Note: "Before IPO" and "After IPO" measure the use of the proceedings to enhance revenue growth. A small difference between the two Xs means funds from the proceedings probably will have little effect on the index.

Rating Scale

Prediction
Revenues will grow, but low gross profit margins, a small market, a common product, and increased competition from bigger players will likely keep the Company from seeing an income for the indefinite future. The Company will attempt to add several switches and other capital equipment over the next few years, and it will seek private investors to fund this effort. The stock sold to them will have a dilutive effect causing a downward drift in price. With increased capacity the Company will want to maximize the use of its equipment by continuing to sell long-distance time to carrier customers at wholesale prices. This will inflate the revenues but do little for the bottom line.

Either stay away or look to short.

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"The Company's mission is to dominate select international telecom markets by strategically building network facilities that allow it to manage both sides of a telephone call. The Company intends to own multiple switches and other network facilities, which allow it to originate and terminate a substantial portion of its own traffic. Further, the Company intends to implement a network hubbing strategy, linking foreign-based switches and other telecommunications equipment together with the Company's marketing base in the United States. To implement this hubbing strategy, the Company intends to: (i) build transmission capacity, including its ability to originate and transport traffic; (ii) acquire additional termination options to increase routing flexibility; and (iii) expand its customer base through focused marketing efforts."

Summary Of Financial Data
In thousands except for Net Income Per Share.

Low Margins
The Company is constrained by razor-thin margins that revenue growth will do little to change. The sale of long-distance time is fundamentally a commodity market. StarTec is at the low end of the margin scale with only barely differentiated services. In this age of deregulation, where customers can switch long-distance companies with hardly more effort than dialing another code, market pressures will keep margins suppressed. Their revenues will grow, they will add equipment that lets them control both sides of the telephone call, their customer base will expand, and still they will have difficulty making money, because their cost of service is, and will continue to remain, high. Low margins are a condition of the industry. The burst of company formation that resulted after FCC deregulation eventually will begin to implode as companies realize that revenue alone, without profit margin, holds no interest to the investor. Whether, or in what form, the Company survives such consolidation is open to speculation. It will stay afloat so long as public and private infusions of capital keep it afloat, because it is years away from margins sufficient to cover its expenses.

In ’94 the Company’s gross margins were 8%. In ’95 they climbed to 13.1%, in ’96 they were back to 7.2%, and in the first 3 months of ’97 they were up again to 13%. From this percentage must be subtracted at least selling and marketing costs and General and Administrative costs. Under the circumstances it’s hard not to take a loss, which indeed has happened every year since ’93. This consistent track record must not be confused with the burdens of high-paced growth. Weak gross profit margins are the culprit, and they will remain a problem despite impressive leaps in revenue.

Lots of Revenue; Little Profit
Revenues for 1996 make the point. They jumped to $32.2 million from $10.5 million the year before, a three-fold increase suggesting that the Company is now exploiting its markets with a vengeance. Beneath the appearance of growth a different picture reveals itself.

Of the $32.2 million, fully 60% of this amount ($19.5 million) came from the sale of time, not to business or residential customers, but to other telecommunications carriers, the so-called carrier customers, at wholesale prices. Selling time to carrier customers appears to be a common practice in the industry. But in ’96 the gross profit margin from this group was 0.9%. That is to say, on every $100,000 in revenue from the carrier customers, the Company managed only $900 in gross profit.

The very clear effect, however, is to bloat revenues dramatically while delivering virtually no income. As a lead-in to an IPO, however, bloated revenues, despite their vapidity, are often sought as an indicator of growth. Although other strategic benefits may accrue from a base of carrier customers, the direct receipt of income isn’t one of them. If the Company is to have any possibility of sustaining itself on its own earnings, it must show gross profit margins at least around 30%. Otherwise, it will fall into the class of companies, which grow every year but do so at a loss and make up the difference through the sale of stock.

Getting The Margins Up
There is every likelihood that the Company will inch its margins up over time. Infusions of capital so it can purchase and install switches in key cities around the country will help. Through ownership of switches it can reduce costs to other companies that currently must fill in the gaps of its own network. A sizable portion of the Offering will be used for just such a switch in New York City. But whether capital equipment expenditures running into the millions can achieve margins of sufficient heft to make for long-term viability—this remains an open issue. In 1996, residential revenues when originating on the Company’s facilities managed a gross margin of 3.8% as compared to a gross margin of 1.5% when originating on other carrier facilities. The difference seems hardly significant.

StarTec Compared To TeleGroup
It is useful to note that StarTec’s strategy for growth already has been implemented by at least one other company, TeleGroup (TGRP). TeleGroup’s objective is almost identical to StarTec’s: Build a network of switches around the world, buy into fiber optic cable, control both sides of the telephone call, do all of this to improve margins, gain a presence, develop a momentum, and provide "services to small- and medium-sized business and high-volume residential customers in…existing core markets."

TeleGroup Enters IPO With More Maturity
The table shown below compares and contrasts the two companies on several different variables. It reveals that TeleGroup entered the IPO in early July, 1997 a far more matured company than StarTec will be doing later on in ‘97. Prior to the IPO it had staked out a solid position (200,000 customers) with reasonably high revenues ($213.2 million) and good gross profit margins for the industry (25–30%). It already had in place a world-wide network consisting of 15 switches in major cities around the world along with other infrastructure including fiber optic lines.

Even so, TeleGroup’s initial stock price opened at $10 and for most of the last month has stayed flat. Recently on news of high quarterly revenues ($80.1 million) the stock moved up briefly to $13.75 but has since fallen back to $12.25 (8/13/97). Support for TeleGroup appears ambivalent. On the one hand, revenues galloping upward are encouraging; on the other, it showed yet another loss for the quarter, which it brushed off as the result of growth.

StartTec’s Rush Toward a Public Offering
In contrast to TeleGroup, StarTec enters the IPO with even less of a track record, claiming 34,000 customers on revenues of $32.2 million and gross profit margins an iffy 13%. Its infrastructure consists of one switch in Washington D.C. and one under construction in New York. The Company has staked out its core markets to be long-distance calls to India, the Philippines, Africa, the Middle East, and other parts of Asia, all originating from the US. Although going after these less-attended niches has its advantages, they also are much smaller. If TeleGroup’s market research is to be believed, Europe and the US account for roughly 43% and 26% respectively of the industry’s worldwide minutes of use in ’95. That is to say, 69% of the world’s telecommunications services take place in those two markets, which is where TeleGroup operates. StarTec appears to have constrained itself to the margins, probably realizing that to be its only hope.

The Measure Of StarTec’s Performance
With StarTec being one-tenth the size of TeleGroup and with less potential, we can use TeleGroup as an upper limit in measuring StarTec’s performance. There will be no substantive reason for the Company’s stock to exceed TeleGroup’s. It is likely that if StarTec’s stock opens at $10, which is far from certain, the most optimistic scenario would have it sustaining that price for a period of time.

Signet Bank Agreement
In July, 1997 the Company entered into an agreement with Signet Bank for a secured, revolving line of credit based against its accounts receivable. It will be able to tap into as much as $10 million through ’97 and another $15 million across ’98 and ’99. Borrowing from Peter to pay Paul, the Company will use $2.5 million of the IPO proceeds to pay down the amount due under the Signet agreement, which is bearing interest at a rate of 9.8%.

StarTec’s Future Potential
After the IPO there will be 7.3 million shares release into the market. On this amount a $10 share of stock will be diluted to $2.74. Such dilution is part and parcel of early stage development companies with little net tangible book value. Investors will be betting on future potential. But where does this lie in a commodity service, which is plied among secondary ethnic niches? The Company has no special technology, it lacks infrastructure, and the prospectus doesn’t reveal a tantalizing marketing message.

Future potential doubtless will be purchased, not with funds generated by the Company itself, but through the sale of stock. To proliferate switches and other equipment at substantial cost is not something they will soon be able to do on their own nickel; thus, there will be numerous returns to the trough to get the necessary funding. The amount of capital expenditures needed to start delivering a profit is unknown. What is clear, though, is that the amount will be great, and the financial burden will be heaved onto the investor. The Signet agreement with its strict antidilutive measures will impose a temporary constraint on the Company’s ability to seek outside funding. After ’99, however, when the agreement terminates we can expect a healthy increase in the number of shares hitting the market. With proceeds from the Offering plus money from the Signet agreement the Company believes it can hang in there for 18 months. Afterwards, it acknowledges, "it will need to raise additional capital from public or private equity…sources…."

A Vice-Grip On Control
Once the dust has settled on the IPO the president still will hold 45.5% of the stock outstanding. The president’s brother-in-law, who owns 300,000 shares has ceded voting rights to the president, thus bringing his effective control up to 49.5% of the stock. For $19 million at $10 a share the beneficial owners will have given away a mere 16.3% of the stock.

Living Well Is The Best Revenge
This deft maneuvering also will net the president an annual salary of $250,000 putting him, according to one estimate, among the top 500 most highly paid executives of public companies. His employee agreement also calls for the usual incentive plans and bonuses accorded to those guiding the corporate ship to glory. If for some reason there is a "change of control" where the president is removed, his harsh landing will be softened with a severance payment equal to $20,830 per month for at least 3 years and possibly longer. He will get this amount even if "the shareholders…approve a plan of complete liquidation" of the Company, i.e., even if the Company skids to a halt.

In reality, though, there is hardly any way to force a change in control. Through staggered voting for members of the board, through ownership of most of the stock, and through layers of legal conditions to be met, the Company ensures its isolation from outside influence. They will take money and in return give stock. The stock will have a vote associated with each share, and the votes will hold no sway over the board.

Conflict Shmonflict
A final note on the president’s employee agreement. Should the president leave, his agreement restricts his competing with the Company for a period of one year. Since his severance will last at least three years, he could well be receiving money from the Company and at the same time competing against it.

Competition
It’s a rosy picture for the consumer. The U.S. Telecommunications Act of 1996 and the World Trade Organization have deregulated the industry on a global scale allowing for the creation of new channels of communication at lower cost with richer service. Bit by bit the governments of countries are disengaging and opening the field to commercial forces. Over the next number of years it means increased competition and a fragmentation of the industry. The Company acknowledges as many as 500 other players clamoring after long distance revenues. Most will be bottom-dwelling feeders with little more than a marketing scheme and a way to bill. Others, however, are to be reckoned with.

Big Boys Poised To Enter
Look for the regional Bells to enter the market as they gain the authority to sell long distance internationally; each of these would bring income-producing, matured operations to the game. As well, look for large international companies to enter the fray on U.S. soil in the same way U.S. companies will try to do abroad.

Every company in telecommunications must submit itself to a nearly impenetrable fog of rules and regulations that come from every level of government in the U.S. and from every country in the world. The future of StarTec, in part, hinges on a range of rulings yet to be decided. Some of them could be beneficial and others potentially very damaging. For example, the FCC in the future will rule on volume discounts in the pricing of the so-called "access charge," which happens to be a major cost to the Company. Volume discounts would confer a significant advantage on larger companies and probably motivate a consolidation in the industry to some extent. At this time, it’s unknown what the ruling will be, but it indicates the turbulence that smaller companies must endure as the heavy hitters jockey for position.

Internet Telephony A Threat
Finally, StarTec and others could get side-swiped by new technologies. Internet telephony is sending a chill down the spine of many a traditional telephone company. Apparently telephone switch technology in conjunction with the Internet is priced at a level that is affordable to most corporations, giving them the ability to become essentially their own telephone companies. One expert claims that such switches "will become as popular as print servers and fax servers in…another two or three years." Lucent Technologies "recently released its Internet Telephony Server…, which can route voice and fax calls from the public switched telephone network to the Internet…using standard phone or fax equipment." It will be poorer in quality "but at dramatically cheaper prices, up to 80% lower than the fixed line service offered by telecom companies…."

This new technology may not have a direct impact on the Company, since it’s targeted toward the small to medium-sized business and residential customers. It should be unsettling nonetheless as these new, unanticipated channels of communication open up.

The bottom line: Competition will be intense.

The Board Of Directors
Overseeing the Company in all its bold strokes will be the board of directors, formed around personal and family relationships. A representative of the IPO’s underwriter also has found his way onto the board. It’s safe to conclude they are not a board of professionals seasoned in the telecommunications industry who can lend credence to, or counterbalance, the strategic directions taken.