ITEM 1. BUSINESS.
GENERAL
Viatel, Inc. (together with its subsidiaries and predecessor the "Company" or "Viatel") is a growing provider of international and national long distance telecommunications services principally in Western Europe, Latin America, the United States and the Pacific Rim and offers its services primarily to small and medium-sized businesses, carriers and other resellers. The Company operates a digital, switch-based telecommunications network in Western Europe including a central switching center in London and nine additional switches in Amsterdam, Antwerp, Barcelona, Brussels, Frankfurt, Madrid, Milan, Paris and Rome connected by digital fiber optic transmission facilities (the "European Network"). In addition, the Company operates a switching center in Omaha, Nebraska which is connected to the central switching center in London by digital fiber optic transmission facilities (together with the European Network, the "Viatel Network"). The Company has achieved rapid growth since its inception in 1991 with telecommunications revenue reaching $50.4 million in 1996. Viatel, Inc. is a Delaware corporation with its principal headquarters located at 800 Third Avenue, New York, New York.
The Company derives revenue primarily through the provision of competitively priced long distance services with value-added features that have not been typically provided by the respective incumbent telecommunications operator ("ITO") in many of the countries in which the Company operates. The Company's services include virtual private networks, dedicated access for high volume users, calling cards, fax service and the provision of switched minutes to wholesale customers. The value-added features include itemized and multicurrency billing, abbreviated dialing and multiple payment methods. Access to the Company's services is obtained through paid access, international toll-free ("ITF"), national toll-free ("NTF"), dedicated line or callback.
The Company conducts its business on a global basis, with a principal focus on Western Europe. Of the Company's telecommunications revenue for 1996, approximately 41.9% was generated in Western Europe, approximately 28.4% was generated in Latin America, approximately 17.0% was generated in North America, primarily from the Company's wholesale business of selling switched minutes to other carriers and approximately 12.4% was generated in the Pacific Rim. The remaining 0.3% was generated in Africa and the Middle East.
BUSINESS STRATEGY
The Company's objective is to be a significant provider of international and national long distance telecommunications services within Western Europe and other deregulating markets. The Company believes it is strategically positioned to take advantage of fundamental changes occurring in the telecommunications industry as a result of global deregulation and rapid advances in technology. In particular, the Company believes that its early entry into the Western European market as an alternative network operator has positioned it to take advantage of the anticipated implementation in 1998 of European Union ("EU") directives to eliminate the ITOs' existing monopolies on
Voice Telephony, defined as the commercial provision for the public of the direct transport and switching of speech in real-time between public switched network termination points, enabling any user to use equipment connected to such a network termination point in order to communicate with another termination point. The Company is currently prohibited from supplying Voice Telephony in most EU member states until 1998. Accordingly, the Company instead provides competitively priced international and national long distance services with value-added features, thus positioning itself to capitalize on anticipated deregulation. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Results -- Substantial Government Regulation."
Key elements of the Company's business strategy include:
- - CAPITALIZE ON ANTICIPATED SETTLEMENT AGREEMENT OBSOLESCENCE. In contrast to many other companies engaged in the sale of international long distance services, the Company is not dependent on settlement agreements with ITOs for traffic origination and termination. The Company believes that deregulation of the dominant geographic telecommunications markets as evidenced by the World Trade Organization ("WTO") Basic Telecommunications Agreement (the "WTO Agreement") could hasten the obsolescence of settlement agreements anticipated by the Company, thus encouraging carriers to consider alternatives to the ITOs for long distance traffic termination. Currently, the European Network is primarily used to originate international long distance traffic from and within Western Europe. The Company plans to further leverage the European Network to take advantage of settlement agreement obsolescence anticipated by the Company by offering other carriers an alternative to the ITOs for long distance traffic origination and termination within Western Europe. While the trend toward settlement agreement obsolescence anticipated by the Company is likely to reduce prices for long distance services, the Company believes that increased utilization of the European Network for both origination and termination of traffic and reduced transmission costs should offset any such price reductions. See "-- Market Opportunity."
- - FOCUS ON THE EUROPEAN MARKET; LEVERAGE EUROPEAN NETWORK. To capitalize on opportunities presented by the changing regulatory environment and the size of the Western European market, the Company intends to further utilize and expand the European Network. During 1996, approximately 41.9% of the Company's telecommunications revenue was generated in Western Europe, with approximately 33.1% of its revenue attributable to calls originated on the European Network. The Company intends to expand the European Network by installing points of presence ("POP") in cities with both significant calling activity directed to the Company's switch-based cities and significant potential for originating and terminating international and national long distance traffic. The Company anticipates installing switches in Vienna and Zurich and POPs in up to 17 Western European cities in 1997, including Berlin, Lyon, Rotterdam, Turin and Valencia. During the first quarter of 1997, the Company installed a switch in Antwerp. The Company is currently upgrading its switch in London and its POP in New York to international gateway switches and anticipates that these improvements will be completed during the second and third quarters of 1997, respectively. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Results."
- - FOCUS ON SMALL AND MEDIUM-SIZED BUSINESSES. The Company's principal target market consists of small and medium-sized businesses for which the cost of long distance telecommunications services represents a significant business expense. The Company believes that these customers tend to focus principally on price and customer service. The Company also believes that, within any particular EU member state, the Company's services and pricing will be more attractive to such customers when, in addition to providing international long distance services, the Company provides national long distance services within such state. The Company believes that its ability to offer national and international long distance services to its targeted customers, and to bundle such services where desirable, will result in increased traffic volume on the European Network due to (i) existing high demand for national long distance service by the Company's targeted customers, (ii) potential savings which the customer would receive by purchasing both services from the Company and (iii) convenience associated with purchasing such services from a single vendor. See "-- Sales and Marketing; Customers."
- - EXPAND WHOLESALE SWITCHED SERVICE. To increase utilization of the Viatel Network, the Company sells switched minutes to wholesale customers and other resellers in the United States and the United Kingdom. Sales to such customers accounted for approximately 16.5% of the Company's telecommunications revenue for 1996 as compared to approximately 6.2% for 1995. The Company intends to continue to expand its wholesale service, thus providing the Company with a source of additional revenue and minutes originating and terminating on the Viatel Network.
- - CONTINUE DEVELOPMENT OF LOCAL SALES DISTRIBUTION CHANNELS. The Company's sales and marketing strategy is to leverage its locally based sales forces, which include direct and indirect sales representatives and telemarketing agents, to establish direct sales forces in other key Western European cities and to augment the efforts of its direct local sales, marketing and customer service functions by utilizing non-exclusive independent representatives. The Company believes that the knowledge of its sales, marketing and customer service personnel of local systems, customs and languages increases the Company's ability to develop and serve its principal target customer base.
- - PURSUE ACQUISITIONS, INVESTMENTS AND STRATEGIC ALLIANCES. The Company expects to pursue selective acquisitions of customer bases or businesses, make investments in companies that complement the Company's current operations or expand its services or network capabilities and engage in strategic alliances. The Company believes that such acquisitions, investments and strategic alliances are an important means of increasing network traffic volume and achieving economies of scale. In particular, the Company believes that, in certain instances, it is more efficient to acquire rather than develop customer bases. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Results -- Risks Associated With Acquisitions, Investments and Strategic Alliances."
MARKET OPPORTUNITY
According to the International Telecommunications Union ("ITU"), the international telephone service industry had total worldwide revenue of approximately $55.0 billion in 1995. While revenue data is not available on a per country basis for Europe, Europe accounted for approximately 45.0% or 24.0 billion of worldwide international outgoing voice and voice band data minutes of use. The Company believes that, during 1996, the Western European countries in which the Company operated represented approximately 22.6% or $13.6 billion of worldwide international outgoing voice and voice band data revenue and approximately 35.2% or 22.3 billion of related minutes of use. The Company also believes that, during 1996, the market for national long distance voice and voice band data revenue in the Western European countries in which the Company operated represented approximately $41.7 billion or 196.9 billion minutes of use.
In the Company's target markets, deregulation and new technologies have resulted in increased competition between telecommunications service providers and increased demand for the transmission of information across national borders. Such deregulation and technological innovation has: (i) decreased the cost of providing toll service; (ii) enabled the provision of sophisticated value-added features; and (iii) allowed other companies to compete with the ITOs.
Historically, the respective ITO in each country had the exclusive right to provide telephone services within that country and, as a result, long distance callers have paid relatively high prices for limited service. Since 1990, the EU telecommunications market has become increasingly liberalized, but the provision of Voice Telephony is reserved to the local ITO in most EU member states until scheduled deregulation in 1998. See "-- Government Regulation." In response to the liberalization of telecommunications services within the EU, a number of different competitors have emerged to compete with the ITOs, including the Company, alliances between large United States telecommunications service providers and ITOs and other competitors that primarily provide long distance service through callback access or through developing networks servicing specific geographic markets. See "--Competition" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which Affect the Company's Future Results -- Competition."
In the telecommunications industry, deregulation has coincided with technological advances, which include utilization of fiber optic cable and improved computer software and processing technology. Fiber optic cable, which has widely replaced traditional copper wire lines for long distance transmission, has dramatically increased the
capacity, speed and flexibility of transmission lines and has virtually eliminated limited capacity as a technical barrier to entry for new international telephone companies. Improvements in computer software and processing technology have allowed the provision of value-added features such as itemized and multicurrency billing, international debit and charge networks and ITF numbers.
The Company believes, along with many industry observers, that the current deregulation in many EU member states, coupled with technological innovation, will lead to market developments similar to those that occurred upon deregulation of long distance telecommunications services in the United States and the United Kingdom, including an increase in traffic volume and the continued introduction of new providers of telecommunications services of varying sizes. While significant reductions in prices and improvements in telecommunications and customer services have occurred and are expected to continue, the Company expects that market prices will continue to permit services to be profitably rendered by industry participants generally. See "-- Government Regulation," " -- Competition" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Results -- Substantial Government Regulation."
The Company further believes that its operating experience in deregulating markets in the United States and the United Kingdom, and its experience as an early entrant into the Western European market as an alternative network operator, will assist it in identifying opportunities and expanding the Viatel Network as other geographic regions with high density telecommunications markets, such as Latin America and the Pacific Rim, start to deregulate. The Company also believes that its position in the Western European telecommunications market and its experience providing international telecommunications services will assist it in establishing a presence in national long distance markets in Western Europe. During 1996, the Company commenced offering national long distance telecommunications service in Spain, Germany and Italy and, based upon favorable results in such markets, has determined to enter the national long distance business in all EU member states in which it currently operates.
On February 15, 1997, representatives of 70 countries, including the United States, finalized the WTO Agreement, which addresses market access, foreign investment and procompetitive regulatory principles for countries generating over 95% of world-wide telecommunications revenue. The WTO Agreement becomes effective January 1, 1998. Although certain countries took specific exceptions to the agreement, the WTO Agreement generally provides (a) market access to U.S. companies for local, long distance and international service through any means of network technology on either a resale or facilities basis, (b) the opportunity for U.S. companies to acquire, establish or hold a significant stake in telecommunications companies in the countries which are a party to the WTO Agreement, and (c) the ability to take advantage of these opportunities within a framework of procompetitive regulatory principles. The Company expects to benefit from the anticipated effects of the WTO Agreement, including the expansion of legally permissible uses of the Company's European Network, but it cannot predict the extent of the opportunities that may be presented.
SERVICES
The Company provides competitively priced long distance services with value-added features that are not typically provided by the respective ITO in many of the countries in which the Company operates. The Company's services include virtual private networks, dedicated access for high volume users, calling cards, fax service and the provision of switched minutes to wholesale customers. The value-added features include itemized and multicurrency billing, abbreviated dialing and multiple payment methods. See "-- The Viatel Network."
Access to the Company's services is obtained either through "dial up access" or "direct access." Dial up access requires the use of: (i) paid access, which requires the customer to pay the ITO for the cost of accessing the Company's services; (ii) callback, which enables the customer to receive a return call providing a dial tone originated from the Company's Omaha, Nebraska switching center; (iii) ITF, which accesses the Omaha, Nebraska switching center by direct dial; or (iv) NTF, which accesses a local switch in the European Network. Customers using direct access are connected to a Company switch by a dedicated leased line.
Paid access accounted for approximately 75.1% of the Company's Western European revenue during 1996. To reduce the Company's costs and improve usage, the Company has evolved from callback and ITF access to access by NTF numbers, paid access and, ultimately, in the case of VIACALL Plus, by direct access. Until regulatory considerations permit, all customers outside of Europe, except for wholesale customers, are expected to continue to access the Company's services through callback or ITF numbers.
The Company's principal services include:
VIACALL - enables virtual private network calling to a pre-defined group of locations within a closed user group that can be modified as required, subject only to regulatory limitations.
VIACALL PLUS - provides dedicated access via a leased line from the customer to the Viatel Network, permitting calling without dialing access or location codes.
VIACALL EXPRESS - provides a paid (local) access or toll free number programmed to dial an existing phone number or system, generally in another country, without the need for special circuits or modifications.
VIAWORLDFAX - permits calling for facsimile and other voice band data services and is marketed exclusively in Western Europe. In the fourth quarter of 1996, the Company simplified access to this service through the use of automatic number identification, where feasible.
VIAISDNFAX - permits companies with ISDN lines and high-volume national and international long-distance fax communications to send fax communications directly to a destination using abbreviated codes, if preferred.
VIACONNECT - provides "anywhere to anywhere" international callback access through manual, automatic, X.25 or Internet initiated callback. These services are also offered with ITF access, subject to pricing considerations.
VIAGLOBE - provides calling card access from over 45 countries. In addition to offering savings over the calling cards of AT&T Corporation, MCI Telecommunications Corporation and other providers of credit-based international calling cards, VIAGLOBE provides 24-hour operator assistance and speed dialing.
VIACARD - introduced in the first quarter of 1997, VIACARD is a prepaid international debit card which provides many of the same features as VIAGLOBE in a prepaid environment. The numerous benefits and opportunities afforded customers with a prepaid card include better internal cost controls and the ability to offer small denomination cards as promotional items.
The Company markets its services under a number of registered and common law service marks and uses various registered logos including "Viatel," a federally registered service mark in the United States.
In certain of the Company's existing and target markets there are laws or regulations that either prohibit or limit, or could be used to prohibit or limit, certain of the transmission methods by which the Company's services are provided and the provision of certain of the Company's services. See "--Government Regulation" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which Could Affect the Company's Future Results -- Substantial Government Regulation."
THE VIATEL NETWORK
The Viatel Network consists of central switching centers in London, England and Omaha, Nebraska and switches, each connected to London by digital fiber optic transmission facilities, in Amsterdam, Antwerp, Barcelona, Brussels, Frankfurt, Madrid, Milan, Paris and Rome. The Company's ownership of switches reduces its reliance on other carriers, enables routing of telecommunications traffic over multiple leased transmission lines, aids in controlling costs and permits the compilation of call record data and other customer information. The Company is using the net proceeds from its initial public offering completed in October 1996 (the "Offering") for the purpose of upgrading and expanding the Viatel Network. The Company has also used and intends to continue to use certain of the proceeds from its Offering to purchase interests in fiber optic cable systems in strategically positioned submarine cables. See "-- Expansion Plans" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations --Liquidity and Capital Resources -- Capital Expenditures and Working Capital."
To originate and terminate calls on the European Network, the Company's switches must have access and egress into and from the public switched telephone network ("PSTN") through local connectivity. Each of the Company's services, other than VIACALL Plus, requires use of the PSTN to connect with a Company switch, using either a NTF number or paid access. For VIACALL Plus, local connectivity is provided by dedicated leased lines that connect a customer's premises directly to a Company switch. In each country in which ViaCALL Plus is offered, local
connectivity is currently provided under tariffed services offered by the ITO. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Results -- Potential Difficulties Associated With Implementing European Expansion Strategy."
THE EUROPEAN NETWORK. The European Network currently consists of a central switching center in London and switches in the nine Western European cities mentioned above. These cities were chosen as switch locations due to the substantial number of international calls originating from such cities. The European Network has been primarily used to originate traffic in Western Europe. The Company anticipates increasing use of the European Network to terminate traffic in Western Europe, particularly if settlement agreements become obsolete. See " -- Business Strategy -- Capitalize on Anticipated Settlement Agreement Obsolescence" and "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Results -- Potential Difficulties Associated With Implementing European Expansion Strategy."
INTERNATIONAL PRIVATE LINE CIRCUITS. The Company's nine switches in Western Europe are connected to the central switching center in London by international private line circuit ("IPLC"). IPLCs are permanent point-to-point connections for voice and voice band data transmissions and are a less expensive alternative to PSTNs, which are typically controlled by the local ITOs. The Company transmits call traffic to Omaha, Nebraska from London and to London from Omaha, Nebraska by an IPLC. The IPLCs connecting the Company's switches to the central switching center in London are leased directly, or indirectly through third parties, from the ITOs in the countries in which such calls originate.
To reduce transmission costs and to provide additional capacity between the United States and London, the Company acquired an interest in fiber optic cable systems in the portion of a transatlantic digital fiber optic cable originating in the United States for transmission of traffic between the United States and Europe. The Company has received approval in principle from the Department of Trade and Industry in England in connection with its International Facilities License, which would allow the ownership of an interest in a transatlantic digital fiber optic cable originating in the United Kingdom. The Company anticipates that this license will be granted in April 1997 following the completion of a 28-day public comment period. Once the Company has obtained its International Facilities License, it intends to acquire an interest in transatlantic digital fiber optic cable originating in the United Kingdom. The Company is also considering acquiring an interest in cross-channel digital fiber optic cable originating in the United Kingdom. The Company has also become a signatory to the FIBEROPTIC Link Around the Globe ("FLAG") agreement. FLAG will provide the Company with added bandwidth capacity on a new transoceanic, intercontinental fiber system, currently under construction.
INTELLIGENT SWITCHES. The Viatel Network utilizes "intelligent switches" which incorporate proprietary software to achieve least cost routing ("LCR"), the process by which the Company optimizes the routing of calls over the Viatel Network for more than 230 countries and territories. LCR allows calls that are not routed over the Viatel Network to be routed directly from the Company's switches through the PSTN to their destinations at the lowest rates. These switches also enable the Company to efficiently perform billing functions and account activation and to render value-added services. See "--Information Systems."
The Viatel Network uses high capacity, programmable switching platforms designed to deploy network-based intelligent services quickly and cost effectively. The switches are modular and scaleable and incorporate advanced technologies such as Integrated Services Digital Network ("ISDN"), hierarchical call control and simplified network management protocol network management software. These switches can also provide a bridge between older and emerging standards. As the Viatel Network continues to evolve, the installed base of switches can be upgraded easily to create a cost effective, scaleable service switching point in an SS7 (an industry standard signaling protocol) based network.
The Company is in the process of installing international gateway switches in London and New York and anticipates that these switches will become operational during the second and third quarters of 1997, respectively.
REDUNDANCY. In general, the Company relies upon the PSTN to provide redundancy in the event of technical difficulties with the Viatel Network. However, the Company maintains two facilities in Omaha, Nebraska to provide some degree of redundancy in its back office operations, billing and switching systems. The Company believes that the strategy of using the PSTN for redundancy is more cost-effective than building its own redundant capacity, although there can be no assurance that this will be the case in the future. To the extent that customer demand over the European Network exceeds the Company's transmission capacity, the Company may elect or be required to route overflow traffic over the PSTN, and the Company may experience reduced margins and/or losses on such calls. The Company's strategy is to monitor its anticipated traffic volume on a regular basis and to increase IPLC and in-country private line circuit capacity before the capacity limitations of such circuits are reached. See "Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Results -- Potential Difficulties Associated With Implementing European Expansion Strategy."
ECONOMIC BENEFITS OF THE NETWORK. The economic benefits to Viatel of owning and operating its own network arise principally from reduced transmission costs. Calls that are not routed through the network generate significantly higher variable costs because they are connected using relatively expensive ITF numbers or callback. In contrast, because the Viatel Network has significant fixed costs associated with its operations, consisting primarily of leased line rental charges, local connectivity and facility/network management costs, calls routed through the Viatel Network have lower variable costs than off-network traffic. Although the current traffic volume through the European portion of the Company's network is too low to achieve desired economies of scale, transmission costs are expected to decline as a percentage of revenue as call traffic through the European Network increases. This economic benefit, however, is primarily limited to traffic which either originates or terminates in a city where the Company has a switch or POP. If a switch or POP does not exist in an origination or destination city, the Company transports the call over the PSTN, at higher transmission costs and reduced margins. Accordingly, as the European Network is expanded, the Company anticipates being able to serve a greater number of customers on a more cost effective basis. In the future, the Company expects that most of its European calling traffic will originate or terminate through the European Network both for international and national long distance calls. In addition, as traffic patterns warrant, the Company expects to further reduce transmission costs by connecting switches directly to one another with private lines, bypassing the Company's switching centers in London and Omaha.
EXPANSION PLANS. The Company intends to use a significant portion of the net proceeds from the Company's initial public offering in October 1996 (the "Offering") to expand and upgrade the Viatel Network. The Company is in the process of upgrading its switch in London and its POP in New York to international gateway switches. When a switch is replaced, it will be redeployed to upgrade POPs in other strategic locations. In the first quarter of 1997, the Company installed a switch in Antwerp. The Company has also purchased an interest in fiber optic cable systems in the portion of a transatlantic digital fiber optic cable originating in the United States for transmission of traffic between the United States and Europe. Once the Company has obtained its International Facilities License, it intends to acquire an interest in transatlantic digital fiber optic cable originating in the United Kingdom. The Company is also considering acquiring an interest in cross-channel digital fiber optic cable originating in the United Kingdom. To further extend the European Network, the Company also anticipates installing switches in Vienna and Zurich and POPs in up to 17 Western European cities in 1997, including Berlin, Lyon, Rotterdam and Valencia. Expanding the European Network to include such additional major European business centers should ultimately reduce transmission costs and increase the addressable market of the European Network. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations --Certain Factors Which May Affect the Company's Future Results -- Potential Difficulties Associated With Implementing European Expansion Strategy."
INFORMATION SYSTEMS
The Company believes that integrated and reliable billing and information systems are key elements for growth and success in the telecommunications industry. Accordingly, the Company has made significant investments to acquire and implement sophisticated information systems which enable the Company to: (i) monitor and respond to customer needs by developing new and customized services; (ii) manage LCR; (iii) provide customized billing information; (iv) provide high quality customer service; (v) detect and minimize fraud; (vi) verify payables to suppliers; and (vii) rapidly integrate new customers. The Company believes that its network intelligence, billing and financial reporting systems enhance its ability to competitively meet the increasingly complex and demanding requirements of the international and national long distance markets. While the Company believes that such systems are currently sufficient for its operations, such network intelligence, selling and financial reporting systems will require enhancements and ongoing investments. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Results -- Dependence on Effective Information Systems."
The Company currently has a turnaround time of approximately 24 hours for new account entry, subject to credit approval. The Company's billing system provides multicurrency billing, itemized call detail, city level detail for destination reporting and electronic output for select accounts. Customers are provided with several payment options, including automated credit card processing and automated direct debiting.
The Company has developed proprietary software to provide telecommunications services and render customer support. In contrast to most traditional telecommunications companies, the software used to support the European Network resides outside of the switches and, therefore, does not currently rely on third party switch manufacturers for upgrades. The Company believes its software configuration facilitates the rapid development and deployment of new services and provides the Company with a competitive advantage. Each switch has a call detail recording function which enables the Company to: (i) achieve accelerated collection of call records; (ii) detect fraud and unauthorized usage; and (iii) permit rapid call detail record analysis. See "-- The Viatel Network --Intelligent Switches."
The Company also uses its proprietary software to assist it in analyzing traffic patterns and determining network usage and busy hour percentage, originating traffic by switching center, terminating traffic by supplier and originating traffic by customer. This data is utilized to optimize LCR, which may result in call traffic being transmitted over the Company's transmission facilities, other carriers' transmission facilities or a combination of such facilities. If traffic cannot be handled over the least cost route due to overflow, the LCR system is designed to transmit the traffic over the next least cost route. The LCR system chooses among the following variables to minimize the cost of a long distance call: (i) over 15 different suppliers; (ii) 24 different time zones; and (iii) multiple choices of terminating carrier per country. The performance of the LCR system is verified based on a daily overflow report generated by the Company's network traffic management and a weekly/monthly average termination cost report generated by the Company's billing system. See "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations -- Certain Factors Which May Affect the Company's Future Results -- Dependence on Effective Information Systems."
SALES AND MARKETING; CUSTOMERS
From 1991 to 1994, the Company's sales and marketing efforts were conducted by independent sales representatives in each of its markets. In late 1994, the Company began establishing its own direct sales forces in certain Western European and Latin American countries to take greater control over the sales and marketing functions and to provide a higher level of customer service. Currently, the Company has direct sales forces in the nine cities in Western Europe in which it has switches. The Company intends to establish direct sales forces in other key Western European cities and to utilize non-exclusive independent representatives to augment the efforts of its direct sales forces. This strategy is expected to provide the Company with the benefits derived from a direct sales organization while minimizing the organizational and other fixed costs associated with such an undertaking. See "Item 2.

ITEM 2. PROPERTIES.
The Company currently occupies approximately 6,000 square feet of office space in New York, New York, which serves as the Company's principal executive office. The lease has an annual rental obligation of approximately $174,300 and expires on January 31, 2001. The Company also leases an aggregate of approximately 17,850 square feet of office space at two sites in Omaha, Nebraska, which serve as the Company's operations center and its United States switching center. The lease terms of the two sites have an annual combined rental obligation of approximately $108,000 and expire on March 31, 1999 and July 31, 2000.
The Company also leases office space in various cities in Europe where it maintains sales offices with annual rents ranging from $17,700 in Rome to $173,400 in Frankfurt (based on foreign currency exchange rates in effect as of March 24, 1997). The Company's aggregate annual rental obligations for its European offices is approximately $709,600 (based on foreign currency exchange rates in effect as of March 24, 1997).
ITEM 3.

ITEM 3. LEGAL PROCEEDINGS.
On January 23, 1996, the Company's former independent sales representative in Madrid (the "Spanish Representative") commenced an arbitration proceeding before the American Arbitration Association in New York claiming a breach by the Company of a contract between the Spanish Representative and the Company relating to the improper termination of such agreement by the Company. The Spanish Representative is seeking $5.8 million in damages. The Company believes that it has meritorious defenses against each of the claims alleged by the Spanish Representative. The Company is vigorously pursuing all defenses available to it.
The Company is also involved from time to time in other litigation incidental to the conduct of its business. The Company believes that any potential adverse determination in the action brought by the Spanish Representative or an adverse decision in any other pending action will not have a material adverse effect on the Company's business, financial condition or results of operations.
ITEM 4.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
EXECUTIVE OFFICERS OF THE COMPANY
The following table sets forth certain information with respect to the executive officers of the Company as of March 24, 1997.
NAME AGE POSITION - ---- --- --------
Martin Varsavsky........ 36 Chairman of the Board, Chief Executive Officer and Director Michael J. Mahoney...... 37 President, Chief Operating Officer and Director Allan L. Shaw........... 33 Vice President, Finance; Chief Financial Officer; Treasurer and Director Lawrence G. Malone...... 45 Vice President, Managing Director, Intercontinental Morten Steen-Jorgensen.. 33 Vice President, Managing Director, Europe Sheldon M. Goldman...... 37 Vice President, Business & Legal Affairs, Assistant Secretary Mark St. J. Courtney.... 37 European General Counsel and Secretary Paolo Di Fraia.......... 36 European Finance Director and Assistant Treasurer
MARTIN VARSAVSKY. Mr. Varsavsky, a founder of the Company, has served as Chairman of the Board and Chief Executive Officer of the Company since September 1996 and as Chief Executive Officer and director of the Company since February 1991. Mr. Varsavsky was also President of the Company from February 1991 through September 1996. In 1985, Mr. Varsavsky founded both Urban Capital Corporation, a commercial real estate development company, and Medicorp Sciences, a biotechnology company which conducts AIDS research. Mr. Varsavsky does not currently hold an officer position with either Urban Capital Corporation or Medicorp Sciences. Mr. Varsavsky is related by marriage to Mr. Juan Manuel Aisemberg, a principal stockholder of the Company.
MICHAEL J. MAHONEY. Mr. Mahoney has served as President and Chief Operating Officer of the Company since September 1996 and as a director of the Company since 1995. Mr. Mahoney was also Executive Vice President, Operations and Technology of the Company from July 1994 to September 1996 and Managing Director, Intercontinental of the Company from January 1996 to September 1996. From August 1990 to June 1994, Mr. Mahoney was employed by SITEL Corporation, a telemarketing services company, most recently as President, Information Services Group. From August 1987 to August 1990, Mr. Mahoney was employed by URIX Corporation, a manufacturer of telecommunications hardware and software, in a variety of sales and marketing positions.
ALLAN L. SHAW. Mr. Shaw has served as Vice President, Finance and Chief Financial Officer of the Company since January 1996 and as Treasurer of the Company since September 1996. Mr. Shaw has served as a director of the Company since June 1996. Prior to becoming the Company's Vice President, Finance and Chief Financial
Officer, Mr. Shaw served as Corporate Controller of the Company from November 1994 to December 1995. From August 1987 to November 1994, Mr. Shaw was employed by Deloitte & Touche LLP, most recently as a Manager. Mr. Shaw is a Certified Public Accountant and a member of the American Institute, United Kingdom Society and New York State Society of Certified Public Accountants.
LAWRENCE G. MALONE. Mr. Malone has served as Vice President and Managing Director, Intercontinental of the Company since September 1996 and served as Vice President of Sales for Carriers/Wholesale of the Company from January 1995 to September 1996. From December 1993 to December 1994, Mr. Malone was employed by Frame Relay Technologies, a communications equipment manufacturer, as Director of Sales. From December 1987 to November 1993, Mr. Malone was employed by Republic Telcom Systems, a voice/data networking company, where he most recently served as Vice President of Sales and Marketing.
MORTEN STEEN-JORGENSEN. Mr. Jorgensen has served as Vice President and Managing Director, Europe of the Company since September 1996. From September 1987 to August 1996, Mr. Jorgensen was employed by NCR, where he most recently served as an Assistant Vice President, Channel Sales and Marketing.
SHELDON M. GOLDMAN. Mr. Goldman has served as Vice President, Business and Legal Affairs since December 1996 and served as United States General Counsel of the Company from April 1996 until December 1996. From January 1987 to March 1996, Mr. Goldman was associated with the law firm of Wien, Malkin & Bettex. Since March 1996, Mr. Goldman has been Of Counsel to the law firm of Brief Kesselman Knapp & Schulman, LLP.
MARK ST. J. COURTNEY. Mr. Courtney has served as European General Counsel of the Company since August 1995 and as Secretary of the Company since March 1996. From December 1992 to July 1995, Mr. Courtney served as European and International Counsel for Legent Corporation, a software company, and from April 1991 to November 1992, Mr. Courtney served as Legal Counsel for ICL, Ltd., a U.K. hardware and computer services company. Mr. Courtney was employed by Lloyds Merchant Bank Ltd., a U.K. investment bank, from November 1985 to March 1991.
PAOLO DI FRAIA. Mr. Di Fraia has served as European Finance Director of the Company since January 1996 and as Assistant Treasurer of the Company since September 1996. From November 1994 to December 1995, Mr. Di Fraia served as European Controller of the Company. From April 1989 to August 1994, Mr. Di Fraia was employed by Philip Crosby Associates, S.A. as European Controller.
SENIOR MANAGEMENT
ALFREDO CANDAL. Mr. Candal has served as the Company's Regional Manager for Latin America since January 1996 and as the Company's Latin American Business Development Manager from May 1995 to December 1995. Prior to such date, Mr. Candal served as the Company's Acting Country Manager for Italy from December 1994 to May 1995 and as the Company's Latin American specialist from October 1993 to December 1994.
FRED HUGHES. Mr. Hughes has served as Vice President, Operations -- Europe of the Company since July 1994. From August 1993 to July 1994, Mr. Hughes served as Director of Telephony of the Company. From January 1991 to August 1993, Mr. Hughes was President of Communications Services Group, a Connecticut-based voice and data communications consulting company. From August 1988 to January 1991, Mr. Hughes was Director of Engineering at Millicom Telecommunications Services, Inc.
GEORGE A. PIERACCINI. Mr. Pieraccini has served as the Company's Corporate Controller since January 1996. Mr. Pieraccini served as Assistant Controller of the Company from November 1994 until December 1995. From October 1991 to November 1994, Mr. Pieraccini was employed by Edward Isaacs & Company LLP, independent Certified Public Accountants, most recently as an Audit Senior. Mr. Pieraccini is a Certified Public Accountant and a member of the American Institute and the New York State Society of Certified Public Accountants.
PHIL WILKEN. Mr. Wilken has served as Vice President of Operations of the Company since joining the Company in March 1996. From October 1995 to February 1996, Mr. Wilken was a private consultant in the telecommunications industry. Mr. Wilken was employed by CNA Insurance Co. in various capacities from January 1983 to September 1995, beginning as a Manager in Network Management and, most recently, as an Assistant Vice President of Teleservices.
PART II
ITEM 5.

ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's common stock, $0.01 per value per share (the "Common Stock") commenced trading on October 18, 1996, on the Nasdaq National Market ("NNM") under the symbol "VYTL". The high and low sales prices for the Common Stock, as reported by the NNM from October 18, 1996 to December 31, 1996 were $12.25 and $8.50, respectively.
On March 24, 1997, there were approximately 80 stockholders of record of the Common Stock. The Company believes that it has in excess of 300 beneficial owners.
The Company has never declared or paid any cash dividends on its Common Stock and does not expect to do so in the foreseeable future. The Company anticipates that all future earnings, if any, generated from operations will be retained to finance the expansion/and continued development of its business. Any future determination with respect to the payment of dividends will be within the sole discretion of the Company's Board of Directors and will depend upon, among other things, the Company's earnings, capital requirements, the terms of then existing indebtedness, applicable requirements of the Delaware General Corporation Law, general economic conditions and such other factors considered relevant by the Company's Board of Directors. In addition, the Company's ability to pay cash dividends is restricted under the terms of the Indenture, dated as of December 15, 1994, and amended October 11, 1996 (as amended, the "Indenture"), between the Company and United States Trust Company of New York, unless certain financial tests are met.
ITEM 6.

ITEM 6. SELECTED FINANCIAL DATA.
The following selected Consolidated Statement of Operations Data, Other Financial Data and Balance Sheet Data as of and for the years ended December 31, 1996, 1995, 1994, 1993 and 1992 have been derived from the Consolidated Financial Statements of the Company and the Notes related thereto, included elsewhere in this Report, which were audited by KPMG Peat Marwick LLP, independent Certified Public Accountants, as of and for the years ended December 31, 1996, 1995, 1994 and 1993 and audited by Edward Isaacs & Company LLP, independent Certified Public Accountants, as of and for the year ended December 31, 1992. This information should be read in conjunction with "Item 7.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
SUMMARY
The following is a discussion of the financial condition and results of operations of the Company for the years ended December 31, 1996, 1995 and 1994. This discussion should be read in conjunction with the Company's Consolidated Financial Statements, including the Notes related thereto, and the other financial data included elsewhere in this Report.
Since its inception in 1991, the Company has invested heavily in developing its ability to provide international telecommunications services within Western Europe and other deregulating markets and in developing and expanding its market presence including, more recently, entering into the national long distance telecommunications markets in certain EU member states. The Company has made substantial investments in software and back office operations, an administrative infrastructure and a direct sales organization in Western Europe. Furthermore, the Company has created an extensive commercial telecommunications network for voice and voice band data in Europe which the Company believes is necessary to render effectively the services it currently offers and intends to offer after the liberalization of regulations relating to Voice Telephony. Consequently, the Company has incurred a high level of expense in connection with its continued expansion which has resulted in substantial net losses since its inception. The Company expects to incur substantial net losses and negative cash flow until at least the years 2001 and 2000, respectively.
During the past two years, several key trends have affected the composition of the Company's telecommunications revenue, which is derived principally from the number of minutes of use billed by the Company, or "billable minutes." First, a growing proportion of the Company's customers, particularly in Western Europe, now access the Viatel Network using paid local access through the PSTN rather than through callback or ITF. This change has had a negative impact on the Company's revenue per minute. Second, the Company expanded its wholesale business, which represented approximately 16.5% and 35.2% of total telecommunications revenue and billable minutes, respectively, for 1996 compared to 6.2% and 21.6% of total telecommunications revenue and billable minutes, respectively, for 1995. Third, Western Europe is becoming an increasingly important market for the Company. During 1996, approximately 41.9% of the Company's telecommunications revenue was generated in Western Europe as compared to approximately 38.2% of the Company's telecommunications revenue during 1995. In contrast, despite an increase of approximately 19.5% over 1995, telecommunications revenue from Latin America represented approximately 28.4% of the Company's telecommunications revenue during 1996 as compared to approximately 37.6% of the Company's telecommunications revenue during 1995. Finally, quarterly revenue growth has fluctuated based on the number of business days and the strength of the U.S. dollar relative to European currencies in which the Company bills its customers.
Both billable minutes and growth in the number of customers exceeded Viatel's expectations for 1996. Revenue per billable minutes, however, have declined more quickly than expected as a result of competitive pressures. The Company believes that these competitive market forces should ultimately have a favorable impact on the average cost per minute as alternative infrastructure is placed in service by third parties. The Company believes that the addition of alternative infrastructure should result in decreased leased line and related costs.
Cost of telecommunications service is comprised of costs associated with the transmission of voice and voice band data telecommunications services. The European Network was developed to reduce the Company's costs of providing telecommunications services and to increase customer usage. This change in service provision has resulted in the Company's customer access methods evolving from callback and ITF access to NTF and paid local access. Calls that are not routed through the European Network generate significantly higher variable costs because they are connected using ITF numbers or callback which are relatively more expensive to the Company. In contrast, because the Viatel Network has significant fixed costs associated with its operations, consisting primarily of leased line rental charges, local connectivity and facility/network management costs, calls routed through the Viatel Network have lower variable costs than off-network traffic. Although the current traffic volume through the European portion of the Company's network is too low to achieve desired economies of scale, transmission costs are expected to decline as a percentage of revenue as call traffic through the European Network increases. See "--
Certain Factors Which May Affect the Company's Future Results -- Potential Difficulties Associated With Implementing European Expansion Strategy" and "Item 1. Business -- The Viatel Network -- The European Network."
The Company's selling, general and administrative expenses include commissions to independent sales representatives and overhead costs associated with its headquarters, back office and network operations and Western European sales offices. The costs associated with maintaining this management infrastructure, along with the Company's selling expenses, are substantially higher than the gross margins currently being generated by the Company.
As a consequence of the establishment of an administrative infrastructure for managing the business, changes in the composition of both telecommunications revenue and transmission costs, development of the European Network and the establishment of direct sales organizations since the Company's inception, the Company's results of operations for the periods presented are not necessarily comparable.
On February 15, 1997, representatives of 70 countries, including the United States, finalized the WTO Agreement, which addresses market access, foreign investment and procompetitive regulatory principles for countries generating over 95% of world-wide telecommunications revenue. The WTO Agreement becomes effective January 1, 1998. Although certain countries took specific exceptions to the agreement, the WTO Agreement generally provides (a) market access to U.S. companies for local, long distance and international service through any means of network technology on either a resale or facilities basis, (b) the opportunity for U.S. companies to acquire, establish or hold a significant stake in telecommunications companies in the countries which are a party to the WTO Agreement, and (c) the ability to take advantage of these opportunities within a framework of procompetitive regulatory principles. The Company expects to benefit from the anticipated effects of the WTO Agreement, including the expansion of legally permissible uses of the Company's European Network, but it cannot predict the extent of the opportunities that may be presented.
RESULTS OF OPERATIONS
The following table summarizes the breakdown of the Company's results of operations as a percentage of revenue:
YEAR ENDED DECEMBER 31, ------------------------ 1996 1995 1994 ---- ---- ----
Telecommunications revenue....................... 100.0% 100.0% 100.0% Cost of telecommunications services.............. 83.6 85.6 87.4 Selling, general and administrative expenses..... 65.2 75.3 54.5 Depreciation and amortization.................... 9.5 8.2 3.0
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995
TELECOMMUNICATIONS REVENUE. Telecommunications revenue increased by 56.0% to $50.4 million on 62.2 million billable minutes for 1996 from $32.3 million on 25.9 million billable minutes for 1995. Telecommunications revenue growth for 1996 was generated primarily from higher traffic volume on the European Network, from growth in the Company's wholesale business and, to a lesser extent, from growth in traffic volume in Latin America and the Pacific Rim. This revenue included approximately $0.62 million of hardware and software sales associated with the provision of telecommunications services.
The overall increase of 140.0% in billable minutes from 1995 to 1996 was partially offset by declining revenue per billable minute. Average revenue per billable minute declined 35% to $.80 in 1996 from $1.23 in 1995 primarily because of (i) a higher percentage of lower-priced intra-European traffic from the European Network, (ii) a higher percentage of low-priced wholesale traffic, (iii) reductions in certain rates charged to retail customers in response to pricing reductions enacted by certain ITOs and (iv) changes in customer access methods. See "-- Cost of Telecommunications Services" and "-- Certain Factors Which May Affect the Company's Future Results --Competition."
Telecommunications revenue per billable minute from the sale of services to retail customers decreased 28.8% to $1.04 in 1996 from $1.46 in 1995. Telecommunications revenue per billable minute from the sale of services to carriers and other resellers increased 8.6% to $.38 in 1996 from $.35 in 1995 primarily as a result of an overall increase in intercontinental call traffic. The number of customers billed rose 97.1% to 18,172 at December 31, 1996 from 9,218 at December 31, 1995. During the second half of 1996, the Company commenced offering domestic long distance telecommunications services in Germany, Italy and Spain.
The Company has significantly increased its wholesale business through which it sells switched minutes to carriers and other resellers at discounted rates to utilize excess network capacity. While the wholesale business has lower average gross margins than the Company's retail business, the telecommunications revenue generated from the wholesale business partially offsets the fixed costs associated with the Viatel Network. The wholesale business represented approximately 16.5% and 35.2% of total telecommunications revenue and billable minutes, respectively, for 1996 as compared to approximately 6.2% and 21.6% of total telecommunications revenue and billable minutes, respectively, for 1995. While the increase in telecommunications revenue represents an approximately 320.0% increase over the corresponding period for 1995, a portion of this increase represents the migration of business formerly conducted by the Company in Africa and the Middle East through indirect sales representatives to carriers which purchase switched minutes from the Company. The Company does not expect telecommunications revenue generated by its wholesale business to continue to grow at this rate.
COST OF TELECOMMUNICATIONS SERVICES. Cost of telecommunications services increased to $42.1 million in 1996 from $27.6 million in 1995 and, as a percentage of telecommunications revenue, decreased to approximately 83.6% from approximately 85.6% for 1996 and 1995, respectively. The corresponding increase in gross margins was primarily due to changes in overall service mix and increased utilization of the European Network. The Company experienced a 35.6% decrease in average cost per billable minute to $.67 during 1996 from $1.04 during 1995. This decrease, which more than offset the effect of the decline in average revenue per billable minute, was attributable primarily to (i) increased traffic being routed through the European Network which resulted in reduced costs on a per minute basis with respect to European long distance telecommunications services, (ii) an increase in switched minutes generated by the Company's wholesale business and (iii) changes in customer access methods.
Gross margins for 1996 were negatively impacted by increases in certain costs related to the expansion of the Company's overall transmission capacity. The fixed costs per minute are expected to decrease as a percentage of telecommunications revenue as traffic volume over the European Network increases. As a result of obtaining additional IPLC capacity, the costs associated with the European Network increased to approximately $4.1 million for 1996 (approximately 8.2% of telecommunications revenue for such period) from approximately $2.0 million for 1995 (approximately 6.3% of telecommunications revenue for such period). IPLCs represent a significant portion of the Company's fixed costs and were not fully utilized in 1996. The Company believes its use of IPLCs will continue to increase and such increase will positively impact the Company's overall gross margins, as a percentage of revenue, as more minutes are routed through the European Network. This benefit, however, is primarily limited to calls that either originate or terminate in a city where the Company has a switch or a POP, because otherwise the Company is required to transport the call over the PSTN at higher transmission costs and reduced margins.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses increased to $32.9 million in 1996 from $24.3 million in 1995 and, as a percentage of telecommunications revenue, decreased to approximately 65.2% in 1996 from approximately 75.3% in 1995. Much of the increased dollar amount of selling, general and administrative expenses is attributable to the costs of building a direct sales force in Western Europe and the Company's continued transition from indirect to direct sales organizations in certain other countries in which the Company does business, and overhead cost associated with the Company's headquarters, back office and network operations. The transition to a direct sales force was significantly completed in 1995 and 1996 is the first year in which the costs of such sales force was incurred throughout the year.
During 1996, the Company took a $1.3 million charge associated with a corporate restructuring undertaken during the year principally for employee termination and relocation costs and the write-down of a portion of the Company's lease for its administrative headquarters in London (the "Reorganization") and an $.85 million expense associated with a French arbitration award against the Company. Had these expenses not been incurred, selling, general and administrative expenses would have decreased to approximately 61.0%, as a percentage of telecommunications revenue. Salary related selling, general and administrative expenses represented approximately 41.0% and 42.1% of total selling, general and administrative expenses for 1996 and 1995, respectively.
The Company is also the subject of an arbitration proceeding in which the Company's former Spanish Representative is seeking $5.8 million in damages. The Company believes that any potential adverse determination
in this arbitration would not have a material adverse effect on the Company's business, financial condition or results of operations. See "Item 3. Legal Proceedings" for details regarding the arbitration proceeding with the Spanish Representative.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense, which includes depreciation of the Viatel Network, increased to approximately $4.8 million in 1996 from approximately $2.6 million in 1995. The increase was due primarily to the depreciation of switches and other equipment placed in service during 1995 and 1996.
EQUIPMENT IMPAIRMENT LOSS. In connection with the replacement of substantial portions of the European Network during 1995, the Company entered into a termination agreement with TeleMedia International, Inc. ("TMI"). Pursuant to the terms of such agreement, the Company prepaid the remaining lease obligation of approximately $1.0 million, thereby acquiring all of the equipment previously leased from TMI, most of which equipment was subsequently redeployed. The Company recorded a non-cash charge of approximately $.6 million in 1995, which represented the original installation costs of such equipment and the difference between the carrying value and the expected selling price of the equipment not expected to be redeployed.
INTEREST. Interest expense increased to approximately $10.8 million in 1996 from approximately $8.9 million in 1995 due to the accretion of non-cash interest on the Company's 15% Senior Discount Notes due January 15, 2005 (the "Notes"). No interest is payable on the Notes until July 15, 2000, at which time semi-annual interest payments will be required through the January 15, 2005 maturity date. Interest income was approximately $1.9 million and $3.3 million for 1996 and 1995, respectively.
YEAR ENDED DECEMBER 31, 1995 COMPARED TO YEAR ENDED DECEMBER 31, 1994
TELECOMMUNICATIONS REVENUE. Telecommunications revenue increased by approximately 23.0% to $32.3 million on 25.9 million billable minutes in 1995 from $26.3 million on 15.0 million billable minutes in 1994. This growth in telecommunications revenue resulted primarily from the use of direct sales organizations in Europe which the Company began to establish in late 1994, the creation of a wholesale business and growth experienced in the Company's revenue derived from the Pacific Rim ($4.4 million in 1995 versus $2.0 million in 1994). Part of this increase was offset by declining revenue per billable minute. Average revenue per billable minute declined by 27.6% to $1.23 in 1995 from $1.70 in 1994. The decrease was primarily due to a change in revenue mix, which in 1995 included a higher percentage of lower-priced intra-European traffic associated with the European Network becoming operational and a higher percentage of wholesale traffic, together with a reduction in rates as a result of the Company's response to price reductions by ITOs. The Company's wholesale business represented approximately 6.2% of telecommunications revenue and approximately 21.6% of billable minutes for 1995. Telecommunications revenue per billable minute from the sale of services to retail customers decreased to $1.46 in 1995 from $1.72 in 1994 while revenue per billable minute from the sale of services to other carriers and resellers was $0.35 in 1995. The number of customers billed rose approximately 42.5% to 9,218 at December 31, 1995 from 6,469 at December 31, 1994.
COST OF TELECOMMUNICATIONS SERVICES. Cost of telecommunications services increased to $27.6 million in 1995 from $23.0 million in 1994 and, as a percentage of telecommunications revenue, decreased to approximately 85.6% from approximately 87.4% for the years ended December 31, 1995 and 1994, respectively. The corresponding increase in gross margin was primarily attributable to changes in customer access methods and changes in service mix attributable to the European Network becoming operational. Accordingly, the Company experienced an approximately 32.0% decrease in average cost per billable minute to $1.04 during 1995 from $1.53 during 1994. This decrease, which more than offset the effect of the decline in average revenue per billable minute, was attributable to a continued decline in U.S. international rates for outbound switched minutes and to increased traffic volume being routed through the European Network, which was used to originate calls accounting for approximately 58.0% of the Company's European-related call revenue during 1995. The increased European Network utilization helped reduce costs associated with intra-European and intercontinental telecommunications services due to the predominantly fixed cost nature of the European Network. On the other hand, during 1994 the Company's gross margin was adversely affected by the delayed implementation of the European Network. The Company had priced its services to be competitive with the ITOs in Spain and Italy in anticipation of the European Network's becoming operational. Due to delays in the implementation of the European Network, however, the Company realized significant losses on this traffic as a result of having to route calls through ITF access instead of through the European Network.
Increases in certain fixed costs related to expansion of the Company's overall transmission capacity negatively impacted the Company's gross margin for the year ended December 31, 1995. As a result of obtaining additional IPLC capacity, the costs associated with the European Network increased to approximately $2.0 million for 1995 (approximately 6.3% of revenue for such period) from approximately $1.1 million for 1994 (approximately 4.1% of revenue for such period). Additionally, the Company incurred costs associated with obtaining redundant fiber optic capacity at the Omaha, Nebraska facility totaling approximately $.5 million (approximately 1.7% of revenue for 1995).
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses increased to $24.3 million in 1995 from $14.3 million in 1994 and, as a percentage of telecommunications revenue, increased to approximately 75.3% in 1995 from approximately 54.5% in 1994. Beginning in the third quarter of 1994, the Company invested significant funds in establishing a physical presence in its various geographic markets in Western Europe and in building an administrative infrastructure in its United States and Western European offices. Such an effort entailed significant expenditures for salary, rent, office and similar expenses. Salaries as a percentage of selling, general and administrative expenses increased to approximately 42.1% in 1995 from approximately 34.4% in 1994.
DEPRECIATION AND AMORTIZATION. Depreciation and amortization expense, which includes depreciation of the Viatel Network, increased to approximately $2.6 million in 1995 from approximately $.8 million in 1994. The increase in such expense was due primarily to the depreciation of the European Network which became operational during October 1994 and the amortization of intangible assets which principally related to acquired employee base and sales force in place associated with the Company's acquisition of independent sales organizations in Italy and Barcelona, which occurred in December 1994, as well as recognizing depreciation for additional switches and other items placed in service during 1994 and 1995.
INTEREST. Interest expense for 1995 increased by approximately $8.1 million from 1994 due to the accretion of non-cash interest on the Notes. This expense was partially offset by interest income of approximately $3.3 million for 1995 derived from the investment of the net proceeds from such issuance in highly liquid debt instruments.
LIQUIDITY AND CAPITAL RESOURCES
The Company has incurred losses from operating activities in each year of operations since its inception and expects to continue to incur operating losses for the next several years. Through December 31, 1996, the Company had incurred $86.0 million of aggregate losses from operating activities. As of February 28, 1997, the Company had $86.1 million of cash, cash equivalents and other liquid investments. The Company believes that, based on its current forecasts it should be able to fund its capital requirements at least until the year 1999 even though cash flow from operations will continue to be negative until at least the year 2000.
CAPITAL EXPENDITURES AND WORKING CAPITAL. The development of the Company's business has required substantial capital expenditures and working capital. The Company will incur substantial capital expenditures significantly in excess of historical levels to upgrade and expand the Viatel Network generally, and the European Network specifically, as well as to develop and expand new and existing services. During 1996, 1995 and 1994, the Company had capital expenditures, including acquisitions of businesses, of approximately $9.4, $11.4 million and $4.8 million, respectively. Historically, the Company has funded its capital expenditures through equity and debt issuances and vendor financings. As of December 31, 1996, the Company had entered into purchase commitments for network upgrades and other items aggregating approximately $7.4 million. Additionally, the Company anticipates making additional capital expenditures during 1997 of approximately $14.9 million. See "-- Certain Factors Which May Affect the Company's Future Results -- Substantial Capital Requirements."
AVERAGE MONTHLY CASH REQUIREMENTS. During 1996, the Company's average current monthly cash requirements were approximately $1.9 million, including approximately $.5 million relating to minimum commitments under carrier contracts. This average excludes approximately (i) $9.4 million for capital expenditures for the purchase of equipment, software and the continued development of the European Network, (ii) $3.6 million incurred in connection with the settlement of the Company's fee dispute for past services with a facilities-based IPLC vendor, and (iii) $1.1 million for other non-recurring items (including $.4 million paid in connection with employee termination and relocation costs).
INTEREST REQUIREMENTS AND DEBT REPAYMENT. Until January 15, 2000, the Notes will accrue interest on a semi-annual basis to their aggregate $120.7 million principal amount. No interest is payable on the Notes until July 15,
2000, at which time semi-annual interest payments will be required through the January 15, 2005 maturity date. If the Company is unable to generate sufficient cash flow from operations to satisfy the debt service requirements on the Notes, the Company will be required to refinance the Notes or raise additional capital. There can be no assurance that any refinancing could be obtained on terms favorable to the Company, if at all, or that any form of additional capital will be available. In addition, the Indenture contains certain restrictive covenants that, among other things, limit the ability of the Company and certain of its subsidiaries to incur indebtedness, make pre-payments of certain indebtedness, use the proceeds from certain sales of assets and pay dividends. There can be no assurance that the Company will be able to comply with such restrictive covenants in the future.
FOREIGN CURRENCY. The Company has exposure to fluctuations in foreign currencies relative to the U.S. Dollar as a result of billing portions of its telecommunications revenue in the local currency in countries where the local currency is relatively stable, while many of its obligations, including the Notes and a substantial portion of its transmission costs, are denominated in U.S. Dollars. In countries with less stable currencies, such as Brazil, the Company bills in U.S. Dollars. For the year ended December 31, 1996, approximately 41.7% of the Company's telecommunications revenue was billed in currencies other than the U.S. Dollar. Furthermore, substantially all of the costs of acquisition and upgrade of the Company's switches have been, and will continue to be, U.S. Dollar denominated transactions.
With the continued expansion of the European Network, a substantial portion of the costs associated with the European Network, such as local access charges and a portion of leased line costs, as well as a majority of local selling expenses, will be charged to the Company in the same currencies as revenue is billed. These developments create a natural hedge against a portion of the Company's foreign exchange exposure. To date, much of the funding necessary to establish the local direct sales organizations has been derived from telecommunications revenue that was billed in local currencies. Consequently, the Company's financial position as of December 31, 1996 and its results of operations for the year then ended were not significantly impacted by fluctuations in the U.S. Dollar in relationship to foreign currencies. See "-- Certain Factors Which May Affect the Company's Future Results -- Risks Associated with International Operations."
INFLATION
The Company does not believe that inflation has had a significant effect on the Company's operations to date.
CERTAIN FACTORS WHICH MAY AFFECT THE COMPANY'S FUTURE RESULTS
LIMITED OPERATING HISTORY; SUBSTANTIAL NET LOSSES AND NEGATIVE CASH FLOW FROM OPERATIONS; EXPECTED FUTURE NET LOSSES AND NEGATIVE CASH FLOW FROM OPERATIONS; SUBSTANTIAL LEVERAGE
The Company commenced operations in 1991 and has only a limited operating history. In addition, to date, the Company has incurred substantial net losses, and, in each of the last three years, has experienced significant increases in expenses associated with the development and expansion of the Viatel Network. The Company expects to incur substantial net losses and negative cash flows from operating activities until at least the years 2001 and 2000, respectively. There can be no assurance that the Company will achieve or sustain profitability or positive cash flows from operating activities in the future. If the Company cannot achieve profitability or positive cash flows from operating activities, it may be unable to meet its working capital or future debt service requirements which would have a material adverse effect on the Company's business, financial condition and results of operations. See "--Substantial Capital Requirements," "-- Variability of Operating Results," "Item 6. Selected Financial Data," and the Company's Consolidated Financial Statements, including the Notes thereto.
In December 1994, the Company issued, for approximately $58.0 million, $120.7 million aggregate principal amount of the Notes. Cash payments of interest are not required on the Notes prior to July 15, 2000, at which point the Company will be required to make annual interest payments of approximately $18.1 million. At December 31, 1996, the Company had total long-term debt of approximately $77.9 million and stockholders' equity of approximately $38.5 million. The Company's leverage could (i) impair the Company's ability to obtain additional future financing to fund working capital, capital expenditures, debt service requirements or acquisitions or for other purposes; (ii) require that all or a substantial portion of the Company's future cash flow from operations may be dedicated to the payment of interest and principal on the Notes; or (iii) make the Company more vulnerable to the effects of a prolonged economic downturn, limit its ability both to withstand competitive pressures and to exploit
new business opportunities and reduce its flexibility in responding to changing business and economic conditions. See "-- Liquidity and Capital Resources -- Interest Requirements and Debt Repayment."
SUBSTANTIAL GOVERNMENT REGULATION
OVERVIEW. The Company's provision of international and national long distance telecommunications services is heavily regulated. Many of the countries in which the Company provides, or intends to provide, services prohibit or limit the service which the Company can provide and the transmission methods by which such service can be provided. For example, the Company provides its customers located outside the EU, and, to a lesser degree within the EU, with access to its services through the use of callback. A substantial number of countries have prohibited certain forms of callback as a mechanism to access the Company's services. This has caused the Company to cease providing services in some jurisdictions and may require it to do so in other countries in the future. There can be no assurance that certain of the Company's services and transmission methods will not continue to be or will not become prohibited in certain jurisdictions, and, depending on the jurisdictions, services and transmission methods affected, there could be a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1. Business -- Government Regulation."
Local laws and regulations differ significantly among the jurisdictions in which the Company operates, and, within such jurisdictions, the interpretation and enforcement of such laws and regulations can be unpredictable. Some EU member states may limit, constrain or otherwise adversely affect the Company's ability to provide certain services. There can be no assurance that certain EU member states will implement, or will implement consistently, the Services Directive or the Full Competition Directive, and either the failure to implement or inconsistent implementation of such directives could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, there can be no assurance that certain EU member states will not begin charging substantial fees for the issuance of licenses to provide Voice Telephony.
UNSETTLED NATURE OF REGULATORY ENVIRONMENT. The Company expects to continue to pursue a strategy of providing its services to the maximum extent it believes permissible under applicable laws and regulations. The Company's aggressive strategy may result in the Company's (i) providing services or using transmission methods that violate local laws or regulations or (ii) failing to obtain formal approvals required under such laws or regulations. Where the Company is found to be in violation of local laws and regulations, it usually seeks to modify its operations so as to comply with such laws and regulations. There can be no assurance, however, that the Company will not be subject to fines, penalties or other sanctions as a result of past violations even though such violations were corrected. If the Company determines, following consultation with regulatory counsel in a jurisdiction, that it has a legal basis for doing so, it may persist in continuing such actions. If the Company's interpretation of applicable laws and regulations proves incorrect, it could lose, or be unable to obtain, regulatory approvals necessary to provide certain of its services or to use certain of its transmission methods. The Company also could have substantial monetary fines and penalties imposed against it. There can be no assurance that the Company has accurately interpreted or will accurately interpret applicable laws and regulations in particular jurisdictions.
There can be no assurance that future United States or foreign regulatory, judicial or legislative changes will not have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1. Business -- Government Regulation."
POTENTIAL DIFFICULTIES ASSOCIATED WITH IMPLEMENTING EUROPEAN EXPANSION STRATEGY
The Company believes that an increasing percentage of its future revenue will be derived from its Western European business operations. Execution of the Company's European expansion strategy, however, is subject to a variety of risks, including operating and technical problems, regulatory uncertainties, possible delays in the full implementation of the Services Directive and competition. The successful implementation of its European expansion strategy will require that the Company, among other things, continue to develop its European Network, back-office capacity and direct sales organizations. There can be no assurance that the Company will successfully implement its European expansion strategy or that the Company's Western European operations will contribute an increasing percentage of revenue in the future.
Expansion and development of the European Network are necessary to enable the Company to meet customer requirements and to increase the number of customers served, thereby increasing traffic volume which is fundamental to the achievement of economies of scale and to the Company's overall financial success. There can be no assurance, however, that the Company will be able to expand and develop the European Network successfully. In
addition, the current traffic volume through the European portion of the Company's network is too low to achieve desired economies of scale, transmission costs are expected to decline as a percentage of revenue as call traffic through the European Network increases and there can be no assurance, however, that the European Network will ever achieve the economies of scale which the Company believes are critical to its overall financial success.
To originate and terminate calls on the European Network, the Company requires "local connectivity," i.e., access and egress into and from the PSTN. Although the Company has been successful to date in obtaining local connectivity, there can be no assurance that the Company will be able to maintain local connectivity or that local connectivity will always be obtained. Currently, the Company obtains its local connectivity from the local ITOs which are, and are expected to continue to be, the Company's competitors.
In addition, under a prior configuration, the Company experienced problems affecting the quality of the voice and voice band data transmission of some calls transmitted over the European Network. These problems resulted from time to time in poor quality voice transmission over the European Network and, in some instances, resulted in interruptions in service. There can be no assurance that the European Network will not experience quality problems or service interruptions in the future. To provide redundancy in the event of technical difficulties with the European Network, the Company relies upon the PSTN. To the extent that calls are transmitted over the PSTN rather than over the European Network, these calls will be more costly to the Company and may result in losses on such calls.
Any failure to expand and develop the European Network successfully would have a material adverse effect on the Company's ability to implement its European expansion strategy, which is a key component of its overall business strategy. Failure to implement successfully the Company's European expansion strategy, or future problems with local connectivity, quality of service or service interruptions would have a material adverse effect on the Company's business, financial condition and results of operations. See "-- Substantial Government Regulation," "-- Competition," "-- Risks Associated with International Operations," " Item 1. Business -- Business Strategy," "Item 1. Business -- The Viatel Network -- The European Network" and "Item 1. Business -- Competition."
SUBSTANTIAL CAPITAL REQUIREMENTS
The Company will require substantial capital expenditures significantly in excess of historical levels to upgrade and expand the Viatel Network generally, and the European Network specifically, as well as to develop and expand new and existing services. Although the Company believes that it has sufficient funds to fund its current capital expenditure plans, actual capital expenditures may vary significantly from the Company's estimates depending on a number of factors, including the pace and extent of network upgrade and expansion, the magnitude of potential acquisitions, investments or strategic alliances, levels of incremental sales and regulatory actions, which, individually or collectively, could cause material changes in the Company's capital expenditure requirements.
The Company will need additional capital to (i) finance its anticipated growth, (ii) fund working capital needs and future debt service obligations, (iii) take advantage of unanticipated opportunities, including more rapid international expansion, acquisitions of customer bases or businesses or investments in, or strategic alliances with, companies that are complementary to the Company's current operations, (iv) develop or expand into new services, such as competitive local exchange carrier services, or (v) otherwise respond to unanticipated competitive pressures. The Company currently expects to obtain any such additional capital through debt offerings and internally generated cash flow. There can be no assurance, however, that the Company will be successful in producing sufficient internally generated cash flow or raising sufficient capital on terms acceptable to the Company, if at all. Moreover, the amount of, and the terms and conditions of the instruments relating to, the Company's current outstanding indebtedness may adversely affect the Company's ability to raise additional capital. See "-- Limited Operating History; Substantial Net Losses and Negative Cash Flow from Operations; Expected Future Net Losses and Negative Cash Flow from Operations; Substantial Leverage" and "-- Liquidity and Capital Resources."
RISKS ASSOCIATED WITH MANAGEMENT OF GROWTH AND IMPLEMENTATION OF GROWTH STRATEGY
The Company's rapid growth has placed, and is expected to continue to place, a significant strain on the Company's administrative, operational and financial resources and has increased demands on its systems and controls. There can be no assurance, however, that the Company will be able to successfully add services or expand its geographic markets or that existing regulatory barriers to its current or future operations will be reduced or eliminated. As the Company increases its services and expands its geographic markets, there will be additional demands on the Company's customer support, sales and marketing and administrative resources and network infrastructure. There can be no assurance that the Company's administrative, operating and financial control systems
and infrastructure will be adequate to maintain and effectively monitor future growth or that the Company will be able to successfully attract, train and manage additional employees. The failure to continue to upgrade the Company's administrative, operating and financial control systems and infrastructure or the occurrence of unexpected expansion difficulties could have a material adverse effect on the Company's business, financial condition and results of operations. See "-- Potential Difficulties Associated With Implementing European Expansion Strategy" and "-- Dependence on Effective Information Systems."
COMPETITION
The international telecommunications industry is highly competitive. The Company's success depends upon its ability to compete with other telecommunications providers in each of its markets. These providers include the ITO in each country in which the Company operates and global alliances among some of the world's largest telecommunications carriers. Other potential competitors include cable television companies, wireless telephone companies, electric and other utilities with rights of way, railways, microwave carriers and large end users which have private networks. The intensity of competition has recently increased and the Company believes that competition will continue to intensify as the number of new entrants increases. Many of the Company's current or potential competitors have substantially greater financial, marketing and other resources than the Company. If the Company's competitors devote significant additional resources to the provision of international or national long distance telecommunications services to the Company's target customer base of small and medium-sized businesses, such action could have a material adverse effect on the Company's business, financial condition and results of operations, and there can be no assurance that the Company will be able to compete successfully against such new or existing competitors.
Competition for customers in the telecommunications industry is primarily based on price and, to a lesser extent, on the type and quality of services offered. The Company prices its services primarily by offering discounts to the prices charged by its competitors, and some of the Company's competitors may be able to use their financial resources to cause severe price competition in the countries in which the Company operates. The Company has experienced, and expects to continue to experience, declining revenue per billable minute in all of its markets, in part as a result of increasing worldwide competition within the telecommunications industry.
The Company believes that the ITOs generally have certain competitive advantages due to their control over local connectivity and apparent close ties with national regulatory authorities. The Company also believes that, in certain instances, some regulators have shown a reluctance to adopt policies and grant regulatory approvals that would result in increased competition for the local ITO. Moreover, the Company believes that it has encountered anti-competitive behavior on the part of certain ITOs. If the Company encounters anti-competitive behavior in countries in which it operates or if the ITO in any country in which the Company operates uses its competitive advantages to the fullest extent, the Company's business, financial condition and results of operations could be materially adversely affected.
RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS
There are certain risks inherent in doing business on an international level, including regulatory limitations restricting or prohibiting the provision of the Company's services, unexpected changes in regulatory requirements, tariffs, customs, duties and other trade barriers, difficulties in staffing and managing foreign operations, longer payment cycles, problems in collecting accounts receivable, political risks, fluctuations in currency exchange rates, foreign exchange controls which restrict or prohibit repatriation of funds, technology export and import restrictions or prohibitions, delays from customs brokers or government agencies, seasonal reductions in business activity during the summer months in Europe and certain other parts of the world and potentially adverse tax consequences resulting from operating in multiple jurisdictions with different tax laws.
Since its inception in 1991, the Company has invested heavily in developing its ability to provide international telecommunications services within Western Europe and other deregulating markets and in developing and expanding its market presence including, more recently, entering into the national long distance telecommunications markets in Spain and Italy. If the Company's operations in Western Europe expand as expected, an increasing portion of the Company's revenue and expenses will be denominated in currencies other than U.S. Dollars, and changes in exchange rates will likely affect the Company's results of operations. Furthermore, international rates charged to customers are likely to decrease in the future for a variety of reasons, including increased competition between existing carriers, new entrants into geographic markets in which the Company operates or intends to operate and additional strategic alliances or joint ventures among large international carriers that facilitate targeted
pricing and cost reductions. Depending on the countries involved, any or all of the foregoing factors could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, there can be no assurance that laws or administrative practices relating to taxation, foreign exchange or other matters in countries within which the Company operates will not change. Any such change could have a material adverse effect on the Company's business, financial condition and results of operations. See "-- Substantial Government Regulation," "-- Competition," "-- Results of Operations - -- Liquidity and Capital Resources -- Foreign Currency," and "Item 1. Business - -- Government Regulation."
RISKS ASSOCIATED WITH ACQUISITIONS, INVESTMENTS AND STRATEGIC ALLIANCES
The Company may, in the future, acquire or engage in efforts to acquire customer bases and businesses from, make investments in, or enter into strategic alliances with, companies which have customer bases, switching capabilities or existing networks in the Company's current markets or in areas into which the Company intends to expand the Viatel Network, generally, and the European Network, specifically. Although the Company is currently evaluating several potential investment opportunities, it does not have any present understanding, commitment or agreement with respect to any acquisition, investment, strategic alliance or related effort (other than a strategic alliance with PSINet Europe Limited for the sale of internet services to Viatel customers). Any future acquisitions, investments, strategic alliances or related efforts will be accompanied by the risks commonly encountered in such transactions or efforts. There can be no assurance that the Company would be successful in overcoming these risks or any other problems encountered with such acquisitions, investments, strategic alliances or related efforts. See "-- Potential Difficulties Associated With Implementing European Expansion Strategy," "-- Risks Associated with International Operations" and "Item 1. Business -- Business Strategy -- Pursue Acquisitions, Investments and Strategic Alliances."
RAPID CHANGES IN TECHNOLOGY AND CUSTOMER REQUIREMENTS
The telecommunications industry is characterized by rapid and significant technological advancement and introduction of new products and services utilizing new technologies. Competitive pressures may force the Company to implement new technologies at substantial cost, and competitors may implement new technologies before the Company is able to implement such technologies, allowing such competitors to provide such enhanced services before the Company is able to. There can be no assurance that the Company will be able to respond to such competitive pressures and implement such technologies on a timely basis or at an acceptable cost. If the Company is unable to respond to competitive pressures, implement new technologies on a timely basis, penetrate new markets in a timely manner in response to changing market conditions or customer requirements, or if new or enhanced services offered by the Company do not achieve a significant degree of market acceptance, any such event could have a material adverse effect on the Company's business, financial condition and results of operations.
DEPENDENCE ON EFFECTIVE INFORMATION SYSTEMS
To efficiently produce customer bills in a timely manner, the Company must record and process millions of call detail records quickly and accurately. While the Company believes that its billing and information systems are currently sufficient for its operations, such systems will require enhancements and ongoing investments, including as volume increases. There can be no assurance that the Company will not encounter difficulties in enhancing its systems or integrating new technology into its systems. The inability of the Company to implement any required system enhancement, to acquire new systems or to integrate new technology in a timely and cost effective manner could have a material adverse effect on the Company's business, financial condition and results of operations. See "Item 1. Business -- Information Systems."
VARIABILITY OF OPERATING RESULTS
The Company's quarterly operating results have fluctuated in the past, primarily as a result of the evolution of the Company's business, and may fluctuate significantly in the future as a result of a variety of factors, including: (i) pricing changes; (ii) changes in the mix of services sold or channels through which those services are sold; (iii) changes in user demand, customer terminations of service, capital expenditures and other costs relating to the expansion of the Viatel Network; (iv) the timing and costs of any acquisitions of customer bases and businesses, services or technologies; (v) the timing and costs of marketing and advertising efforts; (vi) the effects of government regulation and regulatory changes; and (vii) specific economic conditions in the telecommunications industry. Such variability could have a material adverse effect on the Company's business, financial condition and results of operations. Any significant shortfall in demand for the Company's services in relation to the Company's
expectations, or the occurrence of any other factor which causes revenue to fall significantly short of the Company's expectations, would also have a material adverse effect on the Company's business, financial condition and results of operations. In addition, the uncertainty of revenue growth coupled with substantial planned increases in operating expenses and the continued evolution in the Company's transmission methodology from switchless resale to use of the Viatel Network may result in substantial quarterly fluctuations in the Company's operating results which could have a material adverse effect on the Company's business, financial condition and results of operations. See "-- Limited Operating History; Substantial Net Losses and Negative Cash Flow from Operations; Expected Future Net Losses and Negative Cash Flow from Operations; Substantial Leverage," and "Item 6. Selected Financial Data."
RELIANCE ON THIRD PARTIES FOR LEASED CAPACITY
Other than certain interests in digital fiber optic cables, the Company does not currently own any telecommunications transmission lines. As a result, the Company depends upon facilities-based carriers, some of which are or may become competitors of the Company, to provide its services. The Company's profitability depends, in part, on its ability to obtain and utilize leased capacity on a cost-effective basis. The Company leases capacity pursuant to agreements with twelve-month terms and is vulnerable to changes in its lease arrangements, such as price increases and service cancellations. Although the Company believes that it has and will continue to enjoy favorable arrangements with the facilities-based carriers from which it leases transmission lines, there can be no assurance that such arrangements will continue or that leased capacity will continue to be available at cost-effective rates. See "Item 1. Business -- The Viatel Network" and "Item 1. Business -- Carrier Contracts."
ITEM 8.

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The following statements are filed as part of this Report:
FORM 10-K Financial Statements: PAGE NO. ---------
Independent Auditors' Report........................................... 31
Consolidated Balance Sheets as of December 31, 1996 and 1995.......... 32
Consolidated Statements of Operations for the Years Ended December 31, 1996, 1995 and 1994.................................. 33
Consolidated Statements of Stockholders' Equity (Deficit) for the Years ended December 31, 1996, 1995 and 1994...................... 34
Consolidated Statements of Cash Flows for the Years ended December 31, 1996, 1995 and 1994.................................. 35
Notes to Consolidated Financial Statements for the Years Ended December 31, 1996, 1995 and 1994............................ 36
II. Valuation and Qualifying Accounts.................................. 47
All other schedules have been omitted because the required information either is not applicable or is shown in the consolidated financial statements or notes thereto.
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders Viatel, Inc:
We have audited the consolidated financial statements of Viatel, Inc. and subsidiaries as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also audited the financial statement schedule as listed in the accompanying index. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Viatel, Inc. and subsidiaries as of December 31, 1996 and 1995, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1996 in conformity with generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
KPMG PEAT MARWICK LLP
New York, New York March 7, 1997
VIATEL, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS DECEMBER 31, 1996 AND 1995
1996 1995 ------------ ----------- ASSETS
Current Assets: Cash and cash equivalent ..................... $ 75,796,102 $ 8,934,914 Marketable securities, current ............... 8,181,332 25,004,050 Trade accounts receivable, less allowance for doubtful accounts of $602,000 and $473,000, respectively ..... 8,542,305 4,723,664 Other receivable ............................... 4,633,571 2,757,675 Prepaid expenses................................ 789,307 742,803 ------------ ---------- Total current asset ........................ 97,942,617 42,163,106 ------------ ---------- Marketable securities, non-current ............. 9,004,075 1,127,442 Property and equipment, net .................... 21,074,417 15,715,121 Deferred financing and registration fees, less accumulated amortization of $742,000 and $364,000, respectively........................ 3,046,897 3,431,540 Intangible assets, net ......................... 1,973,910 2,070,055 Other assets ................................... 1,622,534 1,106,182 ------------ ----------- $134,664,450 $65,613,446 ============ ===========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current Liabilities: Accrued telecommunications costs ................ $ 11,915,671 $11,056,235 Accounts payable and other accrued expenses ..... 5,916,223 4,591,628 Commissions payable ............................. 349,646 300,655 Current installments of obligations under capital leases................................. 96,064 -- ----------- ---------- Total current liabilities ....................... 18,277,604 15,948,518 ----------- ---------- Long term liabilities: Senior discount notes, less discount of $42,945,967 and $53,416,992, respectively.... 77,754,033 67,283,008 Obligations under capital leases, excluding current installments........................... 149,983 -- ----------- ----------- Total long term liabilities ................. 77,904,016 67,283,008 =========== =========== Commitments and contingencies Stockholders' equity (deficit): Common Stock, $.01 par value. Authorized 50,000,000 shares, issued and outstanding 22,513,226 and 10,736,135 shares, respectively................................. 225,132 107,361 Class A Common Stock, $.01 par value. Authorized 10,000,000 shares, issued and outstanding no shares and 2,904,846 shares, respectively...... ............................ -- 29,048 Additional paid-in capita1 ...................... 125,236,410 30,099,011 Unearned compensation ........................... (130,080) (78,000) Cumulative translation adjustment ............... (862,458) (164,676) Accumulated deficit ............................. (85,986,174) (47,610,824) ----------- ----------- Total stockholders' equity (deficit) ......... 38,482,830 (17,618,080) ------------ ----------- $134,664,450 $65,613,446 ============ ===========
See accompanying notes to consolidated financial statements.
VIATEL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
See accompanying notes to the consolidated financial statements.
VIATEL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
VIATEL, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
See accompanying notes to consolidated financial statements.
VIATEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996, 1995 AND 1994
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(A) DESCRIPTION OF BUSINESS
Viatel, Inc. (the "Company") provides value-added telecommunications services primarily to businesses operating internationally. In order to effectuate a reincorporation in the State of Delaware, VIA USA, Ltd. (a predecessor Colorado corporation) merged with and into its wholly owned subsidiary, Viatel, Inc., on October 11, 1994. The surviving entity, Viatel, Inc., has reflected all assets and liabilities at historical cost.
(B) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant inter-company balances and transactions have been eliminated in consolidation. Investments in affiliates in which the Company has significant influence but does not exercise control are accounted for under the equity method.
(C) CASH AND CASH EQUIVALENTS
The Company's policy is to maintain its uninvested cash at minimum levels. Cash equivalents, which include highly liquid debt instruments purchased with a maturity of three months or less, were $71,765,458 and $3,116,218 at December 31, 1996 and 1995, respectively.
(D) REVENUE
The Company records telecommunications revenue as earned, at the time services are provided.
(E) PROPERTY AND EQUIPMENT
Property and equipment consist principally of telecommunications related equipment such as switches, fiber optic cable systems, remote nodes and related computer software and is stated at cost. Equipment acquired under capital leases is stated at the present value of the future minimum lease payments. Maintenance and repairs are expensed as incurred.
Depreciation is provided using the straight-line method over the estimated useful lives of the related assets. Leasehold improvements are amortized over the life of the lease or useful life of the improvement, whichever is shorter. The estimated useful lives are as follows:
Communications system................................ 5 to 7 years Fiber optic cable systems............................ 15 years Leasehold improvements............................... 2 to 5 years Furniture, equipment and other....................... 5 years
VIATEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996, 1995 AND 1994
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
(F) INTANGIBLE ASSETS
Goodwill, which represents the excess of purchase price over fair value of net assets acquired, is amortized on a straight-line basis over the expected periods to be benefited, seven years.
Acquired employee base and sales force in place represents the intangible assets associated with the acquisition of independent sales organizations and is being amortized over three years.
Deferred financing and registration fees represent debt financing costs incurred to issue and register debt and which are being amortized over the term of the related debt.
The costs of all other intangible assets are being amortized over their useful lives, ranging from one to five years.
The Company's intangible assets are assessed for recoverability at least quarterly. The Company assesses the recoverability of its intangible assets by determining whether the amortization of the related intangible asset balance over its remaining life can be recovered through projections of undiscounted future operating cash flows of the related intangible assets. The amount of intangible asset impairment, if any, is measured based on projected discounted future operating cash flows using a discount rate reflecting the Company's average cost of funds. The assessment of the recoverability of intangible assets will be impacted if estimated future operating cash flows are not achieved.
(G) INCOME TAXES
Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income or expense in the period it occurs.
(H) FOREIGN CURRENCY TRANSLATION
Foreign currency assets and liabilities are translated using the exchange rates in effect at the balance sheet date. Results of operations are translated using the average exchange rates prevailing throughout the year. The effects of exchange rate fluctuations on translating foreign currency assets and liabilities into U.S. dollars are accumulated as part of the foreign currency translation adjustment in stockholders' equity. Gains and losses from foreign currency transactions are included in selling, general and administrative expenses in the period in which they occur. For the years ending December 31, 1996, 1995 and 1994, the Company experienced $10,637 in foreign exchange transaction losses and $107,846 and $15,234 in foreign exchange transaction gains, respectively.
(I) NET LOSS PER SHARE
Net loss per common and common equivalent share is based on the weighted average number of common shares outstanding during each period. Per share amounts have been retroactively restated to give effect to a reverse stock split at a ratio of 3-to-2. (See Note 7).
VIATEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996, 1995 AND 1994
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
(J) CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject the Company to concentration of credit risk consist primarily of temporary cash investments and trade receivables. The Company restricts investment of temporary cash investments to financial institutions with high credit standing. Credit risk on trade receivables is minimized as a result of the large and diverse nature of the Company's worldwide customer base.
(K) RECLASSIFICATIONS
Certain reclassifications have been made to the prior year's financial statements to conform to the current year's presentation.
(L) USE OF ESTIMATES
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 revenue and expenses during the reporting period. Actual results could differ from those estimates.
(M) ADDITIONAL ACCOUNTING POLICIES
Additional accounting policies are incorporated into the notes herein.
(N) STOCK OPTION PLAN
Prior to January 1, 1996, the Company accounted for its stock option plan in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees," and related interpretations. As such, compensation expense was recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price. On January 1, 1996, the Company adopted SFAS No. 123, "Accounting for Stock-Based Compensation," which permits entities to recognize as expense over the vesting period the fair value of all stock-based awards on the date of grant. Alternatively, SFAS No. 123 also allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and pro forma earnings per share disclosures for employee stock option grants made in 1995 and future years as if the fair-value-based method, as defined in SFAS No. 123, had been applied. The Company has elected to continue to apply the provisions of APB Opinion No. 25 and provide the pro forma disclosure required by SFAS No. 123. See Note 10.
(O) IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED OF
The Company adopted the provisions of SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of" on January 1, 1996. SFAS 121 requires that long-lived assets and certain identifiable intangibles be reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceed the fair value of the assets. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. Adoption of SFAS 121 did not have a material impact on the Company's financial position, results of operations, or liquidity.
VIATEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996, 1995 AND 1994
(2) ACQUISITIONS
During December 1994, the Company acquired all of the issued and outstanding stock of two of its independent sales organizations. These acquisitions have been accounted for under the purchase method of accounting and, accordingly, the aggregate purchase price of $1,171,320 has been allocated to the assets acquired and liabilities assumed, based upon their estimated fair values as of the acquisition date. Additionally, the results of operations of these organizations are included in the consolidated statements of operations from dates of acquisition. Included among the assets acquired are intangible assets which principally related to the acquired employee base and sales force in place which will be amortized over three years, which corresponds to the estimated remaining service lives of the employee base and sales force. The allocation of the aggregate purchase price is summarized as follows:
Current assets................................ $ 161,486 Current liabilities........................... (232,865) Property and equipment........................ 102,922 Intangible and other assets acquired ......... 1,139,777 ---------- Total purchase price .................... $1,171,320 ==========
Due to the nature of the organizations acquired, pro forma revenue would equal reported revenue and the pro forma net loss would be $194,007 higher than the reported net loss for the year ended December 31, 1994.
(3) INVESTMENTS IN DEBT SECURITIES
Management determines the appropriate classification of its investments in debt securities at the time of purchase and classifies them as held to maturity or available for sale. The Company does not invest in securities for the purpose of trading and as such does not classify any securities as trading. These investments are diversified among high credit quality securities in accordance with the Company's investment policy. Debt securities that the Company has both the intent and ability to hold to maturity are carried at amortized cost. Debt securities for which the Company does not have the intent or ability to hold to maturity are classified as available for sale. Securities available for sale are carried at fair value, with the unrealized gains and losses, net of tax, reported in a separate component of stockholders' equity.
The amortized cost of debt securities classified as held to maturity are adjusted for amortization of premiums and accretion of discounts to maturity over the estimated life of the security. Such amortization and interest are included in interest income. There were no securities classified as held to maturity as of December 31, 1996.
VIATEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996, 1995 AND 1994
(3) INVESTMENTS IN DEBT SECURITIES (CONTINUED)
The following is a summary of the fair value of securities held to maturity and securities available for sale at December 31, 1996 and 1995:
Unrealized gains or losses on securities classified as available for sale are not material at December 31, 1996 and 1995.
Securities available for sale at December 31, 1996 by contractual maturity are shown below:
Due within one year............................. $ 8,181,332 Due after one year through two years............ 9,004,075 ----------- Total....................................... $17,185,407 ===========
Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
There were no changes in the classification of any securities held to maturity or securities available for sale from the time of purchase to the time of maturity or sale.
(4) PROPERTY AND EQUIPMENT
Property and equipment consists of the following as of December 31:
1996 1995 ----------- ----------- Communications system .......................... $20,514,213 $13,997,966 Fiber optic cable systems ...................... 309,933 -- Leasehold improvements ......................... 2,122,911 1,062,742 Furniture, equipment and other ................. 4,750,137 2,755,600 Construction in progress ....................... 100,962 679,935 ----------- ----------- 27,798,156 18,496,243 Less accumulated depreciation and amortization . 6,723,739 2,781,122 ----------- ----------- $21,074,417 $15,715,121 =========== ===========
At December 31, 1996 and 1995, construction in progress represents a portion of the current expansion of the European Network. As of December 31, 1996 and 1995, $575,100 and $508,600, respectively, of interest has been capitalized with respect to this project.
VIATEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996, 1995 AND 1994
(5) INTANGIBLE ASSETS
Intangible assets consist of the following as of December 31:
1996 1995 ---------- ---------- Acquired employee base and sales force in place ..................... $1,607,225 $1,607,225 Goodwill ............................. 474,065 474,065 Purchased software ................... 1,157,467 661,999 Other ................................ 374,539 133,834 ---------- ---------- 3,613,296 2,877,123 Less accumulated amortization ........ 1,639,386 807,068 ---------- ---------- $1,973,910 $2,070,055 ========== ==========
(6) LONG TERM LIABILITIES
(A) SENIOR DISCOUNT NOTES
On December 21, 1994, the Company issued $120,700,000, representing the aggregate principal amount, of 15% senior unsecured discount notes due January 15, 2005 for approximately $58,000,000. The notes will fully accrete on a semiannual compounding basis to face value on January 15, 2000 with semiannual interest payments commencing July 15, 2000 until maturity.
The notes are redeemable at the Company's option, in whole or in part, at any time on or after January 15, 2000 until maturity at redemption prices that range from 110% to 100% of the notes' face value plus accrued interest. In addition, at any time prior to January 15, 1998, the Company may redeem up to $42,245,000 of the face value of the notes with the proceeds of one or more public equity offerings at 115% of the then accreted value of the notes, plus accrued interest, if any, to the redemption date. Upon a change of control, the Company is required to make an offer to purchase the notes at a purchase price equal to 101% of their accreted value, plus accrued interest, if any. The notes contain certain covenants that, among other things, limit the ability of the Company and certain of its subsidiaries to incur indebtedness, make pre-payments of certain indebtedness and pay dividends.
On December 31, 1996, the Company estimated the fair value of these notes to be $77,800,000 which approximates its accreted value. The estimate is based on quoted market prices for the notes.
(B) NOTE PAYABLE -- MCI
On January 28, 1994, the Company converted $2,666,755 of its outstanding balance to MCI Telecommunications Corporation as of December 31, 1993 to a 7% note secured by the Company's accounts receivable. At December 31, 1994, $966,755 was outstanding under this note and was included in notes payable, current. At December 31, 1995, the note was no longer outstanding.
(7) STOCKHOLDERS' EQUITY
On April 5, 1994, the Company issued 2,140,538 shares of its Common Stock for $8,000,000 and warrants to purchase additional shares of Common Stock. As of December 31, 1995, the warrants have expired and are no longer exercisable. Additionally, certain rights of the Company to repurchase a portion of the shares have expired. Certain of such shares are subject to certain registration rights in the event of public offerings by the Company.
VIATEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996, 1995 AND 1994
(7) STOCKHOLDERS' EQUITY (CONTINUED)
On December 16, 1994, the Company authorized the creation of 10,000,000 shares of non-voting, $.01 par value, Class A Common Stock (the "Class A Common Stock"). On December 21, 1994, 2,904,846 shares of Class A Common Stock were issued for net proceeds of $16,016,221.
On October 23, 1996, the Company completed an initial public offering ("IPO") of its common stock, $.01 par value per share (the "Common Stock"), through which it sold 8,667,000 shares of Common Stock at $12 a share and raised approximately $104 million of gross proceeds ($94.5 million of net proceeds).
In connection with the IPO, all outstanding shares of Class A Common Stock were converted into shares of Common Stock at a ratio of one-to-one and all then outstanding shares of Common Stock were then subject to a reverse stock split at a ratio of 3-to-2. In addition, the Company's stockholders approved an amendment to the Company's Certificate of Incorporation which (i) authorized the Board of Directors to issue up to 1 million shares of Preferred Stock, $.01 par value per share, of which no shares were issued and outstanding at December 31, 1996, in one or more series and to fix the powers, voting rights, designations and preferences of each series and (ii) eliminated the Class A Common Stock.
All earnings per share and share data presented herein have been restated retroactively to reflect the conversion of the Class A Common Stock into Common Stock and the reverse stock split of all then outstanding shares of Common Stock.
(8) INCOME TAXES
The statutory Federal tax rates for the years ended December 31, 1996, 1995 and 1994 were 35%. The effective tax rates were zero for the years ended December 31, 1996, 1995 and 1994 due to the Company incurring net operating losses for which no tax benefit was recorded.
For Federal income tax purposes, the Company has unused net operating loss carryforwards of approximately $64,783,000 expiring in 2007 through 2011. The availability of the net operating loss carryforwards to offset income in future years is restricted as a result of the Company's issuance of its Common Stock and as a result of future sales of Company stock and other events.
The tax effect of temporary differences that give rise to significant portions of the deferred tax assets are as follows:
DECEMBER 31, -------------------------- 1996 1995 ------------ ------------ Accounts receivable principally due to allowance for doubtful accounts......... $ 352,000 $ 166,000 OID Interest not deductible in current period.... 6,914,000 2,933,000 Net operating loss carryforwards 22,674,000 13,231,000 ------------ ------------ Total gross deferred tax assets............ 29,940,000 16,330,000 Less valuation allowance (29,940,000) (16,330,000) ------------ ------------ Net deferred tax assets.................... $ -- $ -- ============ ============
In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income, and tax planning in making these assessments. During 1996 and 1995, the valuation allowance increased by $13,610,000 and $9,703,000, respectively.
VIATEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996, 1995 AND 1994
(9) SEGMENT DATA
The information below summarizes export sales by geographic area.
1996 1995 1994 ----------- ----------- ----------- Latin America .................. $14,401,901 $12,093,771 $12,914,289 Europe ......................... -- -- 7,720,166 Africa ......................... 78,833 1,207,225 1,832,547 Asia/Pacific Rim ............... 6,159,507 4,375,412 2,061,246 Middle East .................... 77,832 554,139 1,449,093 Other .......................... 267,446 369,425 290,400 ----------- ----------- ----------- $20,985,519 $18,599,972 $26,267,741 =========== =========== ===========
In late 1994, the European Network became operational and the Company began to establish direct sales organizations within Europe. For the year ended December 31, 1996, revenue, operating loss, capital expenditures and depreciation expense from this geographic segment were approximately $19,917,000, $14,753,000, $6,475,000 and $2,258,000, respectively. For the year ended December 31, 1995, revenue, operating loss, capital expenditures and depreciation expense from this geographic segment were approximately $11,601,000, $11,076,000, $9,959,000 and $243,000, respectively. Identifiable assets as of December 31, 1996 and 1995 for this geographic segment were approximately $15,103,000 and $10,216,000, respectively. For December 31, 1994 and for the year then ended, results from operations, capital expenditures, depreciation expense and identifiable assets for this geographic segment were not significant.
(10) STOCK OPTION PLAN
During 1993, the Board of Directors approved the 1993 Flexible Stock Incentive Plan (the "Stock Incentive Plan") under which "non-qualified" stock options ("NQSOs") to acquire shares of Common Stock may be granted to employees, directors and consultants of the Company and "incentive" stock options ("ISOs") to acquire shares of Common Stock may be granted to employees, including non-employee directors. The Stock Incentive Plan also provides for the grant of stock appreciation rights ("SARs") and shares of restricted stock to the Company's employees, directors and consultants.
The Stock Incentive Plan provides for the issuance of up to a maximum of 1,833,333 shares of Common Stock and is currently administered by the Compensation Committee of the Board of Directors. Under the Stock Incentive Plan, the option price of any ISO may not be less than the fair market value of a share of Common Stock on the date on which the option is granted. The option price of an NQSO may be less than the fair market value on the date the NQSO is granted if the Board of Directors so determines. An ISO may not be granted to a "ten percent stockholder" (as such term is defined in Section 422A of the Internal Revenue Code) unless the exercise price is at least 110% of the fair market value of the Common Stock and the term of the option may not exceed five years from the date of grant. Common Stock subject to a restricted stock purchase or bonus agreement is transferable only as provided in such agreement. The maximum term of each stock option granted to persons other than ten percent stockholders is ten years from the date of grant.
The per share weighted average fair value of stock options granted during 1996 and 1995 was $2.29 and $2.83, respectively, on the date of grant using the Black-Scholes option pricing model with the following assumptions: (1) a risk free interest rate of 5.5% in 1996 and 7.9% in 1995, (2) an expected life of 10 years for both 1996 and 1995, (3) volatility of approximately 35.9% for both 1996 and 1995 and (4) an annual dividend yield of 0% for both 1996 and 1995.
VIATEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996, 1995 AND 1994
(10) STOCK OPTION PLAN (CONTINUED)
The Company applies APB Opinion No. 25 in accounting for its Stock Incentive Plan and, accordingly, no compensation cost has been recognized for its stock options in the financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options under SFAS No. 123, the Company's net loss would have been increased to the pro forma amounts indicated below:
1996 1995 ----------- ----------- As reported net loss (in 000s) $ (38,375) $ (28,476)
Pro forma net loss (in 000s) (38,986) (28,642)
As reported net loss per share (2.47) (2.09)
Pro forma net loss per share (2.51) (2.10)
Pro forma net loss reflects only options granted during 1996 and 1995. Therefore, the full impact of calculating compensation cost for stock options under SFAS No. 123 is not reflected in the pro forma net loss amounts because compensation cost is reflected over the options' vesting period of three years and compensation cost for options granted prior to January 1, 1995 is not considered.
Stock option activity under the Stock Incentive Plan is shown below:
WEIGHTED AVERAGE EXERCISE NUMBER OF PRICES SHARES -------- ----------
Outstanding at January 1, 1994 ........... $0.75 80,662 Granted .................................. 3.74 316,992 Forfeited ................................ 3.74 (5,000) ----- --------- Outstanding at December 31, 1994 ......... 3.13 392,654 Granted .................................. 5.85 177,654 Forfeited ................................ 3.80 (96,171) ----- --------- Outstanding at December 31, 1995 ......... 4.01 474,137 Granted .................................. 5.85 822,265 Forfeited ................................ 5.77 (187,987) Exercised ................................ 2.70 (138,579) ----- --------- Outstanding at December 31, 1996 ......... 5.42 969,836 ===== ========= Exercisable at December 31, 1996 ......... $4.52 504,370 ===== =========
The range of exercise prices for stock options outstanding and exercisable at December 31, 1996 is $0.75 to $5.85.
Prior to the adoption of the Stock Incentive Plan, 5,913 options were granted. These options were exercised at $0.75 per share during the year ended December 31, 1996.
The exercise price of all options approximates the fair market value of the Common Stock on the date of grant.
VIATEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996, 1995 AND 1994
(10) STOCK OPTION PLAN (CONTINUED)
In addition, prior to the adoption of the Stock Incentive Plan, the Board of Directors authorized the issuance of up to 233,333 shares of Common Stock as compensation to employees and consultants of the Company of which 219,639 are available for issuance at December 31, 1996.
(11) EQUIPMENT IMPAIRMENT LOSS
On August 4, 1995, the Company entered into an agreement (the "Termination Agreement") with TMI USA (Delaware), Inc. ("TMI") which terminated its existing agreements. Pursuant to the terms of the Termination Agreement, the Company prepaid the existing capital lease obligation of $1,025,000, thereby acquiring all of the equipment previously leased from TMI. The capital lease obligation was payable over a three year term expiring on December 31, 1996. In addition, on August 4, 1995, the Company entered into a short-term facilities management agreement with TMI effective through August 31, 1996, pursuant to which TMI performed maintenance, equipment housing, site preparation, network extension and other similar services for the European Network under its present configuration. Thereafter, the Company managed the European Network using its own personnel rather than a third party provider.
As a result of the Termination Agreement, the Company has written off the costs relating to the original installation of such equipment. Accordingly, the Company has recognized non-cash charges of approximately $560,000 which represent the original installation costs of such equipment and the difference between the carrying value and the expected selling price of the equipment not redeployed.
(12) COMMITMENTS AND CONTINGENCIES
(A) LEASES
At December 31, 1996, the Company was committed under non-cancelable operating and capital leases for the rental of office space and for fiber optic cable systems.
The Company's future minimum capital and operating lease payments are as follows:
CAPITAL OPERATING -------- ----------
1997................................... $117,638 $1,199,192 1998 .................................. 111,934 1,102,739 1999 .................................. 51,991 959,363 2000 .................................. -- 883,796 2001 .................................. -- 485,603 Thereafter ............................ -- 1,741,324 -------- ---------- 281,563 $6,372,017 Less interest costs ................... 35,516 ========== -------- $246,047 ========
Total rent expense amounted to $1,530,889, $948,826 and $935,267 for the years ended December 31, 1996, 1995 and 1994, respectively.
VIATEL, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996, 1995 AND 1994
(12) COMMITMENTS AND CONTINGENCIES (CONTINUED)
(B) CARRIER CONTRACTS
The Company has entered into contracts to purchase transmission capacity from various domestic and foreign carriers. By committing to purchase minimum volumes of transmission capacity from carriers, the Company is able to obtain guaranteed rates which are more favorable than those generally offered in the marketplace. The minimum volume commitments are $12,552,000 for the year ending December 31, 1997.
(C) PURCHASE COMMITMENTS
The Company is continually upgrading and expanding the European Network and the Omaha, Nebraska switching facility. In connection therewith, the Company has entered into purchase commitments to expend approximately $7,415,000.
(D) EMPLOYMENT CONTRACTS
The Company has employment contracts with certain officers at amounts generally equal to such officers' current levels of compensation. The Company's remaining commitments at December 31, 1996 for the next three years under such contracts aggregates approximately $1,558,000.
(E) LITIGATION
As a result of the Company's transition to direct sales organizations in Europe, the Company's independent sales representative in Spain has asserted breach of contract and certain other claims. An arbitration proceeding before the American Arbitration Association in New York is pending. The representative in Spain is seeking $5.8 million in damages. The Company believes that it has meritorious defenses against each of the claims alleged and is vigorously pursuing all defenses available to it. The Company believes that any potential adverse determination will not have a material adverse effect on the Company's business, financial condition or results of operations.
(13) REGULATORY MATTERS
The Company is subject to regulation in countries in which it does business. The Company believes that an adverse determination as to the permissibility of the Company's services under the laws and regulations of any such country would not have a material adverse long-term effect on its business.
VIATEL, INC. AND SUBSIDIARIES SCHEDULE VII - VALUATION AND QUALIFYING ACCOUNTS
ITEM 9.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10.

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
Information with respect to executive officers of the Company is presented in Item 4 of this Report under the caption "Executive Officers of the Company."
The information appearing under the captions "Proposal 1 - Election of Directors," "Certain Transactions" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement for its 1997 Annual Meeting of Stockholders (the "1997 Proxy Statement") is incorporated herein by reference.
ITEM 11.

ITEM 11. EXECUTIVE COMPENSATION.
Information appearing under the caption "Executive Compensation" in the 1997 Proxy Statement is incorporated herein by reference.
ITEM 12.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
Information appearing under the caption "Security Ownership of Beneficial Owners and Management" in the 1997 Proxy Statement is incorporated herein by reference.
ITEM 13.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
Information appearing under the caption "Certain Transactions" in the 1997 Proxy Statement is incorporated herein by reference.
PART IV
ITEM 14

ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(A) 1. FINANCIAL STATEMENTS.
The financial statements are included in Part II, Item 8 of this Report.
2. FINANCIAL STATEMENT SCHEDULES AND SUPPLEMENTARY INFORMATION REQUIRED TO BE SUBMITTED.
Any required financial statement schedules are included in Part II, Item 8 of this Report.
(B) Report on Form 8-K.
The Company did not file any Current Reports on Form 8-K during the fourth quarter of 1996.
(C) Index to Exhibits.
The following is a list of all Exhibits filed as part of this Report:
EXHIBIT NO. DESCRIPTION OF DOCUMENTS - -------------- ------------------------
3.1(i)(a) - Amended and Restated Certificate of Incorporation of the Company (incorporated herein by reference to Exhibit 3.1(i)(a) to the Company's Registration Statement on Form S-1, filed on August 7, 1996, Registration No. 333-09699 (the "Company's S-1")).*
3.1(ii) - Amended and Restated Bylaws of the Company (incorporated herein by reference to Exhibit 3.1(ii)(b) of the Company's S-1).*
4.1 - Indenture, dated as of December 15, 1994, between the Company and United States Trust Company of New York, as Trustee (incorporated herein by reference to Exhibit 4.2 to the Company's Registration Statement on Form S-4, filed on May 24, 1995, Registration No. 33-92696 (the "Company's S-4").*
4.2 - Notes Registration Rights Agreement, dated as of December 15, 1994, between the Company and Morgan Stanley & Co. Incorporated in connection with the Company's 15% Senior Discount Notes due 2005 (incorporated herein by reference to Exhibit 4.3 to the Company's S-4).*
4.3 - Company Common Stock Certificate (incorporated herein by reference to Exhibit 4.4 to the Company's S-1).*
4.4 - Amendment No. 1 to the Indenture, dated as of December 15, 1994, between the Company and United States Trust Company of New York, as Trustee (incorporated herein by reference to Exhibit 4.5 to the Company's S-1).*
10.1 - Placement Agreement, dated as of December 15, 1994, between the Company and Morgan Stanley & Co. Incorporated (incorporated herein by reference to Exhibit 10.3 to the Company's S-4).*
10.2 - Common Stock Registration Rights Agreement, dated as of December 15, 1994, among the Company, Martin Varsavsky, Juan Manuel Aisemberg and Morgan Stanley & Co. Incorporated in connection with the Company's shares of non-voting Class A Common Stock (incorporated herein by reference to Exhibit 10.4 to the Company's S-4).*
10.3 - The Company's Amended Flexible Stock Incentive Plan (incorporated herein by reference to Exhibit 10.33 to the Company's S-1).*+
10.4 - Carrier Contract, dated as of May 3, 1993, between the Company and AT&T Corp. (incorporated herein by reference to Exhibit 10.6 to the Company's S-4).*
10.5 - MCI Carrier Agreement, dated as of January 1, 1995, between the Company and MCI Telecommunications Corporation (incorporated herein by reference to Exhibit 10.7 to the Company's S-4).*
10.6 - Mercury Carrier Services Agreement, dated as of March 1, 1994, between the Company and Mercury Communications Limited (incorporated herein by reference to Exhibit 10.8 to the Company's S-4).*
10.7 - Provision and Management Facilities Agreement, dated as of October 17, 1994, between the Company and Mercury Communications Limited (incorporated herein by reference to Exhibit 10.9 to the Company's S-4).*
10.8 - Managed Telecommunications Network Agreement, dated as of February 5, 1993, between the Company and TMI USA, Inc. (Delaware) (incorporated herein by reference to Exhibit 10.10 to the Company's S-4).*
10.9 - Representative Agreement, dated as of June 1, 1993, and as amended as of April 19, 1995, between the Company and Maximiliano Fernandez (incorporated herein by reference to Exhibit 10.11 to the Company's S-4).*
10.10 - Representative Agreement, dated as of April 23, 1993, between the Company and Viatel de Colombia Comunicaciones S.A. (incorporated herein by reference to Exhibit 10.12 to the Company's S-4).*
10.11 - Stock Purchase Agreement, dated as of September 30, 1993, as amended as of April 5, 1994, and as further amended as of December 21, 1994, between the Company and S-C V-Tel Investments, L.P. (incorporated herein by reference to Exhibit 10.13 to the Company's S-4).*
10.12 - Stock Purchase Agreement, dated as of April 5, 1994, between the Company and COMSAT Investments, Inc. (incorporated herein by reference to Exhibit 10.14 to the Company's S-4).*
10.13 - Stock Purchase Agreement, dated as of December 3, 1993, between the Company and Herald L. Ritch (incorporated herein by reference to Exhibit 10.15 to the Company's S-1).
10.14 - Stock Purchase Agreement, dated as of October 1, 1993, between the Company and Robert Conrads (incorporated herein by reference to Exhibit 10.16 to the Company's S-4).*
10.15 - Stock Purchase Agreement, dated as of December 9, 1993, between the Company and Robert Conrads (incorporated herein by reference to Exhibit 10.17 to the Company's S-4).*
10.16 - Shareholders' Agreement, dated as of April 5, 1994, and as amended as of November 22, 1994, by and among the Company, Martin Varsavsky, Juan Manuel Aisemberg and COMSAT Investments, Inc. (incorporated herein by reference to Exhibit 10.19 to the Company's S-4).*
10.17 - Shareholders' Agreement, dated as of September 30, 1993, as amended as of December 9, 1993 and as further amended as of April 5, 1994, November 22, 1994 and December 21, 1994, by and among the Company, Martin Varsavsky and S-C V-Tel Investments, L.P. (incorporated herein by reference to Exhibit 10.21 to the Company's S-4).*
10.18 - Purchase Agreement, dated as of December 8, 1994, between the Company and ECI Telecom, Inc. (incorporated herein by reference to Exhibit 10.22 to the Company's S-4).*
10.19 - Carrier Digital Services Agreement, dated as of November 29, 1994, between the Company and Norline Communications, Inc. (incorporated herein by reference to Exhibit 10.23 to the Company's Form S-4).*
10.20 - Commercial Lease Agreement, dated as of November 1, 1993, and Addendum, dated as of December 8, 1994, between the Company and 123rd Street Partnership in connection with the Company's premises located in Omaha, Nebraska (incorporated herein by reference to Exhibit 10.24 to the Company's Form S-4).*
10.21 - Asset Purchase Agreement, dated as of August 27, 1993, between the Company and Sitel Corporation (incorporated herein by reference to Exhibit 10.26 to the Company's S-4).*
10.22 - Memorandum of Understanding, dated as of August 4, 1994, between the Company and TMI USA, Inc. (incorporated herein by reference to Exhibit 10.27 to the Company's S-4).*
10.23 - Settlement Agreement, dated as of August 4, 1994, between the Company and TMI USA, Inc. (incorporated herein by reference to Exhibit 10.28 to the Company's S-4).*
10.24 - Release and Settlement Agreement, dated as of August 1, 1994, between the Company and AT&T Corp. (incorporated herein by reference to Exhibit 10.29 to the Company's S-4).*
10.25 - Termination Agreement, dated August 4, 1995, between the Company and Telemedia International, Inc. (incorporated herein by reference to Exhibit 10.31 to the Company's S-4).*
10.26 - Facilities Management and Services Agreement, dated as of August 4, 1995, between Viatel U.K. Limited and Telemedia International Ltd. (incorporated herein by reference to Exhibit 10.32 to the Company's S-4).*
10.27 - Agreement of Lease, dated August 7, 1995, between the Company and Joseph P. Day Realty Corp. (incorporated herein by reference to Exhibit 10.33 to the Company's S-4).*
10.28 - Severance Agreement, dated July 30, 1996, between the Company and Alan Levy (incorporated herein by reference to Exhibit 10.30 to the Company's S-1).*+
10.29 - Employment Agreement between the Company and Martin Varsavsky (incorporated herein by reference to Exhibit 10.31 to the Company's S-1).*+
10.30 - Employment Agreement between the Company and Michael J. Mahoney (incorporated herein by reference to Exhibit 10.32 to the Company's S-1).*
10.31 - Amended Flexible Stock Incentive Plan (incorporated herein by reference to Exhibit 10.33 to the Company's S-1).*+
21.1 - Subsidiaries of the Company.
23.1 - Consent of KPMG Peat Marwick LLP.
23.2 - Consent of Edward Isaacs & Company LLP.
24.1 - Power of Attorney (Appears on signature page).
27.1 - Financial Data Schedule.
- ----------
* Incorporated herein by reference.
+ Management contract or compensatory plan or arrangement.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized, in the City and State of New York, on the 28th day of March, 1997.
VIATEL, INC.
By: /S/ MARTIN VARSAVSKY ----------------------------------- Martin Varsavsky Chairman of the Board and Chief Executive Officer
KNOWN BY ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Allan S. Shaw and Sheldon M. Goldman his true and lawful attorney-in-fact and agent, with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities, to sign any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorney-in-fact and agent, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent or their or his substitutes or substitute, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities indicated on the 28th day of March, 1997.
SIGNATURE TITLE(S) --------- --------
/s/ MARTIN VARSAVSKY - ----------------------------------- Chairman of the Board and Martin Varsavsky Chief Executive Officer (Principal Executive Officer)
/s/ MICHAEL J. MAHONEY - ----------------------------------- President, Chief Operating Officer Michael J. Mahoney and Director (Principal Executive Officer)
/s/ ALLAN S. SHAW - ----------------------------------- Vice President, Finance; Allan S. Shaw Chief Financial Officer; Treasurer (Principal Financial and Accounting Officer) and Director
/S/ PAUL G. PIZZANI - ----------------------------------- Director Paul G. Pizzani
/S/ W. JAMES PEET - ----------------------------------- Director W. James Peet
/S/ ANTONIO CARRO - ----------------------------------- Director Antonio Carro