Unassociated Document
 


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

FORM 10-KSB
(mark one)

x
ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended July 31, 2007
 
o
TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______to _________

Commission File Number: 001-15687

ATSI COMMUNICATIONS, INC.
(Name of Small Business Issuer in Its Charter)

Nevada
(State or Other Jurisdiction of Incorporation or Organization)
 
74-2849995
(IRS Employer Identification No.)
     
3201 Cherry Ridge, Building C, Suite 300
San Antonio, Texas
(Address of Principal Executive Offices)
 
 
78230
(Zip Code)

(210) 614-7240
(Issuer’s Telephone Number)

Securities registered under Section 12(b) of the Exchange Act: NONE

Securities registered under Section 12(g) of the Exchange Act:

Common Stock, Par Value $0.001 Per Share
(Title of Class)

Check whether the issuer is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act. o    

Check whether the issuer: (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes o No 

Check if there is no disclosure of delinquent filers in response to Item 405 of Regulation S-B contained in this form, and no disclosure will be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act) o Yes x No

Registrant’s revenues for its most recent fiscal year were $31,692,150

The aggregate market value of the common equity held by non-affiliates of the issuer was $10,518,338 based on the closing price of $0.27 per share on October 15, 2007 as reported on the over-the-counter bulletin board.

There were 38,956,810 shares of issuer ’s Common Stock outstanding as of October 15, 2007.

Transitional Small Business Disclosure Format (check one): o Yes x No
 
 



 
TABLE OF CONTENTS
 
    Page
PART I
 
Item 1. Description of Business
 
3
Overview
 
3
History
 
4
Recent Developments
 
4
Services and Products
 
4
Carrier Services
 
4
Network Services
 
5
Communication Services
 
5
Voice over Internet Protocol Network
 
5
Strategy and Competitive Conditions
 
7
Government Regulations/ Concession License
 
9
Suppliers
 
13
Employees
 
13
Risk Factors
 
13
Item 2. Description of Properties
 
15
Item 3. Legal Proceedings
 
16
Item 4. Submission of Matters to a Vote of Security Holders
 
16
     
PART II
     
Item 5. Market for Registrant’s Common Equity and Related Stockholder Matters
 
16
Item 6. Management’s Discussion and Analysis or Plan of Operations
 
18
Item 7. Financial Statements and Supplementary Data
 
26
Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
 
45
Item 8A.Controls and Procedures
 
45
     
PART III
     
Item 9. Directors, Executive Officers, Promoters and Control Persons, Compliance with Section 16(A) of the Exchange Act
45
Item 10. Executive Compensation
 
47
Item 11. Security Ownership of Certain Beneficial Owners and Management
 
51
Item 12. Certain Relationships and Related Transactions
 
52
Item 13. Exhibits and Reports on Form 8-K
 
52
Item 14. Principal Accountant Fees and Services
 
55
 
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PART I

ITEM I. BUSINESS.

Overview

We are an international telecommunications carrier that utilizes the Internet to provide cost-efficient and economical international communication services. Our current operations consist primarily of providing digital voice communications over the Internet using Voice-over-Internet-Protocol ("VoIP"). We provide high quality voice and enhanced communication services to carriers, telephony resellers and other VoIP carriers through various agreements with service providers in the United States, Mexico, Asia, the Middle East and Latin America utilizing VoIP technology. Our services include:

Carrier Services: We provide VoIP communication services to United States and foreign telecommunications companies who lack transmission facilities, require additional capacity or do not have the regulatory licenses to terminate traffic in Mexico, Asia, the Middle East and Latin America. Typically these telecommunications companies offer their services to the public for domestic and international long distance and VoIP services.

Network Services: We provide private communications links and VoIP gateway services to multi-national and Latin American carriers and enterprise customers who use a high volume of telecommunications services to communicate with their U.S. offices or businesses and need greater dependability than is currently available through their own telecommunications network. These services include data, voice and fax transmission between multiple international offices, as well as Internet and collocation services in the United States. 

Communication Services: We provide retail local phone service and international VoIP long distance service, primarily to the U.S. Hispanic market throughout Texas, mainly in the Rio Grande Valley. Our local phone service includes access to a landline and value-added services such a caller ID and call waiting. These services are offered to our customers on both a prepaid and postpaid basis. In addition, we provide prepaid domestic and international long-distance services with access to our VoIP network platform.

We have had operating losses for almost every quarter since we began operations in 1994. Our operating income from continuing operations were approximately $91,000 and our operating loss $598,000, for the years ended July 31, 2007, and 2006, respectively. Additionally, we had a working capital deficit of approximately $424,000 at July 31, 2007; this represents an improvement in our working capital deficit of approximately of $2,376,000 from our balance at July 31, 2006.

We produced positive operating income during the 2nd, 3rd and 4th quarters of fiscal 2007 and expect to pay our vendors and lenders on time in the future if this trend continues. Additionally, we generated sufficient income from operations to cover our operating expenses during the fiscal year ended July 31, 2007. However, we believe that due to our limited access to capital, we may not be able to support our ongoing operations if we do not continue producing positive operating income in the future. Our ability to continue as a going concern is dependent upon generating sufficient income from operations to cover our operating expense, the ongoing support of our stockholders and customers, and our ability to obtain capital resources to support expansion.

During the twelve months ended July 31, 2007, we received $713,000 from a private placement financing. We also received $35,000 from the exercise of warrants and $16,000 from the exercise of stock options. These funds, along with funds generated from operations, allowed us to cover our operating expenses and other corporate expenses during the nine months ended April 30, 2007. Additionally, on November 3, 2006, we entered into a factoring agreement with CCA Financial Services, Inc. Under the agreement, CCA Financial Services committed to purchase up to $1,000,000 of our monthly receivables. As our ongoing operations require, we will factor our receivables under this new agreement. As of date of this filing, we did not have any outstanding factored receivables under this agreement.
 
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We will continue to pursue cost cutting strategies in order to conserve working capital, which could limit the implementation of our business plan. We are dependent on our operations and the proceeds from future debt or equity investments to fully implement our business plan. If we are unable to continue producing positive cash flow from operations or raise sufficient capital, we will be required to delay or forego some portion of our business plan, which could have an adverse effect on our anticipated results from operations and our financial condition. In addition, we are currently pursuing various financing alternatives including expansion of our current accounts receivable factoring arrangement and exchanging some portion or all of our debt for equity. However, we may not be successful in these efforts or circumstances currently unknown or unforeseen by us may arise that will result in us not being able to obtain additional funding for our business plan.

History

ATSI Communications, Inc., a Nevada corporation, was formed in 2004 as the successor to the business originally incorporated in 1994 as a Canadian holding company, Latcomm International, Inc., with a Texas operating subsidiary, Latin America Telecomm, Inc. Both corporations were renamed “American TeleSource International, Inc.” in 1994. In May 1998, the Canadian corporation completed a share exchange with a newly formed Delaware corporation, also called American TeleSource International, Inc., which resulted in the Canadian corporation becoming the wholly owned subsidiary of the Delaware corporation. Our stockholders voted to change our name from American TeleSource International, Inc. to ATSI Communications, Inc. in 2003 and to reincorporate in the State of Nevada by merger into our wholly owned subsidiary in 2004. We own 49% of ATSI Comunicaciones S.A de C.V. (ATSICOM), a Mexican corporation that holds a 30-year concession allowing for the sale of voice and data services, long distance transport, and the operation of a telecommunications network in Mexico.
 
Recent Developments

During the year ended July 31, 2007 (“fiscal 2007”):

 
·
We expanded our NexTone Intelliconnect™ System by adding 1000 ports of capacity to our Multiprotocol Session Exchange (“MSX”) and Session Border Controller (“SBC”). This network expansion has allowed us to route our traffic more efficiently, improve our call processing, monitor quality of service and support our growth in our core business. In addition, the NexTone™ technology has allowed us to be more competitive and to improve margins in our international VoIP carrier services.
 
 
·
We entered into a $1 Million accounts receivable financing agreement and a $250,000 note payable with CCA Financial Services, Inc. This financing arrangement provided us with access to capital to fund our growth initiatives and allowed us to service top tier customers that required extended payment terms.

Services and Products

We provide three types of services: Carrier Services, Network Services and Communication Services.
 
Carrier Services consists of VoIP communication services sold to United States and foreign telecommunications companies who lack transmission facilities, require additional capacity or do not have the regulatory licenses to terminate traffic in Mexico, Asia, the Middle East and Latin America. Typically these telecommunications companies offer their services to the public for domestic and international long distance and VoIP services. Revenues from this service accounted for approximately 99% of our total revenue during the year ended July 31, 2007. The percentage of our total volume of carrier services traffic sent by customers can fluctuate dramatically, on a quarterly, and sometimes, daily basis. During fiscal 2007, we entered into various reciprocal agreements with our customers that allow them to transport and terminate traffic over our network and allowed us to transmit and terminate traffic over their networks. These reciprocals agreements with our customers were not for a specific period of time or volume of minutes. Under the reciprocal agreements, both parties were given a set of rates for services and each party would decide the volume of minutes it would send to be processed. Therefore, on a month-to-month basis there was not a required volume commitment of minutes from each party and the parties were free to re-route their traffic away to a lower priced provider.  
  
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Network Services consist links and VoIP gateway services to multi-national and foreign carriers and enterprise customers who use a high volume of telecommunications services to communicate with their U.S. offices or businesses and need greater dependability than is currently available through the foreign telecommunication networks. These services include data, voice and fax transmission between multiple international offices and branches as well as Internet and collocation services in the United States. We currently provide network Services to World Data, a Mexican corporation on a month-to-month basis and generate approximately $1,500 per month in revenue. There is no assurance that we will continue to generate this revenue in the future or that we will be able to enter into a long-term contract with World Data or any other customer.

Communication Services consists of retail local telephone service and international VoIP long distance service. We provide these services on both a post use and prepaid basis to individuals in the United States and Mexico, primarily to the U.S. Hispanic Market in the Rio Grande Valley. Our local telephone service provides access to a basic phone services and value-added features such as call waiting and caller ID. Domestic and international long distance services are provided through access to our VoIP platform. Revenues from Communication Services accounted for approximately $113,000 or 1% of our total revenues in fiscal 2007.

Voice over Internet Protocol Networks

The basic technology of traditional telecommunications systems was designed for slow mechanical switches. Communications over the traditional telephone network are routed through circuits that must dedicate all circuit resources to each call from its inception until the call ends, regardless of whether anyone is actually talking on the circuit. This circuit-switching technology incurs a significant cost per call and does not efficiently support the integration of voice with data services. Data networks, however, were designed for electronic switching. They break the data stream into small, individually addressed packages of data (“packets”) that are routed independently of each other from the origin to the destination. Therefore, they do not require a fixed amount of bandwidth to be reserved between the origin and destination of each call and they do not waste bandwidth when it is not being used for actual transmission of information. This allows multiple voice or voice and data calls to be pooled, resulting in these networks being able to carry more calls with an equal amount of bandwidth. Moreover, they do not require the same complex switching methods required by traditional voice telephone networks, instead using a multiplicity of routers to direct each packet to its destination and they automatically route packets around blockages, congestion or outages.

Packet switching can be used within a data network or across networks, including the public Internet. The Internet itself is not a single data network owned by any single entity, but rather a loose interconnection of networks belonging to many owners that communicate using the Internet Protocol (“IP”). By converting voice signals to digital data and handling the voice signals as data, it can be transmitted through the more efficient switching networks designed for data transmissions and through the Internet using the IP. The transmission of voice signals as digitalized data streams over the Internet is known as Voice over Internet Protocol or “VoIP”. A VoIP network has the following advantages over traditional networks:

 
·
Integration of Voice and Data: VoIP networks allow for the integration and transmission of voice, data, and images using the same network equipment.

 
·
Simplification: An integrated infrastructure that supports all forms of communication allows more standardization, a smaller equipment complement, and less equipment management.
 
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·
Network Efficiency: The integration of voice and data fills up the data communication channels efficiently, thus providing bandwidth consolidation and reduction of the costs associated with idle bandwidth. The sharing of equipment and operations costs across both data and voice users can also improve network efficiency since excess bandwidth on one network can be used by the other, thereby creating economies of scale for voice (especially given the rapid growth in data traffic). An integrated infrastructure that supports all forms of communication allows more standardization and reduces the total equipment complement. This combined infrastructure can support dynamic bandwidth optimization and a fault tolerant design. The differences between the traffic patterns of voice and data offer further opportunities for significant efficiency improvements.

 
·
Co-existence with traditional communication mediums: IP telephony can be used in conjunction with existing PSTN switches, leased and dial-up lines, PBXs and other customer premise equipment (CPE), enterprise LANs, and Internet connections. IP telephony applications can be implemented through dedicated gateways, which in turn can be based on open standards platforms for reliability and scalability.

 
·
Cost reduction: Under the VoIP network, the connection is directly to the Internet backbone and as a result the telephony access charges and settlement fees are avoided.

The growth of voice on the Internet was limited in the past due to poor sound quality caused by technical issues such as delays in packet transmission and by bandwidth limitations related to Internet network capacity and local access constraints. However, the continuing addition of data network infrastructure, recent improvements in packet switching and compression technology, and new software algorithms and improved hardware have substantially reduced delays in packet transmissions and resulted in better sound quality. Nevertheless, certain VoIP routes into countries with limited or poor Internet infrastructure continue to lack the consistent quality required for voice transport and termination.

A number of large long distance carriers have announced Internet telephony service offerings. Smaller Internet telephony service providers have also begun to offer low-cost Internet telephony services from personal computers to telephones and from telephones to telephones. Traditional carriers have substantial investments in traditional telephone network technology, and therefore have been slow to embrace Internet technology.

We believe that the infrastructure required for a global network is too expensive for most companies to deploy on their own. This mandates that the network be a combination of gateways owned by different operators. For a network to achieve optimal functionality and quality, however, the gateways need to be interoperable, or able to communicate with one another. Interoperability continues to be a challenge for VoIP providers and recently, technological solutions have emerged that support interoperability between different protocols and/or gateways. Cisco appears to have emerged as a dominant supplier of VoIP gateways and other manufacturers often seek to make their equipment interoperable with Cisco.

Long distance telephone calls transported over the Internet are less expensive than similar calls carried over the traditional telephone network primarily because the cost of using the Internet is not determined by the distance those calls need to travel. Also, routing calls over the Internet is more cost-effective than routing calls over the traditional telephone network because the technology that enables Internet telephony is more efficient than traditional telephone network technology. The greater efficiency of the Internet creates cost savings that can be passed on to the consumer in the form of lower long distance rates or retained by the carrier as higher margins.

By using the public Internet, VoIP providers like ATSI are able to avoid direct payment for transport of communications, instead paying for large “pipes” into the public Internet, billed by bandwidth rather than usage, which transmits calls to a distant gateway. The Internet, which has its origins in programs devised by the Department of Defense to provide multiple routes and therefore redundancy which was largely immune from the failure of a single network element, provides great redundancy and can be “self healing” in the event of an outage in a particular network element or transmission path. Moreover, adding an additional entry or exit point (a Point of Presence or “PoP”) does not require any expensive or time consuming reconfiguration or reprogramming of existing network elements. The new element is simply installed with a specific IP address and it can send or receive information from any other IP address on the Internet.
 
6

 
Strategy and Competitive Conditions 

The long distance telephony market and the Internet telephony market are highly competitive. Our competitors include major telecommunications carriers in the U.S., foreign telecommunications carriers (which may be owned by foreign governments), and numerous small competitors, and we expect to face continuing competition based on price and service offerings from existing competitors and new market entrants in the future. The principal competitive factors in our market include price, coverage, customer service, technical response times, reliability, and network size/capacity. The competitive landscape is rapidly altering the number, identity and competitiveness of the marketplace, and we are unable to determine with certainty the impact of potential consolidation in our industry.

A number of large long distance carriers have introduced services that make Internet telephony or voice services over the Internet available to other carriers. All major telecommunications companies either presently do or could route traffic to destinations worldwide and compete directly with us. Smaller Internet telephony service providers have also begun to offer low-cost Internet telephony services from personal computers to telephones and from telephones to telephones. All major telecommunications companies either presently do or could route traffic to destinations worldwide and compete directly with us. In addition, Internet service providers and other companies currently in related markets have begun to provide voice over the Internet services or adapt their products to enable voice over the Internet services. These related companies may migrate into the Internet telephony market as direct competitors.

Many of our competitors have substantially greater financial, technical and marketing resources, larger customer bases, longer operating histories, greater name recognition and more established relationships in the industry than we have. As a result, certain of these competitors may be able to adopt more aggressive pricing policies that could hinder our ability to market our services. We believe that our key competitive advantages are our ability to deliver reliable, high quality voice service over the Internet in a cost-effective manner. We cannot provide assurances, however, that these advantages will enable us to succeed against comparable service offerings from our competitors. A large number of telecommunications companies, including AT&T, iBasis and Qwest currently provide wholesale voice telecommunications service which competes with our business. These companies have large budgets available for research and development, may further enhance the quality and acceptance of the transmission of voice over the Internet.

Our strategy is to position ourselves to take advantage of the current demonopolization of the Latin American telecommunications markets, as well as the increasing demand for international communications services between foreign markets and the United States. Historically, telecommunications services in Latin America have been provided by state-run companies, operating as a legal or de facto monopoly. Although these companies failed to satisfy the demand for services in their countries, the regulatory scheme effectively precluded competition by foreign carriers. Currently, there is a trend toward demonopolization of the telecommunications industry in Latin America, and many of these countries are in various stages of migration toward a competitive, multi-carrier market. Many Latin American countries produce a significant number of immigrants to the United States, or are becoming homes to U.S. based corporations seeking lower labor costs. At the same time that Latin American markets have been opening up, the demand for telecommunications services between the United States and Latin America (particularly Mexico) has been strengthened by:

 
·
the rapid growth of the Latino segment of the United States population
 
·
Mexico’s status as the top calling partner with the United States
 
·
increase in trade and travel between Latin America and the United States
 
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·
the build-out of local networks and corresponding increase in the number of telephones in homes and businesses in Latin countries
 
·
proliferation of communications devices such as faxes, mobile phones, pagers, and personal computers
 
·
declining rates for services as a result of increased competition.

Carriers buying wholesale termination into Mexico, while cost conscious, are increasingly demanding high reliability and quality in service delivery. Sustainability and growth in this segment depends on specific competitive advantages like proper licenses, network redundancy, favorable termination agreements, or the presence of a business infrastructure and relationships in the specific terminating market. The Company competes with the dominant providers, such as Qwest, as well as other, smaller providers for international long distance services to Mexico. The Company believes that in contrast to the dominant providers, it has a much more focused and cost competitive strategy that targets select higher margin telecommunication niches utilizing VoIP technology. Certain carriers provide termination services in Mexico at lower prices, by using unlicensed IP points of presence. These carriers, however, have several disadvantages including: (i) generally poor quality, (ii) limited capacity, and (iii) poor reliability, since Mexican authorities periodically shut down their operations. In addition, network expansions by existing and newly licensed carriers in Mexico have put pressure on termination prices. The combination of non-conventional termination and the new settlement rates have reduced U.S to Mexico termination prices from an average price of about $0.27 per minute in 1998 to a current rate of $0.07 per minute.

Our strengths include our knowledge of, and relationships within, the telecommunications industry in the United States and certain countries within Latin America, particularly Mexico. Our management and employees have in-depth knowledge of the Mexican culture, business environment and telecommunications industry. As a result, we have been able to obtain a key long distance concession through our 49% ownership in ATSICOM that allows us to both generate and carry traffic within Mexico and between Mexico and the United States.

Government Regulation

Our operations are subject to federal, state and foreign laws and regulations. There is significant uncertainty regarding the application of the Communications Act of 1934 and the regulations adopted by the Federal Communications Commission (“FCC”) to Internet telephone and there is a risk that either the FCC or Congress will impose common carrier restrictions and other requirements of traditional telecommunications providers to providers of VoIP services.

U.S Federal and State Regulation of Carrier Services

We believe that, under U.S. law, the Internet-related services that we provide constitute information services as opposed to regulated telecommunications services, and, as such, are not currently regulated as telecommunications common carriers by the Federal Communications Commission (FCC) or state agencies charged with regulating telecommunications carriers. Nevertheless, aspects of our operations may be subject to state or federal regulation, including regulations governing universal service funding, disclosure of confidential communications and excise tax issues. We cannot provide assurances that Internet-related services will not be actively regulated in the future. Several efforts have been made in the U.S. to enact federal legislation that would either regulate or exempt from regulation services provided over the Internet. Increased regulation of the Internet may slow its growth, particularly if other countries also impose regulations. Such regulation may negatively impact the cost of doing business over the Internet and materially adversely affect our business, operating results, financial condition and future prospects.
 
While the FCC to date has declined to classify VoIP providers as telecommunications carriers for regulatory purposes, various entities have challenged this premise, both before the FCC and at various state government agencies.  However, the FCC has ruled that certain traffic carried in part utilizing the Internet protocol format was nonetheless regulated telecommunications for which certain regulatory obligations applied. The FCC has considered whether to impose surcharges or other common carrier regulations upon certain providers of Internet telephony, primarily those which, unlike us, provide Internet telephony services directly to end users. Recently, the FCC ruled that interconnected VoIP service providers must make contributions to the Universal Service Fund. Additionally, the FCC has a pending proceeding to further examine the question of whether certain forms of VoIP services are information services or telecommunications services. The two are treated differently in several respects, with certain information services being regulated to a lesser degree. The FCC has noted that certain forms of phone-to-phone VoIP services bear many of the same characteristics as more traditional voice telecommunications services and lack the characteristics that would render them information services. The FCC has indicated that the mechanisms for contributing to the Universal Service Fund, issues as to applicability of access charges and other matters will be considered in that context. Adverse rulings or rulemakings could subject us to licensing requirements and additional fees and subsidies.
 
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If the FCC were to determine that certain Internet-related services including Internet telephony services are subject to FCC regulations as telecommunications services, the FCC could subject providers of such services to traditional common carrier regulation, including payment of access charges to local telephone companies. A decision to impose such charges could also have retroactive effect. It is also possible that the FCC may adopt a regulatory framework other than traditional common carrier regulation that would apply to Internet telephony providers. Any such determinations could materially adversely affect our business, financial condition, operating results and future prospects to the extent that any such determinations negatively affect the cost of doing business over the Internet or otherwise slow the growth of the Internet.
 
State regulatory authorities may also retain jurisdiction to regulate certain aspects of the provision of intrastate Internet telephony services. Several state regulatory authorities have initiated proceedings to examine the regulation of such services. Others could initiate proceedings to do so.

Other regulations affecting the Internet in the United States.

Congress has recently adopted legislation that regulates certain aspects of the Internet, including online content, user privacy and taxation. In addition, Congress and other federal entities are considering other legislative and regulatory proposals that would further regulate the Internet. Congress has; for example, considered legislation on a wide range of issues including Internet spamming, database privacy, gambling, pornography and child protection, Internet fraud, privacy and digital signatures. Various states have adopted and are considering Internet-related legislation. Increased U.S. regulation of the Internet may slow its growth, particularly if other governments follow suit, which may negatively impact the cost of doing business over the Internet and materially adversely affect our business, financial condition, results of operations and future prospects. Legislation has also been proposed that would clarify the regulatory status of VoIP service. The Company has no way of knowing whether legislation will pass or what form it might take.

Regulations pertaining to our retail operations.

In the United States, services provided through our retail operations are subject to the provisions of the Communications Act of 1934, as amended, the FCC regulations, and the applicable laws and regulations of the various states and state regulatory commissions.
 
As a carrier offering services to the public, we must comply with the requirements of common carriage under the Communications Act of 1934, including the offering of service on a nondiscriminatory basis at just and reasonable rates, and obtaining FCC approval prior to any assignment of authorizations or any transfer of legal or actual control of the company.
 
We are subject to various specific common carrier telecommunications requirements set forth in the FCC’s rules, including operating, reporting and fee requirements. Both federal and state regulatory agencies have broad authority to impose monetary and other penalties on us for violations of regulatory requirements.
 
9

 
Domestic Service Regulation. We are considered a non-dominant domestic interstate carrier subject to minimal regulation by the FCC. We are not required to obtain FCC authority to initiate or expand our domestic interstate operations, but we are required to obtain FCC approval to transfer control or discontinue service and to file various reports and pay various fees and assessments. Among other things, interstate common carriers must offer service on a nondiscriminatory basis at just and reasonable rates. In addition, as a non-dominant carrier, we are subject to the FCC’s complaint jurisdiction.
 
All interstate telecommunications carriers are required to contribute to the federal universal service programs. The FCC currently is considering revising its universal service funding mechanism. We cannot predict the outcome of these proceedings or their potential effect on us. Although we currently do not provide VoIP services to the end users or consumers, VoIP services that we may provide in the future are not currently subject to direct regulation by the FCC or state regulatory commissions to the extent that they qualify as “enhanced” or “information” services. The FCC defines enhanced services as services that (1) employ computer processing applications that act on the format, content, code, protocol or similar aspects of the subscriber’s transmitted information, (2) provide the subscriber additional, different or restructured information, or (3) involve subscriber interaction with stored information. In 1998, in a non-binding report, the FCC observed that “computer-to-computer” VoIP may be appropriately considered to be unregulated but that “phone-to-phone” VoIP may lack the characteristics that would render them unregulated “information” services. In February 2004, the FCC ruled that free computer-to-computer VoIP service is not “telecommunications service” and that it is an interstate “information service.” Although this order clarifies some of the relevant VoIP issues, the FCC has not yet issued a formal decision as to whether other variations of VoIP services should be subject to traditional common carrier telecommunications service regulation, such as access charge obligations. In March 2004, the FCC released a Notice of Proposed Rulemaking (“NPRM”) regarding VoIP service. The NPRM specifically addresses the regulatory classification and jurisdiction of VoIP; the application of access charges; and how to preserve key public policy objectives such as universal service, 911/emergency services, law enforcement surveillance requirements, and the needs of persons with disabilities. In November 2004, the FCC ruled that services provided by a particular VoIP provider are interstate in nature, and not subject to entry regulations of the various state Public Service Commissions. The FCC, however, declined to rule on whether the service is a regulated telecommunications service or an unregulated information service. In addition, in December 2004, the United States Court of Appeals for the 8th Circuit ruled that such VoIP provider’s service is not subject to state regulation. Subsequently, in a series of orders, the FCC has decided to apply universal service, 911/emergency services, law enforcement surveillance requirements, customer privacy requirements, and requirements relating to the provision of services to speech and hearing-impaired persons to providers of “interconnected” VoIP services (i.e., those that are capable of both originating calls from and terminating calls to users of the public switched telephone network), but in each case the FCC has explicitly declined to decide whether such services are “telecommunications” services subject to more comprehensive regulation. Instead, the FCC continues to examine the appropriate regulatory treatment of VoIP on a piecemeal basis. While initial indications from the FCC suggest that regulation of VoIP will be limited in nature, the future regulatory treatment of other variations of VoIP by the FCC and state regulatory bodies continues to be uncertain. Furthermore, Congressional dissatisfaction with the FCC’s treatment of IP telephony could result in legislation requiring the FCC to impose greater or lesser regulation. Changes to, and further clarifications of, the treatment of VoIP services could result in the imposition of burdensome regulation and fees on some of our services and/or increase certain of our operating costs.
 
State Regulation.  Our intrastate long distance operations are subject to various state laws and regulations, including, in most jurisdictions, certification and tariff filing requirements. Telefamilia Communications, Inc. (Telefamilia), a wholly owned subsidiary of ours, maintains the necessary certificate and tariff approvals, where approvals are necessary, to provide intrastate long distance service in Texas. Telefamilia also maintains the necessary certificate to provide local services in Texas. Texas requires prior approval or notification for certain stock or asset transfers or for the issuance of securities, debt or for name changes. As a certificated carrier, consumers may file complaints against us at the public service commissions. Certificates of authority can generally be conditioned, modified, canceled, terminated, or revoked by state regulatory authorities for failure to comply with state law and/or the rules, regulations and policies of the state regulatory authorities. Fines and other penalties also may be imposed for such violations. Public service commissions also regulate access charges and other pricing for telecommunications services within each state. The Regional Bell Operating Carriers and other Local Exchange Carriers have been seeking reduction of state regulatory requirements, including greater pricing flexibility, which, if granted, could subject us to increased price competition. We may also be required to contribute to universal service funds in Texas.
 
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International Regulation

  The regulatory treatment of Internet telephony outside of the U.S. varies widely from country to country. A number of countries that currently prohibit competition in the provision of voice telephony also prohibit Internet telephony. Other countries permit but regulate Internet telephony. Some countries will evaluate proposed Internet telephony service on a case-by-case basis and determine whether it should be regulated as a voice service or as another telecommunications service. In many countries, Internet telephony has not yet been addressed by legislation or regulation. Increased regulation of the Internet and/or Internet telephony providers or the prohibition of Internet telephony in one or more countries could materially adversely affect our business, financial condition, operating results and future prospects.

The International Settlements Policy governs settlements between top tier U.S. carriers’ and foreign carriers’ costs of terminating traffic over each other’s networks. The FCC recently enacted certain changes in rules designed to allow U.S. carriers to propose methods to pay for international call termination that deviate from traditional accounting rates and the International Settlement Policy. The FCC has also established lower benchmarks for the rates that U.S. carriers can pay foreign carriers for the termination of international services and these benchmarks may continue to decline. These rule changes have lowered the costs of our top tier competitors to terminate traffic in the United States and are contributing to the downward pricing pressure facing us in the carrier market.

Other General regulations

Congress has recently adopted legislation that regulates certain aspects of the Internet, including online content, user privacy and taxation. In addition, Congress and other federal entities are considering other legislative and regulatory proposals on a wide range of issues including Internet spamming, database privacy, gambling, pornography and child protection, Internet fraud, privacy and digital signatures. Various states have adopted and are considering Internet-related legislation. Increased U.S. regulation of the Internet may slow its growth, particularly if other governments follow suit, which may negatively impact the cost of doing business over the Internet and materially adversely affect our business, financial condition, results of operations and future prospects. The Company has no way of knowing whether legislation will pass or what form it might take.

The Telecommunications Act of 1996 (the “Telecom Act”), which became law in February 1996, was designed to dismantle the monopoly system and promote competition in all aspects of telecommunications. The FCC has promulgated and continues to promulgate major changes to their telecommunications regulations. One aspect of the Telecom Act that is of particular importance to us is that it allows Bell Operating Companies or BOCs to offer in-region long distance service once they have taken certain steps to open their local service monopoly to competition. The FCC has now granted such in-region long distance authorization to BOCs throughout the nation. Given their extensive resources and established customer bases, the entry of the BOCs into the long distance market, specifically the international market, has created increased competition for us.

Although we do not know of any other specific new or proposed regulations that will affect our business directly, the regulatory scheme for competitive telecommunications market is still evolving and there could be unanticipated changes in the competitive environment for communications in general. For example, the FCC is currently considering rules that govern how Internet providers share telephone lines with local telephone companies and compensate local telephone companies. These rules could affect the role that the Internet ultimately plays in the telecommunications market.
 
11

 
The International Settlements Policy governs settlements between top tier U.S. carriers’ and foreign carriers’ costs of terminating traffic over each other’s networks. The FCC recently enacted certain changes in our rules designed to allow U.S. carriers to propose methods to pay for international call termination that deviate from traditional accounting rates and the International Settlement Policy. The FCC has also established lower benchmarks for the rates that U.S. carriers can pay foreign carriers for the termination of international services and these benchmarks may continue to decline. These rule changes have lowered the costs of our top tier competitors to terminate traffic in the United States and are contributing to the downward pricing pressure facing us in the carrier market.

Concession License

The Secretaría de Comunicaciones y Transportes (“SCT”) and Comisión Federal de Telecomunicaciones or Federal Telecommunications Comisión (“COFETEL”) issued ATSICOM a 30-year license in June 1998 to install and operate a public network. Under this license, ATSICOM is required to:
 
General requirements

 
·
Maintain approximately $10 million in registered and subscribed capital.
 
·
Install and operate a network in Mexico. The Mexican government must approve the operating plan before it is implemented and any future changes to the operating plan.
 
·
Continuously develop and conduct training programs for its staff.
 
·
Designate an individual responsible for the technical functions to operate the concession.

Concession services requirements

 
·
Provide continuous and efficient services at all times to its customers.
 
·
Establish a complaint center and correction facilities center and report to the Mexican Government on a monthly basis the complaints received and the actions taken to resolve the problems.
 
Tariff Requirements

 
·
Invoice its customer only tariffs rates that have been approved by the Mexican government.
 
Verification and Information requirements
 
 
·
Provide audited financial statements on a yearly basis that includes a detailed description of the fixed assets utilized in the network and accounting reporting by region and location of where the services are being provided.
 
·
Provide quarterly reports and updates on the expansion of the network in Mexico and a description of the training programs and research and development programs.
 
·
Provide statistic reports of traffic, switching capacity and other parameters in the network.

Guarantee requirements

 
·
Post a bond/insurance policy for approximately $500,000 payable to the Mexican Federal Treasury Department in the event the concession is revoked for failure to perform any of the requirements.

Under this concession, we have the right to terminate voice and data communications in Mexico. The revocation or modification of this concession would have a material adverse effect on our business.

12


Suppliers

We rely on various suppliers to provide services in connection with our communication services. We depend on various Global VoIP companies to complete our voice over Internet (VoIP) traffic between US, Mexico, Asia, the Middle East and Latin America. We are not dependent upon any single supplier.

Employees

As of July 31, 2007, we had nine employees, all of whom performed operational, technical and administrative functions. We believe our future success will depend to a large extent on our continued ability to attract and retain highly skilled and qualified employees. We consider our employee relations to be good. None of these aforementioned employees belong to labor unions.

Risk Factors

Our business is subject to various operational and financial risks that could have an adverse effect on our financial condition or our results of operations. In addition the general economic risks associated with operation of a small company in a regulated industry, some of the risk factors that may apply specifically to us are set forth below.

Our results of operations fluctuate from period to period. Our revenue and results of operations have fluctuated and will continue to fluctuate from quarter to quarter in the future due to a number of factors over which we have no control, including:
 
 
·
Many of our customers are not obligated to route a minimum amount of traffic over our system and the amount of traffic we handle may decline if our customers elect to route traffic over systems they operate or systems operated by other providers;
 
·
increased competition from other telecommunication service providers or from service companies in related fields that offer telecommunication services may adversely affect the amount we can charge for traffic routed over our system;
 
·
we may be required to reduce our charges for routing traffic to maintain high utilization of our equipment;
 
·
the termination fees, connection fees and other charges from our suppliers;
 
·
fraudulently sent or received traffic for which we are obligated to pay but which we are unable to bill to any customer;
 
·
changes in call volume among the countries to which we complete calls;
 
·
technical difficulties or failures of our network systems or third party delays in expansion or provisioning system components; and
 
·
our ability to manage our traffic on a constant basis so that routes are profitable.
 
We may be unable to generate sufficient volume of traffic to be profitable. VoIP has only recently been developed and many users are only becoming aware of its potential If the market for VoIP telephony and new services does not develop as we expect, or develops more slowly than expected, we may be unable to maintain a high level of utilization. Some factors that may adversely affect acceptance of VoIP technology include:
 
 
·
perceptions that the quality of voice transmitted over the Internet is low;
 
·
perceptions that VoIP is unreliable;
 
·
our inability to deliver traffic over the Internet with significant cost advantages;
 
·
development by our customers of their own capacity on routes served by us; and
 
·
an increase in termination costs of international calls.

We rely on third parties to provide and maintain the networks over which we transmit traffic. Our business model depends on the availability of the Internet and traditional telephone networks to transmit voice and data. Third parties own and maintain the equipment that translates calls from traditional voice networks to the Internet, and vice versa and other equipment that comprise the Internet for these systems fail to maintain their lines properly, fail to maintain the ability to terminate calls, or otherwise disrupt our ability to provide service to our customers, our ability to complete calls or provide other services could be interrupted.
 
13


 
Our suppliers could increase the cost of services they provide or deny us access to systems that they operate. We maintain relationships with communications service providers in many countries and with other carriers to carry traffic on their systems. There is no assurance that these services will continue to be available to us on acceptable terms, if at all. If we are unable to replace any provider that ceases to provide services to us on acceptable terms, or to identify and develop relationships with new service providers, our ability to provide services in certain countries may be adversely affected.

We are subject to downward pricing pressures and a continuing need to renegotiate overseas rates. As a result of numerous factors, including increased competition and global deregulation of telecommunications services, prices for international long distance calls have been decreasing. This downward trend of prices to end-users has caused us to lower the prices we charge communication service providers for call completion on our network. If this downward pricing pressure continues, we may not be able to offer VoIP services at costs lower than, or competitive with, the traditional voice network services with which we compete. Moreover, in order for us to lower our prices, we have to renegotiate rates with our foreign service providers who complete calls for us. We may not be able to renegotiate these terms favorably enough, or fast enough, to allow us to continue to offer services in a particular country on a cost-effective basis. The continued downward pressure on prices and our inability to renegotiate favorable terms in a particular country could have a material adverse effect on our ability to operate our network.

We are subject to risks relating to operations in foreign countries. Because we provide many of our services internationally, we are subject to additional risks related to providing services into foreign countries. In particular, in order to provide services in some countries, we have forged relationships with foreign operators. Associated risks include:
 
 
·
unexpected changes in tariffs, trade barriers and regulatory requirements relating to Internet access or VoIP;
 
·
economic weakness, including inflation, or political instability in particular foreign economies and markets;
 
·
difficulty in collecting accounts receivable;
 
·
tax, consumer protection, telecommunications, and other laws;
 
·
foreign currency fluctuations, which could result in increased operating expenses and reduced revenues; and
 
·
unreliable government power to protect our rights;

International governmental regulation and legal uncertainties and other laws could limit our ability to provide our services, make them more expensive, or subject us to legal liability. Many countries currently prohibit or limit competition in the provision of traditional voice telephony services. In some of those countries, licensed telephony carriers as well as government regulators and law enforcement authorities have questioned the legal authority of VoIP services. Our failure to qualify as a properly licensed service provider, or to comply with other foreign laws and regulations, could materially adversely affect our business, financial condition, and results of operations. It is also possible that countries may apply to our activities laws relating to services provided over the Internet, including laws governing:
 
 
·
user privacy;
 
·
pricing controls and termination costs;
 
·
characteristics and quality of products and services;
 
·
qualification to do business;
 
·
consumer protection;
 
·
cross-border commerce, including laws that would impose tariffs, duties and other import restrictions;
 
·
copyright, trademark and patent infringement; and
 
·
claims based on the nature and content of Internet materials, including defamation, negligence and the failure to meet necessary obligations.
 
14

 
If foreign governments or other bodies begin to impose related restrictions on VoIP or our other services or otherwise enforce other laws against us or our foreign suppliers, such actions could have a material adverse effect on our operations.

If we are not able to keep up with rapid technological change in a cost-effective way, the relative quality of our services could suffer. The technology upon which our services depend is changing rapidly. Significant technological changes could render the hardware and software that we use obsolete, and competitors may begin to offer new services that we are unable to offer. If we are unable to respond successfully to these developments or do not respond in a cost-effective way, we may not be able to offer competitive services and our business results may suffer.

We may not be able to expand and upgrade our network adequately and cost-effectively to accommodate any future growth. Our VoIP business requires that we handle a large number of international calls simultaneously. As we expand our operations, we expect to handle significantly more calls. If we do not expand and upgrade our hardware and software quickly enough, we will not have sufficient capacity to handle the increased traffic and growth in our operating performance would suffer as a result. Even with such expansion, we may be unable to manage new deployments or utilize them in a cost-effective manner. In addition to lost growth opportunities, any such failure could adversely affect customer confidence in our network and services.

Single points of failure on our network may make our business vulnerable. We operate one network control center in San Antonio, Texas. We have not yet designed a redundant system, provided for excess capacity, or taken other precautions against platform and network failures as well as facility failures relating to power, air conditioning, destruction, or theft. We are vulnerable to a network failure that may prohibit us from offering services.

We depend on our current personnel and may have difficulty attracting and retaining the skilled employees we need to execute our business plan. Our future success will depend, in large part, on the continued service of our key management and technical personnel. If any of these individuals or others we employ are unable or unwilling to continue in their present positions, our business, financial condition and results of operations could suffer.

If the Internet infrastructure is not adequately maintained, we may be unable to maintain the quality of our services and provide them in a timely and consistent manner. Our future success will depend upon the maintenance of the Internet infrastructure, including a reliable network backbone with the necessary speed, data capacity and security for providing reliability and timely Internet access and services. To the extent that the Internet continues to experience increased numbers of users, frequency of use or bandwidth requirements, the Internet may become congested and be unable to support the demands placed on it and its performance or reliability may decline thereby impairing our ability to complete calls and provide other services using the Internet at consistently high quality. The Internet has experienced a variety of outages and other delays as a result of failures of portions of its infrastructure or otherwise. Future outages or delays could adversely affect our ability to complete calls and provide other services. Moreover, critical issues concerning the commercial use of the Internet, including security, cost, ease of use and access, intellectual property ownership and other legal liability issues, remain unresolved and could materially and adversely affect both the growth of Internet usage generally and our business in particular. Finally, important opportunities to increase traffic on our network will not be realized if the underlying infrastructure of the Internet does not continue to be expanded to more locations worldwide.

ITEM 2. DESCRIPTION OF PROPERTIES.

Our executive office is located at 3201 Cherry Ridge, Building C, Suite 300, San Antonio, Texas, consisting of 3,618 square feet. The lease for this facility will expire on November 15, 2011. We pay annual rent of $47,439. We believe that our leased facilities are suitable and adequate for their intended use.
 
15

 
ITEM 3. LEGAL PROCEEDINGS.
 
On October 31, 2002, ATSI filed a lawsuit in the United States District Court for the Southern District Court of New York against several individuals and financial institutions, including the holders of our Series D and E Redeemable Preferred Stock. Among other things, such claims asserted stock fraud and manipulation claims. On July 9, 2004, we filed a separate but related lawsuit in the same court against Sam Levinson and Uri Wolfson. In 2005, Judge Lewis A. Kaplan dismissed the complaints in both actions as to all defendants with prejudice; essentially stating the claims did not plead causes of action under federal law. ATSI appealed those dismissal judgments to the United States Court of Appeals for the Second Circuit. On July 11, 2007 the Court of Appeals affirmed the dismissals.

RGC International Investors, LDC ("RGC"), who had been a Defendant in the New York litigation referenced above, filed a lawsuit in the Chancery Court in Delaware against ATSI on March 20, 2007 asserting it still had rights of enforcement against ATSI to convert preferred stock to common stock or redeem such stock in connection with Certificate of Designation issued regarding such series E preferred stock in October of 2000. ATSI asserted, among other things, that RGC is barred from such relief based on the applicable statute of limitations. In August 2007 the parties reached a confidential settlement agreement. Under the confidential settlement agreement the 1,170 shares of Series E Preferred Stock have been cancelled.

In June 2007, ATSI initiated a declaratory judgment action in the United States District Court for the Western District of Texas against Shaar Fund, Ltd., holder of series D preferred stock who still asserted it had rights under instruments that issued incident to such stock. ATSI asserted that alleged rights asserted by the Shaar Fund Ltd are barred by applicable statute of limitations. On August 2, 2007, Shaar Fund Ltd. filed a separate suit against ATSI in the United States District Court for the Southern District Court of New York asserting it continued to own rights under the instruments relating to the series D preferred stock. By September, 2007, the parties reached an agreement as to the competing suits which led to ATSI dismissing the Texas suit in favor of litigating all remaining issues between it and Shaar Fund Ltd. as to such matters in United States District Court for the Southern District Court of New York. Pleading deadlines have been extended in the New York action as the parties are currently explore a mutual resolution.

In December 2006, ATSI filed suit in Bexar County District Court to recover approximately $63,000 (plus attorney’s fees, legal interest, and court costs) against a company that called itself Lightspeed Telecom, Inc. and its principals or alter egos. The suit is for unpaid telecommunications services provided at the instance of Defendants. ATSI asserts such services were obtained by or at the direction of Defendants without intent to pay, which the individual Defendants deny. Lightspeed admits liability but the two individual Defendants deny liability. This case is currently in the process of being set for trial in 2008.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.

NONE
PART II.

ITEM5.     
MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES.

Market for Common Equity
 
Our common stock is quoted on the OTC Bulletin Board under the symbol “ATSX”. The following table sets forth the high and low bid prices for our common stock from August 1, 2005 through July 31, 2007, as reported by Bloomberg, LP. Price quotations on the OTC Bulletin Board reflect inter-dealer prices, without retail mark-up, markdown or commission, and may not necessarily represent actual transactions.
 
16

 
Fiscal 2006
 
High
 
Low
 
First Quarter
 
$
0.44
 
$
0.14
 
Second Quarter
 
$
0.43
 
$
0.21
 
Third Quarter
 
$
0.51
 
$
0.25
 
Fourth Quarter
 
$
0.39
 
$
0.19
 
               
Fiscal 2007
   
High
   
Low
 
First Quarter
 
$
0.19
 
$
0.34
 
Second Quarter
 
$
0.22
 
$
0.36
 
Third Quarter
 
$
0.19
 
$
0.34
 
Fourth Quarter
 
$
0.23
 
$
0.24
 

Holders

As of July 31, 2007, we had approximately 6,706 common shareholders of record.

Dividends

We have not paid cash dividends on our common stock and we do not anticipate paying a dividend in the future.

Equity Compensation Plans

The following table provides information regarding securities that have been or are authorized to be issued under our equity compensation plans as of July 31, 2007:

 
Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights
Weighted-Average Exercise Price of Outstanding Options, Warrants and Rights
Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans
       
Equity Compensation plans approved by security holders
 
-0-
 
N/A
 
-0-
       
Equity Compensation Plans not approved by security holders
 
5,699,000
 
$.17
 
821,000
       
Total
5,699,000
$.17
821,000

The material features of each equity compensation plan are described in Note 9 of the Notes to the Financial Statements.

Sales of Unregistered Securities

On September 18, 2006, the Company issued 66,226 shares of its common stock to Mr. Richard Benkendorf, a former director, under a settlement agreement. The shares were exempt from registration under Section 4(2) of the Securities Act of 1933, as amended, and were restricted from further transfer without registration.

On October 2, 2007, the Company issued 150,000 shares of its common stock for $34,500 to NetComm Services Corp. upon exercise of warrants. The shares were exempt from registration under Section 4(2) of the Securities Act of 1933, as amended, and were restricted from further transfer without registration.

On January 22, 2007, the Company issued 111,909 shares of its common stock in exchange for 2,750 shares of Series A Convertible Preferred Stock and all accrued dividends thereon. The shares were exempt from registration under Section 3(a)(9) of the Securities Act of 1933, as amended.
 
17

 
On February 7, 2007, the Company issued 137,412 shares of its common stock to Mr. John Fleming, a director, under a settlement agreement. The shares were exempt from registration under Section 4(2) of the Securities Act of 1933, as amended, and were restricted from further transfer without registration.
 
On June 1, 2007, the Company issued 419,081 shares of its common stock to the holders of its debentures dated June 1, 2006. The shares were exempt from registration under Section 4(2) of the Securities Act of 1933, as amended, and were restricted from further transfer without registration.

During the twelve months ended July 31, 2007, the Company issued a total of 495,062 to various professionals in lieu of fees. These shares were exempt from registration under Section 4(2) of the Securities Act of 1933, as amended, and were restricted from further transfer without registration.

During the twelve months ended July 31, 2007, the Company issued a total of 16,149,938 shares of common stock in connection with the conversion and redemption of all outstanding shares of its Series H Convertible Preferred Stock. No compensation was paid to any person in connection with the exchange and the exchange was exempt from registration pursuant to Section 3(a)(9) of the Securities Act of 1033.
 
During the twelve months ended July 31, 2007, the Company issued 137,412 shares of its common stock to Mr. John Fleming, a director, pursuant to a settlement agreement. The transaction was privately negotiated between the Company and Mr. Fleming, with whom the Company has substantial prior relationship. The shares were issued without registration pursuant to Section 4(2) of the Securities Act of 1933.

During the twelve months ended July 31, 2007, the Company issued an aggregate of 2,566,482 shares of its common stock in exchange and conversion of outstanding promissory notes in the original principal amount of $564,600 and accrued interest of $10,292. The promissory notes were originally sold in a private placement that did not involve a public solicitation and all of the note holders certified to the Company that they are accredited investors. In addition, the Company issued 297,270 shares of common stock to the placement agent in connection with the original private placement of the promissory notes. The shares were exempt from registration under Section 4(2) of the Securities Act of 1933 as a private placement.

ITEM 6. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

SPECIAL NOTE: This Annual Report on Form 10-KSB contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities and Exchange Act of 1934, as amended. “Forward looking statements” are those statements that describe management’s beliefs and expectations about the future. We have identified forward-looking statements by using words such as “anticipate,” “believe,” “could,” “estimate,” “may,” “expect,” and “intend.” Although we believe these expectations are reasonable, our operations involve a number of risks and uncertainties, including our ability to continue as a going concern.

The following is a discussion of the consolidated financial condition and results of operations of ATSI Communications, Inc., for the fiscal years ended July 31, 2007 and 2006. It should be read in conjunction with our Consolidated Financial Statements, the Notes thereto, and the other financial information included elsewhere in this annual report on Form 10-KSB. For purposes of the following discussion, fiscal 2007 or 2007 refers to the year ended July 31, 2007 and fiscal 2006 or 2006 refers to the year ended July 31, 2006.
 
18

Sources of revenue and direct cost 

Sources of revenue:

Carrier Services:  We currently provide VoIP communication services to U.S. and foreign telecommunications companies that lack transmission facilities, require additional capacity or do not have the regulatory licenses to terminate traffic in Mexico, Asia, the Middle East and Latin America. Typically, these telecommunications companies offer their services to the public for domestic and international long distance services. In addition, we provide private communications links and VoIP gateway services.

Communication Services: We provide retail local phone service and international VoIP long distance service primarily to the U.S. Hispanic market throughout Texas, mainly in the Rio Grande Valley. Our local phone service includes access to a landline and value-added services such a caller ID and call waiting. These services are offered to our customers on both a prepaid and postpaid basis. We also provide prepaid domestic and long-distance services through our prepaid VoIP network platform. Customers access this platform and complete the call by using their local phone number as a “PIN” or personal identification number.

Network Services: We provide private communication links and VoIP gateway services to multi-national and foreign carriers and enterprise customers who require a high volume of telecommunications services to communicate with their U.S. offices or businesses and need greater dependability than is currently available through the foreign telecommunication networks. These services include data, voice and fax transmission between multiple international offices and branches as well as Internet and co-location services in the United States. 

Direct Costs:

Carrier Services: We incur transmission and termination charges from our suppliers and the providers of the infrastructure and network. The cost is based on a per minute rate and volume of minutes transported and terminated through the network. Additionally, we incur fixed Internet bandwidth charges and per minute billing charges. In some cases we incur installation charges from certain carriers. These installation costs are passed on to our customers for the connection to our VoIP network.

Communication Services: We incur charges for local telephone service and related features from the local exchange carrier. Additionally, we incur a cost per minute and platform fees from our suppliers for long distance services and platform access based on the number of accounts and calls accessed by our customers.

Network Services: Under the network services, we incur bandwidth and co-location charges. The bandwidth charges are incurred as part of the connection links between the customer’s different remote locations and sites to transmit data, voice and Internet services. We also incur co-location charges that are passed through to our customers.
 
Results of Operations

The following table sets forth certain items included in our results of operations in thousands of dollars amounts and variances between periods for the years ended July 31, 2007 and 2006.
   
Years ended July 31,
 
   
2007
 
2006
 
Variances
 
%
 
OPERATING REVENUES:
                 
Carrier services
 
$
31,562
 
$
14,549
 
$
17,013
   
117
%
Communication services
   
113
   
125
   
(12
)
 
-10
%
Network services
   
17
   
22
   
(5
)
 
-23
%
Total operating revenues
   
31,692
   
14,696
   
16,996
   
116
%
                           
Cost of services (exclusive of depreciation and amortization, shown below)
   
29,521
   
13,869
   
15,652
   
113
%
GROSS MARGIN
   
2,171
   
827
   
1,344
   
163
%
                           
Selling, general and administrative expense (exclusive of legal and professional fees)
   
1,625
   
1,138
   
487
   
43
%
Legal and professional fees
   
258
   
195
   
63
   
32
%
Bad debt expense
   
98
   
-
   
98
   
-100
%
Depreciation and amortization expense
   
99
   
92
   
7
   
8
%
OPERATING INCOME (LOSS)
   
91
   
(598
)
 
689
   
115
%
                           
OTHER INCOME (EXPENSE):
                         
Loss on derivative instrument liabilities
   
-
   
(6
)
 
6
   
100
%
Debt forgiveness income
   
-
   
50
   
(50
)
 
-100
%
Interest expense
   
(348
)
 
(151
)
 
(197
)
 
-130
%
Total other income (expense), net
   
(348
)
 
(107
)
 
(241
)
 
-225
%
 
                                     
NET (LOSS) FROM CONTINUING OPERATIONS
   
(257
)
 
(705
)
 
448
   
64
%
                           
DISCONTINUED OPERATIONS
                         
Gain on disposal of discontinued operations
   
-
   
1,652
   
(1,652
)
 
-100
%
NET INCOME FROM DISCONTINUED OPERATIONS
   
-
   
1,652
   
(1,652
)
 
-100
%
                           
NET INCOME (LOSS)
 
$
(257
)
$
947
 
$
(1,204
)
 
-127
%
LESS: PREFERRED DIVIDEND
   
(56
)
 
(959
)
 
903
   
94
%
ADD: REVERSAL OF PREVIOUSLY RECORDED PREFERRED DIVIDEND
   
828
   
-
   
828
   
100
%
                           
NET INCOME (LOSS) TO COMMON STOCKHOLDERS
 
$
515
 
$
(12
)
$
527
   
4392
%
19


Year Ended July 31, 2007 Compared to Year ended July 31, 2006

Operating revenues. Consolidated operating revenues increased by 116% between periods from $14.7 million for the year ended July 31, 2006 to $31.7 million for the year ended July 31, 2007.
 
Carrier Services revenues increased by approximately $17 million, or 117% from the year ended July 31, 2006 to the year ended July 31, 2007. Our VoIP carrier traffic increased from approximately 283 million minutes during the year ended July 31, 2006 to approximately 451 million minutes during the year ended July 31, 2007. The increase in revenue and carrier traffic can mainly be attributed to an increase in customers over the last twelve months. The increase in total customers is as a result of the Company’s ability to offer high quality and dependable VoIP services to multiple countries in the world and greater capacity due to our increase in port capacity in our Nextone Soft Switch.

Communication services revenue decreased approximately 10% or $12,000 from the year ended July 31, 2006 to the year ended July 31, 2007. The decrease in communication services revenue is primarily due to a decrease in retail customers from 159 during the year ended July 31, 2006 to 117 during the year ended July 31, 2007.

Network Services revenues decreased by approximately 23% or $5,000 from the year ended July 31, 2006 to the year ended July 31, 2007. The decrease in network services revenue is primarily due to the decrease in network services customers.
 
Cost of Services (Exclusive of depreciation and amortization). The consolidated cost of services increased by approximately $15.7 million, or 113% from the year ended July 31, 2006 to the year ended July 31, 2007. The increase in cost of services is a direct result of the increase in carrier services revenue. As mentioned above, our carrier traffic increased from approximately 283 million minutes during the year ended July 31, 2006 to approximately 451 million minutes in the year ended July 31, 2007. Cost of services, as a percentage of revenue decreased from 94% during the year ended July 31, 2006 to 93% during the year ended July 31, 2007. Additionally, as a result of the increase in total revenue our gross profits increased from $827,000 during the year ended July 31, 2006 to $2,171,000 during the year ended July 31, 2007.
 
20

 
Selling, General and Administrative (SG&A) Expenses (exclusive of legal and professional fees). SG&A expenses increased $487,000, or 43% from the year ended July 31, 2006 to the year ended July 31, 2007. The increase is primarily attributable to an increase in salaries and wages of approximately $257,000 as a result of the hiring of two new employees, bonuses paid to officers, and accounts receivable-factoring fees of approximately $43,000 during the year ended July 31, 2007. Furthermore, non-cash issuance of common stock and warrants for services increased by $157,000 from the year ended July 31, 2006 to the year ended July 31, 2007. The increase is attributed to the recognition during the year ended July 31, 2007 of approximately $473,000 of non-cash compensation expense associated with stock options issued to employees and directors compared $267,000 in fiscal 2006.

Legal and professional fees. Legal and professional fees increased by $63,000, or 32% from the year ended July 31, 2006 to the year ended July 31, 2007. The increase is attributable to the recognition of approximately $7,500 associated with the preparation of the closing documents for the new accounts receivable factoring agreement. Also, during the year ended July 31, 2007 we recognized approximately $31,000 in professional fees associated with the evaluation of derivative instruments and restructuring of debt and we recognized approximately $45,000 in legal fees associated with a lawsuit filed by the Company for stock fraud and manipulation by various institutions.
 
Bad debt expense. During the year ended July 31, 2007 we recognized $98,000 in bad debt expense for certain accounts receivable we deemed we were unlikely to collect. We did not recognize any bad debt expense during the year ended July 31, 2006.

Depreciation and amortization. Depreciation and amortization increased by $7,000 or 8% year ended July 31, 2006 to the year ended July 31, 2007. The increase is attributed to the amortization during the fiscal 2007 of new computers and equipment acquired during fiscal 2007.

Operating income (loss). The Company’s operating income (loss) improved by $689,000 or 115% from the year ended July 31, 2006 to the year ended July 31, 2007. The improvement in operating income (loss) between periods is attributed to the increase in gross profit of $1,344,000. The increase in gross profit margin was partially offset by the increase in selling, general and administrative expenses, legal and professional fees, and bad debt expense.

Loss on derivative instruments liabilities, net. The Company recognized a loss on derivative instruments of $6,000 during the year ended July 31, 2006. No gain or loss was recognized during the year ended July 31, 2007, as we had no derivative liabilities during 2007.

Debt forgiveness income. Debt forgiveness income decreased by $50,000 from the year ended July 31, 2006 to the year ended July 31, 2007. The decrease is primarily due to the recognition during the year ended July 31, 2006 of $50,000 in debt forgiveness income associated with the settlement of debt for the issuance of common stock. This transaction was related to the settlement of $50,000 in debt with a consultant. This debt was incurred during fiscal 2000 and associated with the commissions incurred as part of the acquisition of the concession license in Mexico. The debt forgiveness income was based on the difference between the market price of ATSI’s equity at the time of issuance and the market price calculated at the time of the settlement of the debt. We did not have any debt forgiveness income in 2007.
 
Interest expense. Interest expense increased by $197,000 from the year ended July 31, 2006 to the year ended July 31, 2007. The increase can be attributed to the beneficial conversion feature of $143,723 recognized with conversion of the $564,600 in notes payable plus accrued interest of $10,292 and to the amortization of approximately $94,000 of deferred financing fees as part of the private placement financing.
 
21

 
Net loss from continuing operations. Net loss from continuing operations improved by $448,000 from the year ended July 31, 2006 to the year ended July 31, 2007. The improvement in net loss between periods is attributed to the increase in operating income, which as partially offset by the increase in interest expense.

Net income from discontinued operations. During the year ended July 31, 2006 we recognized a gain on disposal of discontinued operations of $1,652,000. The gain on disposal of discontinued operations arose from the sale of ATSI’s ownership in ATSIMex Personal S.A de C.V. Under the share purchase agreement the buyer acquired the total ownership and assumed all related liabilities on this entity of $1,652,000 and as a result we recognized a gain of $1,652,000. No gain on disposal of discontinued operation was recognized during the year ended July 31, 2007.

Preferred stock dividends. Preferred stock dividends decreased by $903,000 or 94% between periods, from $959,000 for the year ended July 31, 2006 to $56,000 during the year ended July 31, 2007. The decrease in preferred dividends between periods is mainly attributed to the conversion of Series A Convertible Preferred Stock and Series H Convertible Preferred Stock during 2007.

Reversal of previously recorded preferred stock dividends. During the year ended July 31, 2007, we recognized a reversal of previously recorded dividend expense of $828,000. This reversal occurred as result of the conversion into common stock of 2,750 shares of Series A Convertible Preferred Stock and 11,802,420 shares of Series H Convertible Preferred Stock. At the time of conversion of these securities the market price of ATSI’s stock was higher than at the time of issuance of the securities. As a result, a reversal of preferred dividends was recognized during the period.

Net income (loss) to common stockholders. Net income (loss) to common stockholders improved by $527,000. The improvement in net income applicable to common stockholders is attributed to the cumulative effect of the increase in operating income and the reversal of previously recorded preferred dividend of approximately $828,000.

Liquidity and Capital Resources
 
Cash Position: We had a cash balance of $1,050,000 as of July 31, 2007. Net cash provided by operating activities during the year ended July 31, 2007, was approximately $562,000, attributable to improved operating results from an increase in gross margins offset by working capital changes.

Investing activities during the year ended July 31, 2007, consumed $501,000. We used $306,000 to acquire two certificates of deposit necessary to secure certain obligations of the Company. We used $50,000 on a note receivable issued to a NetSapiens. The note receivable is secured by NetSapiens’ proprietary Starter Platform License. Additionally, we used $145,000 to upgrade our Nextone Soft-switch and other equipment necessary to handle the increase in minutes of voice traffic transported in our network and sustain higher revenues.

Financing activities during the year ended July 31, 2007, generated $953,000 in cash. This cash was primarily generated from proceeds of our private placement of $713,000, proceeds from a notes payable of $550,000, cash proceeds of $35,000 from the exercise of 150,000 warrants and cash proceeds of $16,000 from the exercise of 100,000 stock options. These cash proceeds were offset by debt principal payments of $106,000 associated with two related party notes payable, the principal payments of $104,000 associated with various notes payable, the principal payments of $148,000 associated with advances from shareholders and principal payments of $3,000 associated with our capital leases. Overall, our net operating, investing and financing activities during the year ended July 31, 2007 provided an increase of $1,014,000 in cash.
 
22

 
Our current cash expenses are expected to be approximately $90,000 per month, including wages, rent, utilities, litigation fees and corporate professional fees. We are currently generating sufficient cash from operations to cover all monthly cash expenses, but we cannot predict if, over the next twelve months, we will continue to generate sufficient cash from operations to cover all of our cash expenses. We intend to cover our monthly cash expenses with our cash produced from operations and financing activities. We expect to continue conserving cash resources by paying long-term executive compensation and fees for certain professional services with shares of our common stock. Additionally, on November 3, 2006, we entered into a factoring agreement with CCA Financial Services, Inc. Under the agreement, CCA Financial Services committed to purchase up to $1,000,000 of ATSI’s monthly receivables. As our ongoing operations require, we will continue factoring our receivables under this agreement, which on average has been $850,000 of our monthly receivables. As of the date of this filing, we paid all factor receivables to our factoring agent; we will continue to factor our receivables on a monthly basis as services are rendered to our customers. Furthermore, we will continue to pursue additional debt and equity financings to fund continued growth and increase our cash reserves. However, we presently do not have a definitive agreement in place to obtain such financing. Any additional debt or equity financing may not be available in sufficient amounts or on acceptable terms. If such financing is not available in sufficient amounts or on acceptable terms, the Company's operational results and future financial condition may be adversely affected.

We are not presently paying quarterly interest or dividends on our outstanding convertible debentures and preferred stock. However, we have continued to accrue dividends and interest on such debentures. The increase in accrued liabilities related to the dividends and interest in arrears contributed approximately $76,000 in cash flow savings during the year ended July 31, 2007.
 
Our working capital deficit was $424,000 as of July 31, 2007. This represents an improvement of approximately $2,376,000 from our working capital deficit at July 31, 2006. The improvement can primarily be attributed to the elimination of $1,773,680 of accrued dividends due to the conversion into common stock of 11,802,420 shares of Series H Convertible Preferred Stock and accrued dividends. Additionally, during the year ended July 31, 2007, we reclassified a note payable of $500,000 from long-term liabilities to current liabilities. This note is due in October 2007.

Ongoing operations

We generated sufficient income from operations to cover our operating expenses during the fiscal year ended July 31, 2007. However, we believe that due to our limited access to capital, we may not be able to support our ongoing operations if we do not continue producing positive operating income in the future. Our ability to continue as a going concern is dependent upon generating sufficient income from operations to cover our operating expense, the ongoing support of our stockholders and customers, and our ability to obtain capital resources to support expansion.

During the year ended July 31, 2007, we received $713,000 from the private placement financing, $35,000 from the exercise of warrants and $16,000 from the exercise of stock options. These funds, along with funds generated from operations, allowed us to cover our operating expenses and other corporate expenses during the year ended July 31, 2007. Additionally, on November 3, 2006, we entered into a factoring agreement with CCA Financial Services, Inc. Under the agreement, CCA Financial Services committed to purchase up to $1,000,000 of our monthly receivables. As our ongoing operations require, we will factor our receivables under this agreement. As of date of this filing, we did not have any outstanding factored receivables under this agreement.

We will continue to pursue cost cutting strategies in order to conserve working capital that could limit the implementation of our business plan. We are dependent on our operations and the proceeds from future debt or equity investments to fully implement our business plan. If we are unable to continue producing positive cash flow from operations or raise sufficient capital, we will be required to delay or forego some portion of our business plan, which will have an adverse effect on our anticipated results from operations and our financial condition. Alternatively, we may seek interim financing in the form of private placement of debt or equity securities. Such interim financing may not be available in the amounts or at the time when it is required.
 
23

 
Critical Accounting Policies

Revenue Recognition. ATSI derives revenue from Carrier Services, Network Services, and Communication Services. ATSI records and reports its revenue on the gross amount billed to its customers in accordance with EITF 99-19. Revenue is recognized when persuasive evidence of an arrangement exists, service or network capacity has been provided, the price is fixed or determinable, collectibility is reasonably assured and there are no significant obligations remaining.

Carrier Service: ATSI provides VoIP communication services to U.S. and foreign telecommunications companies, who lack transmission facilities, require additional capacity or do not have the regulatory licenses to terminate traffic in Mexico, Asia, the Middle East and Latin America. Typically these telecommunications companies offer their services to the public for domestic and international long distance services. Carrier service revenue is derived through transporting and terminating minutes of telecommunications traffic over ATSI’s owned or leased VoIP network (Voice over Internet Protocol). ATSI recognizes revenue in the period the service is provided, net of revenue reserves for potential billing credits. Such disputes can result from disagreements with customers regarding the duration, destination or rates charged for each call.

Communication Services: ATSI provides retail local phone service and international VoIP long distance service to the U.S. Hispanic market throughout Texas, mainly in the Rio Grande Valley. Our local phone service includes access to a landline and value-added services such a caller ID and call waiting. These services are offered to our customers in both prepaid and postpaid basis. Additionally, ATSI provides prepaid domestic and long-distance services; under these services ATSI allows our customers to access our prepaid VoIP network platform. The customer will access this platform and be able to complete the call by using their local phone number as their “PIN” or personal identification number. The revenues derived from prepaid local telephone and long-distance are billed monthly in advance and are recognized the following month when services are provided. Additionally, revenues derived from postpaid local telephone and long-distance services are recognized monthly as services are provided.

Network Services: ATSI provides private communication links and VoIP gateway services to multi-national and foreign carriers and enterprise customers who use a high volume of telecommunications services to communicate with their U.S. offices or businesses and need greater dependability than is currently available through the foreign telecommunication networks. These services include data, voice and fax transmission between multiple international offices and branches as well as Internet and collocation services in the United States. ATSI recognizes network services revenue during the period the service is provided.

Direct Cost of Revenue:

Carrier Services: Under carrier services, ATSI incurs termination charges. These charges are related to the fees that ATSI is charged by carriers/vendors for the termination of phone calls into their infrastructure and network to terminate traffic in Mexico, Asia, the Middle East and Latin America. The cost is based on a per minute rate and volume. ATSI also incurs installation charges from various carriers; this cost is passed on to customers for the connection to the VoIP network from ATSI’s carriers.

Network Services: Under network services, ATSI incurs Internet, co-location, and fiber optic charges. The Internet and fiber optic charges are incurred as part of the connection links between the customer’s different remote locations and sites to transmit data, voice and Internet services. Co-location charges are incurred for space utilized to install gateways, servers, and other communications equipment.

Communication Services: ATSI incurs charges for local telephone service and related features from the dominant local exchange carrier. Additionally, ATSI incurs a cost per minute and platform fees from two suppliers for long distance services and platform access.

Stock-based compensation. Effective February 1, 2006, ATSI began recording compensation expense associated with stock options and other forms of equity compensation in accordance with Statement of Financial Accounting Standards No. 123R, Share-Based Payment, as interpreted by SEC Staff Accounting Bulletin No. 107. Prior to February 1, 2006, ATSI had accounted for stock options according to the provisions of Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees”, and related interpretations, and therefore no related compensation expense was recorded for awards granted with no intrinsic value. ATSI adopted the modified prospective transition method as permitted under SFAS No. 123R, and, consequently, has not retroactively adjusted results from prior periods. Under this modified prospective transition method, compensation cost associated with stock options recognized during fiscal 2006 includes the amortization related to the remaining service period of all stock option awards granted prior to February 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123.
 
24

 
Derivative financial instruments. ATSI does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks.

Derivative financial instruments are initially measured at their fair value. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported as charges or credits to income. For option-based derivative financial instruments, ATSI uses the Black-Scholes option-pricing model to value the derivative instruments.

The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period. Derivative instrument liabilities are classified in the balance sheet as current or non-current based on whether or not net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet date.

ATSI evaluates the application of SFAS 133 and EITF 00-19 for all of its financial instruments.

25

 
ITEM 7. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Consolidated Financial Statements of ATSI Communications, Inc. and Subsidiaries 
 
 
Page
Report of Independent Registered Public Accounting Firm
27
Consolidated Balance Sheets for the Years Ended July 31, 2007 and 2006
28
Consolidated Statements of Operations for the Years Ended July 31, 2007 and 2006
29
Consolidated Statements of Comprehensive Income (loss) for the Years Ended July 31, 2007 and 2006
30
Consolidated Statement of Changes in Stockholders’ Deficit for the Years Ended July 31, 2007 and 2006
31
Consolidated Statements of Cash Flows for the Years Ended July 31, 2007 and 2006
32
Notes to Consolidated Financial Statements
33
 
26


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders
ATSI Communications, Inc.
San Antonio, Texas

We have audited the accompanying consolidated balance sheets of ATSI Communications, Inc. and subsidiaries as of July 31, 2007 and 2006, and the related consolidated statements of operations, comprehensive income (loss), stockholders’ deficit and cash flows for each of the two years then ended. These consolidated financial statements are the responsibility of ATSI’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of ATSI as of July 31, 2007 and 2006 and the consolidated results of their operations and its cash flows for each of the two years then ended in conformity with accounting principles generally accepted in the United States of America.

The accompanying consolidated financial statements have been prepared assuming that ATSI will continue as a going concern. As discussed in Note 2 to the consolidated financial statements, ATSI has a working capital deficit, has suffered recurring losses from operations and has a stockholders’ deficit. These conditions raise substantial doubt about ATSI’s ability to continue as a going concern. Management's plans in regard to these matters are also described in Note 2. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

MALONE & BAILEY, PC
www.malone-bailey.com
Houston, Texas

October 15, 2007

27

 
PART 1. FINANCIAL INFORMATION
           
ITEM 1. FINANCIAL STATEMENTS
ATSI COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In thousands, except per share amounts)
 
   
July 31,
 
July 31,
 
   
2007
 
2006
 
           
ASSETS
         
CURRENT ASSETS:
         
Cash and cash equivalents
 
$
1,050
 
$
36
 
Accounts receivable, net of allowance for bad debt of $98 and $0, respectively
   
866
   
621
 
Note receivable
   
50
   
-
 
Prepaid & other current assets
   
94
   
33
 
Total current assets
   
2,060
   
690
 
               
LONG-TERM ASSETS:
             
Certificates of deposit
   
306
   
-
 
               
PROPERTY AND EQUIPMENT
   
499
   
284
 
Less - accumulated depreciation
   
(281
)
 
(182
)
Net property and equipment
   
218
   
102
 
               
Total assets
 
$
2,584
 
$
792
 
               
LIABILITIES AND STOCKHOLDERS' DEFICIT
             
CURRENT LIABILITIES:
             
Accounts payable
 
$
1,071
 
$
676
 
Accounts payable, related parties
   
-
   
42
 
Line of credit, CSI Business Finance
   
-
   
150
 
Accrued liabilities
   
516
   
2,389
 
Current portion of obligation under capital leases
   
3
   
3
 
Notes payable
   
818
   
50
 
Notes payable, related party
   
-
   
106
 
Convertible debentures
   
76
   
74
 
Total current liabilities
   
2,484
   
3,490
 
               
LONG-TERM LIABILITIES:
             
Notes payable
   
177
   
500
 
Convertible debentures
   
158
   
234
 
Obligation under capital leases, less current portion
   
3
   
6
 
Other
   
4
   
4
 
Total long-term liabilities
   
342
   
744
 
                       
Total liabilities
   
2,826
   
4,234
 
               
STOCKHOLDERS' DEFICIT:
             
Series A Cumulative Convertible Preferred Stock, $0.001, 50,000 shares authorized, 0 and 2,750 shares issued and outstanding
   
-
   
-
 
Series D Cumulative Preferred Stock, 3,000 shares authorized, 742 shares issued and outstanding
   
1
   
1
 
Series E Cumulative Preferred Stock, 10,000 shares authorized, 1,170 shares issued and outstanding
   
1
   
1
 
Series H Convertible Preferred Stock, $0.001, 16,000,000 shares authorized, 0 and 11,802,353 shares issued and outstanding, respectively
   
-
   
12
 
Common stock, $0.001 par value, 150,000,000 shares authorized, 37,620,513 and 16,44,768 shares
             
issued and outstanding, respectively
   
38
   
16
 
Additional paid in capital
   
72,222
   
68,775
 
Accumulated deficit
   
(72,505
)
 
(72,248
)
Other comprehensive income
   
1
   
1
 
Total stockholders' deficit
   
(242
)
 
(3,442
)
Total liabilities and stockholders' deficit
 
$
2,584
 
$
792
 
               
See accompanying summary of accounting policies and notes to financial statements.
 
28

 
ATSI COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
 
   
Years ended July 31,
 
   
2007
 
2006
 
OPERATING REVENUES:
         
Carrier services
 
$
31,562
 
$
14,549
 
Communication services
   
113
   
125
 
Network services
   
17
   
22
 
Total operating revenues
   
31,692
   
14,696
 
               
OPERATING EXPENSES:
             
Cost of services (exclusive of depreciation and amortization, shown below)
   
29,521
   
13,869
 
Selling, general and administrative expense (exclusive of legal and professional fees)
   
1,625
   
1,138
 
Legal and professional fees
   
258
   
195
 
Bad debt expense
   
98
   
-
 
Depreciation and amortization expense
   
99
   
92
 
Total operating expenses
   
31,601
   
15,294
 
               
OPERATING INCOME (LOSS)
   
91
   
(598
)
               
OTHER INCOME (EXPENSE):
             
Loss on derivative instrument liabilities
   
-
   
(6
)
Debt forgiveness income
   
-
   
50
 
Interest expense
   
(348
)
 
(151
)
Total other income (expense), net
   
(348
)
 
(107
)
               
NET (LOSS) FROM CONTINUING OPERATIONS
   
(257
)
 
(705
)
               
DISCONTINUED OPERATIONS
             
Gain on disposal of discontinued operations
   
-
   
1,652
 
NET INCOME FROM DISCONTINUED OPERATIONS
   
-
   
1,652
 
               
NET INCOME (LOSS)
 
$
(257
)
$
947
 
LESS: PREFERRED DIVIDEND
   
(56
)
 
(959
)
ADD: REVERSAL OF PREVIOUSLY RECORDED PREFERRED DIVIDEND
   
828
   
-
 
               
NET INCOME (LOSS) TO COMMON STOCKHOLDERS
 
$
515
 
$
(12
)
               
BASIC INCOME (LOSS) PER SHARE:
             
From continuing operations
 
$
0.02
 
$
(0.12
)
From discontinued operations
 
$
-
 
$
0.12
 
Total
 
$
0.02
 
$
0.00
 
               
DILUTED INCOME (LOSS) PER SHARE
             
From continuing operations
 
$
(0.01
)
$
(0.02
)
From discontinued operations
 
$
-
 
$
0.05
 
Total
 
$
(0.01
)
$
0.03
 
               
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING
   
27,908,044
   
13,516,342
 
DILUTED COMMON SHARES OUTSTANDING
   
28,049,739
   
31,287,366
 
 
See accompanying summary of accounting policies and notes to financial statements.
 
29

 
ATSI COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(In thousands, except per share amounts)
 
   
Years ended July 31,
 
   
2007
 
2006
 
       
(Restated)
 
Net income (loss) to common stockholders
 
$
515
 
$
(12
)
               
Foreign currency translation adjustment
   
-
   
(501
)
               
Comprehensive income (loss) to common stockholders
 
$
515
 
$
(513
)
               
 
See accompanying summary of accounting policies and notes to financial statements.
 
30

 
ATSI COMMUNICATIONS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS DEFICIT
(in thousands, except share amounts)
 
                        Additional      
Other
     
 
 
Preferred (A)
 
Preferred (D)
 
Preferred (E)
 
Preferred (H)
 
Common
 
Paid-in
 
Retained
 
Comp.
     
 
 
Shares
 
Par
 
Shares
 
Par
 
Shares
 
Par
 
Shares
 
Par
 
Shares
 
Par
 
Capital
 
(Deficit)
 
Income/Loss
 
Totals
 
                                                                                       
BALANCE, JULY 31, 2005
   
3,750
 
 
   
 
 
   
 
 
   
13,912,300
 
 
14
   
10,396,892
 
 
10
 
$
66,741
 
$
(73,195
)
$
502
 
$
(5,928
)
Shares issued for services
                                   
549,456
   
1
   
127
           
128
 
Shares issued to purchase assets
                                   
180,272
   
-
   
58
           
58
 
Shares issued for P/S conversion
   
(1,000
)
 
                   
(2,309,880
)
 
(2
)
 
2,959,731
   
3
   
167
           
168
 
Shares issued for debt conversion
                           
200,000
   
-
   
866,386
   
1
   
255
           
256
 
Reclass of Series D from debt
           
742
   
1
                           
740
           
740
 
Reclass of Series E from debt
                   
1,170
   
1
                   
1,169
           
1,170
 
Exercise of warrants
                                   
366,666
   
-
   
54
           
54
 
Warrant expense
                                           
49
           
49
 
Preferred stock dividend
                                           
(959
)
         
(959
)
Shares issued for services, employees
                                   
1,125,000
   
1
   
179
           
180
 
Derivative instruments (income) expense
                                           
82
           
82
 
Beneficial conversion feature
                                           
26
           
26
 
Stock option expense
                                           
87
           
87
 
Other comp. income/loss
                                                   
(501
)
 
(501
)
Net income
                                                                         
947
         
947
 
BALANCE, JULY 31, 2006
   
2,750
 
 
   
742
 
 
1
   
1,170
   
1
 
 
11,802,420
   
12
 
 
16,444,403
 
 
16
 
$
68,775
 
$
(72,248
)
$ 
1
 
$
(3,442
)
Shares issued for Services
                                   
1,475,062
   
1
   
333
           
334
 
Common shares issued for Preferred Stock Conversion
   
(2,750
)
 
                   
(11,802,420
)
 
(12
)
 
16,261,847
   
16
   
1,137
           
1,141
 
Exercise of warrants
                                   
150,000
   
2
   
35
           
37
 
Dividends declared
                                           
(56
)
         
(56
)
Reversal of previously recorded preferred dividend
                                           
828
           
828
 
Stock option expense
                                           
267
           
267
 
Proceeds from exercise of options
                                   
100,000
   
1
   
16
           
17
 
Beneficial Conversion Feature, private placement
                                           
144
           
144
 
Shares issued for conversion of notes payable
                                   
3,189,201
   
2
   
743
           
745
 
Net (Loss)
                                                                                   
(257
)
         
(257
)
                                                                                       
BALANCE, JULY 31, 2007
 
 
 
 
   
742
 
 
1
   
1,170
 
 
1
   
 
 
 
 
37,620,513
 
 
38
 
$
72,222
 
$
(72,505
)
$
1
 
$
(242
)
 
See accompanying summary of accounting policies and notes to the consolidated financial statements .
 
31

 
ATSI COMMUNICATIONS, INC. AND SUBSIDIARIES
         
CONSOLIDATED STATEMENTS OF CASH FLOWS
         
(In thousands, except per share amounts)
         
   
Years ended July 31,
 
   
2007
 
2006
 
           
CASH FLOWS FROM OPERATING ACTIVITIES:
         
NET INCOME (LOSS)
 
$
(257
)
$
947
 
Adjustments to reconcile net loss to cash used in operating activities:
             
Gain in disposal of investment
   
-
   
(1,652
)
Debt forgiveness income
   
-
   
-
 
Depreciation and amortization
   
99
   
92
 
Issuance of stock grants and options, employees for services
   
473
   
267
 
Issuance of common stock and warrants for services
   
129
   
176
 
Provisions for losses on accounts receivables
   
98
   
-
 
Loss on derivative instrument liabilities
   
-
   
6
 
Amortization of debt discount
   
152
   
-
 
Changes in operating assets and liabilities:
             
Accounts receivable
   
(343
)
 
(451
)
Prepaid expenses and other
   
(61
)
 
10
 
Accounts payable
   
174
   
101
 
Accounts payable - related parties
   
15
   
43
 
Accrued liabilities
   
83
   
157
 
Net cash provided by / used in operating activities
   
562
   
(304
)
               
CASH FLOWS FROM INVESTING ACTIVITIES:
             
Investment in certificates of deposit
   
(306
)
 
(4
)
Note receivable
   
(50
)
 
-
 
Purchases of property & equipment
   
(145
)
 
-
 
Net cash used in investing activities
   
(501
)
 
(4
)
               
CASH FLOWS FROM FINANCING ACTIVITIES:
             
Proceeds from notes payable, related party
   
-
   
120
 
Payments on notes payable, related party
   
(106
)
 
(30
)
Proceeds from notes payable
   
550
   
50
 
Payments on notes payable
   
(104
)
 
-
 
Payments on advances from shareholders
   
(148
)
 
-
 
Proceeds from advances from shareholders
   
713
   
-
 
Proceeds from line of credit, net
   
-
   
124
 
Proceeds from the exercise of stock options
   
16
       
Proceeds from the exercise of warrants
   
35
   
54
 
Principal payments on capital lease obligation
   
(3
)
 
(3
)
Net cash provided by financing activities
   
953
   
315
 
               
INCREASE IN CASH
   
1,014
   
7
 
CASH AND CASH EQUIVALENTS, beginning of period
   
36
   
29
 
               
CASH AND CASH EQUIVALENTS, end of period
 
$
1,050
 
$
36
 
               
SUPPLEMENTAL DISCLOSURES:
             
Cash paid for interest
 
$
77
 
$
24
 
Cash paid for income tax
   
-
   
-
 
               
NON-CASH INVESTING AND FINANCING TRANSACTIONS
             
Issuance of common stock for conversion of debt
 
$
688
 
$
256
 
Issuance of common stock for accounts payable
   
58
   
-
 
Issuance of common stock for purchase of fixed & intangible assets
   
-
   
58
 
Conversion of preferred stock to common stock
   
1,141
   
167
 
Discount for beneficial conversion feature on convertible debt
   
144
   
26
 
Fair value of derivatives transferred to equity
   
-
   
82
 
Reclass preferred stock from debt to equity
   
-
   
1,912
 
Preferred stock dividends
   
56
   
959
 
Reversal of previously recorded preferred stock dividend
   
(828
)
 
-
 
               
 
See accompanying summary of accounting policies and notes to financial statements.
 
32


ATSI COMMUNICATIONS, INC.
AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business. ATSI Communications, Inc. was incorporated in Nevada on May 24, 2004. ATSI is an international telecommunications carrier that utilizes the Internet to provide economical international communication services to carriers and telephony resellers around the world. ATSI’s continuing operations consist of VoIP carrier services, network services, and retail communication services. ATSI’s primary business consists of providing VoIP communication services to U.S. and foreign telecommunications companies that lack transmission facilities and require additional capacity or do not have the regulatory licenses to terminate traffic in Mexico, Asia, the Middle East and Latin America.

Principles of Consolidation. The consolidated financial statements have been prepared on the accrual basis of accounting under accounting principles generally accepted in the United States. All significant inter-company balances and transactions have been eliminated in consolidation.

Reclassifications. Certain amounts in the consolidated financial statements of the prior year have been reclassified to conform to the presentation of the current year for comparative purposes.

Use of Estimates. In preparing financial statements, management makes estimates and assumptions that affect the reported amounts of assets and liabilities in the balance sheet and revenue and expenses in the statement of expenses. Actual results could differ from those estimates.

Concentration of Credit Risk. Financial instruments that potentially subject ATSI to concentration of credit risk consist primarily of trade receivables. In the normal course of business, ATSI provides credit terms to its customers. Accordingly, ATSI performs ongoing credit evaluations of its customers and maintains allowances for possible losses, which, when realized, have been within the range of management’s expectations. ATSI maintains cash in bank deposits accounts, which, at times, may exceed federally insured limits. ATSI has not experienced any losses in such accounts and ATSI does not believe ATSI is exposed to any significant credit risk on cash and cash equivalents.

Revenue Recognition. ATSI derives revenue from Carrier Services, Network Services, and Communication Services. ATSI records and reports its revenue on the gross amount billed to its customers in accordance with EITF 99-19. Revenue is recognized when persuasive evidence of an arrangement exists, service or network capacity has been provided, the price is fixed or determinable, collectibility is reasonably assured and there are no significant obligations remaining.

Carrier Service: ATSI provides VoIP communication services to U.S. and foreign telecommunications companies, who lack transmission facilities, require additional capacity or do not have the regulatory licenses to terminate traffic in Mexico, Asia, the Middle East and Latin America. Typically these telecommunications companies offer their services to the public for domestic and international long distance services. Carrier service revenue is derived through transporting and terminating minutes of telecommunications traffic over ATSI’s owned or leased VoIP network (Voice over Internet Protocol). ATSI recognizes revenue in the period the service is provided, net of revenue reserves for potential billing credits. Such disputes can result from disagreements with customers regarding the duration, destination or rates charged for each call.

Communication Services: ATSI provides retail local phone service and international VoIP long distance service to the U.S. Hispanic market throughout Texas, mainly in the Rio Grande Valley. Our local phone service includes access to a landline and value-added services such a caller ID and call waiting. These services are offered to our customers in both prepaid and postpaid basis. Additionally, ATSI provides prepaid domestic and long-distance services; under these services ATSI allows our customers to access our prepaid VoIP network platform. The customer will access this platform and be able to complete the call by using their local phone number as their “PIN” or personal identification number. The revenues derived from prepaid local telephone and long-distance are billed monthly in advance and are recognized the following month when services are provided. Additionally, revenues derived from postpaid local telephone and long-distance services are recognized monthly as services are provided.
 
33

 
Network Services: ATSI provides private communication links and VoIP gateway services to multi-national and foreign carriers and enterprise customers who use a high volume of telecommunications services to communicate with their U.S. offices or businesses and need greater dependability than is currently available through the foreign telecommunication networks. These services include data, voice and fax transmission between multiple international offices and branches as well as Internet and collocation services in the United States. ATSI recognizes network services revenue during the period the service is provided.

Direct Cost of Revenue:

Carrier Services: Under carrier services, ATSI incurs termination charges. These charges are related to the fees that ATSI is charged by carriers/vendors for the termination of phone calls into their infrastructure and network to terminate traffic in Mexico, Asia, the Middle East and Latin America. The cost is based on a per minute rate and volume. ATSI also incurs installation charges from various carriers; this cost is passed on to customers for the connection to the VoIP network from ATSI’s carriers.

Network Services: Under network services, ATSI incurs Internet, co-location, and fiber optic charges. The Internet and fiber optic charges are incurred as part of the connection links between the customer’s different remote locations and sites to transmit data, voice and Internet services. Co-location charges are incurred for space utilized to install gateways, servers, and other communications equipment.

Communication Services: ATSI incurs charges for local telephone service and related features from the dominant local exchange carrier. Additionally, ATSI incurs a cost per minute and platform fees from two suppliers for long distance services and platform access.

Cash and Cash Equivalents. For purposes of the statement of cash flows, ATSI considers all highly liquid investments purchased with an original maturity of three months or less to be cash equivalents.

Allowance for Doubtful Accounts. Bad debt expense is recognized based on management’s estimate of likely losses each year based on past experience and an estimate of current year uncollectible amounts. As of July 31, 2007, ATSI’s allowance for doubtful accounts balance was approximately $98,000. There was no allowance for doubtful accounts as of July 31, 2006.

Investment in unconsolidated subsidiary. On May 22, 2003 ATSI sold 51% of its interest in ATSI Comunicaciones S.A de C.V., (ATSICOM) As of July 31, 2007, ATSI has a 49% interest in the profits and equity of ATSICOM, a Mexican corporation engaged in providing telecommunications services. During fiscal 2003, ATSI recorded the investment in the unconsolidated subsidiary in conformity with the equity method of accounting. During the year ended July 31, 2004, ATSI determined that the estimated future cash flows expected from the concession license were less than its carrying value. As a result ATSI recorded an impairment loss of approximately $702,000 to reduce the recorded value of the concession license to zero. Although there is no assurance of future value appreciation, from time to time ATSI will conduct a valuation of its investment in the concession license and record the determined value, if any, in its financial statements. As of July 31, 2007, nothing has come to management’s attention that would require ATSI to make any adjustment to its financial statement.

Property and equipment. Property and equipment is recorded at cost. Additions are capitalized and maintenance and repairs are charged to expense as incurred. Gains and losses on dispositions of equipment are reflected in operations. Depreciation is provided using the straight-line method over the estimated useful lives of the assets, which are one to five years.

Impairment of Long-Lived Assets. ATSI reviews the carrying value of its long-lived assets annually or whenever events or changes in circumstances indicate that the value of an asset may no longer be appropriate. ATSI assesses recoverability of the carrying value of the asset by estimating the future net cash flows expected to result from the asset, including eventual disposition. If the future net cash flows are less than the carrying value of the asset, an impairment loss is recorded equal to the difference between the asset’s carrying value and fair value.
 
34

 
Derivative financial instruments. ATSI does not use derivative instruments to hedge exposures to cash flow, market, or foreign currency risks.

Derivative financial instruments are initially measured at their fair value. For derivative financial instruments that are accounted for as liabilities, the derivative instrument is initially recorded at its fair value and is then re-valued at each reporting date, with changes in the fair value reported as charges or credits to income. For option-based derivative financial instruments, ATSI uses the Black-Scholes option-pricing model to value the derivative instruments.

The classification of derivative instruments, including whether such instruments should be recorded as liabilities or as equity, is re-assessed at the end of each reporting period. Derivative instrument liabilities are classified in the balance sheet as current or non-current based on whether or not net-cash settlement of the derivative instrument could be required within 12 months of the balance sheet date. There are no derivative instrument liabilities as of July 31, 2007.

Income taxes. ATSI recognizes deferred tax assets and liabilities based on differences between the financial reporting and tax bases of assets and liabilities using the enacted tax rates and laws that are expected to be in effect when the differences are expected to be recovered. ATSI provides a valuation allowance for deferred tax assets for which it does not consider realization of such assets to be more likely than not.

Stock-based compensation. Effective February 1, 2006, ATSI began recording compensation expense associated with stock options and other forms of equity compensation in accordance with Statement of Financial Accounting Standards No. 123R, Share-Based Payment, as interpreted by SEC Staff Accounting Bulletin No. 107. Prior to February 1, 2006, ATSI had accounted for stock options according to the provisions of Accounting Principles Board Opinion No. 25,“Accounting for Stock Issued to Employees”, and related interpretations, and therefore no related compensation expense was recorded for awards granted with no intrinsic value. ATSI adopted the modified prospective transition method as permitted under SFAS No. 123R, and, consequently, has not retroactively adjusted results from prior periods. Under this modified prospective transition method, compensation cost associated with stock options recognized during fiscal 2006 includes the amortization related to the remaining service period of all stock option awards granted prior to February 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123.

The following table illustrates the effect on net income loss and net loss per share for the twelve months ended July 31, 2007 if ATSI had applied the fair value provisions of FASB Statement No. 123R, to stock-based employee compensation:

   
 Twelve months ended July 31,
 
   
 2007
 
2006
 
            
Net income (loss) to common
        
shareholders, as reported
$
515,000
 
$
(12,000
)
Add:
stock based compensation determined            
under intrinsic value based method  
-
   
-
 
Less:
stock based compensation determined            
  under fair value based method  
-
   
(281,499
)
               
Pro forma net income (loss) to common stockholders
$
515,000
 
$
(293,499
)
               
Basic net income (loss) per common share:
           
As reported
$
0.02
 
$
0.00
 
Pro forma
$
0.02
 
$
(0.02
)
               
Diluted net income (loss) per common share:
           
  As reported
$
(0.01
)
$
0.03
 
Pro forma
$
(0.01
)
$
(0.01
)
 
35

 
The fair value of each option and warrant granted is estimated on the date of grant using the Black-Scholes option pricing model with the following assumptions:
 
   
For the Years Ended July 31,
 
           
   
2007
 
2006
 
Expected dividends yield
   
0.00
%
 
0.00
%
Expected stock price volatility
   
80
%
 
50
%
Risk-free interest rate
   
4.51
%
 
4.39
%
Expected life of options
   
7 years
   
10 years
 

Basic and diluted net loss per share. The basic net loss per common share is computed by dividing the net loss by the weighted average number of common shares outstanding. Diluted net loss per common share is computed by dividing the net loss adjusted on an "as if converted" basis, by the weighted average number of common shares outstanding plus potential dilutive securities.

Recently issued accounting pronouncements. ATSI does not expect the adoption of any other recently issued accounting pronouncements to have a significant impact on ATSI’s results of operations, financial position or cash flows.

NOTE 2 - GOING CONCERN

As shown in the accompanying financial statements, ATSI incurred net losses from operations of $257,000 and $705,000 in fiscal 2007 and 2006, respectively, has an accumulated deficit of $72.5 million and a working capital deficit of $424,000 as of July 31, 2007. Although we generated sufficient income from operations to cover our operating expenses during the fiscal year ended July 31, 2007, these conditions create doubt as to ATSI’s ability to continue as a going concern. Management plans to continue to improve its financial position through the profitable growth of its operations subject to its capital limitations. Management will also continue to pursue financings that may include raising additional capital through the issuance of debt and sales of common stock, preferred stock. The financial statements do not include any adjustments that might be necessary if ATSI is unable to continue as a going concern.

NOTE 3 - PROPERTY AND EQUIPMENT

Following is a summary of ATSI’s property and equipment at July 31, 2007 and 2006 (in thousands):

   
Useful lives
 
2007
 
2006
 
Telecom equipment & software
   
1-5 years
 
$
499
 
$
284
 
Less: accumulated depreciation
         
(281
)
 
(182
)
Net-property and equipment
       
$
218
 
$
102
 

For the years ended July 31, 2007 and 2006, depreciation and amortization totaled approximately $99,000 and $92,000, respectively.
 
36

 
NOTE 4 -NOTE RECEIVABLE

On July 13, 2007, ATSI agreed to loan $150,000 to NetSapiens Inc. The promissory note receivable has a maturity date of June 26, 2008 and an annual interest rate of 8%. The note will be funded by ATSI in five installments as follows:

1)
$50,000 on July 13, 2007;
2)
$25,000 on August 13, 2007;
3)
$25,000 on September 13, 2007;
4)
$25,000 on October 13, 2007; and
5)
$25,000 on November 13, 2007.

The note is secured by NetSapiens’ proprietary Starter Platform License and SNAPsolution modules and provides for accrual of interest each month with the principal balance due at maturity. Additionally, ATSI can convert at any time the outstanding interest and principal balance into a perpetual NetSapiens’ License. As of July 31, 2007, the principal balance outstanding on the note was $50,000 and ATSI has funded the remaining $100,000 as of October 12, 2007.

NOTE 5 - NOTES PAYABLE

On November 3, 2006, ATSI borrowed $250,000 from CCA Financial Services, Inc. This note bears an interest at the rate of 16%, provides for eleven monthly principal and interest payments of $7,807 and a final payment at maturity of $200,000, is secured by ATSI’s equipment, deposit accounts and accounts receivables and matures on November 3, 2007. ATSI has the option of paying off the total outstanding principal balance at any time without any penalties. In connection with the transaction ATSI paid application, legal and documentation fees of $7,500.

On November 3, 2006, ATSI entered into an accounts receivable factoring agreement with CCA Financial Services, Inc. Under the agreement, CCA Financial Services committed to purchase up to $1,000,000 of ATSI’s accounts receivables. The factoring agreement is for twelve months and ATSI can terminate this agreement at its sole discretion at any time, subject to a $10,000 early termination fee. The factoring rate ranges from 1.00%-1.25% based on the factored amount and number of days outstanding. As our ongoing operations require, we will continue factoring our receivables under this agreement, which on average has been $850,000 of our monthly receivables. As of the date of this filing, we did not have any factored receivables outstanding; we will continue to factor our receivables on a monthly basis as services are rendered to our customers.

During the nine months ended April 30, 2007, ATSI borrowed $564,000 under several notes payable. Which matured on May 28, 2007 and bear an annual interest rate of 12%. On February 1, 2007, ATSI notified the holders of the notes of its intent to convert the outstanding principal and interest into common stock. The conversion price was set by ATSI at $0.22 per share, which was approximately 80% of the market price at February 1, 2007. A beneficial conversion feature for the difference between the closing price and the conversion price was recognized in accordance with EITF 98-5 and EITF 00-27. The beneficial conversion feature is presented as a discount to the related debt or a dividend to the related equity, with an offsetting amount increasing additional paid-in capital. As a result, ATSI recognized $143,723 in discount from the beneficial conversion feature at the time of the issuance and issued 2,566,482 common shares to the note holders. In addition, ATSI issued 238,636 shares of common stock with a fair value of $66,818 and made cash payment of $26,960 for services provided by the placement agents in connection with the placement of the notes. As of July 31, 2007, the entire discount has been expensed by ATSI as the result of the conversion of all notes to common shares.

On February 7, 2007, ATSI paid off its $16,000 note payable with Mr. John Fleming, a director of ATSI.

On March 28, 2007, ATSI borrowed $100,000 from Wells Fargo Bank. This note bears an annual interest rate of 7%, provides for twelve monthly principal and interest payments of $4,481, and is secured by ATSI’s certificate of deposit for $100,000. ATSI has the option of paying off the total outstanding principal balance at any time without any penalties.
 
37

 
On July 25, 2007, ATSI borrowed $200,000 from Wells Fargo Bank. This note bears an annual interest rate of 7.25%, provides for thirty-six monthly principal and interest payments of $6,208 and is secured by ATSI’s certificate of deposit for $200,000. ATSI has the option of paying off the total outstanding principal balance at any time without any penalties.

On June 1, 2006, ATSI restructured it’s 9% Convertible Subordinated Debentures (“Original 9% debentures”) by issuing 416 9% Convertible Subordinated Debentures (“New Debentures”) with a face value of $1,000 each, due June 2011. The New Debentures were issued in exchange for all of the Original 9% Debentures in the aggregate principal amount of $275,000 and $141,000 of accrued interest through June 2006. Each New Debenture accrues interest at the rate of 9% per annum payable annually. The debentures and any accrued interest are subject to an election to convert into common stock by either ATSI or the holders at the higher of (a) $0.27 per share or (b) the average closing price of ATSI’s common stock for the 10 days immediately preceding the date of conversion. The maximum common shares that can be issued upon conversion of the debentures are 1,540,741 common shares. Additionally, the proceeds from the debentures have been discounted by $26,000 to reflect a beneficial conversion feature derived from the difference between the conversion price and the market price at the time of issuance. The discount will be amortized over the life of the debentures using the effective interest method. On June 1, 2007, ATSI issued 419,081 restricted common shares as the 2nd principal payment and accrued interest on the debentures of $83,200 and $29,952, respectively. Additionally, as of July 31, 2007, ATSI had approximately $85,000 in accrued interest associated with these debentures.

ATSI analyzed these instruments for derivative accounting consideration under SFAS 133 and EITF 00-19, and determined that derivative accounting is not applicable.

NOTE 6 - COMMITMENTS AND CONTINGENCIES

Leases:

ATSI leases its office space with monthly payments of $4,085; the lease expires in November 2011. The annual rent expense under the operating lease was $43,486 and $45,442 for 2006 and 2007, respectively. The future minimum lease payments under the operating lease are as follows:

FY2008
 
$
47,439
 
FY2009
   
48,199
 
FY2010
   
49,100
 
FY2011
   
49,250
 
Litigation:

On October 31, 2002, ATSI filed a lawsuit in the United States District Court for the Southern District Court of New York against several individuals and financial institutions, including the holders of our Series D and E Redeemable Preferred Stock. On July 11, 2007, the lawsuit was dismissed by the Court of Appeals.

One of the defendants, RGC International Investors, LDC, filed a lawsuit in the Chancery Court in Delaware against ATSI on March 20, 2007 asserting it still had rights of enforcement against ATSI to convert preferred stock to common stock or redeem such stock in connection with Certificate of Designation issued regarding such series E preferred stock in October of 2000. In August 2007 the parties reached a confidential settlement agreement under which the 1,170 shares of Series E Preferred Stock have been cancelled.

Currently ATSI is still in litigation with Shaar Fund, Ltd., the holders of the series D preferred stock and is involved in settlement negotiations.
 
38


NOTE 7 - EQUITY

Common Stock

During the year ended July 31, 2007 ATSI issued:

 
-
495,062 shares of common stock valued at $128,920 for its placement agent fees and legal and consulting services rendered by various individuals.

 
-
980,000 shares of common stock to its employees and directors for services rendered. ATSI recorded compensation expense of $205,800 in its statement of operations for the aggregate market value of the stock at the date of issuance.

 
-
16,149,938 shares of common stock in connection with the conversion and redemption of 11,802,420 shares of Series H Preferred Stock and accrued premium common shares.

 
-
111,909 shares of common stock in connection with the conversion of 2,750 shares of Series A Preferred Stock and accrued dividend.

 
-
150,000 shares of common stock upon exercise of outstanding warrants for aggregate proceeds of $34,500.

-
100,000 shares of common stock upon exercise of outstanding stock options by an employee for $16,000.

 
-
66,226 shares of common stock to Richard Benkendorf as a payment of $15,226 under a settlement agreement.

 
-
137,412 shares of common stock to John Fleming as a payment of $42,600 under a settlement agreement.

 
-
2,566,482 shares of common stock in connection with the conversion of various notes payable in the principal amount of $564,600 and accrued interest of $10,292.

 
-
419,081 shares of common stock valued at $113,152 in connection with the annual payment on the “New Debentures” dated June 1, 2006.

No dividends were declared on ATSI’s common stock during fiscal 2007 and 2006.

Preferred Stock

The terms of ATSI’s preferred stock restrict ATSI from declaring and paying dividends on ATSI’s common stock until such time as all outstanding dividends have been fulfilled related to the preferred stock. The outstanding preferred stock have liquidation preference prior to common stock and ratably with each other. No dividends were declared on ATSI’s preferred stock during fiscal 2007 and 2006.

Series A Preferred Stock

Series A Preferred Stocks were issued in March 1999. The Series A Preferred Stock and any accumulated, unpaid dividends may be converted into Common Stock for up to one year at the average closing price of the Common Stock for twenty (20) trading days preceding the Date of Closing (the “Initial Conversion Price”). On each Anniversary Date up to and including the fifth Anniversary Date, the Conversion price on any unconverted Preferred Stock, will be reset to be equal to 75% of the average closing price of the stock for the then twenty (20) preceding days provided that the Conversion price can not be reset any lower than 75% of the Initial Conversion Price. As these conversion features were considered a “beneficial conversion feature” to the holder, ATSI allocated approximately $3.6 million of the approximately $5.0 million in proceeds to additional paid-in capital as a discount that has been fully amortized in prior periods. The Series A Preferred Stock is callable and redeemable by ATSI at 100% of its face value, plus any accumulated, unpaid dividends at ATSI’s option any time after the Common Stock of ATSI has traded at 200% or more of the conversion price in effect for at least twenty (20) consecutive trading days. The Series A Preferred Stock holders are entitled to vote, based on number of common stock into which the preferred stock could be converted. Dividends are payable on June 1, September 1, December 1 and March 1.
 
39

 
During fiscal 2007, ATSI issued 111,909 common shares in conversion of 2,750 shares of Series A Preferred Stock. As of July 31, 2007, all Series A Preferred Stock have been converted into common stock.

Series D Preferred Stock

Series D Preferred Stock was issued in February 2000. The Series D Preferred Stock accrues cumulative dividends at the rate of 6% per annum payable quarterly. The Series D Preferred Stock and any accumulated, unpaid dividends may be converted into Common Stock for up to two years at the lesser of a) the market price on the day prior to closing or b) 83% of the five lowest closing bid prices on the ten days preceding conversion. The terms of ATSI’s Series D Preferred Stock allow for mandatory redemption by the holder upon certain conditions. The Series D Preferred Stock allows the holder to elect redemption upon the change of control of ATSI at 120% of the sum of $1,300 per share and accrued and unpaid dividends. Additionally, the holder may elect redemption at $1,270 per share plus accrued and unpaid dividends if ATSI refuses to honor conversion notice or if a third party challenges conversion. The Series D Preferred Stock holders are not entitled to vote.

On January 24, 2003 ATSI received a demand redemption letter from the Series D Preferred holders. ATSI has not issued these shares; it is the position of ATSI that the investor’s shares are not owed. Further ATSI has filed a lawsuit against one or more parties to whom the investors share are allegedly owed.

In June 2007, ATSI initiated a declaratory judgment action in the United States District Court for the Western District of Texas against Shaar Fund, Ltd., holder of series D preferred stock who still asserted it had rights under instruments that issued incident to such stock. ATSI asserted that alleged rights asserted by the Shaar Fund Ltd are bar