062 70,485 Inventories............................................... 40,437 48,591 Deferred income taxes..................................... 33,022 37,185 Other current assets...................................... 22,044 21,381 --------- --------- Total Current Assets.............................. 326,406 232,818 Property and equipment...................................... 63,390 63,602 Goodwill and other intangibles.............................. 306,930 298,780 Other assets................................................ 31,183 18,612 --------- --------- Total Assets...................................... $ 727,909 $ 613,812 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current Liabilities Short-term debt........................................... $ 13,842 $ 17,989 Accounts payable.......................................... 75,388 36,418 Other accrued liabilities................................. 47,515 52,825 --------- --------- Total Current Liabilities......................... 136,745 107,232 Long-term debt.............................................. 140,839 137,864 Noncurrent liabilities...................................... 8,421 8,133 --------- --------- Total Liabilities................................. 286,005 253,229 --------- --------- Stockholders' Equity Preferred stock........................................... 1 -- Common stock.............................................. 450 441 Capital in excess of par value............................ 547,170 472,945 Accumulated deficit....................................... (105,717) (112,803) --------- --------- Total Stockholders' Equity........................ 441,904 360,583 --------- --------- Total Liabilities and Stockholders' Equity........ $ 727,909 $ 613,812 ========= =========
See notes to consolidated financial statements. 1 3 WORLD ACCESS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------- ------------------- 1999 1998 1999 1998 -------- ------- -------- -------- (UNAUDITED) Carrier service revenues.................................... $130,470 $ 629 $329,361 $ 1,892 Equipment sales............................................. 72,569 35,619 194,929 92,303 -------- ------- -------- -------- Total Sales........................................ 203,039 36,248 524,290 94,195 Cost of carrier services.................................... 112,508 590 287,777 1,631 Cost of services network.................................... 4,006 38 13,969 114 Cost of equipment sold...................................... 42,234 18,395 110,924 47,748 Amortization of acquired technology......................... 1,200 -- 3,600 -- -------- ------- -------- -------- Total Cost of Sales................................ 159,948 19,023 416,270 49,493 -------- ------- -------- -------- Gross Profit....................................... 43,091 17,225 108,020 44,702 Research and development.................................... 4,509 1,778 13,282 4,256 Selling, general and administrative......................... 15,596 4,938 43,105 11,493 Amortization of goodwill.................................... 3,346 927 9,715 2,402 Provision for doubtful accounts............................. 1,410 166 2,840 410 In-process research and development......................... -- -- -- 35,400 Restructuring and other charges............................. -- -- -- 590 -------- ------- -------- -------- Operating Income (Loss)............................ 18,230 9,416 39,078 (9,849) Gain on exchange of securities.............................. 8,704 -- 8,704 -- Interest and other income................................... 1,123 857 2,629 2,827 Interest expense............................................ (2,790) (1,641) (7,394) (4,599) -------- ------- -------- -------- Income (Loss) From Continuing Operations Before Income Taxes and Minority Interests.............. 25,267 8,632 43,017 (11,621) Income taxes................................................ 11,013 3,473 20,370 9,379 -------- ------- -------- -------- Income (Loss) From Continuing Operations Before Minority Interests............................... 14,254 5,159 22,647 (21,000) Minority interests in earnings of subsidiary................ -- 1,090 -- 2,623 -------- ------- -------- -------- Income (Loss) From Continuing Operations........... 14,254 4,069 22,647 (23,623) Net income (loss) from discontinued operations.............. (49) 2,962 (702) 2,922 Write-down of discontinued operations to net realizable value..................................................... -- -- (13,662) -- -------- ------- -------- -------- Net Income (Loss).................................. 14,205 7,031 8,283 (20,701) Preferred stock dividends................................... 784 -- 1,197 -- -------- ------- -------- -------- Net Income (Loss) Available to Common Stockholders..................................... $ 13,421 $ 7,031 $ 7,086 $(20,701) ======== ======= ======== ======== Income (Loss) Per Common Share: Basic: Continuing Operations................................... $ 0.37 $ 0.19 $ 0.59 $ (1.16) Discontinued Operations................................. -- 0.14 (0.39) 0.14 -------- ------- -------- -------- Net Income (Loss)....................................... $ 0.37 $ 0.33 $ 0.20 $ (1.02) ======== ======= ======== ======== Diluted: Continuing Operations................................... $ 0.33 $ 0.19 $ 0.56 $ (1.16) Discontinued Operations................................. -- 0.13 (0.36) 0.14 -------- ------- -------- -------- Net Income (Loss)....................................... $ 0.33 $ 0.32 $ 0.20 $ (1.02) ======== ======= ======== ======== Weighted Average Shares Outstanding: Basic 36,509 21,249 36,245 20,346 ======== ======= ======== ======== Diluted 43,491 25,144 40,048 20,346 ======== ======= ======== ========
See notes to consolidated financial statements. 2 4 WORLD ACCESS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY (IN THOUSANDS)
CAPITAL IN PREFERRED COMMON EXCESS OF ACCUMULATED STOCK STOCK PAR VALUE DEFICIT TOTAL --------- -------- ---------- ----------- -------- (UNAUDITED) Balance at January 1, 1999................. $ -- $ 441 $472,945 $(112,803) $360,583 Net and comprehensive net income......... 8,283 8,283 Issuance of preferred shares in private offering.............................. 1 47,750 47,751 Issuance of preferred shares and warrants for acquisition of business........... 18,839 18,839 Dividends on preferred stock............. (1,197) (1,197) Release of escrowed shares for acquisitions of businesses............ 1 2,824 2,825 Issuance of shares for acquisition of business.............................. 1 999 1,000 Issuance of shares for technology license............................... 5 2,186 2,191 Issuance of shares for options and warrants.............................. 2 997 999 Tax benefit from option and warrant exercises............................. 162 162 Other issuances of shares................ 468 468 -------- -------- -------- --------- -------- Balance at September 30, 1999.............. $ 1 $ 450 $547,170 $(105,717) $441,904 ======== ======== ======== ========= ========
See notes to consolidated financial statements. 3 5 WORLD ACCESS, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
NINE MONTHS ENDED SEPTEMBER 30, ------------------- 1999 1998 -------- -------- (UNAUDITED) Cash Flows From Operating Activities: Net income (loss)......................................... $ 8,283 $(20,701) Adjustments to reconcile net income (loss) to net cash from operating activities: Depreciation and amortization.......................... 22,721 5,299 Write-down of discontinued operations to net realizable value................................................. 13,662 -- Income tax benefit from stock warrants and options..... 162 11,614 Special charges........................................ -- 40,226 Minority interests in earnings of subsidiary........... -- 2,623 Provision for inventory reserves....................... 923 224 Provision for bad debts................................ 2,863 556 Stock contributed to employee benefit plan............. 305 147 Changes in operating assets and liabilities, net of effects from businesses acquired: Accounts receivable.................................. (50,251) (17,992) Inventories.......................................... (6,349) (22,226) Accounts payable..................................... 30,904 17,626 Other assets and liabilities......................... (5,800) (9,823) -------- -------- Net Cash From Operating Activities................ 17,423 7,573 -------- -------- Cash Flows From Investing Activities: Acquisitions of businesses, net of cash acquired.......... (3,094) (69,027) Proceeds from sales of assets............................. 8,144 -- Capitalization of software development costs.............. (3,735) (3,137) Expenditures for property and equipment................... (7,944) (8,530) Loans to business partners................................ -- (2,800) -------- -------- Net Cash Used By Investing Activities............. (6,629) (83,494) -------- -------- Cash Flows From Financing Activities: Net proceeds from sale of preferred stock................. 47,751 -- Short-term borrowings..................................... 2,000 2,354 Principal payments under capital lease obligations........ (2,310) -- Repayment of industrial revenue bond...................... (4,072) -- Payment of preferred stock dividends...................... (413) -- Proceeds from exercise of stock warrants and options...... 999 8,101 Long-term debt repayments................................. (3,605) (1,261) Issuance of long-term debt................................ 1,654 7,365 Debt issuance costs....................................... (133) (211) -------- -------- Net Cash From Financing Activities................ 41,871 16,348 -------- -------- Increase (Decrease) in Cash and Equivalents............... 52,665 (59,573) Cash and Equivalents at Beginning of Period............... 55,176 118,065 -------- -------- Cash and Equivalents at End of Period..................... $107,841 $ 58,492 ======== ======== Supplemental Schedule of Noncash Financing and Investing Activities: Issuance of common stock for businesses acquired.......... $ 3,825 $ 38,669 Issuance of preferred stock for business acquired......... 18,539 -- Issuance of common stock for technology license agreements............................................. 2,191 -- Issuance of stock options and warrants for businesses acquired............................................... 300 8,360 Conversion of note receivable to investment in ATI........ -- 4,485
See notes to consolidated financial statements. 4 6 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS NOTE 1. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements include the accounts of World Access, Inc. and its majority owned subsidiaries (the "Company") from their effective dates of acquisition. These financial statements have been prepared in accordance with the instructions to Form 10-Q and do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation of the results of the interim periods covered have been included. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The estimated fair value of financial instruments has been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required in interpreting data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts that the Company could realize in a current market exchange. The fair value estimates presented herein are based on pertinent information available to management as of the respective balance sheet dates. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since that date and current estimates of fair value may differ significantly from the amounts presented herein. The fair values of cash equivalents, accounts receivable, accounts payable and accrued expenses approximate the carrying values due to their short-term nature. The fair values of long-term debt are estimated based on current market rates and instruments with the same risk and maturities and approximate the carrying value. The results of operations for the three and nine months ended September 30, 1999 are not necessarily indicative of the results expected for the full year. Certain reclassifications have been made to the prior period's financial information to conform with the presentations used in 1999. NOTE 2. ACQUISITIONS In May 1999, the Company acquired substantially all the assets and assumed certain liabilities of Comm/Net Holding Corporation and its wholly owned subsidiaries, Enhanced Communications Corporation, Comm/Net Services Corporation and Long Distance Exchange Corporation (Comm/Net Holdings and its wholly owned subsidiaries are collectively referred to herein as "Comm/Net"). Comm/Net, headquartered in Plano, Texas, is a facilities-based provider of wholesale international long distance and wholesale prepaid calling card services, primarily to the Mexican telecommunications markets. In connection with the acquisition, the Company issued 23,174 shares of 4.25% Cumulative Junior Convertible Preferred Stock, Series B (the "Series B Preferred Stock"), valued at approximately $18.5 million, and paid approximately $3.5 million to retire certain Comm/Net notes payable outstanding at the time of acquisition. The Series B Preferred Stock is convertible into shares of the Company's common stock at a conversion rate of $16.00 per common share, subject to standard anti-dilution adjustments. If the closing trading price of the Company's common stock exceeds $16.00 per share for 45 consecutive trading days, the Series B Preferred Stock will automatically convert into common stock. Preferred dividends began accruing July 1, 1999 and are payable quarterly. 5 7 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The acquisition of Comm/Net has been accounted for under the purchase method of accounting. The purchase price allocation to the assets acquired and liabilities assumed was based on information currently available to management as follows (in thousands): Purchase price: Preferred stock issued.................................... $18,539 Debt paid................................................. 3,502 Fees and expenses......................................... 500 ------- Total purchase price.............................. $22,541 Allocation to fair values of assets and liabilities: Current assets............................................ $(8,420) Property and equipment.................................... (3,351) Current liabilities....................................... 8,697 Other assets and liabilities, net......................... 1,182 ------- Goodwill.................................................. $20,649 =======
During 1998, the Company acquired several businesses including (i) a majority interest in NACT Telecommunications, Inc. ("NACT") effective February 27, 1998 (the "NACT Acquisition") and the remaining minority interest in NACT effective October 28, 1998 (the "NACT Merger"); (ii) Telco Systems, Inc. ("Telco" ) effective November 30, 1998 (the "Telco Merger"), and (iii) Cherry Communications Incorporated, d/b/a Resurgens Communications Group ("RCG"), and Cherry Communications U.K. Limited ("Cherry U.K.", and together with RCG, "Resurgens") effective December 14, 1998. These transactions are collectively referred to herein as the "Acquisitions". On a pro forma, unaudited basis, as if the Acquisitions had occurred as of January 1, 1998, total revenues, operating loss from continuing operations, loss from continuing operations and loss from continuing operations per diluted common share for the nine months ended September 30, 1998 would have been approximately $232.4 million, $33.1 million, $45.8 million and $1.34, respectively. The results of Advanced TechCom, Inc. ("ATI"), which was acquired effective January 29, 1998, were not material and therefore are not included in the pro forma disclosure for the nine months ended September 30, 1998. The results of operations of Comm/Net, which was acquired in May 1999, were not material and therefore no pro forma disclosure is presented for the nine months ended September 30, 1999. These unaudited pro forma results have been prepared for comparative purposes only and are not necessarily indicative of the results of operations which would actually have occurred had the Acquisitions been in effect on the date indicated. Purchased in-process research and development ("R&D") expensed in connection with the Acquisitions has been excluded from the pro forma results due to its nonrecurring nature. NOTE 3. SALE OF SERIES A PREFERRED STOCK In April 1999, the Company issued 50,000 shares of 4.25% Cumulative Senior Perpetual Convertible Preferred Stock, Series A (the "Series A Preferred Stock") to The 1818 Fund III, L.P. ("The 1818 Fund III") for an aggregate amount of $50.0 million. The General Partner of The 1818 Fund III is Brown Brothers Harriman & Co. ("BBH"). As part of the above sale, The 1818 Fund III also received an option to purchase an additional $20.0 million in Series A Preferred Stock from the Company prior to June 30, 2000 at the original purchase price per share. The Company allocated approximately $44.8 million of the gross proceeds to the 50,000 shares of Series A Preferred Stock sold and $5.2 million to the option granted to purchase additional shares of Series A Preferred Stock. Each share of Series A Preferred Stock is convertible at the option of the holder into the Company's common stock in accordance with a conversion formula equal to the $1,000 liquidation preference per share 6 8 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) divided by a conversion price of $11.50 per share, subject to adjustment. If the closing trading price of the Company's common stock exceeds $30 per share for 45 consecutive trading days, the Series A Preferred Stock will be automatically converted into the Company's common stock. The Series A Preferred Stock may be voted with the Company's common stock on an as converted basis. The holders of Series A Preferred Stock also have the right to designate one member to the Board of Directors. The holders of Series A Preferred Stock have certain supermajority voting rights upon certain circumstances, such as the authorization of a class of securities having senior or parity rights with the Series A Preferred Stock, a reorganization or liquidation of the Company, or a consolidation or merger of the Company into a third party. Upon the closing of the transaction, Lawrence C. Tucker, a partner at BBH and co-manager of The 1818 Fund III, became a member of the Company's Board of Directors. NOTE 4. GAIN ON EXCHANGE OF SECURITIES In connection with the acquisition of Telco, the Company acquired an investment in the common stock of Omnia Communications, Inc. ("Omnia") and warrants to purchase additional common stock of Omnia. The fair value of the investment in Omnia at the time of the acquisition of Telco was approximately $3.0 million and was accounted for under the cost method. In March 1999, Omnia announced that it had entered into an agreement to be acquired by Ciena Corp. ("Ciena"). In June 1999, the Company exercised the outstanding warrants to purchase additional common stock in Omnia. In July 1999, Ciena's acquisition of Omnia was completed and the Company received approximately 445,000 shares of Ciena common stock in exchange for its holdings of Omnia common stock of which approximately 45,000 shares or 10% are being held in escrow for a period of one year related to certain representations and warranties made by Omnia. In accordance with EITF No. 91-5, Nonmonetary Exchange of Cost-Method Investments, the Company recognized a one-time after tax gain during the three months ended September 30, 1999 of approximately $5.3 million or $0.12 per diluted share on the exchange of the Omnia common stock. NOTE 5. DISCONTINUED OPERATIONS In December 1998, the Company formalized its plan to offer for sale two non-core businesses, (i) the resale and repair of Nortel and other original equipment manufacturers' wireline switching equipment, and (ii) pay telephone refurbishment. On January 5, 1999, the Company formally announced its intention to sell these businesses. In connection therewith, the Company recorded a $3.5 million charge in the fourth quarter of 1998, for the estimated loss to dispose of these discontinued operations. This loss, which was recorded as partial impairment of existing goodwill, was determined by comparing the book value of the net assets of the discontinued operations to their net realizable value. The net realizable value was estimated based on preliminary valuation work performed by an investment banking firm engaged by the Company to assist in the sale of these businesses and a preliminary non-committal offer from a prospective buyer. During the first six months of 1999, the Company and its investment bankers formally solicited offers for the two businesses. The preliminary offer referred to above was eventually withdrawn by the potential suitor and the formal selling process generated only one serious offer for the businesses. After several weeks of negotiations, the Company refused this offer due to its low price and substantial credit risk. During this selling process, the Company's Nortel resale business significantly deteriorated and its pay telephone refurbishment business began showing signs of weakness. Management was cautiously optimistic in early 1999 that the negative market trends and operating losses experienced in its Nortel resale business during the fourth quarter of 1998 were temporary in nature and the market/business would rebound in 1999. Unfortunately, this turnaround did not occur as evidenced by the Company's sales in this business which declined from $12.8 million in the fourth quarter of 1998 to $6.0 million in the first quarter of 1999 and $3.6 7 9 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) million in the second quarter of 1999. Several market pressures influenced this negative trend including increased pricing competition in the secondary equipment market, more aggressive participation in this market by Nortel and other telecom equipment manufacturers and the reluctance of customers to purchase used equipment due to year 2000 compliance concerns. Although the discontinued businesses collectively generated a small profit in the first quarter of 1999, they realized an operating loss of approximately $700,000 in the second quarter of 1999. In July 1999, faced with an unsuccessful selling process and future operating losses, management elected to begin liquidating the Nortel resale and repair business. A formal liquidation plan designed to eliminate future quarterly losses, maximize net cash proceeds and realize significant deferred tax credits, was adopted by management and communicated to all affected employees in July 1999. The pay telephone refurbishment business continues to be offered for sale by the Company. As a result of this plan, the Company recorded a charge of $13.7 million in the second quarter of 1999 to reflect the additional loss now expected to be realized on the liquidation of the Nortel resale and repair business. Significant elements of this charge consisted of $5.6 million to write-off all remaining goodwill, $5.2 million to write-down inventories to estimated realizable value, $1.3 million to write-down leasehold improvements, test equipment and other assets to estimated realizable value, $300,000 for severance benefits, and $300,000 for the estimated loss on the disposal of facility leases. The charge also included approximately $200,000 for net operating losses expected to be incurred by the Company during this liquidation process, which is expected to be completed by November 30, 1999. These businesses have been accounted for as discontinued operations and, accordingly, the results of operations have been excluded from continuing operations in the Consolidated Statements of Operations for all periods presented. The assets and liabilities of the discontinued operations included in the Consolidated Balance Sheets consisted of the following (in thousands):
SEPTEMBER 30, DECEMBER 31, 1999 1998 ------------- ------------ Current Assets Accounts receivable....................................... $2,985 $11,453 Inventories............................................... 4,280 12,083 Other current assets...................................... 107 252 ------ ------- $7,372 $23,788 ====== ======= Noncurrent Assets Property and equipment.................................... $ 593 $ 2,028 Goodwill and other intangibles............................ -- 5,335 Other assets.............................................. 895 -- ------ ------- $1,488 $ 7,363 ====== ======= Current Liabilities Accounts payable.......................................... $1,335 $ 4,083 Other accrued liabilities................................. 1,492 3,741 ------ ------- $2,827 $ 7,824 ====== =======
8 10 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) NOTE 6: PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT OVERVIEW During the first quarter of 1998, $5.4 million and $44.6 million of purchased in-process R&D ("IPR&D") was initially expensed in connection with the acquisition of ATI and the NACT Acquisition, respectively. In connection with the NACT Merger, the Company revalued purchased in-process R&D to reflect the current status of in-process NACT technology and related business forecasts and to ensure compliance with the additional guidance provided by the Securities and Exchange Commission in its September 15, 1998 letter to the American Institute of Certified Public Accountants. The revalued amount approximated the $44.6 million expensed in connection with the NACT Acquisition, therefore no additional charge was recorded for purchased in-process R&D. However, the effect of the revaluation required the Company to reduce the first quarter of 1998 charge related to the purchased in-process R&D by $14.6 million and record an additional charge of $14.6 million in the fourth quarter of 1998, the period in which the NACT Merger was consummated. Consequently, net loss for the nine months ended September 30, 1998 of $35.3 million as reported in the Company's Report on Form 10-Q for the three months ended September 30, 1998 is now reported as $20.7 million in this Form 10-Q Report. During the fourth quarter of 1998, $14.6 million and $50.3 million of purchased in-process R&D was expensed in connection with the NACT Merger and the Telco Merger, respectively. These amounts were expensed as non-recurring charges on the respective acquisition dates. These write-offs were necessary because the acquired technology had not yet reached technological feasibility and had no future alternate use. The value of the purchased in-process technology from ATI was determined by estimating the projected net cash flows related to in-process research and development projects, including costs to complete the development of the technology. These cash flows were discounted back to their net present value. The projected net cash flows from such projects were based on management's estimates of revenues and operating profits related to such projects. These estimates were based on several assumptions, including those summarized below. The value of the purchased in-process technology from NACT and Telco was determined by estimating the projected net cash flows related to in-process research and development projects, excluding costs to complete the development of the technology. These cash flows were discounted back to their net present value. The projected net cash flows from such projects were based on management's estimates of revenues and operating profits related to such projects. These estimates were based on several assumptions, including those summarized below for each respective acquisition. The resultant net present value amount was then reduced by a percentage of completion factor. The percentage of completion for a particular project was determined by dividing the development spending from the inception of the project until the measurement date by the total estimated development spending for the project. This factor more specifically captures the development risk of an in-process technology (i.e., market risk is still incorporated in the estimated rate of return). The nature of the efforts required to develop the purchased in-process technology into commercially viable products principally relate to the completion of all planning, designing, prototyping, verification, and test activities that are necessary to establish that the product can be produced to meet its design specifications, including functions, features, and technical performance requirements. The progress on these activities determines the stage of completion of each project in the life cycle of the development. Projects described as being in the "early" or "early concept" stage are not expected to achieve technological feasibility and commercial application within twelve months from the valuation date. These projects are typically in the stage of documenting hardware and software design and preparation of circuit board layouts. Projects described as being in the "mid" stage of development are expected to achieve technological feasibility and commercial application within 6 to 12 months from the valuation date. These projects are typically in the stage of finalizing 9 11 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) circuit board layouts and performing engineering integration tests prior to prototype builds. Projects described as being in the "late" stage of development are expected to achieve technological feasibility and commercial application within 6 months from the valuation date. These projects are typically in stage of prototype builds, initial system testing, quality assurance and field trials. It should be noted that stages of completion refer to specific development milestones, and do not necessarily directly correlate to the percentage of completion used in the IPR&D valuation. The percentage of completion for the IPR&D valuation is based on the development costs incurred on each acquired IPR&D project as of the acquisition date, as a percentage of the total development costs expected to be incurred on that project, from the inception of its development (prior to the acquisition date) until its development is completed (after the acquisition date). If these projects to develop commercially viable products based on the purchased in-process technology are not successfully completed, the sales and profitability of the Company may be adversely affected in future periods. Additionally, the value of other intangible assets may become impaired. ATI MERGER ATI develops and manufactures a series of high-performance digital microwave and millimeterwave radio equipment. Their products reach across all frequency bands and data rates and offer numerous features. The nature of the in-process research and development was such that technological feasibility had not been attained. Failure to attain technological feasibility would have rendered partially designed equipment useless for other applications. ATI's products are designed for specific frequency bandwidths and, as such, are highly customized to those bandwidths and the needs of customers wishing to operate in them. Products only partially completed for certain bandwidths cannot be used in other bandwidths. Between each product line, various stages of development had been reached. Additionally, within each product line, different units had reached various stages of development. Of the products management considered in-process, none had attained technological feasibility. The purchased in-process technology acquired in the ATI acquisition was comprised of three primary projects related to high-performance, digital microwave and millimeterwave radio equipment. Each project consists of multiple products. These projects were at multiple stages along ATI's typical development timeline. Some projects were beginning testing in ATI labs; others were at earlier stages of planning and designing. The majority of the products were scheduled to be released during 1998, 1999 and early 2000. Revenue projections for the in-process technologies reflected the anticipated release dates of each project. Revenue attributable to in-process technology was estimated to increase within the first three years of the seven-year projection at annual rates ranging from a high of 240.7% to a low of 2.3%, decreasing within the remaining years at annual rates ranging from 30.9% to 60.9% as other products are released in the marketplace. Projected annual revenue attributable to in-process technology ranged from approximately a low of $11.8 million to a high of $71.1 million within the term of the projections. These projections were based on assumed penetration of the existing customer base and movement into new markets. Projected revenues from in-process technology were assumed to peak in 2001 and decline from 2002 through 2004 as other new products are expected to enter the market. In-process technology's contribution to the operating profit of ATI (earnings before interest, taxes and depreciation and amortization) was estimated to grow within the projection period at annual rates ranging from a high of 665.9% to a low of 43.9% during the first four years, decreasing during the remaining years of the projection period similar to the revenue growth projections described above. Projected in-process technology's annual contribution to operating profit (loss) ranged from approximately a low of $(900,000) to a high of $9.1 million within the term of the projections. The discount rate used to value the in-process technology of ATI was 26.0%. This discount rate was estimated relative to the overall business discount rate of 25.0% based on (1) the incomplete status of the 10 12 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) products expected to utilize the in-process technology (i.e., development risk), (2) the expected market risk of the planned products relative to the existing products, (3) the emphasis on different markets than those currently pursued by ATI, and (4) the nature of remaining development tasks relative to previous development efforts. Management estimated that the costs to develop the in-process technology acquired in the ATI acquisition would be approximately $24.3 million in the aggregate through the year 2002. The expected sources of funding were scheduled R&D expenses from the operating budget of ATI. NACT MERGER NACT provides advanced telecommunications switching platforms with integrated applications software and network telemanagement capabilities. NACT designs, develops, and manufacturers all hardware and software elements necessary for a fully integrated, turnkey telecommunications switching solution. The nature of the in-process research and development was such that technological feasibility had not been attained. Failure to attain technological feasibility, especially given the high degree of customization required for complete integration into the NACT solution, would have rendered partially designed hardware and software useless for other applications. Incomplete design of hardware and software coding would create a non-connective, inoperable product that would have no alternative use. NACT's business plan called for a shift in market focus to large customers, both domestic and international; therefore, NACT had numerous projects in development at the time of the acquisition. Additionally, the pending completion of a major release of NACT's billing system required significant development efforts to ensure continued integration with NACT's product suite. The purchased in-process technology acquired in the NACT Acquisition was comprised of 13 projects related to switching and billing systems. These projects were scheduled to be released between February 1998 and April 2000. These projects included planned additions of new products, based on undeveloped technologies, to NACT's suite of STX and NTS products. The projects also include the creation of products for new product suites. The research and development projects were at various stages of development. None of the in-process projects considered in the write-off had attained technological feasibility. The in-process projects do not build on existing core technology; such existing technologies were valued as a separate asset. A brief summary of the significant technologies NACT was developing for their STX and NTS products at the time of the acquisition are as follows: STX Application Switching Platform ("STX"). STX was introduced in May 1996 as an integrated digital tandem switching system which allows scalability from 24 ports to a capacity of 1,024 ports per switch. The STX can be combined with three additional STXs to provide a total capacity of 4,096 ports per system. The current STX is not sufficiently developed to address NACT's objective of targeting larger, more diverse telecommunications companies. To move into this expanded customer base, NACT has multiple development tasks planned for the STX product. NACT plans to incorporate into the STX certain features and enhancements such as SS7 and E1 (discussed below), R-2 signaling, and Integrated Services Digital Network, which are critical to the Company's strategy to broaden its customer base. The SS7 and E1 features are considered new products within the STX family of products. Master Control Unit ("MCU"). MCU is a database hub which can link up to four switches, creating a larger capacity tandem switch. NACT is developing an updated MCU, called the "redundant MCU", which allows for intelligent peripheral or recognition of pre-paid caller numbers. Redundant MCU is an important extension to the MCU system because it will allow a telecommunications company to create an entire switching network outside of the public network owned by major telecommunications firms. NTS Telemanagement and Billing System ("NTS"). NTS performs call rating, accounting, switch management, invoicing, and traffic engineering for multiple NACT switches. NACT recently finished 11 13 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) development of an improved billing system, the NTS 2000, which is designed for real-time transaction processing with graphical user interface and improved call reports. The NTS 2000 is compatible with non-NACT switches. The NTS 2000 also allows for customization of invoices and reports. E1 to T1 Conversion. The T1 is the switchboard hardware used in the STX. The T1 product has been in existence for several years. The E1 is the standard switchboard used in Europe. NACT is creating a technology which facilitates compatibility between the T1 and the switchboard hardware currently used in Europe. In addition, NACT is currently developing enhanced switchboard hardware called the T3, which will allow for more calls to pass through the switchboard at one time. Both development efforts, the T3 and compatibility between E1 and T1, are necessary as NACT moves into international markets. Transmission Control Protocol/Internet Protocol ("TCP/IP") Connectivity. TCP/IP is the most common method of connecting personal computers, workstations and servers. Other historically dominant networking protocols, such as the local area network ("LAN") protocol and international packet exchange/sequence packet exchange, are losing ground to TCP/IP. The addition of TCP/IP is vital relative to NACT's strategic objective of offering voice-over-Internet. 68060. The Company has now completed the incorporation of the Motorola 68060 processing board in the STX application platform to enable the STX to support 2,048 ports per switch or 8,192 ports per integrated MCU system. With this development, the STX can process significantly more call minutes per month, with enhanced processing speed. Signaling System 7 ("SS7/C7"). SS7 is software that allows a call, which normally would have to go through a series of switchboards to reach its destination, to instead skip from the first switchboard to the last. With the addition of this enhancement, the STX switch can interface with carriers more quickly and efficiently. In addition, NACT is developing the C7, which is the European version of the SS7. The seven technologies reflected above represent 11 of the 13 projects that NACT had in development at the time of acquisition. The STX development consists of four separate projects, and the MCU development consists of two separate projects. These projects were at multiple stages along NACT's development timeline. Some projects were beginning testing in NACT labs; others were at earlier stages of planning and designing. These projects were scheduled for release between December 1998 and December 2000. Revenue projections for the in-process technologies reflected the anticipated release dates of each project. Revenue attributable to in-process technology was assumed to increase in the first five years of the 12-year projection at annual rates ranging from 61.4% to 2.81%, decreasing over the remaining years at annual rates ranging from 16.0% to 48.5% as other products are released in the marketplace. Projected annual revenue attributable to in-process technology ranged from approximately a low of $8.0 million to a high of $101.1 million within the term of the projections. These projections were based on assumed penetration of the existing customer base and movement into new markets. Projected revenues from in-process technology were assumed to peak in 2003 and decline from 2004 through 2009 as other new products are expected to enter the market. In-process technology's contribution to the operating profit of NACT (earnings before interest, taxes and depreciation and amortization) was projected to grow within the projection period at annual rates ranging from a high of 67.2% to a low of 2.8% during the first five years, decreasing during the remaining years of the projection period similar to the revenue growth projections described above. Projected in-process technology's annual contribution to operating profit ranged from approximately $2.1 million to $29.3 million within the term of the projections. The discount rate used to value the existing technology of NACT was 14.0%. This discount rate was estimated relative to the overall business discount rate of 15.0% based on (1) the completed status of the 12 14 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) products utilizing existing technology (i.e., the lack of development risk), and (2) the potential for obsolescence of current products in the marketplace. The discount rate used to value the in-process technology of NACT was 15.0%. This discount rate was estimated relative to the overall business discount rate of 15.0% based on (1) the incomplete status of the products expected to utilize the in-process technology (i.e., development risk), (2) the expected market risk of the planned products relative to the existing products, (3) the emphasis on targeting larger customers for the planned products, (4) the expected demand for the products from current and prospective NACT customers, (5) the anticipated increase in NACT's sales force, and (6) the nature of remaining development tasks relative to previous development efforts. Set forth in the table below are details relating to the in-process research and development charge for the seven key NACT technologies, which account for 11 of the 13 development projects (dollar amounts in thousands):
PERCENTAGE OF COMPLETION AS OF ------------------------- ESTIMATED COST TO COMPLETION PERCENTAGE OF COSTS INCURRED AS OF THE ACQUISITION DATE FOR NACT IPR&D AS OF ACQUISITION ACQUISITION --------------------------------- DEVELOPMENT PROJECT CHARGE DATE DATE 9/30/99 1998 1999 2000 - ------------------- ------------- ----------------- ----------- -------- --------- --------- --------- STX Hardware & Software....... 43% $1,347 80% 96% $56 $285 TCPIP......................... 7 227 90 100 8 17 SS7/C7........................ 14 1,280 72 90 54 324 $116 NTS2000....................... 26 1,425 91 100 54 82 E1/T1 conversion.............. 6 125 48 90 20 117 MCU........................... 1 123 24 80 66 334 68060......................... 2 218 48 100 60 178
TELCO MERGER Telco develops and manufactures products focused on providing integrated access for network services. Telco's products can be separated into three categories: (1) broadband transmission products, (2) network access products, and (3) bandwidth optimization products. Telco's products are deployed at the edge of the service provider's networks to provide organizations with a flexible, cost-effective means of transmitting voice, data, video and image traffic over public or private networks. At the time of acquisition, Telco had several primary projects in development relating to next-generation telecommunication and data network hardware. These projects were at various stages in the development process. Some were about to enter the testing phase of the initial hardware prototype, while others were still in the early concept and design specification stages. These projects were scheduled for commercial release at various points in time from December 1998 through early 2000. Telco's in-process research and development projects are being developed to run on new communications protocols and technologies not employed in its current products. These include HDSL, SONET, Voice over IP and ATM inverse multiplexing. Additionally, the products to be commercialized from Telco's in process research and development are expected to include interface support not in Telco's current product line, including E1, DS3 and OC3. A brief description of the significant in-process projects is set forth below: Access 45/60 Release 1. Access 45/60 Release 1 product provides essentially the same functional service as the existing Access 45/60 network access servers by providing highly reliable digital access to public, private and hybrid networks, integrating multiple business applications through cost-effective connections to dedicated, switched and packet network services. However, unlike the current versions, the technology underlying the Release 1 (R1) version is based on high-bit-rate digital subscriber line (HDSL) technology. This HDSL technology will enable high-density voice and data applications to travel simultaneously over one 13 15 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) to ten HDSL lines from a single platform, which will launch the R1 product into a whole new loop market by eliminating the need for service providers to have separate platforms for voice and data at the customer's premises or at the provider's central office. Although the Access 45/60 R1 product is designed to provide a service similar to the current Access 45/60 product, the core functional technology of the new R1 is very different, and the target market of the R1 product is different. This project was in the late stage of development and has been recently completed. EdgeLink 100 E1 -- The EdgeLink 100 E1 version is an addition to the 100 family which will be marketed internationally. Conforming to all applicable ETSI and ITU standards, this product will provide a cornerstone to the next generation of international product offerings. This product was in the early stage of development at the time of acquisition, and is expected to achieve commercial viability by the end of 1999. Software code generation was completed in April 1999. Prototype builds for initial units were completed in June 1999, and initial beta field tests are expected to begin in the fourth quarter of 1999. EdgeLink 300 -- The EdgeLink 300 is an intelligent integrated access device, which will provide low cost integration of voice and data services at the customer premise by incorporating the functionality of several different customer premise devices to allow low cost integration of POTS (plain old telephone service), PBX, corporate LAN access and Internet access services in a single box. The product can be connected to the network via a DS1, SDSL or HDSL. These multiple access choices allow for lowest cost access to customers under various regulatory conditions. This project was acquired by Telco through its acquisition of Synaptyx in October of 1998. This product was in the late stage of development and was introduced in the first half of 1999. SONET Edge Device -- The SONET Edge Device is a next-generation edge device expected to provide access to SONET networks. This access device will be designed to take a T1 voice input from a PBX or an Access60 and convert to SONET formatted tributaries and send it out via a traditional STS1 interface. This project was in the early stage of development at the time of acquisition, and was not expected to reach commercial viability until early 2000. This project has recently been consolidated with the EdgeLink 650/IMA. The consolidated project is currently expected to be introduced in the third quarter of 2000. EdgeLink 600 -- The EdgeLink 600 ATM access device is expected to be the first of Telco's new class of remote access systems designed to support mission-critical multimedia traffic with guaranteed end-to-end quality of service. This device is expected to consolidate mission-critical data, voice and video traffic onto ATM or Frame Relay networks, allowing cost effective video conferencing and voice integration without compromising critical data traffic. These systems will address users who wish to take advantage of the quality and cost effectiveness of ATM but do not wish to run ATM to their desktop. Although much of the hardware and software design documentation and the board layouts have been completed, in the second quarter of 1999 the development of this product has been temporarily suspended to allow the Company to focus its development efforts on completing certain other projects. EdgeLink 650 IMA -- The EdgeLink 650 ATM device will be designed to be a multislot version of the Edgelink600 with DS3 and NxDS1 interface support. This product will incorporate an ATM Inverse Multiplexer (IMA). This product was in the early stage of development at the time of acquisition, and was expected to reach commercial viability in early 2000. This project has recently been consolidated with the SONET Edge Device. The consolidated project is currently expected to be introduced in the third quarter of 2000. Voice-Over-Packet Engines -- Voice-over-packet refers to sending voice transmissions over packet-based communication protocols, such as internet protocols (IP telephony), Frame Relay, or ATM. Telco is currently developing the software and hardware for a generic "engine" to be integrated into the EdgeLink family of products to enable this functionality. This product was in the mid stage of development at the time of 14 16 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) acquisition, and is expected to be commercially viable by mid-2000. Software code generation is expected to be completed in March 2000; prototype builds for initial units are expected to be completed in May 2000; and initial beta field tests are expected to begin in July 2000. HyperSPAN SMUG -- A new application specific integrated circuit (ASIC) is being designed to be integrated into the HyperSPAN multiplexer boards in order to (i) avoid technological obsolescence, and (ii) to reduce production costs. The development of this replacement technology was at an early to mid stage at the time of acquisition and is expected to be commercially viable by early 2000. Set forth in the table below are details relating to the significant Telco in-process research and development projects (dollar amounts in thousands):
PERCENTAGE OF COMPLETION AS OF PERCENTAGE OF ---------------------- ESTIMATED COSTS TO COMPLETION TELCO COSTS INCURRED AS OF THE ACQUISITION DATE FOR IPR&D AS OF ACQUISITION ACQUISITION ------------------------------ DEVELOPMENT PROJECT CHARGE DATE DATE 9/30/99 1998 1999 2000 - ------------------- ------------- ----------------- ----------- -------- ------ -------- -------- Access 45/60 Release 1........... 1% $2,610 72% 98% $ 77 $ 923 EdgeLink 100 E1.................. 4 880 47 85 76 914 EdgeLink 650/IMA/Sonet IAD....... 22 2,920 32 50 422 5,068 $1,000 Voice over Packet................ 11 1,730 45 90 162 1,948 EdgeLink 300..................... 48 2,200 90 100 100 200 EdgeLink 600..................... 12 3,300 85 95 197 393 Hyperspan SMUG................... 2 760 77 95 38 192
If these projects are not completed as planned, the in-process research and development will have no alternative use. Failure of the in-process technologies to achieve technological feasibility may adversely affect the future profitability of World Access. Revenue attributable to Telco's aggregate in-process technology was assumed to increase over the first six years of the projection period at annual rates ranging from a high of 103.6% to a low of 3.8%, reflecting both the displacement of Telco's old products by these new products as well as the expected growth in the overall market in which Telco's products compete. Thereafter, revenues are projected to decline over the remaining projection period at annual rates ranging from 15.2% to 42.6%, as the acquired in process technologies become obsolete and are replaced by newer technologies. Management's projected annual revenues attributable to the aggregate acquired in-process technologies, which assume that all such technologies achieve technological feasibility, ranged from a low of approximately $39.0 million to a high of approximately $276 million. Projected revenues were projected to peak in 2004 and decline thereafter through 2009 as other new products enter the market. The acquired in-process technology's contribution to the operating income was projected to grow over the first five years of the projection period at annual rates ranging from a high of 240.9% to a low of 22.2% with one intermediate year of marginally declining operating income. Thereafter, the contribution to operating income was projected to decline through the projection period. The acquired in-process technology's contribution to operating income ranged from a low of approximately $4.4 million to a high of approximately $70.5 million. The discount rate used to value the existing Telco technology was 20.0%. This discount rate was selected because of the asset's intangible characteristics, the risk associated with the economic life expectations of the technology and potential obsolescence of legacy products, and the risk associated with the financial assumptions with respect to the projections used in the analysis. The discount rate used to value the in-process Telco technologies was 25.0%. This discount rate was selected due to several incremental inherent risks. First, the actual useful economic life of such technologies may differ from the estimates used in the analysis. Second, risks associated with the financial projections on the specific products that comprise the acquired in-process research and development. The third factor was 15 17 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) the incomplete and unproven nature of the technologies. Finally, future technological advances that are currently unknown may negatively impact the economic and functional viability of the in-process R&D. The discount rates used to value in-process research and development are different in each of the three mergers due to the following factors: (i) the nature of the markets for the products under development, including factors such as market size, ability to enter the markets, competitive landscape, possibility of technological obsolescence, and target customer base, and (ii) the nature of the acquired businesses, including the historical success with product introductions, ability to meet development milestones, strength of the sales and marketing organizations, access to market channels and strength of the brand names. NOTE 7. RESTRUCTURING AND OTHER CHARGES SUMMARY During 1998, the Company approved and began implementing two restructuring programs designed to reduce operating costs, outsource manufacturing requirements and focus Company resources on recently acquired business units containing proprietary technology or services. In the first quarter of 1998, the Company approved and began implementing a restructuring program to consolidate several operations and exit the contract manufacturing business. In connection with these activities, the Company recorded restructuring and other charges of approximately $6.6 million of which $1.1 million was charged to continuing operations and $5.5 million was charged to discontinued operations. This restructuring activity was substantially completed as of June 30, 1998. In the fourth quarter of 1998, in connection with the (i) NACT, Telco and Resurgens Mergers; (ii) election of several new outside directors to the Company's Board; and (iii) appointment of a new Chief Executive Officer, the Company approved and began implementing a major restructuring program to reorganize its operating structure, consolidate several facilities, outsource its manufacturing requirements, rationalize its product offerings and related development efforts, and pursue other potential synergies expected to be realized as a result of the integration of recently acquired businesses. In connection with these activities, the Company recorded restructuring and other charges of approximately $43.0 million of which $36.2 million was charged to continuing operations and $6.8 million was charged to discontinued operations. As of the date of this Report, the Company has substantially completed these restructuring activities. 16 18 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The following details the charges during the first nine months of 1999 to reserves established in connection with the fourth quarter 1998 restructuring program (in thousands):
RESERVE BALANCE 1999 RESERVE BALANCE AT 12/31/98 ACTIVITY AT 9/30/99 --------------- -------- --------------- Reorganize Operating Structure Employee termination benefits................... $ 449 $ 307 $ 142 Idle facility costs............................. 258 249 9 Other........................................... 304 278 26 ------ ------ ------ 1,011 834 177 Consolidation of ATI and Telco Employee termination benefits................... 1,175 1,012 163 Idle facility costs............................. 577 207 370 Other........................................... 300 128 172 ------ ------ ------ 2,052 1,347 705 Outsource Manufacturing Employee termination benefits................... 310 310 -- Idle facility costs............................. 365 365 -- Other........................................... 332 332 -- ------ ------ ------ 1,007 1,007 -- Product Line Rationalization...................... 568 338 230 ------ ------ ------ Total................................... $4,638 $3,526 $1,112 ====== ====== ======
Costs associated with the reorganized operating structure consist primarily of termination benefits payable to the Company's former President, which will be paid throughout 1999, and remaining lease obligations on the Company's Equipment Group headquarters facility in Alpharetta, Georgia. In February 1999, Equipment Group personnel relocated to the Company's headquarters in Atlanta and the facility was closed. Restructuring costs also included amounts associated with the consolidation of the Company's ATI operations in Wilmington, Massachusetts into Telco's facility in Norwood, Massachusetts. Manufacturing of ATI's wireless radios has been out-sourced to a contact manufacturer and all other aspects of ATI's operations are being integrated into Telco's existing operating infrastructure. Severance and other termination benefits of approximately $1.2 million are to be paid to approximately 60 ATI employees as the consolidation program is completed during 1999. A provision of $577,000 was recorded for the costs associated with the idle portion of the Wilmington facility, which is leased through November 2000. An integral part of the restructuring program was the Company's decision to outsource all its electrical manufacturing requirements and sell its Alpharetta, Georgia manufacturing facility to an established contract manufacturer. Severance and other termination benefits of $426,000 were provided for in December 1998 to approximately 25 personnel. The Company completed the sale of its manufacturing operations in March 1999. The actual loss incurred in connection with the sale did not differ materially from the amounts recorded in the restructuring charges. As part of this sale agreement, the Company committed to purchase a minimum of $15.0 million of products and services from the contract manufacturer in each of three consecutive 12 month periods beginning April 1, 1999. Costs related to product line rationalization related to the phase out of the Company's Compact Digital Exchange ("CDX") switch. In January 1999, the Company elected to reallocate development resources targeted for the CDX switch as a stand-alone product to the integration of the central office functionally of the 17 19 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) CDX switch and the long-distance functionality of NACT's switch into a common, next generation technology platform. Costs incurred in 1999 related primarily to engineering efforts incurred related to 1998 and prior CDX contracts. NOTE 8. INVENTORIES Inventories consisted of the following (in thousands):
SEPTEMBER 30, DECEMBER 31, 1999 1998 ------------- ------------ Transport and access products............................... $ 7,975 $ 8,723 Switching products.......................................... 1,943 986 Cellular equipment.......................................... 16,401 9,421 Work in progress............................................ 1,881 4,953 Raw materials............................................... 7,957 12,425 ------- ------- Continuing operations....................................... 36,157 36,508 Discontinued operations..................................... 4,280 12,083 ------- ------- Total Inventories................................. $40,437 $48,591 ======= =======
During the first quarter of 1999, in connection with the sale of the Company's Alpharetta, Georgia manufacturing facility and the outsourcing of manufacturing for ATI's wireless radios, the Company sold approximately $3.3 million and $2.1 million of inventories, respectively. In the second quarter of 1999, the Company wrote down inventories of the discontinued operations by $6.5 million to adjust the carrying cost to net realizable value. NOTE 9. REPORTABLE SEGMENT DATA The Company has two reportable segments: telecommunications carrier services ("World Access Telecommunications Group") and telecommunications equipment ("World Access Equipment Group"). The World Access Telecommunications Group provides wholesale international long distance service through a combination of its own international network facilities, various international termination relationships and resale arrangements with other international long distance service providers. The World Access Equipment Group develops, manufactures and markets digital switches, billing and network telemanagement systems, cellular base stations, fixed wireless local loop systems, intelligent multiplexers, digital microwave radio systems and other telecommunications network products. The World Access Telecommunications Group consists of the Resurgens business which was acquired in December 1998, Comm/Net which was acquired in May 1999 and a portion of the NACT business which was acquired in February and October 1998. The Company evaluates performance and allocates resources based on operating income or loss before interest and other income, interest expense and income taxes. The accounting policies of the reportable segments are the same as those described in the summary of significant accounting policies. Intersegment sales and transfers are recorded at cost plus a markup that equals current market prices. There were no significant intersegment sales during the nine months ended September 30, 1999 and the year ended December 31, 1998. 18 20 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) The Company's reportable segments are business units that offer different products and services. The reportable segments are each managed separately due to the unique nature of each segment (i.e., selling telecommunications equipment versus providing international long distance services). The following tables present revenues and other financial information by business segment (in thousands):
FOR THE NINE MONTHS ENDED SEPTEMBER 30, --------------------------------------------------------------------- EQUIPMENT TELECOM CONTINUING DISCONTINUED GROUP GROUP OTHER OPERATIONS OPERATIONS TOTAL --------- -------- ------- ---------- ------------ -------- Revenues from external customers 1999....................................... $195,000 $329,290 $ -- $524,290 $18,702 $542,992 1998....................................... 93,021 1,174 -- 94,195 42,829 137,024 In-process research and development 1999....................................... -- -- -- -- -- -- 1998....................................... 35,400 -- -- 35,400 -- 35,400 Restructuring and other charges 1999....................................... -- -- -- -- 13,662 13,662 1998....................................... 1,055 -- -- 1,055 5,545 6,600 Segment income or loss 1999....................................... 21,072 6,804 (5,229) 22,647 (14,364) 8,283 1998....................................... (19,867) 32 (3,788) (23,623) 2,922 (20,701)
EQUIPMENT TELECOM CONTINUING DISCONTINUED GROUP GROUP OTHER OPERATIONS OPERATIONS TOTAL --------- -------- ------- ---------- ------------ -------- Segment assets As of September 30, 1999................... 384,892 238,476 95,681 719,049 8,860 727,909 As of December 31, 1998.................... 380,721 161,137 40,803 582,661 31,151 613,812
NOTE 10. LITIGATION Following the Company's announcement on January 5, 1999, regarding earnings expectations for the quarter and year ended December 31, 1998, and the subsequent decline in the price of the Company's common stock, 22 putative class action complaints were filed against the Company in the United States District Court for the Northern District of Georgia, Atlanta Division (the "Court"). The Company and certain of its then current officers and directors were named as defendants. A second decline in the Company's stock price occurred shortly after actual earnings were announced on February 11, 1999, and a few of these cases were amended, and additional, similar complaints were filed. The pending cases were consolidated pursuant to an order entered by the Court on April 28, 1999. The Court has deferred ruling on a pending motion regarding the appointment of lead plaintiffs and lead counsel. The plaintiffs filed a Consolidated Amended Class Action Complaint (the "Amended Complaint") on May 28, 1999, naming as defendants the Company and certain of its directors and executive officers. In the Amended Complaint, the plaintiffs have asserted claims for violations of the federal securities laws arising from alleged misstatements of material information in and/or omissions of material information from certain of the Company's securities filings and other public disclosures, principally related to alleged performance problems with the Company's CDX switch and alleged customer and sales problems arising therefrom. Although the issue of class certification has not yet been addressed, the Amended Complaint is filed on behalf of: (a) persons who purchased shares of the Company's common stock during the period from April 29, 1997 through February 11, 1999; (b) shareholders of Telco who received shares of the Company's common stock as a result of the Company's acquisition of Telco that closed on November 30, 1998; and (c) shareholders of NACT who received shares of the Company's common stock as a result of the Company's acquisition of NACT that closed on October 28, 1998. The plaintiffs have requested damages in an unspecified amount and litigation expenses in their Amended Complaint. 19 21 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) On June 28, 1999, the defendants moved to dismiss the Amended Complaint on both substantive and procedural grounds. The motion is currently pending before the Court. Although the Company and the individuals named as defendants deny that they have violated any of the requirements or obligations of the federal securities laws, there can be no assurance that the Company will not sustain material liability as a result of or related to this shareholder suit. NOTE 11. INCOME TAXES The Company's provision for income taxes attributable to continuing operations for the nine months ended September 30, 1999 was $20.3 million or approximately 47.4% of income from continuing operations before income taxes. The provision for income taxes differs from the amount computed by applying the statutory federal and state income tax rates due to non-deductible expenses, primarily goodwill amortization. NOTE 12. SUMMARIZED FINANCIAL INFORMATION OF WA TELCOM PRODUCTS CO., INC. On October 28, 1998, World Access, Inc. reorganized its operations into a holding company structure and changed its name to WA Telcom Products Co., Inc. ("WA Telcom"). As a result of the reorganization, WA Telcom became a wholly-owned subsidiary of WAXS INC., which subsequently changed its name to World Access, Inc. and is the Company filing this Report. Pursuant to the reorganization, the Company exchanged each outstanding share of common stock of WA Telcom for one share of common stock of the Company, converted each option and warrant to purchase shares of common stock of WA Telcom into options and warrants to purchase a like number of shares of common stock of the Company, and fully and unconditionally guaranteed the payment of the $115.0 million aggregate principal amount of 4.5% convertible subordinated notes due October 2002 previously issued by WA Telcom. Set forth below is summarized financial information of WA Telcom presented for the information of its debtholders. The summarized financial information presented below includes the results of operations for the following businesses from their respective dates of acquisitions: Cellular Infrastructure Supply, Inc. -- January 1997; Galaxy Personal Communications Services, Inc. -- July 1997; ATI -- January 1998; NACT -- February 1998; Telco -- November 1998 and Resurgens -- December 1998. BALANCE SHEET INFORMATION (IN THOUSANDS)
SEPTEMBER 30, DECEMBER 31, 1999 1998 ------------- ------------ Current assets.............................................. $165,992 $162,554 Non-current assets.......................................... 313,996 300,139 Total assets................................................ 479,988 462,693 Current liabilities......................................... 111,461 70,976 Non-current liabilities..................................... 142,912 138,529 Stockholders equity......................................... 225,615 253,188 Total liabilities and stockholders equity................... 479,988 462,693
20 22 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) OPERATING STATEMENT INFORMATION (IN THOUSANDS)
NINE MONTHS ENDED SEPTEMBER 30, 1999(1) --------------------- Total sales................................................. $428,498 Gross profit................................................ 65,039 Income (loss) from continuing operations.................... 10,793 Income (loss) from discontinued operations(2)............... (14,364) Net income.................................................. (3,571)
- --------------- (1) No operating statement information is presented for the nine months ended September 30, 1998 as the holding company reorganization was not completed until October 28, 1998. (2) Reflects the Company's plan to sell all of its non-core businesses, which consist of the resale of Nortel and other original equipment manufacturers' wireline switching equipment, third party repair of telecom equipment and pay telephone refurbishment. The discontinued operations had total assets of $8.9 million and $31.1 million as of September 30, 1999 and December 31, 1998, respectively, and total liabilities of $5.0 million and $7.8 million as of September 30, 1999 and December 31, 1998, respectively. NOTE 13. SUBSEQUENT EVENTS FACILICOM MERGER On August 17, 1999 the Company entered into a definitive merger agreement with FaciliCom International, Inc., a privately owned company that is a leading facilities-based provider of European and U.S. originated international long-distance voice, data and Internet services. Pursuant to the terms of the agreement, the shareholders of FaciliCom will receive the following consideration: - an amount of cash and/or the Company's common stock equal in value to $56.0 million; - approximately 369,400 shares, or $369.4 million in aggregate liquidation preference, of World Access Convertible Preferred Stock, Series C; and - approximately 520,000 vested options that each may be exercised for one share of the Company's common stock at an average exercise price of $3.06 per share. Once this transaction has been completed, former FaciliCom shareholders will hold approximately 24% of the Company's common stock on an as-converted basis. The Preferred Stock bears no dividend and is convertible into shares of the Company's common stock at a conversion rate of $20.38 per common share, subject to adjustment in the event of below market issuances of common stock, stock dividends, subdivisions, combinations, reclassifications and other distributions with respect to World Access common stock. If the closing trading price of the Company's common stock exceeds $20.38 per share for 60 consecutive trading days, the Preferred Stock will automatically convert into common stock. Initially, the holders of the Preferred Stock will be entitled to elect four new directors to the Company's Board of Directors. Except for the election of directors, the holders of the Preferred Stock will vote on an as-converted basis with the holders of the Company's common stock. The closing of the transaction is conditioned upon a majority of the holders of FaciliCom 10 1/2% Series B Senior Notes due 2008 agreeing to waive put rights and defaults triggered by the merger and amend the indenture governing the FaciliCom notes to provide additional flexibility under the limitation on indebtedness and limitation on asset sales covenants of the indenture. On October 12, 1999, the Company entered into an agreement with FaciliCom and the holders of a majority in interest of the FaciliCom notes in which the Company agreed, under certain circumstances, to make an exchange offer for the outstanding FaciliCom notes for the exchange consideration and those holders agreed to tender their FaciliCom notes in exchange for the 21 23 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) exchange consideration. Under the terms of the exchange offer, each $1,000 principal amount of FaciliCom notes will be exchanged for: (1) $1,000 principal amount of exchange notes, which have terms and conditions substantially identical in all material respects to the terms of the outstanding FaciliCom notes except: - World Access, and not FaciliCom, is responsible for payment of all amounts due on the exchange notes; - the interest rate on the exchange notes is 13.25% per annum; - the Company will be obligated to make an offer to purchase the exchange notes with the cash proceeds from some asset sales; - the amounts to redeem the exchange notes prior to 2006 are greater than the equivalent payments under the FaciliCom notes; and - the covenants in the indenture governing the terms of the exchange notes allow the Company more flexibility to incur indebtedness, make some restricted payments, enter into some transactions with affiliates, permit restrictions on the payment of dividends, conduct our telecommunications equipment business and undertake some asset sales than was allowed under the FaciliCom indenture; (2) such number of shares of the Company's common stock having an aggregate market value of $50; and (3) a cash payment of $10. The transaction is also subject to the following conditions: - approval of the Company's shareholders at a meeting currently scheduled for December 7, 1999; - expiration of applicable waiting periods under applicable antitrust and anticompetition laws in Sweden, Germany and Finland; and - approval of the transfer to World Access of FaciliCom's telecommunications licenses by the Federal Communications Commission and other applicable regulatory authorities. WorldCom Network Services, Inc., The 1818 Fund III, L.P. and John D. Phillips, which represent in the aggregate approximately 24% of the current voting power of the Company's common stock, have entered into a Voting Agreement whereby they have committed to vote in favor of the merger. Armstrong International Telecommunications, Inc., Epic Interests, Inc. and BFV Associates, Inc., which are the majority stockholders of FaciliCom, have already approved the merger. The merger is expected to close in the fourth quarter of 1999 and will be accounted for as a purchase transaction. PRIVATE PLACEMENT On October 13, 1999 the Company received commitments from a group of institutional and sophisticated investors to purchase $75.0 million of the Company's common stock in a private transaction that is conditioned upon, among other things, and will close simultaneously with the Company's pending merger with FaciliCom. The majority of the proceeds from this private placement will be used to fund the cash portion of the FaciliCom merger, including related fees and expenses. The common stock to be issued will be priced at the average trading value of the Company's common stock during a five day period prior to the closing of the FaciliCom merger, with the purchase price to be no lower than $13.00 per share and no higher than $17.00 per share. 22 24 WORLD ACCESS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED) ISSUANCE OF SECURED LOAN On October 19, 1999, the Company funded a $2.0 million loan to Long Distance International, Inc. ("LDI"), a privately held provider of retail telecommunications services throughout Western Europe, as a participant in a Loan Facility between an existing secured creditor and LDI. Loans made pursuant to the Loan Facility are secured by certain assets of LDI, bear interest at 12.25% per annum and are due July 20, 2000. The Company also has entered into discussions with LDI regarding a potential business transaction between the two companies. 23 25 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS FORWARD LOOKING STATEMENTS This Form 10-Q Report contains certain "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1993, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended, which are intended to be covered by the safe harbors created thereby. Forward-looking statements are statements other than historical information or statements of current condition. Some forward looking statements may be identified by use of such terms as "believes", "anticipates", "intends", or "expects". These forward-looking statements relate to the plans, objectives and expectations of the Company for future operations. In light of the risks and uncertainties inherent in all such projected operational matters, the inclusion of forward-looking statements in this Report should not be regarded as a representation by the Company or any other person that the objectives or plans of the Company will be achieved or that any of the Company's operating expectations will be realized. Factors that could cause actual results to differ from the results discussed in the forward-looking statements include, but are not limited to, the Company's dependence on (i) recently introduced products and products under development; (ii) successful integration of new acquisitions; (iii) the impact of technological change on the Company's products and services; (iv) changes in customer rates per minute; (v) termination of certain service agreements or inability to enter into additional service agreements; (vi) changes in or developments under domestic or foreign laws, regulations, licensing requirements or telecommunications standards; (vii) changes in the availability of transmission facilities; (viii) loss of the services of key officers; (ix) loss of a customer which provides significant revenues to the Company; (x) highly competitive market conditions in the industry; and (xi) concentration of credit risk. The foregoing review of the important factors should not be considered as exhaustive. The Company undertakes no obligation to release publicly the results of any future revisions it may make to forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events. OVERVIEW The Company provides international long distance voice and data services and proprietary network equipment to the global telecommunications markets. The World Access Telecommunications Group (the "Telecommunications Group"), provides wholesale international long distance service through a combination of its own international network facilities, various international termination relationships and resale arrangements with other international long distance service providers. The World Access Equipment Group (the "Equipment Group"), develops, manufactures and markets digital switches, billing and network telemanagement systems, cellular base stations, fixed wireless local loop systems, intelligent multiplexers, digital microwave radio systems and other telecommunications network products. To support and complement its product sales, the Company also provides its customers with a broad range of network design, engineering, testing, installation and other value-added services. During 1998, the Company substantially enhanced its offering of proprietary equipment by acquiring three businesses. In the first quarter of 1998, the Company acquired ATI, a designer and manufacturer of digital microwave and millimeterwave radio systems for voice, data and/or video applications and a majority stake in NACT, a single-source provider of advanced telecommunications switching platforms with integrated telephony software applications and network telemanagement capabilities. In October 1998, the Company acquired the remaining minority interest in NACT. In November 1998, the Company acquired Telco, a designer and manufacturer of broadband transmission, network access and bandwidth optimization products. During 1998, Telco began upgrading its core product portfolio to incorporate new technologies and strategically position it for the impending evolution of telecommunications markets. Prior to its acquisition by the Company, Telco made two strategic acquisitions in 1998 that expanded its product offerings from the circuit switched market into packet switched, frame relay and ATM markets. In December 1998, the Company acquired Resurgens, a provider of wholesale international long distance services. Resurgens now conducts its business as the Telecommunications Group. As a result of the Resurgens 24 26 acquisition, a wholly-owned subsidiary of MCI WorldCom, Inc. ("MCI Worldcom"), a major customer and vendor of Resurgens, now owns approximately 12% of the outstanding common stock of the Company. Through its acquisitions in 1998, the Company believes it is now positioned to offer its customers complete telecommunications network solutions, including access to international long distance, proprietary equipment, and network planning services. The Company's management believes that numerous synergies exist as a result of these acquisitions, including cross-selling opportunities, technology development and cost savings. In December 1998, John D. ("Jack") Phillips was appointed the Company's new President and Chief Executive Officer. Mr. Phillips was formerly the President and Chief Executive Officer of Resurgens. Also in December 1998, two new outside directors joined the Company's Board. In connection with the recently completed acquisitions, the appointment of a new Chief Executive Officer and the election of new directors, the Company approved and began implementing a major restructuring program in late 1998 to reorganize its operating structure, consolidate several facilities, outsource its manufacturing requirements, rationalize its product offerings and related development efforts, and pursue other potential synergies expected to be realized as a result of the integration of recently acquired businesses. As of the date of this Report, the restructuring activities are substantially complete. In December 1998, the Company formalized its plan to offer for sale all of its non-core businesses, which consist of the resale of Nortel and other original equipment manufacturers' wireline switching equipment, third party repair of telecom equipment and pay telephone refurbishment. These businesses have been accounted for as discontinued operations and, accordingly, their results of operations have been excluded from continuing operations in the Consolidated Statements of Operations. In April 1999, the Company raised approximately $47.8 million in equity, net of expenses, through the sale of 50,000 newly issued shares of Series A Preferred Stock to The 1818 Fund III, a private equity partnership organized to acquire substantial, non-controlling, long-term ownership positions in growing, strongly positioned companies. The General Partner of the 1818 Fund III is Brown Brothers Harriman & Co. ("BBH"), America's largest private bank and the oldest owner-managed business partnership in the country. Upon the closing of the transaction, Lawrence C. Tucker, a partner at BBH and co-manager of The 1818 Fund III, became a member of the Company's Board of Directors. In May 1999, the Company acquired substantially all the assets and assumed certain liabilities of Comm/Net, a facilities-based provider of wholesale international long distance and wholesale prepaid calling card services, primarily to the Mexican telecommunications market. Comm/Net's facilities and dedicated bandwidth agreements expand the Telecommunications Group's dedicated network facilities into Mexico and will serve as a foundation for network development in other Latin American countries. On August 17, 1999, the Company entered into a definitive merger agreement with FaciliCom, a leading facilities-based provider of European and U.S. originated international long-distance voice, data and Internet services. FaciliCom has invested over $200 million during the past two years to establish an extensive and high quality switching and transport network throughout Europe. This transaction is expected to be completed in the fourth quarter of 1999 (see Note 13 to "Consolidated Financial Statements"). During the past few years, the Company has significantly strengthened its balance sheet through improved operating results, the recently completed sale of $50.0 million of Series A Preferred Stock, a $115.0 million sale of convertible subordinated notes, a $26.2 million secondary public equity offering and a $75.0 million credit facility. The Company has used this capital for acquisitions and to support the working capital requirements associated with the Company's growth. QUARTERLY 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, the Company believes that 25 27 period-to-period comparisons of its operating results are not necessarily meaningful and should not be relied upon as indications of future performance. The Telecommunications Group carrier service 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 operating expenses in any given period can vary due to factors such as fluctuations in rates charged by carriers to terminate 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; 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 operating results may vary significantly. As the Equipment Group increases its number of telecommunications product offerings, its future operating results may vary significantly depending on factors such as the timing and shipment of significant orders, new product offerings by the Company and its competitors, market acceptance of new and enhanced versions of the Company's products, changes in pricing policies by the Company and its competitors, the availability of new technologies, the mix of distribution channels through which the Company's products are sold, the inability to obtain sufficient supplies of sole or limited source components for the Company's products, gains or losses of significant customers, the timing of customers' upgrade and expansion programs, changes in the level of operating expenses, the timing of acquisitions, seasonality and general economic conditions. 26 28 RESULTS OF CONTINUING OPERATIONS The following table sets forth certain financial data expressed as a percentage of total sales from continuing operations:
THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, ------------------ ----------------- 1999 1998 1999 1998 ------ ------ ----- ------ Carrier service revenues......................... 64.3% 1.7% 62.8% 2.0% Equipment sales.................................. 35.7 98.3 37.2 98.0 ----- ----- ----- ------ Total sales................................. 100.0 100.0 100.0 100.0 Cost of carrier services......................... 55.4 1.6 54.9 1.7 Cost of services network......................... 2.0 0.1 2.7 0.1 Cost of equipment sold........................... 20.8 50.8 21.1 50.7 Amortization of acquired technology.............. 0.6 -- 0.7 -- ----- ----- ----- ------ Total cost of sales......................... 78.8 52.5 79.4 52.5 ----- ----- ----- ------ Gross profit................................ 21.2 47.5 20.6 47.5 Research and development......................... 2.2 4.9 2.5 4.5 Selling, general and administrative.............. 7.7 13.6 8.2 12.2 Amortization of goodwill......................... 1.6 2.6 1.9 2.6 Provision for doubtful accounts.................. 0.7 0.4 0.5 0.4 In-process research and development.............. -- -- -- 37.6 Restructuring and other charges.................. -- -- -- 0.6 ----- ----- ----- ------ Operating income (loss)..................... 9.0 26.0 7.5 (10.4) Gain on exchange of securities................... 4.3 -- 1.6 -- Interest and other income........................ 0.5 2.3 0.5 3.0 Interest expense................................. (1.4) (4.5) (1.4) (4.9) ----- ----- ----- ------ Income (loss) from continuing operations before income taxes and minority interests................................. 12.4 23.8 8.2 (12.3) Income taxes..................................... 5.4 9.6 3.9 10.0 ----- ----- ----- ------ Income (loss) from continuing operations before minority interests................. 7.0 14.2 4.3 (22.3) Minority interests in earnings of subsidiary..... -- 3.0 -- 2.8 ----- ----- ----- ------ Income (loss) from continuing operations.... 7.0% 11.2% 4.3% (25.1)% ===== ===== ===== ======
THREE MONTHS ENDED SEPTEMBER 30, 1999 CONTINUING OPERATIONS COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 1998 CONTINUING OPERATIONS Sales. Total sales increased $166.8 million, or 460.1%, to $203.0 million in the third quarter of 1999 from $36.2 million in the third quarter of 1998. Carrier service revenues were $130.5 million in the third quarter of 1999 as compared to $629,000, in the third quarter of 1998 which consisted of facilities management services at NACT. This increase is due to revenues from Resurgens which was acquired in December 1998 and Comm/Net which was acquired in May 1999 and represented an increase of approximately $17.2 million, or 15.2%, over carrier service revenues realized by the Company in the second quarter of 1999. Equipment sales increased $37.0 million, or 103.7% to $72.6 million in the third quarter of 1999 from $35.6 million in the third quarter of 1998. The increase in equipment sales related to increases in sales of switching products by NACT, cellular equipment by CIS, and the Company's newly acquired transmission and access products business, Telco, which was acquired in November 1998. 27 29 Gross Profit. Gross profit increased $25.9 million, or 150.2%, to $43.1 million in the third quarter of 1999 from $17.2 million in the third quarter of 1998. Gross profit margin decreased to 21.2% in the third quarter of 1999 as compared to 47.5% in the third quarter of 1998. Carrier service gross profit increased to $14.0 million in the third quarter of 1999 from $1,000 in the third quarter of 1998. Gross profit margin was 10.7% in the third quarter of 1999 as compared to 8.2% in the second quarter of 1999. Gross profit margin was 0.2% in the third quarter of 1998, which consisted of facilities management services at NACT. Variable gross margins on these revenues, which excludes the fixed costs associated with the services network, increased to 13.8% in the third quarter of 1999 from the 12.1% that the Company realized in the second quarter of 1999. The increase in variable margins is due to increased economies of scale associated with the internal services network and an increase in the number of direct and transit agreements. Equipment Group gross profit increased $11.9 million, or 69.2%, to $29.1 million in the third quarter of 1999 from $17.2 million in the third quarter of 1998. Gross profit margin decreased to 40.1% in the third quarter of 1999 from 48.4% in the third quarter of 1998. The decreased margin performance of the Equipment Group relates to the $1.2 million of amortization of acquired technology costs in the third quarter 1999 relating to the technology acquired in the Telco and NACT acquisitions, digital radio systems sold by ATI, which included sales of the new WavePLEX radio system which carries a lower profit margin than the Equipment Group's other proprietary products, and lower margins on sales of cellular equipment sold by CIS over the third quarter of 1998, resulting from large contract price negotiations which enabled CIS to obtain sales growth of 39.0% over the third quarter of 1998. Research and Development. Research and development expenses which relate exclusively to the Equipment Group increased $2.7 million, or 153.6%, to $4.5 million in the third quarter of 1999 from $1.8 million in the third quarter of 1998. The increase in expenses was attributable to the acquisitions of Telco, NACT and ATI due to the proprietary nature of their existing products requiring sustaining engineering expenses and their on-going product development efforts. Research and development expenses increased to 6.2% of total equipment sales in the third quarter of 1999 from 5.0% of total equipment sales in the third quarter of 1998. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $10.7 million, or 215.8%, to $15.6 million in the third quarter of 1999 from $4.9 million in the third quarter of 1998. The increase primarily related to expenses associated with the operations of Resurgens and Telco, which were acquired in the fourth quarter of 1998. Economies of scale have resulted in selling, general and administrative expenses decreasing as a percentage of total sales to 7.7% in the third quarter of 1999 from 13.6% in the third quarter of 1998. Amortization of Goodwill. Amortization of goodwill increased $2.4 million to $3.3 million in the third quarter of 1999 from $927,000 in the third quarter of 1998, primarily as a result of the goodwill generated in connection with the fourth quarter 1998 Resurgens and Telco acquisitions. Operating Income. Operating income increased $8.8 million to $18.2 million in the second quarter of 1999 as compared to $9.4 million in the third quarter of 1998. Operating income margin decreased to 9.0% in the third quarter of 1999 from 26.0% in the third quarter of 1998. The reduction in operating income margin is due to the margins of the newly formed Telecommunications Group which are substantially less than those of the Equipment Group and the increased charges to operations for amortization of goodwill and acquired technology . Earning Before Interest, Taxes, Depreciation and Amortization ("EBITDA"). EBITDA increased $16.4 million, or 180.2%, to $25.5 million in the third quarter of 1999 from $9.1 million in the third quarter of 1998. Interest and Other Income. Interest and other income increased $266,000, or 31.0%, to $1.1 million in the third quarter of 1999 from $857,000 in the third quarter of 1998 due to the increase in invested cash balances of the Company resulting from the sale of $50.0 million of Convertible Preferred Stock in the second quarter of 1999. 28 30 Interest Expense. Interest expense increased $1.2 million to $2.8 million in the third quarter of 1999 from $1.6 million in the third quarter of 1998. The increase is primarily related to the interest costs attributable to capital lease obligations at Resurgens and amortization of debt issue costs related to the $75.0 million line of credit received in December 1998. NINE MONTHS ENDED SEPTEMBER 30, 1999 CONTINUING OPERATIONS COMPARED TO NINE MONTHS ENDED SEPTEMBER 30, 1998 CONTINUING OPERATIONS Sales. Total sales increased $430.1 million, or 456.6%, to $524.3 million in the first nine months of 1999 from $94.2 million in the first nine months of 1998. Carrier service revenues were $329.4 million in the first nine months of 1999 as compared to $1.9 million in the first nine months of 1998 which consisted of facilities management services at NACT. This increase is due to revenues from Resurgens which was acquired in December 1998 and Comm/Net which was acquired effective May 1999. Equipment sales increased $102.6 million, or 111.2% to $194.9 million in the first nine months of 1999 from $92.3 million in the first nine months of 1998. The increase in equipment sales related to an increase in sales of cellular equipment sold by CIS, and the Company's newly acquired businesses, including transmission and access products sold by Telco, which was acquired effective November 30, 1998, switching products sold by NACT, which was acquired effective February 28, 1998, and digital radio systems sold by ATI, which was acquired effective January 29, 1998. Gross Profit. Gross profit increased $63.3 million, or 141.6%, to $108.0 million in the first nine months of 1999 from $44.7 million in the first nine months of 1998. Gross profit margin decreased to 20.6% in the first nine months of 1999 as compared to 47.5% in the first nine months of 1998. Carrier service gross profit increased to $27.6 million in the first nine months of 1999 from $147,000 in the first nine months of 1998. Gross profit margin was 8.4% in the first nine months of 1999 as compared to 7.8% in the first nine months of 1998, which consisted of facilities management services at NACT. Variable gross margins on these revenues, which excludes the fixed costs associated with the services network, was approximately 12.6% in the first nine months of 1999 as compared to 11.9% in the first six months of 1999. The change in variable margins is due to increased economies of scale associated with the internal services network and an increase in the number of direct and transit agreements. Equipment Group gross profit increased $35.8 million, or 80.5%, to $80.4 million in the first nine months of 1999 from $44.6 million in the first nine months of 1998. Gross profit margin decreased to 41.2% in the first nine months of 1999 from 48.3% in the first nine months of 1998. The decreased margin performance of the Equipment Group relates to the $3.6 million of amortization of acquired technology costs in the first nine months of 1999 relating to the technology acquired in the Telco and NACT acquisitions, digital radio systems sold by ATI, which included sales of the new WavePLEX radio system which carries a lower profit margin than the Equipment Group's other proprietary products, and lower margins on sales of cellular equipment sold by CIS over the first nine months of 1998, resulting from large contract price negotiations which enabled CIS to obtain significant sales growth of 46.7% over the first nine months of 1998. Research and Development. Research and development expenses which relate exclusively to the Equipment Group increased $9.0 million, or 212.1%, to $13.3 million in the first nine months of 1999 from $4.3 million in the first nine months of 1998. The increase in expenses was attributable to the acquisitions of Telco, NACT and ATI due to the proprietary nature of their existing products requiring sustaining engineering expenses and their on-going product development efforts. Research and development expenses increased to 6.8% of total equipment sales in the first nine months of 1999 from 4.6% of total equipment sales in the first nine months of 1998. Selling, General and Administrative Expenses. Selling, general and administrative expenses increased $31.6 million, or 275.1%, to $43.1 million in the first nine months of 1999 from $11.5 million in the first nine months of 1998. The increase primarily related to expenses associated with the operations of NACT, which was acquired in late February 1998 and expenses related to the operations of Resurgens and Telco, which were 29 31 acquired in the fourth quarter of 1998. Economies of scale have resulted in selling, general and administrative expenses decreasing as a percentage of total sales to 8.2% in the first nine months of 1999 from 12.2% in the first nine months of 1998. Amortization of Goodwill. Amortization of goodwill increased $7.3 million to $9.7 million in the first nine months of 1999 from $2.4 million in the first nine months of 1998, primarily as a result of the goodwill generated in connection with the Resurgens, Telco and NACT acquisitions and additional goodwill amortization recorded relating to the earnouts of CIS and Galaxy. Operating Income (Loss). Operating income increased $48.9 million to $39.1 million in the first nine months of 1999 as compared to a loss of $9.8 million in the first nine months of 1998 due to the significant special charges recorded during the first quarter of 1998 related to acquisitions and restructuring programs. Operating income margin was 7.5% in the first nine months of 1999 as compared to (10.4%) in the first nine months of 1998. Operating income increased $12.4 million, or 46.6%, in the first nine months of 1999 from $26.7 million, before special charges, in the first nine months of 1998. Operating income margin, decreased to 7.5% in the first nine months of 1999 from 28.3%, before special charges, in the first nine months of 1998. The reduction in operating income margin is due to the margins of the newly formed Telecommunications Group which are substantially less than those of the Equipment Group and the increased charges to operations for amortization of goodwill and acquired technology. Earning Before Interest, Taxes, Depreciation and Amortization ("EBITDA"). EBITDA increased $34.3 million, or 131.4%, to $60.4 million in the first nine months of 1999 from $26.1 million before special charges in the first nine months of 1998. Interest and Other Income. Interest and other income decreased $198,000, or 7.0%, to $2.6 million in the first nine months of 1999 from $2.8 million in the first nine months of 1998 due to the reduction in the rate of return on the invested cash balances of the Company in 1999 as compared to 1998. Interest Expense. Interest expense increased $2.8 million to $7.4 million in the first nine months of 1999 from $4.6 million in the first nine months of 1998. The increase is primarily related to the interest costs attributable to capital lease obligations at Resurgens and amortization of debt issue costs related to the $75.0 million line of credit received in December 1998. PURCHASED IN-PROCESS RESEARCH AND DEVELOPMENT Overview. During the first quarter of 1998, $5.4 million and $44.6 million of purchased in-process R&D ("IPR&D") was initially expensed in connection with the acquisition of ATI and the NACT Acquisition, respectively. The $44.6 million of in-process R&D at NACT consisted of 67.3% of the value of NACT products in the development stage that were not considered to have reached technological feasibility as of the date of the NACT Acquisition. In connection with the NACT Merger, the Company revalued purchased in-process R&D to reflect the current status of in-process NACT technology and related business forecasts and to ensure compliance with the additional guidance provided by the Securities and Exchange Commission in its September 15, 1998 letter to the American Institute of Certified Public Accountants. The revalued amount approximated the $44.6 million expensed in connection with the NACT Acquisition, therefore no additional charge was recorded for purchased in-process R&D. However, the effect of the revaluation required the Company to reduce the first quarter of 1998 charge related to the purchased in-process R&D by $14.6 million and record an additional charge of $14.6 million in the fourth quarter of 1998, the period in which the NACT Merger was consummated. Consequently, net loss for the nine months ended September 30, 1998 of $35.3 million as reported in the Company's Report on Form 10-Q for the three months ended September 30, 1998 is now reported as $20.7 million in this Form 10-Q Report. In connection with the Telco Merger in 1998, the Company wrote off purchased in-process R&D totalling $50.3 million. This one-time charge was recorded in the fourth quarter of 1998. The value of the purchased in-process technology from ATI was determined by estimating the projected net cash flows related to in-process research and development projects, including costs to complete the development of the technology. These cash flows were discounted back to their net present value. The 30 32 projected net cash flows from such projects were based on management's estimates of revenues and operating profits related to such projects. The value of the purchased in-process technology from NACT and Telco was determined by estimating the projected net cash flows related to in-process research and development projects, excluding costs to complete the development of the technology. These cash flows were discounted back to their net present value. The projected net cash flows from such projects were based on management's estimates of revenues and operating profits related to such projects. These estimates were based on several assumptions, including those summarized in Note 6 to the Consolidated Financial Statements for each respective acquisition. The resultant net present value amount was then reduced by a stage of completion factor. This factor more specifically captures the development risk of an in-process technology (i.e., market risk is still incorporated in the estimated rate of return). The nature of the efforts required to develop the purchased in-process technology into commercially viable products principally relate to the completion of all planning, designing, prototyping, verification, and test activities that are necessary to establish that the product can be produced to meet its design specifications, including functions, features, and technical performance requirements. The progress on these activities determines the stage of completion of each project in the life cycle of the development. Projects described as being in the "early" or "early concept" stage are not expected to achieve technological feasibility and commercial application within twelve months from the valuation date. These projects are typically in the stage of documenting hardware and software design and preparation of circuit board layouts. Projects described as being in the "mid" stage of development are expected to achieve technological feasibility and commercial application within 6 to 12 months from the valuation date. These projects are typically in the stage of finalizing circuit board layouts and performing engineering integration tests prior to prototype builds. Projects described as being in the "late" stage of development are expected to achieve technological feasibility and commercial application within 6 months from the valuation date. These projects are typically in stage of prototype builds, initial system testing, quality assurance and field trials. It should be noted that stages of completion refer to specific development milestones, and do not necessarily directly correlate to the percentage of completion used in the IPR&D valuation. The percentage of completion for the IPR&D valuation is based on the development costs incurred on each acquired IPR&D project as of the Acquisition Date, as a percentage of the total development costs expected to be incurred on that project, from the inception of its development (prior to the acquisition date) until its development is completed (after the acquisition date). If these projects to develop commercially viable products based on the purchased in-process technology are not successfully completed, the sales and profitability of the Company may be adversely affected in future periods. Additionally, the value of other intangible assets may become impaired. With respect to the NACT in-process projects, as of September 30, 1999, there were no significant changes to the estimated cost to completion as of the acquisition date. The NTS 2000 was introduced and began generating revenues in the first quarter of 1999. The 68060 processing board was introduced and began generating revenues in the second quarter of 1999. The TCPIP functionality was completed and began producing revenue in the third quarter of 1999, slightly behind the original development schedule. All three of these products are generating revenues in line with forecasted revenues as of the acquisition date. The STX switching platform ISDN functionality and E1/T1 conversion products are expected to be introduced and begin generating revenue in the fourth quarter of 1999 as originally scheduled. The SS7/C7 project is expected to be completed during the first half of 2000, in line with the forecasted development. The redundant MCU development is proceeding slower than originally forecasted, and is currently expected to be introduced in 2000. With respect to the Telco in-process projects, as of September 30, 1999, several projects had been consolidated, but in the aggregate there were no significant changes to the estimated cost to completion of the projects as of the acquisition date. The EdgeLink 300 was introduced and began generating revenue in the first quarter of 1999. Revenues are consistent with the forecast used in the IPR&D valuation. The development of the Access 45/60 Release I has been completed, but the product has not been released due to intense price competition. The EdgeLink 100 E1 is expected to be released in the first quarter of 2000, slightly behind the 31 33 original schedule. The SONET Edge Device and the EdgeLink 650 IMA have been consolidated into a new project, EdgeLink MSAC (Multi Service Access Concentrator). This consolidated product is expected to be introduced in the third quarter of 2000. The Voice-over-Packet Engine Project is technically complete, but will not be introduced until IP standards are defined, likely in the first half of 2000. The EdgeLink 600 development has been suspended until early 2000, and the product is expected to be introduced in conjunction with the EdgeLink MSAC product. The HyperSPAN SMUG is expected to be introduced in January 2000, consistent with the initial development schedule. With the exception of revenues attributable to the Access 45/60 Release I, which are not expected to be realized, aggregate revenues for the in-process projects are expected to be consistent with original estimates, but will be realized with an average delay of three to six months. See Note 6 to the Consolidated Financial Statements for further discussion of the valuation of the in-process R&D. RESTRUCTURING AND OTHER CHARGES Summary. During 1998, the Company approved and began implementing two restructuring programs designed to reduce operating costs, outsource manufacturing requirements and focus Company resources on recently acquired business units containing proprietary technology or services. Management carefully reviewed the provisions of EITF 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity" in determining which costs related to the various actions should be included in the special charges. No costs were included in the charge that would derive future economic benefit to the Company, e.g., relocation of existing employees, recruiting and training of new employees and facility start-up costs. In the first quarter of 1998, the Company approved and began implementing a restructuring program to consolidate several operations and exit the contract manufacturing business. In connection with these activities the Company recorded restructuring and other charges of approximately $6.6 million of which $1.1 million was charged to continuing operations and $5.5 million was charged to discontinued operations. This restructuring activity was substantially completed as of June 30, 1998. In the fourth quarter of 1998, in connection with the (i) mergers with NACT, Telco and Resurgens completed in the fourth quarter of 1998; (ii) election of several new outside directors to the Company's Board; and (iii) appointment of a new Chief Executive Officer, the Company approved and began implementing a major restructuring program to reorganize its operative structure, consolidate several facilities, outsource its manufacturing requirements, rationalize its product offerings and related development efforts, and pursue other potential synergies expected to be realized as a result of the integration of recently acquired businesses. In connection with these activities, the Company recorded restructuring and other charges of approximately $43.0 million of which $36.2 million was charged to continuing operations and $6.8 million was charged to discontinued operations. As of the date of this Report, the Company has substantially completed these restructuring activities. 32 34 The following details the 1999 charges to reserves established in connection with the fourth quarter 1998 restructuring program (in thousands):
RESERVE BALANCE 1999 RESERVE BALANCE AT 12/31/98 ACTIVITY AT 9/30/99 --------------- -------- --------------- Reorganize Operating Structure Employee termination benefits................... $ 449 $ 307 $ 142 Idle facility costs............................. 258 249 9 Other........................................... 304 278 26 ------ ------ ------ 1,011 834 177 Consolidation of ATI and Telco Employee termination benefits................... 1,175 1,012 163 Idle facility costs............................. 577 207 370 Other........................................... 300 128 172 ------ ------ ------ 2,052 1,347 705 Outsource Manufacturing Employee termination benefits................... 310 310 -- Idle facility costs............................. 365 365 -- Other........................................... 332 332 -- ------ ------ ------ 1,007 1,007 -- Product Line Rationalization...................... 568 338 230 ------ ------ ------ Total................................... $4,638 $3,526 $1,112 ====== ====== ======
Costs associated with the reorganized operating structure consist primarily of termination benefits payable to the Company's former President, which will be paid throughout 1999, and remaining lease obligations on the Company's Equipment Group headquarters facility in Alpharetta, Georgia. In February 1999, Equipment Group personnel relocated to the Company's headquarters in Atlanta and the facility was closed. Restructuring costs were recorded associated with the consolidation of the Company's ATI operations in Wilmington, Massachusetts into Telco's facility in Norwood, Massachusetts. Manufacturing of ATI's wireless radios is being out-sourced to a contact manufacturer and all other aspects of ATI's operations are being integrated into Telco's existing operating infrastructure. Severance and other termination benefits of approximately $1.2 million are being paid to approximately 60 ATI employees who lost their jobs. Severance and other termination benefits were determined consistent with the Company's severance policy. An accrual associated with the idle portion of the Wilmington facility, which is leased through November 2000, is being charged each period for the idle facility lease cost. An integral part of the restructuring program was the Company's decision to outsource all its electrical manufacturing requirements and sell its Alpharetta, Georgia manufacturing facility to an established contract manufacturer. Severance and other termination benefits of $426,000 were provided for in December 1998 to approximately 25 personnel. The Company completed the sale of its manufacturing operations in March 1999. The actual loss incurred in connection with the sale did not differ materially from the amounts recorded in the restructuring charges. As part of this sale agreement, the Company committed to purchase a minimum of $15.0 million of products and services from the contract manufacturer in each of three consecutive 12 month periods beginning April 1, 1999. Costs related to product line rationalization related to the phase out of the Company's Compact Digital Exchange ("CDX") switch. In January 1999, the Company elected to reallocate development resources targeted for the CDX switch as a stand-alone product to the integration of the central office functionally of the CDX switch and the long-distance functionality of NACT's switch into a common, next generation technology platform. Costs incurred in the first quarter of 1999 relating mainly to engineering efforts incurred related to 1998 and prior CDX contracts were charged to the restructuring accrual. 33 35 DISCONTINUED OPERATIONS Overview. During 1998, the Company broadened its offering of proprietary equipment by acquiring three equipment businesses. The Company acquired ATI, a designer and manufacturer of digital microwave and millimeterwave radio systems for voice, data and/or video applications; NACT, a single-source provider of advanced telecommunications switching platforms with integrated telephony software applications and network telemanagement capabilities and Telco, a designer and manufacturer of broadband transmission, network access and bandwidth optimization products. In connection with the completion of the acquisitions above, the Company decided that certain of the Company's non-proprietary businesses were non-strategic. In December 1998, the Company formalized its plan to offer for sale two non-core businesses, (i) the resale and repair of Nortel and other original equipment manufacturers' wireline switching equipment, and (ii) pay telephone refurbishment. On January 5, 1999, the Company formally announced its intention to sell these businesses. In connection therewith, the Company recorded a $3.5 million charge in the fourth quarter of 1998, for the estimated loss to dispose of these discontinued operations. This loss, which was recorded as partial impairment of existing goodwill, was determined by comparing the book value of the net assets of the discontinued operations to their net realizable value. The net realizable value was estimated based on preliminary valuation work performed by an investment banking firm engaged by the Company to assist in the sale of these businesses and a preliminary non-committal offer from a prospective buyer. During the first six months of 1999, the Company and its investment bankers formally solicited offers for the two businesses. The preliminary offer referred to above was eventually withdrawn by the potential suitor and the formal selling process generated only one serious offer for the businesses. After several weeks of negotiations, the Company refused this offer due to its low price and substantial credit risk. During this selling process, the Company's Nortel resale business significantly deteriorated and its pay telephone refurbishment business began showing signs of weakness. Management was cautiously optimistic in early 1999 that the negative market trends and operating losses experienced in its Nortel resale business during the fourth quarter of 1998 were temporary in nature and the market/business would rebound in 1999. Unfortunately, this turnaround did not occur as evidenced by the Company's sales in this business which declined from $12.8 million in the fourth quarter of 1998 to $6.0 million in the first quarter of 1999 and $3.6 million in the second quarter of 1999. Several market pressures influenced this negative trend including increased pricing competition in the secondary equipment market, more aggressive participation in this market by Nortel and other telecom equipment manufacturers and the reluctance of customers to purchase used equipment due to year 2000 compliance concerns. Although the discontinued businesses collectively generated a small profit in the first quarter of 1999, they realized an operating loss of approximately $700,000 in the second quarter of 1999. In July 1999, faced with an unsuccessful selling process and future operating losses, management elected to begin liquidating the Nortel resale and repair business. A formal liquidation plan designed to eliminate future quarterly losses, maximize net cash proceeds and realize significant deferred tax credits, was adopted, by management and communicated to all affected employees in July 1999. The pay telephone refurbishment business continues to be offered for sale by the Company. As a result of this plan, the Company recorded a charge of $13.7 million in the second quarter of 1999 to reflect the additional loss now expected to be realized on the liquidation of the Nortel resale and repair business. Significant elements of this charge consisted of $5.6 million to write-off all remaining goodwill, $5.2 million to write-down inventories to estimated realizable value, $1.3 million to write-down leasehold improvements, test equipment and other assets to estimated realizable value, $300,000 for severance benefits, and $300,000 for the estimated loss on the disposal of facility leases. The charge also included approximately $200,000 for net operating losses expected to be incurred by the Company during this liquidation process, which is expected to be completed by November 30, 1999. 34 36 These businesses have been accounted for as discontinued operations and, accordingly, the results of operations have been excluded from continuing operations in the Consolidated Statements of Operations for all periods presented. Three Months Ended September 30, 1999 Compared to Three Months Ended September 30, 1998. Sales decreased $12.7 million, or 72.2%, to $4.9 million in third quarter of 1999 from $17.6 million in the third quarter of 1998. This decrease was primarily due to a weakness in the resale of Nortel and other original equipment manufacturers' wireline switching equipment and a decline in pay telephone refurbishment. Gross profit margin before special charges declined to 3.4% in the third quarter of 1999 from 32.6% in the third quarter of 1998. The Company's resale of Nortel equipment business achieved a substantially lower gross margin in the third quarter of 1999 as compared to the gross margin in the third quarter of 1998 because of pricing pressures in its market and reduced sales levels. The Company also experienced margin declines in the telephone refurbishment business in 1999 primarily resulting from the reduced economies of scale related to the decline in its refurbishment revenues. Nine Months Ended September 30, 1999 Compared to Nine Months Ended September 30, 1998. Sales decreased $24.2 million, or 129.4%, to $18.7 million in the first nine months of 1999 from $42.9 million in the first nine months of 1998. This decrease was primarily due to a weakness in the resale of Nortel and other original equipment manufacturers' wireline switching equipment at the Company's AIT business and a decline in pay telephone refurbishment. Gross profit margin before special charges declined to 2.7% in the first nine months of 1999 from 30.8% in the first nine months of 1998. The Company's resale of Nortel equipment business achieved a substantially lower gross margin in the nine months of 1999 as compared to the gross margin in the first nine months of 1998 because of pricing pressures in its market and reduced sales levels. The Company also experienced margin declines in the telephone refurbishment business in 1999 primarily resulting from the reduced economies of scale related to the decline in its refurbishment revenues. During the first nine months of 1998 and 1999, the Company recorded special charges of approximately $5.5 million and $13.7 million, respectively, relating to the non-core businesses (see "-- Restructuring and Other Charges"). LIQUIDITY AND CAPITAL RESOURCES Overview. Cash management is a key element of the Company's operating philosophy and strategic plans. Acquisitions to date have been structured to minimize the cash element of the purchase price and ensure that appropriate levels of cash are available to support the increased product development, marketing programs and working capital normally associated with the growth initiatives of acquired businesses. As of September 30, 1999, the Company had $107.8 million of cash and equivalents and approximately $68.5 million in borrowings available under its credit line to support its current working capital requirements and strategic growth initiatives. Operating Activities. Cash provided from operating activities was approximately $17.4 million and $7.6 million in the first nine months of 1999 and 1998, respectively. Accounts receivable increased $52.6 million, or 74.6%, to $123.1 million at September 30, 1999 from $70.5 million at December 31, 1998. This was mainly due to increased sales activity at the Company (third quarter 1999 total sales were $203.0 million as compared to fourth quarter 1998 total sales of $73.6 million). Average days sales outstanding at September 30, 1999 were approximately 56 days as compared to 88 days at December 31, 1998. The Company's average days outstanding has declined primarily as a result of the Resurgens acquisition, as Resurgens' customers generally pay for services in 30 days or less. MCI WorldCom, the Telecommunications Group's largest customer, prepays the services it purchases twice a month. Equipment Group sales typically have terms of 30 to 60 days, except for sales to international customers, which generally have payment terms in excess of 90 days. The Company also has begun to enter into long-term notes receivable with selected customers. To maximize cash flow, the Company sells the notes where possible on either a non-recourse or recourse basis to a third party financing institution. As of September 30, 1999, the Company has a contingent liability of approximately $21.7 million related to notes sold with 35 37 recourse. The Company believes it has recorded sufficient reserves to recognize the current risk associated with these recourse sales. Inventories decreased $8.2 million, or 16.8%, to $40.4 million at September 30, 1999 from $48.6 million at December 31, 1998. The decrease was due to the sale of $5.2 million of inventories related to the sale of the Company's Alpharetta, Georgia manufacturing facility and the outsourcing of ATI's wireless radios and a $6.5 million write-down to inventories of the discontinued operations in the second quarter of 1999. This decrease was partially offset by an increase in CIS inventories as a result of the timing of large equipment purchases in the first nine months of 1999. Investing Activities. Cash used by investing activities was $6.6 million and $83.5 million for the first nine months of 1999 and 1998, respectively. In May 1999, the Company acquired substantially all the assets and assumed certain liabilities of Comm/Net, a facilities-based provider of wholesale international long distance and wholesale prepaid calling card services, primarily to the Mexican telecommunications markets. In connection, the Company issued 23,174 shares of Series B Preferred Stock, valued at approximately $18.5 million, and paid approximately $3.5 million to retire certain Comm/Net notes payable outstanding at the time of acquisition. The Series B Preferred Stock is convertible into shares of the Company's common stock at a conversion rate of $16.00 per common share, subject to standard anti-dilution adjustments. If the closing trading price of the Company's common stock exceeds $16.00 per share for 45 consecutive trading days, the Series B Preferred Stock will automatically convert into common stock. Preferred stock dividends began accruing effective July 1, 1999. The acquisition of Comm/Net has been accounted for under the purchase method of accounting. In connection with the acquisition of Cellular Infrastructure Supply, Inc. ("CIS"), the Company paid $3.5 million and issued 440,874 shares of common stock up front to the CIS stockholders. In addition, the stockholders of CIS were issued 845,010 restricted shares of common stock. These shares were immediately placed into escrow and, together with $6.5 million in additional purchase price, will be released and paid to the stockholders of CIS contingent upon the realization of certain predefined levels of pre-tax income from CIS's operations during three one-year periods beginning January 1, 1997. The first measurement period for purposes of releasing escrowed shares and paying contingent cash consideration was January 1, 1997 to December 31, 1997. In reviewing CIS's pre-tax income performance as of April 30, 1997, the Company determined that it was determinable beyond a reasonable doubt that the conditions for release and payment for this first period would be met. Accordingly, 317,427 escrowed shares were accounted for as if released and $3.5 million in contingent cash payments were accounted for as if paid as of April 30, 1997. The net effect of this accounting was to increase goodwill and stockholders' equity by approximately $6.5 million at April 30, 1997. These shares were released and payment was made to the former stockholders of CIS on February 15, 1998. The second measurement period for purposes of releasing escrowed shares and paying contingent cash consideration was January 1, 1998 to December 31, 1998. In reviewing CIS's pre-tax income performance as of August 31, 1998, the Company determined that it was determinable beyond a reasonable doubt that the conditions for release and payment for the second period would be met. Accordingly, 244,929 escrowed shares were accounted for as if released and $2.0 million in contingent cash payments were was accounted for as if paid as of August 31, 1998. The net effect of this accounting was to increase goodwill and stockholders' equity by approximately $5.1 million and $3.1 million, respectively, as of August 31, 1998. These escrowed shares were released and payments were made to the former stockholders of CIS on February 15, 1999. The third and final measurement period for purposes of releasing escrowed shares and paying contingent cash consideration is January 1, 1999 to December 31, 1999. In reviewing CIS's pre-tax income performance as of May 31, 1999, the Company determined that it was determinable beyond a reasonable doubt that the conditions for release and payment for the third period would be met. Accordingly, 122,426 escrowed shares were accounted for as if released and $1.0 million in contingent cash payments were accounted for as if paid as of May 31, 1999. The net effect of this accounting was to increase goodwill and stockholders' equity by 36 38 approximately $2.4 million and $1.3 million, respectively, as of May 31, 1999. These escrowed shares will be released and the payment will be made to the former stockholders of CIS on February 15, 2000. In the fourth quarter of 1997, the Company began its three phase acquisition of NACT. During November and December 1997, the Company purchased 355,000 shares of NACT common stock in the open market for approximately $5.0 million. On December 31, 1997, the Company entered into a stock purchase agreement with GST Telecommunications, Inc. ("GST") and GST USA, Inc. ("GST USA") to acquire 5,113,712 shares of NACT common stock owned by GST USA, representing approximately 63% of the outstanding shares of NACT common stock (the "NACT Acquisition"). On February 27, 1998 the NACT Acquisition was completed with GST USA receiving $59.7 million in cash and 1,429,907 restricted shares of the Company's common stock valued at approximately $26.9 million. On February 24, 1998 the Company entered into a merger agreement with NACT pursuant to which the Company agreed to acquire all of the shares of NACT common stock not already then owned by the Company or GST USA. On October 28, 1998, the NACT Merger was completed whereby the Company issued 2,790,182 shares of the Company's common stock valued at approximately $67.8 million for the remaining minority interest of NACT. On December 24, 1997, the Company entered into an agreement to acquire ATI. On January 29, 1998, the transaction was completed in its final form whereby ATI was merged with and into CIS (the "ATI Merger"). In connection with the ATI Merger, the stockholders of ATI received approximately $300,000 and 424,932 restricted shares of the Company's common stock. These shares had an initial fair value of approximately $6.3 million. In addition to the 424,932 shares noted above, the stockholders of ATI were issued 209,050 restricted shares of the Company's common stock. These shares were immediately placed into escrow and will be released to the stockholders of ATI contingent upon the realization of predefined levels of pre-tax net income from ATI's operations during calendar years 1998 and 1999. The pre-tax income of ATI for 1998 fell below the level required to release escrowed shares in 1998. In connection with the Company's sale of its Alpharetta, Georgia manufacturing facility and the outsourcing of the ATI wireless radios, the Company sold certain inventories to established contract manufacturing suppliers. In addition, in connection with the disposal of the Company's resale and repair business the Company sold inventories and other assets. During the first nine months of 1999, the Company received approximately $7.0 million from these asset sales. During each of the first nine months of 1999 and 1998, the Company invested $7.9 million and $8.5 million for capital expenditures, respectively. These expenditures in 1999 were primarily for telecommunications network equipment for the Telecommunications Group, enhancing and standardizing the Company's research and development operating platforms, new test equipment relating to newly introduced products, computer network and related communications equipment designed to facilitate the integration of the recent acquisitions and facility improvements required in connection with the Company's growth. The Company began capitalizing software development costs in the fourth quarter of 1997 in connection with its increased focus on developing proprietary technology and products. Software development costs are capitalized upon the establishment of technological feasibility of the product. During the first nine months of 1999 and 1998, the Company capitalized approximately $3.7 million and $3.1 million of software development costs, respectively. The increase is primarily related to the increased development activities associated with the Company's wireless local loop product and development activities at Telco, NACT and ATI. Financing Activities. Cash provided from financing activities was $41.9 million and $16.3 million for the first nine months of 1999 and 1998, respectively. In December 1998, the Company entered into a $75.0 million revolving line of credit facility (the "Facility"), with a banking syndicate group led by Bank of America, Fleet National Bank and Bank Austria Creditanstalt. The new facility consists of a 364-day revolving line of credit which may be extended under 37 39 certain conditions and provides the Company the option to convert existing borrowings to a three year term loan. Borrowings under the line are secured by a first lien on substantially all the assets of the Company. The Facility, which expires in December 2001, contains standard lending covenants including financial ratios, restrictions on dividends and limitations on additional debt and the disposition of Company assets. Interest is paid at the rate of prime plus 1 1/4% or LIBOR plus 2 1/4%, at the option of the Company. As of September 30, 1999, borrowings of $6.5 million were outstanding under the Facility. The Facility restricts distributions from the Company's consolidated subsidiaries. Accordingly, the assets and cash flows of such subsidiaries, including WA Telcom, the primary obligor on the Notes, may not be used to pay any dividends to the Company. In April 1999, the Company raised approximately $47.8 million in equity, net of expenses, through the sale of 50,000 newly issued shares of Series A Preferred Stock to The 1818 Fund III, a private equity partnership organized to acquire substantial, non-controlling, long-term ownership positions in growing, strongly positioned companies. The General Partner of the Funds is Brown Brothers Harriman & Co., America's largest private bank and the oldest owner-managed business partnership in the country. In September 1998, the Company entered into a loan agreement with the Public Development Authority of Forsyth County, Georgia ( the "Issuer"), in the principal amount of $7,365,000. The issuer issued its tax exempt industrial revenue bonds (the "Bonds") for the sole purpose of financing a portion of the cost of the acquisition, construction and installation of the Company's Alpharetta, Georgia telecommunications equipment and printed circuit boards manufacturing plant. In March 1999, the Company sold the Alpharetta, Georgia based manufacturing operation. At the time of the sale, the Company had qualifying expenditures under the Bonds of approximately $4.1 million. The remaining $3.3 million of the proceeds were restricted for qualifying future expenditures The Bonds were completely repaid in April 1999 as required under the terms and conditions of the Bonds. During the first nine months of 1999, the Company entered into and made principal payments under capital lease obligations of approximately $1.7 million and $2.3 million, respectively. The capital lease obligations relate mainly to leases of the Telecommunications Group network equipment. During the first nine months of 1999 and 1998, the Company received approximately $1.2 million and $19.7 million, respectively, in cash, including related income tax benefits, from the exercises of incentive and non-qualified stock options and warrants by the Company's directors and employees. Income Taxes. As a result of the exercises of non-qualified stock options and warrants by the Company's directors and employees, the Company realized federal income tax benefits during 1998 and 1997 of approximately $19.5 million. Although these tax benefits do not have any effect on the Company's provision for income tax expense, they represent a significant cash benefit to the Company. This tax benefit is accounted for as a decrease in current income taxes payable and an increase in capital in excess of par value. Due to the Company's net operating losses during 1998, approximately $10.5 million of these tax benefits have not yet been utilized and are available to reduce future taxable income of the Company. These benefits are included in Deferred income taxes on the Company's Consolidated Balance Sheet at September 30, 1999. 38 40 The Company's provision for income taxes attributable to continuing operations for the nine months ended September 30, 1999 was $20.4 million or approximately 47.4% of income from continuing operations before income taxes. The provision for income taxes differs from the amount computed by applying the statutory federal and state income tax rates due to non-deductible expenses, primarily goodwill amortization. Summary. The completion of the sale of $50.0 million of Series A Preferred Stock in April 1999, the sale of $115.0 million of convertible notes in October 1997 and the $75.0 million line of credit received in December 1998 have significantly enhanced the financial strength of the Company and improved its liquidity. The Company believes that existing cash balances, available borrowings under the Company's line of credit and cash projected to be generated from operations will provide the Company with sufficient capital resources to support its current working capital requirements and business plans for at least the next 12 months. YEAR 2000 ISSUE The turn of the century, Year 2000, poses a serious challenge for Information Technology ("IT") used by virtually every corporation around the world. The problem arises as a result of past standard industry practices to store year date data in a 2-digit (YY) field, instead of a 4-digit (CCYY) format where the first 2 digits (CC) represent the century and the last 2 digits (YY) represent the year. Thus, in the two digit format, 1999 is stored as 99. This causes programs that perform arithmetic operations, comparisons, or date sorts to possibly generate erroneous results when the program is required to process dates from both centuries. The absence of the century information adds an ambiguity to the date information is stored or processed by the program, and it may also cause problems with data entry and display screens. The problem is further complicated because many applications are not stand-alone, but interface with one or more applications. State of Readiness. The Company is addressing the Year 2000 issue by implementing its comprehensive Year 2000 Readiness Plan (the "Y2K Plan"). The Y2K Plan involves the following phases: (1) developing an inventory of products, systems and equipment that may be affected by the Year 2000 date change, (2) assessment and (3) remediation. Efforts have been underway in certain subsidiaries of the Company since 1997, and a formal Year 2000 Readiness Program was developed in the first quarter of 1998. With the inventory and assessment phases completed for the Company's core businesses, the Company's business units are now focused on remediating Year 2000 issues. In addition, the Company has retained one of the nation's largest and most reputable providers of Year 2000 remediation and compliance services to assist in the execution of the Y2K Plan. The Y2K Plan consists of several phases that overlap in areas and may be in progress simultaneously. The first phase involves developing an inventory of all products, IT and non-IT systems, software, and business infrastructure systems and equipment that may be affected by the Year 2000 date change. External parties, including customers, suppliers and service providers, with which the Company interacts, and which may have Year 2000 readiness issues are also identified. This phase was completed in May 1999. Inventory listings include computers, computer network equipment, routers, servers, computer software, telephony systems, telecommunications equipment, facilities equipment, test equipment, business tools, as well as all suppliers and all Company products. The second phase involves risk and impact assessment, selection of appropriate remediation methods, and resource/cost assessment for compliance. Each inventory item identified in the first phase is assigned a compliance status risk level of critical, moderate, low or no risk. Items associated with critical or moderate risk are addressed with highest priority. Similarly, a risk assessment is made for the customers, suppliers and service providers identified. This phase includes contacting suppliers or manufacturers for information regarding their Year 2000 readiness, technical review of products and systems, and compliance testing. The necessary actions to bring each item into compliance are determined, and remediation costs are estimated. To address potential problems, contingency plans are developed as necessary. This phase was completed in July 1999. Information received from manufacturers and suppliers is maintained in databases to monitor compliance status, and compliance testing has been completed for Company products. The third phase involves the remediation for items found to be non-Year 2000 compliant. This involves replacement of equipment or upgrading of software or hardware. This phase includes communications with the Company's customers and suppliers to determine Year 2000 issues as appropriate. Verification testing is done 39 41 to ensure the effectiveness of the remediation efforts. Capital assets found to be non-compliant have been, or will be replaced or remediated in this phase. This phase is expected to be completed before the end of 1999. Most of the Company's internally controlled software has been remediated and verified. Integrated testing (also known as "end-to-end" testing) is planned and should expose unforeseen compliance problems associated with system interfaces and dependencies. Organizationally, the Company established a Program Management Office ("PMO") and support teams, including the Year 2000 Steering Committee, the Year 2000 Management Team and the Year 2000 Implementation Teams. A representative from the Company's senior management has been appointed as the overall Year 2000 Program Director, who works closely with the support teams and manages the PMO. The Year 2000 Steering Committee consists of the Company's senior managers for Information Technology and Quality, the Company's Chief Financial Officer, and the Company's President and Chief Executive Officer. The committee provides high-level direction for the Y2K Plan and approves requests for Year 2000 resources. The Year 2000 Management Team consists of the business unit managers from each internal department of the Company. Each such manager monitors progress of the program in his or her respective department and allocates resources to remediate Year 2000 issues. The Year 2000 Implementation Teams are directly responsible for ensuring Year 2000 compliance for the Company's products and information systems infrastructure. This includes efforts to ensure suppliers and service providers are able to provide uninterrupted product or services through the Year 2000. The Year 2000 Implementation Teams consist of personnel from each of the Company's internal departments, including: Information Technology, Quality, Operations, Materials, Product Development, Human Resources, Finance and Contracts. Members of the Year 2000 Implementation Teams are responsible for developing the inventory listings and assessing the inventory for compliance, assuring that each Company product is assessed for compliance, handling customer requests for compliance information, auditing Year 2000 test plans and results, and reporting status and progress of team activities to the Company's management on a divisional level and to the PMO. The PMO provides planning and project management support to the teams, as well as assisting in each phase of the Y2K Plan. The Company's Year 2000 outside consultant furnishes expert Year 2000 professionals for the PMO, including a Service Delivery Manager, a Project Manager, Senior Analysts, Analysts and a Project Administrator. The PMO meets with the Company's management weekly to review Y2K Plan status and costs, plan activities and schedule resources, and report progress, status, risks, issues and costs. To aid in communication with the Company's customers, suppliers and business partners, the Company is making Year 2000 readiness and product compliance information available on the internet. This information is updated periodically to include the most current information on products and services. All Transport and Access products have been determined to be Year 2000 compliant, or may be upgraded. Software required for upgrades is presently available. Switching products have also been determined to be Year 2000 compliant, or may be upgraded at no charge, with the exception of the obsolete LCX (superseded by the STX). LCX customers have been contacted to advise them that this product may experience minor data-logging failures associated with the Year 2000, and that the fully compliant STX provides direct replacement. NTS-2000 Billing System software is fully Year 2000 compliant, and compliant NTS-1000 Billing System software was released in April 1999. The Telecommunications Group has assessed their switching and billing systems and identified the required upgrades for Year 2000 compliance, which would cost the Company approximately $2.0 million. As a result of the Company's pending merger with FaciliCom, the Company's management has elected to not upgrade its existing Telecommunications Group systems but rather redirect its traffic over FaciliCom's existing Year 2000 compliant network. This integration program has been carefully planned and tested by Telecommunications Group and FaciliCom personnel, and is expected to be fully functional when the two companies merge in early December. FaciliCom continually updates and maintains its switching and billing 40 42 systems to the state of the art, and to comply with FCC and international regulations, which include Year 2000 specific requirements. Costs. The total cost associated with the Company's Year 2000 remediation initiative is not expected to be material to the Company's financial condition or results of operations. During the first nine months of 1999, the Company spent approximately $900,000 in connection with Year 2000 issues and the Company has spent a total of approximately $2.2 million since 1997 in connection with Year 2000 issues. The Equipment Group estimates $800,000 will be required in 1999 for upgrades and remediation efforts. The estimated total cost of the Company's Year 2000 initiative is not expected to exceed $3.0 million and is being funded through operating cash flows of the Company. Risks. The Company believes, based on currently available information, that it will be able to properly manage its total Year 2000 exposure. There can be no assurance, however, that the Company will be successful in its efforts, or that the computer systems of other companies on which the Company relies will be modified in a timely manner. Additionally, there can be no assurance that a failure to modify such systems by another company, or modifications that are incompatible with the Company's systems, would not have a material adverse effect on the Company's business, financial condition or results of operations. As previously noted, the Company's Telecommunications Group switching and billing systems are not currently Year 2000 compliant. Management has elected to redirect its existing traffic to FaciliCom's network and systems rather than investing $2.0 million in its network, most of which will become redundant upon its merger with FaciliCom. Should the merger not be completed in December 1999 as currently planned, appropriate third party agreements are expected to be entered into by the two companies until such time the Company can upgrade its systems. As a contingency plan, the Company has determined that the date codes within its switches may be turned back a minimum of one year, and when accompanied by programming changes in its billing system, will be able to ensure ongoing, uninterrupted business operations through the Year 2000. Contingency Plans. All of the Company's inventory items that are identified as having a compliance status risk level of critical in the first phase of the Y2K Plan are expected to be Year 2000 compliant within the timeframe planned, and the Y2K Plan is currently on schedule. However, the Company will develop business continuation or "contingency" plans for potential areas of exposure as they are identified. RECENT ACCOUNTING PRONOUNCEMENTS In June 1998, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities." This statement is effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. The future adoption of SFAS 133 is not expected to have a material effect on the Company's consolidated financial position or results of operations. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS At September 30, 1999, the Company was not invested in any market risk sensitive instruments held for either trading purposes or for purposes other than trading. As a result, the Company is not subject to interest rate risk, foreign currency exchange rate risk, commodity price risk, or other relevant market risks, such as equity price risk. The Company invests cash balances in excess of operating requirements in short-term securities, generally with maturities of 90 days or less. In addition, the Company's revolving line of credit agreement provides for borrowings which bear interest at variable rates based on either the prime rate or two percent over the London Interbank Offered Rates. The Company had $6.5 million outstanding pursuant to its revolving line of credit agreement at September 30, 1999. The Company believes that the effect, if any, of reasonably possible near-term changes in interest rates on the Company's financial position, results of operations and cash flows should not be material. 41 43 PART II OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company and certain of its officers and directors are currently defendants in a class action legal proceeding in which the plaintiffs have asserted claims for violations of the federal securities laws arising from alleged misstatements of material information in and/or omissions of material information from certain of the Company's securities filings and other public disclosures. The status of this legal proceeding was reported in the Company's Form 10-Q for the quarter ended June 30, 1999, as amended, and, subsequent thereto, there have been no material developments in the status of such legal proceedings. Although the Company and the individuals named as defendants deny that they have violated any of the requirements or obligations of the federal securities laws, there can be no assurance that the Company will not sustain material liability as a result of or related to this legal proceeding. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS None ITEM 3. DEFAULTS UPON SENIOR SECURITIES None ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None ITEM 5. OTHER INFORMATION None ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 3.1 -- Certificate of Incorporation of the Company and Amendments to Certificate of Incorporation (incorporated by reference herein to Exhibit 3.1 to the Company's Form S-4, filed with the Commission on October 6, 1998, Registration No. 333-65386; Amendment to Certificate of Incorporation incorporated by reference herein to Exhibit 3.2 to Form 8-K of the Company's predecessor, World Access, Inc., filed with the Commission on October 28, 1998). 3.2 -- Certificate of Designation of 4.25% Cumulative Senior Perpetual Convertible Preferred Stock. Series A (incorporated by reference herein to Exhibit 4 to the Company's Form 8-K, filed with the Commission on May 3, 1999). 3.3 -- Certificate of Designation of 4.25% Cumulative Junior Convertible Preferred Stock. Series B (incorporated by reference herein to Exhibit 4.1 to the Company's Form 8-K, filed with the Commission on July 14, 1999). 3.4 -- Bylaws of the Company (incorporated by reference herein to Exhibit 3.2 to the Company's Form S-4, filed with the Commission on October 6, 1998, Registration No. 333-65389). 4.1 -- Certificate of Designation of 4.25% Cumulative Senior Perpetual Convertible Preferred Stock, Series A (incorporated by reference herein to Exhibit B to the Company's Form 8-K, filed with the Commission on May 3, 1999).
42 44 4.2 -- Certificate of Designation of 4.25% Cumulative Junior Convertible Preferred Stock. Series B (incorporated by reference herein to Exhibit 4.1 to the Company's Form 8-K, filed with the Commission on July 14, 1999). 27.1 -- Financial Data Schedule (for SEC use only).
(b) Reports on Form 8-K On July 14, 1999, the Company filed a Report on Form 8-K, as amended on October 5, 1999, announcing that WA Telcom Products Co., Inc., a wholly owned subsidiary of the Company, acquired substantially all the assets and assumed certain liabilities of Comm/Net Holding Corporation and its wholly owned subsidiaries, Enhanced Communications Corporation, Comm/Net Services Corporation and Long Distance Exchange Corporation. On August 17, 1999, the Company filed a Report on Form 8-K announcing that it entered into a definitive merger agreement with FaciliCom International, Inc. 43 45 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized. WORLD ACCESS, INC. By: /s/ MARTIN D. KIDDER ------------------------------------ Martin D. Kidder Vice President and Controller Dated: November 15, 1999 44 EX-27.1 2 FINANCIAL DATA SCHEDULE
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE FINANCIAL STATEMENTS OF WORLD ACCESS, INC. FOR THE NINE MONTHS ENDED SEPTEMBER 30, 1999 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 9-MOS DEC-31-1999 JAN-01-1999 SEP-30-1999 107,841 0 131,415 8,353 40,437 326,406 72,692 9,302 727,909 136,745 115,000 0 1 450 441,453 727,909 524,290 524,290 416,270 416,270 66,102 2,840 7,394 43,017 20,370 22,647 (14,364) 0 0 8,283 0.20 0.20
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