UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2005

OR

|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from _________ to _________

Commission file number 000 -32421

Fusion Telecommunications International, Inc.
—————————————————————  
(Exact name of registrant as specified in its charter)
 
 
Delaware
58-2342021
—————————————
————————
(State or other jurisdiction of
incorporation or organization)
(I.R.S. Employer
Identification No.)
 
 
420 Lexington Avenue, Suite 518, New York New York
10170
————————————————————
—————
(Address of principal executive offices)
(Zip Code)
 
 
(212) 972-2000
——————————————————————
Registrant’s telephone number, including area code


Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes |X|       No |_|

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes |_|       No |X|

The number of shares outstanding of the Registrant's capital stock as of August 12, 2005 is as follows:


Title of each Class
Number of Shares Outstanding
 
Class A Common Stock, $0.01 par value
15,749,391
 
Common Stock, $0.01 par value
11,104,962
 
Redeemable Common Stock Purchase Warrants
7,281,838
 



 

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

INDEX


Part I. Financial Information
Page
 
 
   
      Item l. Financial Statements
3
 
 
   
       Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
17
 
 
   
       Item 3. Quantitative and Qualitative Disclosures About Market Risk
26
 
 
   
       Item 4. Controls and Procedures
26
 
 
   
Part II. Other Information
27
 
 
   
       Item 1. Legal Proceedings
27
 
 
   
       Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
27
 
 
   
       Item 3. Defaults Upon Senior Securities
28
 
 
   
       Item 4. Submission of Matters to a Vote of Security Holders
28
 
 
   
       Item 5. Other Information
28
 
 
   
       Item 6. Exhibits
28
 


2



 
Item 1. FINANCIAL STATEMENTS
PART 1 - FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS

FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Consolidated Balance Sheets
 
 
   
June 30,   
   
December 31,
 
     
2005
   
2004
 
 
   
(unaudited)   
       
ASSETS              
Current assets  
             
Cash and cash equivalents
 
$
17,963,928
 
$
4,368,726
 
Accounts receivable, net of allowance for doubtful accounts of approximately $411,000 and  $414,000, in 2005 and 2004, respectively
 
5,344,964
   
3,145,535
 
Restricted cash
   
75,000
   
145,000
 
Prepaid expenses and other current assets
   
414,930
   
889,761
 
Total current assets
   
23,798,822
   
8,549,022
 
Property and equipment, net
   
3,626,643
   
3,271,474
 
Other assets
             
Security deposits
   
726,517
   
902,028
 
Restricted cash
   
218,176
   
235,276
 
Goodwill
   
761,143
   
 
Intangible assets, net
   
4,873,130
   
 
Other
   
651,503
   
704,317
 
Total other assets
   
7,230,469
   
1,841,621
 
   
$
34,655,934
 
$
13,662,117
 
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
             
Current liabilities
             
Long-term debt, related parties, current portion
 
$
 
$
1,739,025
 
Long-term debt, current portion
   
150,000
   
2,660,281
 
Capital lease obligations, current portion
   
1,092,490
   
1,131,830
 
Accounts payable and accrued expenses
   
8,686,741
   
10,274,688
 
Investment in Estel
   
525,883
   
140,821
 
Liabilities of discontinued operations
   
786,303
   
1,116,090
 
Total current liabilities
   
11,241,417
   
17,062,735
 
Long-term liabilities
             
Capital lease obligations, net of current portion
   
40,837
   
156,495
 
Preferred stock, Series C, subject to mandatory redemption (liquidation preference in the aggregate of approximately $10,932,000 in 2004)
 
   
9,716,026
 
Total long-term liabilities
   
40,837
   
9,872,521
 
Minority interests
   
194,963
   
16,890
 
Commitments and contingencies
             
Stockholders’ equity (deficit)
             
Common stock, $.01 par value, 105,000,000 shares authorized, 11,104,962 and 0 shares issued, and 10,429,381 and 0 shares outstanding in 2005 and 2004, respectively
   
104,294
   
 
Common stock, Class A $.01 par value, 21,000,000 shares authorized, 15,749,391 and 17,479,993 shares issued and outstanding in 2005 and 2004, respectively
   
157,494
   
174,800
 
Capital in excess of par value
   
105,875,521
   
65,127,291
 
Accumulated deficit
   
(82,958,592
)
 
(78,592,120
)
Total stockholders’ equity (deficit)
   
23,178,717
   
(13,290,029
)
   
$
34,655,934
 
$
13,662,117
 

See accompanying condensed notes to consolidated financial statements.
 
 
3

 
 
 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Consolidated Statements of Operations
 
       
Three months ended June 30,  
     
Six months ended June 30, 
 
       
2005 
 
 
2004 
     
2005 
   
2004 
 
       
(unaudited) 
   
(unaudited)  
     
(unaudited)  
   
(unaudited)  
 
                               
Revenues
   
$
19,259,891
 
$
16,117,765
   
$
31,188,943
 
$
26,305,429
 
Operating expenses:
                             
Cost of revenues, exclusive of depreciation and amortization shown separately below
 
17,703,991
   
14,001,283
     
28,701,414
   
22,710,304
 
Depreciation and amortization
     
436,387
   
441,828
     
869,411
   
879,396
 
Selling, general and administrative expenses
     
3,029,680
   
2,313,675
     
5,735,087
   
4,456,091
 
Total operating expenses
     
21,170,058
   
16,756,786
     
35,305,912
   
28,045,791
 
                                           
Operating loss
     
(1,910,167
)
 
(639,021
)
   
(4,116,969
)
 
(1,740,362
)
                               
Other income (expense)
                             
Interest income (expense), net
     
91,380
   
(538,388
)
   
(184,423
)
 
(823,519
)
Forgiveness of debt
     
5,340
   
157,183
     
5,340
   
1,976,595
 
Loss from investment in Estel
     
(142,545
)
 
(164,030
)
   
(299,460
)
 
(318,910
)
Other
     
5,956
   
8,500
     
5,956
   
17,750
 
Minority interests
     
49,155
   
53,264
     
48,084
   
31,381
 
Total other income (expense)
     
9,286
   
(483,471
)
   
(424,503
)
 
883,297
 
                               
Loss from continuing operations
     
(1,900,881
)
 
(1,122,492
)
   
(4,541,472
)
 
(857,065
)
Discontinued operations:
                             
Income from discontinued operations
     
-
   
-
     
175,000
   
-
 
Net loss
   
$
(1,900,881
)
$
(1,122,492
)
 
$
(4,366,472
)
$
(857,065
)
Losses applicable to common stockholders:
                             
Loss from continuing operations
   
$
(1,900,881
)
$
(1,122,492
)
 
$
(4,541,472
)
$
(857,065
)
Preferred stock dividends
     
-
   
(365,961
)
   
-
   
(385,918
)
Net loss applicable to common stockholders from continuing operations
 
(1,900,881
)
 
(1,488,453
)
   
(4,541,472
)
 
(1,242,983
)
Income from discontinued operations
     
-
   
-
     
175,000
   
-
 
Net loss applicable to common stockholders
   
$
(1,900,881
)
$
(1,488,453
)
 
$
(4,366,472
)
$
(1,242,983
)
Basic and diluted net loss per common share:
                             
Loss from continuing operations
   
$
(0.07
)
$
(0.09
)
 
$
(0.19
)
$
(0.08
)
Income from discontinued operations
     
-
   
-
     
0.01
   
-
 
Net loss applicable to common stockholders
   
$
(0.07
)
$
(0.09
)
 
$
(0.18
)
$
(0.08
)
Weighted average shares outstanding
                             
Basic and diluted
     
26,146,204
   
16,542,010
     
23,730,789
   
15,967,983
 

See accompanying condensed notes to consolidated financial statements.
4

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Consolidated Statements of Cash Flows
 
     
Six months ended June 30,    
 
     
2005 
       
2004 
 
     
(unaudited)   
       
(unaudited)   
 
Cash flows from operating activities  
                 
Net loss
 
$
(4,366,472
)
   
$
(857,065
)
Adjustments to reconcile net loss to net cash used in operating activities:
                 
Gain from sale of assets
   
-
       
(17,750
)
Depreciation and amortization
   
869,411
       
879,396
 
Bad debt expense
   
177,000
       
124,439
 
Gain on forgiveness of debt
   
(5,340
)
     
(1,976,595
)
Gain on discontinued operations
   
(175,000
)
     
-
 
Accretion of Series C Preferred Stock
   
287,115
       
687,389
 
Loss from investment in Estel
   
299,460
       
318,910
 
Minority interests
   
(48,084
)
     
(31,381
)
Increase (decrease) in cash attributable to changes in operating assets and liabilities:
                 
Accounts receivable
   
(2,180,712
)
     
(2,565,160
)
Prepaid expenses and other current assets
   
655,197
       
(155,201
)
Other assets
   
(285,376
)
     
11,514
 
Accounts payable and accrued expenses
   
(1,295,101
)
     
(392,578
)
Liabilities of discontinued operations
   
(154,787
)
     
(25,067
)
Net cash used in operating activities
   
(6,222,689
)
     
(3,999,149
)
Cash flows from investing activities:
                 
Purchase of property and equipment
   
(1,064,825
)
     
(739,479
)
Advances to Estel
   
(127,784
)
     
(123,833
)
Payments from Estel
   
82,378
       
-
 
Purchase of Jamaican joint venture, net of cash acquired
   
(146,486
)
     
-
 
Purchase of minority interest in Efonica joint venture, net of cash acquired 
   
(480,555
)
     
-
 
Purchase of Turkey joint venture, net of cash acquired
   
(76,528
)
     
-
 
Return of security deposits
   
175,511
       
89,497
 
Repayments of (payments for) restricted cash
   
87,100
       
(120,000
)
Net cash used in investing activities
   
(1,551,189
)
     
(893,815
)
Cash flows from financing activities
                 
Proceeds from sale of common stock and warrants, net
   
23,888,097
       
1,277,070
 
Proceeds from sale of Series C preferred stock, net
   
-
       
4,628,962
 
Proceeds from exercise of stock options
   
50,250
       
-
 
Proceeds from exercise of warrants
   
85,144
       
-
 
Repayments of escrow advances
   
-
       
(73,330
)
Proceeds from long-term debt
   
-
       
600,000
 
Payment of dividends on Series C preferred stock
   
(664,634
)
     
-
 
Payments of long-term debt and capital lease obligations
   
(1,971,816
)
     
(788,071
)
Contributions from (to) minority stockholders of joint ventures
   
(17,961
)
     
59,578
 
Net cash provided by financing activities
   
21,369,080
       
5,704,209
 
Net increase in cash and cash equivalents
   
13,595,202
       
811,245
 
Cash and cash equivalents, beginning of period
   
4,368,726
       
3,205,645
 
Cash and cash equivalents, end of period
 
$
17,963,928
     
$
4,016,890
 

See accompanying condensed notes to consolidated financial statements.


5


FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Consolidated Statements of Cash Flows (continued)
 
       
Six months ended June 30,  
 
       
2005 
   
2004 
 
       
(unaudited)  
   
(unaudited)  
 
Supplemental disclosure of cash flow information:                
 
Cash paid during the period for interest
 
$
602,717
 
$
114,582
 
Supplemental disclosure of noncash investing and financing activities:              
 
Acquisition of capital leases
 
$
75,354
 
$
 
 
Conversion of accounts payable to common stock
 
$
 
$
2,070
 
 
Note issued in settlement agreement
 
$
 
$
150,000
 
 
Credits received from sale of property and equipment
 
$
 
$
9,250
 
 
Conversion of convertible notes payable and related debt offering costs
 
$
2,444,395
 
$
 
 
Conversion of Series C preferred stock to common stock
 
$
10,003,141
 
$
 
 
Conversion of prepaid offering costs to additional paid in capital
 
$
614,008
 
$
 
 
Conversion of long-term debt to Series C preferred stock
 
$
 
$
585,360
 
 
Issuance of restricted stock for consulting services
 
$
50,000
 
$
 
 
Conversion of escrow advances to Series C preferred stock
 
$
 
$
176,620
 
 
Stock dividends issued
 
$
 
$
573,195
 
 
Stock dividends declared
 
$
 
$
385,918
 
Supplemental disclosure of joint venture acquisition activities:              
 
Fair value of tangible assets, net of cash acquired
 
$
614,284
 
$
 
 
Fair value of indentifiable intangible assets 
   
4,877,900
   
 
 
Goodwill acquired 
   
761,143
   
 
 
Liabilities acquired
   
(377,440
)
 
 
 
Minority interest acquired
   
(244,118
)
 
 
 
Common stock issued excluding shares in escrow
   
(4,928,200
)
 
 
 
Cash paid for acquisition of joint ventures, net of cash acquired 
 
$
703,569
 
$
 

See accompanying condensed notes to consolidated financial statements.


6


FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Condensed Notes to Consolidated Financial Statements

1. Basis of Presentation

The accompanying consolidated financial statements should be read in conjunction with the 2004 Form 10-K for Fusion Telecommunications International, Inc. (the “Company”). These financial statements have been prepared in accordance with instructions to Form 10-Q and Article 10 of Regulation S-X and therefore, omit or condense certain footnotes and other information normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States. In the opinion of the Company’s management, all adjustments (consisting of normal recurring accruals) considered necessary for fair financial statement presentation have been made. The results of operations for an interim period may not give true indication of the results for the year.

Goodwill and Other Intangible Assets

Goodwill represents the excess of the purchase price of an acquired business over the amounts assigned to assets acquired and liabilities assumed. In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwill and Other Intangible Assets,” goodwill is not being amortized but is reviewed for impairment on an annual basis. Other intangible assets consist primarily of the trade name and trademarks associated with the Company’s wholly-owned subsidiary, Efonica FZ, LLC (“Efonica”). These long-lived assets are not amortized because they have indefinite lives. The remaining intangible asset acquired in the Efonica transaction is a customer list, which is being amortized using the straight-line method over the 10 year estimated useful life.

Earnings Per Share

SFAS No. 128, “Earnings Per Share,” requires dual presentation of basic and diluted income per share for all periods presented. Basic income per share excludes dilution and is computed by dividing loss available to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted loss per share reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the loss of the Company.

Basic and diluted loss per share and weighted average shares are the same for the three and six months ended June 30, 2005 and 2004, as all securities are anti-dilutive.

Unexercised stock options to purchase 1,581,290 and 631,486 shares of the Company’s common stock as of June 30, 2005 and 2004, respectively, were not included in the computation of diluted earnings per share because the exercise of the stock options would be anti-dilutive to earnings per share.

Unexercised warrants to purchase 7,539,845 and 286,578 shares of the Company’s common stock as of June 30, 2005 and 2004, respectively, were not included in the computation of diluted earnings per share because the exercise of the warrants would be anti-dilutive to earnings per share.

Non-converted debt to purchase 10,714 shares of the Company’s common stock as of June 30, 2004, was not included in the computation of diluted earnings per share because the conversion of the debt would be anti-dilutive to earnings per share. Had the debt been converted, interest expense would have been reduced by approximately $10,000 during the six months ended June 30, 2004. As of June 30, 2005, the Company did not have any outstanding convertible debt.

Stock-Based Compensation

The Company follows SFAS No. 123, “Accounting for Stock-Based Compensation”. The provisions of SFAS No. 123 allow companies to either expense the estimated fair value of stock options or to continue to follow the intrinsic value method set forth in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) but disclose the pro forma effect on net income (loss) had the fair value of the options been expensed. The Company has elected to continue to apply APB 25 in accounting for its stock option incentive plans.

 
7

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Condensed Notes to Consolidated Financial Statements

If compensation expense for the Company’s stock option incentive plan had been determined based on the fair value at the grant dates as calculated in accordance with SFAS No. 123, the Company’s net loss attributable to common stockholders and net loss per common share would approximate the pro forma amounts below:

     
For the Three Months Ended June 30,  
   
For the Six Months Ended June 30, 
 
     
2005
   
2004
   
2005
   
2004
 
Net loss applicable to common stockholders, as reported
 
$
(1,900,881
)
$
(1,488,453
)
$
(4,366,472
)
$
(1,242,983
)
Deduct: total stock-based compensation expense under fair value method for awards, net of related tax effect
   
(152,218
)
 
(204,367
)
 
(284,064
)
 
(369,165
)
Net loss applicable to common stockholders, pro forma
 
$
(2,053,099
)
$
(1,692,820
)
$
(4,650,536
)
$
(1,612,148
)
Loss per share:
                         
Basic and diluted loss applicable to common stockholders, as reported
 
$
(0.07
)
$
(0.09
)
$
(0.18
)
$
(0.08
)
Basic and diluted loss applicable to common stockholders, pro forma
 
$
(0.08
)
$
(0.10
)
$
(0.20
)
$
(0.10
)

When the Company adopts SFAS 123(R), currently scheduled for the beginning of 2006, the Company will include the expense associated with share-based payments issued to employees in its Consolidated Statements of Operations. The Company has not yet completed its assessment of which valuation model or transition option to select. See further discussion of SFAS 123 (R) in Note 9.

2. Acquisitions

Jamaica

On December 16, 2004, the Company entered into an agreement to acquire 51% of the common stock of a Jamaican company for $150,000. This acquisition was completed to establish the Company as a licensed carrier operation in Jamaica providing the Company an entrance into this emerging market. The Jamaican joint venture did not have any results of operations until the second quarter of 2005. The closing of this acquisition took place on January 11, 2005. The following table summarizes the estimated fair values of the assets acquired and the minority interest on January 11, 2005:

 
$
3,514
 
   Prepaid expenses and other current assets
   
17,385
 
   Property and equipment, net
   
25,800
 
   Other assets
   
100,000
 
   Goodwill
   
147,419
 
   Minority interest
   
(144,118
)
   Total cash paid
 
$
150,000
 



 
8

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Condensed Notes to Consolidated Financial Statements

The initial purchase price allocations may be adjusted within one year of the purchase date for changes in estimates of the fair value of the assets acquired. The excess of the purchase price over the fair values of the assets acquired was allocated to goodwill.

Efonica

During February 2005, the Company closed on its agreement to acquire the 49.8% minority interest in one of its joint ventures, Efonica from Karamco, Inc. This acquisition was completed to better enable Efonica to serve as the retail VoIP services division of Fusion, offering a full suite of VoIP solutions to customers in Asia, the Middle East, Africa, Latin America and the Caribbean. With 100% control, the Company can better leverage the significant experience and relationships of Efonica. The operating results for the 49.8% minority interest acquired are included in the consolidated statement of operations from the date of acquisition. The proforma effect of this acquisition on the statements of operations for the six months ended June 30, 2005, is not material. The proforma effect for the six months ended June 30, 2004, results in a reduction to minority interest of $56,845 and consequently, an increase in net loss of $56,845. The purchase price will be a minimum of $5,500,000 and a maximum of $14,300,000, as adjusted for the approximate $196,000 representing Karamco’s portion of Efonica’s debt owed to the Company as of the closing date and the $500,000 which was paid in cash during February 2005, based upon a multiple of earnings achieved by Efonica during the 12-month period ending February 28, 2006 (4.5 x Efonica’s net income as adjusted for certain intracompany and other expenses). Karamco received cash of $500,000, with the balance paid in shares of common stock. The number of shares issued to Karamco was determined by the $6.45 per share initial price of the common stock at the date of the Company’s IPO. On the date of the transaction, approximately $4,400,000 worth of such shares of common stock (675,581 shares) were issued to Karamco and are being held in escrow until the final valuation of the joint venture is determined after the year ending February 28, 2006. In the event that the purchase price would be lower (based upon Efonica’s net income for that one year period) than $10,000,000, the excess of the common shares in escrow will be returned to the Company for cancellation. In the event that the purchase price would be higher than the $10,000,000 (based upon Efonica’s net income), the Company will issue Karamco additional shares of our common stock (based on the IPO price of $6.45 per share), subject to the $14,300,000 maximum.

Out of the shares issued to Karamco in June 2005, the Company registered for resale 150,000 shares of common stock. The Company was obligated to repurchase the shares from Karamco at the higher of the IPO price or the average five (5) day bid price prior to the sixtieth day after February 11, 2005 (“IPO Prospectus Date”). Karamco may not sell more than $967,500 of stock during the one-year period following the IPO Prospectus Date. If the sale of the 150,000 shares that are to be registered results in less than $967,500 of gross proceeds the Company must pay Karamco the difference between the aggregate gross proceeds of Karamco’s sale of the registered shares and $967,500 (the “Difference Payment”). The Company has paid Karamco $325,000 towards the Difference Payment, which is included in other assets in the June 30, 2005, Consolidated Balance Sheet. In the event the Difference Payment owed is less than $325,000, Karamco shall immediately reimburse the Company for such excess. Karamco’s obligation to reimburse the Company for any excess is secured by an escrow of 50,387 shares of the Company’s common stock owned by Karamco. Karamco is owned by Roger Karam, who became the CEO of Efonica and the Company’s President of VoIP Services upon the effective date.

The following table summarizes the estimated fair values of the assets acquired and liabilities assumed, including $20,316 of related acquisition costs:
 
Cash
 
 
39,581
   
   Accounts receivable
   
64,709
   
   Prepaid expenses and other current assets
   
175,040
   
   Property and equipment, net
   
50,651
   
   Intangible assets
   
4,877,900
   
   Goodwill
   
613,724
   
   Accounts payable, accrued expenses and other
   
(373,269
)
 
   Common stock issued
   
(4,928,200
)
 
   Total cash paid
 
$
520,136
   

The initial purchase price allocations were based upon an independent appraisal. The intangible assets acquired were allocated $4,579,100 to the Efonica trade name and trademarks and $298,800 was allocated to the customer list. In determining the purchase price allocation, the trademark was determined based upon the income approach through the application of the relief from royalties method and the customer list was determined based upon the income approach through the application of the excess earnings method. The rate used to discount the net cash flows to present values was based upon a weighted average cost of capital of approximately 28%. The excess of the purchase price over the fair values of the assets acquired and liabilities assumed was allocated to goodwill.


9



FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Condensed Notes to Consolidated Financial Statements

Turkey

On March 8, 2005, a new wholly owned subsidiary of the Company, Fusion Turkey, LLC entered into a Stock Purchase Agreement to acquire 75% of the shares of LDTS Uzak Mesafe Telekomikasyon ve Iletism Hizmetleri San. Tic. A.S. (“LDTS”), from the existing shareholders. LDTS possesses a telecommunications license approved by the Turkish Telecom Authority. This license will permit the Company to offer VoIP services under its Efonica brand and other Internet services to corporations and consumers in Turkey.

The closing of the acquisition took place on May 6, 2005. The following table summarized the estimated fair value of the assets and liabilities acquired and the minority interest on May 6, 2005:

Cash
 
$
997
 
Prepaid expense and other current assets
   
1,880
 
Other assets
   
178,919
 
Accounts payable and accrued liabilities
   
(4,171
)
Minority interest
   
(100,000
)
   
$
77,625
 
 
The primary net asset acquired was the license (included in other assets), which was issued on March 17, 2004, and is valid for 15 years. Consequently, the license is being amortized over the remaining term. As the transaction closed on May 6, 2005, the Consolidated Statements of Operations for the three and six months ended June 30, 2005, include activity related to this subsidiary. The proforma effect of this acquisition is not materially different than its presentation in the Consolidated Statements of Operations.

3. Discontinued operations

During 2001, management of the Company decided to cease the operations of its domestic retail telecommunication services business lines. In connection with this decision, a liability at December 31, 2004, of approximately $984,000 remained which related to trade payables and accrued expenses. During the six months ended June 30, 2005, the Company determined that one of the accrued liabilities would be settled for $175,000 less than the amount that was accrued at December 31, 2004, which resulted in a gain on discontinued operations of $175,000.

4. Goodwill and identifiable intangible assets

The changes in the amount of goodwill for the six months ended June 30, 2005, by reporting segment are as follows:

 
 
   
VoIP to Consumers and Corporations 
   
Internet, Managed Private Networks
and Other
   
Total
 
Balance as of December 31, 2004
 
$
 
$
 
$
 
Goodwill for Jamaican acquisition
   
   
147,419
   
147,419
 
Goodwill for purchase of Efonica minority interest
   
613,724
   
   
613,724
 
Balance as of June 30, 2005
 
$
613,724
 
$
147,419
 
$
761,143
 

Identifiable intangible assets, net, as of June 30, 2005, are composed of:

 
$
4,581,810
 
Customer list
   
291,320
 
   
$
4,873,130
 


10


FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Condensed Notes to Consolidated Financial Statements

These identifiable intangible assets were acquired in connection with the Company's purchase of the 49.8% minority interest in its Efonica joint venture. The trademarks are not subject to amortization as they have an indefinite life. Amortization on the customer list during the three and six months ended June 30, 2005, was $7,480. There was no customer list amortization during 2004. The following table presents estimated amortization expense for the remaining six months of 2005, and each of the succeeding calendar years.

2005   
$
14,930
 
2006
   
29,880
 
2007
   
29,880
 
2008
   
29,880
 
2009
   
29,880
 
Thereafter
   
156,870
 
   
$
291,320
 

5. Accounts payable and accrued expenses

Accounts payable and accrued expenses consist of the following at June 30, 2005, and December 31, 2004:

 
   
June 30, 2005 
   
December 31, 2004
 
               
Trade accounts payable
 
$
5,619,031
 
$
5,662,058
 
Accrued expenses
   
1,654,497
   
2,050,175
 
Interest payable
   
291,723
   
814,262
 
Dividends payable on Series C Preferred Stock
   
   
664,635
 
Deferred revenue
   
847,905
   
971,456
 
Other
   
273,585
   
112,102
 
   
$
8,686,741
 
$
10,274,688
 

6. Long-term debt and capital lease obligations

At June 30, 2005, and December 31, 2004, components of long-term debt and capital lease obligations of the Company are comprised of the following:

 
         
June 30, 2005 
   
December 31, 2004
 
                     
Convertible notes payable
   
(a
)
$
 
$
250,000
 
Demand notes payable
   
(b
)
 
   
898,931
 
Promissory notes payable
   
(c
)
 
150,000
   
150,000
 
Demand notes payable
   
(d
)
 
   
81,790
 
Promissory notes payable
   
(e
)
 
   
150,000
 
Promissory notes payable
   
(f
)
 
   
25,000
 
Promissory notes payable
   
(g
)
 
   
102,000
 
Promissory notes payable
   
(h
)
 
   
233,252
 
Convertible notes payable
   
(i
)
 
   
2,508,333
 
Capital lease obligation
   
(j
)
 
1,133,327
   
1,288,325
 
Total long-term debt and capital lease obligations
         
1,283,327
   
5,687,631
 
Less current portion
         
1,242,490
   
5,531,136
 
         
$
40,837
 
$
156,495
 

(a) Balance at December 31, 2004, represented two convertible subordinated note agreements. Interest rate was 9.25% at December 31, 2004, payable semi-annually on January 31 and July 31. During February 2005, these notes were paid in full upon completion of the Company’s IPO.

(b) Two officers of the Company entered into various loan agreements with the Company in exchange for demand notes payable. The interest rates ranged from 4.0%-4.75% per annum and were due on demand. During February 2005, these notes were paid in full upon completion of the Company’s IPO.

11

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Condensed Notes to Consolidated Financial Statements

(c) During February 2004, the Company entered into a settlement agreement for $600,000. In the same month, the Company paid $450,000 and agreed to make 12 monthly payments for the remaining $150,000. The debt has not been repaid as of June 30, 2005, as the debtor has not complied with the terms of the settlement agreement.

(d) Balance at December 31, 2004, represented promissory notes to three stockholders. The interest rates ranged from 4.75%-12.00% per annum and were due on demand. During February 2005, these notes were paid in full upon completion of the Company’s IPO.

(e) Balance at December 31, 2004, related to various promissory notes. Interest rate was 4.75% per annum. During February 2005, these notes were paid in full upon completion of the Company’s IPO.

(f)  Balance at December 31, 2004, represented promissory note which bore interest at 4.5% per annum. Principal and interest were payable in one lump sum on the earlier of 15 days from the completion of an IPO or September 1, 2005. During February 2005, this note was repaid in full upon completion of the Company’s IPO.

(g) Balance at December 31, 2004, represented a loan agreement which bore interest at 15%. During February 2005, the note was repaid in full upon completion of the Company’s IPO.

(h) The balance at December 31, 2004, relates to promissory notes to various stockholders for the purpose of resolving the Company’s capital lease debt service contract with the lessor of the equipment under lease. The notes accrued interest at 8% per annum. The balance also related to an equipment lease with a non-related party. These notes were all repaid during the six months ended June 30, 2005.

(i) Balance at December 31, 2004, represented two convertible notes, which bore interest at 6.5% per annum. In February 2005, these notes were automatically converted into 651,515 common shares (based upon a conversion price of $3.85 per share) upon the completion of the Company’s IPO.

(j) At June 30, 2005 and December 31, 2004, approximately $720,000 of the capital lease obligations were in default and accordingly has been classified as currently due.

7. Series C Preferred Stock

At December 31, 2004, there were 109,962 shares of the $90 Series C Convertible Redeemable Preferred Stock (“Series C Preferred Stock”) outstanding. The holders of the Series C Preferred Stock were entitled to receive cumulative dividends of 8% per share per annum which were payable annually beginning on December 18, 2004, and were payable in cash, unless the Company completed its IPO before December 18, 2004. Since the IPO was not completed until February 2005, the dividends on the Series C Preferred Stock of approximately $665,000 were paid on January 18, 2005. Upon the closing of the Company’s initial public offering during February 2005, the 109,962 outstanding shares of the Series C Preferred Stock were automatically converted into 3,141,838 shares of the Company’s common stock and 3,141,838 Redeemable Common Stock Purchase Warrants. There was no beneficial conversion feature associated with this conversion.

8. Equity Transactions

On February 17, 2005, the Company closed its initial public offering of securities of 3,600,000 shares of common stock at a price of $6.45 per share and 3,600,000 redeemable common stock purchase warrants at $0.05 per warrant. Gross proceeds of the offering were approximately $23,400,000. Total estimated offering costs were approximately $3,000,000, which resulted in net proceeds to the Company of $20,400,000. On March 30, 2005, the Company’s underwriters exercised their over-allotment option and purchased an additional 480,000 shares of common stock and 540,000 purchase warrants. The Company received an additional $2,900,000 in net proceeds from the closing on the over-allotment option.

Subsequent to the IPO, the Company has two classes of outstanding common stock. The holders of the Class A Common Stock have identical rights and privileges as the regular common stock, except that they will not be able to transfer shares of Class A Common Stock until the first anniversary of the date of the prospectus, which was February 11, 2005. After the date of the IPO, the Class A Common Stock may be converted at the option of the holder, without the consent of the underwriters, if the holder executes and delivers a lock up agreement preventing the public sale of the common stock until the first anniversary of the date of the IPO. The Class A common stock will automatically convert into the regular common stock on the first anniversary of the date of the IPO.

Upon completion of the IPO, $2.5 million of convertible debt was converted into 651,515 shares of common stock. In addition, 1,439,643 shares of common stock were issued (of which 675,581 shares are held in escrow) in connection with the Company’s acquisition of the 49.8% minority interest in Efonica (see Note 2 for further discussion). In accordance with SFAS No. 141, since 675,581 of these shares are held in escrow and this consideration is contingent on specified events in the future, these shares are not reflected as outstanding as of June 30, 2005. In addition, as discussed in Note 7, all outstanding Series C preferred stock was converted into common stock.
 
12

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Condensed Notes to Consolidated Financial Statements

During the six months ended June 30, 2005, a director exercised stock options which resulted in the issuance of 21,429 shares of common stock and two individuals exercised warrants, which resulted in the issuance of 28,572 shares of Class A common stock.

On April 19, 2005, the Company entered into a consulting service agreement. In connection with this agreement, the Company issued 11,363 shares of restricted common stock based upon a price of $4.40 per share. Subsequent to June 30, 2005, the restricted shares have been released in accordance with the agreement. The $50,000 expense associated with these shares is being amortized over the one-year term of the agreement.

9. Current Accounting Pronouncements

In May 2005, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 154, “Accounting Changes and Error Corrections.” SFAS No. 154 is a replacement of APB No. 20 and FASB Statement No. 3 SFAS No. 154 provides guidance on the accounting for and reporting of accounting changes and error corrections. It establishes retrospective application as the required method for reporting a change in accounting principle. SFAS No. 154 provides guidance for determining whether retrospective application is impractical. The reporting of a correction of an error, by restating previously issued financial statements, is also addressed by SFAS No. 154. SFAS No. 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will adopt this pronouncement at the beginning of fiscal year 2006.

In December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123(R)”). This Statement requires companies to expense the estimated fair value of stock options and similar equity instruments issued to employees. Currently, companies are required to calculate the estimated fair value of these share-based payments and can elect to either include the estimated cost in earnings or disclose the pro forma effect in the footnotes to their financial statements. The Company has chosen to disclose the pro forma effect. The fair value concepts were not changed significantly in SFAS 123(R); however, in adopting this Standard, companies must choose among alternative valuation models and amortization assumptions. The valuation model the Company has used continues to be available, but the Company has not yet completed its assessment of the alternatives. In April 2005, the SEC announced a deferral of the effective date of SFAS 123(R) for calendar year companies until the beginning of 2006.

10. Contingencies

Legal Matters

On April 15, 2003, World Access, Inc., a former customer, brought an action against the Company for recovery of preferential transfers and other claims under the Bankruptcy Code in the United States Bankruptcy Court, Northern District of Illinois Eastern Division (In Re: World Access, Inc., et al vs. Fusion Telecommunications International, Inc., Adv. Pro. No. 03 A 00851). The suit seeks damages in the amount of approximately $335,000 for alleged avoidance of preferential transfers, recovery of transfers, setoff, recovery setoff, payment of improperly setoff debt, turnover of property, and damages for overdue debt and turnover of property. The Company filed a proof of claim with the court in the amount of approximately $85,000 for amounts that were due at the time this customer filed bankruptcy. In March 2005, the Company settled this matter for $5,500, and agreed to waive the Company’s proof of claim in the amount of approximately $85,000. The Company expects to execute the formal settlement agreement on or before September 1, 2005.
 
On May 28, 2003, Jack Grynberg, et al., an investor in one of the Company’s private offerings, filed a complaint with the Denver District Court, State of Colorado ( Jack Grynberg, et al v. Fusion Telecommunications International, Inc., et al, 03-CV-3912) seeking damages in the amount of $400,000 for the purchase of an interest in Fusion's 1999 private placement offering of subordinated convertible notes through Joseph Stevens & Company, Inc., a registered broker dealer. This complaint asserted the following claims for relief: Breach of Fiduciary Duty, Civil Theft, Deceptive Trade Practices, Negligent Misrepresentation, Deceit Based on Fraud, Conversion, Exemplary Damages and Prejudgment Interest. On June 25, 2004, the Company filed with the Court a Motion to dismiss, which was granted. The plaintiffs have filed an appeal of the motion, which is pending.
 
Due to the regulatory nature of the industry, the Company is periodically involved in various correspondence and inquiries from state and federal regulatory agencies. Management does not expect the outcome of these inquiries to have a material impact on the operations or the financial condition of the Company.
 
13


FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Condensed Notes to Consolidated Financial Statements
11. Segment Information

The Company has four reportable segments that it operates and manages which are organized by products and services. The Company measures and evaluates its reportable segments based on revenues and cost of revenues. This segment income excludes unallocated corporate expenses and other adjustments arising during each period. The other adjustments include transactions that the chief operating decision makers exclude in assessing business unit performance due primarily to their non-operational and/or non-recurring nature. Although such transactions are excluded from the business segment results, they are included in reported consolidated earnings. Each segment is managed according to the products, which are provided to the respective customers, and information is reported on the basis of reporting to the Company’s Chief Operating Decision Maker.

The Company’s segments and their principal activities consist of the following:

Traditional Voice — This segment includes the termination of voice telephony minutes from or to the countries served by the Company, utilizing traditional Time Division Multiplexing (TDM) and “circuit-switched” technology. Typically, this will include interconnection with traditional telecommunications carriers either located internationally or those carriers that interconnect with the Company at its US Points of Presence (POP) and provide service to other destinations.

VoIP (Voice over Internet Protocol) to Carriers — VoIP includes the termination of voice telephony minutes by the Internet rather than older circuit-switched technology. This permits far less costly and more rapid interconnection between the Company and international telecommunications carriers.

VoIP (Voice over Internet Protocol) to Consumers and Corporations — Primarily through the Company’s Efonica subsidiary and Estel joint venture, the Company provides VoIP services targeted to end-users and corporations. The Company offers services that permit consumers or corporations to originate calls via IP telephones or telephone systems that use the Internet for completion to standard telephone lines anywhere in the world. The Company also provides PC-to-phone service that utilizes the Internet to allow consumers to use their personal computers to place calls to the telephone of their destination party.

Internet, Managed Private Networks & Other — The Company provides Internet connectivity to telecommunications carriers, Internet Service Providers, government entities, and multinational customers via its POPs in the US, India, and through its partners elsewhere. The Company also offers point-to-point private lines, virtual private networking, and call center communications services to customers in its target markets. Lastly, the Company offers the Interview desktop-to-desktop video conferencing service to customers anywhere in the world.
 
Operating segment information for the three months ended June 30, 2005 and 2004, is summarized as follows:

June 30, 2005
   
Traditional Voice
   
VoIP to Carriers
   
VoIP to Consumers and Corporations
   
Internet, Managed Private Networks & Other
   
Corporate & Unallocated
   
Consolidated
 
Net revenues
 
$
2,628,360
 
$
15,166,072
 
$
995,856
 
$
469,603
 
$
-
 
$
19,259,891
 
Cost of revenues (exclusive of depreciation and amortization)
$
(2,464,576
)
$
(14,245,323
)
$
(734,518
)
$
(259,574
)
$
-
 
$
(17,703,991
)
Depreciation and amortization
 
$
(35,402
)
$
(340,694
)
$
(16,567
)
$
(4,589
)
$
(39,135
)
$
(436,387
)
Selling, general and administrative
 
$
(80,720
)
$
(1,132,000
)
$
(653,179
)
$
(177,548
)
$
(986,233
)
$
(3,029,680
)
Other income (expense)
 
$
67,931
 
$
(123,376
)
$
24,554
 
$
16,521
 
$
23,656
 
$
9,286
 
Net income (loss)
 
$
115,593
 
$
(675,321
)
$
(383,854
)
$
44,413
 
$
(1,001,712
)
$
(1,900,881
)
Capital Expenditures
 
$
83,395
 
$
472,733
 
$
31,697
 
$
14,995
 
$
66,981
 
$
669,801
 

14


FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Condensed Notes to Consolidated Financial Statements

June 30, 2004
   
Traditional Voice
   
VoIP to Carriers
   
VoIP to Consumers and Corporations
   
Internet, Managed Private Networks & Other
   
Corporate & Unallocated
   
Consolidated
 
Net revenues
 
$
4,308,334
 
$
10,751,327
 
$
495,621
 
$
562,483
 
$
-
 
$
16,117,765
 
Cost of revenues (exclusive of depreciation and amortization)
$
(3,758,378
)
$
(9,477,701
)
$
(365,865
)
$
(399,339
)
$
-
 
$
(14,001,283
)
Depreciation and amortization
 
$
(123,270
)
$
(258,590
)
$
(7,536
)
$
(11,757
)
$
(40,675
)
$
(441,828
)
Selling, general and administrative
 
$
(455,608
)
$
(955,950
)
$
(166,612
)
$
(33,292
)
$
(702,213
)
$
(2,313,675
)
Other income (expense)
 
$
(198,366
)
$
(683,843
)
$
(3,283
)
$
(64,574
)
$
466,595
 
$
(483,471
)
Net income (loss)
 
$
(227,288
)
$
(624,757
)
$
(47,675
)
$
53,521
 
$
(276,293
)
$
(1,122,492
)
Capital Expenditures
 
$
130,417
 
$
334,536
 
$
15,617
 
$
19,322
 
$
55,544
 
$
555,436
 

Operating segment information for the six months ended June 30, 2005 and 2004, is summarized as follows:

June 30, 2005
   
Traditional Voice
   
VoIP to Carriers
   
VoIP to Consumers and Corporations
   
Internet, Managed Private Networks & Other
   
Corporate & Unallocated
   
Consolidated
 
Net revenues
 
$
5,478,519
 
$
22,445,110
 
$
2,183,261
 
$
1,082,053
 
$
-
 
$
31,188,943
 
Cost of revenues (exclusive of depreciation and amortization)
$
(5,267,874
)
$
(21,148,210
)
$
(1,652,585
)
$
(632,745
)
$
-
 
$
(28,701,414
)
Depreciation and amortization
 
$
(137,794
)
$
(601,434
)
$
(24,226
)
$
(27,182
)
$
(78,775
)
$
(869,411
)
Selling, general and administrative
 
$
(507,097
)
$
(2,119,690
)
$
(860,066
)
$
(284,194
)
$
(1,964,040
)
$
(5,735,087
)
Other income (expense)
 
$
(87,690
)
$
(328,234
)
$
(14,936
)
$
(17,298
)
$
23,655
 
$
(424,503
)
Income (loss) from continuing operations
 
$
(521,936
)
$
(1,752,458
)
$
(368,552
)
$
120,634
 
$
(2,019,160
)
$
(4,541,472
)
Income from discontinued operations
 
$
175,000
 
$
-
 
$
-
 
$
-
 
$
-
 
$
175,000
 
Net income (loss)
 
$
(346,936
)
$
(1,752,458
)
$
(368,552
)
$
120,634
 
$
(2,019,160
)
$
(4,366,472
)
Capital Expenditures
 
$
168,338
 
$
689,671
 
$
67,085
 
$
33,248
 
$
106,483
 
$
1,064,825
 

June 30, 2004
   
Traditional Voice
   
VoIP to Carriers
   
VoIP to Consumers and Corporations
   
Internet, Managed Private Networks & Other
   
Corporate & Unallocated
   
Consolidated
 
Net revenues
 
$
6,676,994
 
$
17,666,897
 
$
836,003
 
$
1,125,535
 
$
-
 
$
26,305,429
 
Cost of revenues (exclusive of depreciation and amortization)
$
(5,821,462
)
$
(15,533,514
)
$
(588,632
)
$
(766,696
)
$
-
 
$
(22,710,304
)
Depreciation and amortization
 
$
(240,542
)
$
(505,012
)
$
(12,278
)
$
(40,548
)
$
(81,016
)
$
(879,396
)
Selling, general and administrative
 
$
(860,928
)
$
(1,764,348
)
$
(242,338
)
$
(145,126
)
$
(1,443,351
)
$
(4,456,091
)
Other income (expense)
 
$
1,100,396
 
$
(334,966
)
$
(2,435
)
$
(57,391
)
$
177,693
 
$
883,297
 
Net income (loss)
 
$
854,458
 
$
(470,943
)
$
(9,680
)
$
115,774
 
$
(1,346,674
)
$
(857,065
)
Capital Expenditures
 
$
168,929
 
$
446,975
 
$
21,151
 
$
28,476
 
$
73,948
 
$
739,479
 
 
15

 
 
   
Traditional Voice  
   
VoIP to Carriers
   
VoIP to Consumers and Corporations
   
Internet, Managed Private Networks & Other
   
Corporate & Unallocated
   
Consolidated
 
Assets
                                     
June 30, 2005
 
$
1,728,304
 
$
6,929,922
 
$
6,452,743
 
$
340,847
 
$
19,204,118
 
$
34,655,934
 
                                       
December 31, 2004
 
$
2,074,700
 
$
4,563,839
 
$
547,588
 
$
433,707
 
$
6,042,283
 
$
13,662,117
 

The Company employs engineering and operations resources that service across multiple product lines. Depreciation and indirect operating expenses were allocated to each product line based upon their respective revenues. The amounts reflected as Corporate and unallocated represent those expenses that were not appropriate to allocate to each product line.
 
 
 
 
 
 
 
16

 
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of our financial condition and results of operations should be read together with our consolidated financial statements and the related condensed notes thereto included in another part of this quarterly report. This discussion contains certain forward-looking statements that involve substantial risks and uncertainties. When used in this report the words “anticipate,”“believe,”“estimate,”“expect” and similar expressions as they relate to our management or us are intended to identify such forward-looking statements. Our actual results, performance or achievements could differ materially from those expressed in, or implied by, these forward-looking statements. Historical operating results are not necessarily indicative of the trends in operating results for any future period.

Overview

We are an international communications carrier delivering VoIP, private networks, Internet access, Internet protocol video conferencing and other advanced services to, from, in and between emerging markets in Asia, the Middle East, Africa, the Caribbean and Latin America.
Our corporate strategy focuses our resources on VoIP and the emerging international markets. We seek to gain early entry in high growth emerging markets, often in partnership with local organizations that have strong distribution channels, regulatory experience, market intelligence, the ability to deliver local loops and the capability of providing customer service support. This approach enables us to introduce our Internet protocol communications services in these markets, thereby benefiting from the time-to-market advantages, expanded geographic reach and reduced capital requirements that local partnerships afford. Our network utilizes the most currently available Softswitch technology, relieving us of the burden of costly, inefficient legacy systems and allowing more rapid and cost-effective deployment and expansion of services worldwide. Additionally, we are currently in the process of expanding our infrastructure to better support the growth of our VoIP services to consumers and corporations.

The following table summarizes our results of operations for the periods indicated:

     
Three Months  
   
Six Months 
 
     
Ended June 30,  
   
Ended June 30, 
 
     
2005
   
2004
   
2005
   
2004
 
Revenues
 
$
19,259,891
 
$
16,117,765
 
$
31,188,943
 
$
26,305,429
 
Operating expenses:
                         
Cost of revenues
   
17,703,991
   
14,001,283
   
28,701,414
   
22,710,304
 
Depreciation and amortization
   
436,387
   
441,828
   
869,411
   
879,396
 
Selling, general and administrative
   
3,029,680
   
2,313,675
   
5,735,087
   
4,456,091
 
Total operating expenses
   
21,170,058
   
16,756,786
   
35,305,912
   
28,045,791
 
                                        
Operating Loss
   
(1,910,167
)
 
(639,021
)
 
(4,116,969
)
 
(1,740,362
)
                           
Other income (expense):
                         
Interest income (expense), net
   
91,380
   
(538,388
)
 
(184,423
)
 
(823,519
)
Forgiveness of debt
   
5,340
   
157,183
   
5,340
   
1,976,595
 
Loss from investment in Estel
   
(142,545
)
 
(164,030
)
 
(299,460
)
 
(318,910
)
Other
   
5,956
   
8,500
   
5,956
   
17,750
 
Minority interests
   
49,155
   
53,264
   
48,084
   
31,381
 
Total other income (expense)
   
9,286
   
(483,471
)
 
(424,503
)
 
883,297
 
                           
Loss from continuing operations
   
(1,900,881
)
 
(1,122,492
)
 
(4,541,472
)
 
(857,065
)
Income from discontinued operations
   
-
   
-
   
175,000
   
-
 
Net loss
 
$
(1,900,881
)
$
(1,122,492
)
$
(4,366,472
)
$
(857,065
)

 
17

The following table presents our historical operating results as a percentage of revenues for the periods indicated:

     
Three Months
Ended June 30,
   
Six Months
Ended June 30, 
 
     
2005
   
2004
   
2005
   
2004
 
Revenues
   
100.0%
 
 
100.0%
 
 
100.0%
 
 
100.0%
 
Operating expenses:
                         
Cost of revenues
   
91.9%
 
 
86.9%
 
 
92.0%
 
 
86.3%
 
Depreciation and amortization
   
2.3%
 
 
2.7%
 
 
2.8%
 
 
3.4%
 
Selling, general and administrative
   
15.7%
 
 
14.4%
 
 
18.4%
 
 
17.0%
 
Total operating expenses
   
109.9%
 
 
104.0%
 
 
113.2%
 
 
106.7%
 
                                   
Operating loss
   
-9.9%
 
 
-4.0%
 
 
-13.2%
 
 
-6.7%
 
                           
Other income (expense)
                         
Interest income (expense), net
   
0.5%
 
 
-3.3%
 
 
-0.6%
 
 
-3.1%
 
Forgiveness of debt
   
0.0%
 
 
1.0%
 
 
0.0%
 
 
7.5%
 
Loss from investment in Estel
   
-0.7%
 
 
-1.0%
 
 
-1.0%
 
 
-1.2%
 
Other
   
0.0%
 
 
0.1%
 
 
0.0%
 
 
0.1%
 
Minority interests
   
0.2%
 
 
0.2%
 
 
0.2%
 
 
0.1%
 
Total other income (expense)
   
0.0%
 
 
-3.0%
 
 
-1.4%
 
 
3.4%
 
                           
Loss from continuing operations
   
-9.9%
 
-7.0%
 
 
-14.6%
 
 
-3.3%
 
Income from discontinued operations
   
0.0%
 
 
0.0%
 
 
0.6%
 
 
0.0%
 
Net loss
   
-9.9%
 
 
-7.0%
 
 
-14.0%
 
 
-3.3%
 
 
Revenues

Historically, we have generated the majority of our revenue from voice traffic sold to other carriers, with a primary focus on VoIP terminations to the emerging markets. We have increased our business in this area through an internal focus on the growth of our existing customer base, which is primarily U.S. based, as well as the addition of new customers, and the establishment of in-country partnerships that help us to more quickly deploy direct VoIP terminating arrangements with postal telephone and telegraph companies and other licensed carriers in emerging markets. Although we believe that this business continues to be strong, ongoing competitive and pricing pressures have caused us to increase our focus on higher margin, value-added services (VoIP to consumers and businesses, Internet access, Internet protocol videoconferencing and private networks) and market them to, or in conjunction with, international carriers, Internet service providers, cable companies and wireless operators on a direct, co-branded or private label basis.

In an effort to further increase margins, expand our customer base, and develop more stable revenue streams, we have begun to selectively target enterprise customers (large corporations, government entities and other businesses). Revenues generated from sales to these customers are primarily derived from the sale of the value-added services mentioned above. With a primary focus on marketing VoIP services to these enterprise customers, we believe we will recognize higher margin and stronger growth opportunities. While this does not yet represent a significant portion of our revenue base, we expect to continue to increase our emphasis in this area. We believe that this will complement our carrier business with a higher margin and more stable customer base.

In 2002, we established Efonica F-Z, LLC, as a retail services company marketing VoIP products to consumer and corporate customers in emerging markets. Beginning in the Middle East, Asia and Africa, then extending into Latin America, Efonica’s services are primarily sold through distribution channels on a pre-paid basis. Efonica’s customers can place calls from anywhere in the world to any destination using a personal computer, Internet protocol telephone or regular telephone when accompanied by a hardware device that may be purchased through Efonica. We believe that the introduction of advanced features such as voicemail, call waiting and call forwarding enhance this value-added offering. We expect to add these features by the end of the year. In February 2005, we closed on the purchase of the 49.8% minority interest in Efonica.

Our increased focus on VoIP services to enterprise customers resulted in a growing upward trend for this product segment. During the first six months of 2005, VoIP services to consumers and corporations accounted for 7.0% of our total consolidated revenue compared to 3.2% in the first six months of 2004.

18

 
We manage our revenues by product and customer. We manage our costs by provider (vendor). We track total revenue at the customer level because our sales force has to manage the revenue generation at the customer level, and invoices are billed to and collected at the customer level. We also have to track the same revenues by product, because different products have different billing and payment terms, and individual customers may have multiple billing and payment terms if they purchase multiple products.

We manage our revenue segments based on gross margin, which is net revenues less cost of revenues, rather than on net profitability, due to the fact that our infrastructure is built to support all products, rather than individual products. This applies both to the capital investments made (such as switching and transmission equipment), and to Selling, General and Administrative resources. The majority of our sales, and operations personnel support all product lines, and are not separately hired to support individual product segments. For segment reporting purposes, all expenses below cost of revenues are allocated based on percentage of revenues unless the items can be specifically identified to one of the product segments.

We manage our cost of revenues by managing the margins that we realize from individual providers. We also monitor the cost of revenue terminated over our own networks (On-net) versus cost of revenue terminated by third party providers (Off-net). Our On-net cost of revenues are managed through our relationships with strategic partners and our joint ventures, routing traffic to those networks where we can effectively do so. Our Off-net cost of revenues are managed by routing to our third party providers based on a least cost approach, and focusing on maximizing margins by providers. Most providers offer multiple destinations for termination, and give better rates for higher volumes.

Off-net revenue does not typically mirror On-net revenue in regional geographic termination percentages, because Off-net revenues are terminated by those other third party providers, and may terminate anywhere in the world. On-net revenues only terminate to areas supported by our own network of strategic partners that we have agreements with and also typically have made investments with. If we have traffic to On-net destinations that exceeds our capacity, we overflow such traffic to other providers (Off-net).

Total Consolidated Revenue includes VoIP to carriers, Traditional Voice to carriers, VoIP to Consumers, and Internet, Private Network & Other. Revenues are further broken down between On-net and Off-net as mentioned above. All categories of revenue are recorded and tracked at the product and customer level.
 
Fusion Telecommunications International

Terminating Revenue by Geographic Region

On-Net Versus Off-Net

Period
 
 
Caribbean
 
 
Latin America
 
 
Asia
 
 
Middle East
 
 
Africa
 
 
Consolidated Terminating On-Net Revenue
 
 
Consolidated Off-Net Revenue
 
 
Total Consolidated Revenue
 
Three Months Ended
June 30, 2005
 
$
534,536
 
$
-
 
$
450,325
 
$
365,943
 
$
38,879
 
$
1,389,683
 
$
17,870,208
 
$
19,259,891
 
     
2.8
%
 
0.0
%
 
2.3
%
 
1.9
%
 
0.2
%
 
7.2
%
 
92.8
%
     
                                                   
Three Months Ended
June 30, 2004
 
$
578,707
 
$
38,083
 
$
2,755,589
 
$
942,421
 
$
161,318
 
$
4,476,118
 
$
11,641,647
 
$
16,117,765
 
     
3.6
%
 
0.2
%
 
17.1
%
 
5.8
%
 
1.0
%
 
27.7
%
 
72.3
%
     

Period
   
Caribbean
   
Latin America
   
Asia
   
Middle East
   
Africa
   
Consolidated Terminating On-Net Revenue
   
Consolidated Off-Net Revenue
   
Total Consolidated Revenue
 
Six Months Ended
June 30, 2005
 
$
982,325
 
$
-
 
$
1,641,212
 
$
879,680
 
$
52,221
 
$
3,555,438
 
$
27,633,505
 
$
31,188,943
 
     
3.1
%
 
0.0
%
 
5.3
%
 
2.8
%
 
0.2
%
 
11.4
%
 
88.6
%
     
                                                   
Six Months Ended
June 30, 2004
 
$
605,176
 
$
38,083
 
$
5,278,159
 
$
2,453,660
 
$
238,308
 
$
8,613,386
 
$
17,692,043
 
$
26,305,429
 
     
2.3
%
 
0.1
%
 
20.1
%
 
9.3
%
 
0.9
%
 
32.7
%
 
67.3
%
     


Regional percentages are calculated based on Total Consolidated Revenue.


 
19


OPERATING EXPENSES

Our operating expenses during the six months ended June 30, 2005 and 2004, are categorized as cost of revenues, depreciation and amortization, loss on impairment, and selling, general and administrative expenses.

Cost of revenues includes costs incurred with the operation of our leased network facilities, and the purchase of voice termination and Internet protocol services from other telecommunications carriers and Internet service providers. We continue to work to lower the variable component of the cost of revenue through the use of least cost routing, and continual negotiation of usage-based and fixed costs with domestic and international service providers.

Depreciation and amortization includes depreciation of our communications network equipment, amortization of leasehold improvements of our switch locations and administrative facilities, and the depreciation of our office equipment and fixtures.

Selling, general and administrative expenses include salaries and benefits, commissions, occupancy costs, sales, marketing and advertising, professional fees and other administrative expenses.

COMPANY HIGHLIGHTS

The following summary of significant events during the six months ended June 30, 2005, highlights the accomplishments and events that have influenced our performance during that time period.

 
Capital fund-raising — In February 2005, we closed on our initial public offering of securities of 3,600,000 shares of common stock at a price of $6.45 per share and 3,600,000 redeemable common stock purchase warrants at $.05 per warrant. Net proceeds of the offering were approximately $20.4 million. On March 30, 2005, our underwriters exercised their over-allotment option and purchased an additional 480,000 shares of common stock and 540,000 purchase warrants. We received an additional $2.9 million in net proceeds from the closing on the over-allotment option.
 
 
Debt Reduction — Upon completion of our IPO we repaid approximately $1.5 million in outstanding debt. In addition, $2.5 million of convertible debt was converted into 651,515 shares of common stock. During May 2005, we repaid an additional $0.2 million of debt.
 
 
Conversion of Series C preferred stock - The $10.0 million liability related to the 109,962 shares of outstanding Series C preferred stock was converted into equity (3,141,838 shares of common stock).
 
 
Revenue Growth — Revenue grew 18.6% in the first six months of 2005, over the first six months of 2004, and revenue in our VoIP to consumers and corporations segment grew 161.2% in the first six months of 2005 over the first six months of 2004.
 
 
Purchase of a Jamaica Entity — In January 2005, we concluded the purchase of a 51.0% interest in Convergent Technologies, which has international and domestic license agreements with the Jamaican government.
 
 
Purchase of Efonica —In February 2005, we acquired the remaining 49.8% interest in our Efonica joint venture.
 
 
Turkey Purchase Agreement — In May 2005, we closed on the stock purchase agreement with an entity in Turkey to acquire 75% of the shares from the existing Shareholders. This subsidiary will enable us to provide VoIP services under our Efonica brand and other Internet Services to corporation and consumers in Turkey.
 

The information in our period-to-period comparisons below represents only our results from continuing operations.

Three Months Ended June 30, 2005, Compared with Three Months Ended June 30, 2004.

Revenues

Consolidated revenues increased $3.1 million or 19.5% to approximately $19.3 million in the three months ended June 30, 2005, compared to $16.1 million in the three months ended June 30, 2004. Revenues for VoIP services to consumers and corporations represented $0.5 million or 15.9% of the consolidated revenue growth, increasing from $0.5 million in the second quarter 2004, to $1.0 million in the second quarter 2005, mainly due to the growth of Efonica.

VoIP services sold to carriers increased $4.4 million or 41.1% in the second quarter of 2005, versus the second quarter of 2004. This increase represented 140.5% of the consolidated revenue growth for the quarter. The majority of the technical difficulties associated with the migration to the new Softswitch were addressed in the second quarter of 2005. This is evidenced by the significant growth of the VoIP services sold to carriers product segment to 78.7% of total consolidated revenue for the three months ended June 2005 versus 66.7% of total consolidated revenue for the three months ended June 2004. Traditional Voice services sold to carriers decreased $1.7 million or 39.0% in the second quarter of 2005, versus the second quarter of 2004, as we continue to execute our corporate strategy to focus our resources on the VoIP product segments.

Revenues from our Internet, Private Network & Other Services decreased $0.1 million or 16.5% from $0.6 million in the second quarter 2004, to $0.5 million in the second quarter 2005 due to the cancellation of a government contract.

20


Cost of Revenues

Consolidated cost of revenues increased $3.7 million or 26.4% to $17.7 million in the second quarter of 2005 from $14.0 million in the second quarter of 2004. Approximately $3.5 million of this increase was attributable to an increase in voice services to carriers, of which $4.8 million was an increase in VoIP services cost of revenues to carriers, offset by a decrease of $1.3 million in cost of revenues for Traditional Voice services to carriers.

The cost of revenues for VoIP services to consumers and corporations grew $0.3 million in the second quarter 2005, from $0.4 million to $0.7 million in the second quarter 2004, due primarily to the rapid growth in that revenue base. Cost of revenues for Internet, Private Network & Other decreased $0.1 million from $0.4 million with the second quarter of 2004 to $0.3 million in the second quarter of 2005.

Consolidated gross margin decreased $0.6 million or 26.5% for the second quarter 2005 over the second quarter 2004. Gross margin for total Voice services to carriers decreased by $0.7 million, but was partially offset by an improvement in the gross margin for VoIP services to consumers and corporations of $0.1 million. Gross margin for Internet, Private Networks and Other remained flat for the second quarter of 2005 over the second quarter of 2004. The decline in gross margin for voice services to carriers was caused primarily by price pressure sensitivity associated with several of our key routes, both on-net and off-net.

Operating Expenses

Depreciation and Amortization. Depreciation and amortization remained consistent at $0.4 million during the three months ended June 30, 2005 and 2004. Although depreciation increased as a result of assets added during 2004 and the first six months of 2005, including the new Softswitch, this increase was offset by a decrease resulting from certain assets becoming fully depreciated during 2004 and the first quarter of 2005.

Selling, General and Administrative. Selling, general and administrative expenses increased $0.7 million or 30.9% to $3.0 million during the three months ended June 30, 2005, from $2.3 million during the three months ended June 30, 2004. This increase is primarily attributed to increased salaries and benefits, as more personnel have been required to support our revenue growth and expansion of our infrastructure. In addition, also increasing as a result of growth and our becoming a public company in February 2005, have been our legal and professional fees, advertising/marketing expenses and bad debt expense. As a percentage of revenues, selling, general and administrative expenses increased from 14.4% during 2004 to 15.7% during 2005. We believe that as we execute our business strategies, selling, general and administrative expenses as a percentage of revenue will begin to decline.

Operating Loss. Our operating loss increased $1.3 million or 198.9% to a loss of $1.9 million during the three months ended June 30, 2005, from a loss of $0.6 million during the three months ended June 30, 2004. The increase in operating loss was primarily attributable to both the decrease in gross margin and the increase in selling, general and administrative expenses associated with infrastructure growth and public company compliance requirements.

Other Income (Expense). Total other income (expense) changed from other expense of approximately $0.5 million during the three months ended June 30, 2004, to other income of $9,286 during the three months ended June 30, 2005. During the three months ended June 30, 2005, we had interest expense of $0.1 million in contrast to interest income of $0.5 million during the three months ended June 30, 2004. The 2004 period included accretion of $0.5 million (in accordance with SFAS 150) related to our then outstanding Series C preferred stock. There was no accretion during the three months ended June 30, 2005, due to this preferred stock converting to common stock in connection with our IPO. In addition, interest expense was higher during the three months ended June 30, 2004, as the Company had significant outstanding debt during this quarter (balance at June 30, 2004, was approximately $3.9 million) of which a significant portion was repaid during February 2005, in connection with our IPO (balance at June 30, 2005, was approximately $1.1 million). We also had an increase in interest income during the three months ended June 2005 versus the three months ended June 2004, as a result of our investment of the IPO proceeds. Gain on debt forgiveness decreased by $0.2 million to $5,340 in 2005 from $0.2 million in 2004. Both the 2004 and 2005 gains on debt forgiveness were attributed to settlement of network obligations. The loss from investment in Estel remained consistent during the three months ended June 30, 2005 and 2004, decreasing $21,000 in 2005. Minority interest changed from $53,264 during 2004 to a $49,155 during 2005.
 
Net Loss. The primary factors impacting our net loss for the three months ended June 30, 2005, were a decrease in gross margin, an increase in selling, general and administrative, the reduction in forgiveness of debt, net with an improvement in interest income (expense) net.
 
Six Months Ended June 30, 2005, Compared with Six Months Ended June 30, 2004.

Revenues

Consolidated revenues increased $4.9 million or 18.6% to approximately $31.2 million in the six months ended June 30, 2005, compared to $26.3 million in the six months ended June 30, 2004. Revenues for VoIP services to consumers and corporations represented $1.4 million or 27.6% of the consolidated revenue growth, increasing from $0.8 million in the six months ended June 30, 2004, to $2.2 million in the six months ended June 30, 2005, mainly due to the growth of Efonica.
 
21


Revenues for VoIP services sold to carriers increased $4.8 million or 27.0% in the six months ended June 30, 2005, versus the six months ended June 30, 2004. This increase represented 97.8% of the consolidated revenue growth for the quarter. During the six months ended June 30, 2005 growth in revenues for VoIP services sold to carriers was impacted, primarily during the first quarter of 2005, by technical difficulties associated with the migration to the new Softswitch. However a significant portion of these issues were addressed in the second quarter 2005 and revenues are again trending upward. Additionally, Traditional Voice services sold to carriers decreased $1.2 million or 17.9% in the six months ended June 30, 2005, versus the six months ended June 30, 2004 as we continue our to focus our resources on VoIP services.
 
Revenues from our Internet, Private Network & Other Services remained fairly consistent at $1.1 million in both the six months ended June 30, 2005, and the six months ended June 30, 2004. .

Cost of Revenues

Consolidated cost of revenues increased $6.0 million or 26.4% to $28.7 million in the six months ended June 30, 2005, from $22.7 million in the six months ended June 30, 2004. Approximately $5.1 million of this increase was attributable to an increase in voice services to carriers, of which $5.6 million was an increase in VoIP services to carriers, offset by a decrease of $0.5 million in Traditional Voice services to carriers.

The cost of revenues for VoIP services to consumers and corporations grew $1.1 million in the six months ended June 30, 2005, from $0.6 million to $1.7 million, due primarily to the rapid growth in that revenue base. Cost of revenues for Internet, Private Network & Other decreased $0.1 million or 17.5% to $0.6 million for the six months ended June 30, 2005 from $0.7 million for the six months ended June 30, 2004, due to negotiated cost reductions for government contracts.

Consolidated gross margin decreased $1.1 million for the six months ended June 2005 over 2004. Gross margin for total Voice services to carriers decreased by $1.5 million, which was partially offset by an improvement in the gross margin for VoIP services to consumers and corporations of $0.3 million. In addition, we had a decrease in gross margin for Internet, Private Networks and Other of $0.1 million.

T