CALL Magicjack Vocaltec Ltd - Ordinary Shares (delisted)

NOTE 1 –DESCRIPTION OF BUSINESS AND BASIS OF PRESENTATION

Description of Business

magicJack VocalTec Ltd. and its subsidiaries (the “Company”) is the cloud communications leader that invented the magicJack device as well as other telecommunication products and services. The Company is a vertically integrated group of companies, with capabilities including Voice-over-Internet-Protocol (“VoIP”) services and related equipment sales, micro-processor chip design and development of the magicJack   device. In addition to residential consumers, the Company provides VoIP services and related equipment to small to medium sized businesses at competitive prices and wholesales telephone service to VoIP providers and telecommunication carriers.  In 2016, the Company acquired a provider of hosted Unified Communication as a Service (“UCaaS”) and seller of hardware and network equipment focusing on medium-to-large, multi-location enterprise customers.

magicJack devices weigh about one ounce and plug into the USB port on a computer or into a power adapter and high speed Internet source, providing users with complete phone service for home, business and travel. magicJack devices come with the right to access the Company’s servers ("access right"), which provides customers the ability to obtain free telephone services. Access rights are renewable. The Company currently offers the magicJack GO version of the device, which has its own CPU and can connect a regular phone directly to the user’s broadband modem/router and function as a standalone phone without using a computer.  The sale of devices is done through distribution channels that include retailers, wholesalers and direct to customer sales via the Company’s web-site.

The Company also offers magicJack mobile apps, which are applications that allow users to make and receive telephone calls through their smart phones or devices. The Company currently offers the magicApp, magicJack Connect and magicJack Spark. The magicApp and magicJack Connect are mobile apps available for both iOS and Android. In 2017, the Company launched magicJack Spark on iOS and Android devices.  The mobile apps allow customers to place and receive telephone calls in the U.S. or Canada on their mobile devices through either an existing or new magicJack account. The mobile apps also give users the ability to add a second phone number to their smart phone for a monthly or annual fee. Customers may purchase international minutes to place telephone calls through the magicJack device or mobile apps to locations outside of the U.S. and Canada.

The Company was incorporated in the State of Israel in 1989 and is domiciled in Netanya, Israel, with executive and administrative offices, a warehouse and a customer care call center in West Palm Beach, Florida. In addition the Company has offices for technology management in Franklin, Tennessee, research and development in Plano, Texas, and Sunnyvale, California and the UCaaS provider in Fort Lauderdale, Florida.

Basis of Presentation

The Company’s unaudited condensed consolidated financial statements are prepared in conformity with United States Generally Accepted Accounting Principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the Company’s unaudited condensed consolidated financial statements do not include all of the information and footnotes required by GAAP for complete financial statements that were included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016. Management believes, however, that all adjustments of a normal, recurring nature considered necessary for a fair presentation have been included. The balance sheet at December 31, 2016 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements.

The Company’s unaudited condensed consolidated financial statements are the basis for the discussion and analysis of the Company’s results of operations, liquidity and capital resources. References to authoritative accounting literature in this report, where applicable, are based on the Accounting Standards Codification (“ASC”). The Company’s functional and reporting currency is the United States Dollar (“U.S. Dollar”), which is the currency of the primary economic environment in which its consolidated operations are conducted. Transactions and balances originally denominated in U.S. Dollars are presented at their original amounts. Transactions and balances in currencies other than U.S. Dollars, including New Israeli Shekels (“NIS”) and Polish Zloty (“PLN”), are re-measured in dollars and any gains or losses are recognized in the Company's unaudited condensed consolidated statement of operations in the period they occur.

Prior to 2016, the Company prepared its consolidated financial statements on the basis of being a single reporting entity. In 2016, with the acquisition of North American Telecommunications Corporation (“NATC”) d/b/a Broadsmart (“Broadsmart”) and the internal development of magicJack SMB, Inc. (“SMB”), the Company began reporting the results of its operations as separate reportable segments – “Core Consumer,” “Enterprise” and “SMB”. During the first quarter of 2017, management restructured the Company to absorb all operations and functions of the SMB Segment within the Core Consumer segment. Accordingly, this segment will not show activity for periods after March 31, 2017. Refer to Note 16, “Segment Reporting” for further details.

 

Approximately 85% and 86% of the Company’s consolidated revenues in the three and nine months ended September 30, 2017, respectively, were from sales to customers located in the United States. Approximately 90% of the Company’s consolidated revenues in the three and nine months ended September 30, 2016 were from sales to customers located in the United States.

The majority of Core Consumer segment revenues were generated from sales of the magicJack product line and accompanying software access rights, which were $16.8 million and $19.2 million for the three months ended September 30, 2017 and 2016, respectively, and $52.0 million and $58.8 million for the nine months ended September 30, 2017 and 2016, respectively. The Core Consumer segment also provides its customers with the ability to make prepaid international calls by purchasing prepaid minutes for use with the magicJack devices and mobile apps. Revenues generated from the usage of prepaid minutes were $1.1 million and $1.4 million for the three months ended September 30, 2017 and 2016, respectively, and $3.5 million and $4.6 million for the nine months ended September 30, 2017 and 2016, respectively. Revenues generated from access and wholesale charges were $0.9 million and $1.2 million for the three months ended September 30, 2017 and 2016, respectively, and $2.9 million and $3.9 million for the nine months ended September 30, 2017 and 2016, respectively.

The Enterprise segment was launched with the acquisition of Broadsmart on March 16, 2016.  The majority of Enterprise segment revenues were generated from Broadsmart hosted UCaaS services and sales of hardware and equipment which were $2.6 million and $2.8 million for the three months ended September 30, 2017 and 2016, respectively, and $8.3 million and $6.2 million for the nine months ended September 30, 2017 and 2016, respectively.

The SMB segment did not generate significant revenue for the three and nine months ended September 30, 2016, or the three months ended March 31, 2017.

Basis of Consolidation

The Company’s unaudited condensed consolidated financial statements include the accounts of magicJack VocalTec and its wholly owned subsidiaries. The results of Broadsmart Global, Inc. have been included since March 17, 2016.  The results of SMB have been included since the first quarter of 2016.  All intercompany balances and transactions have been eliminated in consolidation. Certain reclassifications may have been made to prior period financial statement amounts to conform to the current presentation. The results for the three and nine months ended September 30, 2017 may not be indicative of the results for the entire year ending December 31, 2017. The interim unaudited condensed consolidated financial statements should be read in conjunction with the Company's financial statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this report and in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016 filed on March 16, 2017.

Noncontrolling Interest

During the year ended December 31, 2016, the Company formed a new subsidiary and entered into a joint venture with an unrelated third party which resulted in the Company having a 60% controlling interest in the joint venture which began selling a line of high-technology residential consumer products in the fourth quarter of fiscal year 2016. On March 31, 2017, this interest was reduced to 36% and on June 30, 2017 the Company sold its remaining interest to the unrelated third party.  Based on the difference between the sales price from the agreement and the carrying value of the asset, the Company recognized an impairment loss of $0.4 million in general and administrative expense in the Core Consumer segment of the unaudited condensed consolidated statement of operations for the nine months ended September 30, 2017.

The operations of the joint venture for the three and nine months ended September 30, 2017 and 2016 were not significant to the Company’s financial statements. The Company’s consolidated financial statements for the three and nine months ended September 30, 2016, include adjustments to income attributable to magicJack VocalTec Ltd. common shareholders of $0.2 million and $0.5 million, respectively, to recognize the impact of the noncontrolling interest.  The Company’s consolidated financial statements did not include any adjustments to income attributable to magicJack VocalTec Ltd. common shareholders for the three and nine months ended September 30, 2017. The Company has determined that the joint venture did not meet either the aggregation criteria to be combined with the existing Core Consumer segment or the quantitative thresholds to be treated as a separate reportable segment. As such, it was included in the “Other” category of the Company’s segment reconciliation. Refer to Note 16, “Segment Reporting,” for further details.

 

NOTE 2 – SUMMARY OF ACCOUNTING POLICIES

A summary of significant accounting policies used in preparing the Company’s financial statements, including a summary of recent accounting pronouncements that may affect its financial statements in the future, follows:

Use of Estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Such estimates and judgments are revised periodically as required. Actual results could differ from those estimates. Significant estimates include allowances for billing adjustments and doubtful accounts, the recoverability of long-lived assets and goodwill, income taxes, income tax valuation allowance, uncertain tax liabilities, the value of ordinary shares issued in asset acquisitions, business combinations or underlying the Company’s ordinary share options, and estimates of likely outcomes related to certain contingent liabilities.

The Company evaluates its estimates on an ongoing basis. The Company's estimates and assumptions are based on factors such as historical experience, trends within the Company and the telecommunications industry, general economic conditions and on various other assumptions that it believes to be reasonable under the circumstances. The results of such assumptions form the basis for making judgments about the carrying values of assets and liabilities that are not readily available. Actual results may differ from the Company's estimates and assumptions as a result of varying market and economic conditions, and may result in lower revenues and net income.

Fair Value

The Company accounts for financial instruments in accordance with ASC 820, "Fair Value Measurements and Disclosures", which provides a framework for measuring fair value and expands required disclosure about fair value measurements of assets and liabilities. ASC 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. ASC 820 also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Observable inputs are inputs that market participants would use in pricing the asset or liability developed based on market data obtained from sources independent of the Company. Unobservable inputs are inputs that reflect the Company’s judgements about the assumptions market participants would use in pricing the asset or liability developed based on the best information available in the circumstances.

The hierarchy is broken down into three levels based on the reliability of inputs as follows:

 

Level 1 –

Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities.

 

Level 2 –

Valuations based on inputs other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly.

 

Level 3 –

Valuation based on inputs that are unobservable and significant to the overall fair value measurement.

When available, the Company uses quoted market prices to determine fair value, and it classifies such measurements within Level 1. Fair value measurements are classified according to the lowest level input or value-driver that is significant to the valuation. Fair value includes the consideration of nonperformance risk. Nonperformance risk refers to the risk that an obligation (either by a counterparty or the Company) will not be fulfilled. For the Company's financial assets traded in an active market (Level 1), the nonperformance risk is included in the market price. The Company’s assets and liabilities measured on a recurring basis at fair value may include marketable securities and time deposits. As of September 30, 2017 and December 31, 2016, all of them were Level 1 instruments. The fair value of Level 2 securities is estimated based on observable inputs other than quoted prices in active markets for identical assets and liabilities, quoted prices for identical or similar assets or liabilities in inactive markets, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities. The carrying amounts of the Company’s financial instruments, including cash and cash equivalents, accounts payable and accrued expenses are expected to approximate fair value because of their immediate availability, near term maturities or potential interest payments at settlement.

 

Cash and Cash Equivalents

The Company considers all highly liquid investments with a maturity at acquisition of three months or less to be cash equivalents.

 

Investments

Investments consist of interest bearing time deposits with maturity dates of greater than 90 days totaling $369 thousand and $447 thousand at September 30, 2017 and December 31, 2016, respectively.  The value of time deposits at September 30, 2017 and December 31, 2016 was determined based on face value, which approximates fair value and is a Level 1 input. There was no realized gain or loss on investments for the three and nine months ended September 30, 2017 and 2016.

Allowance for Doubtful Accounts and Billing Adjustments

The Company maintains an allowance for doubtful accounts and billing adjustments based on the expected collectability of its accounts receivables. That estimate is based on historical collection experience, current economic and market conditions and a review of the current status of each customer’s trade accounts receivable. The allowance includes estimates of billing adjustments, which are negotiated with other telecommunications carriers and are common in the telecommunications industry.

Certain Risks and Concentrations

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash and cash equivalents, investments and accounts receivable. Cash equivalents generally consist of money market instruments.

The Company places its cash and cash equivalents in high quality financial institutions and management believes that the Company is not exposed to any significant risk on its cash accounts. The Company maintains accounts with various banks and brokerage organizations and constantly monitors the creditworthiness of these institutions. Cash accounts at each U.S. bank are insured by the Federal Deposit Insurance Corporation (“FDIC”) up to $250 thousand in the aggregate and may exceed federally insured limits. Cash accounts at Israeli or Polish banks are not insured. The Company has never experienced any losses related to these balances. At September 30, 2017, the Company had cash and cash equivalents totaling $51.3 million, which included (i) $50.4 million in U.S. financial institutions, and (ii) $0.9 million in foreign financial institutions.

The Company’s non-interest bearing cash balances in U.S. banks which included $1.8 million in one individual financial institution, were fully insured, except for $106 thousand that exceeded insurance limits at September 30, 2017. The Company had money market accounts with financial institutions with balances totaling approximately $48.5 million at September 30, 2017.

For the Core Consumer segment, no telecommunication carrier accounted for more than 10% of the segment’s gross accounts receivable at September 30, 2017 and December 31, 2016. One U.S. retail customer accounted for approximately 13% of the segment’s gross accounts receivable at September 30, 2017 and three retail customers accounted for approximately 34% of the segment’s gross accounts receivable at December 31, 2016. For the three and nine months ended September 30, 2017 and 2016, no telecommunications carrier or retailer accounted for more than 10% of the segment’s total operating revenues.

For the Enterprise segment, two U.S. retail customers accounted for approximately 36% of gross accounts receivable at September 30, 2017. No customer accounted for more than 10% of gross accounts receivable at December 31, 2016.  For the three months ended September 30, 2017 and 2016, two customers accounted for approximately 27% and 30% of the segment’s total operating revenues, respectively. For the nine months ended September 30, 2017 and 2016, two customers accounted for approximately 30% and 28% of the segment’s total operating revenues, respectively.

For the SMB segment, accounts receivable were not significant at December 31, 2016. The segment’s operating revenues were not significant for the three and nine months ended September 30, 2016 or the three months ended March 31, 2017.

Inventories

Inventories are stated at the lower of cost or market, with cost primarily determined using the first-in first-out cost method. Inventory is written off at the point it is determined to be obsolete.

Receivable from Earnout Escrow

The 2016 acquisition of Broadsmart, described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2016, included a contingent earnout payment of $2.0 million in cash, if the acquired assets generated 2016 revenues of at least $15.6 million. The $2.0 million was paid into escrow at the time of closing. Revenues for the year ended December 31, 2016 did not reach the target and the Company recorded the funds on the accompanying unaudited condensed consolidated balance sheets as a receivable from earnout escrow.  These funds were received during the nine months ended September 30, 2017.

 

Property, Equipment and Depreciation Expense

Property and equipment are accounted for under ASC 360, “Property, Plant and Equipment” and consist primarily of servers, computer hardware, furniture, and leasehold improvements. Property and equipment are stated at cost and depreciated using the straight-line method over their estimated useful lives, which range from three to fifteen years. Leasehold improvements are depreciated over the shorter of the term of the lease or useful life of the assets. The cost of substantial improvements is capitalized while the cost of maintenance and repairs are charged to operating expenses as incurred.  Refer to Note 5, “Property and Equipment” for further details.

The Company reviews property and equipment for possible impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be fully recoverable. Determination of recoverability is based on an estimate of undiscounted future cash flows resulting from the use of the asset and its eventual disposition. Measurement of an impairment loss is based on the fair value of the asset compared to its carrying value. P roperty and equipment to be disposed of are reported at the lower of carrying amount or fair value less costs to sell. Management believes there was no impairment of the Company’s property or equipment at September 30, 2017.

The Company’s hardware consists of routers, gateways and servers that enable the Company’s telephony services. Some of these assets may be subject to technological risks and rapid market changes due to the introduction of new technology, products and services and changing customer demand. These changes may result in future adjustments to the estimated useful lives and the carrying value of these assets. Changes in estimated useful lives are accounted for on a prospective basis starting with the period in which the change in estimate is made in accordance with ASC 250-10, “Accounting Changes and Error.”

Intangible Assets

Identifiable intangible assets are stated at cost and accounted based on whether the useful life of the asset is definite or indefinite. Identified intangible assets with definite useful lives are amortized using the accelerated and straight-line methods over their estimated useful lives, which range from one to seventeen years. Intangible assets with indefinite lives are not amortized to operations, but instead are reviewed for impairment at least annually, or more frequently if there is an indicator of impairment.

The Company reviews definite lived intangible assets subject to amortization for possible impairment using a three-step approach.  Under the first step, management determines whether an indicator of impairment is present (a “Triggering Event”). If a Triggering Event has occurred, the second step is to test for recoverability based on a comparison of the asset’s carrying amount with the sum of the undiscounted cash flows expected to result from the use of the asset and its eventual disposition . If the sum of the undiscounted cash flows is less than the carrying amount of the asset, the third step is to recognize an impairment loss for the excess of the asset’s carrying amount over its fair value. Intangible assets subject to amortization to be disposed of are reported at the lower of carrying amount or fair value less costs to sell.

The Company recognized impairment charges of $16.6 million and $0.5 million on intangible assets during the nine months ended September 30, 2017 and 2016, respectively. Refer to Note 3, “Impairment of Intangible Assets, Including Goodwill” and Note 6, “Intangible Assets” for further details.

The costs of developing the Company’s intellectual property rights, intellectual property right applications and technology are charged to research and development expense as incurred.

Goodwill

Goodwill represents the excess of the purchase price over the fair value of the identifiable net assets acquired in a business combination. Goodwill is not amortized to operations, but instead is reviewed for impairment at least annually, or more frequently if there is an indicator of impairment. Indicators include, but are not limited to: sustained operating losses or a trend of poor operating performance and a decrease in the Company’s market capitalization below its book value.

The Company’s valuation methodology for assessing impairment requires management to make judgments and assumptions based on historical experience and projections of future operating performance. If these assumptions differ materially from future results, the Company may record impairment charges in the future.

With the acquisition of Broadsmart and the founding of SMB in 2016, management began evaluating each of these new business lines separately and has allocated goodwill between the three reporting units that correspond to the reportable segments – “Core Consumer,” “Enterprise” and “SMB”. Refer to Note 7, “Goodwill” and Note 16, “Segment Reporting” for further details.

 

The Company may utilize a qualitative assessment to determine if it is "more-likely-than-not" that the fair value of the reporting unit is less than its carrying value. If so, an impairment test must be performed. If not, no further testing is required and the Company documents the relevant qualitative factors that support its fair value. Qualitative factors may include, but are not limited to: macroeconomic conditions, industry and market considerations, cost factors that may have a negative effect on earnings, overall financial performance, and other relevant entity-specific events.

In prior years, the Company used the two-step goodwill impairment test.  In January 2017, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2017-04, “Intangibles – Goodwill and Other” which eliminated step two of the goodwill impairment test. The Company adopted ASU 2017-04 on a prospective basis in the first quarter of 2017.

The Company recognized impairment charges of $14.9 million on goodwill for the Enterprise reporting unit, the full balance for that unit, during the nine months ended September 30, 2017. There was no impairment of goodwill during the nine months ended September 30, 2016. Refer to Note 3, “Impairment of Intangible Assets, Including Goodwill” and Note 7, “Goodwill” for further details.

Deferred Revenues

Deferred revenues for the Core Consumer segment consist primarily of billings and payments for magicJack devices and access rights renewals received in advance of revenue recognition. The Company bills and collects in advance for magicJack devices, which include an initial access right period, and access right renewals.  The Company recognizes revenue from device sales and access right renewals ratably over the access right period, as described above.

For the Enterprise segment, deferred revenues consist of UCaaS hardware or equipment purchased but not yet delivered. The Company recognizes revenue from UCaaS hardware or equipment sales in the period they are delivered and put into service.

Deferred revenues to be recognized over the next twelve months are classified as current on the consolidated balance sheets, with the remainder classified as non-current.

Net Revenues

Net revenues consists of revenue from sales of magicJack devices   to retailers, wholesalers or directly to customers, access right renewal fees, fees charged for shipping magicJack devices, usage of domestic and international prepaid minutes, access charges to other carriers, recurring sales of the Company’s hosted UCaaS voice services, non-recurring sales of equipment related to its UCaaS services and other miscellaneous charges. The Company typically enters into multi-year agreements, typically with durations of three to five years, to provide the hosted voice and other services. The Company earns revenue from the sale of the hardware and network equipment necessary to operate its UCaaS services directly to its customers. All revenue is recorded net of sales returns and allowances.

Revenue Recognition

The Company recognizes revenue in accordance with ASC 605, "Revenue Recognition", which provides authoritative guidance on revenue recognition. For arrangements that include more than one product or service (deliverables), the Company applies Section 25 of ASC 605, “Multiple-Element Arrangements”. ASC 605-25 establishes criteria for separating deliverables into different units of accounting and allocating consideration to those units of accounting.  The Company is transitioning to ASC 606, “Revenue from Contracts with Customers”, which will be implemented in 2018.

Core Consumer Segment

magicJack Devices

 magicJack devices include an initial access right, which qualify as multiple deliverables per ASC 605-25.  Since the device and initial access right are interdependent and not sold separately, they are accounted for as a combined unit of accounting. Direct sales of devices include shipping charges and 30 days to return the device and cancel the service.  For retail sales of devices, there is a delay between shipment to the retailer and the ultimate sale to a customer (end-user). Based on sales and inventory data provided by retail partners, the Company’s estimate of the delay was 30 days and 90 days for the three and nine months ended September 30, 2017 and 2016, respectively. The Company defers revenue recognition on direct sales for the 30 day return period and on retail sales for the delay period, after which the Company recognizes the revenue from device sales ratably over the remaining initial access right period.

 

 

Access Right Renewals and Mobile Apps

Customers may renew access rights for periods ranging from one month to five years. The revenue associated with access right renewals is deferred and recognized ratably over the extended access right period. Revenue from the sale of mobile apps is recognized ratably over the access right period.

Other magicJack-Related Products

The Company offers customers other optional products related to their magicJack devices and services, such as insurance, custom or vanity phone numbers, Canadian phone numbers, the ability to either change their existing phone numbers or port them to a magicJack device, and battery powerbanks for mobile devices. These revenues are recognized at the time of sale, with the exception of sales of the battery powerbank which are recognized when shipped.

Prepaid Minutes and Access and Wholesale Charges

The Company generates revenues from the sales of prepaid international minutes to customers, fees for origination of calls to 800-numbers, and access fees charged to other telecommunication carriers on a per-minute basis for Interexchange Carriers (“IXC”) calls terminated on the Company’s servers. Revenues from access fee charges to other telecommunication carriers are recorded based on rates set forth in the respective state and federal tariffs or negotiated contract rates, less a provision for billing adjustments. Revenues from prepaid minutes and access and wholesale charges are recognized as minutes are used.

Sales Return Policy

The Company offers some of its direct sales customers a 30-day free trial before they have to pay for their magicJack device. The Company does not recognize revenue until the 30-day trial period has expired and a customer’s credit card has been charged.

Returns from retailers are accepted on an authorized basis for devices deemed defective. The Company may offer certain retailers the limited right to return any unsold merchandise from their initial stocking orders. The Company also accepts returns of battery powerbanks for mobile devices within 30 days of sale. The Company estimates potential returns under these arrangements at point of sale and re-estimates potential returns on a quarterly basis. For the three and nine months ended September 30, 2017 and 2016, the Company’s estimates of returns and actual returns from initial stocking orders have not been materially different.

Enterprise Segment

UCaaS services and equipment sales related to the Broadsmart subsidiary qualify as multiple deliverables per ASC 605-25.  Since the equipment and services are sold separately and can be used with other products and services, they are accounted for as separate units of accounting. The Company recognizes revenues from sales of its hosted services in the period the services are provided over the term of the respective customer agreements. Customers are billed monthly in advance for these recurring services and in arrears for one time service charges and other certain usage charges.  Revenues from sales of hardware and network equipment are recognized in the period that the equipment is delivered. Revenues from the sale of equipment purchased but not yet delivered are deferred and recognized in the period that the hardware or equipment is delivered and put into service.

SMB Segment

The SMB segment provided phone equipment and services that were interdependent and not sold separately. As such they were accounted for as a combined unit of accounting under ASC 605-25.  Some agreements included a refund period or a promotion for free introductory service.  Revenue recognition was deferred for either period, after which the Company recognized the revenue for the combined unit ratably over the remaining service period.  Revenues from this segment were not significant for the three and nine months ended September 30, 2016.  The SMB segment did not generate significant revenue for the three months ended March 31, 2017.  During the first quarter of 2017, management restructured the Company to absorb all operations and functions of the SMB segment within the Core Consumer segment. Accordingly, this segment will not show activity for periods after March 31, 2017.

 

Cost of Revenues

Core Consumer Segment

Cost of revenues for the Core Consumer segment includes direct costs of operation of the Company’s servers, which are expensed as incurred. These costs include the Company’s internal operating costs, depreciation and amortization expense, access and interconnection charges to terminate domestic and international telephone calls on the public switched telephone network and related taxes. Direct costs also include regulatory costs, server maintenance, and costs to co-locate the Company’s equipment in other telephone companies’ facilities. Direct costs of producing magicJack devices are deferred on shipment and charged to cost of sales ratably over the initial access right period. Deferred costs are included in current assets in the Company’s consolidated balance sheets.

Costs incurred for shipping and handling and credit card charges are included in cost of revenues and are expensed as incurred. Costs for shipping and handling and credit card charges were $0.7 million and $0.9 million for the three months ended September 30, 2017 and 2016, respectively, and $2.4 million and $2.7 million for the nine months ended September 30, 2017 and 2016, respectively. Starting in the second quarter of 2017, these amounts include SMB.

Enterprise Segment

Cost of revenues related to the Company’s UCaaS services include direct costs of providing the services, which are expensed as incurred. These costs include charges for access to the public switched telephone network, internet service for its customers, maintenance costs for its software, commissions, credit card charges, contract labor for installation and depreciation and amortization. The Company also incurs costs for hardware and equipment sold to customers, along with related delivery costs, which are recognized in the period they are delivered and put into service.

SMB Segment

Costs of revenue for the SMB segment included direct costs of providing the services, which were expensed as incurred, and costs for phone equipment, which were recognized ratably over the service period.  Costs of revenue from this segment were not significant for the three and nine months ended September 30, 2016. The SMB segment did not incur significant costs of revenue for the three months ended March 31, 2017.

 

Research and Development Expenses

The Company’s research and development activities consist primarily of the design and development of its proprietary software used in the magicJack devices, mobile apps and servers, as well as the development of new products and applications for use in its VoIP service offerings. The Company accounts for research and development costs in accordance with applicable accounting pronouncements. These pronouncements specify that costs incurred internally in researching and developing a product should be charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all costs should be capitalized until the product is available for general release to customers. The Company has determined that technological feasibility for its products is reached after all high-risk development issues have been resolved through internal and customer base testing. Generally, new products offered to customers and improvements to the Company’s servers are placed in service on attainment of technological feasibility. The Company has not capitalized any of its research and development activities and related costs.

 

Share-based Compensation

Share-based compensation generally consists of option grants or ordinary share and restricted stock awards to directors, officers, employees or consultants. We account for share-based compensation in accordance with ASC 718, "Compensation - Stock Compensation", which requires companies to estimate the fair value of equity-based payment awards on the date of grant based on the fair value of the award. The value of the portion of the award that is ultimately expected to vest is recognized as an expense over the requisite service period. Refer to Note 12, “Share-Based Compensation” for further details.

Income Taxes

The Company recognizes deferred tax assets and liabilities for the expected tax consequences of temporary differences between the tax basis of assets and liabilities and their book basis using enacted tax rates. Any changes in enacted tax rates or tax laws are included in the provision for income taxes in the period of enactment. The Company’s net deferred tax assets consist primarily of foreign net operating loss carry-forwards, timing differences between recognition of income for book and tax purposes, and the tax benefit related to the impairment of intangible assets, including goodwill, in the Enterprise segment. The Company records a valuation allowance to reduce the net deferred tax assets to the amount that it estimates is more-likely-than-not to be realized. The Company periodically reviews the composition of its deferred tax assets and related valuation allowances and will make adjustments if available evidence indicates that it is more likely than not a change in the carrying amounts is required. The Company increased the valuation allowance by $15 thousand and $44 thousand during the three and nine months ended September 30, 2017, respectively. The Company increased the valuation allowance by $0.3 million and decreased the valuation allowance by $0.2 million during the three and nine months ended September 30, 2016, respectively.

The Company assesses its income tax positions and records tax benefits for all years subject to examination based upon its evaluation of the facts, circumstances and information available at the reporting date. For those tax positions where it is more likely than not that a tax benefit will be sustained, the Company has recorded the largest amount of tax benefit that may potentially be realized upon ultimate settlement with a taxing authority that has full knowledge of all relevant information. For those income tax positions that are not more likely than not, no tax benefit has been recognized in the financial statements. The Company revised its liability for uncertain tax positions by a decrease of $20 thousand and an increase of $1.6 million in the three and nine months ended September 30, 2017, respectively, due primarily to an increase in uncertain tax positions related to various state issues and the revaluation impact of certain Israeli uncertain tax positions.  The Company revised its liability for uncertain tax positions by an increase of $0.3 million and $1.5 million in the three and nine months ended September 30, 2016, respectively, due primarily to an increase in uncertain tax positions related to various state issues and the revaluation impact of certain Israeli uncertain tax positions.

The Company records its income tax expense for interim financial statements by using an estimated annual effective income tax rate based on its expected annual results after consideration of permanent nontaxable items. The tax benefits of net operating loss carry-forwards expected to be realized through 2017 and changes in other deferred tax assets and liabilities are recognized during interim periods based on an annual forecast as of the interim reporting date. At September 30, 2017, the estimated annual effective income tax rate is expected to approximate 22.0%, excluding discrete tax items, which includes federal, foreign, state and local taxes. This rate may fluctuate due to changes in jurisdictional income and to the timing of other discrete period transactions during the remainder of the year.

Comprehensive Income

Comprehensive income attributable to common shareholders, as defined, includes all changes in equity (net assets) during a period from non-owner sources. There were no items of comprehensive income in the nine months ended September 30, 2017 and 2016.

Earnings (Loss) per Share Attributable to Common Shareholders

Net income or loss per share attributable to the Company’s common shareholders – basic, is calculated by dividing net income (loss) attributable to common shareholders by the weighted average number of common shares outstanding during each period. Net income or loss per share attributable to the Company’s common shareholders – diluted, is computed using the weighted average number of common and dilutive potential common shares outstanding during the period. Potential common shares consist of shares issuable upon the exercise of options to purchase ordinary shares or the vesting of restricted stock.

Business Combinations

The Company accounts for business combinations under ASC 805, “Business Combinations” using the acquisition method of accounting. The acquisition method of accounting requires that the purchase price, including the fair value of contingent consideration, of the acquisition be allocated to the assets acquired and liabilities assumed using the fair values determined by management as of the acquisition date. Goodwill as of the acquisition date is measured as the excess of consideration transferred over the net of the acquisition date fair values of assets acquired and the liabilities assumed. While the Company uses its best estimates and assumptions as part of the purchase price allocation process to accurately value assets acquired and liabilities assumed at the acquisition date, the Company’s estimates are inherently uncertain and subject to refinement. As a result, during the measurement period, which may be up to one year from the acquisition date, the Company records adjustments to the assets acquired and liabilities assumed, with the corresponding offset to goodwill to the extent the Company identifies adjustments to the preliminary purchase price allocation. Upon the conclusion of the measurement period and final determination of the values of assets acquired or liabilities assumed, any subsequent adjustments are recorded to the consolidated statements of operations. The Company includes the results of all acquisitions in its Consolidated Financial Statements from the date of acquisition. Acquisition related transaction costs, such as banking, legal, accounting and other costs incurred in connection with an acquisition, are expensed as incurred in general and administrative expense.

 

Acquisition-related integration costs also include expenses directly related to integrating and reorganizing acquired businesses, employee retention costs, recruiting costs, certain moving costs, certain duplicative costs during integration and asset impairments. These costs are expensed as incurred in general and administrative expense.

Recent Accounting Pronouncements

In May 2014, the FASB issued ASU 2014-09, “Revenue from Contracts with Customers”, which is the new ASC 606. The standard requires entities to recognize revenue through the application of a five-step model, which includes identification of the contract, identification of the performance obligations, determination of the transaction price, allocation of the transaction price to the performance obligations, and recognition of revenue as the entity satisfies the performance obligations. On July 9, 2015, the FASB deferred the effective dates of the standard by one year. As a result, the standard will be effective for annual and interim periods beginning after December 15, 2017. Early adoption is permitted, but cannot precede the original effective date (annual and interim reporting periods beginning after December 15, 2016). The standard allows for either full retrospective adoption, meaning the standard is applied to all of the periods presented, or a modified retrospective adoption, meaning the standard is applied only to the most current period presented. In March 2016, the FASB issued ASU 2016-08, “Principal versus Agent Considerations (Reporting Revenue Gross versus Net)” to provide clarification regarding the application of the principal-versus-agent guidance. In April 2016, the FASB issued ASU 2016-10, “Identifying Performance Obligations and Licensing” to clarify the guidance for identifying performance obligations and accounting for licenses of intellectual property. In May 2016, the FASB also issued ASU 2016-12, “Narrow-Scope Improvements and Practical Expedients” which provides narrow scope improvements and technical expedients on assessing collectibility, presentation of sales taxes, evaluating contract modifications and completed contracts at transition and the disclosure requirement for the effect of the accounting change for the period of adoption. In December 2016, the FASB issued ASU 2016-20, “Technical Corrections and Improvements to Topic 606” which made minor corrections and improvements to certain narrow aspects of the guidance. The Company will adopt the requirements of the new standard in the first quarter of 2018 and has preliminarily selected the modified retrospective transition method. Under this method, the standard will be applied only to the most current period presented and the cumulative effect of applying the standard will be recognized at the date of initial application.  The Company is also considering optional practical expedients related to applying the new standard to its costs of obtaining contracts and to its portfolios of contracts. The Company is reviewing its accounting policies, processes, and system requirements and has engaged consultants to assist with and document the analysis as well as the implementation of any required changes. The Company is also evaluating the potential impact on the Company’s financial condition, results of operations and cash flows, as well as its financial statement disclosures. The Company anticipates completing its assessment by December 31, 2017.

In July 2015, the FASB issued ASU 2015-11, "Simplifying the Measurement of Inventory". This ASU applies to inventory that is measured using first-in, first-out ("FIFO") or average cost. Under the updated guidance, an entity should measure inventory that is within scope at the lower of cost and net realizable value, which is the estimated selling prices in the ordinary course of business, less reasonably predicable costs of completion, disposal and transportation. Subsequent measurement is unchanged for inventory that is measured using last-in, first-out ("LIFO"). The Company adopted ASU 2015-11 on a prospective basis in the first quarter of 2017.  Prior periods were not retrospectively adjusted.

In February 2016, the FASB issued ASU 2016-02, “Leases”. ASU 2016-02 requires that long-term lease arrangements be recognized on the balance sheet. The standard is effective for annual and interim periods beginning after December 15, 2018, and early adoption is permitted. The Company is currently evaluating the guidance to determine the potential impact on the Company’s financial condition, results of operations and cash flows.

In March 2016, the FASB issued ASU 2016-09, “Compensation - Stock Compensation: Improvements to Employee Share-Based Payment Accounting”. ASU 2016-09 changed the accounting for certain aspects of stock options and other share-based compensation. This accounting standard requires companies to recognize excess tax benefits or expenses related to the vesting or settlement of employee share-based awards (i.e., the difference between the actual tax benefit realized and the tax benefit initially recognized for financial reporting purposes) as income tax benefits or expenses in the quarterly Financial Statements. The standard also requires companies to record a windfall tax benefit when it arises, subject to normal valuation allowance considerations, instead of delaying recognition until the benefit reduces current taxes payable. The Company adopted ASU 2016-09 on a prospective basis in the first quarter of 2017. For the nine months ended September 30, 2017, this adoption had no tax impact to the Company.  The Company will continue to monitor this for each reporting period going forward.

 

In August 2016, the FASB issued ASU 2016-15, “Classification of Certain Cash Receipts and Cash Payments”. ASU 2016-15 reduces the diversity of how certain cash receipts and cash payments are presented and classified in the statement of cash flows under Topic 230, Statement of Cash Flows, and other Topics. The standard is effective for annual and interim periods beginning after December 15, 2017, and early adoption is permitted.  The ASU should be applied retrospectively to all periods presented. The Company is currently evaluating the guidance to determine the potential impact on the Company’s financial condition, results of operations and cash flows.

In October 2016, the FASB issued ASU 2016-16, “Intra-Entity Transfers of Assets Other than Inventory”. ASU 2016-16 requires an entity to recognize the income tax consequences of intra-entity transfers of assets other than inventory when the transfer occurs. The standard is effective for annual and interim periods beginning after December 15, 2017, and early adoption is permitted.  The ASU should be applied retrospectively as an adjustment to retained earnings. The Company is currently evaluating the guidance to determine the potential impact on the Company’s financial condition, results of operations and cash flows.

In January 2017, the FASB issued ASU 2017-04, “Intangibles – Goodwill and Other”.  ASU 2017-04 eliminates step two of the goodwill impairment test. The standard is effective for annual and interim periods beginning after December 15, 2019, and early adoption is permitted.  The Company early adopted ASU 2017-04 on a prospective basis in the first quarter of 2017. Prior periods were not retrospectively adjusted.

In May 2017, the FASB issued ASU 2017-09, “Compensation - Stock Compensation: Scope of Modification Accounting”. ASU 2017-09 provides guidance on determining which changes to share-based awards require modification accounting under ASC 718. The standard is effective for annual and interim periods beginning after December 15, 2017, and early adoption is permitted.  The Company is currently evaluating the guidance to determine the potential impact on the Company’s financial condition, results of operations and cash flows.

NOTE 3 – IMPAIRMENT OF INTANGIBLE ASSETS, INCLUDING GOODWILL

As part of the Company’s quarterly impairment reviews for intangible assets with indefinite lives, including goodwill, management determined that there were no impairment indicators as of September 30, 2017; however, there were impairment indicators at the Enterprise segment as of March 31, 2017.

As was previously disclosed in the Company’s Form 10-K filed on March 16, 2017, the Broadsmart business which comprises the Enterprise segment was underperforming and steps were being taken to improve operating results including the February 2017 hiring of a new Chief Operating Officer for the segment and the hiring of additional sales and marketing personnel dedicated to obtaining new business.  The new Chief Operating Officer for the Enterprise segment and the new Executive Management team completed a comprehensive review of the Enterprise segment’s business prospects and through this process revised the projections for its operating results downward .  Additionally, Broadsmart received notification in early April 2017 that a major customer would not be renewing its contract and management anticipates the loss of another one of the Enterprise segment’s significant customers.  Combined, these customers accounted for approximately 29% of the Enterprise segment’s revenue in 2016.  Management considered the revised projections and customer losses to be indicators of potential impairment, and accordingly performed impairment testing of its long-lived assets and indefinite-lived intangible assets, including goodwill, as of March 31, 2017 utilizing its revised projections for Broadsmart.

Based on the impairment indicators as of March 31, 2017 discussed above, the Company engaged an independent third party to perform a valuation of the Enterprise reporting unit’s long-lived assets and indefinite-lived intangible assets, including goodwill as of March 31, 2017. The valuation estimated the fair value of Broadsmart’s identified intangible assets not subject to amortization based on the relief from royalty method, which requires an estimate of a reasonable royalty rate, identification of relevant projected revenues and expenses, and selection of an appropriate discount rate. The Company recorded an impairment charge of $0.9 million for the carrying value in excess of the fair value.

For long-lived assets, including definite-lived intangible assets subject to amortization, management totaled the undiscounted cash flows expected to result from the use of these assets and their eventual disposition and noted that the sum did not exceed the carrying amount of the assets, indicating further impairment testing was necessary for these assets as of March 31, 2017. The estimated fair value of definite-lived intangible assets subject to amortization as of March 31, 2017, was based on discounted future cash flows.  The Company recorded impairment losses of $15.7 million for the carrying value in excess of the fair value.

Based on a discounted future cash-flows approach, the third party valuation estimated the fair value of the Enterprise reporting unit to be $17.9 million.  Recognition of the goodwill impairment resulted in a tax benefit which was recorded as a deferred tax asset.  Since the deferred tax asset increases the carrying value of the reporting unit, it would result in an additional impairment. The accounting guidance requires an entity to calculate the impairment charge and the deferred tax effect using a simultaneous equation method, which effectively grosses up the goodwill impairment charge to account for the related deferred tax benefit so that the resulting carrying value does not exceed the calculated fair value. The simultaneous equation calculation resulted in an impairment charge that exceeded the carrying value of the goodwill. Since the guidance limits goodwill impairments to the carrying value of goodwill, the Company recognized an impairment loss of $14.9 million, the full carrying value of goodwill.

 

In total, impairment losses of $31.5 million were recognized in operating expenses of the Enterprise segment for the first quarter ended March 31, 2017.  The impaired assets were (in thousands):

 

 

The Company (recovered) wrote-off obsolete inventory of approximately ($33) thousand and $146 thousand during the three months ended September 30, 2017 and 2016, respectively, and $370 thousand and $229 thousand during the nine months ended September 30, 2017 and September 30, 2016, respectively. Inventory write-offs are reflected in cost of revenues in the unaudited condensed consolidated statements of operations.

* The estimated useful life for leasehold improvements is the shorter of the term of the lease or life of the asset.

Depreciation expense for the three months ended September 30, 2017 and 2016 was $0.3 million. Depreciation expense for the nine months ended September 30, 2017 and 2016 was $1.0 million and $0.9 million, respectively.

 

 

Amortization expense for the three months ended September 30, 2017 and 2016 was $0.7 million and $1.0 million, respectively. Amortization expense for the nine months ended September 30, 2017 and 2016 was $2.4 million and $2.7 million, respectively.

As part of the Company’s quarterly impairment reviews for intangible assets with indefinite lives, including goodwill, management determined that there were no impairment indicators as of September 30, 2017; however, there were impairment indicators at the Enterprise segment as of March 31, 2017.  Due to   the knowable impairment indicators discussed in Note 3, “Impairment of Intangible Assets, Including Goodwill”, the Company engaged an independent third party to perform a valuation of the Enterprise reporting unit’s long-lived assets and indefinite-lived intangible assets, including goodwill, as of March 31, 2017. Based on the results of the valuation, impairment losses of $16.6 million were recognized on the following intangible assets in operating expenses under the Enterprise segment in the unaudited condensed consolidated statements of operations for the quarter ended March 31, 2017:

 

 

During the three and nine months ended September 30, 2016, impairment losses of $0.5 million were recognized in General and Administrative expense under the Consumer segment in the statement of operations. The impairments were comprised of: (i) a Telecom license included in the “Other” category of amortizable intangible assets for $249 thousand (net of accumulated amortization) deemed obsolete, and (ii) domain names not subject to amortization for $249 thousand that were not renewed.

Based on the carrying value of identified intangible assets recorded at September 30, 2017, the amortization expense for the future fiscal years is expected to be as follows (in thousands):

 

 

 

As part of the Company’s quarterly impairment reviews for intangible assets with indefinite lives, including goodwill, management determined that there were no impairment indicators as of September 30, 2017; however, there were impairment indicators at the Enterprise segment as of March 31, 2017.  Due to   the knowable impairment indicators discussed in Note 3, “Impairment of Intangible Assets, Including Goodwill”, the Company engaged an independent third party to perform a valuation of the Enterprise reporting unit’s long-lived assets and indefinite-lived intangible assets, including goodwill, as of March 31, 2017.

Based on a discounted future cash-flows approach, the third party valuation estimated the fair value of the Enterprise reporting unit to be $17.9 million.  Recognition of the goodwill impairment resulted in a tax benefit which was recorded as a deferred tax asset.  Since the deferred tax asset increases the carrying value of the reporting unit, it would result in an additional impairment. The accounting guidance requires an entity to calculate the impairment charge and the deferred tax effect using a simultaneous equations method, which effectively grosses up the goodwill impairment charge to account for the related deferred tax benefit so that the resulting carrying value does not exceed the calculated fair value.  The resulting impairment is limited to the carrying value of goodwill.  In the valuation performed for the Company the impairment calculated using the simultaneous equation method resulted in an impairment charge that exceeded the carrying value of the goodwill.  Accordingly, an impairment loss of $14.9 million on goodwill was recognized in operating expenses under the Enterprise segment in the unaudited condensed consolidated statements of operations for the three months ended March 31, 2017.

The application of the goodwill impairment test requires judgment, including the identification of reporting units, assigning assets and liabilities to reporting units, assigning goodwill to reporting units, and determining the fair value of each reporting unit. Significant judgment, and the use of significant estimates and assumptions, is required to estimate the fair value of reporting units, including estimating future cash flows, future market conditions, and determining the appropriate discount rates, growth rates, and operating margins, among others.

The discounted cash flow analyses factor in assumptions on revenue and expense growth rates. These estimates are based upon the Company’s historical experience, best estimates of future activity, and a cost structure necessary to achieve the related revenues.

Additionally, these discounted cash flow analyses factor in expected amounts of working capital and weighted average cost of capital. The Company believes the assumptions are reasonable. However, there can be no assurance that its estimates and assumptions made for purposes of the goodwill impairment testing, at the annual Measurement Date, will prove to be accurate predictions of the future. Changes in these estimates and assumptions as previously noted, could result in the need to conduct additional goodwill impairment tests in the future and could ultimately result in an impairment charge. In addition, a change in the Company’s reporting units could materially affect the determination of the fair value for each reporting unit, which could trigger impairment in the future. The Company will continue to review its results against forecasts and assess its assumptions to ensure they continue to be appropriate.

 

NOTE 8 – DEFERRED COSTS AND REVENUES

All deferred costs and deferred revenues to be recognized over the next twelve months are classified as current on the Company’s unaudited condensed consolidated balance sheets. The remaining deferred revenue amounts are classified as non-current on the unaudited condensed consolidated balance sheets.

Deferred revenues were comprised of the following at September 30, 2017 and December 31, 2016 (in thousands):

 

 

* Deferred revenue, non-current, is comprised entirely of deferred revenues originating from the sale of access right renewals.

Costs necessary to fulfill the Company’s obligations to provide VoIP telephone service to new and existing customers who have purchased magicJack devices, mobile apps or renewed access rights are expensed as incurred. For the Core Consumer segment, such costs were approximately $2.4 million and $2.9 million for the three months ended September 30, 2017 and 2016, respectively, and $7.5 million and $9.6 million for the nine months ended September 30, 2017 and 2016, respectively. For the Enterprise segment, such costs were approximately $0.6 million and $0.8 million for the three months ended September 30, 2017 and 2016, respectively, and $1.9 million and $1.7 million for the nine months ended September 30, 2017 and 2016, respectively. Costs related to providing broadband telephone service to SMB segment customers were not significant for the three and nine months ended September 30, 2016 and the three months ended March 31, 2017.

Deferred revenues as of September 30, 2017 are expected to be recognized in future years as follows (in thousands):

 

 

NOTE 9 – OTHER LIABILITIES

As of September 30, 2017 and December 31, 2016, other non-current liabilities primarily consisted of provisions for uncertain tax positions of $12.1 million and $10.4 million, respectively.

 

NOTE 10 – COMMITMENTS AND CONTINGENCIES

Legal Proceedings

The Company is subject to various legal proceedings and claims, including intellectual property claims, contractual and commercial disputes, employment claims, state and local tax matters and other matters which arise in the ordinary course of business. The Company vigorously defends claims made against it, and management regularly evaluates the status of legal proceedings in which the Company is involved in order to assess whether a loss is probable or there is a reasonable possibility that a loss or additional loss may have been incurred and to determine if accruals are appropriate. While the outcome of these claims cannot be predicted with certainty, management does not believe that the outcome of any of these legal matters will have a material adverse effect on the Company’s business, operating results, financial condition or cash flows. However, an unexpected adverse resolution of one or more of these matters could have a material adverse effect on the Company’s results of operations in a particular fiscal year or quarter.

On March 11, 2016, a purported class action lawsuit was filed against the Company, its then Chief Executive Officer, Gerald Vento, and its then Chief Financial Officer, Jose Gordo (together, “the Defendants”), in the United States District Court for the Southern District of New York. Thereafter, on August 18, 2016, the Plaintiff filed an Amended Complaint.  The Amended Complaint alleges that the Company and Mr. Gordo made false and misleading statements regarding the financial performance and guidance during the alleged class period of November 12, 2013 to March 12, 2014. The Plaintiff asserted claims that (i) the Company and Mr. Gordo violated Section 10(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and SEC Rule 10b-5; and (ii) that Mr. Vento and Mr. Gordo violated Section 20(a) of the Exchange Act by virtue of their control over the Company.  For himself and for the class, the Plaintiff seeks damages, attorneys' fees and costs, and equitable/injunctive relief or such other relief as the court deems proper. The Defendants answered the Amended Complaint on December 23, 2016.  On June 23, 2017, the parties agreed in principle to a mediated settlement in which the Defendants would pay $3,650,000 to settle all claims, while denying all claims and allegations against them by the Plaintiff   subject to negotiation of a definitive Stipulation of Settlement, which would then have to be approved by the Court. The parties thereafter entered into a definitive Stipulation of Settlement.  On September 29, 2017, the court entered an order granting preliminary approval to the settlement and scheduled a final hearing on approval of the settlement for January 19, 2018. The Company has insurance coverage applicable to this settlement with a retention amount of $1.0 million. As of September 30, 2017, the Company has accrued $0.3 million of expense, reflecting anticipated future expenditures for the remaining deductible under its insurance coverage.

On August 11, 2017, a putative class action lawsuit was filed against the Company and its Board of Directors in the United States District Court for the Southern District of Florida.  The complaint alleges claims against the Company and its Board of Directors for violations of Sections 14(a) and 20(a) of the Securities Exchange Act of 1934, arising from statements in the April 2017 Proxy and the July 2017 Proxy that allegedly misrepresented material facts. The Company has not responded to the initial complaint but plans to file a motion to dismiss.  The Company believes that the case is without merit and cannot estimate the amount of potential liability, if any, that could arise from this issue.  The Company does not believe that the case will have a material adverse effect on its business, operating results, financial condition or cash flows.

 

Tax Contingencies

The Company believes that it files all required tax returns and pays all required federal, state and municipal taxes (such as sales, excise, utility, and ad valorem taxes), fees and surcharges. The Company is the subject of inquiries and examinations by various states and municipalities in the normal course of business. In accordance with generally accepted accounting principles, the Company makes a provision for a liability for taxes when it is both probable that a liability has been incurred and the amount of the liability can be reasonably estimated. These provisions are reviewed at least quarterly and adjusted to reflect the impact of negotiations, settlements, rulings, advice of legal counsel, and other information and events pertaining to a particular case. The Company vigorously defends its rights and tax positions. However, if a government entity were to prevail in any matter, it could have a material adverse effect on the Company’s financial condition, results of operation and cash flows. In addition, it is at least reasonably possible that a potential loss may exist for tax contingencies in addition to the provisions taken by the Company. For those potential additional tax contingencies which can be reasonably estimated, that additional potential liability ranges from $0 to $2.5 million.

The Company is currently under examination for potential state tax liabilities.  On June 8, 2017, the Company offered to settle the examinations for payment of $0.6 million and the agreement to remit certain taxes on a prospective basis. As of September 30, 2017, the Company has not reached agreement with the taxing authority.

 

NOTE 11 –TREASURY STOCK

In January 2017, the Company reclassified 16,666 shares previously issued out of treasury stock as they had been issued as new ordinary shares. In April 2017, the Company issued 6,996 of its ordinary shares held as treasury shares with a cost of $86 thousand, or $12.32 per share, to Board members as a result of restricted stock vesting. In May 2017, the Company issued 76,211 of its ordinary shares held as treasury shares with a cost of $939 thousand, or $12.32 per share, to an executive officer as a result of restricted stock vesting. In May 2017, the Company purchased 20,844 of its ordinary shares at $6.50 per share, for an aggregate purchase price of approximately $135 thousand, in settlement of the withholding tax liability on the vesting of the restricted stock.

 

NOTE 12 – SHARE-BASED COMPENSATION

The Company has granted ordinary share optionsand restricted stock as an alternative or supplement to the compensation of its executives, employees, directors and outside consultants. The Company’s share-based compensation program is a long-term retention program intended to attract and reward talented executives, employees and outside consultants, and align their interests with stockholders. The Company is currently granting share-based awards under the Amended and Restated magicJack VocalTec Ltd. 2013 Stock Incentive Plan and the Amended and Restated magicJack VocalTec Ltd. 2013 Israeli Stock Incentive Plan (together, the “2013 Plans”). In July 2013, the shareholders approved the 2013 Plans at the annual general meeting of shareholders to allow grants of ordinary share options, restricted stock and ordinary shares. In April 2014 and July 2017, the shareholders approved amendments to the 2013 Plans increasing the number of share based awards available for grant. As of September 30, 2017, the aggregate number of shares subject to awards under the 2013 Plans, as amended, was 5,600,000. The Company had previously granted shares under the VocalTec amended Master Stock Plan (the “2003 Plan”) which expired in April 2013. The Company’s policy is to recognize compensation expense for awards with only service conditions and a graded vesting on a straight-line basis over the requisite vesting period for the entire award.

The Company’s share-based compensation expense for ordinary share options and restricted stock for the three and nine months ended September 30, 2017 and 2016 was as follows (in thousands):

 

 

The detail of total share-based compensation recognized by classification on the unaudited condensed consolidated statements of operations for the three and nine months ended September 30, 2017 and 2016 was as follows (in thousands):

 

 

The decrease in share-based compensation is due primarily to forfeitures related to reduced headcount and awards that fully vested in prior periods.

 

 

 

(1)	The aggregate intrinsic value is the amount by which the market value for the Company's common stock exceeds the weighted average exercise price of the outstanding stock options on the measurement date.

 

(2)

In 2017, two former executive officers surrendered a total of 1,244,777 ordinary share options with a weighted average exercise price of $14.57. Additionally, 1,256,837 options with a weighted average strike price of $7.70 were forfeited by terminated executives in the SMB and Enterprise segments. The surrender of options resulted in a $2.4 million increase in tax expense during the second quarter.

 

Share-based compensation expense recognized for ordinary share options was approximately $0.4 million for the three months ended September 30, 2017 and 2016, and $1.0 million and $1.9 million for the nine months ended September 30, 2017 and 2016, respectively. No ordinary share options were exercised during the nine months ended September 30, 2017. The total intrinsic value of ordinary share options exercised during the nine months ended September 30, 2016 was $6 thousand. As of September 30, 2017, there was approximately $5.7 million of unrecognized share-based compensation expense related to unvested ordinary share options, which is expected to be recognized over a weighted average remaining period of 2.42 years.

The Company uses the Black-Scholes option pricing model to determine the fair value of stock options. The determination of the fair value of share-based payment awards on the date of grant using an option-pricing model is affected by the Company’s stock price, as well as assumptions regarding a number of complex and subjective variables. These variables include the Company’s expected stock price volatility over the term of the awards, assumed employee exercise behaviors, risk-free interest rate and expected dividends. For purposes of valuing ordinary share options, the Company used historical volatility at the date of grant. The approximate risk-free interest rate was based on the U.S. Treasury yield for comparable periods. The Company has experienced forfeitures in the past and estimates a forfeiture rate for awards issued when deemed applicable. The expected term of the ordinary share options was calculated using the simplified method in accordance with section 10-S99 of ASC 718, "Compensation - Stock Compensation".  The Company does not expect to pay dividends on its ordinary shares in the foreseeable future. Accordingly, the Company used a dividend yield of zero in its option pricing model. The Company granted 2,896,304 ordinary share options during the nine months ended September 30, 2017 with a weighted average fair value of $2.14. The Company granted 1,107,040 ordinary share options during the nine months ended September 30, 2016 with a weighted average fair value of $2.75.  The grants were measured using the following assumptions:

 

 

Restricted Stock

The Company may also award restricted stock to its executives, employees, directors and outside consultants under the 2013 Plans, which may vest based on service or a combination of service and other conditions, such as market share price . The compensation expense for the award will be recognized assuming that the requisite service is rendered regardless of whether the market conditions are achieved. During the nine months ended September 30, 2017 and 2016 the Company granted 276,890 and 295,305 restricted stock awards, respectively, under the 2013 Plans, as amended.

The following table summarizes the Company’s restricted stock award activity for the nine months ended September 30, 2017:

 

 

Share-based compensation expense recognized for restricted stock was approximately $0.3 million and $0.5 million for the three months ended September 30, 2017 and 2016, respectively, and $1.0 million and $1.3 million for the nine months ended September 30, 2017 and 2016, respectively. As of September 30, 2017, there was approximately $2.5 million in unrecognized share-based compensation costs related to restricted stock. The unrecognized share-based compensation expense is expected to be recognized over a weighted average remaining vesting period of 0.57 years.

 

The Company primarily operates in the U.S. and Israel, and the Company’s Israeli operations are subject to a statutory income tax rate of 24% in 2017 and 23% in 2018 which is lower than the Company’s U.S. federal income tax rate of 34% as of September 30, 2017.

For the three months ended September 30, 2017, the Company recorded income tax expense of $1.6 million, which is higher than the expected tax expense of $1.4 million, using the statutory income tax rate of 34% due to reductions in the Company’s deferred tax assets related to the forfeiture of options totaling $0.5 million and other smaller discrete items. The discrete items noted above were partially offset by the lower jurisdictional tax rate charged on the operating income of the Company’s Israeli operations

For the nine months ended September 30, 2017, the Company recorded an income tax benefit of ($7.2) million, which is lower than the expected tax benefit of ($10.0) million, using the statutory rate of 34%, due, in part, to revaluations of the Israel net operating loss carryforwards of ($0.8) million, increases to uncertain tax positions of $1.8 million, and a reduction to deferred tax assets related to surrender of stock options and option forfeitures of $2.8 million. The discrete items noted above were partially offset by the lower jurisdictional tax rate charged on the operating income of the Company’s Israeli operations.

 

NOTE 14 – NET INCOME (LOSS) ATTRIBUTABLE TO COMMON SHAREHOLDERS PER SHARE

Net income (loss) attributable to common shareholders per share – basic, is calculated by dividing net (loss) income attributable to the Company’s common shareholders (the “Numerator”), by the weighted average number of common shares outstanding during the period, (the “Denominator”). Net (loss) income attributable to common shareholders per share – diluted, is computed by increasing the basic denominator to include the number of ordinary shares that would have been issued if the Company’s dilutive potential common shares had been exercised or vested.  The Company’s potential common shares are the share-based awards ( ordinary share options and restricted stock)   discussed in Note 12, “Share-Based Compensation”.

The Company calculates the diluted denominator using the treasury stock method, which assumes that all exercise proceeds are used to repurchase common shares, reducing the net number of shares to be added. Share-based awards only have a dilutive effect when the average stock price for the period exceeds their exercise price (“in the money”) and the entity has net income.

The following table presents the computation of basic and diluted net (loss) income per common share attributable to shareholders (in thousands, except for per share information):

 

 

NOTE 15 – BROADSMART ACQUISITION

In March 2016, the Company acquired the assets of Broadsmart for approximately (i) $38.0 million in cash, (ii) 233,402 shares of the Company's ordinary shares issued from treasury stock with a fair value of $1.7 million based on closing market price per share as of the date of the acquisition, and (iii) additional contingent cash payments of (a) up to $0.2 million, if two certain individuals ($0.1 million for each) previously employed by Broadsmart do not accept the Company's employment offer, and (b) $2.0 million, if the acquired assets generated 2016 revenues of at least $15.6 million.

At the time of closing, $3.0 million of the cash consideration was paid into escrow to cover indemnification claims by the Company against the sellers. No asset or liability is included in the accompanying unaudited condensed consolidated balance sheets for this item.

The acquired assets and liabilities were recorded at their estimated fair values on the balance sheet for the Enterprise segment on March 17, 2016. The results of operations of the Broadsmart business have been included in the Company’s consolidated financial statements, under the Enterprise segment, since that date. During the year ended December 31, 2016, the Company recognized an impairment loss of $0.5 million on one of the Broadsmart intangible assets.  During the first quarter ended March 31, 2017, the Company recognized impairment charges of $31.5 million on Broadsmart intangible assets, including goodwill.  The carrying value of the Broadsmart business after the impairment was $18.5 million at March 31, 2017. Refer to Note 3, “Impairment of Intangible Assets, Including Goodwill”, Note 6, “Intangible Assets” and Note 7, “Goodwill” for further details.

Neither of the contingent payments had been made as of September 30, 2017. The $0.2 million is included in accrued expenses and other current liabilities in the accompanying unaudited condensed consolidated balance sheets. The $2.0 million was paid into escrow at the time of closing. Revenues for the year ended December 31, 2016 did not reach the target and the Company recorded a $2.0 million receivable from earnout escrow and a gain on mark-to-market in the accompanying unaudited condensed consolidated balance sheets and statements of operations.

 

On June 23, 2017, the founders of Broadsmart left the Company.  On August 4, 2017, the Company reached a mutual agreement with the founders that included release to the Company of $1.0 million of the $3.0 million held in escrow to cover indemnification claims and the $2.0 million earn-out amount.  The remaining $2.0 million will remain in escrow until March 2019, pursuant to the provisions of the purchase agreement, to cover potential claims by the Company for telecommunications taxes.  During the nine months ended September 30, 2017, the Company collected both escrow amounts.  The $1.0 million was recorded as a gain on mark-to-market, less amounts due from the founders and the $2.0 million receivable from earnout escrow was removed.

The agreement also provided that the Company will execute an agreement to acquire certain assets of North American Telecommunications Inc. (“NATC”) for $10 thousand, subject to any required regulatory approvals.

 

The pro forma results are based on estimates and assumptions, which the Company believes are reasonable. The pro forma results include adjustments primarily related to amortization of acquired intangible assets, depreciation, interest expense, and transaction costs expensed during the period.

NOTE 16 – SEGMENT REPORTING

Reportable segments are defined under U.S. GAAP as components of an enterprise for which separate financial information is available and evaluated regularly by a company's chief operating decision makers in deciding how to allocate resources and assess performance.

Historically, the Company has not had separate reportable segments. However, with the acquisition of Broadsmart and the founding of the SMB business during 2016, management evaluated each of these new business lines separately and determined that the Company had separate reportable segments – “Core Consumer,” “Enterprise” and “SMB”. These segments were organized by the products and services that are sold and the customers that are served.  During the first quarter of 2017, management restructured the Company to absorb all operations and functions of the SMB segment within the Core Consumer segment. Accordingly, the SMB segment will not show activity for periods after March 31, 2017.  The below table includes an “Other” segment to capture the Company’s interest in a joint venture that does not meet either the aggregation criteria to be combined with the existing Core Consumer segment or the quantitative thresholds to be treated as a reportable segment.  The Company measures and evaluates its reportable segments based on revenues and gross profit margins. The Company’s segments and their principal activities consist of the following:

Core Consumer

This segment represents a vertically integrated group of companies, a micro-processor chip design company, an appserver and session border controller company, a wholesale provider of VoIP services, a softphone company, the developer and provider of the magicJack device, and a wholesaler of telephone service to VoIP providers and telecommunication carriers. This segment represents the historical magicJack Core Consumer business.

magicJack is the cloud communications leader that invented the magicJack device and other magicJack products and services. magicJack devices and mobile apps provide customers the ability to make and receive telephone calls in the U.S. or Canada with no additional cost.   Customers may also purchase international minutes to place telephone calls outside of the U.S. and Canada.

Enterprise

This segment includes Broadsmart, which is a provider of UCaaS hardware and connectivity for enterprise customers.

 

SMB

Through this segment, started during 2016, the Company provided VoIP services to small to medium sized businesses.  The expenses of this restructuring included severance for the majority of the employees in the segment and future rent payments for the Alpharetta, GA office.

Other

This segment included the Company’s 60% controlling interest in a joint venture which began selling a line of high-technology residential consumer products in the fourth quarter of fiscal year 2016. On March 31, 2017, this interest was reduced to 36% and on June 30, 2017 the Company sold its remaining interest to the unrelated third party. The Company has determined that the joint venture did not meet either the aggregation criteria to be combined with the existing Core Consumer segment or the quantitative thresholds to be treated as a reportable segment. As such, it was included in the “Other” segment.

 

Selected information for the three and nine month periods ended September 30, 2017 and 2016 and as of September 30, 2017 and December 31, 2016 is presented by reportable segment below (in thousands):

		For the Three Months Ended September 30, 2017
		Previous Core Consumer				SMB				Revised Core Consumer				Enterprise				Other				Intercompany				Consolidated
Statement of Operations:
Net revenues		$	19,010				-			$	19,010				2,691				-				(44	)		$	21,657
Cost of revenues			6,099				-				6,099				1,731				-				-				7,830
Gross profit (loss)			12,911				-				12,911				960				-				(44	)			13,827
Marketing			1,563				-				1,563				370				-				-				1,933
General and
administrative			6,656				-				6,656				718				-				(44	)			7,330
Impairment of goodwill
and intangible assets			-				-				-				-				-				-				-
Research and
development			1,472				-				1,472				5				-				-				1,477
Gain on mark-to-market			(894	)			-				(894	)			-				-				-				(894	)
Operating expenses			8,797				-				8,797				1,093				-				(44	)			9,846
Operating income (loss)			4,114				-				4,114				(133	)			-				-				3,981
Other Data:
Depreciation expense		$	254				-			$	254				67				-				-			$	321
Amortization expense		$	472				-			$	472				184				-				-			$	656

 

		For the Nine Months Ended September 30, 2017
		Previous Core Consumer				SMB				Revised Core Consumer				Enterprise				Other				Intercompany				Consolidated
Statement of Operations:
Net revenues		$	58,774				116			$	58,890				8,462				-				(117	)		$	67,235
Cost of revenues			19,441				131				19,572				5,875				-				-				25,447
Gross profit (loss)			39,333				(15	)			39,318				2,587				-				(117	)			41,788
Marketing			4,525				1,089				5,614				846				-				-				6,460
General and
administrative			25,930				1,056				26,986				2,830				-				(117	)			29,699
Impairment of goodwill
and intangible assets			-				-				-				31,527				-				-				31,527
Research and
development			3,836				596				4,432				6				-				-				4,438
Gain on mark-to-market			(894	)			-				(894	)			-				-				-				(894	)
Operating expenses			33,397				2,741				36,138				35,209				-				(117	)			71,230
Operating income (loss)			5,936				(2,756	)			3,180				(32,622	)			-				-				(29,442	)
Other Data:
Depreciation expense		$	790				21			$	811				175				-				-			$	986
Amortization expense		$	1,196				-			$	1,196				1,215				-				-			$	2,411

 

		September 30, 2017
		Previous Core Consumer				SMB				Revised Core Consumer				Enterprise				Other				Intercompany				Consolidated
Balance Sheet Data:
Goodwill		$	32,304				-			$	32,304				-				-				-			$	32,304
Total assets		$	123,257				-			$	123,257				20,140				-				(33	)		$	143,364