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 September 30, 2006

OR

o 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 1718, New York, New York
10170
(Address of principal executive offices)
(Zip Code)
 
 
(212) 201-2400
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 o

Indicate by check mark whether the registrant is a large accelerated filer, accelerated filer, or non-accelerated filer. See definition of “accelerated filer and large accelerated filer” as defined in Rule 12b-2 of the Exchange Act.
 
 Large Accelerated Filer o
  Accelerated Filer o
 Non-Accelerated Filer x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o       No x
 
The number of shares outstanding of the Registrant's capital stock as of November 7, 2006, is as follows:

Title of each Class
   
Number of Shares Outstanding
 
Common Stock, $0.01 par value
   
26,971,465
 
Redeemable Common Stock Purchase Warrants
   
7,641,838
 
 


FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

INDEX

 
Page
Part I. Financial Information
 
 
Item l. Financial Statements
3
 
 
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
18
 
 
Item 3. Quantitative and Qualitative Disclosures About Market Risk
27
 
 
Item 4. Controls and Procedures
27
 
 
Part II. Other Information
 
 
 
Item 1. Legal Proceedings
29
   
Item 1A. Risk Factors
29
 
 
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
30
 
 
Item 3. Defaults Upon Senior Securities
31
 
 
Item 4. Submission of Matters to a Vote of Security Holders
31
 
 
Item 5. Other Information
31
 
 
Item 6. Exhibits
31

2


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

FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Consolidated Balance Sheets
 
   
 
September 30,
2006
 
 
December 31,
2005
 
   
 (unaudited)
      
ASSETS
           
Current assets
           
Cash and cash equivalents
 
$
2,410,477
 
$
14,790,504
 
Accounts receivable, net of allowance for doubtful accounts of approximately $587,000 and $414,000 at
September 30, 2006 and December 31, 2005, respectively
   
4,017,183
   
2,952,760
 
Restricted cash
   
365,000
   
 
Prepaid expenses and other current assets
   
1,089,362
   
1,242,266
 
Assets held for sale
   
258,465
   
245,305
 
Total current assets
   
8,140,487
   
19,230,835
 
Property and equipment, net
   
7,217,900
   
4,270,966
 
Other assets
             
Security deposits
   
173,368
   
331,891
 
Restricted cash
   
416,566
   
218,176
 
Goodwill
   
4,971,221
   
5,118,640
 
Intangible assets, net
   
4,919,216
   
4,861,012
 
Other assets
   
130,247
   
354,259
 
Total other assets
   
10,610,618
   
10,883,978
 
TOTAL ASSETS
 
$
25,969,005
 
$
34,385,779
 
 
LIABILITIES AND STOCKHOLDERS’ EQUITY
             
Current liabilities
             
Long-term debt, current portion
 
$
150,000
 
$
150,000
 
Capital lease/equipment financing obligations, current portion
   
939,920
   
1,419,965
 
Accounts payable and accrued expenses
   
10,898,771
   
9,269,341
 
Investment in Estel
   
600,011
   
771,182
 
Liabilities of discontinued operations
   
235,085
   
620,809
 
Total current liabilities
   
12,823,787
   
12,231,297
 
Long-term liabilities
             
Capital lease/equipment financing obligations, net of current portion
   
39,404
   
7,650
 
Other long-term liabilities
   
   
4,357,497
 
Total long-term liabilities
   
39,404
   
4,365,147
 
Commitments and contingencies
             
Minority interests
   
669
   
67,694
 
Stockholders’ equity
             
Common stock, $0.01 par value, 105,000,000 shares authorized, 26,971,465 and 11,114,962 shares issued, and
             
26,946,465 and 10,439,387 shares outstanding at September 30, 2006 and December 31, 2005, respectively
   
269,465
   
104,394
 
Common stock, Class A $0.01 par value, 21,000,000 shares authorized, 0 and 15,739,963 shares issued
             
and outstanding at September 30, 2006 and December 31, 2005, respectively
   
   
157,400
 
Capital in excess of par value
   
110,504,674
   
105,447,041
 
Accumulated deficit
   
(97,668,994
)
 
(87,987,194
)
Total stockholders’ equity
   
13,105,145
   
17,721,641
 
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY
 
$
25,969,005
 
$
34,385,779
 

See accompanying condensed notes to consolidated financial statements.
 
3


FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Consolidated Statements of Operations
 
     
Three months ended
   
Nine months ended
 
     
September 30,
   
September 30,
 
     
2006
   
2005
   
2006
   
2005
 
     
(unaudited)
   
(unaudited)
   
(unaudited)
   
(unaudited)
 
Revenues
 
$
11,728,524
 
$
9,123,742
 
$
31,793,793
 
$
40,312,685
 
Operating expenses:
                         
Cost of revenues, exclusive of depreciation and amortization shown separately below
   
10,635,840
   
8,280,078
   
28,623,555
   
36,981,492
 
Depreciation and amortization
   
386,702
   
358,669
   
864,544
   
1,228,080
 
Loss on impairment
   
147,419
   
   
147,419
   
 
Selling, general and administrative expenses (includes $134,311 and $633,976 non-cash
compensation for the three months and nine months ended September 30, 2006,
respectively)
   
3,630,624
   
2,767,564
   
11,245,347
   
8,369,906
 
Advertising and marketing
   
683,392
   
32,857
   
1,008,142
   
149,290
 
Total operating expenses
   
15,483,977
   
11,439,168
   
41,889,007
   
46,728,768
 
Operating loss
   
(3,755,453
)
 
(2,315,426
)
 
(10,095,214
)
 
(6,416,083
)
                           
Other income (expense)
                         
Interest income
   
58,694
   
139,733
   
294,272
   
322,603
 
Interest expense
   
(30,972
)
 
(32,457
)
 
(90,486
)
 
(399,750
)
Gain on settlements of debt
   
   
52,539
   
465,854
   
57,879
 
Loss from investment in Estel
   
(48,128
)
 
(192,566
)
 
(118,766
)
 
(492,026
)
Other
   
25,305
   
(10,731
)
 
63,616
   
(4,774
)
Minority interests
   
58,498
   
71,073
   
67,025
   
119,157
 
Total other income (expense)
   
63,397
   
27,591
   
681,515
   
(396,911
)
                           
Loss from continuing operations
   
(3,692,056
)
 
(2,287,835
)
 
(9,413,699
)
 
(6,812,994
)
Discontinued operations:
                         
Income (loss) from discontinued operations
   
(233,993
)
 
(53,305
)
 
(268,101
)
 
105,382
 
Net loss
 
$
(3,926,049
)
$
(2,341,140
)
$
(9,681,800
)
$
(6,707,612
)
Basic and diluted net loss per common share:
                         
Loss from continuing operations
 
$
(0.14
)
$
(0.09
)
$
(0.35
)
$
(0.28
)
Income (loss) from discontinued operations
   
(0.01
)
 
   
(0.01
)
 
0.01
 
Net loss per common share
 
$
(0.15
)
$
(0.09
)
$
(0.36
)
$
(0.27
)
Weighted average shares outstanding
                         
Basic and diluted
   
26,894,779
   
26,179,151
   
26,664,096
   
24,555,878
 
 
See accompanying condensed notes to consolidated financial statements.

4

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Consolidated Statements of Cash Flows
 
   
 Nine months ended September 30,
 
   
 2006
 
2005
 
   
 (unaudited)
 
(unaudited)
 
Cash flows from operating activities
          
Net loss
 
$
(9,681,800
)
$
(6,707,612
)
Adjustments to reconcile net loss to net cash used in operating activities:
             
Gain from sale of assets
   
(40,980
)
 
 
Depreciation and amortization
   
864,544
   
1,228,080
 
Loss on impairment - continuing operations
   
147,419
   
 
Loss on impairment - discontinued operations
   
211,426
   
 
Bad debt expense (recovery)
   
(60,250
)
 
226,000
 
Stock based compensation
   
633,976
   
 
Gain on forgiveness of debt
   
(465,854
)
 
(57,879
)
Gain on discontinued operations
   
   
(175,000
)
Accretion of Series C Preferred Stock
   
   
287,115
 
Loss from investment in Estel
   
118,766
   
492,026
 
Minority interests
   
(67,025
)
 
(119,156
)
Increase (decrease) in cash attributable to changes in operating assets and liabilities:
             
Accounts receivable
   
(1,319,173
)
 
425,471
 
Prepaid expenses and other current assets
   
173,735
   
339,831
 
Other assets
   
21,652
   
(275,181
)
Accounts payable and accrued expenses
   
1,511,396
   
(1,408,683
)
Liabilities of discontinued operations
   
(385,724
)
 
(158,371
)
Net cash used in operating activities
   
(8,337,892
)
 
(5,903,359
)
Cash flows from investing activities:
             
Purchase of property and equipment - continuing operations
   
(2,901,253
)
 
(1,524,835
)
Purchase of property and equipment - discontinued operations
   
   
(6,993
)
Advances to Estel
   
(58,696
)
 
(164,547
)
Payments from Estel
   
83,759
   
116,287
 
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
   
   
(92,971
)
Return of security deposits
   
158,523
   
156,136
 
Payments of restricted cash
   
(563,390
)
 
137,100
 
Payments for other intangible assets
   
(84,497
)
 
 
Net cash used in investing activities
   
(3,365,544
)
 
(2,006,864
)
Cash flows from financing activities
             
Proceeds from sale of common stock and redeemable common stock purchase warrants, net
   
   
23,884,533
 
Proceeds from exercise of stock options
   
   
50,250
 
Proceeds from exercise of warrants
   
500
   
85,144
 
Payment of dividends on Series C preferred stock
   
   
(664,634
)
Payments of long-term debt and capital lease/equipment financing obligations
   
(677,091
)
 
(2,286,706
)
Contributions to minority stockholders of joint ventures
   
   
(17,961
)
Net cash provided by (used in) financing activities
   
(676,591
)
 
21,050,626
 
Net increase (decrease) in cash and cash equivalents
   
(12,380,027
)
 
13,140,403
 
Cash and cash equivalents, beginning of period
   
14,790,504
   
4,368,726
 
Cash and cash equivalents, end of period
 
$
2,410,477
 
$
17,509,129
 

See accompanying condensed notes to consolidated financial statements.

5

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC.
AND SUBSIDIARIES

Consolidated Statements of Cash Flows (continued)
 
   
Nine months ended September 30,
 
   
 2006
 
 2005
 
     
(unaudited)
   
(unaudited)
 
Supplemental disclosure of cash flow information:
             
Cash paid during the period for interest
 
$
47,121
 
$
608,839
 
Supplemental disclosure of non-cash investing and financing activities:
             
Acquisition of capital leases /equipment financing obligations
 
$
228,800
 
$
737,425
 
Acquisition of short term financing agreement
 
$
553,888
 
$
 
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
 
Release of Efonica shares from escrow
 
$
4,357,497
 
$
 
Issuance of restricted stock for consulting services
 
$
66,250
 
$
50,000
 
Issuance of Common Stock for attainment of certain earn outs in Intellectual
Property Transfer Agreement
 
$
90,000
 
$
 
Liability for acquisition of Intellectual Property Transfer Agreement
 
$
30,000
 
$
 
Supplemental disclosure of joint venture acquisition activities:
             
Fair value of tangible assets, net of cash acquired
 
$
 
$
654,791
 
Fair value of identifiable intangible assets
   
   
4,877,900
 
Goodwill acquired
   
   
761,143
 
Liabilities acquired
   
   
(401,504
)
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
 
$
 
$
720,012
 
 
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 condensed notes to consolidated financial statements should be read in conjunction with the 2005 Form 10-K for Fusion Telecommunications International, Inc. and its Subsidiaries (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 a true indication of the results for the year.

During the nine months ended September 30, 2006 and 2005, comprehensive loss was equal to the net loss amounts presented for the respective periods in the accompanying Consolidated Statements of Operations.

Advertising and Marketing

Advertising and marketing costs primarily relate to the Company’s on-line Efonica advertising campaign. In connection with this campaign, the costs of production are expensed as incurred. The costs of communicating this advertising are expensed when received by the on-line consumer (i.e., consumer receives a link to the Efonica website as a result of a search engine keyword search). The Company’s costs also include newspaper ads for its Efonica retail services, product press releases, and exhibitions the Company attends to promote these retail services.

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 earnings available to common stockholders by the weighted-average number of common shares outstanding during the period. Diluted earnings 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 earnings of the Company.

Unexercised stock options to purchase 2,791,479 and 1,602,426 shares of the Company’s common stock as of September 30, 2006 and 2005, 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 7,788,505 and 7,436,172 shares of the Company’s common stock as of September 30, 2006 and 2005, 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.

Stock-based Compensation

On January 1, 2006, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (SFAS No. 123R”), that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for either equity instruments of the enterprise or liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. SFAS No. 123R eliminates the ability to account for share-based compensation transactions, as the Company formerly did, using the intrinsic value method as prescribed by Accounting Principles Board (APB”), Opinion No. 25, “Accounting for Stock Issued to Employees,” and generally requires that such transactions be accounted for using a fair-value-based method and recognized as an expense in the Company’s Consolidated Statements of Operations.

The Company adopted SFAS No. 123R using the modified prospective method, which required the application of the accounting standard as of January 1, 2006. The Company’s consolidated financial statements as of September 30, 2006, and for the three and nine months ended September 30, 2006, reflect the impact of adopting SFAS No. 123R. In accordance with the modified prospective method, the consolidated financial statements for prior periods have not been restated to reflect, and do not include, the impact of SFAS No. 123R.
 
7

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. Basis of Presentation (continued)

Stock-Based compensation expense recognized during the period is based on the value of the portion of stock-based payment awards that is ultimately expected to vest. Stock-based compensation expense recognized in the Consolidated Statements of Operations during the three and nine months ended September 30, 2006, includes compensation expense for stock-based payment awards granted prior to, but not yet vested, as of December 31, 2005, based on the grant date fair value estimated in accordance with SFAS No. 123R. As stock-based compensation expense recognized in the Consolidated Statement of Operations for the three and nine months ended September 30, 2006, is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. SFAS No. 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. When estimating forfeitures, the Company considered termination behaviors as well as trends for actual option forfeiture. In the pro forma information required under SFAS No. 148 (“Accounting for Stock-Based Compensation - Transition and Disclosure - an amendment of FASB Statement No. 123”) for the periods prior to 2006, the Company accounted for forfeitures as they occurred.

The Company has recognized compensation expense based on the estimated grant date fair value method using the Black-Scholes valuation model. For these awards, the Company has recognized compensation expense using a straight-line amortization method. The impact on the Company’s results of operations of recording employee stock-based compensation for the three and nine months ended September 30, 2006, was an expense of $101,186 and $534,404, respectively, which is included in selling, general and administrative expenses in the Consolidated Statements of Operations.

The following table illustrates the effect on the net loss and loss per share as if the Company had applied the fair value recognition provisions of SFAS No. 123R for the three and nine months ended September 30, 2005.

   
For the Three Months Ended
September 30, 2005
 
 For the Nine Months Ended
September 30, 2005
 
            
Net loss applicable to common stockholders, as reported
 
$
(2,341,140
)
$
(6,707,612
)
Deduct: total stock-based compensation expense under fair value method
for awards, net of related tax effect
   
(162,122
)
 
(446,186
)
 
Net loss applicable to common stockholders, pro forma
 
$
(2,503,262
)
$
(7,153,798
)
Loss per share:
             
Basic and diluted loss, as reported
 
$
(0.09
)
$
(0.27
)
Basic and diluted loss, pro forma
 
$
(0.10
)
$
(0.29
)

Use of Estimates

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America 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 consolidated financial statements and the reported amounts of revenues and expenses during the period. Actual results could differ from those estimates.

Reclassifications

Certain reclassifications have been made to the 2005 amounts to conform to the 2006 presentation.
 
8

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
2. Going Concern
 
At September 30, 2006, the Company had a working capital deficit of $4,683,300 and an accumulated deficit of $97,668,994. The Company has continued to sustain losses from operations, and for the nine months ended September 30, 2006 and 2005 has incurred a net loss of $9,681,800 and $6,707,612, respectively. In addition, the Company has not generated positive cash flow from operations since inception. The Company is reviewing options to raise additional capital through debt and/or equity financing. While management believes that its current cash resources should be adequate to fund its operations for the remainder of the year, the Company’s long-term liquidity is dependent on its ability to successfully complete the rollout of its full suite of retail VoIP paid services and effectively market its paid services, in order to attain profitable operations in the future. The Company cannot make any guarantees if and when it will be able to attain profitability. These factors, among others, indicate that the Company may be unable to continue operations as a going concern. No adjustment has been made in the consolidated financial statements to the amounts and classification of assets and liabilities which could result, should the Company be unable to continue as a going concern.
 
3. Acquisitions and Joint Ventures

Pakistan

In July 2002, the Company acquired a 75% equity interest in a joint venture with Turner Hill Investments, L.P. (“Turner Hill”) to provide VoIP services for calls terminating in Pakistan by the Pakistan Telecommunications Company Limited (“PTCL”). Turner Hill subsequently assigned its interest to Braddon Corporate Holdings Limited (“Braddon”).

As of December 31, 2005, a rolling advance of $415,500 was owed to the Company by PTCL. During February 2006, PTCL returned $389,000 of the rolling advance, which was reflected in prepaid expenses and other current assets in the December 31, 2005 Consolidated Balance Sheet. The remaining rolling advance balance of $26,500 is currently being disputed (reflected in security deposits in the September 30, 2006 Balance Sheet) along with a $58,960 receivable balance from PTCL (reflected in prepaids and other current assets in the September 30, 2006 Balance Sheet).

Turkey

During the quarter ended September 30, 2006, the Company decided to begin winding up and liquidating its Turkey joint venture. This decision was a result of various challenges the Company encountered from an increasingly complicated and constantly changing regulatory environment in Turkey, which made it very difficult to enter the market. These regulatory difficulties included an unstable environment as well as the selling of Turk-Telecom, which was a government owned entity, to a private company. As a result of this decision, the operations of this subsidiary are being treated as a discontinued operation. See Note 5 for further discussion.

Jamaica

As the Company’s business plan for its Jamaican joint venture evolved, the Company found a business partner who is willing to purchase the subsidiary’s switching equipment and accept assignment of the leased premises. Although there is no guarantee the agreement will close, an agreement has been executed, whereby the Company will receive $425,000. Under this agreement, the Company will retain the license, as it hopes to enter into a business relationship with the entity acquiring the assets or other entities. The fixed assets being sold in this agreement, as of September 30, 2006, are reflected as Assets Held for Sale in the Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005. Although, the Company intends to do business in Jamaica in the future, the Company reviewed the $147,419 of recorded goodwill for impairment, and determined it was impaired as a result of the changes in the Company’s business plan, and consequently wrote off this goodwill during the quarter ended September 30, 2006.

iFreedom

On November 14, 2005, the Company entered into an agreement to acquire the assets of iFreedom Communications International Holdings Limited and a number of its subsidiaries, (“iFreedom”), an entity that markets monthly recurring international VoIP service plans geared to meet the needs of consumers and businesses in emerging markets. The agreement provided for a purchase price of $500,000 in cash, and 1,100,000 shares of restricted common stock, of which 750,000 shares were to be held in escrow and were subject to a performance based earn out. Under the terms of the agreement, the Company would have acquired iFreedom’s customer base as well as operations in Hong Kong, the Philippines, Malaysia, the United Kingdom, and the United States. As certain closing conditions were not met by iFreedom, the parties tried to work in good faith to renegotiate the terms and conditions of the transaction, but were not successful. The Company no longer intends to pursue this transaction.
 
9


FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS


3. Acquisitions and Joint Ventures (continued)

Until early August 2006, the Company had been providing termination services to iFreedom, which have aggregated outstanding charges of approximately $594,108 as of September 30, 2006. iFreedom has entered into a non interest-bearing Note with respect to these charges. iFreedom has executed a secured promissory note evidencing and securing their indebtedness to the Company, and has started repaying the balance due to the Company for the termination services the Company has provided to iFreedom.

4. Prepaid expenses and other current assets

Prepaid expenses and other current assets consist of the following at September 30, 2006 and December 31, 2005.

   
September 30, 2006
 
December 31, 2005
 
   
(unaudited)
      
            
Prepaid expenses
 
$
542,352
 
$
425,832
 
Prepaid insurance
   
117,624
   
105,884
 
Prepaid advertising/marketing
   
171,191
   
 
Due from PTCL
   
58,960
   
447,505
 
Other current assets
   
199,235
   
263,045
 
   
$
1,089,362
 
$
1,242,266
 

5. Discontinued operations

Prior to 2006, the Company’s discontinued operations related to Management’s decision in 2001 to cease the operations of its domestic retail telecommunication services business lines. The Company continues its efforts to settle certain of these remaining liabilities. As a result of these efforts, the Company recognized a gain of $175,000 during the nine months ended September 30, 2005. The remaining liability at December 31, 2005, of approximately $621,000, is related to trade payables and accrued expenses associated with the discontinued retail telecommunications services. During the nine months ended September 30, 2006, the Company paid approximately $386,000 of these outstanding liabilities.

As discussed in Note 3, the Company decided in the quarter ended September 30, 2006, to dissolve its subsidiary in Turkey. The dissolution and liquidation should be completed during the fourth quarter. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, the Company has classified the operating results of its Turkey joint venture as a discontinued operation in the accompanying Consolidated Financial Statements. All prior periods have been reclassified to conform to the current year presentation. These discontinued operations affect only the Company’s VoIP to Consumers and Corporations segment. The following is a summary of the operating results of the discontinued operations.

   
Three months ended
 
Nine months ended
 
   
September 30,
 
September 30,
 
   
2006
 
2005
 
2006
 
2005
 
   
(unaudited)
 
(unaudited)
 
(unaudited)
 
(unaudited)
 
                   
Depreciation and amortization
 
$
350
  $
 
$
1,049
  $
 
Loss on impairment
   
211,426
   
   
211,426
   
 
Selling, general and administrative expenses
   
22,217
   
49,181
   
55,626
   
65,494
 
Advertising and marketing
   
   
4,464
   
   
4,464
 
Other
   
   
(340
)
 
   
(340
)
Gain on settlement of debt
   
   
   
   
(175,000
)
(Income) loss from discontinued operations
 
$
233,993
  $
53,305
 
$
268,101
  $
(105,382
)
 
10

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

6. Accounts payable and accrued expenses

Accounts payable and accrued expenses consist of the following at September 30, 2006 and December 31, 2005:

   
September 30, 2006
 
December 31, 2005
 
   
(unaudited)
      
            
Trade accounts payable
 
$
7,007,808
 
$
6,134,373
 
Accrued expenses
   
2,608,257
   
1,892,216
 
Interest payable
   
378,234
   
334,869
 
Deferred revenue
   
351,037
   
810,837
 
Short-term financing agreement
   
404,407
   
 
Other
   
149,028
   
97,046
 
   
$
10,898,771
 
$
9,269,341
 

During the nine months ended September 30, 2006, the Company entered into a short-term financing agreement for $553,888 to purchase certain hardware, software and software support from an equipment vendor. The payments are due on a monthly basis over a 9-month period. The vendor is charging a 7% finance charge for the $241,000 hardware portion of the purchase.

7. Long-term debt and capital lease/equipment financing obligations

At September 30, 2006, and December 31, 2005, components of long-term debt and capital lease/equipment financing obligations of the Company are comprised of the following:

   
September 30, 2006
 
December 31, 2005
 
   
(unaudited)
      
            
Promissory notes payable
 
$
150,000
 
$
150,000
 
Capital lease/equipment financing obligations
   
979,325
   
1,427,615
 
Total long-term debt and capital lease/equipment financing obligations
   
1,129,325
   
1,577,615
 
Less current portion
   
(1,089,921
)
 
(1,569,965
)
   
$
39,404
 
$
7,650
 

 Promissory note payable

During February 2004, the Company entered into a settlement agreement for $600,000. In the same month, the Company paid $450,000 and executed a promissory note wherein the Company agreed to make 12 monthly payments for the remaining $150,000. The promissory note has not been repaid as of September 30, 2006, as the other party in the settlement agreement has not complied with the terms of the agreement.

Capital lease/equipment financing obligations

The Company entered into several financing agreements for equipment purchases during 2005 and prior. The Company has imputed an interest rate of 10.0% related to these agreements, which are payable every 90 days over a 12-18 month period.

During the nine months ended September 30, 2006, the Company entered into a capital lease agreement for $228,800 (balance is approximately $153,000 at September 30, 2006). The interest rate is 7.3% and payments are due every 90 days over a 16-month period.

At September 30, 2006 and December 31, 2005, approximately $720,000 of the capital lease obligations was in default and accordingly has been classified as currently due. See Legal Matters section of Note 11 for further discussion.

Future aggregate principal payments for the Company’s debt and capital lease/equipment financing obligations as of September 30, 2006 are as follows:

Total minimum payments due during the period ending September 30, 2007
 
$
1,507,435
 
Less amount representing interest
   
(378,111
)
Present value of minimum payments
   
1,129,324
 
Less current portion
   
(1,089,920
)
   
$
39,404
 
 
11

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

8. Equity Transactions

On February 17, 2005, the Company closed its initial public offering 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 had two classes of outstanding common stock. The holders of the Class A Common Stock had identical rights and privileges to the regular common stock, except that they were able to transfer shares of Class A Common Stock until February 11, 2006. On that date, the 15,739,963 shares of outstanding Class A Common Stock were automatically converted into shares of common stock.

Upon completion of the IPO, convertible debt with a balance of $2,508,333 was converted into 651,515 shares of common stock. In addition, 1,439,643 shares of common stock were issued in connection with the Company’s acquisition of the 49.8% minority interest in Efonica. In addition, all outstanding Series C preferred stock was converted into common stock.

During March 2006, 14,286 shares of common stock were issued upon the exercise of a warrant to purchase the shares at a price of $0.035 per share.

On March 28, 2006, the Company entered into a consulting service agreement. In connection with the agreement, the Company issued 50,000 shares of restricted common stock. Of these shares, 25,000 shares were given to the consultant upon the signing of the agreement. The other 25,000 shares are being held in escrow until the sixth (6th) month anniversary, at which time 12,500 shares will be released. The remaining 12,500 shares will be released upon the ninth (9th) month anniversary, unless the agreement has been terminated, pursuant to the Company’s right to terminate. The $66,250 expense associated with the 25,000 shares given to the consultant was amortized over the six-month term. The Company has continued to use this consultant after the sixth (6th) month anniversary and, consequently, released the (1st) 12,500 shares subsequent to September 30, 2006.

9. Gain on settlements of debt

During December 2003, the Company entered into a debt settlement agreement with a domestic carrier. The provisions of the agreement provided that $555,000 due to the carrier would be resolved with a service agreement whereby the carrier received a reduced rate for certain minutes of traffic that passed through the Company’s network through December 2005. The Company and the carrier continued to comply with the terms of this agreement until it was settled as discussed below. Since the settlement agreement was entered into, approximately $89,000 of deferred revenue was recognized in connection with this service agreement.

During June 2006, the service agreement was cancelled and the carrier released the Company of all remaining indebtedness under the December 2003 settlement agreement. Consequently, the remaining deferred revenue balance of approximately $466,000 was recorded as a gain on settlement of debt.

10. New Accounting Pronouncements

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140,” which simplifies accounting for certain hybrid financial instruments by permitting fair value re-measurement for any hybrid instrument that contains an embedded derivative that otherwise would require bifurcation and eliminates a restriction on the passive derivative instruments that a qualifying special-purpose entity may hold. SFAS No. 155 is effective for all financial instruments acquired, issued or subject to a re-measurement (new basis) event occurring after the beginning of an entity’s first fiscal year that begins after September 15, 2006. The adoption of SFAS No. 155 is not expected to have an impact on the Company’s results of operations or financial position.

In March 2006, the FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets - an amendment of FASB Statement No. 140,” which establishes, among other things, the accounting for all separately recognized servicing assets and servicing liabilities by requiring that all separately recognized servicing assets and servicing liabilities be initially measured at fair value, if practicable. SFAS No. 156 is effective as of the beginning of an entity’s first fiscal year that begins after September 15, 2006. The adoption of SFAS No. 156 is not expected to have an impact on the Company’s results of operations or financial position.
 
12


FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

10. New Accounting Pronouncements (continued)

In June 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (“FIN No. 48”). FIN No. 48 clarifies the accounting for uncertainty in income taxes recognized in the financial statements in accordance with SFAS No. 109, “Accounting for Income Taxes.” The interpretation is effective for fiscal years beginning after December 15, 2006. The Company does not expect the adoption of this FIN will have a material impact on its financial statements.

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB No. 108”). SAB No. 108 clarifies the SEC staff’s beliefs regarding the process of quantifying financial statement misstatements and is effective for fiscal years ending after November 15, 2006. The Company does not expect SAB No. 108 to have a material impact on its financial statements.

In September 2006, the FASB issued SFAS No. 157 “Fair Value Measurements”, which establishes a framework for measuring fair value and requires expended disclosure about the information used to measure fair value. The statement applies whenever other statements require, or permit, assets or liabilities to be used to measure fair value. The statement does not expand the use of fair value in any new circumstances and is effective for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years, with early adoption encouraged. The Company does not expect the adoption of this statement to have a material impact on its financial condition or results of operations.

11. Commitments and contingencies 

Legal Matters 

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 against us: 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 Company was awarded attorneys’ fees by the court. The plaintiffs have filed an appeal of the motion, which is still pending as of the date of this filing.
 
On March 30, 2006, an equipment vendor filed a complaint with the Circuit Court in Broward County, State of Florida seeking damages in the amount of $1,379,502 allegedly due on two promissory notes plus accrued interest through March 1, 2006 and attorney costs. Management asserted a counterclaim against the vendor and an affiliated company and is vigorously prosecuting the counterclaim. The Company’s legal counsel has advised that, at this stage, they cannot accurately predict the likelihood of an unfavorable outcome or quantify the amount or range of potential loss, if any. Accordingly, with the exception of amounts previously accrued by the Company under the capital lease arrangement, no adjustment that may result from resolution of these uncertainties has been made in the Company’s accompanying financial statements.

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 Company’s operations or financial condition.

Letters of Credit

In connection with the Company’s relocation of its New York office during April 2006, the lease amendment required the Company to provide a Letter of Credit in favor of the landlord in the amount of approximately $428,000. The Letter of Credit was obtained in January 2006, and is secured by $239,000 in money market funds. The Company also received an $189,000 line of credit that would be drawn down, should the Company default on the lease terms.

During July 2006, in connection with the Company’s 75% owned subsidiary in Turkey, the Company provided a Letter of Credit for 250,000 Euros (approximately $0.3 million) to the Telekomunikasyon Kurumu Telecommunication Administrator. This Letter of Credit is to secure a license to do business as a long distance telecommunication services company in Turkey. The guarantee is effective until January 1, 2007. Since the Company has since discontinued these operations in Turkey (See Note 3), it is in the process of requesting authorization to cancel this Letter of Credit and secure the return of the funds.

Intellectual Property Transfer Agreement

On February 15, 2006, the Company entered into an Intellectual Property Transfer Agreement with Xtreme VoIP Corp. (“Xtreme”) pursuant to which the Company purchased a software application and other intellectual property rights (the “Intellectual Property”) relating to a VoIP software solution that will allow Directed Peer-to-Peer Internet phone connections between SIP-enabled devices without the need to route the calls through a network of third-party computers, as typically occurs in a peer-to-peer environment.
 
13

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

11. Commitments and contingencies  (continued)

The purchase price of the Intellectual Property is $600,000, of which $60,000 has been paid in cash. An additional $90,000 was paid with the issuance of 52,254 shares of common stock, as a result of certain earn outs having been met during the quarter ended September 30, 2006. An additional $30,000 will be paid when the final earn out threshold is met. However, the $30,000 is recorded as a liability as of September 30, 2006, since the contract requires a minimum payment of $180,000. On the second anniversary of this agreement, the Company has the option of (i) reverting the agreement and the Intellectual Property back to Xtreme, while retaining a perpetual non-exclusive, paid-up, royalty free license to utilize and sub-license the Intellectual Property, or (ii) keeping the Intellectual Property and complying with the terms of the agreement, which provides for final payment of the balance due by the fourth anniversary. In the event that the Company does not revert the assets, and licenses the Intellectual Property as a product to third parties, but not a sale of the Intellectual Property in its entirety, until the sixth (6th) anniversary of this agreement, Xtreme will be entitled to receive a royalty equal to 20% of software sales sold by the Company. Any royalties paid to Xtreme or gains in the market value of stock received by Xtreme based on the last closing price of an aggregate of 30 days during the four year period when Xtreme is free to sell such shares with the highest market value, shall be applied to the remaining consideration. In the event that the assets revert back to Xtreme and in the event that the Company sub-licenses the Intellectual Property as a product to third parties, Xtreme will be entitled to a royalty equal to 50% of the software sales.

During April 2006, the Company filed a patent application with the United States Patent and Trademark Office for this technology.

12. Segment information

The Company operates and manages three reportable segments, 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 Makers.

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

Voice to Carriers — Voice to Carriers includes VoIP to Carriers, which is the termination of voice telephony minutes by the Internet rather than the circuit-switched technology. VoIP permits a less costly and more rapid interconnection between the Company and international telecommunications carriers. This segment also includes traditional voice (the termination of voice telephony minutes from or to the countries served by the Company utilizing Time Division Multiplexing (TDM) and “circuit-switched” technology). Typically, this segment will include interconnection with traditional telecommunications carriers either located internationally, or those carriers that interconnect with the Company at its U.S. Points of Presence (POP) and provide service to international destinations. These minutes are sold to carriers on a wholesale basis.

VoIP to Consumers and Corporations — The Company provides VoIP services targeted to end-users and corporations, primarily through its Efonica brand. 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 U.S. and India, and through its partners elsewhere.
 
14


FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

12. Segment information (continued)

Operating segment information for the three months ended September 30, 2006 and 2005 is summarized as follows:

Three months ended September 30, 2006
 
Voice to Carriers
 
VoIP to Consumers and Corporations
 
Internet, Managed Private Networks & Other
 
Corporate & Unallocated
 
Consolidated
 
                       
Net revenues
 
$
10,942,103
 
$
435,734
 
$
350,687
 
$
 
$
11,728,524
 
Cost of revenues (exclusive of depreciation and amortization)
 
$
(10,053,527
)
$
(462,880
)
$
(119,433
)
$
 
$
(10,635,840
)
Depreciation and amortization
 
$
(207,555
)
$
(147,971
)
$
(5,666
)
$
(25,510
)
$
(386,702
)
Loss on impairment
 
$
 
$
 
$
 
$
(147,419
)
$
(147,419
)
Selling, general and administrative
 
$
(1,371,486
)
$
(1,041,021
)
$
(31,407
)
$
(1,186,710
)
$
(3,630,624
)
Advertising and marketing
 
$
 
$
(683,392
)
$
 
$
 
$
(683,392
)
Other income (expense)
 
$
(22,856
)
$
32,027
 
$
(4,085
)
$
58,311
 
$
63,397
 
Income (loss) from continuing operations
 
$
(713,321
)
$
(1,867,503
)
$
190,096
 
$
(1,301,328
)
$
(3,692,056
)
Income (loss) from discontinued operations
 
$
 
$
 
$
 
$
(233,993
)
$
(233,993
)
Net income (loss)
 
$
(713,321
)
$
(1,867,503
)
$
190,096
 
$
(1.535,321
)
$
(3,926,049
)
Capital Expenditures
 
$
 
$
217,781
 
$
 
$
90,987
 
$
308,768
 
 
Three months ended September 30, 2005
 
 Voice to Carriers
 
 VoIP to Consumers and Corporations
 
 Internet, Managed Private Networks & Other
 
 Corporate & Unallocated
 
 Consolidated
 
                                 
Net revenues
 
$
7,855,850
 
$
813,365
 
$
454,527
 
$
 
$
9,123,742
 
Cost of revenues (exclusive of depreciation and amortization)
 
$
(7,442,721
)
$
(572,973
)
$
(264,384
)
$
 
$
(8,280,078
)
Depreciation and amortization
 
$
(295,560
)
$
(17,379
)
$
(14,427
)
$
(31,303
)
$
(358,669
)
Selling, general and administrative
 
$
(1,104,801
)
$
(473,267
)
$
(148,786
)
$
(1,040,710
)
$
(2,767,564
)
Advertising and marketing
  $    
$
  $     
$
(32,857
)
$
(32,857
)
Other income (expense)
 
$
(58,031
)
$
(5,410
)
$
(4,289
)
$
95,321
 
$
27,591
 
Income (loss) from continuing operations
 
$
(1,045,263
)
$
(255,664
)
$
22,641
 
$
(1,009,549
)
$
(2,287,835
)
Income (loss) from discontinued operations
 
$
 
$
 
$
 
$
(53,305
)
$
(53,305
)
Net income (loss)
 
$
(1,045,263
)
$
(255,664
)
$
22,641
 
$
(1,062,854
)
$
(2,341,140
)
Capital Expenditures
 
$
365,606
 
$
35,396
 
$
19,301
 
$
46,700
 
$
467,003
 
 
15

 
FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

12. Segment information (continued)

Operating segment information for the nine months ended September 30, 2006 and 2005, is summarized as follows:

Nine months ended September 30, 2006
 
Voice to Carriers
 
VoIP to Consumers and Corporations
 
Internet, Managed Private Networks & Other
 
Corporate & Unallocated
 
Consolidated
 
                       
Net revenues
 
$
28,835,850
 
$
1,766,776
 
$
1,191,167
 
$
 
$
31,793,793
 
Cost of revenues (exclusive of depreciation and amortization)
 
$
(26,594,300
)
$
(1,484,338
)
$
(544,917
)
$
 
$
(28,623,555
)
Depreciation and amortization
 
$
(592,817
)
$
(177,846
)
$
(23,453
)
$
(70,428
)
$
(864,544
)
Loss on impairment
 
$
 
$
 
$
 
$
(147,419
)
$
(147,419
)
Selling, general and administrative
 
$
(4,252,905
)
$
(2,128,898
)
$
(194,488
)
$
(4,669,056
)
$
(11,245,347
)
Advertising and marketing
 
$
(13,500
)
$
(994,642
)
$
 
$
 
$
(1,008,142
)
Other income
 
$
558,838
 
$
33,851
 
$
22,772
 
$
66,054
 
$
681,515
 
Income (loss) from continuing operations
 
$
(2,058,834
)
$
(2,985,097
)
$
451,081
 
$
(4,820,849
)
$
(9,413,699
)
Income (loss) from discontinued operations
 
$
 
$
 
$
 
$
(268,101
)
$
(268,101
)
Net income (loss)
 
$
(2,058,834
)
$
(2,985,097
)
$
451,081
 
$
(5,088,950
)
$
(9,681,800
)
Capital Expenditures
 
$
140,602
 
$
1,694,669
 
$
 
$
1,065,972
 
$
2,901,243
 

Nine months ended September 30, 2005
 
Voice to Carriers
 
VoIP to Consumers and Corporations
 
Internet, Managed Private Networks & Other
 
Corporate & Unallocated
 
Consolidated
 
                       
Net revenues
 
$
35,779,479
 
$
2,996,626
 
$
1,536,580
 
$
 
$
40,312,685
 
Cost of revenues (exclusive of depreciation and amortization)
 
$
(33,858,805
)
$
(2,225,558
)
$
(897,129
)
$
 
$
(36,981,492
)
Depreciation and amortization
 
$
(1,034,788
)
$
(41,605
)
$
(41,609
)
$
(110,078
)
$
(1,228,080
)
Selling, general and administrative
 
$
(3,937,588
)
$
(1,127,333
)
$
(432,980
)
$
(2,872,005
)
$
(8,369,906
)
Advertising and marketing
  $     
$
  $    
$
(149,290
)
$
(149,290
)
Other income (expense)
 
$
(473,955
)
$
(20,346
)
$
(21,587
)
$
118,977
 
$
(396,911
)
Income (loss) from continuing operations
 
$
(3,525,657
)
$
(418,216
)
$
143,275
 
$
(3,012,396
)
$
(6,812,994
)
Income (loss) from discontinued operations
 
$
175,000
 
$
 
$
 
$
(69,618
)
$
105,382
 
Net income (loss)
 
$
(3,350,657
)
$
(418,216
)
$
143,275
 
$
(3,082,014
)
$
(6,707,612
)
Capital Expenditures
 
$
1,223,615
 
$
102,481
 
$
52,549
 
$
153,183
 
$
1,531,828
 

16


FUSION TELECOMMUNICATIONS INTERNATIONAL, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

12. Segment information (continued)

   
Voice to Carriers
 
VoIP to Consumers and Corporations
 
Internet, Managed Private Networks & Other
 
Corporate & Unallocated
 
Consolidated
 
Assets
                     
September 30, 2006
 
$
8,061,771
 
$
14,640,613
 
$
293,639
 
$
2,972,982
 
$
25,969,005
 
December 31, 2005
 
$
7,516,881
 
$
10,453,247
 
$
322,176
 
$
16,093,475
 
$
34,385,779
 

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 & Unallocated represent those expenses that were not appropriate to allocate to each product line.
 
17


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 notes thereto included in another part of this Quarterly Report. This discussion contains certain forward-looking statements; within the meaning of the Private Securities Litigation Reform Act of 1995, 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. The forward looking statements are made as of the date of this Quarterly Report on Form 10-Q and we do not undertake to update the forward looking statements or to update the reasons that actual results could differ from those projected in the forward looking statements.

Overview

We are an international communications carrier delivering VoIP services to, from, in and between emerging markets in Asia, the Middle East, Africa, Latin America, and the Caribbean. We also offer on a limited basis, private networks, Internet access, and other advanced services. Our corporate strategy focuses our resources on customizing VoIP services to meet the demands of international communities of interest in emerging markets around the world including use of the worldwide Internet area code ™ we developed, which provides a simple and universal method for our customers to retain existing calling patters and place calls by simply adding “10” to the beginning of existing landline or mobile telephone numbers. We seek to gain early entry in high growth emerging markets, often in partnership with local organizations that have strong distribution channels, regulatory experience, and market intelligence. Additionally, we have worked over the last 18 months to build a carrier grade retail infrastructure to expand our VoIP service and feature options and to better support the growth of our VoIP services to consumers and corporations. We recently put into production the first phase of our retail infrastructure. As this retail usage terminates over our voice to carrier infrastructure, we are better able to recognize beneficial synergies, such as improved utilization of our available capacity.

The following table summarizes our results of operations for the periods indicated:
 
   
Three Months
Ended September 30,
 
Nine Months
Ended September 30,
 
   
2006
 
2005
 
2006
 
 2005
 
Revenues
 
$
11,728,524
 
$
9,123,742
 
$ 
31,793,793
 
$
40,312,685
 
Operating expenses:
                         
Cost of revenues
   
10,635,840
   
8,280,078
   
28,623,555
   
36,981,492
 
Depreciation and amortization
   
386,702
   
358,669
   
864,544
   
1,228,080
 
Loss on impairment
   
147,419
   
   
147,419
   
 
Selling, general and administrative
   
3,630,624
   
2,767,564
   
11,245,347
   
8,369,906
 
Advertising and marketing
   
683,392
   
32,857
   
1,008,142
   
149,290
 
Total operating expenses
   
15,483,977
   
11,439,168
   
41,889,007
   
46,728,768
 
Operating Loss
   
(3,755,453
)
 
(2,315,426
)
 
(10,095,214
)
 
(6,416,083
)
                           
Other income (expense):
                         
Interest income
   
58,694
   
139,733
   
294,272
   
322,603
 
Interest expense
   
(30,972
)
 
(32,457
)
 
(90,486
)
 
(399,750
)
Gain on settlements of debt
   
   
52,539
   
465,854
   
57,879
 
Loss from investment in Estel
   
(48,128
)
 
(192,566
)
 
(118,766
)
 
(492,026
)
Other
   
25,305
   
(10,731
)
 
63,616
   
(4,774
)
Minority interests
   
58,498
   
71,073
   
67,025
   
119,157
 
Total other income (expense)
   
63,397
   
27,591
   
681,515
   
(396,911
)
                           
Loss from continuing operations
   
(3,692,056
)
 
(2,287,835
)
 
(9,413,699
)
 
(6,812,994
)
Discontinued operations:
                         
Income (loss) from discontinued operations
   
(233,993
)
 
(53,305
)
 
(268,101
)
 
105,382
 
Net loss
 
$
(3,926,049
)
$
(2,341,140
)
$ 
(9,681,800
)
$
(6,707,612
)
 
18

 
The following table presents our historical operating results as a percentage of revenues for the periods indicated:
 
   
Three Months
Ended September 30,
 
Nine Months
Ended September 30,
 
   
2006
 
2005
 
2006
 
 2005
 
Revenues
   
100.0
%
 
100.0
%
 
100.0
%
 
100.0
%
Operating expenses:
                         
Cost of revenues
   
90.7
%
 
90.8
%
 
90.0
%
 
91.7
%
Depreciation and amortization
   
3.2
%
 
3.9
%
 
2.7
%
 
3.0
%
Loss on impairment
   
1.3
%
 
0.0
%
 
0.5
%
 
0.0
%
Selling, general and administrative
   
31.0
%
 
30.3
%
 
35.4
%
 
20.8
%
Advertising and marketing
   
5.8
%
 
0.4
%
 
3.2
%
 
0.4
%
Total operating expenses
   
(132.0
%)
 
(125.4
%)
 
(131.8
%)
 
(115.9
%)
Operating Loss
   
(32.0
%)
 
(25.4
%)
 
(31.8
%)
 
(15.9
%)
                           
Other income (expense):
                         
Interest income
   
0.5
%
 
1.5
%
 
0.9
%
 
0.8
%
Interest expense
   
(0.3
%)
 
(0.4
%)
 
(0.3
%)
 
(1.0
%)
Gain on settlements of debt
   
0.0
%
 
0.6
%
 
1.5
%
 
0.1
%
Loss from investment in Estel
   
(0.4
%)
 
(2.1
%)
 
(0.4
%)
 
(1.2
%)
Other
   
0.2
%
 
(0.1
%)
 
0.2
%
 
0.0
%
Minority interests
   
0.5
%
 
0.8
%
 
0.2
%
 
0.3
%
Total other income (expense)
   
0.5
%
 
0.3
%
 
2.1
%
 
(1.0
%)
                           
Loss from continuing operations
   
(31.5
%)
 
(25.1
%)
 
(29.7
%)
 
(16.9
%)
Discontinued operations:                          
Income (loss) from discontinued operations
   
(2.0
%)
 
(0.6
%)
 
(0.8
%)
 
0.3
%
Net loss
   
(33.5
%)
 
(25.7
%)
 
(30.5
%)
 
(16.6
%)

Revenues
 
Historically, we have generated the majority of our revenues from voice traffic sold to other carriers, with a primary focus in the last several years on VoIP termination to emerging markets. We have focused on growing our existing customer base, which is primarily U.S. based, as well as adding new customers, and establishing direct VoIP terminating arrangements with telecommunication carriers in emerging markets around the world. Although we believe that this business continues to be of value to our strategy, ongoing competitive and pricing pressures have caused us to increase our focus on higher margin, value-added services (primarily VoIP to consumers and businesses), and to market these services to, or in conjunction with, distribution partners on a direct, co-branded or private label basis.

In an effort to further increase margins, expand our retail customer base, and develop more stable revenue streams, we have begun to focus significant effort and resources on building our VoIP business to consumers and corporations. While this does not yet represent a significant portion of our revenue base, we are increasing our emphasis in this area. We believe that this will complement our carrier business with a higher margin and more stable base of retail customers.
 
In 2002, we acquired a 50.2% equity interest in a joint venture with Karamco, Inc., and established Efonica F-Z, LLC, as a retail services company marketing VoIP services 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. In February 2005, we closed on the purchase of the 49.8% minority interest in Efonica.

On June 19, 2006, we launched our Efonica VoIP service. This new service, coupled with the simultaneous introduction of our patent-pending Worldwide Internet Area Code, gives us the potential to change the way people throughout the world communicate. We believe that there is value to creating a worldwide Internet calling community, and since our launch, we have added over 750,000 subscribers, from over 100 countries and currently have more than 10,000 paid subscribers. We will continue to develop and launch a wide variety of paid services. We will market our paid services to our free subscribers and sell paid service packages through physical and online distribution partners. In addition to all of the basic features of our free service, our paid packages include a number of value added features.
 
19


We manage our carrier revenues by product and customer. We manage our carrier costs by provider (vendor). We track carrier 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 from us.
 
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 certain Selling, General and Administrative resources. For example, the majority of our 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 use of resources or percentage of revenues.
 
OPERATING EXPENSES

Our operating expenses during the nine months ended September 30, 2006 and 2005, are categorized as cost of revenues; depreciation and amortization; loss on impairment; administrative; and advertising and marketing.

Cost of revenues includes costs incurred from 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. It also includes amortization of our Efonica customer list.

Loss on impairment includes losses associated with our review of long-lived assets, including goodwill, on an annual basis as well as whenever events or circumstances may indicate that an asset’s carrying amount is not recoverable.

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

Advertising and marketing expenses currently relate primarily to our on-line Efonica advertising campaign. They also include newspaper ads for our Efonica retail services, product press releases, and costs associated with exhibitions we attend to promote these retail services.

COMPANY HIGHLIGHTS

The following summary of significant events during the nine months ended September 30, 2006, highlights the accomplishments and events that have influenced our performance during that time period. This nine-month period includes many significant accomplishments including the launch of our VoIP services under our global Efonica brand and the introduction of our patent-pending Worldwide Internet Area Code.
 
·
Acquired Proprietary Technology - Acquired proprietary directed SIP peer-to-peer technology that avoids routing Internet phone calls through network of users’ computers;
     
·
New Partnership - Announced partnership with AnchorFree to market VoIP services to users of large WI-FI network;
     
·
Licensed Market-Leading Technology - Licensed Global IP Sound’s market-leading technology to power its VoIP softphone;
     
·
Filed Patent Application - Filed patent application for our proprietary VoIP technology for SIP peer-to-peer VoIP communication;
     
·
Completion of Softphone Development - Completed development of our proprietary PC-based VoIP softphone, which allows us to differentiate our Efonica® VoIP offering;
     
·
Launched Free Internet Service - Launched new free Internet phone service, which allows Efonica® subscribers worldwide to make free calls without computers. We also created the Worldwide Internet Area Code™ which allows subscribers to use their existing telephone numbers preceded by a “10”;
     
·
Worldwide Internet Area Code Patent - Filed patent application for Worldwide Internet Area Code™;
     
·
Introduction of EFO Out - We introduced one of our new paid services, EFO Out, which allows users to call any landline or mobile telephone number in the world at extremely competitive prices;
     
·
Jinti Partnership - Entered into a strategic partnership with Jinti, a rapidly growing Chinese community services site that currently attracts in excess of 3 million unique visitors from China each month;
     
·
Marketing Alliance with MasterCard worldwide - We entered into a retail marketing alliance with MasterCard Worldwide to offer our suite of premium paid VoIP communication services to MasterCard cardholders;
     
·
Efonica subscribers exceed 750,000 - Since launching our new Efonica VoIP service on June 19, 2005, we have registered more than 750,000 subscribers and currently have more than 10,000 paid subscribers; and
 
20

 
·
Efonica Services in Jordan - Introduction of our Efonica VoIP services in Jordan to allow us to continue to connect communities worldwide, due to our securing exclusive rights to a Jordanian Telecommunications License.

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

Three Months Ended September 30, 2006, Compared with Three Months Ended September 30, 2005.

Revenues

Consolidated revenues were $11.7 million during the three months ended September 30, 2006, compared to $9.1 million during the three months ended September 30, 2005, an increase of $2.6 million or 28.5%. This increase in revenue was due to an increase in our voice services sold to carriers segment. We expect our revenue from our voice services sold to carriers to continue to increase in future quarters.

Voice services sold to carriers increased to $10.9 million from $7.9 million during the three months ended September 30, 2006 and 2005, respectively. This was the fourth consecutive quarter that carrier revenues have increased.

Revenues for VoIP services to consumers and corporations decreased to $0.4 million during the three months ended September 30, 2006, from $0.8 million during the three months ended September 30, 2005. As we had been focusing on our new suite of retail VoIP services, we had scaled back some existing customers and made a strategic decision to service a broader spectrum of customers once our new products are deployed. Since our launch in June, the majority of our efforts centered on enhancing our free Efonica service offerings. Now, we are focused on introducing additional premium services in the near term and driving revenue growth through upselling existing customers and marketing our services through our growing number of retail distribution partners worldwide.

Revenues from our Internet, private network & other services decreased to $0.4 million during the three months ended September 30, 2006, from $0.5 million during the three months ended September 30, 2005, primarily due to the loss of two customers.

Cost of Revenues

Consolidated cost of revenues increased $2.3 million or 28.5% to $10.6 million during the three months ended September 30, 2006 from $8.3 million during the three months ended September 30, 2005. This percentage increase is consistent with the revenue percentage increase and relates primarily to the voice services to carriers.

The cost of revenues for voice services to carriers increased $2.6 million or 35.1% to $10.1 million during the three months ended September 30, 2006 from $7.5 million during the three months ended September 30, 2005. This increase is a result of the increase in revenues for our voice services to carriers.

The cost of revenues for VoIP services to consumers and corporations decreased $0.1 million or 19.2%, to $0.5 million during the three months ended September 30, 2006 from $0.6 million during the three months ended September 30, 2005, due to the reduction in volume mentioned above. The cost of revenues for VoIP services in 2006 also included $0.1 million in promotional expense for the third quarter related to our new retail VoIP service. This promotional expense resulted from our giving new customers a test account to try one of our premium service offerings for free.

Cost of revenues for Internet, private network & other decreased $0.1 million or 54.8% to $0.1 million during the three months ended September 30, 2006, from $0.2 million during the three months ended September 30, 2005. This decrease is a result of the revenue decreases previously discussed. When the revenues ceased, the corresponding cost of revenues decreased as well.

The consolidated gross margin percentage was 9.3% during the three months ended September 30, 2006, which was consistent with the margin percentage of 9.2% during the three months ended September 30, 2005. Our gross margin for VoIP services to consumers and corporations of (6.2%) was negatively impacted by costs associated with the promotions we ran to introduce our new premium services during our recent Efonica launch. Without the promotional expense, our gross margin for this segment would have been 22.4%. Absolute consolidated gross margin dollars increased by $0.2 million, which was attributable to improved margin in the voice to carrier segment services sold.

Operating Expenses

Depreciation and Amortization. Depreciation and amortization remained consistent at $0.4 million during the three months ended September 30, 2006 and 2005. Our depreciation expense remained consistent. Our depreciation expense decreased as a result of many of our assets being fully depreciated during the three months ended September 30, 2006, which were not fully depreciated during the three months ended September 30, 2005. This decrease was net with an increase in our depreciation expense as a result of the amortization of fixed assets associated with our retail VoIP infrastructure and our relocated New York headquarters.
 
21


Loss on Impairment. Loss on impairment during the three months ended September 30, 2006, relates to a $0.1 million write-off of goodwill recorded in connection with our Jamaican joint venture. This write-off resulted from changes in our business plans for that entity including the future sale of switching equipment and a future lease assignment.

Selling, General and Administrative. Selling, general and administrative expenses increased $0.8 million or 31.2% to $3.6 million during the three months ended September 30, 2006, from $2.8 million during the three months ended September 30, 2005. This increase is primarily attributed to increased salaries and benefits of approximately $0.4 million, as more personnel have been required to support our growth and our retail VoIP infrastructure. In addition, contributing to the 2006 increase is approximately $0.1 million of employee compensation expense recorded in connection with our adoption of SFAS 123(R) on January 1, 2006. Also increasing as a result of our growth, our VoIP retail services infrastructure, and our becoming a public company in February 2005, have been our legal and professional fees, which increased by approximately $0.1 million and equipment operating/maintenance expenses which increased by approximately $0.1 million. We believe that as we execute our business strategies and complete our VoIP retail rollout, selling, general and administrative expenses as a percentage of revenues will begin to decline.

Marketing and Advertising. Marketing and advertising expenses increased $0.7 million during the three months ended September 30, 2006, from $33,000 during the three months ended September 30, 2005. This increase is a result of our more aggressive marketing plan for our retail VoIP services.

Operating Loss. Our operating loss increased $1.5 million or 62.2% to a loss of $3.8 million during the three months ended September 30, 2006, from a loss of $2.3 million during the three months ended September 30, 2005. The increase in operating loss was primarily attributable to the increase in our gross profit of $0.2 million net with the $0.9 million increase in our selling, general and administrative expenses due to Company growth, the implementation of SFAS 123 on January 1, 2006 (which resulted in non-cash employee compensation expense of approximately $0.1 million), and public company compliance requirements and $0.7 million of advertising/marketing expenses associated with our retail VoIP infrastructure.

Other Income (Expense). Total other income (expense) remained fairly consistent increasing by $36,000 to other income of $63,000 during the three months ended September 30, 2006 from other income of $28,000 during the three months ended September 30, 2005. Contributing to this increase in other income is a reduction in the loss from our investment in Estel of approximately $0.1 million.

Net Loss. The primary factors causing our increased net loss of $1.6 million, is the $0.9 million increase in selling, general and administrative expenses, and $0.7 million increase in advertising and marketing expenses.

Nine Months Ended September 30, 2006, Compared with Nine Months Ended September 30, 2005.

Revenues

Consolidated revenues were $31.8 million during the nine months ended September 30, 2006, compared to $40.3 million during the nine months ended September 30, 2005, a decrease of $8.5 million or 21.1%. This decrease can be attributed to the fact that the three months ended June 30, 2005 represented an unusually large peak period for the voice to carrier segment (included a one time revenue opportunity of approximately $9 million). Although our consolidated revenues for the nine months ended September 30, 2006 declined from the nine months ended September 30, 2005, they have been increasing quarter over quarter since the fourth quarter of 2005. This quarter over quarter increase in revenue was primarily from our voice services sold to carriers segment.

The decrease in voice services sold to carriers represented the majority of the consolidated revenue reduction. Voice services sold to carriers decreased $7.0 million or 19.4%, to $28.8 million during the nine months ended September 30, 2006 from $35.8 million during the nine months ended September 30, 2005. As previously indicated, there was an unusually large peak period in the second quarter of 2005, but carrier revenues have continued to increase during the past four quarters.

Revenues for VoIP services to consumers and corporations represented $1.2 million of the consolidated revenue reduction, decreasing to $1.8 million during the nine months ended September 30, 2006, from $3.0 million during the nine months ended September 30, 2005. As we had been focusing on our new suite of retail VoIP services, we had scaled back some existing customers and made a strategic decision to service a broader spectrum of customers once our new products are deployed. Since our launch in June, the majority of our efforts centered on enhancing our free Efonica service offerings. Now, we are focused on introducing additional premium services in the near term and driving revenue growth through upselling existing customers and marketing our services through our growing number of retail distribution partners worldwide.

Revenues from our Internet, private network & other services decreased $0.3 million or 22.5% to $1.2 million during the nine months ended September 30, 2006, from $1.5 million during the nine months ended September 30, 2005 due to the loss of two customers.

Cost of Revenues

Consolidated cost of revenues decreased $8.4 million or 22.6% to $28.6 million during the nine months ended September 30, 2006 from $37.0 million during the nine months ended September 30, 2005. The decrease in consolidated cost of revenues is primarily a result of the volume decrease in voice to carrier revenues, which decreased $7.3 million or 21.5% to $26.6 million during the nine months ended September 30, 2006, from $33.9 million during the nine months ended September 30, 2005.
 
22


The cost of revenues for voice services to carriers decreased $7.3 million or 21.5% to $26.6 million during the nine months ended September 30, 2006 from $33.9 million during the nine months ended September 30, 2005. This decrease is a result of the decrease in revenues for our voice services to carriers.

The cost of revenues for VoIP services to consumers and corporations decreased $0.7 million or 33.3%, to $1.5 million during the nine months ended September 30, 2006 from $2.2 million during the nine months ended September 30, 2005, due to the reduction in volume mentioned above. The cost of revenues for VoIP services in 2006 also included $0.1 million in promotional expense during the third quarter related to our new VoIP retail services. This promotional expense resulted from our giving new customers a test account to try one of our premium service offerings for free.

Cost of revenues for Internet, private network & other decreased 39.3% to $0.5 million during the nine months ended September 30, 2006 from $0.9 million during the nine months ended September 30, 2005, due to the loss of two customers and other revenue reductions.

Consolidated gross margin decreased $0.1 million or 4.8% to $3.2 million during the nine months ended September 30, 2006 from $3.3 million during the nine months ended September 30, 2005. Gross margin for voice services to carriers increased by $0.3 million offset by a decline in gross margin for VoIP services to consumers and corporation of $0.5 million. Contributing to the decline in gross margin for VoIP services to consumers and corporations was the $0.1 million of promotional expense previously discussed.

The consolidated gross margin percentage increased to 10.0% during the nine months ended September 30, 2006 from 8.3% during the nine months ended September 30, 2005. This increase relates primarily to the voice services to carriers segment due to improved routing management.

Operating Expenses

Depreciation and Amortization. Depreciation and amortization decreased by $0.3 million or 29.6% to $0.9 million during the nine months ended September 30, 2006, from $1.2 million during the nine months ended September 30, 2005. Our depreciation expense decreased primarily as a result of many our assets being fully depreciated during 2006, which incurred depreciation expense during all or a portion of the first nine months of 2005. This decrease is not with an increase in depreciation expense due to amortization of fixed assets associated with our retail VoIP infrastructure and our relocated New York headquarters.

Loss on Impairment. Loss on impairment during the nine months ended September 30, 2006, relates to a $0.1 million write-off of goodwill recorded in connection with our Jamaican joint venture. This write-off resulted from changes in our business plans for that entity including the future sale of switching equipment and a future lease assignment.

Selling, General and Administrative. Selling, general and administrative expenses increased $2.8 million or 34.4% to $11.2 million during the nine months ended September 30, 2006, from $8.4 million during the nine months ended September 30, 2005. This increase is primarily attributed to increased salaries and benefits of approximately $1.4 million, as more personnel have been required to support our growth and our retail VoIP infrastructure. In addition, contributing to the 2006 increase is approximately $0.5 million of employee compensation expense recorded in connection with our adoption of SFAS123(R) on January 1, 2006. Our legal and professional fees increased by approximately $0.3 million. This increase along with increases in costs associated with travel, occupancy and our software/equipment are a result of our growth, public company requirements and our VoIP retail service infrastructure. We believe that as we execute our business strategies and complete our VoIP retail rollout, selling, general and administrative expenses as a percentage of revenues will begin to decline.

Marketing and Advertising. Marketing and advertising expenses increased $0.9 million or 575.3% to $1.0 million during the nine months ended September 30, 2006, from $0.1 million during the nine months ended September 30, 2005. This increase is a result of our more aggressive marketing plan for our retail VoIP services.

Operating Loss. Our operating loss increased $3.7 million or 57.3% to a loss of $10.1 million during the nine months ended September 30, 2006, from a loss of $6.4 million during the nine months ended September 30, 2005. The increase in operating loss was primarily attributable to the increase of $2.9 million in our selling, general and administrative expenses due to company growth, the implementation of SFAS 123 on January 1, 2006, (resulted in additional non-cash employee compensation expense during 2006 of approximately $0.5 million), and public company compliance requirements and $0.9 million in and advertising/marketing expenses associated with our retail VoIP infrastructure.

Other Income (Expense). Total other income (expense) changed to other income of approximately $0.7 million during the nine months ended September 30, 2006 from other expense of $0.4 million during the nine months ended September 30, 2005.

Interest income remained fairly consistent at $0.3 million during the nine months ended September 30, 2006 and 2005. Interest expense decreased $0.3 million or 77.4% to $0.1 million during the nine months ended September 30, 2006 from $0.4 million during the nine months ended September 30, 2005. The $0.4 million of interest expense during the nine months ended September 30, 2005, consisted primarily of accretion on the Series C Preferred Stock which was converted to common stock in connection with our February 2005 IPO, at which point the accretion ceased. In addition, during 2005, interest expense included interest for debt outstanding between January 1, 2005 and February 17, 2005, at which point we used our IPO proceeds to repay a significant portion of our interest-bearing debt. Interest expense during the nine months ended September 30, 2006 and 2005 includes primarily interest on our capital lease/equipment financing leases.
 
23


Gain on settlements of debt increased to $0.5 million during the nine months ended September 30, 2006 from approximately $0.1 during the nine months ended September 30, 2005. The 2006 gain on settlement relates to a debt settlement agreement we entered into during 2003 with a domestic carrier. The provisions of the agreement provided that $555,000 due to the carrier would be resolved with a service agreement whereby the carrier received a reduced rate for certain minutes of traffic that passed through our network through December 2005. Both parties continued to comply with the terms of the agreement past December 2005. During June 2006, the service agreement was cancelled and the carrier released us of all remaining indebtedness under the settlement agreement. Consequently, we recorded the remaining deferred revenue balance of approximately $466,000 as a gain on settlement of debt.

The loss from investment in Estel decreased $0.4 million to $0.1 million during the nine months ended September 30, 2006, from $0.5 million during the nine months ended September 30, 2005. This reduction is primarily due to a reduction in the Estel allowance for doubtful accounts.

Net Loss. The primary factors impacting our net loss of $9.7 million for the nine months ended September 30, 2006, were the decrease in depreciation and amortization expense, increase in selling, general and administrative and marketing/advertising expenses, gain on debt settlement during 2006, and the decrease in the net loss from our investment in Estel during the nine months ended September 30, 2006.

Liquidity and Capital Resources

Since our inception, we have incurred significant operating and net losses. In addition, we are not generating positive cash flows from operations. As of September 30, 2006, we had stockholders’ equity of approximately $13.1 million and a working capital deficit of approximately $4.7 million. Our positive stockholders’ equity is a result of the February 2005 closing of our initial public offering. Our IPO included 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 $3.0 million, which resulted in net proceeds of 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 approximately $2.9 million in net proceeds from the closing on the over-allotment option. The net proceeds from the offering were immediately used to repay a significant portion of our debt that was outstanding. The proceeds have been and will continue to be used for working capital and general corporate purposes; to fund the purchase of equipment for expanded capacity, international deployment, expanded service offerings and consumer hardware; the payment of debt, capital leases and related interest; international expansion; and marketing and advertising.

We are currently reviewing options to raise additional capital through debt and/or equity financing. While management believes that our current cash resources should be adequate to fund our operations through the end of the year, our long-term liquidity is dependent on our ability to successfully complete the rollout of our full suite of retail VoIP paid services and effectively market our paid services, in order to attain future profitable operations. We cannot make any guarantees if and when we will be able to attain future profitability. These factors, among others, indicate that we may be unable to continue operations as a going concern.

Below is a summary of our cash flows for the periods indicated. These cash flow results are consistent with prior years in that we continue to use significant cash in connection with our operating and investing activities. In addition, during 2006, we used cash in financing activities, in contrast to having cash being provided by financing activities, which has been the case in previous years.

A summary of our cash flows for the periods indicated is as follows:
 
   
Nine months ended September 30,
 
   
2006
 
2005
 
Cash used in operating activities
 
$
(8,377,892
)
$
(5,903,359
)
Cash used in investing activities
   
(3,365,544
)
 
(2,006,864
)
Cash provided by (used in) financing activities
   
(676,591
)
 
21,050,626
 
Increase (decrease) in cash and cash equivalents
   
(12,380,027
)
 
13,140,403
 
Cash and cash equivalents, beginning of period
   
14,790,504