Title of each class		Name of each exchange on which registered
Ordinary Shares, par value NIS 0.01 per share		New York Stock Exchange ( “ NYSE ” )

 

 

ITEM 4A.      UNRESOLVED STAFF COMMENTS

 

None.

ITEM 5.      OPERATING AND FINANCIAL REVIEW AND PROSPECTS

 

The following operating and financial review and prospects should be read in conjunction with “Item 3. Key Information – A- Selected Financial Data” and our consolidated financial statements and accompanying notes appearing elsewhere in this annual report. Our financial statements have been prepared in accordance with International Financial Reporting Standards, or IFRS, which differ in certain respects from U.S. Generally Accepted Accounting Principles, or U.S. GAAP.  Following our adoption of IFRS, as issued by the IASB, we are no longer required to reconcile our financial statements prepared in accordance with IFRS to U.S. GAAP.

 

In accordance with the instructions of the Israeli Accounting Standard No. 29, “Adoption of International Financial Reporting Standards (IFRS)”, which was published in July 2006, we have adopted IFRS as issued by the IASB, with effect from January 1, 2008, based upon the guidance in IFRS 1, "First-time adoption of IFRSs", and have prepared our financial statements according to IFRS.

 

This discussion contains forward-looking statements.  We have based these forward-looking statements on our current expectations and projections about future events.  Our actual results may differ materially from those anticipated in these forward-looking statements as a result of many important factors, including those set forth under “Item 3. Key Information – D. Risk Factors” and elsewhere in this annual report.

 

A. OPERATING RESULTS

 

Overview

 

General

 

We are the leading provider of cellular communications services in Israel in terms of number of subscribers, revenues, revenues from services, EBITDA and EBITDA margins as of December 31, 2009, providing services to approximately 3.292 million subscribers in Israel with an estimated market share of 34.6%.

 

We earn revenues and generate our primary sources of cash by offering a broad range of cellular services through our network covering substantially all of the populated territory of Israel. These services include basic and advanced cellular telephone services, text and multimedia messaging services and advanced cellular content and data services. We also provide international roaming services to our subscribers in 177 countries as of December 31, 2009 as well as to subscribers of foreign networks visiting Israel. We offer our subscribers a wide selection of handsets of various leading global manufacturers as well as extended warranty services. We have an advanced fiber-optic transmission infrastructure of approximately 1,500 kilometers. Together with our complementary microwave-based infrastructure, our fiber-optic infrastructure connects the majority of our cell sites with the remainder connected using supplemental transmission capacity leased from Bezeq, the incumbent landline operator. Having our own transmission network enables us to save

 

70

---

 

substantial operating cash lease costs that would be associated with complete reliance on Bezeq’s infrastructure, although these savings are partially offset by maintenance costs and microwave spectrum fees.  It also allows us to sell transmission and data services to business customers and telecommunications operators. Following the receipt of our license to provide landline telephone services in Israel in 2006,  we began to offer these services and as of February 2008, additional advanced landline services, through our NGN system, to selected landline business customers. Although we do not expect revenues from landline telephony services to amount to a material portion of our revenues in 2010, we consider landline telephone services to be a future growth opportunity and we believe that revenues from these services will continue to grow in 2010.

 

Our management evaluates our performance through focusing on our key performance indicators, which include among others: number of subscribers, churn rate, average minutes of usage per subscriber, or MOU, average revenue per subscriber, or ARPU, EBITDA (as defined in “Results of Operations”), operating income and net income.  These key performance indicators are primarily affected by the competitive and regulatory landscape in which we operate and our ability to adapt to the challenges posed. We have modified our process for calculating our number of subscribers at various times in the past. This modification impacts the comparability of our subscriber count and other key performance indicators.

 

Our competitive landscape is characterized by a highly penetrated cellular market.  Competition is intense and attracting new subscribers and retaining existing subscribers has become increasingly difficult and costly. The competition in our market has further increased as a result of the implementation of number portability in December 2007, as it has removed a deterrent to switching providers. We intend to drive revenue growth primarily by: focusing on core business and synergetic complementary business; maintaining and enhancing our strong brand; retaining our existing subscribers; increasing our ARPU by offering new and advanced services as well as increasing our Internet, content, data services and land line services revenues; and attracting new subscribers. In particular, in addition to being an important factor in selecting a cellular provider, we believe that content, data and other value-added services are a potential growth engine for increasing revenues. Since the full launch of our 3.5G HSPA based services, in 2006, revenues from our content and data services have grown significantly. The cellular industry is primarily regulated by the Ministry of Communications. See “Item 4. Information on the Company – B. Business Overview - Government Regulations.”  While our pricing is not generally regulated, certain of our rates and pricing mechanisms are subject to regulation. In particular, the annual reduction of interconnect tariffs by the Ministry of Communications commencing in March 2005 and ending in 2008, adversely affected our results and required us to find alternative sources of revenues to compensate for these reductions. Following a Government resolution adopted in August 2008, to review the interconnect fees and adjust them accordingly, the Ministry of Communications is currently reviewing interconnect fees. Commencing January 1, 2009, the basic airtime charging unit, as well as the interconnect tariff unit, was decreased from a 12-second basic charging unit to a one-second basic charging unit. Additionally, in September 2007 our general license was further amended in a manner that prevents us from offering our subscribers calling plans using airtime charging units other than the basic airtime charging unit. Commencing January 1, 2009, our license prevents us from raising tariffs to non-business customers having an obligation to purchase our services for a predefined period during such period. We took steps to address the effects of these amendments including initiating new and innovative marketing plans. In February 2010, a proposed amendment to

 

71

---

 

the Communications Law, requiring cellular operators to provide "limited credit" services to their post-paid subscribers, passed the preliminary phase of enactment in the Israeli parliament.

 

The construction and operation of our cell sites and other transmission facilities are highly regulated and require us to obtain various consents and permits. See “Item 4. Information on the Company – B. Business Overview - Government Regulations—Permits for Cell Site Construction.” We have experienced difficulties in obtaining some of these consents and permits, particularly in obtaining building permits for cell sites from local planning and building authorities. See “Item 3. Key Information – D. Risk Factors. We may not be able to obtain permits to construct and operate cell sites.”  However, even though 22 criminal and administrative proceedings (with two cell site subject to a demolition order) are outstanding as of December 31, 2009, we do not expect that the demolition of these facilities would have a material impact on our results of operations and financial condition. In December 2008, the Minister of Environmental Protection signed the Non-Ionizing Radiation Regulations, which do not include a section setting restrictions (including maximum levels of exposure to non ionizing radiation) in relation to the operation of cell sites and other facilities, that had appeared in the earlier draft legislation. This Section is in the process of being enacted and the Supreme Court postponed the hearing of a petition filed in connection with such regulations until further update by  the Minister of Environmental Protection and the Minister of Communications. If such restrictions are subsequently adopted, they will, among other things, limit our ability to construct new sites and renew operating permits for a number of our existing sites, especially in residential areas.  National Zoning Plan 36 is in the process of being revised. If proposed changes are  approved, they will harm our ability to construct new cell sites, make the process of obtaining building permits for the construction and operation of cell sites more cumbersome and costly, could  adversely affect our existing network and may delay the future deployment of our network.  Moreover, if we are unable to obtain or renew consents and permits or rely on exemptions from obtaining permits for our existing sites or other facilities, we will be required to demolish or relocate these cell sites and facilities. Our inability to relocate cell sites or other facilities in a timely manner and/or our inability to obtain the permits and consents for new cell sites, or rely on exemptions, could adversely affect our existing network resulting in the loss of subscribers, prevent us from meeting the network coverage and quality requirements contained in our license and adversely impact our network build-out, all of which may have a material adverse result on our results of operations and financial condition.

 

Our profitability is also affected by other factors, including changes in our cost of revenues and selling, general and administrative expenses, including depreciation and finance expenses.

 

Following the acquisition by DIC of a majority interest in us in September 2005, DIC brought in a new management team, including Ami Erel, the Chairman of our Board of Directors, who has been President and CEO of Bezeq, Amos Shapira, our Chief Executive Officer who has been chief executive officer of Kimberly-Clark’s Israeli subsidiary and of El Al Airlines, Tal Raz, our Chief Financial Officer (until September 2009, at which time he was replaced as Chief Financial Officer in September 2009 by Yaacov Heen, one of our top financial executives, and continues to serve as our director), formerly one of the founders and a director of Partner, one of our principal competitors, and Adi Cohen, our VP Marketing, who had been marketing manager of Shufersal, Israel's largest retail chain, and previously, Partner's marketing manager. Our management team has implemented a series of initiatives to drive growth, including the continued enhancement of our distinctive brand, greater focus

 

72

---

 

on customer service and new sales campaigns, including the launch of new content and data services, alongside a continued managerial focus on ongoing efficiency increase. This streamlining has improved our operating cost structure and reduced our general and administrative expenses. Following implementation of these initiatives, our revenues and operating income increased in 2007 by approximately 8% and 36%, respectively (compared with 2006), in 2008 by approximately 6% and 21%, respectively (compared with 2007) and in 2009 by approximately 1% and 5%, respectively (compared with 2008). Notwithstanding these savings and management’s continued focus on cost cutting initiatives, we expect that the higher cost of 3G enabled handsets to support our advanced content and data services may increase the costs related to subscriber acquisition and retention and handset repairs.

 

Our results are also impacted by currency fluctuations.  While substantially all of our revenues are denominated in NIS, for 2009, approximately 36% of cash outflow was denominated in, or linked to, other currencies, mainly U.S. dollars.  These payments included capital expenditures, some cell site rental fees, payments to equipment including handset suppliers. Changes to the Israeli CPI, may also impact our results as our debentures (excluding Series E) and some of our expenses are linked to the Israeli CPI.  Any devaluation of the NIS against the U.S. dollar or other foreign currencies will therefore increase the NIS cost of our expenses that are not denominated in NIS or are linked to those currencies and any increase in the Israeli CPI will increase the financial expenses associated with our debentures.  We enter into derivative instruments to mitigate the effect of the various market risks associated with these expenses.  See “Item 11 - Quantitative and Qualitative Disclosures About Market Risk.”

 

Further, we incurred significant debt in late 2005 and in the first half of 2006, which increased our financial expenses compared with historical results. We issued approximately NIS 2.0 billion ($530 million) principal amount of two series of debentures which bear interest at the rates of 5.0% and 5.3% and are linked to the Israeli CPI.  In addition, in October 2007 and February 2008, we issued two new series of debentures to the public in Israel, for an aggregate principal amount of approximately NIS 1,647 million ($436 million) which bear interest at annual rates of 4.60% and 5.19%, respectively and are linked to the Israeli CPI. Further, in April 2009 we issued to the public in Israel, additional debentures of our existing series of debentures bearing annual interest rate of 5.19% as well as debentures of a new series, Series E, which bears interest at an annual rate of 6.25%, without any linkage, for an aggregate principal amount of approximately NIS 975 million ($ 258 million) See “Item 5. Operating and Financial Review and Prospects – A. Debt Service”.

 

In February 2006, our Board of Directors adopted a policy to distribute each year at least 75% of our annual net income. Our net income was determined under Israeli GAAP for periods until December 31, 2007 and for periods commencing on or after January 1, 2008, is determined under IFRS, following the adoption of IFRS in accordance with the Israeli Accounting Standard No. 29 “Adoption of International Financial Reporting Standards”. In March 2007, our Board resolved to distribute dividends within the boundaries of the February 2006 dividend policy and until resolved otherwise, on a quarterly basis. During 2006, we distributed cash dividends in the aggregate amount of NIS 3.83 billion mainly from retained earnings accumulated over the previous years, in 2007 and 2008 we distributed cash dividends in the aggregate amount of NIS 655 and 1,530 million, respectively.   Prior to 2006, we had not distributed dividends since our inception.

 

In 2009, we distributed cash dividends in the aggregate amount of approximately NIS 1.19 billion, including the dividend declared for the fourth quarter of 2008. Our board of

 

73

---

 

directors has also declared a cash dividend for the fourth quarter of 2009 of NIS 2.60 per share, or approximately NIS 257 million in the aggregate, which will be paid on March 31, 2010.  

 

Any dividends may be declared solely by our Board of Directors, which will take into account the factors set out in “Item 8. Financial Information – A. Statements and Other Financial Information - Dividend Policy”. The dividend per share that we will pay for the fourth quarter of 2009 does not reflect the level of dividends that will be paid for future quarterly periods, which can change at any time in accordance with the policy set out above. See “Item 8. Financial Information – A. Statements and Other Financial Information - Dividend Policy” and “—Liquidity and Capital Resources—Dividend payments.”  Also, in the future our Board of Directors may determine that our cash needs for debt service, capital expenditures or operations may increase and that it would not be prudent to distribute dividends.

 

On February 9, 2007, we closed the initial public offering of our ordinary shares and their listing on the NYSE. The offering was made solely by certain of our existing shareholders, and we did not receive any proceeds. The selling shareholders agreed to bear the out-of-pocket expenses of the offering. This offering fulfilled the agreement of our majority shareholder, DIC, with some of our other shareholders to endeavor to cause us to undertake an initial public offering by 2009 and it enables us to take advantage of the equity and debt capital raising opportunities available to a public company in the capital markets, to have the ability to use equity based compensation schemes as a tool to incentivize management to generate positive operating results and to provide access to certain of our shareholders to sell their shares. In July 2007, our shares were dual listed on the TASE. As a public dual-listed company, our legal and financial compliance costs are higher than as a private company and some activities are more time-consuming and costly.

 

Change in accounting policy regarding Subscriber Acquisition and Retention Costs

 

In the second quarter of 2009, we decided to change our accounting policy regarding subscriber acquisition and retention costs and to recognize certain subsidies provided to handsets, which are sold with a service agreement containing guaranteed minimum future revenue, as additional costs that are eligible for capitalization. Under our previous accounting policy, capitalized subscriber acquisition and retention costs included only deferred costs in respect of sales commissions related to the acquisition and retention of subscribers, provided the costs could be measured reliably and were directly attributable to obtaining a specific subscriber, and we recognized subsidies on handset sales as an expense in the period incurred. The change in policy has been retrospectively applied to all reported periods starting from January 1, 2007 , when the relevant criteria for capitalizing these costs were first met, and therefore, the comparable data for previous years has been amended to reflect this change in accounting policy. The retrospective application of that accounting policy change increased our retained earnings, as of January 1, 2009 by approximately NIS 48 million and had the following effect on our results of operations for all of the periods reported herein.

 

		Year Ended December 31,
		2007				2008
		(In NIS millions)
Decrease in purchase of handsets			(77	)			(76	)
Increase in amortization expense			15				70
Increase in operating income			62				6
Increase in income tax			18				2
Increase in net income			44				4
Increase in basic and diluted earnings per share (in NIS)			0.45				0.04
Increase in EBITDA			77				76

 

 

74

---

 

2006 Share Incentive Plan

 

In September 2006, our Board of Directors approved an option plan for our employees, officers and directors. The plan had an initial pool of 2,500,000 shares in respect of which options and restricted stock units, or RSUs, may be granted. In October and November 2006, we granted options to purchase an aggregate of 2,414,143 ordinary shares at an exercise price of $12.60 per share. Among those grants were options to purchase up to 450,000 ordinary shares to each of Ami Erel, our Chairman of the Board, and Amos Shapira, our Chief Executive Officer. The remainder of the options grants was made to our senior employees. In March 2007, August 2008 and August 2009, we granted additional options to purchase an aggregate of 30,786, 27,500 and 74,164 ordinary shares, respectively, at an exercise price of $12.60, $25 and $24.65 per share, respectively, to certain of our senior employees, under the terms of the plan.  Distribution of cash dividends before the exercise of these options will reduce the exercise price of each option by an amount equal to the gross amount of the dividend per share distributed. During 2008 and 2009, 844,591 and 546,417 shares, respectively, were issued due to the exercise of options, which constitute substantially all vested options and approximately three quarters of the amount of options granted, by Messrs. Ami Erel and Amos Shapira and other grantees; 300,817 and 90,177 options, respectively, were canceled (due to our net exercise mechanism); and 4,125 and 7,759 options, respectively, previously granted to senior employees were revoked and returned to the option pool. As of December 31, 2009, the number of outstanding options to purchase ordinary shares amounted to704,674. However, the terms of the 2006 Share Incentive Plan provide for a net exercise mechanism, the result of which is to require us to issue a smaller number of ordinary shares than represented by the outstanding options. Unless the Board of Directors otherwise approves, the number of ordinary shares issuable by us upon the exercise of an option will represent a market value that is equal to the difference between the market price of the ordinary shares and the option exercise price of the exercised options, at the date of exercise. In 2008, we amended the option plan and the terms of our outstanding options as follows: (1) the definition of corporate transactions triggering accelerated vesting of the options, was changed to DIC ceasing to “control” us (as the term “control” is defined in the Israeli Securities Law, namely the ability to direct a company's activities) (previously - upon a decrease in DIC's share ownership to less than 50.01% of our outstanding share capital); (2) we are required to provide the grantees with a ten day period to exercise the options upon the occurrence of a corporate transaction. An additional change was approved only in regards to options already granted prior to the adoption of the amendment: when a grantee is dismissed without cause, an additional period of up to six (6) months from the date of dismissal will be allowed for vesting of the third or fourth portions of the options to occur.

 

In general, the options and RSUs vest in four equal installments on each of the first, second, third and fourth anniversaries of the date of grant. Under IFRS, we are required to expense the grant date fair value of the options over their vesting period. In accordance with these standards, we estimated the total compensation cost related to the options granted in 2006 to be approximately NIS 53 million as of the date of grant, to be recognized over the vesting period commencing on February 9, 2007, the date of completion of our initial public offering. In 2007 we expensed approximately NIS 29 million of the total compensation cost. During 2008 we reevaluated the total compensation cost related to the options granted and

 

75

---

 

increased it by approximately NIS 4 million.  Due to sales in 2008 of our ordinary shares held by DIC, that led to a reduction in DIC’s ownership to below 50.01%, the vesting of the options granted in 2006 and 2007 was considered accelerated for accounting purposes and the balance of the total compensation cost, related to those grants, in the amount of approximately NIS 28 million, was expensed during 2008.

 

Revenues

 

We derive our revenues primarily from the sale of cellular network services (such as airtime), handsets and other services, including content and value added services, extended handset warranties and the provision of transmission and landline services.  Revenues from airtime are derived from subscribers originating calls on our network and from interconnect revenues from other operators for calls terminating on our network. Revenues also include roaming charges that we bill to our subscribers for the use of the networks of our roaming partners outside Israel, to which we refer as outbound roaming, and charges that we bill to our roaming partners whose subscribers use our network, to which we refer as inbound roaming.

 

Our revenues are usually affected by seasonality. The third quarter of the year is usually the strongest quarter with the highest revenues, since it occurs in the summer season,  characterized by longer daylight hours (facilitating higher airtime usage) and increased incoming and outgoing tourism (facilitating higher roaming revenues) . The fourth quarter of the year is usually the weakest quarter with lower revenues, since the Jewish holiday season, characterized by reduced usage, usually occurs in this quarter, and since it occurs in the fall-winter seasons, characterized by shorter daylight hours (resulting in lower airtime usage).

 

Cost of revenues

 

The principal components of our cost of revenues are interconnect fees, the purchase of handsets, accessories and spare parts, content cost, cell site leasing costs, outbound roaming services fees, royalty payments to the government of Israel, salaries and network development and maintenance. Our cost of revenues also includes depreciation of the cost of our network equipment and amortization of our spectrum licenses and capitalized handset subsidies.  See “—Application of Critical Accounting Policies and Use of Estimates—Long-lived assets - depreciation.”

 

Selling and marketing expenses

 

Selling and marketing expenses consist primarily of sales force salaries and commissions, advertising, public relations and promotional expenses.  We compensate our sales force through salaries and incentives. Our selling and marketing expenses also include depreciation, mainly of leasehold improvements and equipment in our service centers and points of sales and amortization of capitalized sales commissions.

 

General and administrative expenses

 

General and administrative expenses consist primarily of salaries and compensation, professional and consultancy fees, leases and maintenance of our offices, bad debt and doubtful accounts allowance, and other administrative expenses. Our general and administrative expenses also include depreciation and maintenance fees, mainly for our billing and information systems.

 

76

---

 

Other income and expenses

 

Other income and expenses consist primarily of capital gains or losses from sale of capital assets.

 

Financial income and expenses

 

Financial income and expenses consist primarily of interest expense on long-term and short-term loans and interest on our debentures, the interest income component of handset long-term installment sales, the effects of fluctuations in currency exchange rates, Israeli CPI adjustments related to the Israeli CPI-linked debentures and other expenses, and income or losses relating to financial derivative instruments that do not qualify for hedge accounting according to IFRS.

 

Income Tax

 

Generally, Israeli companies were subject to Corporate tax on their taxable income at the rate of 26% for the 2009 tax year which will decrease to 25% for the 2010 tax year. The Israeli Economic Efficiency Improvement Law (legislative amendments for the implementation of the economic program for the years 2009 and 2010), enacted in July 2009, provides, among others, for an additional gradual reduction of the corporate tax rate. According to this Law the Corporate tax rate will decrease to 24% for the 2011 tax year, to 23% for the 2012 tax year, to 22% for the 2013 tax year, to 21% for the 2014 tax year, to 20% for the 2015 tax year and to 18% for the 2016 tax year and thereafter.  Israeli companies are generally subject to capital gains tax at a rate of 25% for capital gains (other than gains deriving from the sale of listed securities) derived from assets purchased after January 1, 2003. A deferred tax asset or liability is created for temporary differences between income recognized for tax purposes and for accounting purposes.

 

Results of Operations - Comparison of 2007, 2008 and 2009

 

The following table sets forth key performance indicators for the periods indicated:

 

		Year Ended December 31,												Change**
			2007*				2008*			2009				2008 vs. 2007				2009 vs. 2008
Subscribers at end of period(1) (in thousands)			3,073				3,187				3,292				3.7	%			3.3	%
Period churn rate(1)(2)			16.3	%			18.9	%			19.6	%		2.6pp				0.7pp
Average monthly usage per subscriber (MOU) (in minutes)(1)(3)			322				329				331				2.2	%			0.6	%
Average monthly revenue per subscriber (ARPU) (1)(4) (in NIS)			150				149				144				(0.7	%)			(3.4	%)
Operating income (in NIS millions)			1,394				1,690				1,768				21.2	%			4.6	%
Net income (in NIS millions)			919				989				1,182				7.6	%			19.5	%
EBITDA(5) (in NIS millions)			2,187				2,482				2,529				13.5	%			1.9	%
Operating income margin(6)			23.0	%			26.3	%			27.3	%			3.3	pp			1.0	pp
EBITDA margin(7)			36.1	%			38.7	%			39.0	%			2.6	pp			0.3	pp

*	Retrospective application due to accounting policy change regarding Subscriber Acquisition and Retention Costs.

 

 

---

**	pp denotes percentage points and this measure of change is calculated by subtracting the 2007 measure from the 2008 measure and the 2008 measure from the 2009 measure, respectively.

 

(1)

Subscriber data refer to active subscribers. Commencing in 2006, we use a six-month method of calculating our subscriber base, which means that we deduct subscribers from our subscriber base after six months of no revenue generation or activity on our network by or in relation to both the post-paid and pre-paid subscriber.  The six-month method is, to the best of our knowledge, consistent with the methodology used by other cellular providers in Israel.

 

(2)	Churn rate is defined as the total number of voluntary and involuntary permanent deactivations in a given period expressed as a percentage of the number of subscribers at the beginning of such period.  Involuntary permanent deactivations relate to subscribers

 

 

77

---

 

who have failed to pay their arrears for the period of six consecutive months.  Voluntary permanent deactivations relate to subscribers who terminated their use of our services.

 

(3)

Average monthly minutes of use per subscriber (MOU) is calculated by dividing the total billable minutes (of outgoing and incoming calls from other networks, excluding roaming usage) during the month, by the average number of subscribers during such month, and by dividing the sum of such results for all months in the reported period by the number of months in the period. Following the regulatory requirement to change the basic airtime charging unit from twelve-seconds to one-second units commencing January 1, 2009, MOU for  2007 and 2008 has been adjusted to the same per-one second unit basis to enable a comparison. MOU for 2007 and 2008 based on the former charging units were 348 and 350 minutes, respectively.

 

(4)

Average monthly revenue per subscriber (ARPU) is calculated by dividing revenues from cellular services for the period by the average number of subscribers during the period and by dividing the result by the number of months in the period.  Revenues from inbound roaming services are included even though the number of subscribers in the equation does not include the users of those roaming services.  Inbound roaming services are included because ARPU is meant to capture all service revenues generated by a cellular network, including roaming services.  Revenues from sales of extended warranties are included because they represent recurring revenues generated by subscribers, but revenues from sales of handsets, repair services and transmission services are not.  We, and industry analysts, treat ARPU as a key performance indicator of a cellular operator because it is the closest meaningful measure of the contribution to service revenues made by an average subscriber.

 

We have set out below the calculation of ARPU for each of the periods presented:

 

		Year Ended December 31,
		2007				2008				2009
		(In NIS millions, except number of subscribers and months)
Revenues			6,050				6,417				6,483
less revenues from equipment sales			635				745				751
less other revenues*			93				135				162
Revenues used in ARPU calculation  (in NIS millions)			5,322				5,537				5,570
Average number of subscribers			2,955,855				3,105,022				3,215,492
Months during period			12				12				12
ARPU (in NIS, per month)			150				149				144

*      Other revenues include revenues from repair services, transmission services and land-line services.

 

(5)

EBITDA is a non-GAAP measure and is defined as income before financial income (expenses), net; other income (expenses), net; income tax; depreciation and amortization.  We present EBITDA as a supplemental performance measure because we believe that it facilitates operating performance comparisons from period to period and company to company by backing out potential differences caused by variations in capital structure (most particularly affecting our interest expense given our recently incurred significant debt), tax positions (such as the impact on periods or companies of changes in effective tax rates or net operating losses) and the age of, and depreciation expenses associated with, fixed assets (affecting relative depreciation expense and the impact of purchase accounting (affecting depreciation and amortization expense).  EBITDA should not be considered in isolation or as a substitute for operating income or other statement of operations or cash flow data prepared in accordance with Israeli GAAP as a measure of our profitability or liquidity.  EBITDA does not take into account our debt service requirements and other commitments, including capital expenditures, and, accordingly, is not necessarily indicative of amounts that may be available for discretionary uses. In addition, EBITDA, as presented in this annual report, may not be comparable to similarly titled measures reported by other companies due to differences in the way these measures are calculated.

 

   The following is a reconciliation of EBITDA with net income and operating income:

 

		Year Ended December 31,
			2007*				2008*			2009
		(In NIS millions)
Net income			919				989				1,182
Financing expenses, net			147				310				219
Income taxes			328				391				367
Operating income			1,394				1,690				1,768
Other expenses (income), net			3				(29	)			6
Depreciation and amortization			790				821				755
EBITDA			2,187				2,482				2,529

* Retrospective application due to accounting policy change regarding Subscriber Acquisition and Retention Costs.

 

 

(6)	Operating income margin is defined as operating income as a percentage of total revenues for each of the applicable periods.

 

(7)	EBITDA margin is defined as EBITDA as a percentage of total revenues for each of the applicable periods.

 

The following table sets forth our selected consolidated statements of operations as a percentage of total revenues from operations for the periods indicated:

 

 

78

---

 

		Year Ended December 31,
		2007				2008				2009
Revenues			100.0	%			100.0	%			100.0	%
Cost of revenues			54.8	%			52.9	%			51.4	%
Gross profit			45.2	%			47.1	%			48.6	%
Selling and marketing expenses			11.3	%			10.9	%			11.0	%
General and administrative expenses			10.8	%			10.3	%			10.2	%
Other (income) expenses, net			0.1	%			(0.4	%)			0.1	%
Operating income			23.0	%			26.3	%			27.3	%
Financial expenses, net			2.4	%			4.8	%			3.4	%
Income before taxes			20.6	%			21.5	%			23.9	%
Income tax			5.4	%			6.1	%			5.7	%
Net income			15.2	%			15.4	%			18.2	%

 

Revenues

 

		Year Ended December 31,												Change
		2007				2008				2009				2008 vs. 2007				2009 vs. 2008
		(In NIS millions)
Revenues			6,050				6,417				6,483				6.1	%			1.0	%

The increase in revenues in 2009 was mainly due to a 31% increase in revenues from content and value added services (including SMS), as well as a significant increase in revenues from land-line services. The increase in revenues was partially offset by a substantial decrease in roaming revenues following the reduction in incoming and outgoing tourism resulting from the global economic slowdown. The increase in revenues was also offset in part by a decrease in revenues from domestic voice services mainly due to the ongoing airtime price erosion.

 

The increase in revenues in 2008 was mainly due to a 37% increase in revenues from content and value added services (including SMS), an increase in revenues from extended warranty services and an increase in revenues from sale of handsets and accessories, as well as a significant increase in revenues from land-line services. The increase in revenues was partially offset by the reduction of interconnect tariffs by the Ministry of Communications in March 2008 and the ongoing airtime price erosion.

 

The following table sets forth the breakdown of our revenues for the periods indicated based on the various sources thereof:

 

		2007								2008								2009
		Revenues				% of Total Revenues				Revenues				% of Total Revenues				Revenues				% of Total Revenues
		(NIS in millions)								(NIS in millions)
Voice services:
Outgoing air time*			2,861				47.3	%			2,878				44.8	%			2,806				43.3	%
Incoming air time			1,188				19.7	%			1,169				18.2	%			1,176				18.1	%
Roaming			424				7.0	%			423				6.6	%			340				5.3	%
Total voice services			4,473				74.0	%			4,470				69.6	%			4,322				66.7	%
Content and value added services**			492				8.1	%			674				10.5	%			882				13.6	%
Other services***			450				7.4	%			528				8.3	%			528				8.1	%
Total services			5,415				89.5	%			5,672				88.4	%			5,732				88.4	%
Handsets and accessories			635				10.5	%			745				11.6	%			751				11.6	%
Total			6,050				100.0	%			6,417				100.0	%			6,483				100.0	%

*	Including air time packages and interconnect.

 

**	Consists of content services, text messages and data services.

 

***	Consists of fixed monthly subscription fees, extended warranty fees, land-line services and others.

 

 

79

---

 

During 2009, revenues from services (comprising 88.4% of total revenues) increased by approximately 1%, compared with 2008.  This increase in revenues from services resulted mainly from an increase in our subscriber base of approximately 3.3% (mainly among “post-paid” subscribers), an increase in revenues from content and value added services, as well as an increase in revenues from land-line services. These increases were partially offset by the significant decrease in roaming revenues and the ongoing airtime price erosion.

 

During 2008, revenues from services (comprising 88.4% of total revenues) increased by approximately 5%, compared with 2007.  This increase in revenues from services resulted mainly from an increase in our subscriber base of approximately 3.7% (mainly among “post-paid” subscribers), an increase in revenues from content and value added services, as well as an increase from land-line services and extended warranty services. These increases were partially offset by the reduction in interconnect tariffs and the ongoing airtime price erosion.

 

During 2008 and 2009, revenues from content and value added services increased by approximately 37% and 31%, respectively compared with the previous respective years, mainly as a result of the growth in content services, text messages and sales of data packages, which is significantly attributable to the growth of our 3G subscriber base. As a percentage of service revenues, revenues from content and value added services increased from 9.1% in 2007 to 11.9% in 2008 and to 15.4% in 2009, and as percentage of total revenues, from 8.1% in 2007 to 10.5% in 2008 and 13.6% in 2009.

 

In 2009, revenues from other services remained the same as in 2008 and were affected mainly by an increase in revenues from land-line services, which was offset mainly by a decrease in fixed monthly subscription fees.  As a percentage of total revenues, revenues from other services decreased to 8.1% in 2009 from 8.3% in 2008.

 

During 2008, revenues from other services increased by approximately 17% mainly as a result of the increase in extended warranty fees, land-line services and fixed monthly subscription fees.  As a percentage of  total revenues, revenues from other services increased to 8.3% in 2008 from 7.4% in 2007.

 

During 2008 and 2009, handset and accessories revenues (comprising 11.6% of total revenues) increased by 17.3% and 0.8%, respectively compared with the previous respective years.  This increase primarily resulted from an increase in the average handset sale price due to the larger amount of advanced 3G handsets in the mix of handsets sold in 2008 compared with 2007 and in 2009 compared with 2008. The increase was offset in part by a decrease in the total amount of handsets sold during those years compared with the previous years which resulted from more aggressive sales campaigns launched in 2007 compared with 2008 and in 2008 compared with 2009.

 

The following table sets forth the breakdown of our revenues for the periods indicated based on the types of subscribers:

 

		2007								2008								2009
		Revenues				% of Total Revenues				Revenues				% of Total Revenues				Revenues				% of Total Revenues
		(NIS in millions)								(NIS in millions)
Individual			4,377				72.3	%			4,626				72.1	%			4,775				73.7	%
Business*			1,524				25.2	%			1,654				25.8	%			1,622				25.0	%
Other*			149				2.5	%			137				2.1	%			86				1.3	%
Total			6,050				100.0	%			6,417				100.0	%			6,483				100.0	%

 

80

---

 

*	Consists of revenues from inbound roaming services and other services.

 

A breakdown of revenues according to types of subscribers (individual and business) during 2009 shows an approximately 3% increase, compared with 2008, in revenues attributable to individual subscribers, which resulted mainly from a higher subscriber base and increased usage. Revenues attributable to business subscribers decreased approximately 2%, mainly as a result of a significant decrease in outbound roaming revenues following the global economic slowdown and the airtime price erosion. Other revenues decreased 37% in 2009 compared with 2008, mainly due to a significant decrease in revenues from inbound roaming services, which resulted from a reduction in incoming tourism also following the global economic slowdown.

 

A breakdown of revenues according to types of subscribers (individual and business) during 2008 shows an approximately 6% increase in revenues attributable to individual subscribers and an approximately 9% increase in revenue attributable to business subscribers, compared with 2007. These increases are the result of a higher subscriber base and increased usage.

 

The following table sets forth the breakdown of our revenues for the periods indicated based on the types of subscription plans:

 

		2007								2008								2009
		Revenues				% of Total Revenues				Revenues				% of Total Revenues				Revenues				% of Total Revenues
		(NIS in millions)								(NIS in millions)
Pre-paid			729				12.0	%			696				10.9	%			657				10.1	%
Post-paid			5,172				85.5	%			5,584				87.0	%			5,741				88.6	%
Other*			149				2.5	%			137				2.1	%			86				1.3	%
Total			6,050				100.0	%			6,417				100.0	%			6,483				100.0	%

 

* Consists of revenues from inbound roaming services and other services.

 

A breakdown of revenues according to types of subscription plans (pre-paid and post-paid) shows that the increase in revenues in 2009 compared with 2008 and in 2008 compared with 2007 resulted from post-paid subscribers. This increase was primarily the result of an increase in revenues from services resulting from an increase in usage of content and value-added services, in land-line services and from the expansion of our subscriber base.

 

Cost of revenues and gross profit

 

		Year Ended December 31,												Change
			2007*				2008*			2009				2008 vs. 2007				2009 vs. 2008
		(In NIS millions)
Cost of revenues-services			2,592				2,641				2,643				1.9	%			0.1	%
Cost of revenues-equipment			723				755				690				4.3	%			(8.6	%)
Total cost of revenues			3,315				3,396				3,333				2.4	%			(1.9	%)
Gross profit			2,735				3,021				3,150				10.5	%			4.3	%

 

* Retrospective application due to accounting policy change regarding Subscriber Acquisition and Retention Costs.

 

The slight increase in services cost of revenues in 2009 compared with 2008, resulted mainly from an increase in interconnect fees due to an increase in the number of outgoing calls completed in other operators' networks, an increase in cost of content and value-added

 

81

---

 

services due to increased usage and a one-time provision in the amount of NIS 15 million related to a dispute with the Ministry of Communications regarding frequencies fees. These increases were offset mainly by a decrease in roaming related expenses due to the reduction in outgoing tourism, in depreciation expenses and in royalties paid to the Ministry of Communications resulting from a decline in the royalties' rate.

 

The increase in services cost of revenues in 2008 compared with 2007, resulted mainly from an increase in interconnect fees due to an increase in the number of outgoing calls completed in other operators' networks, an increase in cost of content and value-added services due to increased usage and an increase in handsets repair cost due to higher maintenance cost for the advanced handsets sold. The increase was partially offset by a decrease in rent and related expenses and in royalties paid to the Ministry of Communications resulting from a decline in the royalties' rate.

 

The decrease in equipment cost of revenues in 2009 compared with 2008, resulted primarily from a decrease in the total amount of handsets sold during 2009 compared with 2008, mainly due to more aggressive sales campaigns launched in 2008 compared with 2009. This decrease was partially offset by an increase in the average handset cost due to a larger amount of advanced 3G handsets sold during 2009.

 

The increase in equipment cost of revenues in 2008 compared with 2007, resulted primarily from an increase in the average handset cost due to a larger amount of advanced 3G handsets sold during 2008 and an increase in currency hedging expenses related to handsets purchases, which was partially offset by increased efficiency in handset procurement.

 

The increase in gross profit in 2009 compared with 2008 and in 2008 compared with 2007, resulted mainly from increases in revenues from content and value added services and revenues from landline services. The increase also benefited from a decrease in handsets subsidy. These increases were partially offset by the ongoing airtime price erosion.

 

Selling and marketing expenses and general and administrative expenses

 

		Year Ended December 31,												Change
		2007				2008				2009				2008 vs. 2007				2009 vs. 2008
		(In NIS millions)
Selling and marketing expenses			685				701				716				2.3	%			2.1	%
General and administrative expenses			653				659				660				0.9	%			0.2	%
Total			1,338				1,360				1,376				1.6	%			1.2	%

The increase in selling and marketing expenses in 2009 compared with 2008, was mainly due to an increase in amortization expenses. This increase was partially offset by a decrease in advertising and customer retention expenses. The deferral of sales commissions in 2009 amounted to approximately NIS 64 million compared with approximately NIS 60 million in 2008. Amortization of deferred sales commissions increased in 2009 to approximately NIS 60 million compared with approximately NIS 36 million in 2008.

 

The increase in selling and marketing expenses in 2008 compared with 2007, was mainly due to an increase in payroll expenses resulting from the expansion of our services and sales teams at the end of 2007 and the beginning of 2008, as part of our preparation for the implementation of number portability and our strategy to constantly improve service level and customer satisfaction. The increase also resulted from an increase in customer retention expenses.  These increases were partially offset by a decrease in advertising and postage

 

82

---

 

expenses. Following the expanded marketing of innovative new plans with guaranteed revenues during 2007 and according to accounting standards, we are required to defer sales commissions related to acquisition and retention of subscribers with guaranteed revenues and to recognize such commissions as intangible assets, to be amortized over the expected life of such subscribers' guaranteed revenues. We commenced deferring these commissions in the fourth quarter of 2007.  The deferred sales commissions in 2008 amounted to approximately NIS 60 million compared with approximately NIS 21 million in 2007. Amortization of deferred sales commissions increased in 2008 to approximately NIS 36 million compared with approximately NIS 2 million in 2007.

 

General and administrative expenses in 2009 remained similar to 2008, and were affected by a significant increase in bad debts and doubtful accounts expenses, mainly due to the global economic slowdown and following the implementation of number portability, which allows subscribers to switch to another cellular operator without settling their outstanding debt first. This increase was offset by a decrease in payroll expenses, mainly due to a decrease in compensation expenses related to our share incentive plan, mostly expensed during 2008. The increase in general and administrative expenses was also offset by a decrease in maintenance cost related to our information systems and in depreciation and amortization expenses in 2009 compared with 2008.

 

General and administrative expenses increased in 2008 compared with 2007, as a result of an increase in bad debts and doubtful accounts expenses, mainly following the implementation of number portability. This increase was partially offset by a decrease in depreciation and amortization expenses in 2008.

 

Other income (expenses), net

 

		Year Ended December 31,
		2007				2008				2009
		(In NIS millions)
Other income (expenses), net			(3	)			29				(6	)

 

Other expenses in 2009 consisted mainly of capital losses which resulted from deletion of certain equipment items.

 

Other income in 2008 consisted mainly of capital gains from sales of certain surplus underground pipes for fiber optic cables.

 

Financing expenses, net

 

		Year Ended December 31,
		2007				2008				2009
		(In NIS millions)
Financing expenses			(287	)			(393	)			(370	)
Financing income			140				83				151
Financing expenses, net			(147	)			(310	)			(219	)

Financing expenses, net decreased in 2009 compared with 2008, primarily due to gains from our hedging portfolio, mainly from our CPI hedging transactions, as well as from embedded derivatives income in 2009 compared with embedded derivatives expense in 2008 mainly due to the one-time reversal of financing income in the amount of NIS 29 million in

 

83

---

 

 

the second quarter of 2008, following a clarification of the Israel Accounting Standard Board to the International Accounting Standard no. 39. The decrease in financing expenses, net also resulted from a decrease in CPI linkage expenses associated with our debentures due to the decreased inflation rate of 3.8% in 2009 compared with 4.5% in 2008. These decreases were partially offset by an increase in interest expenses associated with our debentures, due to the increase in our outstanding indebtedness following the issuance of our new series of debentures and the expansion of existing series in April 2009.

 

Financing expenses, net increased in 2008 compared with 2007, resulting primarily from an increase in interest and CPI linkage expenses associated with our debentures, due to the increase in our outstanding indebtedness following the issuance of our new series of debentures in October 2007 and the expansion of these series in February 2008 and the increased inflation rate of 4.5% in 2008 compared with 2.8% in 2007. The increase also resulted from embedded derivatives expenses in 2008 compared with embedded derivatives income in 2007. This increase was partially offset by a decrease in interest expenses related to our credit facility which was voluntarily prepaid in full in March 2008.

 

Interest and CPI linkage expenses associated with the principal amount of the debentures, and interest expenses resulting from the credit facility (voluntarily prepaid in full, in March 2008) incurred during 2009, 2008 and 2007 were approximately NIS 370 million, NIS 367 million and NIS 249 million, respectively.

 

Income tax

 

		Year Ended December 31,												Change
		2007				2008				2009				2008 vs. 2007				2009 vs. 2008
		(In NIS millions)
Income tax			328				391				367				19.2	%			(6.1	%)

Income tax in 2009 decreased by 6.1% compared with 2008, resulting from the reduction in income tax rate to 26% in 2009 from 27% in 2008 and a reduction of deferred tax liabilities and the recognition of a one-time tax income of approximately NIS 41 million in the third quarter of 2009, due to the enactment of the Economic Efficiency Improvement Law (legislative amendments for the implementation of the economic program for the years 2009 and 2010), in July 2009, which provides, among others, for an additional gradual reduction of the Corporate tax rate from 25% for the 2010 tax year down to 18% for the 2016 tax year and thereafter. The decrease in income tax was partially offset by an increase in income before income tax.

 

Income tax in 2008 increased by 19.2% compared with 2007, resulting from the increase in income before income tax and pursuant to the release in 2007 of a tax provision in the amount of approximately NIS 55.5 million, which was recorded in 2006. The increase was partially offset by a reduction in income tax rate to 27% in 2008 from 29% in 2007.

 

Net income

 

		Year Ended December 31,												Change
		2007				2008				2009				2008 vs. 2007				2009 vs. 2008
		(In NIS millions)
Net income			919				989				1,182				7.6	%			19.5	%

 

 

84

---

 

The increase in net income in 2009 compared with 2008, was due primarily to an increase of 1% in revenues, while total operating expenses decreased by 1%, leading to an increase of 4.6% in operating income. The increase also resulted from a decrease in financing expenses and income tax.

 

The increase in net income in 2008 compared with 2007, was due primarily to an increase of 6.1% in revenues while total operating expenses increased by only 2.2%, leading to an increase of 21.2% in operating income. This increase was partially offset by the significant increase in financing expenses and the increase in income tax.

 

B. LIQUIDITY AND CAPITAL RESOURCES

 

General

 

Our liquidity requirements relate primarily to working capital requirements, debt service, capital expenditures for the expansion and improvement of our networks and payment of dividends. Until the end of 2005, these requirements had been funded largely through funds generated from operations and bank borrowings. However, in late 2005 and the first half of 2006, we raised significant additional capital by issuing two series of debentures in the aggregate principal amount of approximately NIS 2.0 billion ($530 million) and by establishing a credit facility of $350 million (voluntarily prepaid in full and terminated in March 2008). Our Board of Directors, at the request of our shareholders, determined to incur such debt, and pay dividends in excess of the amount of such debt with available cash and proceeds of the borrowings, to increase the leverage in our capital structure and improve our shareholders’ expected rate of return on our equity. In addition, in October 2007, we issued two new series of debentures to the public in Israel, for a total principal amount of approximately NIS 1,072 million ($284 million)  and in February 2008 we issued, in a private placement, additional debentures of these two new series, for a total principal amount of approximately NIS 575 million ($152 million). In April 2009, we raised additional debt by issuing additional debentures of an existing series as well as debentures of a new series, for a total amount of approximately NIS 975 million ($258 million).

 

In February 2010, the Committee for Establishing Parameters for Institutional Bodies' Investments in Nongovernmental Bonds, nominated by the commissioner of Capital Markets, Insurance and Savings in the Ministry of Finance, published a final report of its conclusions and recommendations. The committee's  report, includes recommendations for regulatory intervention of the commissioner, in establishing internal procedures to be followed by Israeli institutional investors before   investing in non-governmental debentures and recommendations that Israeli institutional investors would be required to set a policy with respect to the incorporation of rights to demand immediate rep aym ent in the debentures , recommendations that the debentures include certain contractual terms and covenants and the information necessary for institutional investors' examination of investment in the debentures and for their ongoing monitoring, to be required from Israeli institutional investors before investing in non-governmental debentures, as well as recommendations for establishing cooperation mechanism among Israeli institutional investors regarding certain issues related to investment in non-governmental debentures. There is no certainty as to which recommendations will be adopted, if any. If the committee's report recommendations are adopted, they may adversely affect our possibilities of raising debt from Israeli institutional investors as well as the terms and price of such debt raising.

 

We believe that our free cash flow together with our financial reserves will be sufficient to fund our anticipated cash needs for working capital, capital expenditures and debt service for at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending to support marketing and subscriber retention efforts, the expansion of sales and marketing

 

85

---

 

activities and the timing of introductions of new products and enhancements to existing products.

 

In February 2006, our Board of Directors adopted a policy to distribute each year at least 75% of our annual net income (determined in accordance with Israeli GAAP for periods until December 31, 2007 and in accordance with IFRS - for periods commencing on or after January 1, 2008), subject to compliance with applicable law, our license and contractual obligations and so long as the distribution would not be detrimental to our cash needs or to any plans approved by our Board of Directors. See “Item 8. Financial Information – A. Consolidated Statements and Other Financial Information – Dividend Policy.”  It is possible that our Board of Directors’ estimate of our cash needs will be incorrect, or that events could occur that could increase our cash needs beyond anticipated. If that occurs, we may not have sufficient cash to cover these needs as a result of prior dividend payments, and we would need to identify additional sources of financing, which could include equity or debt financing.  We may not be able to obtain such financing on acceptable terms or at all.

 

Dividend payments

 

During 2009, we distributed cash dividends in the aggregate amount of NIS 1.19 billion ($314 million), including the dividend declared for the fourth quarter of 2008 in the amount of NIS 270 million ($72 million), based on net income and existing retained earnings.  During 2008, we distributed cash dividends in the aggregate amount of NIS 1.53 billion ($405 million), based on net income and existing retained earnings. During 2007, we distributed cash dividends in the aggregate amount of NIS 655 million ($174 million) based on net income and existing retained earnings.

 

Debt service

 

Shelf Prospectus

 

In March 2009, we filed a shelf prospectus with the Israeli Securities Authority and the Tel Aviv Stock Exchange. The shelf prospectus will allow us, from time to time, to offer and sell debt, equity and warrants in Israel, in one or more offerings, subject to a supplemental shelf offering report, in which we will describe the terms of the securities offered and the specific details of the offering. At this stage, no decision has been made as to the execution of any such offering, nor as to its scope, terms and timing, if executed, and there is no certainty that such offering will be executed.

 

Public debentures

 

In December 2005 and January 2006, we issued two series of debentures (Series A and Series B) to institutional and other investors in private placements. In May 2006, we issued additional debentures of the existing two series. The debentures are listed on the Tel Aviv Stock Exchange. As of December 31, 2009, these debentures consist of approximately NIS 710 million ($188 million) aggregate principal amount of Series A Debentures (after we repaid the first three principal payments in July 2008 and in January and July 2009, in the sum of approximately NIS 118 millions ($31 million) each). and approximately NIS 925 million ($245 million) aggregate principal amount of Series B Debentures. The Series A Debentures bear interest at the rate of 5.0% per year, and are linked (principal and interest) to

 

86

---

 

 

the Israeli CPI. The principal is payable in nine semiannual payments commencing in July 2008, and the interest is payable semiannually commencing in July 2006. The Series B Debentures bear interest at the rate of 5.3% per year, and are linked (principal and interest) to the Israeli CPI. The principal is payable in five annual payments commencing in January 2013, and the interest is payable annually commencing in January 2007.

 

The Series A and B debentures are unsecured and do not restrict our ability to issue additional debentures of any class or distribute dividends in the future. The Series A and B debentures contain standard terms and obligations including restriction on our ability to create liens on our assets, other than fixed liens on assets provided in connection with financing the purchase of such assets.

 

In October 2007 we issued two new series of debentures (Series C and Series D) to the public in Israel. The debentures are listed for trading on the Tel Aviv Stock Exchange.

 

The Series C and D Debentures were issued for a total principal amount of NIS 245 million ($65 million) and approximately NIS 827 million ($219 million), respectively. In February 2008 we issued, in a private placement, additional debentures of Series C in a principal amount of NIS 81 million ($21 million) and additional Series D Debentures in a principal amount of approximately NIS 494 million ($131 million)   and in April 2009 (under the above Shelf Prospectus), we issued to the public in Israel additional Series D debentures in a principal amount of approximately NIS 186 million ($49 million)   for a total consideration of approximately NIS 215 million ($57 million).   As of December 31, 2009, these debentures consist, of approximately NIS 254 million ($67 million) aggregate principal amount of Series C Debentures (after we repaid the first two principal payments in March  and September 2009, in the sum of approximately NIS 36 millions ($10 million) each) and approximately NIS 1,507 million ($399 million) aggregate principal amount of Series D Debentures.

 

The Series C principal is payable in nine equal semiannual payments on March 1 and September 1, for each of the years 2009 through 2012 (inclusive) and on March 1, 2013. The interest on Series C debentures is payable semiannually on March 1 and on September 1, for each of the years 2008 through 2012 (inclusive) and on March 1, 2013. The Series D principal is payable in five equal annual payments on July 1, for each of the years 2013 through 2017 (inclusive). The interest on Series D debentures is payable annually on July 1, for each of the years 2008 through 2017 (inclusive). Series C and D debentures bear an annual interest rate of 4.60% and 5.19%, respectively and are linked (principal and interest) to the Israeli CPI for August 2007.

 

The Series C and D debentures are unsecured and do not restrict our ability to issue additional debentures of any class or distribute dividends in the future.  The Series C and D debentures contain standard terms and obligations.

 

In April 2009, we issued to the public in Israel a new Series E debentures in a principal amount of approximately NIS 789 million ($209 million) at an interest rate of 6.25% per annum, without any linkage, for a total consideration of approximately NIS 785 million ($208 million). The Series E principal is payable in six equal annual payments on January 5, of each of the years 2012 through 2017 (inclusive). The interest on Series E debentures is payable annually on January 5, of each of the years 2010 through 2017 (inclusive). The debentures were issued in a public offering in Israel based on the aforementioned shelf prospectus and were listed for trading on the Tel Aviv Stock Exchange.

 

87

---

 

 

The Series E debentures are unsecured and do not restrict our ability to issue additional debentures of any class or distribute dividends in the future.  The Series E debentures contain standard terms and obligations.

 

Our debentures are rated ilAA/Stable by Standard & Poor's Maalot rating company.

 

Other credit facilities

 

As of December 31, 2009, there were no other credit facilities outstanding.

 

Capital expenditures

 

Our accrual capital expenditure in 2007, 2008 and 2009 amounted to NIS 651 million, NIS 633 million and NIS 663 million, respectively. Accrual capital expenditure is defined as investment in fixed assets and intangible assets, such as spectrum licenses, during a given period. The amounts of capital expenditure have been adjusted to include capitalized subscriber acquisition and retention cost.  For the periods under review, a key focus of our capital investment has been the enhancement and expansion of our networks and transmission infrastructure.

 

Cash flows from operating activities

 

Cash flows from operating activities increased by 18.4% in 2009 to NIS 2,088 million from NIS 1,763 million in 2008. The increase resulted mainly from the slight decrease in income tax payments in 2009 compared with 2008, while income before income tax increased.

 

Cash flows from operating activities decreased by 3.1% in 2008 to NIS 1,763 million from NIS 1,820 million in 2007. The decrease resulted mainly from the increased expenditure related to the expansion in our workforce and the increase in subscriber retention and acquisition costs, especially at the beginning of 2008 following the introduction of number portability in December 2007, as well as from   an increase in income tax paid during 2008, which included a one-time catch up payment of NIS 70 million for 2007 accrued tax liability. These increases were partially offset by other operating activities.

 

Cash flows from investing activities

 

The net cash flows from operating activities is the main capital resource for our investment activities. In 2007, 2008 and 2009, our net cash used in investing activities amounted to NIS 560 million, NIS 546 million and NIS 782 million, respectively.  The payments were primarily for the expansion of the technological networks and information systems infrastructures. The increase in 2009 compared with 2008, resulted mainly from the investment in our current debentures portfolio according to our investment policy, which totaled NIS 212 million in 2009.

 

Cash flows from financing activities

 

In 2009, the net cash used in financing activities amounted to NIS 678 million compared with NIS 1,853 million in 2008. The decrease resulted primarily from a decrease in cash dividend paid mainly due to the special dividend paid in April 2008, a decrease in repayments of long-term loans from banks in 2008 and an increase in proceeds from issuance

 

88

---

 

of debentures in 2009. These were partially offset by an increase in repayments of debentures.

 

In 2008, the net cash used in financing activities amounted to NIS 1,853 million compared with NIS 405 million in 2007. The increase was primarily due to an increase in cash dividend paid and a decrease in proceeds from issuance of debentures.

 

During 2008, we voluntarily prepaid in full the outstanding balance of our credit facility in the amount of NIS 648 million and received net amount of NIS 589 million from the expansion of two existing series of debentures in February 2008. We also made debentures' payments of principal in the aggregate amount of NIS 125 million and interest payments in the aggregate amount of NIS 175 million mostly related to our debentures. Furthermore, during 2008, we paid cash dividends in the amount of NIS 1.525 billion (excluding the difference between withholding tax in respect of the last dividends distributed in 2007 and 2008, which were paid subsequent to balance sheet dates).

 

During 2007, 2008 and 2009, the average outstanding amount of long-term liabilities (long-term loans and debentures) was NIS 3.2 billion, NIS 3.8 billion and NIS 4.3 billion, respectively.

 

Working capital

 

Our working capital as of December 31, 2009 was NIS 1,254 million, compared with NIS 461 million as of December 31, 2008.  The increase in working capital was primarily due to the increase in cash and cash-equivalents and in current investments, resulting mainly from the issuance of debentures in 2009.

 

Our working capital as of December 31, 2008 was NIS 461 million, compared with working capital of NIS 716 million as of December 31, 2007.  The decrease in working capital was mainly due to the decrease in cash and cash-equivalents, resulting mainly from the increase in cash dividend distributed in 2008 compared with 2007. This decrease was partially offset by a decrease in trade payables and accrued expenses, due to the higher balances at the end of 2007 attributed to our preparation for number portability launched in December 2007.

 

Trade receivables

 

Trade receivables consist of outstanding amounts due from customers, mainly for cellular services and handsets and accessories, net of the allowance for doubtful accounts.  Most of our handset sales are made on an installment basis (generally, 36 monthly payments).  Installments due in the twelve months following the balance sheet date are included in current trade receivables; the remaining installments are included in long-term receivables.  As of December 31, 2009, net current trade receivables amounted to NIS 1,579 million compared with NIS 1,478 million as at December 31, 2008 and NIS 1,385 million as at December 31, 2007.  This increase was primarily due to the increase in our revenues.  The current maturity of long-term receivables as of December 31, 2009 was NIS 695 million, compared with NIS 666 million as at December 31, 2008.

 

C.  RESEARCH AND DEVELOPMENT, PATENTS AND LICENSES, ETC.

 

Not applicable.

 

89

---

 

 

D. TREND INFORMATION

 

Trend information is included throughout the other sections of this Item 5.

 

E. OFF-BALANCE SHEET ARRANGEMENTS

 

There are no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on our financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

 

F. TABULAR DISCLOSURE OF CONTRACTUAL OBLIGATIONS

 

Set forth below is a description of our contractual cash obligations, in millions of NIS, as of December 31, 2009.

 

		Total				2010					2011- 2013				2014-2015			2016 and Beyond
Long-term debt obligations (including interest)(1)			5,706				566				2,123				1,580				1,437
Operating lease obligations			643				215				327				101				—
Purchase obligations			441				194				247				—				—
Total			6,790				975				2,697				1,681				1,437

 

(1)

Interest does not include (a) payments that could be required under our interest-rate swap agreements; such payments will depend upon changes in interest rates and could vary significantly, or (b) any increase in interest that would be required based on increases in the Israeli CPI.

 

Application of Critical Accounting Policies and Use of Estimates

 

The preparation of our financial statements requires management to make judgments, estimates and assumptions that affect the amounts reflected in the consolidated financial statements and accompanying notes, and related disclosure of contingent assets and liabilities.  We base our estimates upon past experience, where applicable, various factors, external sources and on other assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.  Actual results may differ from these estimates under different assumptions or conditions, and could have a material impact on our reported results.

 

In many cases, the accounting treatment of a particular transaction, event or activity is specifically dictated by accounting principles and does not require management’s judgment in its application, while in other cases, management’s judgment is required in the selection of the most appropriate alternative among the available accounting principles, that allow different accounting treatment for similar transactions.

 

We believe that the accounting policies discussed below are critical to our financial results and to the understanding of our past and future performance, as these policies relate to the more significant areas involving management’s estimates and assumptions.  We consider an accounting estimate to be critical if: (1) it requires us to make assumptions because information was not available at the time or it included matters that were highly uncertain at the time we were making our estimate and (2) changes in the estimate or different estimates that we could have selected may have had a material impact on our financial condition or results of operations.

 

90

---

 

 

Revenue recognition

 

Nature of critical estimate items

 

As described in Note 3.J to our consolidated financial statements included elsewhere in this annual report, revenues derived from usage of our networks, including airtime, interconnect, content and value added services and roaming revenues are recognized when the services are provided and all other revenue recognition criteria are met. Sale of handsets with accompanying services constitutes a revenue arrangement with multiple deliverables. Accordingly, consideration received for handsets, up to their fair value, that is not contingent upon delivery of additional items (such as the service), is recognized as equipment revenues upon the delivery of the equipment to the subscriber, when all revenue recognition criteria are met. Consideration for services is recognized as service revenues, when earned. In revenue arrangements including more than one deliverable, the arrangement consideration is allocated to each deliverable based on the fair value of the individual element. Revenue is recognized when the significant risks and rewards of ownership have been transferred to the buyer, recovery of the consideration is probable, the associated costs and possible return of goods can be estimated reliably, there is no continuing management involvement in regards to the goods and the amount of revenue can be measured reliably.

 

Assumptions / approach used

 

We determine the fair value of the individual elements based on prices at which the deliverable is regularly sold on a stand alone basis, after considering volume discounts where appropriate. The accounting estimates used in the results of operations related to the recognition of revenue require us to make assumptions about possible future billing adjustments arising from disputes with subscribers and discounts not taken into consideration at the time of billing.

 

Effect if different assumptions used

 

Management believes that the determination of fair value of the individual elements (relevant to revenue recognition) for each reporting period represent its best estimate, but the actual fair value can differ from the estimate selected.  The impact of variances in actual performance versus the amounts recorded could have an adverse effect on the accounts receivable reported on the balance sheet and the results reported in the statements of operations, and could be material to our financial condition.

 

Long-lived assets – depreciation

 

Nature of critical estimate items

 

The cellular communications industry is capital intensive. The depreciation of operating assets constitutes a significant operating cost for us. We have substantial investments in tangible long-lived assets, primarily our communications networks.

 

Assumptions / approach used

 

 We depreciate our property, plant and equipment using the straight line method. Separate individual significant components are depreciated over their individual estimated useful lives. We periodically review changes in our technology and industry conditions to determine adjustments to estimated remaining useful lives and depreciation rates.

 

91

---

 

 

Effect if different assumptions used

 

Changes in technology or changes in our intended use of these assets can cause the estimated period of use or the value of these assets to change.  Actual economic lives may differ from estimated useful lives.  Periodic reviews could result in a change in our assets’ depreciable lives, and therefore, in our depreciation expense in future periods.

 

Impairment of long-lived assets

 

Nature of critical estimate items

 

We review finite-lived long-lived assets, principally consisting of property, plant and equipment, and spectrum licenses for impairment based on the requirements of International Accounting Standard No. 36, or whenever events or changes in circumstances indicate that their carrying values may not be recoverable through the present value of anticipated cash flows from the continued use of the asset, including those expected at the time of its future retirement and disposal. If necessary, we reduce the carrying values of the assets to their estimated fair values.

 

Assumptions / approach used

 

In analyzing finite-lived long-lived assets for potential impairment, significant assumptions that are used in determining the discounted cash flows of the asset group include:

 

·

cash flows attributed to the asset group;

 

·

future cash flows for the asset group, including estimates of residual values, which incorporate our views of growth rates for the related business and anticipated future economic conditions; and

 

·

period of time over which the assets will be held and used.

 

Effect if different assumptions used

 

The use of different estimates and assumptions within our discounted cash flow modes (e.g., growth rates, future economic conditions, estimates of residual values) could result in discounted cash flows that are lower than the current carrying value of an asset group, thereby requiring the need to reduce the carrying value to the discounted cash flow amount.

 

The use of different discount rates when determining the fair value of the asset group could result in different fair values, and impact any related impairment charges.

 

Accounts receivable - bad debt and allowance for doubtful accounts

 

Nature of critical estimate items

 

We maintain an allowance for doubtful accounts to reflect estimated losses resulting from impairment of accounts receivables.

 

Assumptions / approach used

 

 

92

---