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                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549
 
                                   FORM 10-K
 
[X]  ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934
 
                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997
 
[ ]  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
     SECURITIES EXCHANGE ACT OF 1934
 
                       COMMISSION FILE NUMBER:
 
                           HERMES EUROPE RAILTEL B.V.
             (Exact name of registrant as specified in its charter)
 
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                 NETHERLANDS                                        NONE
       (State or other jurisdiction of             (I.R.S. Employer Identification Nos.)
        incorporation or organization)
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                              TERHULPSESTEENWEG 6A
                                 1560 HOEILAART
                                    BELGIUM
                    (Address of principal executive offices)
 
                                 (322) 658-5200
                        (Registrant's telephone number)
 
          Securities registered pursuant to Section 12(b) of the Act:
 
                                      None
 
          Securities registered pursuant to Section 12(g) of the Act:
 
                                      None
 
     Indicate by check mark whether the registrants (1) have filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) have been subject to such
filing requirements for the past 90 days.  Yes [ ]     No [X]
 
     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained in this Form 10-K, and will not be
contained, to the best of the registrants' knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form 10-K
or any amendment to this Form 10-K  [X]. Not Applicable.
 
     On March 31, 1998, there were outstanding 190,468 shares of Common Stock of
Hermes Europe Railtel B.V., of which 20,161 shares were held by non-affiliates.
There is no established market for the registrant's voting stock. Accordingly,
the registrant is unable to estimate the value of shares held by non-affiliates.
 
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              ITEM OF FORM 10-K                      DOCUMENT INCORPORATED BY REFERENCE
              -----------------                      ----------------------------------
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             Part IV, Item 14(c)                                  Exhibits
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                           HERMES EUROPE RAILTEL B.V.
 
                                   FORM 10-K
                          YEAR ENDED DECEMBER 31, 1997
 
                               TABLE OF CONTENTS
 
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PART I
ITEM 1.   Business....................................................     1
          Introduction................................................     1
          Business and Marketing Strategy.............................     3
          Services....................................................     5
          Pricing.....................................................     6
          Customers...................................................     7
          Network Design..............................................     8
          Competition.................................................    10
          HER Recapitalization........................................    11
          Licenses and Regulatory Issues..............................    12
          Managing Rapid Growth.......................................    16
          Employees...................................................    17
          Glossary of Telecommunications Industry Terms...............    17
ITEM 2.   Properties..................................................    20
ITEM 3.   Legal Proceedings...........................................    20
ITEM 4.   Submission of Matters to a Vote of Security Holders.........    20
PART II
          Market for the Company's Common Equity and Related
ITEM 5.     Stockholder Matters.......................................    20
ITEM 6.   Selected Consolidated Financial Data........................    20
          Management's Discussion and Analysis of Financial Condition
ITEM 7.     and Results of Operations.................................    21
ITEM 8.   Consolidated Financial Statements...........................    25
          Changes In and Disagreements with Accountants on Accounting
ITEM 9.     and Financial Disclosure..................................    41
PART III
ITEM 10.  Directors and Executive Officers of the Company.............    41
ITEM 11.  Executive Compensation......................................    44
          Security Ownership of Certain Beneficial Owners and
ITEM 12.    Management................................................    48
ITEM 13.  Certain Relationships and Related Transactions..............    48
PART IV
          Exhibits, Financial Statement Schedules and Reports on Form
ITEM 14.    8-K.......................................................    50
SIGNATURES............................................................    53
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                                     PART I
 
ITEM 1. BUSINESS
 
     To aid the reader, a "Glossary of Telecommunications Industry Terms," which
defines certain terms used in this "Business" section and elsewhere in this
Report, follows commencing on page 17.
 
INTRODUCTION
 
     Hermes Europe Railtel B.V. ("HER" or the "Company") is developing, and
operating the initial segments of, a pan-European high capacity fiber optic
network that is designed to interconnect a majority of the largest Western and
Central European cities and to transport international voice, data and
multimedia/image traffic for other carriers throughout Western and Central
Europe. HER is an 89%-held indirect subsidiary of Global TeleSystems Group,
Inc., a Delaware corporation ("GTS"), that is a provider of a broad range of
telecommunications services to businesses, other telecommunications service
providers and consumers in Russia, the Commonwealth of Independent States, and
Western and Central Europe. See "-- HER Recapitalization" for information
concerning the other shareholders of HER.
 
     HER's objective is to become the leading pan-European carriers' carrier by
providing centrally managed cross-border telecommunications transmission
capacity to telecommunications companies including traditional public
telecommunications operators ("PTOs") and new entrants, such as alternative
carriers, global consortia of telecommunications operators, international
carriers, Internet backbone networks, resellers, value-added networks and other
service providers ("New Entrants") on an approximately 18,000 kilometer pan-
European high capacity fiber optic network designed to interconnect a majority
of the largest Western and Central European cities. As of April 1, 1998, HER's
network linked Brussels, Antwerp, Rotterdam, Amsterdam, London, Paris, and
Frankfurt. HER expects the initial five country network and Switzerland to be
placed in operation in the second quarter of 1998. This segment of the network
is expected to deliver managed transport services over approximately 3,800
kilometers of fiber optic cable linking, in addition to the above cities, the
cities of Dusseldorf, Munich, Stuttgart, Zurich and Geneva. The full 18,000
kilometer network is expected to become fully operational during the year 2000.
HER also plans to lease capacity on a transatlantic cable linking the European
network to North America and is exploring various interconnectivity options to
Russia and Asia. Such intercontinental interconnectivity will help HER to
satisfy the needs of its European customers with respect to outgoing traffic and
to attract additional non-European customers with traffic terminating in Europe.
HER commenced commercial service over the Brussels-Amsterdam portion of the
network in late 1996, and the London-Paris portion in November 1997. HER's
Network Operations Center located in Brussels, Belgium and its backup center
located in Antwerp, Belgium are fully operational and house network management
and customer support services which operate 24 hours a day, seven days a week.
Billing and customer service functions are also operational.
 
     The European telecommunications market has historically been dominated by
monopoly PTOs. This system has ensured the development of broad access to
telecommunications services in Europe, but it has also restricted the growth of
high quality and competitively priced pan-European voice and data services. The
current liberalization occurring in Europe is intended to address these
structural deficiencies by breaking down PTO monopolies, allowing new
telecommunications operators to enter the market and increasing the competition
within the European telecommunications market. In March 1996, the European
Commission adopted a directive (the "Full Competition Directive") requiring the
full liberalization of all telecommunications services in most EU member states
by January 1, 1998. The Company expects that full liberalization in these
European countries will lead to the emergence of New Entrants with new and
competitive service offerings. HER expects this increase in competition will
result in lower prices and a substantial increase in the volume of traffic and
range of telecommunication services provided. HER believes that as a result of
the increased call volume and growth in value added services, participants in
these markets will require significant amounts of new cross-border
telecommunications transport capacity to provide their services.
 
     The Hermes network will offer PTOs and New Entrants an attractive
alternative for the transport of cross-border European telecommunications
traffic. In the traditional system, PTOs own and control circuits
 
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only within their national borders, and as a result, cross-border traffic must
be passed from one PTO to another PTO at the national boundary. No single PTO
therefore owns or controls end-to-end circuits for cross-border calls. The
alternative for carriers of this traffic will be to build their own transport
capacity or use International Private Leased Circuits ("IPLCs") which are
provisioned by combining half-circuits on the networks of two or more PTOs. The
Company believes that there are a number of problems with these options that
result in HER being well-positioned to become the leading independent carriers'
carrier in Western and Central Europe. In particular, building their own
transport capacity is unlikely to be an attractive option for most carriers
because of the high traffic volumes required to justify the expense, the need to
focus resources on marketing and customer service, the time commitment and the
regulatory and administrative complexities involved, particularly in obtaining
the rights of way across national borders. Likewise, IPLCs provided by the PTOs
also have a number of disadvantages, including high prices, lack of end-to-end
quality control, lack of redundancy, low quality due to diversity of network
systems and equipment, limited availability of bandwidth and long lead times for
provisioning.
 
     HER's objective is to become the leading pan-European carriers' carrier by
providing centrally managed cross-border telecommunications transmission
capacity to telecommunications companies including PTOs and New Entrants. HER
intends to offer these target customers a better transport system than is
currently available in Europe with a higher and more consistent level of
transmission quality, redundancy, network functionality and service across
Europe at lower prices. Development of the HER network is dependent upon, among
other things, HER's continuing ability to obtain the necessary financing,
rights-of-way, licenses and other regulatory approvals in a timely and
cost-effective manner.
 
     HER is developing an approximately 18,000 kilometer, pan-European high
capacity fiber optic network designed to interconnect a majority of the largest
Western and Central European cities. Each access point of the network will be
placed in operation as it is linked to the network. HER intends to build the
network using the most accessible and cost-efficient infrastructure base in each
of the regions served, including using rights-of-way and existing infrastructure
of railways, motorways, pipeline companies, waterways and power companies. HER
plans a flexible approach to the network build-out plan and intends to fine-tune
the scope, route and design of the network based upon the evaluation of customer
demand. Historically, HER has experienced substantial delays in concluding these
agreements and developing its network. There can be no assurance that HER will
be successful in concluding necessary agreements, or that delays in concluding
such agreements will not materially and adversely affect the speed or successful
completion of the network. The successful and timely completion of the network
will also depend on, among other things, (i) the availability to HER of
substantial amounts of additional capital and financing, (ii) timely performance
by various third parties of their contractual obligations to engineer, design
and construct portions of the network and (iii) HER's ability to obtain and
maintain applicable governmental approvals. In addition, although HER believes
that its cost estimates and the build-out schedule are reasonable, there can be
no assurance that the actual construction costs or time required to complete the
network build-out will not substantially exceed current estimates. Any
significant delay or increase in the costs associated with development of the
HER network could have a material adverse effect on HER.
 
     HER expects to continue to roll-out full telecommunications transport
service on the initial network in the first five countries linking the
additional cities of Dusseldorf, Suttgart, Munich, Zurich and Geneva by June 30,
1998. This initial network in the first five countries and Switzerland is
expected to consist of approximately 3,800 kilometers of fiber optic cable
covering countries which, in 1995, originated over 60% of all outgoing calls and
terminated over 60% of all incoming calls in the countries to be served by the
full network. Network coverage is planned to be expanded to include the cities
of Berlin, Stockholm, Copenhagen, and Milan in the third quarter of 1998. By the
year 2000, the 18,000 kilometer HER network is expected to have points of
presence in at least 33 cities in 15 European countries, including Southern and
Central Europe. HER also plans to lease capacity on a transatlantic cable
linking the European network with North America and is exploring various
interconnectivity options to Russia and Asia.
 
     HER has entered into agreements for the construction and/or lease of fiber
optic routes for the initial network in the first five countries. Contracts have
been concluded with respect to the portion of the network connecting Germany
with each of France, the Netherlands and Switzerland. Additional contracts have
been
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concluded in Switzerland, Denmark, Sweden, Spain and Italy. HER continues to
negotiate rights-of-way and other infrastructure arrangements in order to extend
its network in Western Europe. HER will need to negotiate similar agreements to
complete the network in four Central European countries. Buildout of the HER
network is subject to numerous risks and uncertainties that could delay
deployment or increase the costs of the network, or make the network
commercially unfeasible.
 
     Development of the HER network is capital intensive. Management expects
that approximately $290 million in capital expenditures will be incurred in
connection with the buildout of the HER network, with approximately $35 million
required for the roll out of the initial five country network that is expected
to be completed in the second quarter of 1998. While HER raised approximately
$265 million in a private placement of its senior notes in August 1997 (of which
$56.6 million has been placed in escrow for the first two years' interest
payments on the notes), additional financing may need to be obtained to
construct the HER network and there can be no assurance that such additional
financing will be completed. Failure to obtain necessary financing may require
HER to delay or abandon its plans for deploying the remainder of the network and
would adversely affect the viability of HER, which could have a material adverse
effect on the operations of the Company. HER's revenues and the cost of
deploying its network and operating its business will depend upon a variety of
factors including, among other things, HER's ability to (i) effectively and
efficiently manage the expansion of its network and operations, (ii) negotiate
favorable contracts with suppliers, (iii) obtain additional licenses, regulatory
approvals, rights-of-way and infrastructure contracts to complete and operate
the network, (iv) access markets and attract sufficient numbers of customers and
(v) provide and develop services for which customers will subscribe. HER's
revenues and costs are also dependent upon factors that are not within HER's
control such as regulatory changes, changes in technology, increased competition
and various factors such as strikes, weather and performance by third-parties in
connection with the development of the network. Due to the uncertainty of these
factors, actual costs and revenues may vary from expected amounts, possibly to a
material degree, and such variations would likely affect HER's future capital
requirements. HER must obtain additional infrastructure provider agreements for
the long-term lease of dark fiber, rights-of-way and other permits to install
fiber optic cable from railroads, utilities and governmental authorities to
build out the network. There can be no assurance that HER will be able to
maintain all of its existing agreements, rights and permits or to obtain and
maintain the additional agreements, rights and permits needed to implement its
business plan on acceptable terms. Loss of substantial agreements, rights and
permits or the failure to enter into and maintain required arrangements for the
HER network could have a material adverse effect to enter on HER's business. In
addition, HER depends on third parties for leases of dark fiber for substantial
portions of its network. There can be no assurance that HER will be able to
enter into and maintain required arrangements for leased portions of the HER
network, which could have a material adverse effect on HER's business.
 
     HER was formed on July 6, 1993 by HIT Rail B.V. ("HIT Rail"). HIT Rail was
incorporated in 1990 by eleven national railways to carry out telecommunications
engineering activities in order to construct and exploit a data communications
network for railway traffic. GTS-Hermes, Inc., a Delaware corporation
("GTS-Hermes") purchased a 34.4% interest in HER in 1994 and has increased its
interest to 50% in 1995 and to 79% in 1997. In March 1998, GTS-Hermes increased
its ownership of HER to 89% by purchasing a portion of HIT Rail's ownership
interest in HER. GTS-Hermes is a wholly owned subsidiary of GTS. HER's principal
business office is located at Terhulpsesteenweg 6A, 1560 Hoeilaart, Belgium, and
its telephone number is (322) 658-5200. In an effort to expand its presence in
Europe, HER has formed wholly owned subsidiaries in the Netherlands, Ireland,
the United Kingdom, Germany, France, Italy and Spain to conduct marketing and
other activities. In Belgium, the activities of the Network Operations Center
have been transferred to Hermes Network Services B.V.B.A. (formerly Hermes
Europe Railtel N.V.), a wholly owned subsidiary of HER. Following the
development of its corporate structure, HER will be a holding company with
limited assets and will operate its business through subsidiaries.
 
BUSINESS AND MARKETING STRATEGY
 
     The overall strategy of HER is to offer PTOs and New Entrants pan-European
cross-border telecommunications transport services to help them, in turn, more
successfully meet the needs of their end-user customers. The HER network also
provides a vehicle through which a carrier can compete in markets where it
 
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does not own infrastructure. HER expects to enter the market ahead of similar
competition and encourage a wide variety of carriers to use its network with
service offerings that meet their needs. HER's primary service offerings are
large-capacity circuits for "wholesale" customers such as PTOs and New Entrants.
HER's focus on carriers is designed to complement and not compete with carriers'
own business objectives in providing services to end-users.
 
     To establish HER as the leading carriers' carrier for international
telecommunications within Europe, HER offers its customers significantly higher
quality transmission and extended/advanced network capabilities at a competitive
price by focusing on the following:
 
     High Capacity International Network Facilities. The HER network is designed
to offer its customers access to high capacity network facilities outside their
domestic markets, providing cross-border capabilities without requiring
customers to invest in network infrastructure or being constrained by a narrow
range of capacity offerings. With STM-64 technology and Wavelength Division
Multiplexing ("WDM") upgrades, HER's fiber deployment plan provides for the
equivalent of 128 fiber pairs of capacity across Europe.
 
     Uniform Network Architecture. The HER network is designed to offer managed
transport services from country to country and across multiple countries
utilizing a single uniform network, in contrast to services currently available
that use multiple providers over several networks with varying technologies and
each under the control of separate, not necessarily compatible, network control
systems. The HER network's uniform technology enhances service by providing
quality and reliability as well as uniformity of features throughout the
network.
 
     Diverse Routing. The HER network architecture includes diverse, redundant
routes that are designed to provide high levels of reliability. The network is
designed to provide availability of over 99.98% for most routes and to provide
customers with a wide range of telecommunications transmission capacity. To
achieve this level of reliability without the use of a network similar to the
HER network, HER believes that carrier customers would need to purchase
additional dedicated circuits to provide for redundancy.
 
     Rapid Provisioning. HER services provide access to the network, such that
additional capacity can be provided to customers on the HER network on a rapid
basis. This access provides a level of capabilities that HER believes is
unavailable in Europe today. This ability to rapidly provide service is largely
due to HER's development of capacity substantially in excess of HER's forecasted
requirements.
 
     - Flexibility. HER services are focused on providing customers flexibility
       across the network through which the customer may minimize risk by
       enabling network rerouting, eventually even under customer direct
       control.
 
     - Advanced Technology. HER is deploying SDH technology which, by using WDM
       techniques and hardware, is upgradeable and will permit significant
       expansion of transmission capacity without increasing the number of fiber
       pairs in the network. This technology also provides the basis for
       structuring advanced operating features, such as virtual private network
       service and ATM-based services. Additionally, the SDH technology deployed
       by HER may be upgraded.
 
     - Innovative Pricing. Currently the price of high-bandwidth E1 equivalent
       circuits on transborder European routes is artificially high and not
       necessarily related to the cost of such circuits. HER offers competitive
       pricing. HER also offers highly tailored contract terms and volume
       discounts, which allow carrier customers to plan more efficiently the
       fixed costs of their service portfolio. Customers can select varying
       capacity, access, guaranteed availability and contract terms at
       competitive prices. Customers sourcing from PTOs are generally limited to
       order from a very narrow set of capabilities offered under inflexible
       pricing plans.
 
     Although HER and GTS have relationships with certain PTOs or other access
providers for specific projects, they do not have wide-ranging alliances with
any of the major consortia or large Western telecommunications companies.
Additionally, HER's strategy calls for it to focus on carriers' carrier
services, so that it will limit overlap of target markets with its carrier
customers in end user markets. HER believes that this independence will make it
an attractive service provider for carriers who may otherwise be reluctant to
obtain services from other providers of intra-European transport that also may
be their competitors in the retail market.
 
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     GTS is considering the expansion of its local exchange business to Western
Europe from Central Europe through the acquisition of existing local carriers,
the construction of its own local networks, or some combination thereof. If GTS
implements this strategy, these local networks could be integrated with hubs and
gateways operated by GTS and could enter into contractual or other arrangements
with HER. It is unknown whether this strategy, if consummated, could have an
adverse effect on HER's plans to attract PTO's, New Entrants and other customers
as an independent carrier's carrier.
 
SERVICES
 
     HER's primary service is large capacity cross-border European circuits
provided to carriers and service providers over an integrated, managed
pan-European network structure thus providing a service for wholesale customers
such as PTOs and New Entrants. The HER network will be based on SDH technology,
which provides for digital transmission capability upon which a broad range of
advanced functionality may be built and which offers network availability,
flexibility, bandwidth speeds and error performance not otherwise available to
carriers for transport of telecommunications traffic across national borders in
Western and Central Europe. The network is designed to provide customers with a
wide variety of bandwidth speeds, ranging from VC12/E1 Standard (equivalent to
2.048 Mbps) to STM-1/E4 Standard (equivalent to 155 Mbps) and beyond.
 
     HER will provide high quality cross-border transmission services for
licensed or otherwise authorized telecommunications providers. Services are
based on the principle of adding greater value than currently available in the
market while retaining competitive prices.
 
     Point-to-Point Transport Service. The current market for cross-border
transport is served by IPLCs provided by PTOs. IPLCs are formed by combining
half-circuits from two PTOs between customer locations, often with additional
PTOs providing transit segments. Under the IPLC service, overall service quality
guarantees generally are not provided and only a limited range of bandwidth is
available, usually only E1 and in certain instances, E3. The Company believes
that HER's Point-to-Point Transport Service will be a major improvement to the
PTO-based approach because it provides a greater range of bandwidths (from 2
Mbps (E1 or VC-12) to 140/155 Mbps (E4 or VC-4)) and allows customers to choose
a service level agreement with guarantees appropriate for their applications,
including guarantees for on-time service delivery and service availability.
 
     Point-to-Point Transport Service consists of two services, "Integrated" and
"Node-to-Node." The HER "Integrated" service provides an end-to-end service
between customer-specified locations where the customer can request for HER to
arrange for "last mile" services from the HER node location to the customer's
location. The HER "Node-to-Node" service can be selected when the customer
prefers to provide its own services to reach the local HER node location. In
Node-to-Node Service, HER guarantees service only on its portion of the network
between HER nodes. Both services are competitively priced relative to current
service offerings. A premium is charged for the highest guaranteed level of
service which incorporates an end-to-end, fully diverse, protected, "Integrated"
service. The customer can choose flexible contract terms from one to five or
more years' duration, with volume discount schemes designed to ensure that HER
remains a cost-effective solution.
 
     Virtual Infrastructure Service. Carriers and operators that plan to expand
their operations to become pan-European service providers as the European
marketplace is liberalized require a flexible and cost-effective means of
telecommunications transport. To date such service providers obtain
international transport service by leasing IPLCs. Leasing IPLCs requires a
carrier to lease channels on a segment-by-segment basis from multiple PTOs,
linking the target cities under arrangements having fixed capacity and pricing
structure for each segment of the carrier's network. Leasing IPLCs has several
disadvantages, including (i) difficulty in obtaining discount/volume pricing
schemes since there is no single provider of pan-European coverage, (ii) delays
in implementation due to numerous contractual negotiations and having to
interconnect numerous IPLCs, (iii) limited availability of pan-European leased
capacity at high bandwidth and (iv) variability of quality due to multiple
operators and the absence of a single uniform network. Operators could also
construct
 
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their own network, which is expensive, time-consuming and complex and which may
not be justified by such operators' traffic volume.
 
     HER's Virtual Infrastructure Service will offer a new solution and an
attractive alternative to leasing IPLCs or building infrastructure. This service
will enable HER's customers to obtain a uniform pan-European or cross-border
network under one service agreement by allowing the customer to select any
number of cities along the HER network at a pricing structure based on the
overall amount of leased capacity for the customer's entire network. The key
feature behind Virtual Infrastructure Service is that it gives the customer the
ability to add or reconfigure capacity in 24 hours between locations connected
in the Virtual Infrastructure Service, thereby enabling the customers to respond
almost immediately to changes in traffic. By being able to transfer capacity
among the network routes, HER's customers are able to avoid over- and
under-utilization of leased channels. This service offering provides a customer
with the benefits of ownership (rapid provisioning, freedom to rearrange and
control) with a "pay-as-you-go" managed service offering, without the burdens of
up-front investment and costs required to build a network, and without having to
manage the on-going maintenance and operation of the network.
 
     The service would be delivered through pre-installed physical facilities at
each of the customer locations. These facilities are designed to ensure that
most growth or changes in customer requirements can be addressed purely by
remote logical reconfiguration from the HER Network Operations Center. This
remote network management ability is inherent in SDH technology and allows rapid
provisioning and high quality of service.
 
     Ring Service. Most medium to large carriers and operators purchase network
capacity in excess of actual requirements, and prefer to have physical
configuration control over their networks. The HER Ring Service connects
multiple customer locations with multiple VC-4 paths in a ring configuration.
The customer has direct control over the configuration of the VC-3 and VC-12
paths within the ring, and has exclusive control over the routing. Additional
ring capacity can be added with no service interruption and additional customer
locations may be added to the ring with minimal service interruption. Because
HER is not required to configure 'idle" bandwidth or to manage the 'SDH subnet"
this service can be provided at a very competitive rate vis-a-vis other
point-to-point services.
 
     Sales and marketing of HER's services are conducted through its sales and
marketing department, which includes a director and senior sales managers
responsible for various regions and customer segments. Additionally, HER expects
that certain of its infrastructure providers that develop domestic
telecommunications businesses, or other local network access providers, can
provide an effective distribution channel to smaller carrier customers.
 
PRICING
 
     Currently the price of cross-border pan-European calls are often
significantly higher than the underlying cost of transport and terminating such
calls and higher than the price of intra-country calls or transborder calls to
and from liberalized markets. The low cost of operating the network enables HER
to attractively and competitively price services in the face of declining
overall tariffs for telecommunication services. HER's low-cost basis is due to,
among other things, its use of up-to-date technology without the burden of
legacy networks, which requires fewer employees to operate.
 
     The term of a typical customer agreement currently ranges from 1 to 3
years. The customer agrees to purchase, and HER agrees to provide, cross-border
transmission services. In general the customer agrees to pay certain
non-recurring charges upfront and recurring charges on an annual basis, payable
in twelve monthly installments. If the customer terminates the service order
prior to the end of the contract term, it is generally required to pay HER a
cancellation charge equal to three months service for each of the twelve months
remaining in the contract term. HER guarantees transmission services to a
certain service level. If such levels are not met or HER fails to deliver
service by the committed delivery date, the customer is eligible for a credit
against charges otherwise payable in respect of the relevant link.
 
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CUSTOMERS
 
     HER's high capacity, SDH-based fiber optic network is designed to enable
PTOs and New Entrants to integrate high quality, cross-border capacity into
their end user offerings. As of January 1998, twenty customers were under
contract for service on the HER network, including PTOs, a global consortium of
PTOs, Internet service providers, an international carrier, value added network
("VANs") and resellers. HER provided capacity of approximately 446 E1 equivalent
circuits as of January 1998. The type and quality of HER's customers validates
the concept of the HER network, and illustrates the type of customers who will
be attracted to the full network. The success of this limited network also
demonstrates the demand for cross-border transport services. In total, HER is
targeting seven major market segments or customer groups which can be
characterized as follows:
 
     -  Existing PTOs. This customer segment consists of the traditional
        European PTOs that generally participate in the standard bilateral
        agreements for cross-border connectivity. Hermes provides a vehicle for
        PTOs to compete in non-domestic markets both before and after January 1,
        1998. As of January 1, 1998, both reserved and non-reserved traffic can
        be transported by alternative infrastructure providers, thus vastly
        expanding the available PTO market for HER.
 
     - Global Consortia of Telecommunications Operators. Many of the largest
       PTOs and international carriers have pooled resources and formed
       consortia in order to compete more effectively in important
       telecommunications markets such as those in Western Europe particularly
       outside their home markets. Prior to liberalization of the provision of
       switched voice services in Western European markets, one of the primary
       objectives of these consortia is to provide non-reserved pan- European
       services to multinational business customers, including X.25/frame relay
       (high speed data network) service and closed-user group voice services.
       Under the current regulatory framework, consortia would otherwise be
       required to purchase leased lines at negotiated retail rates, even within
       their home countries. HER believes that it provides an attractive
       alternative at better pricing in those environments where such a
       consortium does not already own its infrastructure. Furthermore, HER
       believes that it is well positioned to provide cross-border connectivity
       between different domestic infrastructures of these alliances.
 
     - International Carriers. This customer segment consists of non-European
       carriers with traffic between European and other international gateways.
       Such carriers include Teleglobe, GTS-Monaco Access and eventually the
       U.S. Regional Bell Operating Companies. HER can provide these customers a
       pan-European distribution network to gather and deliver traffic to and
       from their own and other hubs.
 
     - Alternative Carriers. This segment consists of second carriers, cable TV
       and mobile carriers and competitive access providers. These new carriers
       have chosen to compete with the incumbent PTOs in their respective
       countries, and the Company believes that they would look favorably to an
       alternative such as HER. HER believes that this segment will sustain the
       largest growth as competition emerges in Europe. HER also believes that
       non-PTO competitors in Europe will prefer to use a non-PTO alternative
       like HER to meet their cross-border telecommunication transport needs.
 
     - Internet Backbone Networks. Internet backbone networks are a fast
       emerging segment and are expected to generate significant requirements
       for the services HER offers. These require large capacity international
       connectivity services between Internet nodes (point of interconnection
       between local Internet service providers) in all local European markets.
       The Internet segment is experiencing significant growth in demand for
       transmission capacity.
 
     - Resellers. Resellers are carriers that do not own transmission
       facilities, but obtain communications services from another carrier for
       resale to the public. Resellers are also a growing segment of the market
       and are expected to increase in conjunction with the liberalization of
       the European telecommunications market. In the U.S., for example,
       resellers were a significant factor in the expansion of competition.
 
     - VANs and other Service Providers. VANs are data communications systems in
       which special service features enhance the basic data transmission
       facilities offered to customers. Many of these networks
                                        7
<PAGE>   10
 
       are targeted to the data transfer requirements of specific international
       customer segments such as airlines and financial institutions. VANs'
       basic network transmission requirement is to connect data switches or
       processors. VANs currently purchase their own international circuits and
       build additional resiliency into their network infrastructure. HER will
       allow them to meet these needs cost-effectively, and to extend their
       services to new markets or customers without substantial capital
       investment.
 
     HER expects that additional demand for alternative service providers will
come from increased usage of dedicated circuits for Internet access, private
lines for the deployment of wide-area networks by large corporations, "single
source" local and long distance services by small and medium-sized businesses
and emerging broad band applications such as cable TV programming distribution
(other than broadcast) to the end user.
 
NETWORK DESIGN
 
     Network Architecture. The network architecture is based on a highly meshed
flat topology which covers a wide geographical area with large distances between
individual network nodes. This architecture allows rerouting of traffic at
electronic speeds in the event of a network failure. This approach also lowers
network cost by enabling each node to be sized to match anticipated traffic
volumes rather than to a standard capacity. Individual nodes can be configured
to connect any trunk to any other in the nodes, thus enabling efficient
transmission of traffic. Each node will be connected to at least two other nodes
enabling rerouting of traffic in the event of a network failure. HER believes
that its network will be the first cross border pan-European network with such
redundancy.
 
     The HER network has been designed to be controlled by a single network
management center and supported by advanced operational support systems. A
centralized network center can pinpoint overloaded pathways or malfunctioning
circuitry and reroute traffic much more quickly than networks controlled by
separate network centers operated by PTOs in different countries. HER primarily
uses Alcatel for the supply of transmission equipment and network management
systems. HER's advanced operational support systems allow it to correct network
failures and isolate equipment faults with greater speed and at a lower cost
than is the case with heterogeneous multi-operator networks. Critical elements
of the network, including network maintenance and control systems, are designed
with redundancy in order to ensure a high quality of service. The network design
has several important resilience features including: multiple paths to each
node, built-in hardware redundancy and redundant power supplies. For all network
routings, there will be at least two paths. Should service failure occur on one
route, the network is designed to automatically re-route traffic to another
route. HER believes that these techniques will result in performance of 99.98
percent or better for premium service customers for most routes.
 
     HER expects to operate the entire network and to own substantially all of
the network equipment as well as some segments of the fiber optic cable. A
substantial part of the fiber is leased on a long-term basis. Long-term leases
for fiber are advantageous to HER because they reduce the capital expense burden
of building large quantities of capacity before they can be used. Where HER
leases dark fiber, the infrastructure provider will generally be responsible for
maintaining such fiber optic cable. HER will enter into agreements with Alcatel
and infrastructure providers and other third parties to supply and/or maintain
the equipment for the HER network.
 
     Considerations Pertaining to Technology of the Network. The
telecommunications industry is subject to rapid and significant changes in
technology and such technological advances may reduce the relative effectiveness
of existing technology and equipment. The Company obtains telecommunications
equipment from a number of vendors, upon whom it is dependent for the adaptation
of such equipment to meet varying local telecommunications standards. The cost
of implementation of emerging and future technologies could be significant.
There can be no assurance that the Company will maintain competitive services or
that the Company will obtain appropriate new technology on a timely basis or on
satisfactory terms. Any failure by the Company to maintain competitive services
or obtain new technologies could have a material adverse effect on the Company's
business, financial condition and results of operations.
 
                                        8
<PAGE>   11
 
     Development and operation of the HER network are also subject to certain
technological risks. The network has been designed to utilize SDH technology.
While SDH represents an advanced, new transmission technology, HER's ability to
upgrade technology from this platform may be important in establishing and/or
maintaining a cost advantage over competitive carriers. There can be no
assurance that the HER network will achieve the technical specifications for
which it was designed or that HER will be able to upgrade the network as
technological improvements in telecommunications equipment are introduced.
Failure to achieve current specifications for, or future upgrades of, the
network may materially and adversely affect the viability of the HER network and
could have a material adverse effect on the business and prospects of the
Company.
 
     Network Capacity. The network will consist of Synchronous Digital Hierarchy
("SDH") STM-16 links managed by equipment and operating centers owned by HER and
running on dark fiber leased from infrastructure providers or built by HER on
leased rights of way. Each line system and multiplexer works initially at the
2.5 Gbps (STM-16) level. The most important types of equipment used or to be
used in this network are Add- Drop Multiplexors ("ADMs") and regenerators and a
variety of optical amplifiers for boosting optical signals. The STM-16 links are
expected, where needed, to be upgraded to STM-64. Furthermore, fibers will be
multiplexed using WDM, also as required. Additional capacity can be achieved by
adding new fiber accesses to a given city over alternative routes, thereby
achieving more meshing and the resulting improved network availability.
 
     Network Agreements. HER has entered into agreements and letters of intent
with various infrastructure providers for construction and/or dark fiber lease
of portions of the HER network. HER's agreements for leases of portions of the
network typically required the infrastructure provider to provide a certain
number of pairs of dark fiber and node and/or regenerator sites along the
network route commencing on certain dates provided by HER. The term of a lease
agreement typically ranges from 10 to 18 years. An agreement typically contains
optical specification standards for the fiber and methods of testing. HER is
allowed to use the cable for the transmission of messages and in other ways,
including increasing capacity. The infrastructure provider also provides space
for the location of equipment and spare parts and guarantees the provision of
power and other utilities together with environmental controls and security to
ensure the proper functioning of the equipment. The infrastructure provider is
typically responsible for maintenance of the cable and the provision of first
line maintenance to equipment and permits HER access to such facilities. Access
arrangements to the nodes are also provided so that connection may be made to
HER customers or to the rest of the network. An agreement also provides for an
annual price for the provision of fiber and for the facilities and maintenance.
The agreements typically provide for termination by the parties only for
material breach, with a 90 day minimum cure period. The agreements typically
contain a transition period after termination of the agreement to allow HER to
continue to serve its customers until it can reach agreement with an alternative
infrastructure provider.
 
     Local Access. Access to the HER network will be provided to clients through
SDH access lines including at the STM-1 or STM-4 level. However, customers who
continue to use the older PDH technology may also access the HER network. In
each city, as a HER point of presence is deployed, HER may contract with a local
access network supplier for "last mile" services to customer locations. HER will
not invest in building local access infrastructure but such connectivity can be
supplied on a case-by-case basis via preferred local access partner
arrangements. Currently Telfort in the Netherlands and Belgacom in Belgium are
providing local access to the operating Amsterdam-Brussels route. In London and
Paris, HER has contracted with local access providers to connect the HER network
to intra-city networks in those cities. Pursuant to this agreement, HER can
offer its carrier customers local connectivity in those cities. Various Local
Access Network Suppliers may also be interested in HER for the purpose of
linking the business centers in which they are active. Therefore, the Company
believes that the relationships between HER and local access network suppliers
can benefit both parties.
 
                                        9
<PAGE>   12
 
     Network Routes. HER's planning dates for operation in certain cities and
kilometers covered by the initial network in the first five countries and
Switzerland are set forth below.
 
Expected to be operational as of:
 
April 30, 1998 -- Brussels, Antwerp, Rotterdam, Amsterdam, London, Paris,
Strasbourg, Frankfurt, Zurich and Geneva -- covering approximately 3,000
kilometers.
 
June 30, 1998 -- Above cities and Dusseldorf, Stuttgart and Munich -- covering
approximately 3,800 kilometers.
 
     HER expects to have an aggregate of approximately 10,000 kilometers
completed at the end of 1998 and the entire 18,000 kilometer network completed
by the year 2000. Hermes also plans to lease capacity on a transatlantic cable
linking the European network with North America in 1999.
 
     The routes planned to be operational in the second quarter of 1998 are
currently under construction. "Under construction" means that with respect to
each of the segments that make up each of these routes, one of the following is
occurring: (i) HER has contracted to build or is contracting to build the fiber
optic cable segment, and (ii) HER has leased or will lease such segment of dark
fiber optic cable from a third party who has built or is currently building such
segment. The dates set forth above may be subject to delays due to a variety of
factors, many of which are beyond the control of the Company.
 
     HER is deploying the network along the rights-of-way of a variety of
alternative sources, including railways, motorways, waterways, pipelines and
utilities. The rights-of-way of HER-built portions of the network will be
provided pursuant to long-term leases or other arrangements entered into with
railways, highway commissions, pipeline owners, utilities or others. It is the
policy of HER to evaluate multiple alternative infrastructure suppliers in order
to maximize flexibility. As a result of its network development activities to
date, HER has gained access to infrastructure for its network routes which, in
certain cases, HER believes will be difficult for its competitors to duplicate.
 
COMPETITION
 
     The European and international telecommunications industries are
competitive. HER's success depends upon its ability to compete with a variety of
other telecommunications providers offering or seeking to offer cross-border
services, including (i) the respective PTO in each country in which HER operates
and (ii) global alliances among some of the world's largest telecommunications
carriers. HER expects that some of these potential competitors may also become
its customers. HER believes that the ongoing liberalization of the European
telecommunications market will attract New Entrants to the market and increase
the intensity of competition. Competitors in the market compete primarily on the
basis of price and quality. HER intends to focus on these factors and on service
innovation as well. HER business plan anticipates substantial head-to-head
competition as well as indirect competition.
 
     WorldCom, Inc. ("WorldCom") recently announced plans to construct a
pan-European fiber network, the first phase of which is expected to connect
London, Amsterdam, Frankfurt, Brussels and Paris by early 1998. Although the
Company believes that the proposed WorldCom pan-European network is primarily
intended to carry WorldCom traffic, WorldCom has stated that any excess capacity
on such network will be used to provide a competitive carrier's carrier service.
 
     Viatel, Inc. ("Viatel") also recently announced its intention to build a
pan-European fiber optic network connecting select cities in Belgium, France,
the Netherlands and the United Kingdom. Excess capacity would be available for
other carriers. Viatel has stated that, assuming that it obtains necessary
financing, construction would begin in spring 1998 and the network would become
operational in 1999.
 
     In addition, Esprit Telecom Group plc also recently announced plans to
construct an SDH fiber optic ring network that will connect the United Kingdom,
France, the Netherlands and Belgium.
 
     HER also competes with respect to its "point-to-point" transborder service
offering against circuits currently provided by PTOs through International
Private Leased Circuits. In addition, the liberalization of
 
                                       10
<PAGE>   13
 
the European telecommunications market is likely to attract additional entrants
to both the "point-to-point" and other telecommunications markets.
 
     If HER's competitors, many of whom possess greater technical, financial and
other resources than HER, devote significant resources to the provision of
pan-European, cross-border telecommunications transport services to carriers,
such action could have a material adverse effect on HER's business, financial
condition and results of operations. There can be no assurance that HER will be
able to compete successfully against such new or existing competitors.
 
HER RECAPITALIZATION
 
     During 1997, HER completed a recapitalization (the "HER Recapitalization"),
wherein HER extended rights to subscribe to additional shares of HER to
GTS-Hermes, HIT Rail and the eleven railways comprising the HIT Rail consortium.
Pursuant thereto, GTS-Hermes and two of the eleven railways that comprise the
HIT Rail consortium have exercised their subscription rights, while HIT Rail and
the other nine railways have declined to exercise their subscription rights. HER
has issued (i) 150,592 shares to GTS-Hermes in exchange for the conversion of
loans and additional consideration, (ii) 24,007 shares to HIT Rail in exchange
for the conversion of loans, (iii) 11,424 shares to Societe Nationale des
Chemins de Fer Belges S.A. de Droit Public/Nationale Maatschappij der Belgische
Spoorwegen N.V. Van Publiek Recht (the Belgian national railway) ("SNCB/NMBS")
and (iv) 4,365 shares to AB Swed Carrier (a wholly owned subsidiary of SJ, the
Swedish national railway). As a result, GTS-Hermes owns 79.1%, HIT Rail owns
approximately 12.6%, SNCB/NMBS owns 6.0% and AB Swed Carrier owns 2.3% of the
issued HER shares. Pursuant to the HER Recapitalization, HER, GTS-Hermes, HIT
Rail, SNCB/NMBS and AB Swed Carrier have executed a new Shareholders Agreement,
the principal terms of which are set forth below. In March 1998, HIT Rail sold
all its shares in HER to GTS-Hermes, SNCB/NMBS and AB Swed Carrier. As a result
of such sale, GTS-Hermes, SNCB/NMBS and Swed Carrier currently own 170,307,
13,610, and 6,551 shares of HER, respectively, or 89.42%, 7.15%, and 3.44%,
respectively, of HER.
 
     Under the new Shareholders Agreement, actions to be taken by shareholders
will be adopted by a simple majority vote with the exception of certain actions
which will require at least 85% of the votes cast: (i) purchase by HER of its
own shares and any redemption thereof, (ii) exclusion of preemptive rights in
the case of the issuance of new shares and the transfer of shares held by HER,
except in the event of a public listing of the shares or of new shares or of an
offering of shares or options on new shares (warrants) to professional investors
in order to obtain further funding, (iii) winding up or dissolution of HER, (iv)
any amendment to the articles of association other than those pertaining to
increases in the authorized capital of HER or to convert HER into an N.V.
("Naamloze Vennootschap") to enable a public listing of shares or new shares,
(v) any amendment to the scope of HER's business, (vi) the declaration of
dividends and (vii) the admission of new shareholders to the Shareholders
Agreement. In addition, the Shareholders Agreement provides that (a) if
GTS-Hermes is the owner of at least 50% of the issued shares, then it will have
the right to make a binding nomination for the appointment of half of the
members of the Board of Supervisory Directors or (b) if GTS-Hermes is the owner
of at least two-thirds of the issued shares, then it will have the right to make
a binding nomination for the appointment of half of the members of the Board of
Supervisory Directors plus one member more, appointed pursuant to nominations by
all other shareholders. As long as HIT Rail is the owner of at least one share,
HIT Rail will be entitled to make a binding nomination for the appointment of at
least one member of the Supervisory Board. The Shareholders Agreement also
provides that shareholders who participated in the capital restructuring other
than GTS-Hermes and HIT Rail with a shareholding of at least 6.8% subject to
adjustment in the discretion of the other shareholders will be entitled to make
a binding nomination for the appointment of one member of the Board of
Supervisory Directors. Shareholders who participated in the capital
restructuring other than GTS-Hermes and HIT Rail who hold fewer than 6.8% of the
issued share capital of HER will be entitled on a rotating basis to make one
binding nomination for the appointment of a member of the Board of Supervisory
Directors for two-year periods. As a result of the March 1998, sale by HIT Rail
of all its shares, HIT Rail no longer has any rights or obligations, except as
set forth below, under the Shareholders Agreement and GTS-Hermes, acting alone,
can approve all the matters described above which require an 85% HER shareholder
vote.
 
                                       11
<PAGE>   14
 
  Articles of Association and Shareholders Agreement
 
     Under the Articles of Association and the Shareholders Agreement, HER's
shareholders have preemptive rights in connection with issuances of ordinary
shares and options on shares to be issued in proportion to the total nominal
value of the shares held by each of them. Preemptive rights can be exercised for
four weeks after the date the notice of the offer is received by the
shareholders.
 
     The Shareholders Agreement provides that HER or its designated vendor will
provide fiber capacity in its network for use by the shareholders of HER on fair
commercial terms, use, quantity and price to be negotiated on a bilateral basis.
In the Shareholders Agreement, HIT Rail has covenanted to (i) use its best
efforts to establish such commercial agreements between individual HIT Rail
shareholders and HER, to obtain rights of way from individual HIT Rail
shareholders and to cooperate in obtaining such licenses as may advance the
business of HER, (ii) use its best efforts to ensure that the HIT Rail
shareholders cooperate in obtaining such license in accordance with the business
plan of HER and as may be necessary or advisable in furtherance of HER's
business, (iii) will not, so long as both HIT Rail and GTS-Hermes are
shareholders of HER and for one year after HIT Rail ceases to be a shareholder,
agree with any entity other than GTS-Hermes or HER to assist or cooperate in the
development of any pan-European telecommunications operator and (iv) use its
best efforts to obtain on HER's behalf such materials as may be required and
arrange inspection visits of selected rights of way for the purpose of making
initial cost estimates.
 
     The foregoing summary of the Shareholders Agreement does not purport to be
complete and is qualified in its entirety by reference to the Shareholders
Agreement, which is an Exhibit to this Report.
 
LICENSES AND REGULATORY ISSUES
 
     A summary discussion of the regulatory framework in the countries of the
network in the first five countries and the next five countries into which HER
expects to develop the network is set forth below. This discussion is intended
to provide a general outline, rather than a comprehensive discussion, of the
more relevant regulations and current regulatory posture of the various
jurisdictions.
 
     National authorities in individual member states of the EU are responsible
for regulating the operation (and in some cases the construction) of
telecommunications infrastructure. HER believes that the adoption of the Full
Competition Directive and the various related Directives adopted by the European
Parliament and the Council of the EU have resulted in the removal of most
regulatory barriers to the operation of telecommunications infrastructure in the
countries of the initial network in the first five countries.
 
     HER requires licenses, authorizations or registrations in all countries to
operate the network. There can be no assurance that HER will be able to obtain
such licenses, authorizations or registrations or that HER's operations will not
become subject to other regulatory, authorization or registration requirements
in the countries in which it plans to operate. Licenses, authorizations or
registrations have been obtained in the United Kingdom, the Netherlands,
Belgium, France and Germany and a trial concession has been granted in
Switzerland. HER intends to file applications in other countries in anticipation
of service launch in accordance with the network roll-out plan.
 
     On June 28, 1990, the European Commission, in an effort to promote
competition and efficiency in the European Union, issued a directive (the "1990
Directive") requiring EU member states to immediately liberalize all
telecommunication services with the exception of voice telephony to the general
public (basic voice services provided over the public switched voice network).
This step liberalized value added services and voice services over corporate
networks and/or "closed user groups," although the exact definitions of the
terms used in the 1990 Directive were not altogether clear.
 
     On July 22, 1993, the Council of EU agreed that all voice telephony
services in EU member states should be liberalized by January 1, 1998 subject to
additional transitional periods of up to five years to allow member states with
less developed networks to achieve the necessary adjustments. It was agreed that
such exemptions would be granted to Spain, Ireland, Greece and Portugal, subject
to formal application and satisfaction of certain requirements. Luxembourg,
because of the small size of its market, would be eligible for a special
transitional period of up to two years.
                                       12
<PAGE>   15
 
     In April 1995, a communication from the European Commission sought to
clarify the types of services that were liberalized by the 1990 Directive,
stating that the burden of proof as to why a service should be considered
"reserved" and therefore not open to competition should be upon the PTOs and the
regulatory authorities of member states. Along with this statement came the
threat of formal procedures under the Treaty of Rome against member states that
do not implement the 1990 Directive "within a reasonable time." Procedures have
been brought so far against Italy, Greece, Germany and Spain for failing to
apply the requirements of the 1990 Directive.
 
     On March 13, 1996, the European Commission adopted the Full Competition
Directive extending the 1990 Directive to all services, requiring that licensing
procedures for these services be transparent and non-discriminatory, requiring
member states to fully liberalize alternative infrastructure to allow a
competitive market for "non-reserved" services such as data, value added
services and non-public (closed-user group) switched voice services by July 1,
1996 and mandating open competition in all public telecommunications services,
including voice telephony to the general public, by January 1, 1998 (except for
countries to which grace periods were granted in accordance with the 1993
Council Resolution).
 
     On April 10, 1997, the European Parliament and the Council of Ministers
adopted a Directive on a common framework for general authorizations and
individual licenses in the field of telecommunications services, including
networks. Licenses must be awarded through open, non-discriminatory and
transparent procedures and applications will be required to be dealt with in a
timely fashion. The number of licenses may only be restricted to the extent
required to ensure the efficient use of radio frequencies or for the time
necessary to make available sufficient numbers in accordance with EC law.
 
     HER believes that many European countries have revised telecommunications
regulations to comply with the 1990 Directive and the Full Competition Directive
and that such changes will enhance HER's ability to obtain other necessary
regulatory approvals for its operations.
 
     As a multinational telecommunications company, HER is subject to varying
degrees of regulation in each of the jurisdictions in which it provides its
services. Local laws and regulations and the interpretation of such laws and
regulations, differ significantly among the jurisdictions in which HER operates.
There can be no assurance that future regulatory, judicial and legislative
changes will not have a material adverse effect on HER, that domestic or
international regulators or third parties will not raise material issues with
regard to HER's compliance or noncompliance with applicable regulations or that
regulatory activities will not have a material adverse effect on HER. The
Company has had favorable experience obtaining, maintaining and renewing
licenses in the past. However, there can be no assurance that HER will be able
to obtain, maintain or renew licenses to provide the services it currently
provides and plans to provide, that such licenses will be issued or renewed on
terms or with fees that are commercially viable, or that licenses required by
future ventures can be obtained by the Company or its partners. The loss of or a
substantial limitation upon the terms of these telecommunications licenses could
have a material adverse effect on the Company.
 
     A substantial portion of HER's strategy is based upon the timely
implementation of regulatory liberalization of EU telecommunications market on
January 1, 1998 under existing European Community ("EC") directives. Although EU
member states have a legal obligation to liberalize their markets in accordance
with their requirements, certain more detailed aspects of the EU regulatory
framework to apply in the liberalized environment after January 1, 1998 still
remain to be adopted. In addition, Ireland, Portugal, Spain, Luxembourg and
Greece have been granted extensions from the January 1, 1998 deadline. There can
be no assurance that each EU member state will proceed with the expected
liberalization on schedule, or at all, or that the trend toward liberalization
will not be stopped or reversed in any of the countries. Accordingly, HER faces
the risk that it will establish the HER network and make capital expenditures in
a given country in anticipation of regulatory liberalization which does not
subsequently occur.
 
     In order to give effect to EC directives in each member state, national
governments must pass legislation liberalizing their respective markets. This
applies not only to the liberalization requirements set out in existing EC
directives, but also to requirements set out in directives which have yet to be
adopted. The implementation of EC directives in the telecommunications sector
has been inconsistent or ambiguous in some EU member states. Such implementation
could limit, constrain or otherwise adversely affect HER's ability to provide
                                       13
<PAGE>   16
 
certain services. Furthermore, national governments may not necessarily pass
legislation implementing an EC directive in the form required, or at all, or may
pass such legislation only after a significant delay. Even if a national
legislature enacts appropriate regulation within the time frame established by
the EU, there may be significant resistance to the implementation of such
legislation from PTOs, regulators, trade unions and other sources. Further,
HER's provision of services in Europe may be materially adversely affected if
any EU member state imposes greater restrictions on non-EU international
services than on international services within the EU. These and other potential
obstacles to liberalization could have a material adverse effect on HER's
operations by preventing HER from establishing its network as currently
intended, as well as a material adverse effect on the Company.
 
     The regulatory framework in certain jurisdictions in which HER provides its
services is briefly described below.
 
  United Kingdom
 
     Since the elimination in 1991 of the United Kingdom telecommunications
duopoly consisting of British Telecommunications and Mercury, it has been the
stated goal of Oftel, the United Kingdom telecommunications regulatory
authority, to create a competitive marketplace from which detailed regulation
could eventually be withdrawn. The United Kingdom has already liberalized its
market beyond the requirements of the Full Competition Directive, and most
restrictions on competition have been removed in practice as well as in law. HER
has received a license from the Secretary of State for Trade and Industry which
grants it the right to run a telecommunications system or systems in the United
Kingdom connected to an overseas telecommunications system and to provide
international services over such systems. Like the licenses granted to other
providers of international facilities-based services, the license granted to HER
on December 18, 1996 was for an initial six months' duration and thereafter is
subject to revocation on one month's notice in writing. The short duration of
these initial licenses was adopted for administrative convenience on the
opening-up of the United Kingdom market for international facilities-based
services. The Department of Trade and Industry ("DTI") has confirmed that it
intends to replace the initial licenses with new licenses and that it would not
normally expect to revoke an initial license without replacing it with another
license giving an equivalent authorization. The DTI is currently discussing with
license holders the arrangements to put these new licenses into effect and
although the DTI has indicated that the new licenses are expected to be of 25
years duration, there can be no certainty that this will be the case or that the
new licenses will not contain terms or conditions unfavorable to HER.
 
  The Netherlands
 
     On July 1, 1997 the Dutch government abolished the prohibition on the use
of fixed infrastructure for the provision of public voice telephony, thereby
complying with the requirements of the Full Competition Directive six months
ahead of schedule. On August 1, 1996, HER was granted a license for the
installation, maintenance and use of a fixed telecommunications infrastructure.
 
     An entirely new Telecommunications Bill was introduced to the Second
Chamber (the House of Representatives) of the Parliament on September 15, 1997.
The new Telecommunications Act is intended to confirm the full liberalization of
the telecommunications market according to European Community standards. It is
not expected that the new Telecommunications Act will detrimentally affect the
conduct of business by HER.
 
  Belgium
 
     Belgium has implemented the "alternative infrastructure" provider provision
of the Full Competition Directive. The decision-making process regarding the
adoption of the full package of liberalization legislation (including licensing
regimes for voice telephony and public network infrastructure) is in the final
stages and is anticipated to be completed by mid - 1998.] Given the fact that
the implementation of the EC Directives is late, the Belgian authorities have
made public that they will work during the first months of 1998 with a system of
provisional licenses. HER has obtained, through a wholly-owned subsidiary, a
license from the
 
                                       14
<PAGE>   17
 
Belgian regulatory authority to provide liberalized services using alternative
infrastructure and is currently operating under its license in Belgium on the
Brussels-Amsterdam route. HER also has authorization to build infrastructure
between major Belgian population centers and the relevant border crossings. The
liberalization legislation is expected to require all previously licensed
operators to apply for new licenses or authorizations. HER expects that, in such
event, its existing licenses and authorizations would be renewed in due course,
although there can be no assurance that this will be the case.
 
  Germany
 
     Germany has approved legislation to implement the Full Competition
Directive and remove all remaining restrictions on competition from January
1998. HER was granted a license by the German regulatory authorities on July 18,
1997. The license permits HER to operate the portions of the network in Germany
connecting Dusseldorf, Frankfurt and Stuttgart; Dusseldorf to the Dutch border;
and Stuttgart to the French and Swiss borders. HER expects to extend its license
in Germany as appropriate in order to enable it to operate the remaining
portions of the network in Germany.
 
  France
 
     A new regulatory agency, the Autorite de Regulation des Telecommunications
("ART"), was established in France effective January 1, 1997. In 1996, France
approved legislation to implement the Full Competition Directive and to remove
all remaining restrictions on competition from January 1998. HER applied for an
authorization to operate its network in specific regions of France, which was
approved on October 22, 1997. In October 1997, HER obtained authorization to
operate its network in specific regions of France. Such authorization requires
prior notification to and approval of the ART of any substantial changes in the
capital of HER or its controlling shareholder. HER intends has notified ART of
the initial public offering of GTS's common stock and intends to notify the ART
of the March 1998 increase to approximately 89% of GTS-Hermes' ownership in HER.
 
  Switzerland
 
     The Swiss Parliament has recently passed a new Telecommunications Law which
will enter into force on January 1, 1998. Although Switzerland is not a Member
State of the EU, the effect of the law is largely to mirror the EC
telecommunications liberalization Directives and therefore from that date
existing voice telephony monopoly will be abolished and such services will be
fully liberalized. An independent national regulatory authority has previously
been established. HER obtained a trial concession on October 30, 1997, in order
to roll out its network and to provide its services in advance of the full
liberalization coming into effect on January 1, 1998. This concession expired on
December 31, 1997. HER has filed an application for a concession for the
operation of a telecommunications infrastructure and was granted a provisional
concession on March 16, 1998. The provisional concession takes retroactive
effect as of January 1, 1998 and HER expects that the Swiss regulatory authority
will grant HER a final concession by the end of the third quarter 1998. However,
no assurance can be given that such new concession will be granted or granted on
terms acceptable to HER.
 
  Italy
 
     Although in the past Italy has been dilatory in implementing EC
liberalization measures, Italy enacted legislation on July 31, 1997 which
substantially completes the liberalization of services in accordance with the
Full Competition Directive. The Parliament has also approved the creation of an
independent national regulatory authority for the telecommunications and
audiovisual sectors. The most recent EC liberalization Directives relating to
licensing and interconnection has been implemented. HER intends to apply for a
license to provide its services in due course.
 
                                       15
<PAGE>   18
 
  Spain
 
     Under the Full Competition Directive Spain was granted the right to request
a delay of up to five years in liberalizing fully its telecommunications market.
However, the Spanish government and the European Commission have agreed that
full liberalization should take place on December 1, 1998. In order to ensure
effective liberalization from that date, the Commission Decision granting the
eleven month extension sets out a timetable of interim measures leading up to
full liberalization. These measures include the passing of legislation
authorizing regional cable operators to provide telecommunications services and
the adoption of a new General Telecommunications Bill effectively transposing EC
Directives into Spanish law. Further RETEVISION, S.A. has been granted a second
national operator's license to compete with the national PTO and Spain has
agreed to grant a third national operator license in early 1998. HER intends to
apply for a license to provide its services in due course.
 
  Sweden
 
     Full liberalization of the Swedish telecommunications market occurred in
1993. A new Telecommunications Act was passed this year to reinforce the powers
of the national regulatory authority, to ensure conformity with EC Directives
and to supplement the pre-existing licensing regime with a general authorization
regime for services other than telephony services, mobile services and leased
lines. HER intends to register to provide its services in due course.
 
  Denmark
 
     With the liberalization of infrastructure from July 1, 1997 Denmark has
fully liberalized its telecommunications markets in accordance with the
requirements of the relevant EC Directives. An independent national regulatory
authority has been established. According to the Danish rules, HER will not
require any regulatory approval in order to install or operate the network in
Denmark.
 
     In addition, to the discussion above, HER intends to file applications in
other countries in anticipation of service launch in accordance with the HER
network roll-out plan. The terms and conditions of HER's licenses,
authorizations or registrations may limit or otherwise affect HER's scope of
operations. There can be no assurance that HER will be able to obtain, maintain
or renew licenses, authorizations or registrations to provide the services it
currently provides and plans to provide, that such licenses, authorizations or
registrations will be issued or renewed on terms or with fees that are
commercially viable, or that the licenses, authorizations or registrations
required in the future can be obtained by HER. The loss of, or failure to
obtain, these licenses, authorizations or registrations or a substantial
limitation upon the terms of these licenses, authorizations or registrations
could have a material adverse effect on HER and the Company.
 
MANAGING RAPID GROWTH
 
     As a result of the Company's past and expected continued growth and
expansion, significant demands have been placed on the Company's management,
operational and financial resources and on its systems and controls. In order to
manage its growth effectively, the Company must continue to implement and
improve its operational and financial systems and controls, purchase and utilize
additional telecommunications facilities and expand, train and manage its
employee base. Inaccuracies in the Company's forecasts of market demand could
result in insufficient or excessive telecommunications facilities and
disproportionate fixed expenses for certain of its operations. There can be no
assurance that the Company will be able to construct and operate the entire HER
network as currently planned, expand with the markets in which its ventures are
currently operating or expand into additional markets at the rate presently
planned by the Company, or that any existing regulatory barriers to such
expansion will be reduced or eliminated. As the Company proceeds with its
development and expansion, there will be additional demands on the Company's
customer support, sales and marketing and administrative resources and network
infrastructure. There can be no assurance that the operating and financial
control systems and infrastructure of the Company and its ventures will be
adequate to maintain and effectively manage future growth. The failure to
continue to upgrade the administrative,
 
                                       16
<PAGE>   19
 
operating and financial control systems or the emergence of unexpected expansion
difficulties could materially and adversely affect the Company's business,
results of operations and financial condition.
 
EMPLOYEES
 
     On December 31, 1997, HER employed a total of 130 persons. The Company
believes its future success will depend on its continued ability to attract and
retain highly skilled and qualified employees. The Company believes that its
relations with its employees are good.
 
     Although HER's employees are not unionized, unions represent employees of
the Company's railroad partners in HER. Under the agreements contemplated
between HER and its railroad partners, some of these employees will be required
to construct and maintain certain portions of the HER network. There can be no
assurances that unionized employees of HER's partners will not experience labor
unrest.
 
GLOSSARY OF TELECOMMUNICATIONS INDUSTRY TERMS
 
     Accounting Rate Mechanism (ARM) -- The current system of bilateral
settlement agreements between PTOs under which tariffs for cross-border
pan-European-switched voice traffic are determined.
 
     Add-drop multiplexer (ADM) -- A multiplexer which controls cross connect
between individual circuits by software, permitting dynamic cross connect of
individual 64 kbps circuits within an E-1 line.
 
     Asynchronous Transfer Mode (ATM) -- A switching and transmission technology
that is one of general class of packet technologies that relay traffic by way of
an address contained within the first five bits of a switching and transmission
of mixed voice, data, and video at varying rates. The ATM format can be used by
many different information systems, including LANs.
 
     Bps -- Bits per second; the basic measuring unit of speed in a digital
transmission system; the number of bits that a transmission facility can convey
between a sending location and a receiving location in one second.
 
     Backbone -- The through-portions of a transmission network, as opposed to
spurs which branch off the through-portions.
 
     Bandwidth -- The information-carrying capability of a transmission medium
is measured by its bandwidth, which is the relative range of frequencies that
can be passed without distortion by such medium. Bandwidth is measured in Hertz,
but may also be expressed as the number of bits that can be transmitted per
second.
 
     Capacity -- Refers to transmission.
 
     Carrier -- A provider of communications transmission services by fiber,
wire, or radio.
 
     CCIT -- International Telegraph and Telephone Consultative Committee.
 
     Closed User Group -- A group of customers with some affiliation with one
another and which are treated for regulatory purposes as not being the public.
 
     Competitive Local Telecommunications Provider -- A company that provides
its customers with an alternative to the local telephone company for local
transport of private line, special access and transport of switched access
telecommunications services. Competitive Local Telecommunications Providers are
also referred to in the industry as alternative local telecommunications service
providers (ALTS), Competitive Access Providers (CAPs) and Competitive Local
Exchange Carriers (CLECs).
 
     Dark Fiber -- Fiber that lacks the requisite electronic and optronic
equipment necessary to use the fiber for transmission.
 
     Dedicated -- Refers to telecommunications lines dedicated to or reserved
for use by particular customers along predetermined routes (in contrast to
telecommunications lines within the local telephone company's public switched
network).
 
                                       17
<PAGE>   20
 
     Digital -- Describes a method of storing, processing and transmitting
information through the use of distinct electronic or optical pulses that
represent the binary digits 0 and 1. Digital transmission/switching technologies
employ a sequence of discrete, distinct pulses to represent information, as
opposed to the continuously variable analog signal.
 
     E1 -- Data transmission rate of approximately 2 Mbps.
 
     E3 -- Data transmission rate of approximately 34 Mbps.
 
     Enhanced Network Services -- Telecommunications services providing digital
connectivity, primarily for data applications, via frame relay, ATM, or digital
interexchange private line facilities. Enhanced network services also include
applications on such networks, including Internet access and other Internet
services.
 
     Frame Relay -- A wide area transport technology that organizes data into
units called frames instead of providing fixed bandwidth as with private lines.
A high-speed, data-packet switching service used to transmit data between
computers. Frame Relay supports data units of variable lengths at access speeds
ranging from 56 kilobits per second to 1.5 megabits per second. This service is
well-suited for connecting local area networks, but is not presently well-suited
for voice and video applications due to the variable delays which can occur.
Frame Relay was designed to operate at high speeds on modern fiber optic
networks.
 
     Gbps -- Gigabits per second, which is a measurement of speed for digital
signal transmission expressed in billions of bits per second.
 
     GSM -- Global System for Mobile Communications, formerly known as Groupe
Speciale Mobile. GSM began as a pan-European standard for digital cellular
systems. The name was changed to reflect the fact that the standard has been
adopted by several countries in Asia.
 
     Hertz -- The unit for measuring the frequency with which an electromagnetic
signal cycles through the zero-value state between lowest and highest states.
One Hz (Hertz) equals one cycle per second. kHz (kilohertz) stands for thousands
of Hertz; MHz (megahertz) stands for millions of Hertz.
 
     Interconnect -- Connection of a telecommunications device of service to the
PSTN.
 
     Interconnection -- Connection of a piece of telephone equipment to the
telephone network, or a data terminal to a data communications network. Also
refers to the connection of one communications network to another so that users
of one network can communicate with users of another network.
 
     International Simple Resale -- Refers to the wholesale purchase of IPLCs
from facilities-based carriers and the reselling of such capacity to customers
for switched telephone service.
 
     IPLC -- International Private Leased Circuits.
 
     ITU -- International Telecommunications Union; a United Nations treaty
organization whose purpose is to accredit international telecommunications
standards. ITU signatories can turn ITU-approved standards into law through
international treaties such as the treaties governing use of the radio spectrum
for international satellite telecommunications and broadcasting.
 
     Kbps -- Kilobits per second, which is a measurement of speed for digital
signal transmission expressed in thousands of bits per second.
 
     Local Area Network (LAN) -- The interconnection of computers for the
purpose of sharing files, programs and peripheral devices such as printers and
high-speed modems. LANs may include dedicated computers or file servers that
provide a centralized source of shared files and programs. LANs are generally
confined to a single customer's premises and may be extended or interconnected
to other locations through the use of bridges and routers.
 
     Local Loop -- The local loop is that portion of the local telephone network
that connects the customer's premises to the local exchange provider's central
office or switching center. This includes all the facilities starting from the
customer premise interface which connects to the inside wiring and equipment at
the customer premise to a terminating point within the switching wire center.
 
                                       18
<PAGE>   21
 
     Mbps -- Megabits per second, which is a measurement of speed for digital
signal transmission expressed in millions of bits per second.
 
     Multiplexing -- The use of some means to inter-leave narrow-band or
slow-speed data from multiple sources in order to make use of a wide-band or
high-speed channel.
 
     Nodes -- Locations within the network housing electronic equipment and/or
switches which serve as intermediate connection points to send and receive
transmission signals.
 
     Plesiochronous Digital Hierarchy (PDH) -- A method of controlling the
timing between transmission and switching systems that is not synchronized but
rather relies on highly accurate clocks to minimize the slip rates between
switching nodes.
 
     Points of Presence (POPs) -- Locations where a carrier has installed
transmission equipment in a service area that serves as, or relays calls to, a
network switching center of that carrier.
 
     PSTN -- Public switched telecommunications network.
 
     Public Telecommunication Operator (PTO) -- A licensed telecommunications
common carrier.
 
     Redundant Electronics -- Describes a telecommunications facility using two
separate electronic devices to transmit the telecommunications signal so that if
one device malfunctions, the signal may continue without interruption.
 
     Regeneration/amplifier -- Devices which automatically re-transmit or boost
signals on an out-bound circuit.
 
     Route Kilometers -- The number of kilometers along which fiber optic cables
are installed.
 
     Route Mile -- The number of miles along which fiber optic cables are
installed.
 
     STM-1 -- Data transmission rate of approximately 155 Mbps.
 
     STM-4 -- Data transmission rate of approximately 622 Mbps.
 
     STM-16 -- Data transmission of approximately 2,488 Mbps.
 
     STM-64 -- Data transmission rate of approximately 9,952 Mbps.
 
     Switch -- A mechanical or electronic device that opens or closes circuits
or selects the paths or circuits to be used for the transmission of information.
Switching is a process of linking different circuits to create a temporary
transmission path between users.
 
     Synchronous Digital Hierarchy (SDH) -- SDH is a set of standards for
optical communications transmission systems that define optical rates and
formats, signal characteristics, performance, management and maintenance
information to be embedded within the signals and the multiplexing techniques to
be employed in optical communications transmission systems. SDH facilitates the
interoperability of dissimilar vendors' equipment and benefits customers by
minimizing the equipment necessary for telecommunications applications. SDH also
improves the reliability of the local loop connecting customers' premises to the
local exchange provider, historically one of the weakest links in the service
delivery.
 
     Time Divisions Multiplexing (TDM) -- A multiplexing technique allowing
multiple signals to be carried simultaneously on a fiber by allocating resources
on a time interval basis.
 
     Trunk -- A telephone circuit with a switch at both ends. A trunk may
connect two central office switches, or two PBXs, or a PBX and a central office
switch.
 
     Wavelength Division Multiplexing (WDM) -- A multiplexing technique allowing
multiple different signals to be carried simultaneously on a fiber by allocating
resources according to frequency on non-overlapping frequency bands.
 
     X.25 -- A CCITT standard governing the interface between data terminals and
data circuit termination equipment for terminals on packet-switched data
networks.
                                       19
<PAGE>   22
 
ITEM 2. PROPERTIES
 
     The Company leases, under long-term leases, office space to serve as sales
office and/or administrative facilities, including its 14,760 square-foot
headquarters just outside of Brussels, Belgium.
 
     HER leases, under long-term leases, portions of railroad, utility and other
rights-of-way for its fiber-optic routes. HER is creating a fiber optic network
consisting of optical fiber pairs, which are leased under long-term leases, and
technical sites leased under long-term leases.
 
ITEM 3. LEGAL PROCEEDINGS
 
     The Company is not a party to any legal proceedings that it believes will
have a material adverse effect on the Company.
 
ITEM 4. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS
 
     During the fourth quarter, there were not any matters that were submitted
to a vote of the Company's security holders.
 
                                    PART II
 
ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
     As discussed under "Business -- HER Recapitalization," HER's common equity
is privately held and not traded on any United States or foreign exchange or
market.
 
     As of March 31, 1998, the Company's common equity was held by three holders
of record.
 
     The Company has not paid any dividend on its common stock and does not
intend to pay dividends in the foreseeable future. In addition, the indenture
governing the Company's 11 1/2% Senior Notes due 2007 contains restrictions on
the making of restricted payments (in the form of the declaration of certain
dividends or distributions, the purchase, redemption or other acquisition of any
capital stock of the Company, the payments of principal on any Subordinated
Indebtedness, as defined in such indenture, prior to any scheduled payment or
maturity, unless (A) no Default or Event of Default, as defined in the
indenture, shall have occurred and be continuing, (B) the Company is able
immediately after giving effect to such a restricted payment to satisfy an
incurrence of indebtedness test and (C) the aggregate of any restricted payments
do not exceed the Basket, as defined in the indenture. In addition, the Company
and certain operating subsidiaries of the Company may enter into future
financings, the terms of which may include dividend restrictions.
 
     During the year ended December 31, 1997 the Company issued securities which
were not registered under the Securities Act of 1933, as amended (the
"Securities Act") as described under "Business -- HER Recapitalization." In
addition, in August 1997, HER sold $265 million aggregate principal amount of
its 11 1/2% Senior Notes due 2007 (the "Notes") at a purchase price of 100%,
pursuant to a purchase agreement. Donaldson, Lufkin and Jenrette Securities
Corporation, UBS Securities LLC and Lehman Brothers acted as initial purchasers
under such purchase agreement and resold the Notes to a limited number of
qualified institutional buyers as defined in Rule 144A under the Securities Act
and to non-U.S. persons outside the United States. Exemption from registration
was claimed under Rule 144A and Regulation S under the Securities Act.
 
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
 
     The selected consolidated financial data of the Company presented below
under the captions Statement of Operations Data for the years ended December 31,
1994, 1995, 1996 and 1997 and Balance Sheet Data as of December 31, 1995, 1996
and 1997 has been derived from consolidated financial statements of the Company
audited by Ernst & Young Reviseurs d'Entreprises S.C.C. The selected
consolidated financial data of the Company as of December 31, 1994 have been
derived from unaudited financial statements which, in the
                                       20
<PAGE>   23
 
opinion of management, include all adjustments, consisting of only normal
recurring accruals, necessary for a fair presentation of such information for
the unaudited periods. The Company did not declare or pay any cash dividends
during the periods indicated. The following information should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the Company's consolidated financial statements
and notes thereto included elsewhere in this Report.
 
<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31,
                                                     ------------------------------------------
                                                     1994(1)     1995        1996        1997
                                                     -------    -------    --------    --------
                                                                   (IN THOUSANDS)
<S>                                                  <C>        <C>        <C>         <C>
STATEMENT OF OPERATIONS DATA:
  Revenues.........................................  $    --    $    --          48    $  5,373
  Operating costs and expenses:
     Cost of revenues..............................       --         --       4,694       9,972
     Selling, general and administrative...........      183      6,637      10,552      18,493
  Loss from operations.............................     (183)    (6,637)    (15,198)    (23,092)
  Other income/(expense):
     Interest income...............................       18        125         508       6,596
     Interest expense..............................       --         (9)       (153)    (12,826)
     Foreign currency (losses) gains...............      (55)        19      (1,126)       (367)
  Net loss.........................................  $  (220)   $(6,502)   $(15,969)   $(29,689)
</TABLE>
 
<TABLE>
<CAPTION>
                                                                AS OF DECEMBER 31,
                                                    ------------------------------------------
                                                     1994      1995        1996        1997
                                                    ------    -------    --------    ---------
                                                                  (IN THOUSANDS)
<S>                                                 <C>       <C>        <C>         <C>
BALANCE SHEET DATA:
  Total current assets............................  $  908    $ 6,430    $  7,528      249,325
  Property and equipment, net.....................      47      4,671      20,303      204,944
  Total assets....................................     955     11,101      27,831      495,850
  Total current liabilities.......................      90      6,785      11,915       61,980
  Long-term debt, less current portion............      --         10         499      265,383
  Long-term portion of capital lease
     obligations..................................      --         --          --      117,645
  Total liabilities...............................      90      6,795      12,414      445,008
  Shareholders' loans.............................      --      8,353      34,863           --
  Shareholders' equity............................     866     (4,047)    (19,446)      50,842
OTHER DATA (IN THOUSANDS):
  EBITDA(2).......................................    (233)    (6,607)    (15,666)     (19,704)
  Net cash used in operating activities...........    (167)    (2,655)    (11,540)      (4,417)
  Net cash used in investing activities...........     (52)    (4,405)    (20,781)    (107,466)
  Net cash provided by financing activities.......   1,028     11,644      28,924      317,500
</TABLE>
 
---------------
 
(1) Although the Company was formed on July 6, 1993, the Company had no
    operations prior to 1994.
 
(2) EBITDA is earnings (loss) from operations before interest, taxes,
    depreciation and amortization. EBITDA is a measure of a company's
    performance commonly used in the telecommunications industry, but should not
    be construed as an alternative to net income (loss) determined in accordance
    with GAAP as an indicator of operating performance or as an alternative to
    cash from operating activities determined in accordance with GAAP as a
    measure of liquidity.
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS
 
     The following is a discussion of the financial condition and results of
operations of the Company as of December 31, 1997, 1996 and 1995 and for the
years ended December 31, 1997, 1996, and 1995. The following discussion should
be read in conjunction with the Company's Consolidated Financial Statements and
the notes related thereto.
 
                                       21
<PAGE>   24
 
SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS
 
     Certain statements contained in "Management's Discussion and Analysis of
Financial Condition and Results of Operations" including, without limitation,
those concerning (i) projected traffic volume, (ii) future revenues and costs
and (iii) changes in the Company's competitive environment, contain
forward-looking statements concerning the Company's operations, economic
performance and financial condition. Because such statements involve risks and
uncertainties, actual results may differ materially from those expressed or
implied by such forward-looking statements.
 
     In addition, any statements that express, or involve discussions as to,
expectations, beliefs, plans, objectives, assumptions or future events or
performance (often, but not always, through the use of words or phrases such as
"will likely result," "are expected to," "will continue," "is anticipated,"
"estimated," "intends," "plans," "projection" and "outlook") are not historical
facts and may be forward-looking and, accordingly, such statements involve
estimates, assumptions and uncertainties which could cause actual results to
differ materially from those expressed in the forward-looking statements.
Accordingly, any such statements are qualified in their entirety by reference
to, and are accompanied by, the factors discussed throughout this Report. Among
the key factors that have a direct bearing on the Company's results of
operations are the potential risk of delay in implementing the Company's
business plan; the political, economic and legal aspects of the markets in which
the Company operates; competition and the Company's need for additional
substantial financing. These and other factors are discussed herein under
"Business," "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and elsewhere in this Report.
 
     The factors described in this Report could cause actual results or outcomes
to differ materially from those expressed in any forward-looking statements of
the Company made by or on behalf of the Company, and investors, therefore,
should not place undue reliance on any such forward-looking statements. Further,
any forward-looking statement speaks only as of the date on which such statement
is made, and the Company undertakes no obligation to update any forward-looking
statement or statements to reflect events or circumstances after the date on
which such statement is made or to reflect the occurrence of unanticipated
events. New factors may emerge from time to time, and it is not possible for
management to predict all of such factors. Further, management cannot assess the
impact of each such factor on the Company's business or the extent to which any
factor, or combination of factors, may cause actual results to differ materially
from those contained in any forward-looking statements.
 
OVERVIEW
 
     The Company is developing and operating the initial segments of a
pan-European high capacity fiber optic network and has been delivering services
to customers since November 1996 when the Brussels-Amsterdam route came into
operation. During the last quarter of 1997, the cities of London and Paris were
added to the network and came into commercial operation.
 
RESULTS OF OPERATIONS
 
     Revenue. The Company's consolidated revenues for the year ended December
31, 1997 were $5.4 million. The revenues for the year ended December 31, 1996
were minimal and there were no revenues for the year ended December 31, 1995.
The Company's first route, Brussels-Amsterdam, began to generate revenues in the
fourth quarter of 1996 and in the fourth quarter of 1997, the
Amsterdam-London-Paris routes came into operation and began to generate
revenues.
 
     Cost of Revenue. The Company's cost of revenues for the years ended
December 31, 1997 and 1996 were $10.0 million and $4.7 million, respectively. In
1995, the Company had no cost of revenue. The increase in cost of revenues in
1997 as compared with 1996 was associated with the costs related to operating
and maintaining the network routes, local access costs, and the depreciation of
the in-service network.
 
     Gross Margin. The Company had a negative gross margin of $(4.6) million for
both of the years ended December 31, 1997 and 1996. There were no gross margins
for the year ended December 31, 1995. The
 
                                       22
<PAGE>   25
 
growth in the Company's revenues in 1997 as compared to 1996 was fully offset by
its increase in cost of revenues during the same period.
 
     Selling, General and Administrative Expenses. Selling, general and
administrative expenses for the years ended December 31, 1997, 1996, and 1995
were $18.5 million, $10.6 million and $6.6 million, respectively. The increase
since 1995 in selling, general and administrative expenses is reflective of the
growth of the Company's business operations and support personnel. The Company
had 130 employees as of December 31, 1997 as compared to 101 employees as of
December 31, 1996 and 29 employees as of December 31, 1995.
 
     Interest. Interest expense for the years ended December 31, 1997 and 1996
was $12.8 million and $0.2 million, respectively. Interest expense was minimal
for the year ended December 31, 1995. The increase in interest expense in 1997
is attributable to the interest and related costs associated with the issuance
in August 1997 of $265 million aggregate principal amount of 11.5% Senior Notes
due 2007 (the "Senior Notes").
 
     Interest income for the years ended December 31, 1997, 1996 and 1995 was
$6.6 million, $0.5 million and $0.1 million, respectively. The increase in 1997
was the result of investing the excess cash generated from the issuance of the
Senior Notes in various highly liquid investments.
 
LIQUIDITY AND CAPITAL RESOURCES
 
     The primary sources of funding for HER through December 31, 1997 have been
cash equity contributions of $103.2 million and net proceeds of $251.3 million
from the private placement of the Senior Notes.
 
     Development of the HER fiber optic network is capital intensive. The
build-out of the network is expected to require approximately $290.0 million of
capital expenditures, with approximately $35 million required for the initial
five country network that is expected to be completed in the second quarter of
1998. See "Business -- Introduction." As of December 31, 1997, approximately
$52.2 million has been spent on network capital expenditure. An additional
$150.8 million has been capitalized in connection with long-term fiber lease
arrangements. In August 1997, HER completed the issuance of $265.0 million
aggregate principal amount of the Senior Notes. The Senior Notes are general
unsecured obligations of HER. HER currently estimates that its capital resources
will be sufficient to fund operations and expected network development through
December 1998, at which time it may be required to obtain additional funds.
Sources of capital to fund network development after 1998 may include internally
generated funds, bank debt and vendor financing. Any failure to obtain necessary
financing may require HER to delay or abandon its plans for deploying the
remainder of the network and would jeopardize the viability of HER.
 
     The Company had a positive working capital balance of $187.3 million as of
December 31, 1997 as compared to a negative working capital of $4.4 million at
December 31, 1996. The Company had an accumulated deficit of $52.4 million as of
December 31, 1997, including net losses of $29.7 million, $16.0 million and $6.5
million for the years ended December 31, 1997, 1996 and 1995, respectively.
 
     The Company had cash and cash equivalents of $204.3 million and $2.0
million at December 31, 1997 and 1996, respectively. The Company had $57.8
million and $3.8 million of restricted cash at December 31, 1997 and 1996,
respectively, primarily representing the Company's obligation to place into
escrow the first four scheduled semi-annual interest payments on the Senior
Notes.
 
     During the years ended December 31, 1997 and 1996, the Company used $4.4
million and $11.5 million, respectively, of cash for operating activities. Cash
used for investing activities was $107.5 million and $20.8 million for the years
ended December 31, 1997 and 1996, respectively. The use of cash in operating and
investing activities reflects the developmental state of the Company's
commercial activities and the engineering and equipment costs associated with
the initial build-out of the fiber optic network.
 
     The Company has developed risk management policies that establish
guidelines for managing foreign exchange risk. The Company is currently
evaluating the materiality of foreign exchange exposures in different countries
and the financial instruments available to mitigate this exposure. The Company
is designing reporting processes to monitor the potential exposure on an ongoing
basis and expects to implement this
 
                                       23
<PAGE>   26
 
process before the end of 1998. The Company will use the output of this process
to execute financial hedges to cover foreign exchange exposure when practical
and economically justified.
 
     In April 1998, the Company consummated a transaction to hedge the foreign
exchange exposure resulting from the issuance of the Senior Notes.
 
YEAR 2000 COMPLIANCE
 
     The Company is currently in the process of assessing its year 2000
compliance costs and of converting its computer systems to year 2000 compliant
software. This process includes obtaining confirmations from the Company's
primary vendors that plans are being developed or are already in place to
address processing of transactions in the year 2000. The Company does not expect
that the cost of converting such systems will be material to its financial
condition or results of operations. The Company currently believes it will be
able to achieve year 2000 compliance by the end of 1999, and currently does not
anticipate any material disruption in its operations as the result of any
failure by the Company to be in compliance or that year 2000 compliance costs
will have a material effect on the Company's earnings.
 
                                       24
<PAGE>   27
 
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS
 
                         INDEX TO FINANCIAL STATEMENTS
 
                           HERMES EUROPE RAILTEL B.V.
 
YEAR END FINANCIAL STATEMENTS
 
<TABLE>
<CAPTION>
 
<S>                                                           <C>
Report of Ernst & Young Reviseurs d'Entreprises S.C.C.,
  Independent Auditors......................................    26
Consolidated Balance Sheets as of December 31, 1996 and
  1997......................................................    27
Consolidated Statements of Operations for the years ended
  December 31, 1995, 1996, and 1997.........................    28
Consolidated Statements of Cash Flows for the years ended
  December 31, 1995, 1996, and 1997.........................    29
Consolidated Statements of Shareholders' Equity for the
  years ended December 31, 1995, 1996, and 1997.............    30
Notes to Consolidated Financial Statements..................    31
</TABLE>
 
                                       25
<PAGE>   28
 
             REPORT OF ERNST & YOUNG REVISEURS D'ENTREPRISES S.C.C.
                              INDEPENDENT AUDITORS
 
To the Board of Directors and the Shareholders of
Hermes Europe Railtel B.V.
 
     We have audited the accompanying consolidated balance sheets of Hermes
Europe Railtel B.V. as of December 31, 1996 and 1997, and the related
consolidated statements of operations, cash flows, and shareholders' equity for
each of the three years in the period ended December 31, 1997. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
 
     We conducted our audits in accordance with auditing standards generally
accepted in the 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 financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Hermes Europe
Railtel B.V. at December 31, 1996 and 1997, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
December 31, 1997, in conformity with generally accepted accounting principles
in the United States.
 
                                        Ernst & Young Reviseurs d'Entreprises
                                        S.C.C.
                                        Represented by
 
                                        L. Swolfs
                                        Partner
 
Brussels, Belgium
February 26, 1998
 
                                       26
<PAGE>   29
 
                           HERMES EUROPE RAILTEL B.V.
 
                          CONSOLIDATED BALANCE SHEETS
 
                                     ASSETS
 
<TABLE>
<CAPTION>
                                                                    DECEMBER 31,
                                                                --------------------
                                                                  1996        1997
                                                                --------    --------
                                                                   (IN THOUSANDS,
                                                                 EXCEPT SHARE DATA)
                                                                --------------------
<S>                                                             <C>         <C>
Current assets
  Cash and cash equivalents.................................    $  2,013    $204,327
  Restricted cash...........................................       3,840      29,539
  Accounts receivable.......................................          84       2,129
  Due from affiliated companies.............................         491          49
  Other assets..............................................       1,100      13,281
                                                                --------    --------
          Total current assets..............................       7,528     249,325
Property and equipment, net.................................      20,303     204,944
Deferred financing costs, net...............................          --      13,310
Restricted cash.............................................          --      28,271
                                                                --------    --------
          TOTAL ASSETS......................................    $ 27,831    $495,850
                                                                ========    ========
 
                        LIABILITIES AND SHAREHOLDERS' EQUITY
 
Current liabilities
  Accounts payable and accrued expenses.....................    $  8,476    $ 37,457
  Due to affiliated companies...............................       3,344       1,311
  Deferred income...........................................          24       1,436
  Other current liabilities.................................           8         236
  Debt maturing within one year.............................          63          50
  Current portion of capital lease obligations..............          --      21,490
                                                                --------    --------
          Total current liabilities.........................      11,915      61,980
Long-term debt, less current portion........................         499     265,383
Long-term portion of capital lease obligations..............          --     117,645
                                                                --------    --------
          TOTAL LIABILITIES.................................      12,414     445,008
Commitments and contingencies
Shareholders' loans.........................................      34,863          --
 
                                SHAREHOLDERS' EQUITY
 
Common stock, 1000 guilders par value (305 shares authorized
  and 80 shares issued and outstanding at December 31, 1996;
  297,000 shares authorized and 190,468 shares issued and
  outstanding at December 31, 1997..........................          45      96,757
Additional paid-in capital..................................       2,884      10,130
Cumulative translation adjustment...........................         316      (3,665)
Accumulated deficit.........................................     (22,691)    (52,380)
                                                                --------    --------
          TOTAL SHAREHOLDERS' EQUITY........................     (19,446)     50,842
                                                                --------    --------
          TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY........    $ 27,831    $495,850
                                                                ========    ========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
 
                                       27
<PAGE>   30
 
                           HERMES EUROPE RAILTEL B.V.
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                                                    YEAR ENDED DECEMBER 31,
                                                              -----------------------------------
                                                                1995         1996         1997
                                                              ---------   ----------   ----------
                                                                (IN THOUSANDS, EXCEPT WEIGHTED
                                                              AVERAGE SHARES AND PER SHARE DATA)
<S>                                                           <C>         <C>          <C>
Revenues....................................................   $    --     $     48     $  5,373
                                                               -------     --------     --------
Operating costs and expenses:
  Cost of revenues..........................................        --        4,694        9,972
  Selling, general and administrative.......................     6,637       10,552       18,493
                                                               -------     --------     --------
                                                                 6,637       15,246       28,465
                                                               -------     --------     --------
Loss from operations........................................    (6,637)     (15,198)     (23,092)
Other income/(expense):
  Interest income...........................................       125          508        6,596
  Interest expense..........................................        (9)        (153)     (12,826)
  Foreign currency (losses) gains...........................        19       (1,126)        (367)
                                                               -------     --------     --------
                                                                   135         (771)      (6,597)
                                                               -------     --------     --------
Net loss before income taxes................................    (6,502)     (15,969)     (29,689)
Income taxes................................................        --           --           --
                                                               -------     --------     --------
Net loss....................................................   $(6,502)    $(15,969)    $(29,689)
                                                               =======     ========     ========
Net loss per share..........................................   $(90.31)    $(199.61)    $  (0.33)
                                                               =======     ========     ========
Weighted average common shares outstanding..................        72           80       89,957
                                                               =======     ========     ========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
 
                                       28
<PAGE>   31
 
                           HERMES EUROPE RAILTEL B.V.
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                                                 YEAR ENDED DECEMBER 31,
                                                             --------------------------------
                                                              1995        1996        1997
                                                             -------    --------    ---------
                                                                      (IN THOUSANDS)
<S>                                                          <C>        <C>         <C>
OPERATING ACTIVITIES
Net loss...................................................  $(6,502)   $(15,969)   $ (29,689)
Adjustments to reconcile net loss to net cash used in
  operating activities:
  Depreciation and amortization............................       11         683        4,257
  Deferred interest........................................       --         130           --
  Non-cash compensation....................................       --          --        2,651
  Changes in assets and liabilities:
     Accounts receivable...................................       --         (87)      (2,116)
     Deposits..............................................      (16)       (627)      (9,807)
     Accounts payable and accrued expenses.................    4,364       4,336       30,991
     Other changes in assets and liabilities...............     (512)         (6)        (704)
                                                             -------    --------    ---------
Net cash used in operating activities......................   (2,655)    (11,540)      (4,417)
INVESTING ACTIVITIES
  Purchases of property and equipment......................   (4,405)    (16,807)     (51,830)
  Restricted cash..........................................       --      (3,974)     (55,636)
                                                             -------    --------    ---------
Net cash used in investing activities......................   (4,405)    (20,781)    (107,466)
FINANCING ACTIVITIES
  Proceeds from debt.......................................       19         564      268,678
  Payment of debt issue costs..............................       --          --      (14,139)
  Net proceeds from issuance of common stock...............    1,732          --       50,993
  Proceeds from shareholders' loans........................    7,942      27,358       13,205
  Due to affiliated companies, net.........................    1,951       1,002       (1,237)
                                                             -------    --------    ---------
Net cash provided by financing activities..................   11,644      28,924      317,500
Effect of exchange rate changes on cash and cash
  equivalents..............................................      333        (374)      (3,303)
                                                             -------    --------    ---------
Net increase (decrease) in cash and cash equivalents.......    4,917      (3,771)     202,314
Cash and cash equivalents at beginning of year.............      867       5,784        2,013
                                                             -------    --------    ---------
Cash and cash equivalents at end of year...................  $ 5,784    $  2,013    $ 204,327
                                                             =======    ========    =========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
 
                                       29
<PAGE>   32
 
                           HERMES EUROPE RAILTEL B.V.
 
                CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
              FOR THE YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
 
<TABLE>
<CAPTION>
                                      COMMON STOCK      ADDITIONAL   CUMULATIVE                      TOTAL
                                    -----------------    PAID-IN     TRANSLATION   ACCUMULATED   SHAREHOLDERS'
                                    SHARES    AMOUNT     CAPITAL     ADJUSTMENT      DEFICIT        EQUITY
                                    -------   -------   ----------   -----------   -----------   -------------
                                                        (IN THOUSANDS, EXCEPT SHARE DATA)
<S>                                 <C>       <C>       <C>          <C>           <C>           <C>
BALANCE AT DECEMBER 31, 1994......       61        32        996            58          (220)           866
Proceeds from the sale of common
  stock...........................       19        13      1,888            --            --          1,901
Translation adjustment............       --        --         --          (312)           --           (312)
Net loss..........................       --        --         --            --        (6,502)        (6,502)
                                    -------   -------    -------       -------      --------       --------
BALANCE AT DECEMBER 31, 1995......       80        45      2,884          (254)       (6,722)        (4,047)
Translation adjustment............       --        --         --           570            --            570
Net loss..........................       --        --         --            --       (15,969)       (15,969)
                                    -------   -------    -------       -------      --------       --------
BALANCE AT DECEMBER 31, 1996......       80        45      2,884           316       (22,691)       (19,446)
Recapitalization, net of tax......  190,388    96,712      4,633            --            --        101,345
Compensatory stock options........       --        --      2,613            --            --          2,613
Translation adjustment............       --        --         --        (3,981)           --         (3,981)
Net loss..........................       --        --         --            --       (29,689)       (29,689)
                                    -------   -------    -------       -------      --------       --------
BALANCE AT DECEMBER 31, 1997......  190,468   $96,757    $10,130       $(3,665)     $(52,380)      $ 50,842
                                    =======   =======    =======       =======      ========       ========
</TABLE>
 
   The accompanying notes are an integral part of these financial statements.
 
                                       30
<PAGE>   33
 
                           HERMES EUROPE RAILTEL B.V.
 
                   NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 1: NATURE OF BUSINESS OPERATIONS
 
     Hermes Europe Railtel B.V. ("the Company") is developing and operating the
initial segments of a pan-European high capacity fiber optic network that is
designed to interconnect a majority of the largest Western and Central European
cities, and to transport international voice, data and multimedia/image traffic
for other carriers throughout Western and Central Europe.
 
     The Company's objective is to become the leading pan-European carriers'
carrier by providing centrally managed crossborder telecommunications
transmission capacity to telecommunications companies including traditional
public telecommunications operators ("PTOs") and new entrants, such as
alternative carriers, global consortia of telecommunications operators,
international carriers, Internet backbone networks, resellers, value-added
networks and other service providers ("New Entrants").
 
     The European telecommunications market has historically been dominated by
monopoly PTOs. This system has ensured the development of broad access to
telecommunications services in Europe, but has also restricted the growth of
high quality and competitive priced pan-European voice and data services. The
current liberalization occurring in Europe is intended to address these
structural deficiencies by breaking down PTO monopolies, allowing new
telecommunications operators to enter the market and increasing the competition
within the European Telecommunications market. In March 1996, the European
Commission adopted a directive (the "Full Competition Directive") requiring the
full liberalization of all telecommunications services in most EU member states
by January 1, 1998. The company expects that full liberalization in these
European countries will lead to the emerge of New Entrants with new and
competitive service offerings. The Company expects this increase in competition
will result in lower prices and a substantial increase in the volume of traffic
and range of telecommunications services provided. The Company believes that as
a result of the increased call volume and growth in value added services,
participants in these markets will require significant amounts of new
cross-border telecommunications transport capacity to provide their services.
 
     In an effort to generate sufficient capital resources to continue its
buildout of the network and sustain working capital requirements, the Company
undertook a recapitalization (the "Recapitalization") during the first quarter
of 1997, which was completed in September 1997. Prior to the Recapitalization,
the Company was 50% owned by HIT Rail B.V. ("HIT Rail"), a consortium of eleven
European railway companies, and 50% owned by GTS-Hermes, Inc. ("GTS-Hermes"), a
U.S. holding company that is a wholly-owned subsidiary of Global TeleSystems
Group, Inc., a provider of a broad range of telecommunications services to
businesses, other telecommunications service providers and consumers through its
operations of voice and data networks, international gateways, local access and
cellular networks and the provision of various value-added services, in markets
outside the United States.
 
     Pursuant to the Recapitalization, the Company offered to GTS-Hermes, HIT
Rail and the eleven individual members of the HIT Rail consortium the right to
subscribe to additional common stock of the Company. GTS-Hermes and two of the
members of HIT Rail, Societe Nationale des Chemins de Fer Belges S.A. de Droit
Public/Nationale Maatschappij der Belgische Spoorwegen N.V. ("NMBS") and AB Swed
Carrier ("Swed Carrier"), exercised their rights, while HIT Rail and the nine
remaining members of HIT Rail declined to participate.
 
     As a result of the finalization of the Recapitalization, total shareholder
loans of ECU 39.4 million (approximately $48.5 million) from, collectively,
GTS-Hermes, HIT Rail, NMBS and Swed Carrier were transferred into equity.
Additionally, GTS-Hermes contributed ECU 46.0 million (approximately $51.8
million) and NMBS contributed a ten-year fiber optic cable lease with a fair
value of ECU 1.8 million (approximately $2.0 million).
 
                                       31
<PAGE>   34
                           HERMES EUROPE RAILTEL B.V.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
     The ownership of the Company as a result of the Recapitalization is as
follows:
 
<TABLE>
<CAPTION>
                                                              SHARES    OWNERSHIP %
                                                              -------   -----------
<S>                                                           <C>       <C>
GTS-Hermes..................................................  150,632       79.1%
HIT Rail....................................................   24,047       12.6
NMBS........................................................   11,424        6.0
Swed Carrier................................................    4,365        2.3
                                                              -------      -----
          Total.............................................  190,468      100.0%
                                                              =======      =====
</TABLE>
 
     In an additional effort to obtain capital resources, the Company completed
a debt offering in August 1997 that raised $265.0 million (see Note 4, "Debt
Obligations").
 
     The Company was a development stage enterprise through December 31, 1996.
 
NOTE 2: SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
BASIS OF PRESENTATION
 
     The financial statements include the accounts of Hermes Europe Railtel
B.V., its Belgian branch, HER Network Services B.V.B.A. (formerly Hermes Europe
Railtel N.V.), Hermes Europe Railtel (UK) Limited, Hermes Europe Railtel
(Holdings) B.V. and Beheer- en Beleggingsmaatschappij Vesto B.V. All significant
intercompany accounts and transactions are eliminated upon consolidation.
 
RECLASSIFICATIONS
 
     Certain reclassifications have been made to the 1995 and 1996 consolidated
financial statements in order to conform to the 1997 presentation.
 
CASH AND CASH EQUIVALENTS
 
     The Company considers all highly liquid investments with a maturity of
three months or less at the time of purchase to be cash equivalents. The Company
had $3.8 million and $57.8 million of restricted cash at December 31, 1996 and
1997, respectively. The restricted cash is primarily related to cash held in
escrow for interest payments (see Note 4, "Debt Obligations").
 
PROPERTY AND EQUIPMENT
 
     Property and equipment is stated at cost. Depreciation, which includes the
amortization of assets recorded under capital leases, is calculated on a
straight-line basis over the lesser of the estimated lives ranging from five to
ten years for telecommunications equipment and five to ten years for furniture,
fixtures and equipment and other property, or their contractual term. A
substantial part of the costs includes construction in process, which is
currently related to the configuration and buildout of the network, and these
costs primarily consist of labor. These costs are transferred to
telecommunications equipment in service as construction is completed and/or
equipment is placed in service. Depreciation is recorded commencing with the
first full month that assets are placed into service. Maintenance and repairs
are charged to expense as incurred.
 
     In accordance with Statement of Financial Accounting Standards ("SFAS") No.
34, "Capitalization of Interest Costs," the Company intends to capitalize
material interest costs associated with the construction of capital assets for
business operations and amortize the costs over the assets' useful lives. The
Company has not capitalized any interest costs through 1997.
 
                                       32
<PAGE>   35
                           HERMES EUROPE RAILTEL B.V.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
DEFERRED FINANCING COSTS
 
     Deferred financing costs are amortized on a straight-line basis over the
lesser of their estimated useful lives or their contractual term, generally ten
years. In accordance with APB 17, "Intangible Assets," the Company continues to
evaluate the amortization period to determine whether events or circumstances
warrant revised amortization periods. Additionally, the Company considers
whether the carrying value of such assets should be reduced based on the future
benefits of its deferred financing costs.
 
LONG-LIVED ASSETS
 
     In accordance with SFAS No. 121, long-lived assets to be held and used by
the Company are reviewed to determine whether any events or changes in
circumstances indicate that the carrying amount of the asset may not be
recoverable. For long-lived assets to be held and used, the Company bases its
evaluation on such impairment indicators as the nature of the assets, the future
economic benefit of the assets, any historical or future profitability
measurements, as well as other external market conditions or factors that may be
present. If such impairment indicators are present or other factors exist that
indicate that the carrying amount of the asset may not be recoverable, the
Company determines whether an impairment has occurred through the use of an
undiscounted cash flow analysis of assets at the lowest level for which
identifiable cash flows exist. If an impairment has occurred, the Company
recognizes a loss for the difference between the carrying amount and the
estimated value of the asset. The fair value of the asset is measured using
quoted market prices or, in the absence of quoted market prices, fair value is
based on an estimate of discounted cash flow analysis. Based on its analysis for
the years ended December 31, 1996 and 1997, the Company determined that there
was not an impairment of its long-lived assets.
 
INCOME TAXES
 
     The Company uses the liability method of accounting for income taxes.
Deferred income taxes result from temporary differences between the tax basis of
assets and liabilities and the basis as reported in the consolidated financial
statements.
 
FOREIGN CURRENCY TRANSLATION
 
     The accounting records of Hermes Europe Railtel B.V., Hermes Europe Railtel
(Holdings) B.V. and Beheer-en Beleggingsmaatschappij Vesto B.V. are maintained
in Dutch guilders. The accounting records of the Belgian branch and HER Network
Services B.V.B.A. (formerly Hermes Europe Railtel N.V.) company are maintained
in Belgian francs. The accounting records of Hermes Europe Railtel (UK) Limited
are maintained in British pounds. The functional currency for the Company has
been determined to be the Belgian franc. Therefore, the Dutch guilder statements
and the British pound statements have been remeasured into Belgian franc
equivalents, consolidated with the Belgian branch and Belgian B.V.B.A.
statements and then translated into U.S. dollar equivalents for the purpose of
preparing the accompanying financial statements in accordance with accounting
principles generally accepted in the United States.
 
     The Company follows a translation policy in accordance with SFAS No. 52,
"Foreign Currency Translation." Assets and liabilities are translated at the
rates of exchange at the balance sheet date. Income and expense accounts are
translated at average monthly rates of exchange. The resultant translation
adjustments are included in the cumulative translation adjustment, a separate
component of shareholders' equity. Gains and losses from foreign currency
transactions are included in the operations.
 
                                       33
<PAGE>   36
                           HERMES EUROPE RAILTEL B.V.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
REVENUE RECOGNITION
 
     The Company's revenue is associated with its customers' right to use the
network and is recognized on a straight-line basis over the terms of the
customer contracts. Billings received in advance of service being performed are
deferred and recognized as revenue as the service is performed.
 
NET LOSS PER SHARE
 
     During 1997, the Company adopted SFAS No. 128, "Earnings Per Share," which
requires the Company to present basic and fully diluted earnings per share for
all years presented. The Company's net loss per share calculation (basic and
fully diluted) is based upon the weighted average common shares issued. There
are no reconciling items in the numerator or denominator of the Company's net
loss per share calculation. Employee stock options (see Note 5, "Employee
Benefits") have been excluded from the net loss per share calculation because
their effect would be anti-dilutive.
 
FAIR VALUE OF FINANCIAL INSTRUMENTS
 
     The Company believes that the carrying amount of its assets and liabilities
reported in the balance sheets approximates their fair value.
 
OFF BALANCE SHEET RISK AND CONCENTRATION OF CREDIT RISK
 
     Financial instruments that potentially subject the Company to concentration
of credit risk consist primarily of cash and cash equivalents and accounts
receivable. At December 31, 1996, the Company maintained most of its cash and
cash equivalents in high quality European financial institutions. At December
31, 1997, the Company maintained most of its cash and cash equivalents in high
quality U.S. financial institutions. The Company extends credit to various
customers and establishes an allowance for doubtful accounts for specific
customers that it determines to have significant credit risk.
 
     The Company does not now hedge against foreign currency fluctuations,
although the Company is currently considering alternatives to hedge the foreign
exchange exposure resulting from the issuance of $265.0 million senior notes
(see Note 4, "Debt Obligations"). Under current practices, the Company's results
from operations could be adversely affected by fluctuations in foreign currency
exchange rates.
 
STOCK BASED COMPENSATION
 
     SFAS No. 123, "Accounting for Stock-Based Compensation," establishes a fair
value method of accounting for employee stock options and similar equity
instruments. The fair value method requires compensation cost to be measured at
the grant date based on the value of the award and is recognized over the
service period. SFAS No. 123 allows companies to either account for stock-based
compensation under the new provisions of SFAS No. 123 or under the provisions of
APB No. 25, "Accounting for Stock Issued to Employees." The Company has elected
to account for its stock-based compensation in accordance with the provisions of
APB No. 25 and presents pro forma disclosures of net loss as if the fair value
method had been adopted.
 
USES OF ESTIMATES IN PREPARATION OF FINANCIAL STATEMENTS
 
     The preparation of these consolidated financial statements, in conformity
with generally accepted accounting principles, requires management to make
estimates and assumptions that affect amounts in the financial statements and
accompanying notes and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
 
                                       34
<PAGE>   37
                           HERMES EUROPE RAILTEL B.V.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
NEW ACCOUNTING STANDARDS
 
     The Financial Accounting Standards Board has issued two new standards which
become effective for reporting periods beginning after December 15, 1997. SFAS
No. 130, "Reporting Comprehensive Income," requires additional disclosures with
respect to certain changes in assets and liabilities that previously were not
required to be reported as results of operations for the period. The Company
will begin making the additional disclosures required by SFAS No. 130 in the
first quarter of 1998. SFAS No. 131, "Disclosures about Segments of an
Enterprise and Related Information," requires financial and descriptive
information with respect to "operating segments" of an entity based on the way
management disaggregates the entity for making internal operating decisions. The
Company will begin making the disclosures required by SFAS No. 131 with
financial statements for the period ending December 31, 1998.
 
NOTE 3: SUPPLEMENTAL BALANCE SHEET INFORMATION
 
<TABLE>
<CAPTION>
                                                                 DECEMBER 31,
                                                              -------------------
                                                               1996        1997
                                                              -------    --------
                                                                (IN THOUSANDS)
<S>                                                           <C>        <C>
Other assets consists of:
  Deposits..................................................  $   606    $  9,577
  VAT receivable............................................      402       1,184
  Interest receivable.......................................       --         918
  Other assets..............................................       92       1,602
                                                              -------    --------
Total other assets..........................................  $ 1,100    $ 13,281
                                                              =======    ========
Property and equipment, net consists of:
  Telecommunications equipment in service...................  $ 4,947    $198,723
  Furniture, fixtures and equipment.........................    2,507       3,409
  Leasehold improvements....................................      543         840
  Construction in process...................................   12,981       6,255
                                                              -------    --------
                                                               20,978     209,227
     Less: accumulated depreciation.........................      675       4,283
                                                              -------    --------
Total property and equipment, net...........................  $20,303    $204,944
                                                              =======    ========
Accounts payable and accrued expenses consists of:
  Trade accounts payable....................................  $ 5,445    $ 19,678
  Accrued interest..........................................       10      11,621
  Accrued salaries and bonuses..............................    1,150       2,058
  Accrued consulting expense................................      152         968
  Accrued vacation expense..................................      774       1,094
  Other.....................................................      945       2,038
                                                              -------    --------
Total accounts payable and accrued expenses.................  $ 8,476    $ 37,457
                                                              =======    ========
</TABLE>
 
                                       35
<PAGE>   38
                           HERMES EUROPE RAILTEL B.V.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
NOTE 4: DEBT OBLIGATIONS
 
     Company debt consists of:
 
<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                              ----------------
                                                              1996      1997
                                                              ----    --------
                                                               (IN THOUSANDS)
<S>                                                           <C>     <C>
Senior notes, due August 15, 2007 at 11.5% interest payable
  semiannually..............................................  $ --    $265,000
Other financing agreements..................................   562         433
                                                              ----    --------
Total debt outstanding......................................   562     265,433
  Less: debt maturing within one year.......................    63          50
                                                              ----    --------
Total long-term debt........................................  $499    $265,383
                                                              ====    ========
</TABLE>
 
     On August 15, 1997, the Company issued aggregate principal amount $265.0
million of senior notes due August 15, 2007 (the "Senior Notes"). The Senior
Notes are general unsecured obligations of the Company, with interest payable
semiannually at a rate of 11.5%. Approximately $56.6 million of the net proceeds
of the offering was placed in escrow for the first four semiannual interest
payments commencing on February 15, 1998. The Company may redeem the Senior
Notes, in whole or in part, any time on or after August 15, 2002 at specific
redemption prices. The Company may also redeem the Senior Notes at a price equal
to 111.5% of the principal amount prior to August 15, 2000 with net cash
proceeds of a public equity offering with gross proceeds of at least $75.0
million or in certain other circumstances specified in the indenture for the
Senior Notes, provided, however, that at least two-thirds of the principal
amount of the Senior Notes originally issued remain outstanding after each such
redemption. Pursuant to the covenants in the offering, the Company has filed an
S-4 registration statement with the Securities and Exchange Commission to
exchange registered senior notes, with the same terms and conditions as the
Senior Notes, for the Senior Notes.
 
     On a pro forma basis, assuming the Senior Notes had been outstanding as of
January 1, 1997, the Company's net loss would have been $50.1 million for 1997,
as a result of interest expense of $30.5 million and amortization expense of
$1.4 million related to amortizing $13.7 million of deferred financing fees over
the term of the Senior Notes.
 
     Aggregate maturities of long-term debt, as of December 31, 1997, are as
follows: 1998 -- $0.05 million, 1999 -- $0.05 million, 2000 -- $0.06 million,
2001 -- $0.06 million, 2002 -- $0.07 million, and $265.2 million thereafter.
 
NOTE 5: EMPLOYEE BENEFITS
 
     The Company established a pension plan in 1995 that covers substantially
all of its employees upon twenty-five years of age and at least one year of
service. The benefits are based on years of service and the employee's
compensation. The Company has entered into an arrangement, an annuity contract,
with an insurance company for the provision of a group insurance policy ("the
Policy"). Under the Policy, the insurance provider has undertaken a legal
obligation to provide specified benefits to participants in return for a fixed
premium; accordingly, the Company no longer bears significant financial risk.
Premium payments for the Policy are partly paid by the employee, based on
specified terms that consider the employee's annual salary, with the remaining
premium paid by the employer. Premiums are intended to provide not only for
benefits attributed to service to date but also for those expected to be earned
in the future.
 
     The Company's pension costs for 1995, 1996 and 1997 were $0.05 million,
$0.4 million and $0.7 million, respectively.
 
     In the fourth quarter of 1997, the Company implemented a stock option plan
for its key officers and employees (the "Stock Option Plan"). The ownership
dilution caused by the Stock Option Plan is not
 
                                       36
<PAGE>   39
                           HERMES EUROPE RAILTEL B.V.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
expected to be significant. As a result of issuing options under the Stock
Option Plan, the Company will incur a non-cash charge of approximately $3.7
million, of which $2.6 million was recorded during the fourth quarter and the
remaining $1.1 million will be recognized in 1998.
 
     The Company applies the provisions of APB No. 25 in accounting for its
stock option incentive plans. The effect of applying SFAS No. 123 on the net
loss as reported is not representative of the effects on reported net loss for
future years due to the vesting period of the stock options and the fair value
of additional stock options in future years. Had compensation expense been
determined in accordance with the methodology of SFAS No. 123, the Company's net
loss for the year ended December 31, 1997 would have been approximately $29.9
million. The fair value of options granted was estimated between $51.80 and
$456.63 per share using the Black-Scholes option pricing with the following
assumptions: expected volatility of .50, dividend yield 0%, risk free interest
rate of 5.79% and an expected life of five years.
 
     The Company maintains the Stock Option Plan, with the maximum number of
shares of common stock available for grant under the Stock Option Plan of
24,760. All options granted under the Stock Option Plan were at exercise prices
that were at least equal to the fair market value of common stock at the date of
grant. Generally, all options granted under the Stock Option Plan vest over a
three-year period from the date of grant and expire ten years from the date of
grant. There were a few exceptions in which the granting of options had
instantaneous vesting rights.
 
     Additional information with respect to stock option activity is summarized
as follows:
 
<TABLE>
<CAPTION>
                                                              YEAR ENDED DECEMBER 31, 1997
                                                              ----------------------------
                                                                         WEIGHTED AVERAGE
                                                              SHARES      EXERCISE PRICE
                                                              -------    -----------------
<S>                                                           <C>        <C>
Outstanding at beginning of year............................      --          $    --
Options granted.............................................  10,166           379.92
Options exercised...........................................      --               --
Options canceled or expired.................................      --               --
                                                              ------          -------
Outstanding at end of year..................................  10,166           379.92
                                                              ======          =======
Options exercisable at year end.............................   6,244          $107.20
</TABLE>
 
     The following table summarizes information about stock options outstanding:
 
<TABLE>
<CAPTION>
                                                 OPTIONS OUTSTANDING                OPTIONS EXERCISABLE
                                      ------------------------------------------   ----------------------
                                                        WEIGHTED
                                                        AVERAGE        WEIGHTED                  WEIGHTED
              RANGE OF                                 REMAINING        AVERAGE                  AVERAGE
         EXERCISE PRICE AT              NUMBER      CONTRACTUAL LIFE   EXERCISE      NUMBER      EXERCISE
         DECEMBER 31, 1997:           OUTSTANDING      (IN YEARS)        PRICE     EXERCISABLE    PRICE
         ------------------           -----------   ----------------   ---------   -----------   --------
<S>                                   <C>           <C>                <C>         <C>           <C>
$83.12..............................     5,500             8           $   83.12      3,895      $ 83.12
$100.00 to $191.31..................     2,762             8              113.92      2,032       112.59
$378.43 to $2,887.62................     1,904             9            1,623.15        317       368.46
                                        ------                                        -----
                                        10,166             8           $  379.92      6,244      $107.20
                                        ======                                        =====
</TABLE>
 
                                       37
<PAGE>   40
                           HERMES EUROPE RAILTEL B.V.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
NOTE 6: INCOME TAXES
 
     The components of loss before income taxes were as follows:
 
<TABLE>
<CAPTION>
                                                           YEAR ENDED DECEMBER 31,
                                                       -------------------------------
                                                        1995        1996        1997
                                                       -------    --------    --------
                                                               (IN THOUSANDS)
<S>                                                    <C>        <C>         <C>
Pretax loss:
  Domestic (the Netherlands).........................  $  (422)   $   (608)   $ (7,154)
  Foreign............................................   (6,080)    (15,361)    (22,535)
                                                       -------    --------    --------
                                                       $(6,502)   $(15,969)   $(29,689)
                                                       =======    ========    ========
</TABLE>
 
     No current income taxes are due, as the Company incurred losses due to the
start-up activities in the Belgian branch and the Company.
 
     A deferred tax asset is recorded on temporary differences between earnings
as reported in the financial statements and earnings for income tax purposes.
The following table summarizes major components of the Company's deferred tax
assets:
 
<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                       -------------------------------
                                                        1995        1996        1997
                                                       -------    --------    --------
                                                               (IN THOUSANDS)
<S>                                                    <C>        <C>         <C>
Deferred tax assets:
  Net operating loss carryforwards...................  $ 3,919    $ 11,729    $ 16,918
                                                       -------    --------    --------
Total deferred tax asset.............................    3,919      11,729      16,918
  Less: valuation allowance..........................   (3,919)    (11,729)    (16,918)
                                                       -------    --------    --------
Total................................................  $    --    $     --    $     --
                                                       =======    ========    ========
</TABLE>
 
     As of December 31, 1997, the Company had net operating loss carryforwards
for Belgian and Dutch income tax purposes of approximately $43.1 million, which
are recoverable from profits for an unlimited period of time.
 
NOTE 7: SUPPLEMENTAL CASH FLOW INFORMATION
 
     The following table summarizes non-cash investing and financing activities
for the year ended December 31, 1997:
 
<TABLE>
<CAPTION>
                                                                YEAR ENDED
                                                               DECEMBER 31,
                                                                   1997
                                                               ------------
                                                              (IN THOUSANDS)
<S>                                                           <C>
Transfer of shareholders' loans to equity...................     $ 48,491
Contribution of fiber optic cable lease.....................        1,989
Non cash compensation (stock options).......................        2,613
Capitalization of leases....................................      139,135
</TABLE>
 
     There were no significant non-cash activities in 1996.
 
     The Company paid interest of $0.02 million, $0.01 million and $1.2 million
in 1995, 1996 and 1997, respectively.
 
                                       38
<PAGE>   41
                           HERMES EUROPE RAILTEL B.V.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
NOTE 8: COMMITMENTS AND CONTINGENCIES
 
OPERATING LEASES
 
     Operating lease commitments are primarily for office space and car rental.
The office lease of the first office building has a term of nine years, expiring
on June 30, 2005, with an option to cancel January 1, 2002 upon the payment of
certain penalties. In addition, the Company received a reduction in annual
expense during the first three years of the lease. This reduction is being
amortized over the first six years of the lease, using a straight-line method.
On April 29, 1997, the Company entered into a lease for a second office
building, with annual payments of $0.4 million beginning in October 1997 and
expiring on June 30, 2005.
 
     Rental expense aggregated approximately $0.5 million, $0.7 million and $1.0
million for the years ended December 31, 1995, 1996 and 1997, respectively.
 
CAPITAL LEASES
 
     Assets and liabilities under capital leases are included in the
consolidated balance sheets as follows :
 
<TABLE>
<CAPTION>
                                                                DECEMBER 31,
                                                              ----------------
                                                              1996      1997
                                                              ----    --------
                                                               (IN THOUSANDS)
<S>                                                           <C>     <C>
Telecommunications equipment in service.....................  $ --    $150,787
  Less: accumulated amortization............................    --    $    482
                                                              ----    --------
                                                              $ --    $150,305
                                                              ====    ========
</TABLE>
 
     Future minimum payments, by year and in the aggregate, under the capital
leases and other non-cancelable operating leases with initial or remaining terms
in excess of one year as of December 31, 1997 were as follows :
 
<TABLE>
<CAPTION>
                                                           CAPITAL LEASES    OPERATING LEASES
                                                           --------------    ----------------
                                                                     (IN THOUSANDS)
<S>                                                        <C>               <C>
December 31, 1998........................................     $ 26,679            $1,599
                1999.....................................       14,217             1,448
                2000.....................................       15,300             1,251
                2001.....................................       16,465             1,041
                2002.....................................       16,630               924
Thereafter...............................................      152,016             1,155
                                                              --------            ------
Total minimum lease payments.............................      241,307            $7,418
                                                                                  ======
Less amount representing interest........................      102,172
                                                              --------
Present value of net minimum lease payments..............      139,135
Less current portion of capital lease obligations........       21,490
                                                              --------
Long-term portion of capital lease obligations...........     $117,645
                                                              ========
</TABLE>
 
MAJOR CUSTOMERS
 
     In 1997, the Company had two major customers, representing $1.8 million and
$1.2 million or 34.2% and 21.7% of revenue, respectively. There were no major
customers in 1995 and 1996.
 
OTHER MATTERS
 
     In the ordinary course of business, the Company may be party to various
legal and tax proceedings, and subject to claims, certain of which relate to the
regulatory environments in which the Company currently
 
                                       39
<PAGE>   42
                           HERMES EUROPE RAILTEL B.V.
 
           NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
 
operates or intends to operate. In the opinion of management, the Company's
liability, if any, in all pending litigation, or other legal proceeding or other
matter other than what is discussed above, will not have a material effect upon
the financial condition, results of operations or liquidity of the Company.
 
NOTE 9: RELATED PARTY TRANSACTIONS
 
     The Company received financing through shareholders' loan transactions
provided by HIT Rail, GTS-Hermes, NMBS, and Swed Carrier. The Company had
outstanding shareholders' loans from HIT Rail and GTS-Hermes of $14.0 million
and $20.9 million, respectively, at December 31, 1996. All shareholder loans
outstanding were converted into equity during 1997 as part of the
Recapitalization (see Note 1, "Nature of Business Operations").
 
NOTE 10: SUBSEQUENT EVENTS
 
     Subsequent to December 31, 1997, the Company further entered into
contractual commitments to lease fibre pairs, including facilities and
maintenance and utilizing the partial routes for laying fibre optic cable. Based
on the contract provisions, these commitments are currently estimated to
aggregate approximately $12.9 million. The commitments have expected lease terms
of ten to twenty-one years with options for renewal rights of one and one-half
to five additional years.
 
     In an effort to expand its presence in Europe, the Company incorporated
subsidiary companies in The Netherlands, Ireland, The United Kingdom, Germany,
France, Italy and Spain. In Belgium, the activities of the Network Operations
Centre have been transferred to HER Network Services B.V.B.A (formerly Hermes
Europe Railtel N.V.).
 
NOTE 11: EVENTS OCCURRING SUBSEQUENT TO DATE OF AUDIT REPORT
 
     In March 1998, HIT Rail sold all of its shares in the Company to
GTS-Hermes, NMBS and Swed Carrier. As a result of the sale, GTS-Hermes, NMBS and
Swed Carrier will own 89.4%, 7.2% and 3.4% of the Company, respectively.
 
                                       40
<PAGE>   43
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE
 
     None.
 
                                    PART III
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY.
 
MEMBERS OF THE BOARD OF SUPERVISORY DIRECTORS AND THE BOARD OF MANAGING
DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY
 
     The Members of the Board of Supervisory Directors and the Board of Managing
Directors and executive officers of the Company and their respective ages and
positions with the Company as of December 31, 1997 are set forth below.
[GTS-Hermes is entitled to propose another member for appointment to the Board
of Supervisory Directors and the railways that become shareholders pursuant to
the HER Recapitalization will also be entitled to propose for appointment
another director to the Board of Supervisory Directors.]
 
BOARD OF SUPERVISORY DIRECTORS
 
<TABLE>
<CAPTION>
NAME                         AGE                             POSITION
----                         ---                             --------
<S>                          <C>    <C>
Gerald W. Thames.........    50     President, Chief Executive Officer and Director of GTS
Bernard J. McFadden......    64     Director of GTS, GTS-Hermes representative on the Board of
                                      Supervisory Directors of HER
Bo C. O. Hamnell.........    58     Senior Vice President and Director of Finance of the
                                      Swedish State Railway and Chief Executive Officer of
                                      ABSwedcarrier.
</TABLE>
 
BOARD OF MANAGING DIRECTORS
 
     GTS-Hermes, Inc.
 
EXECUTIVE OFFICERS OF THE COMPANY
 
<TABLE>
<CAPTION>
NAME                         AGE                             POSITION
----                         ---                             --------
<S>                          <C>    <C>
Jan Loeber...............    53     Managing Director (Principal Executive Officer)
Gerard J. Caccappolo.....    55     Corporate Director of Marketing and Sales
Peter Magnus.............    36     Corporate Director of Strategy and Planning
Bruce C. Rudy............    42     Corporate Director of Business Development and Regulatory
John Allan Shearing......    48     Corporate Operations and Engineering Director
Jan De Wispelaere........    38     Corporate Legal Director
Steven Andrews...........    51     Corporate Administration Director
Francois Note............    39     Corporate Financial Director -- Chief Financial Officer
                                      (Principal Financial and Accounting Officer) (as of April
                                      1, 1998)
</TABLE>
 
BOARD OF SUPERVISORY DIRECTORS
 
     The general affairs and business of the Company and the board which manages
the Company (the "Board of Managing Directors") (Directie) are supervised by a
board appointed by the general meeting of shareholders (the "Board of
Supervisory Directors") (Raad van Commissarissen).
 
     The Company's Articles of Association (the "Articles of Association")
provide for at least four and no more than ten supervisory directors who must be
natural persons ("Supervisory Directors") to serve on the Board of Supervisory
Directors. Under the law of the Netherlands, a Member of the Board of
Supervisory Directors of a Company cannot be a member of the Board of Managing
Directors of the same Company. The
 
                                       41
<PAGE>   44
 
members of the Board of Supervisory Directors are appointed by the general
meeting of shareholders. The Board of Supervisory Directors elects a chairman
from among its members. See "Certain Relationships and Related Transactions."
Under the new Shareholders Agreement, resolutions of the Board of Supervisory
Directors will require the approval of a majority of the Supervisory Directors
present. The quorum for a valid meeting is a majority of the members of the
Supervisory Board with a minimum of four members. The Board of Supervisory
Directors meets four times a year and also upon the request of its chairman or
the Board of Managing Directors. Pursuant to the Articles of Association,
Supervisory Directors may be suspended or dismissed by the general meeting of
shareholders. The remuneration or compensation of the Supervisory Directors is
determined by the general meeting of shareholders.
 
     While the Board of Managing Directors is the executive body of the Company
and is responsible for managing its affairs and representing the Company in its
dealings with third parties, the primary responsibility of the Board of
Supervisory Directors is to supervise the policies enacted by the Board of
Managing Directors and the general course of affairs of the Company. The Board
of Supervisory Directors advises the Board of Managing Directors. In the
fulfilment of their duties, members of the Board of Supervisory Directors are
required to act in the best interests of the Company.
 
BOARD OF MANAGING DIRECTORS
 
     The Board of Managing Directors, having one managing director (GTS-Hermes),
is charged with the management of the Company in accordance with the business
plan of the Company under the supervision of the Board of Supervisory Directors.
Jan Loeber acts on behalf of GTS-Hermes in this capacity. Under the Articles of
Association, the Board of Managing Directors must obtain the approval of the
Board of Supervisory Directors in order to take the following actions: (a) to
adopt and amend the business plan and the annual budget of the Company; (b) to
incur expenses in excess of the adopted or amended annual budget; (c) to incur
loans outside of the Company's ordinary business, except draw-downs of amounts
previously approved on the Company's account with a bank designated by the Board
of Supervisory Directors; (d) to lend sums which exceed the amounts previously
approved by the Board of Supervisory Directors outside the Company's ordinary
business; (e) to commit the Company to guarantee debts of third parties outside
the Company's ordinary business; (f) to extend the Company's business into a new
line of business and to discontinue the business of the Company; and (g) to
alienate a considerable part of the assets of the Company.
 
     The Articles of Association provide that the Board of Managing Directors
shall consist of one member. The member of the Board of Managing Directors is
appointed by the general meeting of shareholders. The general meeting of
shareholders may suspend or dismiss the member of the Management Board by a vote
of a majority of votes cast in a meeting in which at least four-fifths of the
issued capital is present or represented. If the office of the sole member of
the Board of Managing Directors is vacated or the sole member is prevented from
acting, the Board of Supervisory Directors is charged temporarily with
management of the Company and may appoint one or more of the directors of the
Board of Supervisory Directors to represent the Company. The compensation and
other terms and conditions of employment of the member of the Board of Managing
Directors is determined by the general meeting of shareholders.
 
SUPERVISORY DIRECTORS
 
     Gerald W. Thames, Member of the Supervisory Board. Mr. Thames is President,
Chief Executive Officer and a Director of GTS. Mr. Thames joined GTS as Chief
Executive Officer in February 1994, and has served as a director of GTS since
February 1994. From 1990 to 1994, Mr. Thames was President and Chief Executive
Officer for British Telecom North America and Syncordia, a joint venture company
focused on the international outsourcing market. Mr. Thames has spent over 18
years in senior positions with telecommunications companies, where he was
responsible for developing start-up telecommunications companies, including 15
years with AT&T, where he rose to the position of General Manager of Network
Services for the Northeast Region of AT&T Communications.
 
     Bernard J. McFadden, Member of Supervisory Board. Mr. McFadden has served
as a director of GTS since February 1994. Mr. McFadden currently serves as an
independent consultant to GTS. Prior to 1994,
 
                                       42
<PAGE>   45
 
Mr. McFadden worked for 32 years with ITT Corporation, where he served as
President and Chief Executive Officer of ITT's Telecom International Group. Mr.
McFadden's career in international telecommunications includes a four and
one-half year assignment as President and Chief Operating Officer of Alcatel
Trade International, S.A.
 
     Bo C. O. Hamnell, Member of Supervisory Board. Mr. Hamnell is Senior Vice
President and Director of Finance of SJ, the Swedish State Railway, a position
he has held since June 1993. Mr. Hamnell also serves as Chief Executive Officer
of AB Swedcarrier, a holding company for the SJ investments. Previously, Mr.
Hamnell has served as Chief Financial Officer starting in the early 1970's for
Bull General Electric and later Honeywell Bull and Compagnie Des Machines Bull
in both Scandinavia and in France. In the mid-1980's, Mr. Hamnell served as Vice
President and President for the Swedish Finance Group, Finax, with operations in
Sweden and Western Europe. Mr. Hamnell also served as part owner and vice
president of a group of companies in the electronics and finance business. Mr.
Hamnell has University degrees in Economics and business administration. Mr.
Hamnell is Chairman of the finance company SJ Invest AB and of the captive
insurance company SweRe AB and a board member of Scandlines AB, Svelast AB,
Swedcarrier AB, TGOJ AB, Combitrans Sweden AB, Rail-Combi AB and Eurofima S/A in
Basel, Switzerland.
 
EXECUTIVE OFFICERS OF THE COMPANY
 
     Jan Loeber, Managing Director. Mr. Loeber has overall responsibility for
the development and operations of the Company. Mr. Loeber joined GTS in January
1995. From October 1992 to December 1994, Mr. Loeber was a Managing Director of
B.T. Securities Corporation, where he was responsible for investment banking for
telecommunications clients. From April 1990 to September 1992, Mr. Loeber held
positions as Managing Director of Unitel Ltd. (now Mercury One 2 One) in the
United Kingdom, Group President of Nokia North America Inc., Vice President of
ITT Corporation and Marketing and Product Management Director of ITT Europe. Mr.
Loeber also spent almost ten years with AT&T, where his last position was
Executive Director, Bell Laboratories. Mr. Loeber has over 22 years of
experience in the telecommunications industry and an additional nine years of
experience in information technology with the Pentagon, IBM and Chemical Bank of
New York.
 
     Gerard J. Caccappolo, Corporate Director of Marketing and Sales. Mr.
Caccappolo joined HER in January 1995 as Director of Marketing and Sales,
responsible for market and customer segmentation, services development, and
pricing and sales strategies. Prior to joining HER, from September 1988 to
December 1994, he was Vice President of Marketing and Sales -- International
Carriers at Ascom Timeplex Equipment (Telecommunications) Manufacturer.
 
     Peter Magnus, Corporate Director of Strategy and Planning. Mr. Magnus
joined HER in January 1995 as Financial Director -- Chief Financial Officer,
responsible for treasury, financing, accounting and budgets, and served in that
capacity until October 1997, when he was appointed to his current position.
Prior to joining HER, from January 1992 to December 1994, he was Controller of
the Belgian operations of Cargill N.V.
 
     Bruce C. Rudy, Corporate Director of Business Development and
Regulatory. Mr. Rudy joined HER in 1996 and is Director of Business Development,
Planning and Regulatory Affairs, responsible for business planning, financial
modeling, shareholder relations and development. Mr. Rudy previously worked for
Lochridge & Company, Inc. Management Consultants in Boston, where he was a
senior consultant from September 1989 to December 1995.
 
     John Allan Shearing, Corporate Operations and Engineering Director. Mr.
Shearing joined HER in November 1995 as Director of Operations, with
responsibility for network operations, customer service and information systems.
Before joining HER, Mr. Shearing spent eight years at S.W.I.F.T. as Network
Operations Director and also managing the acceptance and implementation of a new
generation of network systems and applications.
 
     Jan De Wispelaere, Corporate Legal Director. Mr. De Wispelaere joined HER
as a consulting attorney in 1995 and has since been promoted to the position of
Legal Director -- Corporate Secretary and General Counsel. Prior to joining HER,
from January 1994 to November 1995, Mr. De Wispelaere had been with
 
                                       43
<PAGE>   46
 
Stanbrook & Hooper -- European Community Lawyers. Prior to that, he was with
Scott Paper Company and SD Warren Group as Senior Counsel for five years. He has
held since 1993 positions as a member of the Board of Directors and Management
Board of the German Scott -- Feldm(&)uhle HQ Company, as well as several Scott
Paper operating entities in Europe.
 
     Steven Andrews, Corporate Administration Director. Mr. Andrews joined HER
in September 1997, assuming responsibility for human resources; corporate, press
and shareholder communications; quality and facilities-purchasing. Before
joining HER, Mr. Andrews was an executive of US West with recent assignment as
president of Media One and president of US West Spectrum Enterprises
International.
 
     Francois Note, Corporate Financial Director -- Chief Financial Officer (as
of April 1, 1998). In his position at HER, Mr. Note is responsible for treasury,
financing, accounting and budgets. Prior to joining HER, Mr. Note was employed
by Sandoz AG where he held different positions in the financial area. Since 1995
he was Head of Group Controlling at Sandoz and held this position after the
merger of Ciba Geigy and Sandoz, which resulted in the survivor company Novartis
International.
 
ITEM 11. EXECUTIVE COMPENSATION
 
COMPENSATION OF DIRECTORS
 
     The directors on the Board of Supervising Directors and the Board of
Managing Directors receive no fees from the Company for serving as directors.
Mr. McFadden currently serves as an independent consultant to GTS pursuant to a
consulting agreement, under which he receives a consulting fee of $100,000 per
annum. One of his duties under the consulting agreement is to serve as a member
of the Board of Supervisory Directors of HER.
 
EXECUTIVE COMPENSATION
 
     The following table sets forth each component of compensation paid or
awarded to, or earned by, the chief executive officer (who is the Managing
Director of HER) and the four most highly compensated executive officers other
than the chief executive officer (collectively, the "Named Executive Officers")
during the fiscal year ended December 31, 1997.
 
                           SUMMARY COMPENSATION TABLE
 
<TABLE>
<CAPTION>
                                                                                           LONG-TERM
                                                                                         COMPENSATION
                                     ANNUAL COMPENSATION                                    AWARDS
                                     --------------------                    -------------------------------------
                                                              OTHER ANNUAL   RESTRICTED STOCK       SECURITIES        ALL OTHER
                                      SALARY       BONUS      COMPENSATION       AWARD(S)       UNDERLYING OPTIONS   COMPENSATION
NAME AND PRINCIPAL POSITION   YEAR     ($)          ($)           ($)              ($)                 (#)               ($)
---------------------------   ----   --------     -------     ------------   ----------------   ------------------   ------------
<S>                           <C>    <C>          <C>         <C>            <C>                <C>                  <C>
Jan Loeber(1)                 1997   $235,000     $78,608       $46,598(2)          -0-               4,812(4)         $179,450(10)
  Managing Director           1996    235,000      78,608        42,806(2)             (3)              3.5(4)           12,986(10)
Gerald J. Caccappolo(1)       1997    173,750      80,000        32,043(6)          -0-               1,714(4)            4,000(5)
  Corporate Director of       1996    160,000      40,000        42,108(6)          -0-                 1.5(4)            3,750(5)
  Marketing and Sales
Peter Magnus                  1997    136,391(7)   63,980(7)           (8)          -0-                 687(4)              -0-
  Corporate Director of       1996    129,889(7)   32,472(7)           (8)          -0-                 0.5(4)              -0-
  Strategy and Planning
Bruce Rudy(1)                 1997    140,500      13,500        15,096(9)          -0-                 476(4)            3,850(5)
  Corporate Director of       1996    135,000      13,509        18,416(9)          -0-                 0.5(4)            2,532(5)
  Business Development and
  Regulatory
John Shearing                 1997    186,678      31,491(7)           (8)          -0-                 476(4)              -0-
  Corporate Operations        1996    173,594(7)   35,163(7)           (8)          -0-                  --                 -0-
  Director
</TABLE>
 
---------------
 
 (1) The terms of the Named Executive Officer's employment are included in an
     agreement between the Named Executive Officer and GTS. Such Named Executive
     Officer is seconded to the Company for a fee.
 
                                       44
<PAGE>   47
 
 (2) For 1997, the amount listed represents the sum of a cost of living
     allowance of $16,450, a tax equalization payment of $13,953 that
     compensates Mr. Loeber for the higher taxes he pays because he resides in
     Belgium instead of the United States, use of a Company car and a gross-up
     payment for certain tax liabilities in the amount of $11,648. For 1996, the
     amount listed represents the sum of a cost of living allowance of $16,450,
     paid home leave of 9,031, use of a Company car and a gross-up payment of
     $12,778 for certain tax liabilities.
 
 (3) Mr. Loeber has been granted a restricted stock award of 30,000 shares of
     GTS common stock which vests in equal thirds, beginning in January 2, 1997.
 
 (4) For 1997, represents stock options awarded under The Key Employee Stock
     Option Plan of Hermes Europe Railtel B.V. (the "HER Stock Option Plan") For
     1996, represents stock options granted under the GTS-Hermes, Inc. 1994
     Stock Option Plan (the "GTS-Hermes Plan"). The stock options granted in
     1997 are in substitution for the stock options granted in 1996, which have
     been cancelled.
 
 (5) These Named Executive Officers participate in the GTS 401(k) plan to which
     GTS contributed the amounts indicated for 1997 and 1996.
 
 (6) Mr. Caccappolo received a cost of living allowance of $12,163 and $11,200
     in 1997 and 1996, respectively, and resides in a Company apartment which
     the Company paid the equivalent of $16,109 and $17,928 per year in rent in
     1997 and 1996, respectively. In addition, the Company provided Mr.
     Caccappolo with the use of a Company car in 1997 and 1996.
 
 (7) Converted from Belgian Francs to U.S. Dollars at an exchange rate of
     BF35.77=$1.00 and BF32.04=$1.00 in 1997 and 1996, respectively.
 
 (8) Perquisites and other personal benefits paid to Mr. Magnus and Mr. Shearing
     during 1997 and 1996 were less than the lesser of $50,000 and 10 percent of
     the total of annual salary and bonus reported for the Named Executive
     Officer.
 
 (9) Mr. Rudy received a housing allowance of $15,096 and $16,855 during 1997
     and 1996, respectively. In addition, the Company provided Mr. Rudy with the
     use of a Company car in 1997 and 1996.
 
(10) This amount represents premiums paid by GTS for $1,000,000 in term life
     insurance for Mr. Loeber and contributions to Mr. Loeber's account by GTS
     under the 401(k) Plan. For 1997, the amount also includes $156,700 which
     represents the value at December 31, 1997 of 10,000 shares of GTS
     restricted common stock which vested in 1997.
 
                    OPTION GRANTS IN THE LAST FISCAL YEAR(1)
 
<TABLE>
<CAPTION>
                                           NUMBER OF     % OF TOTAL
                                           SECURITIES     OPTIONS
                                           UNDERLYING    GRANTED TO    EXERCISE OR                GRANT DATE
                                            OPTIONS     EMPLOYEES IN      BASE       EXPIRATION     PRESENT
                  NAME                     GRANTED(#)   FISCAL YEAR    PRICE($/SH)      DATE      VALUE($)(2)
                  ----                     ----------   ------------   -----------   ----------   -----------
<S>                                        <C>          <C>            <C>           <C>          <C>
Jan Loeber...............................    4,812         47.33%         83.12         2006       2,234,019
Gerard J. Caccappolo.....................    1,714         16.86%        100.00         2006         776,185
Peter Magnus.............................      687          6.76%         83.12         2006         318,947
Bruce Rudy...............................      476          4.68%        191.31         2006         189,305
John Shearing............................      476          4.68%        378.43         2007         148,998
</TABLE>
 
---------------
 
(1) Each stock option vests one-third on each of the first three anniversaries
    of the date of grant, with one exception in which 100% vested immediately.
    The Company established the HER Stock Option Plan to replace the GTS-Hermes
    Plan during the fourth quarter of 1997. The options outstanding under the
    GTS-Hermes Plan were cancelled and replaced by options under the HER Stock
    Option Plan.
 
(2) The present value of each grant is estimated on the date of the grant using
    the Black-Scholes option pricing model with the following weighted-average
    assumptions: dividend yield 0%, expected volatility of 0.50, risk-free
    interest rate of 5.79 and expected life of five years.
 
                                       45
<PAGE>   48
 
            AGGREGATED OPTION EXERCISES IN THE LAST FISCAL YEAR AND
                        FISCAL YEAR-ENDED OPTION VALUES
 
<TABLE>
<CAPTION>
                                                     NUMBER OF SECURITIES          VALUE OF UNEXERCISED
                                                    UNDERLYING UNEXERCISED         IN-THE-MONEY OPTIONS
                                                     OPTIONS AT FY-END(#)             AT FY-END($)(2)
                     NAME                        EXERCISABLE/UNEXERCISABLE(1)    EXERCISABLE/UNEXERCISABLE
                     ----                        ----------------------------    -------------------------
<S>                                              <C>                             <C>
Jan Loeber.....................................      3,208/1,604                   1,417,551/708,775
Gerard J. Caccappolo...........................       1,143/571                     485,775/242,675
Peter Magnus...................................         687/0                          303,572/0
Bruce Rudy.....................................        317/159                       105,780/53,057
John Shearing..................................        159/317                       23,305/46,463
</TABLE>
 
---------------
 
(1) No options were exercised during the year ended December 31, 1997.
 
(2) Based on $525.00 per share value of common stock as of December 31, 1997
    less the exercise price.
 
KEY EMPLOYEE STOCK OPTION PLAN OF HERMES EUROPE RAILTEL B.V.
 
     HER has adopted the Key Employee Stock Option Plan of Hermes Europe Railtel
B.V. (the "New Plan"). Under the New Plan certain employees of HER will be
granted stock options to purchase HER common stock. Subject to adjustment in the
event of certain changes in capitalization, a maximum of 24,760 shares of HER
common stock will be authorized for grant under the New Plan which shall be
granted in the form of depository receipts (each a "Receipt"). Each Receipt will
represent a beneficial interest in one share of HER common stock that is subject
to stock options under the New Plan.
 
     The New Plan is administered by a committee composed of three members of
the Board of Supervising Directors which will have broad discretion to determine
who shall receive awards under the New Plan, the terms of such awards and
interpret the New Plan. The New Plan shall become effective upon its adoption by
the Board of Supervising Directors and shall continue in effect until 2004,
unless terminated earlier by the Board of Supervising Directors.
 
     Each stock option granted under the New Plan shall have a term of ten
years, except those granted in 1997 reflected in the table above. The exercise
price of each such stock option will be determined at the time of grant. In
addition the stock options granted under the New Plan will become exercisable at
such times and under such conditions as determined by the committee.
 
     The Board of Supervising Directors may amend or terminate the New Plan at
any time, provided that the rights of participants are not impaired.
 
PENSION PLAN
 
     In 1995, the Company established a defined benefit pension plan (the
"Pension Plan") that covers substantially all of its employees that are at least
twenty-five years of age and have at least one year of service. The benefits are
based on years of service and the employee's compensation at retirement. Messrs.
Magnus and Shearing participate in the Pension Plan. Each participant in the
Pension Plan will receive a lump sum at retirement equal to 450% of final annual
salary up to a specified ceiling which changes every year (in 1997 the ceiling
was BF1,352,000) plus 910% of the excess multiplied by the years of service
divided by 35. The maximum years of service taken into account under the formula
is 35. The normal retirement age is 60. The Company has entered into an
agreement with an insurance company for the provision of a group insurance
policy (the "Policy"). Under the Policy, the insurance provider has undertaken a
legal obligation to provide specified benefits to participants in return for a
fixed premium; accordingly, the Company does not bear significant financial
risk. Premium payments for the Policy are partly paid by the employee based on
specified terms that consider the employee's annual salary, with the remaining
premium paid by the Company. Premiums are intended to provide not only for
benefits attributed to service to date but also for those expected to be earned
in the future. (See Note 5 to the Notes to Consolidated Financial Statements).
Upon termination of employment prior to retirement age, employer contributions
cease and the participant may
 
                                       46
<PAGE>   49
 
decide to receive the cash surrender value of the policy, to continue paying
premiums or cease paying premiums but in either case maintaining the policy
which is paid out according to its terms.
 
                               PENSION PLAN TABLE
 
<TABLE>
<CAPTION>
                                                  YEARS OF SERVICE
                           --------------------------------------------------------------
      REMUNERATION             15           20           25           30           35
      ------------         ----------   ----------   ----------   ----------   ----------
<S>                        <C>          <C>          <C>          <C>          <C>
$125,000.................  $  370,313   $  493,750   $  617,188   $  740,625   $  863,200
$150,000.................     467,870      623,829      779,786      935,744    1,090,610
$175,000.................     565,508      754,011      942,513    1,131,056    1,318,200
$200,000.................     663,100      884,140    1,105,170    1,326,210    1,545,700
$225,000.................     760,703    1,014,271    1,267,838    1,521,405    1,773,200
$250,000.................     858,300    1,144,400    1,430,500    1,716,600    2,000,000
$300,000.................   1,053,490    1,404,660    1,755,820    2,106,990    2,455,700
$400,000.................   1,443,880    1,925,181    2,406,476    2,887,771    3,365,700
$450,000.................   1,639,080    2,185,440    2,731,800    3,278,160    3,820,700
$500,000.................   1,834,270    2,445,700    3,057,120    3,668,550    4,275,700
</TABLE>
 
The above pension benefits are based on the following formula:
(260% S1 + 910% S2) X N/35
 
<TABLE>
<S>  <C>  <C>
S     =   annual salary
S1    =   S up to the "ceiling"
S2    =   S above the "ceiling"
N     =   years of service up to a maximum of 35
</TABLE>
 
For purposes of this calculation the "ceiling" is U.S. $42,200.
 
EMPLOYMENT AGREEMENTS
 
     All the Named Executive Officers have employment agreements with either the
Company (the "Company Employment Agreements") or GTS (the "GTS Employment
Agreements"). The Company reimburses GTS for payments made to Named Executive
Officers under contracts with GTS. The Employment Agreements generally are each
for a term of two to three years and include an automatic renewal provision
unless either party provides notice of termination on or prior to 90 days
thereof.
 
     Messrs. Magnus and Shearing have Company Employment Agreements. The
following is a summary of the material terms of such agreements. Mr. Magnus'
Company Employment Agreement was entered into by the parties on January 3, 1995
for an initial term ending December 31, 1996. The parties have agreed to extend
the term for an indefinite period of time. Mr. Magnus' initial gross annual
salary was BF4,080,000. He may also receive a yearly performance-based bonus of
up to 30% of his base salary based at the discretion of the Company. Under the
agreement, Mr. Magnus is entitled to the use of a company car. The agreement
also provides that Mr. Magnus shall be granted an option to buy shares under the
GTS-Hermes Plan under a separate stock option agreement.
 
     Mr. Shearing's Company Employment Agreement was entered into by the parties
of November 1, 1995 for an undetermined period of time. Mr. Shearing's initial
annual salary was BF2,800,000, which is net of all tax and social security
contributions. Mr. Shearing's gross salary for fiscal year 1997 was BF6,677,487.
He may also receive a yearly performance-based bonus of up to 20% of his base
salary at the discretion of the Company. Mr. Shearing participates in the
Company's pension plan and is provided with a company car.
 
     See "Certain Relationships and Related Transactions" for a description of
the GTS Employment Agreements.
 
                                       47
<PAGE>   50
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
     The following table sets forth certain information regarding the beneficial
ownership of the Ordinary Shares of the Company, as of December 31, 1997, by
each beneficial owner of 5% or more of the Ordinary Shares and by executive
officers and directors of the Company as a group, as adjusted for the March 1998
sale by HIT Rail of its ownership interest in the Company. See Item 13 -- "HER
Recapitalization."
 
<TABLE>
<CAPTION>
                                                                   AS ADJUSTED FOR MARCH 1998
                                      AS OF DECEMBER 31, 1997           SALE BY HIT RAIL
                                    ---------------------------    ---------------------------
                                    NUMBER OF SHARES    PERCENT    NUMBER OF SHARES    PERCENT
                                    ----------------    -------    ----------------    -------
<S>                                 <C>                 <C>        <C>                 <C>
GTS-Hermes, Inc...................      150,632          79.09%        170,307          89.42%
HIT Rail B.V.(1)..................       24,047          12.63             -0-            -0-
SNCB/NMBS.........................       11,424           6.00          13,610           7.15
AB Swed Carrier...................        4,365           2.29           6,551           3.44
Jan Loeber........................        3,208           1.68           3,208           1.68
Gerard J. Caccappolo..............        1,143              *           1,143              *
Peter Magnus......................          687              *             687              *
Bruce Rudy........................          317              *             317              *
John Shearing.....................          159              *             159              *
Other officers....................          730              *             730              *
All directors and executive
officers as a group(2)............        6,244           3.28           6,244           3.28
          Total...................      196,712                        196,712
                                        -------                        -------
</TABLE>
 
---------------
 
 *  Less than 1%
(1) The members of HIT Rail are +Osterreichische Bundesbahnen, Societe Nationale
    des Chemins de Fer Belges, Danske Statsbaner, Societe Nationale des Chemins
    de Fer Francais, Deutsche Bundesbahn, Ente Ferrovie dello Stato, Nederlandse
    Spoorwegen, Red Nacional de los Ferrocarriles Espanoles, Statens Jarnvagar,
    Schweizerische Bundesbahnen and Racal-BRT.
(2) Represents stock options in shares of the Company exercisable within 60 days
    of December 31, 1997.
 
ITEM. 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
     HER was formed on July 6, 1993 by HIT Rail, a consortium of eleven Western
European railways. HIT Rail was incorporated in 1990 by these national railways
to carry out telecommunications engineering activities in order to construct and
exploit a data communications network for railway traffic. GTS-Hermes purchased
a 34.4% interest in HER in 1994, increased its interest to 50% in 1995,
approximately 79% in 1997, and approximately 89% in March 1998.
 
     GTS-Hermes is a wholly owned subsidiary of GTS. GTS is a U.S.-based
provider of a broad range of telecommunications services to businesses, other
telecommunications service providers and consumers in Russia and the
Commonwealth of Independent States, Western and Central Europe and Asia. GTS is
organized in the state of Delaware. At December 31, 1997, GTS had approximately
37.6 million shares of common stock outstanding and shareholders' equity of
$113.7 million.
 
                                       48
<PAGE>   51
 
HER RECAPITALIZATION
 
     HER has completed a recapitalization (the "HER Recapitalization"), wherein
HER extended rights to subscribe to additional shares of HER to GTS-Hermes, HIT
Rail and the eleven railways comprising the HIT Rail consortium. Pursuant
thereto, GTS-Hermes and two of the eleven railways that comprise the HIT Rail
consortium have exercised their subscription rights, while HIT Rail and the
other nine railways have declined to exercise their subscription rights. HER has
issued (i) 150,592 shares to GTS-Hermes in exchange for the conversion of loans
and additional consideration, (ii) 24,007 shares to HIT Rail in exchange for the
conversion of loans, (iii) 11,424 shares to SNCB/NMBS and (iv) 4,365 shares to
AB Swed Carrier (a wholly owned subsidiary of SJ, the Swedish national railway).
As a result, GTS-Hermes owns 79.08%, HIT Rail owns 12.63%, SNCB/NMBS owns 6.00%
and AB Swed Carrier owns 2.29% of the issued HER shares. Pursuant to the HER
Recapitalization, HER, GTS-Hermes, HIT Rail, SNCB/NMBS and AB Swed Carrier have
executed a new Shareholders Agreement, the principal terms of which are set
forth below. In March 1998, HIT Rail sold all its shares in HER to GTS-Hermes,
SNCB/NMBS and AB Swed Carrier. As a result of such sale, GTS-Hermes, SNCB/NMBS
and Swed Carrier currently own 170,307, 13,610, and 6,551 shares of HER,
respectively, or 89.42%, 7.15% and 3.44%, respectively, of HER.
 
     Under the new Shareholders Agreement, actions to be taken by shareholders
will be adopted by a simple majority vote with the exception of certain actions
which will require at least 85% of the votes cast: (i) purchase by HER of its
own shares and any redemption thereof, (ii) exclusion of preemptive rights in
the case of the issuance of new shares and the transfer of shares held by HER,
except in the event of a public listing of the shares or of new shares or of an
offering of shares or options on new shares (warrants) to professional investors
in order to obtain further funding, (iii) winding up or dissolution of HER, (iv)
any amendment to the articles of association other than those pertaining to
increases in the authorized capital of HER or to convert HER into an N.V.
("Naamloze Vennootschap") to enable a public listing of shares or new shares,
(v) any amendment to the scope of HER's business, (vi) the declaration of
dividends and (vii) the admission of new shareholders to the Shareholders
Agreement. In addition, the Shareholders Agreement provides that (a) if
GTS-Hermes is the owner of as least 50% of the issued shares, then it will have
the right to make a binding nomination for the appointment of half of the
members of the Board of Supervisory Directors or (b) if GTS-Hermes is the owner
of at least two-thirds of the issued shares, then it will have the right to make
a binding nomination for the appointment of half of the members of the Board of
Supervisory Directors plus one member more, appointed pursuant to nominations by
the other shareholders. As long as HIT Rail is the owner of at least one share,
HIT Rail will be entitled to make a binding nomination for the appointment of at
least one member of the Supervisory Board. The Shareholders Agreement also
provides that shareholders who participated in the HER Recapitalization other
than GTS-Hermes and HIT Rail with a shareholding of at least 6.8% subject to
adjustment in the discretion of the other shareholders will be entitled to make
a binding nomination for the appointment of one member of the Board of
Supervisory Directors. Shareholders who participated in the HER Recapitalization
other than GTS-Hermes and HIT Rail who hold fewer than 6.8% of the issued share
capital of HER will be entitled on a rotating basis to make one binding
nomination for the appointment of a member of the Board of Supervisory Directors
for two-year periods. As a result of the March 1998 sale by HIT Rail of all its
shares, HIT Rail no longer has any rights or obligations, except as set forth
below, under the Shareholders Agreement and GTS- Hermes, acting alone, can
approve all the matters described above which require an 85% HER shareholder
vote.
 
ARTICLES OF ASSOCIATION AND SHAREHOLDERS AGREEMENT
 
     Under the Articles of Association and the Shareholders Agreement, HER's
shareholders have preemptive rights in connection with issuances of ordinary
shares and options on shares to be issued in proportion to the total nominal
value of the shares held by each of them. Preemption rights can be exercised for
four weeks after the date the notice of the offer is received by the
shareholders.
 
     The Shareholders Agreement provides that the Company or its designated
vendor will provide fiber capacity in its Network for use by the shareholders of
the Company on fair commercial terms, use, quantity and price to be negotiated
on a bilateral basis. In the Shareholders Agreement, HIT Rail has covenanted to
(i) use its best efforts to establish such commercial agreements between
individual HIT Rail shareholders and
                                       49
<PAGE>   52
 
the Company, to obtain rights of way from individual HIT Rail shareholders and
to cooperate in obtaining such licenses as may advance the business of the
Company, (ii) use its best efforts to ensure that the HIT Rail shareholders
cooperate in obtaining such license in accordance with the business plan of the
Company and as may be necessary or advisable in furtherance of the Company's
business, (iii) will not, so long as both HIT Rail and GTS-Hermes are
shareholders of the Company and for one year after HIT Rail ceases to be a
shareholder, agree with any entity other than GTS-Hermes and the Company to
assist or cooperate in the development of any pan-European telecommunications
operator and (iv) use its best efforts to obtain on the Company's behalf such
materials as may be required and arrange inspection visits of selected rights of
way for the purpose of making initial cost estimates.
 
     The foregoing summary of the Shareholders Agreement does not purport to be
complete and is qualified in its entirety by reference to the Shareholders
Agreement.
 
SHAREHOLDER LEASES AND LOANS
 
     The Company has also entered into a contracts with SNCB/NMBS for the
provision of fiber and facilities for portions of the initial five country
network. SNCB/NMBS is a direct shareholder of HER. As such, it is entitled to
propose a nominee for appointment to the Board of Supervisory Directors of the
Company.
 
     In January and February 1997, additional loans of ECU 6.4 million
(approximately $7.5 million) were advanced to the Company by GTS-Hermes. In
addition, loans of ECU 5.4 million (approximately $6.1 million) were advanced to
the Company in February and April 1997 by individual members of the HIT Rail
consortium. The loans were converted into equity as part of the HER
Recapitalization.
 
GTS EMPLOYMENT AGREEMENTS
 
     Messrs. Loeber, Caccappolo and Rudy are parties to GTS Employment
Agreements. Each GTS Employment Agreement provides the relevant Named Executive
Officer with a salary, bonus and a standard company welfare benefits package as
well as the use of an automobile, cost of living allowance, tax equalization and
certain other fringe benefits. In addition, the GTS Employment Agreements
include severance benefit provisions. Finally, the GTS Employment Agreements
include noncompete and nonsolicitation clauses that cover the term of employment
and twelve months thereafter. Under the GTS Agreements, each party employee is
entitled to participate in the GTS-Hermes Plan. In addition, Mr. Loeber received
a restricted stock award of 30,000 shares of GTS common stock.
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
a) The following documents are filed as part of this report:
 
     1 Consolidated Financial Statements
 
     The following consolidated financial statements of the Company are included
in Part II, Item 8 of this report:
 
     - Consolidated Statements of Operations for each of the Three Years Ended
       December 31, 1997, 1996 and 1995
 
     - Consolidated Balance Sheets as of December 31, 1997 and 1996
 
     - Consolidated Statements of Cash Flows for each of the Three Years Ended
       December 31, 1997, 1996 and 1995
 
     - Consolidated Statements of Changes in Stockholders' Equity (Deficit) for
       each of the Three Years Ended December 31, 1997, 1996 and 1995
 
     - Notes to Consolidated Financial Statements
 
                                       50
<PAGE>   53
 
     2 Consolidated Financial Statement Schedules
 
     All other schedules are omitted because they are not applicable or not
required, or because the required information is either incorporated herein by
reference or included in the financial statements or notes thereto included in
this report.
 
b) Reports on Form 8-K
 
<TABLE>
<CAPTION>
DATE OF REPORT                                 SUBJECT OF REPORT
--------------                                 ------------------
<S>                                            <C>
None
</TABLE>
 
c) Exhibits
 
<TABLE>
<CAPTION>
      DESIGNATION                                DESCRIPTION
      -----------                                -----------
<C>                      <S>
         3.1*            -- Deed of Incorporation and Articles of Association, as
                            amended to date
         4.1*            -- Form of Outstanding Note (contained in Indenture filed as
                            Exhibit 4.3)
         4.2*            -- Form of Exchange Note (contained in Indenture filed as
                            Exhibit 4.3)
         4.3*            -- Indenture, dated August 19, 1997, among the Company,
                            Global TeleSystems Group, Inc. and The Bank of New York,
                            as Trustee
         4.4*            -- Registration Rights Agreement, dated August 19, 1997,
                            between the Company and Donaldson, Lufkin & Jenrette
                            Securities Corporation, UBS Securities LLC and Lehman
                            Brothers Inc.
         4.5*            -- Escrow Agreement, dated August 19, 1997, among the
                            Company and The Bank of New York, as Trustee and as
                            Escrow Agent
        10.1*            -- Shareholders Agreement among the Company, GTS-Hermes
                            Inc., HIT Rail B.V., SNCB/NMBS and AB Swed Carrier
        10.2*            -- Employment Agreement, dated as of January 3, 1995,
                            between SFMT, Inc. and Jan Loeber
        10.3*            -- Employment Agreement, dated as of January 3, 1995,
                            between SFMT, Inc. and Gerard Caccappolo
        10.4*            -- Employment Agreement, dated as of January 1, 1996,
                            between GTS Group, Inc. and Bruce Rudy
        10.5*            -- Employment Agreement between the Company and Peter Magnus
        10.6*            -- Employment Agreement, dated as of September 26, 1995,
                            between the Company and J.A. Shearing
        10.7*            -- License, dated December 18, 1996, granted by the
                            Secretary of State for Trade and Industry relating to the
                            United Kingdom
        10.8*            -- Registration, dated July 26, 1996, granted by IBPT
                            relating to Belgium
        10.9*            -- Authorization Letter, dated August 1, 1996, granted by
                            Hoofdirectie Telecommunicate & Post relating to the
                            Netherlands
        10.10*           -- License, dated May 28, 1997, granted by BMPT relating to
                            Germany
        10.11*+          -- Agreement, dated April 1, 1997, between Eastern Group
                            Telecoms Limited and the Company
        10.12*+          -- Agreement, dated January 16, 1997, between SNCB/NMBS and
                            the Company
        10.13*+          -- Agreement, dated February 3, 1997, between SANEF and the
                            Company
        10.14**          -- License, dated October 22, 1997 granted by the Secretary
                            of State of Industry relating to France
        10.15**          -- Authorization Letter, dated March 16, 1998, granted by
                            the Deputy Director of Federal Communication Office
                            relating to Switzerland.
</TABLE>
 
                                       51
<PAGE>   54
 
<TABLE>
<CAPTION>
      DESIGNATION                                DESCRIPTION
      -----------                                -----------
<C>                      <S>
        10.16**+         -- Fiber Agreement, dated September 24, 1997
        10.17**+         -- Fiber Agreement, dated October 8, 1997
        10.18**+         -- Fiber Agreement, dated December 15, 1997
        21.1**           -- List of Subsidiaries
        27.1**           -- Financial Data Schedule for the Year Ended December 31,
                            1997
</TABLE>
 
---------------
 
*  Incorporated by reference to the correspondingly numbered Exhibit to
   Amendment No. 4 to the Company's Registration Statement on Form S-4
   (Commission File No. 333-37719).
 
** Filed herewith.
 
+  Confidential material has been redacted and filed separately with the
   Securities and Exchange Commission.
 
                                       52
<PAGE>   55
 
                                   SIGNATURES
 
     Pursuant to the requirements of the Section 13 or 15 (d) of the Securities
Exchange Act 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, in Hoeilaart, Belgium,
on this 15th day of April, 1998.
 
                                            HERMES EUROPE RAILTEL B.V.
 
                                            By:       /s/ JAN LOEBER
                                              ----------------------------------
                                              Name: Jan Loeber
                                              Title: Managing Director
 
     Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated on the 15th day of April, 1998.
 
<TABLE>
<C>                                                    <S>
                   /s/ JAN LOEBER                      Managing Director (Principal Executive
-----------------------------------------------------    Officer)
                    (Jan Loeber)
 
                  /s/ FRANCOIS NOTE                    Corporate Financial Director -- Chief
-----------------------------------------------------    Financial Officer (Principal Financial and
                   (Francois Note)                       Accounting Officer)
 
                /s/ GERALD W. THAMES                   Member of Board of Supervisory Directors
-----------------------------------------------------
                 (Gerald W. Thames)
 
               /s/ BERNARD J. MCFADDEN                 Member of Board of Supervisory Directors
-----------------------------------------------------
                (Bernard J. McFadden)
 
                 /s/ BO C.O. HAMNELL                   Member of Board of Supervisory Directors
-----------------------------------------------------
                  (Bo C.O. Hamnell)
 
                   /s/ JAN LOEBER                      Member of Board of Managing Directors
-----------------------------------------------------
                  GTS-Hermes, Inc.
                   By Jan Loeber,
                Senior Vice President
                 and Representative
</TABLE>
 
                                       53
<PAGE>   56
 
                               INDEX TO EXHIBITS
 
<TABLE>
<CAPTION>
      DESIGNATION                                DESCRIPTION
      -----------                                -----------
<C>                      <S>
         3.1*            -- Deed of Incorporation and Articles of Association, as
                            amended to date
         4.1*            -- Form of Outstanding Note (contained in Indenture filed as
                            Exhibit 4.3)
         4.2*            -- Form of Exchange Note (contained in Indenture filed as
                            Exhibit 4.3)
         4.3*            -- Indenture, dated August 19, 1997, among the Company,
                            Global TeleSystems Group, Inc. and The Bank of New York,
                            as Trustee
         4.4*            -- Registration Rights Agreement, dated August 19, 1997,
                            between the Company and Donaldson, Lufkin & Jenrette
                            Securities Corporation, UBS Securities LLC and Lehman
                            Brothers Inc.
         4.5*            -- Escrow Agreement, dated August 19, 1997, among the
                            Company and The Bank of New York, as Trustee and as
                            Escrow Agent
        10.1*            -- Shareholders Agreement among the Company, GTS-Hermes
                            Inc., HIT Rail B.V., SNCB/NMBS and AB Swed Carrier
        10.2*            -- Employment Agreement, dated as of January 3, 1995,
                            between SFMT, Inc. and Jan Loeber
        10.3*            -- Employment Agreement, dated as of January 3, 1995,
                            between SFMT, Inc. and Gerard Caccappolo
        10.4*            -- Employment Agreement, dated as of January 1, 1996,
                            between GTS Group, Inc. and Bruce Rudy
        10.5*            -- Employment Agreement between the Company and Peter Magnus
        10.6*            -- Employment Agreement, dated as of September 26, 1995,
                            between the Company and J.A. Shearing
        10.7*            -- License, dated December 18, 1996, granted by the
                            Secretary of State for Trade and Industry relating to the
                            United Kingdom
        10.8*            -- Registration, dated July 26, 1996, granted by IBPT
                            relating to Belgium
        10.9*            -- Authorization Letter, dated August 1, 1996, granted by
                            Hoofdirectie Telecommunicate & Post relating to the
                            Netherlands
        10.10*           -- License, dated May 28, 1997, granted by BMPT relating to
                            Germany
        10.11*+          -- Agreement, dated April 1, 1997, between Eastern Group
                            Telecoms Limited and the Company
        10.12*+          -- Agreement, dated January 16, 1997, between SNCB/NMBS and
                            the Company
        10.13*+          -- Agreement, dated February 3, 1997, between SANEF and the
                            Company
        10.14**          -- License, dated October 22, 1997 granted by the Secretary
                            of State of Industry relating to France
        10.15**          -- Authorization Letter, dated March 16, 1998, granted by
                            the Deputy Director of Federal Communication Office
                            relating to Switzerland.
        10.16**+         -- Fiber Agreement, dated September 24, 1997
        10.17**+         -- Fiber Agreement, dated October 8, 1997
        10.18**+         -- Fiber Agreement, dated December 15, 1997
</TABLE>
<PAGE>   57
 
<TABLE>
<CAPTION>
      DESIGNATION                                DESCRIPTION
      -----------                                -----------
<C>                      <S>
        21.1**           -- List of Subsidiaries
        27.1**           -- Financial Data Schedule for the Year Ended December 31,
                            1997
</TABLE>
 
---------------
 
*  Incorporated by reference to the correspondingly numbered Exhibit to
   Amendment No. 4 to the Company's Registration Statement on Form S-4
   (Commission File No. 333-37719).
 
** Filed herewith.
 
+  Confidential material has been redacted and filed separately with the
   Securities and Exchange Commission.