MANAGEMENT S DISCUSSION AND ANALYSIS For the three months ended March 31, 2010 Dated May 21, 2010 Management's Discussion and Analysis ( MD&A ) is intended to help shareholders, analysts and other readers understand the dynamics of s ( Telehop ) business and the key factors underlying its financial results. It explains trends in Telehop s financial condition and operating results for the three months ended March 31, 2010, compared with the operating results for the three months ended March 31, 2009. The MD&A should be read in conjunction with the Unaudited Interim Consolidated Financial Statements for the three months ended March 31, 2010 and the annual Management s Discussion and Analysis for 2009. Forward-Looking Statements The consolidated financial statements and information and analysis in the management's discussion and analysis necessarily includes amounts and conclusions based on informed judgments and estimates of the expected effects of current events and transactions with appropriate consideration as to materiality. In addition, in preparing the financial information, management must interpret the requirements described above, make determinations as to the relevancy of information to be included, and make estimates and assumptions that affect reported information. Certain statements in the MD&A also constitute forward-looking statements. Such forwardlooking statements involve known and unknown risks, uncertainties, and other factors that may cause the results, performance or achievements of Telehop to be materially different from those expressed or implied by such statements. Such factors include, amongst others, the following: general economic and business conditions, demographic changes, regulation, major technology changes, and timing of product introductions, competition, and the ability of Telehop to attract and retain key employees. Readers are cautioned not to place undue reliance on forward-looking statements as various factors could cause actual future results, conditions or events to differ materially from expectations or estimates expressed in the forward-looking statements. Page 1 of 12
CORE BUSINESS Telehop (the Company) is a full-service long distance provider operating within the telecommunications industry and is registered with the Canadian Radio-television and Telecommunications Commission ( CRTC ) as a licensed Class A Telecom Carrier. Telehop s core network resides in Toronto, Ontario, with virtual points-of-presence in major cities across Canada. We earn our revenues from the access to, and the use of, our telecommunications network and infrastructure. We sell one type of service which is packaged in different forms which includes casual calling, subscriptions and wholesale and VoIP - HomePhone. Casual Calling Telehop s Casual Calling services allow any user to access Telehop's long distance Equal Access network from most telephones across Canada, without having to subscribe to the service, or pay any monthly fees. The dial-around service or casual calling service allows a user to bypass or dial around their existing longdistance provider on any call by entering the digits 10-10-620 or 10-10-100 before making a call, without having to switch carriers. Any calls made using Telehop s 10-10-620 and 10-10-100 Casual Calling services appear on the customers regular, monthly telephone bills at Telehop s discounted rates. Telehop has entered into Billing & Collection Agreements with a number of major Local Exchange Carriers ( LECs ) across Canada. Subscriptions Equal Access The Company is a provider of Equal Access long distance services worldwide to its residential and business customers. The term Equal Access refers to a long distance service that offers equal ease of access to all customers. This allows Telehop customers to directly dial long distance calls on Telehop's network using the normal 1+ or 011+ dialing pattern. Wholesale Telehop s wholesale service is based on trading bulk minutes worldwide with high volume users who wish to carry their calls through our network. These high volume users often repackage the minutes purchased from us at discounted rates with their own unique services which are then sold to their customers. VoIP - Telehop HomePhone Telehop successfully completed its final testing and development phase for its voice-over-internet protocol (VoIP) home phone service called Telehop HomePhone. The product was first made available in the second quarter of fiscal 2008 on a trial basis with limited marketing. The first quarter introduced new marketing campaign highlighting the new products features and economies. Mobile More Telehop introduced it s Mobile More Cell Phone Calling Service this quarter to great response. Mobile More is a service that allows cell phone users to minimize their use of outgoing cell minutes. It is a call-back service, the customer calls a number Telehop provides and hangs up before there is an answer. This service will then call the customer back and provide a dial tone to allow them to call using their incoming cell phone minutes. Mobile more allows cell phone users to reduce their monthly cell phone costs to the minimum plan allowed by their provider, thereby saving them potentially hundreds of dollars. Page 2 of 12
FINANCIAL REVIEW Revenue for first quarter 2010 was $2,921,745 with a net loss of $107,383 or $(0.01) per common share compared to revenue of $3,477,153 and net loss of $330,704 or $(0.02) per common share for the first quarter 2009. Our revenue was $555,408 or 16.0% less quarter for quarter which is attributable to a reduction in our retail long-distance business of $457,813 and a reduction in our wholesale long-distance business of $97,595. Our gross margin as a percentage of revenue for the first quarter was 40.7% compared to 37.5% for the same quarter in 2009. Operating expenses decreased from $1,776,265 in first quarter 2009 by $433,910 or 24.4% to $1,342,355. The majority of the decrease relates to cost reductions implemented through 2009. The end result, of a reduction in revenue with higher gross margins and an decrease in operating expenses, is that we recorded a net loss for first quarter 2010 of $107,383 compared to net loss of $330,704 for same quarter 2009. We completed the first quarter with $716,001 of cash and working capital of $949,058 with no bank debt. We have reduced our expenses on an ongoing basis and have implemented a strategic initiative which we believe will help us increase the value of our Company. KEY PERFORMANCE INDICATORS (KPI s) AND NON-GAAP MEASURES We measure the success our strategy through a number of key performance indicators, which are outlined below. The following key performance indicators are not measurements in accordance with GAAP and should not be used as an alternative to net income or any other measure of performance under GAAP. Gross Margin Gross margin is determined by deducting all telecommunications-related expenses from operating revenues. Telecommunications expenses include fixed and variable carrier costs, billing and collections charges to local exchange carriers and support costs for all telecommunications facilities. Gross margin is an indicator of the company s profit directly tied to its services before general operating expenses. Calls and Minutes Calls and minutes are determined by the number of calls and minutes that have been completed by customers through the Company s network, which are tracked through call detail records. This indicator is a measure of how well the Company has increased overall volume in customer usage of its network. Average Revenue per Minute (ARPM) Average revenue per minute is determined by dividing total operating revenues by total number of minutes completed. This indicator serves to measure how well the company has maintained or increased its longdistance rates per minute. EBITDA Earnings before interest, taxes, depreciation and amortization (EBITDA) is a standard used in the telecommunications industry to assist in understanding and comparing operating results. The Company believes that this measure is important in assessing its profitability before the impact of depreciation and Page 3 of 12
amortization and non-operating factors. EBITDA is also a useful measure of the Company s ability to service debt, invest in capital equipment or distribute dividends to its shareholders. EBITDA is not defined by GAAP and should be used as a supplement and not a substitute for the Company s results of operations. RESULTS OF OPERATIONS ($Thousands except for KPI's) 2010 2009 % Change Consolidated Income Statement Operating revenues $2,922 $3,477-16.0% Gross margin 1,190 1,303-8.7% Gross margin % 40.7% 37.5% 8.6% Operating costs 1,342 1,776 24.4% General and administration 634 839 24.4% Marketing and selling 417 632 34.0% Development and technical 217 215-0.9% Amortization 73 90 18.9% Interest 1 1 0.0% Operating income (loss) (152) (471) 67.7% EBITDA (78) (382) 79.6% Other income - 3-100.0% Net income (loss) (107) (331) 67.7% Earnings (loss) per share - basic (0.01) (0.02) 50.0% Earnings (loss) per share - diluted (0.01) (0.02) 50.0% Consolidated Statement of Cash Flows Cash provided (used) by operating activities (63) (204) 69.1% Cash used by investing activities (44) (30) -46.7% Cash provided (used) by financing activities (4) (8) 50.0% Key Performance Indicators Minutes (thousands) 58,062 69,857-16.9% Calls (thousands) 14,239 13,718 3.8% Average revenue per minute (ARPM) 0.050 0.050 0.0% Operating Revenues Consolidated operating revenues declined quarter to quarter by $555,408 or 16.0% to $2,921,745. This was attributed to the 16.9% decline in minutes. This is due to our decision to maintain and in some instances increase our rates, which resulted in lower revenue. Comparison of revenue by Core Business Product Line For the quarters ending March 31, 2010 2009 Retail revenue $ 2,561,813 $ 3,019,626 Wholesale 359,932 457,527 Total revenues $ 2,921,745 $ 3,477,153 Page 4 of 12
Retail Revenue There has been a concerted effort to convert customers from Casual Calling to a paid Subscription basis. This effort is paying off and combined with Telehop s engaging of Call Centers for outbound tele-sales has resulted in an increase in the number of subscribers for our Subscription business. Our plan is to market our newest products, Telehop HomePhone (VoIP), and Mobile More to these subscribers. Wholesale revenue Wholesale revenue has a significantly lower gross margin than the other lines of business. Wholesale customers buy bulk minutes from Telehop at discounted prices. This line of business is very competitive and margins for the overall Canadian market in this segment have declined. Telehop has maintained its unit pricing in Wholesale and in some instances increased unit pricing, which resulted in revenue declining. Gross Margin For the three month periods ending: March 31, 2010 December 31, 2009 March 31, 2009 Revenue $ 2,921,745 $ 2,970,418 $ 3,477,153 Gross margin 1,190,487 1,165,108 1,303,111 As a % of revenue 40.7% 39.2% 37.5% Gross margin as a % of revenue has increased by 3.2% from 37.5% in the first quarter 2009 to 40.7% this quarter. Operating Expenses For the quarters ending March 31 2010 2009 +/- General & administration $ 633,855 $ 838,540 204,685 Marketing & selling 417,460 631,951 214,491 Development & technical support 217,246 214,576 (2,670) Amortization 72,978 89,977 16,999 Interest 816 1,221 405 Operating expenses $ 1,342,355 $ 1,776,265 433,910 Overall operating expenses of $1,342,355 are $433,910 or 24.4% less than the $1,776,265 recorded in the first quarter 2009. We measure expenses on a total basis, monitoring them very closely and Page 5 of 12
adjusting them where it is felt they are required. The changes in operating expenses by line item are discussed below. General & administration expenses of $633,855 is a decrease of $204,685 or 24.4% from the $838,540 incurred for the first quarter 2009, largely due to adjustments in staffing levels to reflect our expected volumes. Marketing and selling expenses of $417,460 is a decrease of $214,491 or 33.9%. We focused our marketing efforts on return based directives and discontinued the services of an unproductive offshore call centre. We will continue to invest in marketing programs supporting our strategic initiatives. Development and technical support expenses increased by $2,670 or 1.2% quarter to quarter from $214,576 to $217,246 and is in line with our expectations of costs to support our network and develop new products. Amortization expenses decreased by $16,999 or 18.9% compared to the same period last year. The decrease was mainly driven by certain assets that became fully amortized in 2009. EBITDA and Operating Income EBITDA increased to $(78,074) from $(381,956) and operating loss decreased to $(151,868) from $(473,154) compared to the same period last year. The reduction in the loss is due to a cost cutting focus and an increase in gross margins. Page 6 of 12
QUARTERLY RESULTS SUMMARY The following table sets forth certain unaudited consolidated statements of operation for the most recent quarters of operations ending March 31, 2010. The operating results for any quarter are not necessarily indicative of results for any future period. Summary of results 2010 2009 2008 ($000 s) Q1 Q4 Q3 Q2 Q1 Q4 Q3 Q2 Q1 Revenue 2,922 2,970 3,388 3,562 3,477 3,776 3,986 4,248 4,371 Telecom costs 1,731 1,805 1,638 2,099 2,174 2,404 2,357 2,786 2,707 Gross margin 1,190 1,165 1,749 1,463 1,303 1,372 1,629 1,462 1,664 Gross margin as a % 41% 39% 52% 41% 38% 36% 41% 34% 38% Operating expenses General & administrative 634 910 730 628 839 1,218 893 1,096 1,067 Marketing & selling 417 473 493 774 632 670 510 727 586 Development & technical support 217 242 229 230 215 345 258 201 229 1,268 1,625 1,541 1,633 1,686 2,233 1,661 2,024 1,881 EBITDA -78-461 298-170 -382-861 -32-562 -218 Amortization 73 77 89 91 90 100 111 105 107 Loss on disposal assets - 1 - - - - - - 39 Interest expense 1 4 1-1 - 1-2 Unusual Item - -676 - - - - - - - Other income - 1 3 3 3-8 -15-19 -28 Income (loss) before tax -152-1,205 212-258 -471-953 -129-647 -336 Income tax (recovery) -44-291 85-15 -140-379 -28-193 -132 Net income (loss) -107-914 127-243 -331-574 -101-454 203 Earnings (loss) per share (0.01) (0.07) 0.01 (0.02) (0.02)(0.04) (0.01) (0.03) (0.02) Diluted earnings (loss) per share (0.01) (0.07) 0.01 (0.02) (0.02)(0.04) (0.01) (0.03) (0.02) FINANCIAL CONDITION The following table presents the changes in Consolidated balance sheets in the three months ended March 31, 2010 as compared to December 31, 2009: Page 7 of 12
Mar. 31 Dec. 31 ($Thousands) 2010 2009 Changes Current Assets Cash and cash equivalents 716 827 (111) -13.4% Accounts receivable 1,733 2,424 (691) -28.5% Income taxes recoverable 184 151 33 21.9% Future income taxes 200 200-0.0% Prepaid expenses and deposits 92 119 (27) -22.7% Current Liabilities Accounts payable and accrued liabilities 1,960 2,657 (697) -26.2% Obligations under capital lease 17 17-0.0% Non-Current Liabilities Future income taxes - 11 (11) -100.0% Obligations under capital lease 8 12 (4) -33.3% Capital assets, net 567 596 (29) -4.9% Total shareholders' equity 1,508 1,608 (100) -6.2% CAPITAL RESOURCES AND LIQUIDITY Since December 31, 2009, the Company s working capital has decreased by $86,714 from $1,035,772 at December 31, 2009 to $949,058 at March 31, 2010. Capital expenditures for the three months ended March 31, 2010 were $44,085 compared with $30,334 for the three months ended March 31, 2009. The Company s working capital is adequate for it to meet its ongoing obligations, including its long term debt obligations. Liquidity risk arises from our general funding needs and in the management of our assets and liabilities. We manage liquidity risk to maintain sufficient liquid financial resources to fund our balance sheet and meet our commitments and obligations in the most cost-effective manner possible. Operating Leases We have long-term operating lease agreements for our corporate office and switch facility, both of which expire in 2011 and lease of office equipment which expires in 2015. Capital Leases We have a capital lease agreement for a voice recognition system purchased to support and increase productivity at our call centre. The capital lease includes a purchase option and expires in 2011. Sources and Uses of Cash The Company s cash flows from operating, investing and financing activities, as presented in the consolidated statements of cash flows, are summarized in the following table: Page 8 of 12
Three months ended (thousands except ratios) March-10 March-09 $Change % Change Cash provided (used) by operating activities (63) (204) 141 69% Cash used in investing activities (44) (30) (14) -47% Cash used by financing activities (4) (8) 4 50% Decrease in cash (111) (242) 131 54% Cash and cash equivalents 716 1,031 (315) 31% Current assets 2,926 3,951 (1,025) 26% Current liabilities 1,977 1,949 28-1% Working capital 949 2,002 (1,053) 53% Current ratio 1.5 2.0 Our liquidity needs continue to be met through cash generated from operations and from existing cash. The Company s strong working capital position has enabled us to overcome current challenges with a cash position of $716,001 and no bank debt as at March 31, 2010. Cash used by operating activities decreased by $140,745 to $63,194, which was largely attributed to the $691,051 reduction in accounts receivable due to increased focus on collections of outstanding accounts. Cash used in investing activities were consistent with the same period last year at $44,085 compared to $30,334. The capital outlays were for normal operating needs. Cash used by financing activities decreased by $4,110 as the efforts to retire company stock were discontinued. Capitalization As at March 31, 2010 the Company had 13,391,000 common shares outstanding and 525,000 share options, which are exercisable at an average strike price of $0.215 per share prior to February 2015. RISKS AND RISK MANAGEMENT The following areas summarize the principal risks and uncertainties that could affect Telehop s future results. Competition Telecommunications providers are continually increasing the range of services they offer as well as lowering their long-distance rates to become more competitive. Telehop intends on mitigating these risks through offering more innovative solutions that will remove itself from the price sensitive market, and further reduce its cost structure in anticipation of future price declines. Technology The market for the Company s services is characterized by rapid change and technological improvements. Failure to respond in a timely and cost-effective way to these technological developments could result in serious harm to the Company s business and operating results. A substantial portion of the Company s revenues are derived and expected to continue to be derived from providing telecommunications services that are based upon today s leading technologies and that are capable of adapting to future technologies. Telehop Page 9 of 12
has invested into various VOIP technologies, which have been put on hold, as part of its strategy to be at the forefront of technological changes in the telecommunications industry. Regulatory Regulatory changes issued by the Canadian Radio and Telecommunications Commission (CRTC) could have a material adverse impact on Telehop s procedures, costs and revenues. The company is federally regulated by the CRTC and Industry Canada. The CRTC regulates certain tariff charges in which Telehop pays to certain local carrier exchanges and may issue changes which may have a material unfavorable impact on the Company s financial results. To mitigate these risks, the Company monitors industry developments very closely through industry advisors. Management Team Telehop operates with a small but effective and experienced management team that strives to oversee all aspects of operations, and by calling upon the services of financial, industry and technology experts in areas when deemed appropriate. The replacement of any management team member may have an adverse impact on operating results as their experience and skills may be difficult to find and match in the event of a management change. However, all team members are encouraged to document each of their key tasks and responsibilities as a means of mitigating this risk. Niche Company As a niche telecommunications long-distance provider serving primarily ethnic communities, the Company at this time does not have the full diversification in services compared to other larger telecommunications companies. Therefore, the Company is exposed to unforeseen changes in the long-distance market which could adversely affect the Company s future financial results. To mitigate these risks steps have been taken toward being a more diversified company by offering not only long-distance services but as a provider of additional telecommunications services. VoIP Patents There have been legal disputes over the impropriety of the use of VoIP technology by some prominent marketers of VoIP products and services. The original patent holder(s) of VoIP technology may in the future take legal action against any distributor or marketer of VoIP products and services without legal consent by the patent holder(s). Telehop is a distributor of VoIP technology, and not a developer. The Company does not believe it will be committing any patent violation acts as licensing fees would be incurred to use such technology. However, legal risks exist as the extent in which we are using VoIP technology may be challenged in the future. Foreign Exchange The Company s functional currency is the Canadian dollar, but it regularly transacts in U.S. dollars for a portion of its business activities. The assets, liabilities, revenues and expenses denominated in U.S. dollars will be affected by changes in the exchange rate fluctuations in the market between the Canadian and U.S. dollar. The Company s foreign exchange risk management includes the use of foreign currency forward contracts and options contracts to fix the exchange rates on the U.S. dollar to mitigate its foreign exchange exposure on Page 10 of 12
expenses. As at March 31, 2010 the Company did possess foreign currency forward contracts. The contract entered into fixes the exchange rate at which the company will acquire U.S. dollars to the extent of its forecasted requirements until May 31, 2010. We document all relationships between derivatives and the items they hedge and our risk management objective and strategy for using hedges. This process includes linking every derivative to: a specific asset or liability, or a specific firm commitment, or an anticipated transaction. We assess the effectiveness of a derivative in managing an identified risk when hedge accounting is initially applied, and on an ongoing basis thereafter. If a hedge becomes ineffective, we stop using hedge accounting. Any premiums paid for derivatives used in hedging relationships are deferred and expensed to earnings over the term of the contract. Any forward premiums or discounts on forward foreign exchange contracts that are used to hedge debt denominated in foreign currencies are amortized expense as utilized. Our cash flow hedges are used to mitigate the foreign currency risk on certain debt instruments and purchase commitments. We use foreign exchange forward contracts to manage the exposure to anticipated transactions denominated in foreign currencies. Changes in the fair value of these derivatives are recognized in our statement of comprehensive income, except for any ineffective portion, which is recognized immediately in income. Realized gains and losses in accumulated other comprehensive income are reclassified to the statement of operations in the same periods as the corresponding hedged items are recognized in income. Cash flow hedges that mature within one year are included in Prepaid and other expenses or Accounts payable and accrued liabilities. Credit The Company is subject to credit risk through accounts receivables, which consists of amounts represented by the large number of subscription services customers which are invoiced directly, and amounts owed from various Local Exchange Carriers ( LEC s ) from casual calling revenues. More than 50% of the Company s accounts receivables are owed by a few LECs across Canada. The LEC s provide billing and collection services on behalf of the Company through billing and collections agreements. Credit risks are mitigated from this group of LECs by purchasing long-distance services from them, which offsets at least 50% of the accounts receivables. CONTINGENT LIABILITIES (i) The Company received a notice of claim from a vendor for marketing services it believes the Company was committed to pay. The amount of the claim against the Company is approximately $230,000. The Company is vigorously defending such claims as it strongly believes it had never made such commitments. The outcome is not currently determinable. No amount has been recorded in the Consolidated Financial Statements in relation to this claim. Page 11 of 12
(ii) From time to time the Company has been, and expects to continue to be, subject to legal proceedings and claims in the ordinary course of our business. Such claims, even if lacking merit, could result in the expenditure of significant financial and managerial resources. The Company is not aware of any legal proceedings or claims that it believes will have, individually or in the aggregate, a material adverse effect on the Company s financial condition or results of operation. Page 12 of 12