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| ARBX > SEC Filings for ARBX > Form 10-Q on 11-Aug-2008 | All Recent SEC Filings |
11-Aug-2008
Quarterly Report
Overview
We are a leading solutions provider for the telecommunication industry, based primarily upon an electronic market for trading, routing and settling communications capacity. Members of our exchange, consisting primarily of communications services providers, buy and sell voice minutes and Internet capacity through our centralized, efficient and liquid marketplace. Communications services providers that do not use our exchange generally individually negotiate and buy access to the networks of other communications services providers to send voice calls and Internet capacity outside of their networks. We believe that we provide a cost-effective and efficient alternative to these direct connections. With a single interconnection to our exchange, members have access to all of our other members' networks. Members directly or indirectly place orders through our web-based interface. Sellers on the exchange post sell orders to offer voice calls and Internet capacity for specific destinations, or routes, at various prices. We independently assess the quality of these routes and include that information in the sell order. Buyers enter buy orders based on route quality and price and are matched to sell orders by our fully automated trading platform and our proprietary software. When a buyer's order is matched to a seller's order, the voice calls or Internet capacity are then routed through our state-of-the-art facilities. We invoice and process payments for our members' transactions and manage the credit risk of buyers primarily through our credit management programs with third parties.
Revenue
We generate revenues from both the trading that members conduct on our exchange, which we refer to as trading revenues, and the fees we charge members for the ability to trade on our exchange, which we refer to as fee revenues. Our trading revenue represents the aggregate dollar value of the calls that are routed through our switches at the price agreed to by the buyer and seller of the capacity. For example, if a 10-minute call is originated in France and routed through our facilities to a destination in India for $0.11 per minute, we record $1.10 of trading revenue for the call. Under our AssuredAxcess product, our members contract to buy minutes to specific markets at fixed rates. We may generate profit or incur losses associated with trading revenue on AssuredAxcess and other transactions executed on the exchange. Historically, such losses have not been material to our operating results. Our system automatically records all traffic terminated through our switches.
We record trading revenues because:
• all traffic traded on our exchange is routed through one of our switches; and
• we are obligated to pay sellers for the minutes they sell on our exchange regardless of whether we ultimately collect from buyers.
Our fee revenues represent the amounts we charge buyers and sellers for the following:
• a monthly minimum fee based on the amount of capacity that members have connected to our switches and overage fees for the number of minutes or megabytes that are routed through our switches in excess of amounts allowed under the monthly minimum, or collectively referred to as access fees, which comprised approximately 80% and 78% of fee revenues for the six months ended June 30, 2007 and June 30, 2008, respectively;
• a credit risk management fee, which is a charge for the credit management, clearing and settlement services we provide;
• a membership fee to join our exchange; and
• additional services as utilized by our members for items such as premium service offerings and accelerated payment terms.
Costs and Expenses
Our cost of trading revenues consists of the cost of calls, which are routed through our switches at the price agreed to by both the buyer and seller of the capacity. Using the example above in the caption "Revenues", we would record cost of trading revenues equal to $1.10, an amount that we would pay to the seller.
Operations and development expense consists of costs related to supporting our exchange, such as salaries, benefits, and related costs of engineering, technical support, product and software development, and system support personnel, as well as facilities and interconnect costs. Sales and marketing consists of salaries, benefits, commissions, and related costs of sales and marketing personnel, trade shows and other marketing activities. General and administrative costs consist of salaries, benefits, and related costs of corporate, finance, and administrative personnel, facilities costs, bad debt expense and outside service costs, such as legal and accounting fees.
Digital Media
In August 2006, we established a new subsidiary, Arbinet Digital Media Corporation, to explore and develop products and services to address the large and growing market opportunity presented by the exchange of digital media. As part of our digital media strategy, in December 2006, the Company, through its wholly-owned subsidiary, Broad Street Digital Inc., acquired all of the outstanding common stock of Flowphonics Limited (now known as Broad Street Digital Limited ("Broad Street Digital")), a license management platform for intellectual property rights and digital content distribution. The purchase price was approximately $2.1 million, including transaction costs.
To increase resources available for our core businesses, in the first quarter of 2008, we announced a decision to explore strategic alternatives for Broad Street Digital Limited. As a result of this decision, we recognized an impairment charge of approximately $2.3 million, in the fourth quarter of 2007, to write down the intangible and long lived assets of Broad Street Digital Limited to their estimated fair value. On August 5, 2008, we entered into an agreement to sell substantially all of the assets of Broad Street Digital. The agreement contains certain closing conditions, and we expect to complete the sale in the third quarter. In connection with the sale, we recorded a write down of $250, to adjust the carrying value of the Broad Street Digital assets to the estimated net proceeds from the transaction. In addition, during the second quarter of 2008, we made a decision to cease all activities related to the digital media market. As a result, the digital media segment has been presented as a discontinued operation in the accompanying financial statements for all periods presented.
Critical Accounting Policies and Estimates
Our management's discussion and analysis of our financial condition and results of our operations are based on our consolidated financial statements, which have been prepared in accordance with U.S. generally accepted accounting principals. The preparation of these financial statements requires management to make estimates and judgments that affect the amounts reported for assets, liabilities, revenues, expenses and the disclosure of contingent liabilities. Our significant accounting policies are more fully described in Note 1 to our consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2007.
Our critical accounting policies are those that we believe are both important to the portrayal of our financial condition and results of operations and often involve difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. Management evaluates these estimates, including those related to bad debts, income taxes, long-lived assets, restructuring, contingencies and litigation on an ongoing basis. The estimates are based on historical experience and on various assumptions about the ultimate outcome of future events. Our actual results may differ from these estimates because we did not estimate correctly.
We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:
• Long-lived assets. We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable, in accordance with SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" or ("SFAS No. 144"). Factors we consider important, which could trigger an impairment review, include the following:
• significant underperformance relative to historical or projected future operating results;
• significant changes in the manner of or use of the acquired assets or the strategy for our overall business; and
• significant industry, economic or competitive trends.
• Income taxes. We have net deferred tax assets, reflecting net operating loss ("NOL"), carryforwards and other deductible differences, which may reduce our taxable income in future years. These net deferred tax assets are offset by a valuation allowance resulting in no tax benefit being recognized related to these net deferred tax assets. We are required to periodically assess the realization of our deferred tax assets and changes in circumstances may require adjustments in future periods. The amount of net deferred tax assets actually realized could vary if there are differences in the timing or amount of future reversals of existing deferred tax liabilities or changes in the amounts of future taxable income. If it becomes more likely than not that we will recognize a future tax benefit from the deferred tax assets, we may need to reverse some or all of our valuation allowance. When evaluating our ability we were to record a net deferred tax asset, SFAS No. 109, "Accounting for Income Taxes," requires us to consider all sources of taxable income as well as all available evidence to determine that it is more likely than not that we will be able to utilize this asset. At December 31, 2007, a full valuation allowance in the amount of $41.6 million has been recorded against net deferred tax assets since at that date, the Company was unable to conclude that it was more likely than not that it would realize those assets. We will continue to refine and monitor all available evidence during future periods in order to more fully evaluate the recoverability of the Company's deferred tax assets.
On January 1, 2007 we adopted FASB Interpretation No. 48, "Accounting for Uncertainty in Income Taxes-an Interpretation of FASB Statement No. 109, Accounting for Income Taxes" ("FIN 48") to account for uncertain tax positions. FIN 48 requires that we recognize in our financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. Included in our Consolidated Balance Sheet at June 30, 2008 is approximately $39 of other long-term liabilities associated with uncertain tax positions in the various jurisdictions in which we conduct business.
The application of income tax law is inherently complex. Tax laws and regulations are voluminous and at times ambiguous, and interpretations of and guidance regarding income tax laws and regulations change over time. This requires us to make many subjective assumptions and judgments regarding our income tax exposures. Changes in our assumptions and judgments can materially affect our financial position, results of operations and cash flows.
• Allowance for doubtful accounts. We maintain an allowance for doubtful accounts for estimated losses resulting from the failure of members on our exchange to make required payments. The amount of our allowance is based on our historical experience and an analysis of our outstanding accounts receivable balances. If the financial condition of our members deteriorates, resulting in additional risk in their ability to make payments to us, then additional allowances may be required which would result in an additional expense in the period that this determination is made. While credit losses have historically been within our range of expectations and our reserves, we cannot guarantee that we will continue to experience the same level of doubtful accounts that we have in the past.
• Goodwill and Other Intangible Assets. We follow the guidance of SFAS No. 142, "Goodwill and Other Intangible Assets," which requires that purchased goodwill and certain indefinite-lived intangibles no longer be amortized but, instead, goodwill is subject to an annual assessment for impairment by applying a fair value approach. In assessing the recoverability of our goodwill and other intangibles, we must make assumptions regarding estimated future cash flows. If such assumptions change in the future, we may be required to record impairment charges for these assets.
• Litigation reserves. The establishment of litigation reserves requires judgments concerning the ultimate outcome of pending litigation against the Company and its subsidiaries. These reserves are based on the application of SFAS No. 5, "Accounting for Contingencies," ("SFAS No. 5") which requires us to record a reserve if we believe an adverse outcome is probable and the amount of the probable loss is capable of reasonable estimation. In applying judgment, management utilizes among other things, opinions and estimates obtained from outside legal counsel to apply the standards of SFAS No. 5. Accordingly, estimated amounts relating to certain litigation have met the criteria for the recognition of a liability under SFAS No. 5. Litigation by its nature is uncertain and the determination of whether any particular case involves a probable loss or the amount thereof requires the exercise of considerable judgment, which is applied as of a certain date. The required reserves may change in the future due to new matters, developments in existing matters or if we determine to change our strategy with respect to any particular matter.
• Share-Based Compensation. Effective January 1, 2006, the Company adopted SFAS No. 123R, "Share-Based Payment" ("SFAS No. 123R"). SFAS No. 123R requires all share-based payments to employees, including grants of stock options, to be expensed over the requisite service period based on the grant-date fair value of the awards and requires that the unvested portion of all outstanding awards upon adoption be recognized using the same fair value and attribution methodologies previously determined under SFAS No. 123, "Accounting for Stock-Based Compensation." The Company uses the Black-Scholes valuation method.
Results of Operations
Comparison of Six Months Ended June 30, 2007 and 2008
Trading revenues and cost of trading revenues
Trading revenues decreased 6.4% from $251.6 million for the six months ended June 30, 2007 to $235.4 million for the six months ended June 30, 2008. The decrease in trading revenues was due to a decrease in the volume traded by our members and a lower average trade rate for minutes bought and sold on the exchange. Specifically, the factors affecting trading revenues included:
A total of 7.0 billion minutes were bought and sold on Arbinet's exchange in the six months ended June 30, 2008, a decrease of 1% from the 7.1 billion minutes for the six months ended June 30, 2007. There were 956 million completed calls in the six months ended June 30, 2008, representing a 5% increase over the 907 million completed calls for the six months ended June 30, 2007. This was offset by a decrease in the average call duration from 3.9 minutes per call on our exchange for the six months ended June 30, 2007 to 3.7 minutes per call for the six months ended June 30, 2008. The lower average call duration was primarily a result of a change in the mix of geographic markets and the mix of fixed versus mobile minutes traded on our exchange. The volatility in average call duration and mix of geographic markets is expected to continue in the future.
As a result of the decrease in trading revenues, cost of trading revenues decreased 6.4% from $251.8 million for the six months ended June 30, 2007 to $235.6 million for the six months ended June 30, 2008.
Fee revenues
Fee revenues increased 4.6% from $25.1 million for the six months ended June 30, 2007 to $26.3 million for the six months ended June 30, 2008. On a per minute basis, fee revenues increased from $0.0035 in the six months ended June 30, 2007 to $0.0038 in the six months ended June 30, 2008. Average fee revenue per minute increased primarily as a result of changes in the mix of both geographic markets and members trading activity on the exchange. In addition, we experienced increased sales of certain premium service offerings and increased rapid clear fees related to accelerated payments to members. In the future, we may provide incentives to improve liquidity in our exchange and that, along with members continuing to achieve higher volume levels, may lead to a decline in average fee revenue per minute.
Operations and development
Operations and development costs increased 3.4% from $10.1 million for the six months ended June 30, 2007 to $10.4 million for the six months ended June 30, 2008. This increase was primarily due to higher interconnection costs of $0.4 million, $0.4 million of moving costs relating to the relocation of our London switch to a co-location facility, which was offset by a decrease in utilities of $0.1 million for the London premises that were exited. In addition, compensation related expenses decreased $0.2 million and certain hardware and software maintenance expenses decreased $0.1 million.
Sales and marketing
Sales and marketing expenses increased 19.3% from $4.9 million for the six months ended June 30, 2007 to $5.8 million for the six months ended June 30, 2008. This increase is mainly due to $0.9 million of compensation related expenses.
General and administrative
General and administrative expenses decreased 16.9% from $7.4 million for the six months ended June 30, 2007 to $6.1 million for the six months ended June 30, 2008. This decrease was primarily related to a reduction in professional fees of $1.8 million and increased employee compensation related costs of $0.5 million. .
Depreciation and amortization
Depreciation and amortization decreased 6.6% from $4.0 million for the six months ended June 30, 2007 to $3.7 million for the six months ended June 30, 2008. This decrease is primarily attributable to certain assets which are fully depreciated.
Severance charge
During the six months ended June 30, 2007, we recognized a charge of approximately $1.0 million, representing severance charges related to a resignation agreement entered into with our former Chief Executive Officer and President and to a workforce reduction of certain employees. There were no such charges for the six months ended June 30, 2008.
Reserve for Litigation
During the six months ended June 30, 2007, we recognized a charge of $1.9 million representing management's estimate of potential loss exposure in certain litigation matters.
Interest and other income/expense
Interest income decreased 56.5% from $1.5 million for the six months ended June 30, 2007 to $0.6 million for the six months ended June 30, 2008. This decrease was primarily due to lower average invested amounts of cash, cash equivalents and marketable securities in 2008 versus 2007, coupled with lower interest rates. Interest expense principally reflects fees paid by the Company under its third party credit arrangements. Other income (expense), net decreased $0.6 million for the six months ended June 30, 2008 compared to June 30, 2007, reflecting a decrease of $0.2 million in net gains on foreign currency translation and a reduction of $0.4 million in late fees charged to our members.
Provision for income taxes
The Company recorded an income tax provision of approximately $162 and $180, for the six months ended June 30, 2007 and 2008, respectively. The income tax provision in 2007 represented the statutory requirements for state taxes. The income tax provision in 2008 is based upon the Company's 2008 estimated effective annual tax rate of approximately 5.0%.
On January 1, 2007, we adopted the provisions of FIN 48, which requires that we recognize in our financial statements the impact of a tax position, if that position is more likely than not of being sustained on audit, based on the technical merits of the position. Approximately $200 of interest relating to uncertain tax positions has been included in the income tax provision for the six months ended June 30, 2008.
Discontinued operations
Bell Fax, Inc.
In October 1999, the Company ceased the operations of Bell Fax, Inc. ("Bellfax"), a wholly-owned subsidiary. Bellfax was engaged in the sale and rental of telecommunication equipment and operating international routes. In the first quarter of 2008, management determined that the remaining liabilities of Bellfax were no longer required. Accordingly, $226, net of income tax of $11, has been recorded as income from discontinued operations for the six months ended June 30, 2008.
Broad Street Digital Limited
In the first quarter of 2008, the Company announced that it was exploring strategic alternatives for Broad Street Digital Limited and expected to divest the business in 2008. As a result of this decision, the operating activities, assets and liabilities and cash flows related to Broad Street Digital Limited have been presented as a discontinued operation in the accompanying financial statements for all periods presented.
On August 5, 2008, we entered into an agreement to sell substantially all of the assets of Broad Street Digital. The agreement contains certain closing conditions, and we expect to complete the sale in the third quarter. In connection with the sale, the Company recorded a write down of $250, to adjust the carrying value of the Broad Street Digital assets to the estimated fair value of net proceeds from the transaction.
During the second quarter of 2008, the Company ceased all activities related to the digital media market. As a result, the digital media segment has been presented as a discontinued operation in the accompanying financial statements for all periods presented.
Trading revenues and cost of trading revenues
Trading revenues increased 0.7% from $122.1 million for the three months ended June 30, 2007 to $123.0 million for the three months ended June 30, 2008. The slight increase in trading revenues was due to an increase in the volume of minutes traded on our exchange principally due to an increase in the number of members on our exchange from 908 on June 30, 2007 to 1,091 on June 30, 2008. This increase in volume was partially offset by a lower average trade rate per minute. A total of 3.55 billion minutes were bought and sold on Arbinet's exchange in the three months ended June 30, 2008, an increase of 2.1% from the 3.48 billion minutes for the three months ended June 30, 2007. This increase was due to 502.9 million completed calls in the three months ended June 30, 2008, representing an 8.1% increase over the 465.4 million completed calls for the three months ended June 30, 2007. These gains were partially offset by a decrease in the average call duration from 3.7 minutes per call on our exchange for the three months ended June 30, 2007 to 3.5 minutes per call for the three months ended June 30, 2008. The lower average call duration was primarily a result of a change in the mix of geographic markets and the mix of fixed versus mobile minutes traded on our exchange. The volatility in average call duration and mix of geographic markets is expected to continue in the future.
As a result of increases in trading revenues, cost of trading revenues increased 0.7% from $122.2 million for the three months ended June 30, 2007 to $123.1 million for the three months ended June 30, 2008.
Fee revenues
Fee revenues increased 8.5% from $12.5 million for the three months ended June
30, 2007 to $13.6 million for the three months ended June 30, 2008. Fee revenues
increased as a result of increased trading activities on the exchange and
favorable pricing. Average fee revenue per minute was $0.0039 in the three
months ended June 30, 2008 compared to $0.0036 in the three months ended June
30, 2007. Average fee revenue per minute increased primarily as a result of
changes in the mix of geographic markets traded, and members trading activity on
the exchange. In addition, we experienced increased sales of premium service
offerings and increased rapid clear fees related to accelerated payments to
members. In the future, we may provide incentives to improve liquidity in our
exchange and that, along with members continuing to achieve higher volume
levels, may lead to a decline in average fee revenue per minute.
Operations and development
Operations and development costs increased 1.3% for the three months ended June 30, 2007 compared to the three months ended June 30, 2008. These net costs remained flat over the two periods being compared.
Sales and marketing
Sales and marketing expenses increased 26.2% from $2.5 million for the three months ended June 30, 2007 to $3.2 million for the three months ended June 30, 2008 primarily due to higher compensation related expenses.
General and administrative
General and administrative expenses decreased 9.9% from $3.5 million for the three months ended June 30, 2007 to $3.2 million for the three months ended June 30, 2008. This decrease was principally attributable to a reduction of professional fees of $0.6 million, offset by higher employee related compensation expense of $0.3 million.
Depreciation and amortization
Depreciation and amortization remained flat for the three months ended June 30, 2007 compared to the three months ended June 30, 2008.
Severance charges
During the three months ended June 30, 2007, we recognized a charge of approximately $1.0 million, representing severance charges related to a resignation agreement entered into with our former Chief Executive Officer and President and to a workforce reduction of certain employees. There were no such charges for the three months ended June 30, 2008.
Reserve for Litigation
During the three months ended June 30, 2007, we recognized a charge of $0.8 million representing management's estimate of potential loss exposure in certain litigation matters.
Interest and other income/expense
Interest income decreased from $0.7 million for the three months ended June 30, 2007 to $0.2 million for the three months ended June 30, 2008. This decrease was primarily due to lower average balances in 2008 versus 2007 of invested cash and marketable securities. Interest expense decreased from $0.2 million for the three months ended June 30, 2007 to $0.1 million for the three months ended June 30, 2008. This decrease is principally due to lower fees paid by the company under its third party credit arrangements.
Other income (expense), net decreased $0.4 million for the three months ended June 30, 2008 compared to June 30, 2007. The decrease principally reflects a $0.1 million reduction in net gains on foreign currency translation and a $0.2 million reduction in late fees charged to our members.
Provision for income taxes
The Company recorded an income tax provision of approximately $76 and $99 for the three months ended June 30, 2007 and 2008, respectively. The income tax provision in 2007 represented the statutory requirements for state taxes. The income tax provision in 2008 is based upon the Company's 2008 estimated effective annual tax rate of approximately 5.0%.
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