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INTERMETRO COMMUNICATIONS, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statements This Report contains financial projections and other "forward-looking statements," as that term is used in federal securities laws, about our financial condition, results of operations and business. These statements include, among others: statements concerning the potential for revenues and expenses and other matters that are not historical facts. These statements may be made expressly in this Report. You can find many of these statements by looking for words such as "believes," "expects," "anticipates," "estimates," or similar expressions used in this Report. These forward-looking statements are subject to numerous assumptions, risks and uncertainties that may cause our actual results to be materially different from any future results expressed or implied by us in those statements. The most important factors that could prevent us from achieving our stated goals include, but are not limited to, the risks and uncertainties discussed in the "Business" "Risk Factors" and "Management's Discussion and Analysis of Financial Condition and Results of Operations" sections, as applicable, of our Annual Report on Form 10-K for the year ended December 31, 2011 (the "2011 10-K") as well as the following: (a) our success in renegotiating and settling the terms of our indebtedness and other liabilities; (b) Our ability to raise additional financing to the extent necessary to continue to operate our business; (c) volatility or decline of our stock price; (d) potential fluctuation in quarterly results; (e) our failure to earn revenues or profits; (f) inadequate capital and barriers to raising capital or to obtaining the financing needed to implement our business plans; (g) changes in demand for our products and services; (h) rapid and significant changes in markets; (i) litigation with or legal claims and allegations by outside parties; (j) insufficient revenues to cover operating costs; (k) the possibility we may be unable to manage our growth; (l) extensive competition; (m) loss of members of our senior management; (n) our dependence on local exchange carriers; (o) our need to effectively integrate businesses we acquire; (p) risks related to acceptance, changes in, and failure and security of, technology; and (q) regulatory interpretations and changes. We caution you not to place undue reliance on forward looking statements, which speak only as of the date of this Report. The cautionary statements contained or referred to in this section should be considered in connection with any subsequent written or oral forward-looking statements that we or persons acting on behalf of us may issue. We do not undertake any obligation to review or confirm analysts' expectations or estimates or to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date of this Report or to reflect the occurrence of unanticipated events. The following discussion should be read in conjunction with our condensed consolidated financial statements and notes to those statements. 20 -------------------------------------------------------------------------------- Table of Contents Background InterMetro Communications, Inc., (hereinafter, "we," "us," "InterMetro" or the "Company") is a Nevada corporation which through its wholly owned subsidiary, InterMetro Communications, Inc. (Delaware) (hereinafter, "InterMetro Delaware"), is engaged in the business of providing voice over Internet Protocol ("VoIP") communications services. General We have built a national, private, proprietary voice-over Internet Protocol, or VoIP, network infrastructure offering an alternative to traditional long distance network providers. We use our network infrastructure to deliver voice calling services to traditional long distance carriers, broadband phone companies, VoIP service providers, wireless providers, other communications companies and end users. Our VoIP network utilizes proprietary software, configurations and processes, advanced Internet Protocol, or IP, switching equipment and fiber-optic lines to deliver carrier-quality VoIP services that can be substituted transparently for traditional long distance services. We believe VoIP technology is generally more cost efficient than the circuit-based technologies predominantly used in existing long distance networks and is easier to integrate with enhanced IP communications services such as web-enabled phone call dialing, unified messaging and video conferencing services. We focus on providing the national transport component of voice services over our private VoIP infrastructure. This entails connecting phone calls of carriers or end users, such as wireless subscribers, residential customers and broadband phone users, in one metropolitan market to carriers or end users in a second metropolitan market by carrying them over our VoIP infrastructure. We compress and dynamically route the phone calls on our network allowing us to carry up to approximately eight times the number of calls carried by a traditional long distance company over an equivalent amount of bandwidth. In addition, we believe our VoIP equipment costs significantly less than traditional long distance equipment and is less expensive to operate and maintain. Our proprietary network configuration enables us to quickly, without modifying the existing network, add equipment that increases our geographic coverage and calling capacity. We enhanced our network's functionality by implementing Signaling System 7, or SS-7, technology. SS-7 allows access to customers of the local telephone companies, as well as customers of wireless carriers. SS-7 is the established industry standard for reliable call completion, and it also provides interoperability between our VoIP infrastructure and traditional telephone company networks. While we expect to continue to add to capacity, as of September 30, 2012 and 2011, the SS-7 network expansion was a fully operating and revenue generating component of our VoIP infrastructure. A key aspect of our current business strategy is to focus on sales to increase these voice minutes. We are advancing our research and development efforts and are focused on producing a next-generation routing product. This technology is currently in alpha testing and no assurances are provided. The technology is designed to significantly reduce what we would otherwise need in capital expenditures for future revenue growth. Overview History. InterMetro began business as a VoIP on December 29, 2006 and began generating revenue at that time. Since then, we have increased our revenue to approximately $21.0 million for the year ended December 31, 2011. Trends in Our Industry and Business A number of trends in our industry and business could have a significant effect on our operations and our financial results. These trends include: Increased competition for end users of voice services. We believe there are an increasing number of companies competing for the end users of voice services that have traditionally been serviced by the large incumbent carriers. The competition has come from wireless carriers, competitive local exchange carriers, or CLECs, and interexchange carriers, or IXCs, and more recently from broadband VoIP providers, including cable companies and DSL companies offering broadband VoIP services over their own IP networks. All of these companies provide national calling capabilities as part of their service offerings, however, most of them do not operate complete national network infrastructures. These companies previously purchased national transport services exclusively from traditional carriers, but are increasingly purchasing transport services from us. Merger and acquisition activities of traditional long distance carriers. Recently, the three largest operators of traditional long distance service networks were acquired by or have merged with several of the largest local wireline and wireless telecommunications companies. AT&T Corp. was acquired by SBC Communications Inc., MCI, Inc. was acquired by Verizon Communications, Inc. and Sprint Corporation and Nextel Communications, Inc. engaged in a merger transaction. While we believe it is too early to tell what effects these transactions will have on the market for national voice transport services, we may be negatively affected by these events if these companies increase their end user bases, which could potentially decrease the amount of services purchased by our carrier customers. In addition, these companies have greater financial and personnel resources and greater name recognition. However, we could potentially benefit from the continued consolidation in the industry, which has resulted in fewer competitors. 21 -------------------------------------------------------------------------------- Table of Contents Regulation. Our business has developed in an environment largely free from regulation. However, the Federal Communications Commission ("FCC") and many state regulatory agencies have begun to examine how VoIP services could be regulated, and a number of initiatives could have an impact on our business. These regulatory initiatives include, but are not limited to, proposed reforms for universal service, the intercarrier compensation system, FCC rulemaking regarding emergency calling services related to broadband IP devices, and the assertion of state regulatory authority over us. Complying with regulatory developments may impact our business by increasing our operating expenses, including legal fees, requiring us to make significant capital expenditures or increasing the taxes and regulatory fees applicable to our services. One of the benefits of our implementation of SS-7 technology is to enable us to purchase facilities from incumbent local exchange carriers under switched access tariffs. By purchasing these traditional access services, we help mitigate the risk of potential new regulation related to VoIP. Our Business Model Historically, we have been successful in implementing our business plan through the expansion of our VoIP infrastructure. Since our inception, we have grown our customer base to include over 200 customers, including several large publicly-traded telecommunications companies and retail distribution partners. In connection with the addition of customers and the provision of related voice services, we have expanded our national VoIP infrastructure. Revenue. We generate revenue primarily from the sale of voice minutes that are transported across our VoIP infrastructure. In addition, ATI, as a reseller, generates revenues from the sale of voice minutes that are currently transported across other telecom service providers' networks. However, we have migrated a significant amount of these revenues on to our VoIP infrastructure and continue to migrate ATI's revenues. We negotiate rates per minute with our carrier customers on a case-by-case basis. The voice minutes that we sell through our retail distribution partners are typically priced at per minute rates, are packaged as calling cards and are competitive with traditional calling cards and prepaid services. Our carrier customer services agreements and our retail distribution partner agreements are typically one year in length with automatic renewals. We generally bill our customers on a weekly or monthly basis with either a prepaid balance required at the beginning of the week or month of service delivery or with net terms determined by the customers' creditworthiness. Factors that affect our ability to increase revenue include: · Changes in the average rate per minute that we charge our customers. Our voice services are sold on a price per minute basis. The rate per minute for each customer varies based on several factors, including volume of voice services purchased, a customer's creditworthiness, and, increasingly, use of our SS-7 based services, which are priced higher than our other voice transport services. · Increasing the net number of customers utilizing our VoIP services. Our ability to increase revenue is primarily based on the number of carrier customers and retail distribution partners that we are able to attract and retain, as revenue is generated on a recurring basis from our customer base. We expect increases in our customer base primarily through the expansion of our direct sales force and our marketing programs. Our customer retention efforts are primarily based on providing high quality voice services and superior customer service. We expect that the addition of SS-7 based services to our network will significantly increase the universe of potential customers for our services because many customers will only connect to a voice service provider through SS-7 based interconnections. · Increasing the average revenue we generate per customer. We increase the revenue generated from existing customers by expanding the number of geographic markets connected to our VoIP infrastructure. Also, we are typically one of several providers of voice transport services for our larger customers, and can gain a greater share of a customer's revenue by consistently providing high quality voice service. · Acquisitions. We expect to expand our revenue base through the acquisition of other voice service providers. We plan to continue to acquire businesses whose primary cost component is voice services or whose technologies expand or enhance our VoIP service offerings. We expect that our revenue will increase in the future primarily through the addition of new customers gained from our direct sales and marketing activities and from acquisitions. 22 -------------------------------------------------------------------------------- Table of Contents Network Costs. Our network, or operating, costs are primarily comprised of fixed cost and usage based network components. In addition, ATI incurs usage based costs from its underlying telecom service providers. We generally pay our fixed network component providers at the beginning or end of the month in which the service is provided and we pay for usage based components on a weekly or monthly basis after the delivery of services. Some of our vendors require a prepayment or a deposit based on recurring monthly expenditures or anticipated usage volumes. Our fixed network costs include: · SS-7 based interconnection costs. During the first nine months of 2006, we added a significant amount of capacity, measured by the number of simultaneous phone calls our VoIP infrastructure can connect in a geographic market, by connecting directly to local phone companies through SS-7 based interconnections purchased on a monthly recurring fixed cost basis. As we expand our network capacity and expand our network to new geographic markets, SS-7 based interconnection capacity will be the primary component of our fixed network costs. Until we are able to increase revenues based on our SS-7 services, these fixed costs significantly reduce the gross profit earned on our revenue. · Other fixed costs. Other significant fixed costs components of our VoIP infrastructure include private fiber-optic circuits and private managed IP bandwidth that interconnect our geographic markets, monthly leasing costs for the collocation space used to house our networking equipment in various geographic markets, local loop circuits that are purchased to connect our VoIP infrastructure to our customers and usage based vendors within each geographic market. Other fixed network costs include depreciation expense on our network equipment and monthly subscription fees paid to various network administrative services. The usage-based cost components of our network include: · Off-net costs. In order to provide services to our customers in geographic areas where we do not have existing or sufficient VoIP infrastructure capacity, we purchase transport services from traditional long distance providers and resellers, as well as from other VoIP infrastructure companies. We refer to these costs as "off-net" costs. Off-net costs are billed on a per minute basis with rates that vary significantly based on the particular geographic area to which a call is being connected. · SS-7 based interconnections with local carriers. The SS-7 based interconnection services that are purchased from the local exchange carriers, include a usage based, per minute cost component. The rates per minute for this usage based component are significantly lower than the per minute rates for off-net services. The usage based costs for SS-7 services continue to be the largest cost component of our network as we grow revenue utilizing SS-7 technology. Our fixed-cost network components generally do not experience significant price fluctuations. Factors that affect these network components include: · Efficient utilization of fixed-cost network components. Our customers utilize our services in identifiable fixed daily and weekly patterns. Customer usage patterns are characterized by relatively short periods of high volume usage, leaving a significant amount of time during each day where the network components remain idle. Our ability to attract customers with different traffic patterns, such as customers who cater to residential calling services, which typically spike during evening hours, with customers who sell enterprise services primarily for use during business hours, increases the overall utilization of our fixed-cost network components. This decreases our overall cost of operations as a percentage of revenues. 23 -------------------------------------------------------------------------------- Table of Contents · Strategic purchase of fixed-cost network components. Our ability to purchase the appropriate amount of fixed-cost network capacity to (1) adequately accommodate periods of higher call volume from existing customers, (2) anticipate future revenue growth attributed to new customers, and (3) expand services for new and existing customers in new geographic markets is a key factor in managing the percentage of fixed costs we incur as a percentage of revenue. From time to time, we also make strategic decisions to add capacity with newly deployed technologies, such as the SS-7 based services, which require purchasing a large amount of network capacity in many geographic markets prior to the initiation of customer revenue. We expect that both our fixed-cost and usage-based network costs will increase in the future primarily due to the expansion of our VoIP infrastructure and use of off-net providers related to the expected growth in our revenues. Our usage-based network components costs are affected by: · Fluctuations in per minute rates of off-net service providers. Increasing the volume of services we purchase from our vendors typically lowers our average off-net rate per minute, based on volume discounts. Another factor in the determination of our average rate per minute is the mix of voice services we use by carrier type, with large fluctuations based on the carrier type of the end user which can be local exchange carriers, wireless providers or other voice service providers. · Sales mix of our VoIP infrastructure capacity versus off-net services. Our ability to sell services connecting our on-net geographic markets, rather than off-net areas, affects the volume of usage based off-net services we purchase as a percentage of revenue. · Acquisitions of telecommunications businesses. Long term, we expect to continue to make acquisitions of telecommunications companies. As we complete these acquisitions and add an acquired company's traffic and revenue to our operations, we may incur increased usage-based network costs. These increased costs will come from traffic that remains with the acquired company's pre-existing carrier and from any of the acquired company's traffic that we migrate to our SS-7 services or our off-net carriers. We may also experience decreases in usage based charges for traffic of the acquired company that we migrate to our network. The migration of traffic onto our network requires network construction to the acquired company's customer base, which may take several months or longer to complete. Sales and Marketing Expense . Sales and marketing expenses include salaries, sales commissions, benefits, travel and related expenses for our direct sales force, marketing and sales support functions. Our sales and marketing expenses also include payments to our agents that source carrier customers and retail distribution partners. Agents are primarily paid commissions based on a percentage of the revenues that their customer relationships generate. In addition, from time to time we may cover a portion or all of the expenses related to printing physical cards and related posters and other marketing collateral. All marketing costs associated with increasing our retail consumer user base are expensed in the period in which they are incurred. We expect that our sales and marketing expenses will increase in the future primarily due to increases in our direct sales force. General and Administrative Expense . General and administrative expenses include salaries, benefits and expenses for our executive, finance, legal and human resources personnel. In addition, general and administrative expenses include fees for professional services, occupancy costs and our insurance costs, and depreciation expense on our non-network depreciable assets. Our general and administrative expenses also include stock-based compensation on option grants to our employees and options and warrant grants to non-employees for goods and services received. 24 -------------------------------------------------------------------------------- Table of Contents Results of Operations for the Three Months Ended September 30, 2012 and 2011 The following table sets forth, for the periods indicated, the results of our operations expressed as a percentage of revenue: Three Months Ended September 30, 2012 2011 Net revenues 100 % 100 % Network costs 76 83 Gross profit 24 17 Operating expenses: Sales and marketing 4 4 General and administrative 14 19 Impairment of goodwill - 9 Total operating expenses 18 32 Operating income (loss) 6 (15 ) Accounts payable write-off and gain on forgiveness of debt 4 32 Interest expense (5 ) (6 ) Net income 5 % 11 % Net Revenues. Net revenues increased $584,000, or 11.8%, to $5.5 million for the three months ended September 30, 2012 from $4.9 million for the three months ended September 30, 2011. We have continued to increase new customers and expand revenue to certain existing customers. This has been partially offset by the loss of certain low-margin customers, primarily attributable to ATI, combined with decreased revenues from existing customers. Specifically, while the addition of new customers and increased revenues from existing customers contributed approximately $3.3 million to revenue in the three months ended September 30, 2012 these revenue gains were offset by an approximate $2.7 million decrease in revenue attributable to the loss of customers or decreased revenue from existing customers. Network Costs. Network costs increased 81,000, or 2.0%, to $4.2 million for the three months ended September 30, 2012 from $4.1 million for the three months ended September 30, 2011. Included within total network costs, variable network costs increased by $240,000 to $4.0 million (72.1% of revenues) for the three months ended September 30, 2012 from $3.7 million (75.8% of revenues) for the three months ended September 30, 2011. Fixed network costs decreased by $159,000 to $223,000 for the three months ended September 30, 2012 from $382,000 for the three months ended September 30, 2011. There were reductions to fixed network expenses during the three months ended September 30, 2012 as part of streamlining the use of fixed cost facilities. Gross margin increased to 23.8% for the three months ended September 30, 2012 from a gross margin of 16.5% for the three months ended September 30, 2011. The decrease in variable costs as a percentage of revenues and the increase in gross margin were related primarily to changes in traffic patterns during the three months ended September 30, 2012 as well as the reduction in fixed cost. Sales and Marketing. Sales and marketing expenses increased $22,000, or 13.3% to $188,000 for the three months ended September 30, 2012 from $166,000 for the three months ended September 30, 2011. Sales and marketing expenses as a percentage of net revenues were 3.4% for the three months ended September 30, 2012 and 2011. The increase is in direct relation to the increase in revenues. General and Administrative. General and administrative expenses decreased $172,000 or 18.0% to $782,000 for the three months ended September 30, 2012 from $954,000 for the three months ended September 30, 2011. General and administrative expenses as a percentage of net revenues were 14.2% and 19.3% for the three months ended September 30, 2012 and 2011, respectively. Bad debt expense was $0 in the three months ended September 30, 2012 as compared to $110,000 in the three months ended September 30, 2011. A $37,000 decrease in payroll for ATI also contributed to the decrease in general and administrative expense from the previous period. General and administrative expenses for the three months ended September 30, 2012 included stock-based compensation of $36,000. Impairment of goodwill. The Company determined that due to the decline in revenue and operating income of ATI in 2011, the carrying value of the Company's goodwill was not fully recoverable and took a charge for the impairment of goodwill in the amount of $450,000 in the three months ended September 30, 2011. 25 -------------------------------------------------------------------------------- Table of Contents Accounts Payable Write Off and Gain on Forgiveness of Debt. During the three months ended September 30, 2012, the Company recorded a gain on forgiveness of debt of $216,000 related to cash payment plan agreements with vendors for amounts less than the liability recorded in account payable and accrued expenses. During the three months ended September 30, 2011, the Company entered into numerous cash payment plan agreements with vendors for amounts less than the liability recorded in accounts payable and accrued expenses. As a result of these agreements, the Company recorded a gain on forgiveness of debt of $1,087,000 for the three months ended September 30, 2011. In addition, the Company wrote-off certain accounts payable for Competitive Local Exchange Carriers ("CLEC") that resulted in a gain of $527,000 for the same period in 2011and was included in accounts payable write-off. The CLEC accounts payable were written off based on a two year statute of limitations on such accounts payable balances. Interest Expense, net. Interest expense, net decreased $25,000, or 7.9%, to $292,000 for the three months ended September 30, 2012 from $317,000 for the three months ended September 30, 2011. Results of Operations for the Nine months Ended September 30, 2012 and 2011 The following table sets forth, for the periods indicated, the results of our operations expressed as a percentage of revenue: Nine months Ended September 30, 2012 2011 Net revenues 100 % 100 % Network costs 76 77 Gross profit 24 23 Operating expenses: Sales and marketing 3 4 General and administrative 17 17 Impairment of goodwill - 3 Total operating expenses 20 24 Operating income 4 (1 ) Accounts payable write-off and gain on forgiveness of debt 4 23 Interest expense (6 ) (5 ) Net income 2 % 17 % Net Revenues. Net revenues decreased approximately $1.7 million, or 10.2%, to $14.9 million for the nine months ended September 30, 2012 from $16.6 million for the nine months ended September 30, 2011 Though we have continued to increase new customers, this has been offset by a reduction in offering third party low margin services and attributable to both decreasing revenues from existing customers in certain areas and the loss of certain customers. The addition of new customers and increased revenues from existing customers contributed approximately $5.3 million to revenue in the nine months ended September 30, 2012. These gains were offset by an approximate $7.0 million decrease in revenue attributable to the loss of customers or decreased revenue from existing customers. Network Costs. Network costs decreased $1.5 million, or 11.5%, to $11.2 million for the nine months ended September 30, 2011 from $12.7 million for the nine months ended September 30, 2011. Included within total network costs, variable network costs decreased by $1.1 million to $10.5 million (70.7% of revenues) for the nine months ended September 30, 2012 from $11.6 million (69.9% of revenues) for the nine months ended September 30, 2011. Fixed network costs decreased by $402,000 to $749,000 for the nine months ended September 30, 2012 from $1.2 million the nine months ended September 30, 2011. Gross margin increased to 24.2% for the nine months ended September 30, 2012 from a gross margin of 23.1% for the nine months ended September 30, 2011. The increase in gross margin was related primarily to changes in traffic patterns during the nine months ended September 30, 2012 as well as the reduction in fixed cost. Sales and Marketing. Sales and marketing expenses decreased $92,000, or 15.3% to $511,000 for the nine months ended September 30, 2012 from $603,000 for the nine months ended September 30, 2011. Sales and marketing expenses as a percentage of net revenues were 3.4% and 3.6% for the nine months ended September 30, 2012 and 2011, respectively. The decrease is primarily attributable to the decrease in ATI revenues from which agent commissions are paid. In addition, a change in product mix resulted in a decrease in certain high percentage commissions. 26 -------------------------------------------------------------------------------- Table of Contents General and Administrative. General and administrative expenses decreased $253,000 or 8.9% to $2.6 million for the nine months ended September 30, 2012 from $2.8 million for the nine months ended September 30, 2011. General and administrative expenses as a percentage of net revenues were 17.3% and 17.1% for the nine months ended September 30, 2012 and 2011, respectively. Bad debt expense was $0 in the nine months ended September 30, 2012 as compared to $152,000 in the nine months ended September 30, 2011. A $101,000 decrease in payroll for ATI, a $65,000 reduction in insurance cost and a $61,000 reduction in legal fees also contributed to the decrease in general and administrative expense from the previous period. General and administrative expenses for the nine months ended September 30, 2012 included stock-based compensation of $213,000. Impairment of goodwill. The Company determined that due to the decline in revenue and operating income of ATI in 2011, the carrying value of the Company's goodwill was not fully recoverable and took a charge for the impairment of goodwill in the amount of $450,000 in the nine months ended September 30, 2011. Accounts Payable Write Off and Gain on Forgiveness of Debt. During the nine months ended September 30, 2012, the Company entered into numerous cash payment plan agreements with vendors for amounts less than the liability recorded in accounts payable and accrued expenses. As a result of these agreements, the Company recorded a gain on forgiveness of debt of $329,000 for the nine months ended September 30, 2012. Also, the Company has a policy, based on the statute of limitations, as prescribed by law, to write-off accounts payable with written contract more than four years old with no current activity and two years when there is no written agreement. The Company recorded a gain of $293,000 for the nine months ended September 30, 2012 related to these write-offs which is included in accounts payable write-off. During the nine months ended September 30, 2011, the Company entered into numerous cash payment plan agreements with vendors for amounts less than the liability recorded in accounts payable and accrued expenses. As a result of these agreements, the Company recorded a gain on forgiveness of debt of $3,010,000 for the nine months ended September 30, 2011. In addition, the Company wrote-off certain accounts payable for Competitive Local Exchange Carriers ("CLEC") that resulted in a gain of $864,000 for the same period, and is included in accounts payable write-off. The CLEC accounts payable were written off based on a two year statute of limitations on such accounts payable balances. Interest Expense, net. Interest expense, net decreased $39,000, or 4.3%, to $868,000 for the nine months ended September 30, 2012 from $907,000 for the nine months ended September 30, 2011. Liquidity and Capital Resources At September 30, 2012, we had $489,000 in cash as compared to cash of $390,000 at December 31, 2011. The Company's working capital position, defined as current assets less current liabilities, has historically been negative and was negative $10.0 million at September 30, 2012 and negative $12.7 million at December 31, 2011. Significant changes in cash flows from September 30, 2012 as compared to September 30, 2011: Net cash provided by operating activities was $273,000 for the nine months ended September 30, 2012 as compared to net cash used in operating activities of $237,000 for the nine months ended September 30, 2011. Net income for the nine months ended September 30, 2012 included non-cash gains of approximately $622,000 while the non-cash gains included in net income for the period ending September 30, 3011 were approximately $3.9 million and such gains are subtracted from net income in arriving at net cash provided by operating activities. The most significant adjustments increasing cash from operating activities in the nine months ended September 30, 2012 were the increase in accounts payable and accrued expenses and the non-cash expense of stock based compensation. Net cash used in investing activities for the nine months ended September 30, 2012 was $33,000 which was attributable to the purchase of computers and network-related equipment. Purchases of network-related equipment were $30,000 in the nine months ended September 30, 2011. Net cash used in financing activities for the nine months ended September 30, 2012 was $141,000 as compared to cash used in financing activities of $105,000 for the nine months ended September 30, 2011. The primary use of cash for financing activities for the nine months ended September 30, 2012 was $118,000 in principal payments of lines of credit. The primary use of cash for financing activities for the nine months ended September 30, 2011 was a $100,000 payment for the exercise of a warrant put. The Company had a working capital deficit of $10,006,000 and a stockholders' deficit of $12,793,000 as of September 30, 2012. The Company's ability to continue as a going concern will require additional financings if its ability to generate cash from operations does not fund required payments on its debt obligations. Obligations to the Company's debt holders include interest and principal payments to its secured note holders (see Note 7), principal and interest due on its revolving line of credit (see Note 11) and settlement payments due (see Note 6). The loan under the revolving line of credit is secured by substantially all of the Company's assets. The Company has other significant matters of importance, including contingencies such as vendor disputes and lawsuits discussed in Note 12 that could have material adverse consequences, including cessation of operations at any time. 27 -------------------------------------------------------------------------------- Table of Contents If the Company were to require additional financings in order to fund ongoing operations there can be no assurance that it will be successful in completing the required financings, that could ultimately cause the Company to cease operations. The consolidated financial statements do not include any adjustments relating to the recoverability and classification of asset carrying amounts or the amount and classification of liabilities that might result should the Company be unable to continue as a going concern. There are many claims and obligations that could ultimately cause the Company to cease operations. The report from the Company's independent registered public accounting firm relating to the year ended December 31, 2011 states that there is substantial doubt about the Company's ability to continue as a going concern. Management believes that the losses in past years were primarily attributable to costs related to building out and supporting a telecommunications infrastructure, and the requirement for continued expansion of the customer base, in order for the Company to become profitable. This resulted in the Company taking on debt and delaying payment to certain vendors. The Company may be required to obtain other financing during the next twelve months or thereafter as a result of future business developments, including any acquisitions of business assets or any shortfall of cash flows generated by future operations in meeting the Company's ongoing cash requirements. Such financing alternatives could include selling additional equity or debt securities, obtaining long or short-term credit facilities, or selling operating assets. Management continues to work with its historical vendors in order to secure the continued extension of credit. Management believes that cash flows from operations and additional debt conversions are integral to management's plan to retire past due obligations and be positioned for growth. No assurance can be given, however, that the Company will be successful in restructuring its debt on terms favorable to the Company or at all. Should the Company be unsuccessful in this restructuring, material adverse consequences to the Company could occur such as cessation of its operations. Any sale of additional common stock or convertible equity or debt securities would result in additional dilution to the Company's stockholders. Credit Facilities Revolving Credit Facility - In April 2008, the Company entered into a convertible revolving credit agreement pursuant to which the Company may access funds up to $1.5 million. In September 2008, the Company entered into Amendment No. 1 to the agreement which increased the access to $2.0 million, in November 2008 the Company entered into Amendment No 2 to the agreement which increased the access to $2.4 million and in May 2009 the Company entered into Amendment No. 4 to the agreement which increased the access to $2.55 million. The availability of loan amounts at December 31, 2009 under the revolving credit agreement was to expire on April 30, 2009. The Company entered into Amendment No. 5 to the agreement as of January 31, 2010 that extended the expiration to April 30, 2010. The Company entered into Amendment No. 6 on September 29, 2010, effective April 30, 2010, that extended the expiration to March, 30, 2011and Amendment No. 7 as of December 31, 2010 that lowered the amount of the principal reduction payments required as of December, 31, 2010. The Company entered into Amendment No. 8 as of March 30, 2011 that extended the expiration to June 30, 2011, Amendment No.9 as of June 30, 2011 that extended the expiration to September 30, 2011, Amendment No.10 as of September 30, 2011 that extended the expiration to November 30, 2011, Amendment No. 11 that extended the expiration to March 30, 2012, Amendment No. 12 that extended the expiration to May 30, 2012 and Amendment No. 13 that extended the expiration to August 16, 2012. As of September 30, 2012, the Company is permitted to borrow an amount not to exceed 85% of its eligible accounts receivable. As of September 30, 2012, the Company had borrowed $2.025 million. The Company's obligations are secured by all of the assets of the Company. Annual interest on the loans is equal to the greater of (i) the sum of (A) the Prime Rate (B) 4% or (ii) 15%, and shall be payable in arrears prior to the maturity date, on the first business day of each calendar month, and in full on August 16, 2012. The Agreement includes covenants that the Company must maintain including financial covenants pertaining to cash flow coverage of interest and fixed charges, limitations on the ratio of debt to cash flow and a minimum ratio of current assets to current liabilities. The Company is not in compliance with the financial covenants as of September 30, 2012. (See Note 11 to the Consolidated Financial Statements for detailed discussion.) Effective October 12, 2012 the Company secured a new credit facility with Transportation Alliance Bank, Inc. ("TAB Bank"). and entered into agreements with Moriah to pay off its debt. The Company has secured a $3,000,000 senior credit facility with TAB Bank pursuant to which the Company is permitted to borrow $3,000,000, up to 85% of its eligible accounts, at any time until the maturity date of September 29, 2014. This facility generally accrues interest at the greater of (i) 9.50% per annum, or (ii) the sum of the lender's stipulated prime rate plus 6.25%. The Company initially borrowed $1,338,000 from this facility. The loan provides for interest-only monthly payments, is generally secured by all the Company's assets but subject to certain prior liens, and includes financial covenants pertaining to cash flow coverage of interest and fixed charges and a requirement for a minimum level of tangible net worth. 28 -------------------------------------------------------------------------------- Table of Contents Critical Accounting Policies and the Use of Estimates Our financial statements are prepared in accordance with accounting principles generally accepted in the U.S. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, costs and expenses and related disclosures. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. We evaluate our estimates and assumptions on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions. We believe that the following accounting policies involve the greatest degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our financial condition and results of operations. Revenue Recognition. We recognize our VoIP services revenues when services are provided, primarily on usage. Revenues derived from sales of calling cards through related distribution partners are deferred upon the sale of the cards. These deferred revenues are recognized as revenues generally when all usage of the cards occurs. The Company has revenue sharing agreements based on successful collections. The Company recognizes revenue from these customers at time of invoicing based on the history of collections with such customers. We recognize revenue in the period that services are delivered and when the following criteria have been met: persuasive evidence of an arrangement exists, the fees are fixed and determinable, no significant performance obligations remain for us and collection of the related receivable is reasonably assured. Our deferred revenues consist of fees received or billed in advance of the delivery of the services or services performed in which cash receipt is not reasonably assured. This revenue is recognized when the services are provided and no significant performance obligations remain or when cash is received for previously performed services. We assess the likelihood of collection based on a number of factors, including past transaction history with the customer and the credit worthiness of the customer. Generally, we do not request collateral from our customers. If we determine that collection of revenues are not reasonably assured, we defer the recognition of revenue until the time collection becomes reasonably assured, which is generally upon receipt of cash. Stock-Based Compensation. The Company has adopted FASB ASC 718 "Compensation - Stock Compensation". The Company is applying the "modified prospective transition method" under which it continues to account for nonvested equity awards outstanding at the date of adoption of FASB ASC 718 in the same manner as they had been accounted for prior to adoption, that is, it would continue to apply APB 25 in future periods to equity awards outstanding at the date it adopted FASB ASC 718, unless the options are modified or amended. For grants to employees under the 2004 plan and 2007 plan in the year ended December 31, 2008, the Company estimated the fair value of each option award on the date of grant using the Black-Scholes option-pricing model using the assumptions noted in the following table. Expected volatility is based on the historical volatility of a peer group of publicly traded entities. The expected term of the options granted is derived from the average midpoint between vesting and the contractual term, as described in the SEC's Staff Accounting Bulletin No. 107, "Share-Based Payment." The risk-free rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant. Accounts Receivable and the Allowance for Doubtful Accounts Accounts receivable consist of trade receivables arising in the normal course of business. We do not charge interest on our trade receivables. The allowance for doubtful accounts is our best estimate of the amount of probable credit losses in our existing accounts receivable. We review our allowance for doubtful accounts monthly. We determine the allowance based upon historical write-off experience, payment history and by reviewing significant past due balances for individual collectibility. If estimated allowances for uncollectible accounts subsequently prove insufficient, additional allowance may be required. Impairment of Long-Lived Assets We assess impairment of our other long-lived assets in accordance with the provisions of FASB ASC 360, "Property, Plant and Equipment". An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable. Factors considered by us include: · Significant underperformance relative to expected historical or projected future operating results; · Significant changes in the manner of use of the acquired assets or the strategy for our overall business; and · Significant negative industry or economic trends. 29-------------------------------------------------------------------------------- Table of Contents When we determine that the carrying value of a long-lived asset may not be recoverable based upon the existence of one or more of the above indicators of impairment, an estimate is made of the future undiscounted cash flows expected to result from the use of the asset and its eventual disposition. If the sum of the expected future undiscounted cash flows and eventual disposition is less than the carrying amount of the asset, an impairment loss is recognized in the amount by which the carrying amount of the asset exceeds the fair value of the asset, based on the fair market value if available, or discounted cash flows if not. To date, we have not had an impairment of long-lived assets and are not aware of the existence of any indicators of impairment. Goodwill We record goodwill when consideration paid in a business acquisition exceeds the fair value of the net tangible assets and the identified intangible assets acquired. The Company accounts for goodwill and intangible assets in accordance with FASB ASC 350 "Goodwill and Other". FASB ASC 350 requires that goodwill and intangible assets with indefinite useful lives not be amortized, but instead be tested for impairment. FASB ASC 350 also requires the Company to amortize intangible assets over their respective finite lives up to their estimated residual values. At September 30, 2012, management does not believe there is any impairment in the value of goodwill. Accounting for Income Taxes We account for income taxes using the asset and liability method in accordance with FASB ASC 740 "Income Taxes", which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amounts and tax bases of the assets and liabilities. We periodically review the likelihood that we will realize the value of our deferred tax assets and liabilities to determine if a valuation allowance is necessary. We have concluded that it is more likely than not that we will not have sufficient taxable income of an appropriate character within the carryforward period permitted by current law to allow for the utilization of certain of the deductible amounts generating deferred tax assets; therefore, a full valuation allowance has been established to reduce the deferred tax assets to zero at September 30, 2012 and 2011. In addition, we operate within multiple domestic taxing jurisdictions and are subject to audit in those jurisdictions. These audits can involve complex issues, which may require an extended period of time for resolution. Although we believe that our financial statements reflect a reasonable assessment of our income tax liability, it is possible that the ultimate resolution of these issues could significantly differ from our original estimates. Net Operating Loss Carryforwards As of September 30, 2012 and December 31, 2011, our net operating loss carryforwards for federal tax purposes were approximately $39 million and $40 million, respectively. These net operating losses occurred subsequent to our business combination in December 2006. Contingencies and Litigation We evaluate contingent liabilities including threatened or pending litigation in accordance with FASB ASC 450 "Contingencies" and record accruals when the outcome of these matters is deemed probable and the liability is reasonably estimable. We make these assessments based on the facts and circumstances and in some instances based in part on the advice of outside legal counsel. It is not unusual in our industry to occasionally have disagreements with vendors relating to the amounts billed for services provided. We currently have disputes with vendors that we believe did not bill certain charges correctly. While we have paid the undisputed amounts billed for these non-recurring charges based on rate information provided by these vendors, as of September 30, 2012, there is approximately $61,000 of unresolved charges in dispute. We are in discussion with these vendors regarding these charges and may take additional action as deemed necessary against these vendors in the future as part of the dispute resolution process. Contractual Obligations We have no capital lease obligations at September 30, 2012. The operating lease for our corporate offices expires March 31, 2013 with a monthly lease payment of $14,000. There are no significant provisions in our agreements with our network partners that are likely to create, increase, or accelerate obligations due thereunder other than changes in usage fees that are directly proportional to the volume of activity in the normal course of our business operations. 30 -------------------------------------------------------------------------------- Table of Contents The following table reflects a summary of our contractual obligations at September 30, 2012: Payments Due by Period (Dollars in Thousands) Less Than More Than Contractual Obligations Total 1 Year 1-3 Years 3-5 Years 5 Years Operating lease obligations 84 84 - - - Total $ 84 $ 84 $ - $ - $ - Recent Accounting Pronouncements For a discussion of the impact of recently issued accounting pronouncements, see the subsection entitled "Recent Accounting Pronouncements" contained in Note 1 of the Notes to Condensed Consolidated Financial Statements under "Item 1. Financial Statements". |