<PAGE>
          
================================================================================
               UNITED STATES SECURITIES AND EXCHANGE COMMISSION
                            Washington, D.C.  20549

                                   FORM 10-K
(Mark one)
 (X) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                         ACT OF 1934 [NO FEE REQUIRED]
                                        
                  For the fiscal year ended December 31, 1998
                                        
                                       OR
                                        
 ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
                    EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
                                        
                       Commission file number 000-21043
                                        
                        Pacific Gateway Exchange, Inc.
            (Exact name of registrant as specified in its charter)

         Delaware                                 94-3134065
(State or other jurisdiction of          (IRS Employer Identification No.)
 incorporation or organization)

        533 Airport Boulevard, Suite 505, Burlingame, California 94010
                   (Address of principal executive offices)

                        Telephone Number: 650-375-6700
             (Registrant's telephone number, including area code)

          Securities registered pursuant to Section 12(g) of the Act:
                                        
                   Common Shares, Par Value $.0001 per Share
          Preferred Share Purchase Rights, Par Value $.0001 per Share
                               (Title of class)


     Indicate by check mark whether the registrant (1) has 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) has been subject to such
filing requirements for the past 90 days.    Yes   X        No
                                                 -----         -----

     Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

     The aggregate market value of voting stock held by non-affiliates of the
registrant on March 17, 1999, was approximately $565,700,000, computed upon the
basis of the closing sales price of the Common Shares on that date.  For the
purposes of this computation, shares held by directors (and shares held by any
entities in which they serve as officers) and executive officers of the
registrant have been excluded.  Such exclusion is not intended, nor shall it be
deemed to be, an admission that such persons are affiliates of the registrant.

     As of March 17, 1999, there were outstanding 19,257,112 Common Shares of
$.0001 par value, of the registrant

                      Documents Incorporated by Reference
                                        
1.   The Registrant's definitive proxy statement to be filed with the Securities
and Exchange Commission not later than 120 days after the end of the
Registrant's fiscal year pursuant to Regulation 14A relating to the 1999 Annual
General Meeting of Shareholders.

================================================================================
<PAGE>
 
                        PACIFIC GATEWAY EXCHANGE, INC.

                               TABLE OF CONTENTS


<TABLE>
<CAPTION>
                                                                     Page
Item                                                                Number
----                                                                ------
                                    PART I
<S>   <C>                                                             <C>
1.    Business                                                         1

2.    Properties                                                      28

3.    Legal Proceedings                                               28

4.    Submission of Matters to a Vote of Security Holders             28

      Executive Officers                                              29

                                    PART II

5.    Market for the Registrants Common Stock and Related
      Stockholder Matters                                             31

6.    Selected Financial Data                                         31

7.    Management's Discussion and Analysis of Financial Condition
      and Results of Operations                                       32

7A.   Quantitative and Qualitative Disclosures about Market Risk      39

8.    Financial Statements and Supplementary Data                     40

9.    Changes in and Disagreements with Accountants on Accounting
      and Financial Disclosure                                        56

                                    PART III

10.   Directors and Executive Officers                                56

11.   Executive Compensation                                          56

12.   Security Ownership of Certain Beneficial Owners and Management  56

13.   Certain Relationships and Related Transactions                  56

                                    PART IV

14.   Exhibits, Financial Statement Schedules, and Reports on
      Form 8-K                                                        56
</TABLE> 
<PAGE>
 
PART I

ITEM 1.  BUSINESS

Note on forward-looking statements

     This Annual Report contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended.  Forward-looking
statements are statements other than historical information or statements of
current condition.  Some forward-looking statements may be identified by use of
terms such as "believes," "anticipates," "plans," "intends" or "expects." These
forward-looking statements relate to the plans, objectives and expectations of
Pacific Gateway Exchange, Inc. ("Pacific Gateway" or the "Company") regarding
its future operations or financial performance or related to the Company's
expectations regarding the telecommunications industry.  In light of the
inherent risks and uncertainties of any forward-looking statement, the inclusion
of forward-looking statements in this report should not be regarded as a
representation by the Company or any other person that the forward-looking
statements will come true.  The revenues and results of operations of the
Company, and future developments in the telecommunications industry, are
difficult to forecast and could differ materially from those projected in the
forward-looking statements as a result of numerous factors, including the
following: (i) changes in international settlement rates; (ii) changes in the
ratios between outgoing and incoming traffic and changes in expected future
revenue from delayed proportional return traffic from foreign partners pursuant
to certain operating agreements; (iii) foreign currency fluctuations; (iv)
termination of certain operating agreements or inability to enter into
additional operating agreements; (v) inaccuracies in the Company's forecasts of
traffic; (vi) changes in or developments under domestic or foreign laws,
regulations, licensing requirements or telecommunications standards; (vii)
foreign political or economic instability; (viii) changes in the availability of
transmission facilities such as domestic, international and undersea fiber optic
cable facilities or in the feasibility and expense of building or leasing such
facilities; (ix) loss of the services of key officers, such as Howard A.
Neckowitz, Chairman of the Board, President and Chief Executive Officer or Gail
E.  Granton, Executive Vice President, International Business Development and
Secretary; (x) loss of a customer which provides significant revenues to the
Company; (xi) highly competitive market conditions in the industry and rapid
technological change; (xii) future management decisions regarding, for example,
acquisitions, capital expenditures or financings;  (xiii) concentration of
credit risk; (xiv) natural disasters and catastrophic events including network
outages or failures; (xv) opportunities for (and problems relating from) the
acquisition of other companies or offshore facilities; (xvi) difficulties that
may be encountered in the development of bandwidth services; including
construction delays, regulatory obstacles and the availability of opportunities
for additional bandwidth purchases; (xvii) uncertainties in the development of
ethnic marketing programs and new business lines, such as the Company's
commencement of Internet operations and sales to switchless resellers relating,
for example, to the difficulty of hiring appropriate personnel and competitive
conditions; (xviii) Internet growth at slower rates than expected due to market
conditions or (xix) any failure of our computer systems or the computer systems
of third parties that are material to our operations (such as the computer
systems of service providers, suppliers and brokers) to process correctly
information relating to dates in and after the year 2000. See "Risk Factors" for
additional reasons why the forward-looking statements may not be realized. The
foregoing review of important factors, including those discussed in detail
below, should not be construed as exhaustive; the Company undertakes no
obligation to release publicly the results of any future revisions it may make
to forward-looking statements to reflect events or circumstances after the date
hereof or to reflect the occurrence of unanticipated events.

Summary

     The Company is a rapidly growing facilities-based international
telecommunications carrier that provides low-cost, high quality
telecommunications services to both wholesale and retail customers worldwide.
Through its owned international network, and to a lesser degree leased capacity
and satellite circuits, the Company is able to terminate telecommunications
traffic to any country in the world that has 

                                       1
<PAGE>
 
direct dial service with the United States. From 1995 to 1998, the Company's
revenues increased from $76.4 million to $466.3 million, its earnings before
interest expense, income taxes, depreciation and amortization ("EBITDA")
increased from $4.6 million to $35.9 million, and its net income increased
from $1.8 million to $19.9 million.

     Pacific Gateway is evolving from a wholesale provider of international
voice traffic to a diversified telecommunications company positioned to succeed
in the emerging market for high capacity bandwidth.  Pacific Gateway began as an
U.S. centric supplier of wholesale service to U.S. long distance companies.  To
complement its U.S. operations, and to provide differentiated sources of
revenues and profits, Pacific Gateway has added extensive offshore operations
and retail operations in the U.S. and abroad.  In addition, Pacific Gateway is
now deploying its own high capacity fiber optic network that will enable the
Company to lower the costs of its own operations, to be an active player in the
convergence of voice, data and video traffic, and to provide a platform for its
own Internet operations.  The Company expects to launch its  Internet
subsidiary, PGE Express, in the future to provide Internet access and co-
location to the Internet community. Pacific Gateway's evolution places it firmly
within two major growth areas: global facilities-based traffic and data
transmission.

     Pacific Gateway began in 1991, providing high quality, low cost
international service to the many U.S. long distance companies created by the
breakup of the Bell system.   In 1997, Pacific Gateway transformed itself from a
U.S.-centric provider of wholesale service to become a global provider of
telecommunication services.   Pacific Gateway has now established operations in
the United Kingdom, Germany, France, Russia, Japan, Australia and New Zealand.
Pacific Gateway was one of the first U.S. companies to obtain a facilities-based
license in Japan to provide wholesale,  retail and data services. The Company
has initiated retail operations in the United States, featuring "dial around"
services, prepaid calling cards,  international toll-free and travel services
and marketing to switchless resellers.  The Company has created ethnic marketing
programs focused on the Filipino and Japanese communities to accelerate its
retail service offerings.

     These retail programs leverage the sophisticated array of switches,
facilities and operating agreements that the Company developed for its wholesale
business.  In 1998, the Company's management moved to position Pacific Gateway
to become a key player in the convergence of the Internet, voice, data and video
traffic. As the first step in this strategic initiative, the Company has begun
to assemble its own international fiber optic network so that it may become a
global supplier of high bandwidth services as well as a company preeminent in
the origination and termination of global voice traffic. In 1998, the Company
committed to purchase major interests in the Japan-U.S. and TAT-14 Cable Systems
and now is planning the procurement of the necessary backhaul and inland service
segments, both in the U.S. and abroad. The Company plans to continue to invest
in new fiber optic cable networks connecting to strategic global locations. The
Company believes that this strategy should pay off in several ways: first, it
should help the Company's wholesale and retail business by giving the Company
its own source of low cost, high quality transmission facilities. Second,
because the Company bought these interests in significant quantity and at
attractive prices, the Company has the opportunity to realize gains on the sale
of these interests. Third, the Company may be able to swap these interests for
inland service capacity in the U.S. and abroad. Fourth, this strategy should
enable Pacific Gateway to answer the call of Internet Service Providers ("ISPs")
for global bandwidth services able to accommodate the exploding popularity of
the Internet. Finally, and no less important, the Company's commitment to build
and operate its own global fiber optic network will serve as an ideal platform
for the Company's own Internet operations. The Company's Internet subsidiary,
PGE Express, will serve the Internet community by providing co-location of
facilities and access to Pacific Gateway's state-of-the-art global network.

Business Overview

     The Company commenced operations in 1991 to provide international switched
services to the numerous long distance carriers created by the deregulation of
the U.S. telephone industry.  Since then, as a strategic response to regulatory
and technological developments, the Company has undertaken three 

                                       2
<PAGE>
 
strategic initiatives. First, as foreign countries have followed the lead of
the U.S. in liberalizing telecommunications regulation, the Company has
initiated operations offshore to provide wholesale and retail service. Second,
in response to technological innovation and consumer demand, the Company is
entering the market for emerging and value-added services. Third, the Company
is positioning itself to become a global player in the burgeoning market for
high capacity bandwidth and Internet services. To accelerate the growth of all
of its business lines, the Company may consider acquisition possibilities and
expects to increase its purchases and construction of network so that the
Company will be positioned to meet the emerging demand for higher bandwidth
services created by the advent of the Internet and future technological
developments. At December 31, 1998, the Company provided international
telecommunication services to approximately 163 customers worldwide, excluding
U.S. retail customers, including all of the largest U.S.-based long distance
carriers.

     The Company's U.S. wholesale operations primarily serve large U.S.-based
global carriers that seek competitive rates and high quality overflow line
capacity, as well as small and medium-sized long distance companies that are
unable to invest in their own international transmission facilities.  For the
year ended December 31, 1998, U.S. wholesale operations represented
approximately 84% of the Company's revenues.  Although the Company believes that
its U.S. wholesale operations will continue to grow, it expects that these
operations will contribute a declining percentage of its revenues as the Company
continues to expand into foreign markets and emerging and value-added services.

     The Company's offshore operations provide foreign originating switched
services to wholesale and retail customers located outside the U.S.  The Company
has installed switching facilities in the United Kingdom,  Russia, Japan and New
Zealand. In addition, the Company derives revenue by terminating traffic that
originates in Germany, France and Australia. For the year ended December 31,
1998, approximately 12% of the Company's revenues were generated by its offshore
operations. The Company expects to continue to expand to additional locations
that begin to liberalize and become competitive. The Company anticipates that
these operations will constitute an increasing percentage of its revenues.

     As part of its initiative to focus on emerging and value-added services,
the Company has begun to market its international long distance services
directly to certain retail customers in the United States and overseas.  The
Company has ethnic marketing programs to target the Filipino and Japanese
markets and, beginning in the first quarter of 1999, the Chinese and Vietnamese
markets.  The Company plans to expand its ethnic marketing program to additional
ethnic communities in 1999.  In addition to ethnic marketing, the Company
provides other value-added services, including global prepaid card services
through its subsidiary, Global Time. The Company has begun trials of voice over
IP services and offers dial around services and international 800 services. The
Company has formed a new subsidiary, PGE Express, which plans to provide
services to the Internet community, including Internet connectivity and co-
location,  to a wide-range of Internet content providers, web hosting companies
and Internet service providers. For the year ended December 31, 1998, value-
added services contributed 4% to the Company's revenues.  The Company believes
that growth in the demand for these higher-margin services will translate into
increased revenues in the future.

     The Company has partial ownership interests in 19 digital undersea fiber
optic cable systems in the Atlantic, Pacific and Caribbean regions and operating
agreements that provide for the exchange of traffic with foreign carriers.  In
1998, the Company committed to invest in two new undersea fiber optic cable
construction projects: the Japan-U.S. Cable Network, which will connect the U.S.
with Japan, and the TAT-14 Cable Network, which will connect the United States
with the United Kingdom, France, Germany, the Netherlands and Denmark. Both
cable projects are expected to be in operation in 2000.  The Company may use
this bandwidth capacity for its own services or it may offer to sell bandwidth
capacity for cash, swap bandwidth capacity for other system needs such as
switching capabilities or capacity in other cable systems, or use bandwidth
capacity as an investment tool for bandwidth intensive enterprises.

                                       3
<PAGE>
 
     In addition, the Company believes that its bandwidth capacity will be
instrumental in the development and success of its own Internet operations.  The
Company expects that its bandwidth and Internet operations will become its
fourth business segment.

     The Company's expanding business lines and network enable it to exploit
major developments in the international telecommunications industry.  Firstly,
the Company is positioning itself to take advantage of the rapid growth of the
Internet, which is emerging as a global medium for communications and commerce.
The Company expects the demand for international Internet services to grow
exponentially as a result of many factors including increased use of personal
computers, improvements in networking, increased network applications, emerging
technologies which make use of the Internet and easier, faster and cheaper
Internet access.  The Company is poised to develop opportunities in this area
through its investment in high capacity bandwidth.  In addition, the Company is
launching a new subsidiary, PGE Express, which plans to focus on Internet
services.  Second, recent regulatory developments, including an agreement (the
"WTO Agreement") entered into by over 60 countries under the auspices of the
World Trade Organization (the "WTO") and regulations promulgated by the Federal
Communications Commission ("FCC"), have opened international telecommunications
markets to competition and created new opportunities for the Company.  The
Company believes that these developments will increase the number of foreign
carriers and the demand for the Company's U.S. wholesale and offshore services.
In addition, these developments should decrease the Company's termination costs
and improve profitability by creating alternative foreign carriers to terminate
calls at reduced rates.  Third, the international telecommunications industry is
expected to experience considerable growth in the foreseeable future. The
Company believes that its recent strategic initiatives enable it to capture
opportunities for revenue expansion that arise from the emergence of the
Internet, the continuing deregulation and the growth of international
telecommunications markets.

Industry Background

     The international telecommunications market consists of all calls that
originate in one country and terminate in another.  This market can be divided
into two major segments: the U.S.-originated international market (the "U.S.-
Originated Market"), consisting of all international calls which either
originate or terminate in the United States, and the overseas-originated
international market (the "Overseas-Originated Market"), consisting of calls
between countries other than the United States. This industry is undergoing a
period of fundamental change that has resulted in substantial growth in
international telecommunications traffic. According to the FCC, the U.S.-
Originated Market grew at an annual rate of 18.2% from $19.2 billion to $22.7
billion in 1997.

     The 1984 deregulation of the U.S. telecommunications industry resulted in
the establishment of numerous long distance telecommunication companies.  To be
successful, these start-up carriers needed to offer a full range of services to
their customers, including international long distance.  Because most of these
carriers did not have the capital resources necessary to invest in international
facilities, new carriers, such as the Company, emerged to meet the increased
demand for affordable international bandwidth.

     Deregulation and privatization of foreign markets is also presenting
opportunities for long distance carriers overseas.  By eroding the traditional
monopolies held by single national providers, many of which are wholly or
partially government owned, deregulation is allowing new carriers to emerge in
foreign markets and providing U.S.-based providers, such as the Company, the
opportunity to negotiate more favorable agreements with foreign providers.  In
addition, deregulation in certain foreign countries is enabling U.S.-based
providers to establish local switching and transmission facilities in order to
terminate their own traffic and to carry international long distance traffic
originated in that country.  The Company believes that the growth in traffic
originated in markets outside of the U.S. will be higher than the growth in
traffic originated within the U.S. due to recent deregulation in many foreign
markets, relative economic growth rates and increasing access to
telecommunications facilities in emerging markets.

                                       4
<PAGE>
 
     In February 1997, over 60 countries signed the WTO Agreement on basic
telecommunications services under the auspices of the WTO, which became
effective February 5, 1998.  Under the WTO Agreement, countries committed to
open markets to competition in telecommunications services, improve foreign
investment opportunities in the telecommunications industry and adopt pro-
competitive regulatory principles.  Although the Company is unable to predict
the exact effects this agreement will have, it believes the WTO Agreement will
provide the Company with lower access costs and an expanded market potential.

     The Company believes that a number of trends in the international
telecommunications market will continue to drive growth in international
transmission usage.  These trends include the entry of new telecommunications
providers,  lower retail rates caused by reductions in domestic access charges
and international settlement rates, growth in the number of telephones in
service internationally, the proliferation of facsimile, cellular telephone and
paging communications, and growth associated with data transmissions and the use
of the Internet and other new technologies.  The Company also expects growth in
the market for emerging and value-added services, such as enhanced facsimile
service, video conferencing, and virtual private network services as carriers
respond to the challenges presented by the convergence of voice and data
telecommunications technologies.

Services

     The Company's operations comprise three lines of business: U.S. wholesale
operations, offshore operations, and emerging and value-added services. The
Company provides these services through its network of switching facilities
(located either in the U.S. or offshore) and digital undersea fiber optic cables
and to a lesser degree through leased capacity and satellite circuits. Through
these facilities and its operating agreements with foreign carriers, the Company
can deliver traffic to or between all countries in the world that have direct
dial service with the United States.  As of December 31, 1998, the Company had
44 operating agreements with foreign carriers in 28 countries.  In the future,
the Company will also provide high bandwidth services as a separate line of
business.

     As the following diagram illustrates, a typical international telephone
call that originates in the U.S. first travels through the local carrier's
switched network to the caller's domestic long distance carrier. The domestic
long distance carrier then carries the call to an international gateway switch.
An international carrier, such as the Company, picks up the call at its gateway
switch and sends it through a digital undersea fiber optic cable or satellite
circuit to the corresponding international gateway switch operated by an
international carrier in the destination country.  The long distance carrier in
that country then routes the call to its customer through the domestic telephone
network. Foreign-originated traffic is routed back to the United States in a
similar manner.

                   [INTERNATIONAL SWITCHED SERVICES CHART]


U.S. Wholesale Operations

     International Switched Services.  The Company's international switched
services consist of international switched calls that either originate in the
U.S. or constitute return traffic to the U.S. from foreign long-distance
carriers. Revenues from international switched services are derived from
country-specific, usage-sensitive rates charged to the Company's carrier
customers and return traffic from its foreign partners.  In the U.S., the
Company operates international gateway switches in Los Angeles, New York and
Dallas.  Traffic to Asia and the Pacific Rim generally is routed via the Los
Angeles gateway, traffic to Europe and Latin America generally is routed via the
New York gateway and traffic to Mexico generally is routed via the Dallas
gateway.  U.S. wholesale international switched services represented
approximately 81.3%, 91.1% and 91.6% of the Company's revenues in 1998, 1997 and
1996, respectively.

                                       5
<PAGE>
 
     Domestic Switched Services.  The Company's domestic switched services
consist of switched long distance calls that originate and terminate within the
United States.  The Company's originating network, which provides access and
egress to local network providers, extends to geographical areas around its
switching facilities in Los Angeles (serving most major metropolitan areas in
California, Arizona and Nevada), New York (serving selected metropolitan
locations in New York, Washington, D.C., Massachusetts, Pennsylvania,
Connecticut, New Jersey and Virginia) and Dallas (serving metropolitan areas in
Texas). The Company provides domestic switched services as a cost-effective
means to terminate its return traffic in the foregoing areas and to offer
services to U.S.-based long distance resellers that do not own or lease
switching facilities ("switchless resellers"). The Company inaugurated a
switchless resale marketing program in December 1998. The Company believes
switchless resale is an area with growth potential.  Domestic switched services
accounted for approximately 2.5%, 2.6% and 7.4% of the Company's total revenues
in 1998, 1997 and 1996, respectively.

     International Private Line Services.  The Company provides dedicated point-
to-point connections (those that do not use a public switched network) between
U.S. locations and foreign locations on a selective basis to certain carriers to
help them meet the needs of their end-users.  Typical end-users are
multinational corporations or government agencies that have a high volume of
voice and data communications between two or more international locations.  For
example, a typical private line would connect the New York and London branches
of an international bank.  International private line services represented less
than 1% of the Company's revenues in 1998, 1997 and 1996.

Offshore Operations

     The Company's offshore operations have grown as a direct result of the
increased volume of international telecommunications traffic and the
deregulation of telecommunications markets in many foreign countries.  Revenues
from the Company's offshore operations are derived from country-specific, usage-
sensitive rates charged to the Company's carrier customers and traffic
terminated in its international switching facilities. The Company has switching
facilities in the United Kingdom, Russia, Japan and New Zealand.  In addition,
the Company derives revenues from traffic originating in Germany, France and
Australia.

     Although the Company's extensive international network enables it to
compete in numerous foreign markets, it is focusing its strategy on developing a
significant presence in a defined set of geographical routes -- particularly in
Europe, Latin America, Asia and the Pacific Rim --  where it believes it has
either competitive advantages through strong relationships with foreign partners
or the opportunity to gain market share and increase its volume of higher-
margin, value-added services. The Company is also developing switching sites in
Germany and Australia with additional sites expected in the near future.  The
Company expects to expand its offshore services offered to include retail
prepaid calling cards enabling it to gain access to the higher margin retail
traffic in these offshore markets.

     Offshore operations accounted for approximately 12.0% and 5.9% of the
Company's total revenues in 1998 and 1997, respectively.  The Company did not
have offshore operations in 1996.

Emerging and Value-Added Services

     In response to technological innovations and consumer demand, the Company
has recently begun broadening its focus to include a variety of emerging and
value-added services to retail and wholesale customers.

     Emerging Services.  The Company is using its existing network and cost
structure to provide international long distance services to certain ethnic
retail markets. In addition, the Company and Globe Telecom formed a joint
venture, PinTouch, to market international long distance services to the
Filipino-American community.  The Company also has ethnic marketing arrangements
with the Japanese-American

                                       6
<PAGE>
 
community. During the first quarter of 1999, the Company began marketing to
Chinese and Vietnamese communities. The Company expects to continue to expand to
new ethnic markets in the U.S. and abroad where its wholesale operations provide
a competitive cost structure.

     Value-added Services.  Value-added services, which the Company provides to
its carrier customers, currently include international toll-free service
(available in certain countries), global prepaid card services, offered through
its subsidiary, Global Time, dial around services and, on a trial basis, voice
transmissions over the Internet.  By providing such services, the Company
enables its carrier customers to offer a broader range of international services
to their end-user customers, which the Company expects will stimulate additional
higher margin international traffic over its network.

     In the aggregate, emerging and value-added services accounted for 4.2% of
the Company's revenues in 1998 and less than 1% of the Company's revenues in
1997 and 1996.

     Bandwidth Services. In 1998, the Company committed to invest approximately
$156 million in undersea fiber optic cable construction commitments, which will
substantially increase the Company's high quality bandwidth capacity.  In
particular, the Company committed to invest $86 million in the Japan-U.S. Cable
Network, an undersea cable system connecting Japan and the United States.  This
system is initially planned to operate at 80 gigabits per second and is
ultimately expandable to 640 gigabits per second.  The Company will initially
have 40 STM-1's on this system, expandable to 300 STM-1's.  In addition, the
Company made a $70 million commitment on the TAT-14 cable network, which will
connect the United States with the UK, France, Germany, the Netherlands and
Denmark.  This system, using Synchronous Digital Hierarchy (SDH) technology is
planned to operate at 640 gigabits per second.  Both of these cable projects are
expected to become operational during 2000.

     The Company has formed a bandwidth sales group whose mission is to
capitalize on the opportunities available to the Company as a result of the
Company's recent investments in undersea cable projects such as the Japan-U.S.
and TAT-14 undersea cable projects.  Along with providing cost efficiencies for
existing switching operations, the Company intends to market bandwidth capacity
as well as use some of the new bandwidth capacity for its own Internet and
multimedia applications, such as videoconferencing and distance learning.  The
Company may also swap bandwidth capacity for switching capabilities and use some
of the capacity as an investment tool for bandwidth intensive enterprises.  The
Company expects that bandwidth services will become a separate operating segment
for financial reporting purposes.

Sales and Marketing

     The Company sells its services to long distance international
telecommunications companies, foreign partners and retail customers.  At
December 31, 1998, the Company had 44 operating agreements and approximately 163
customers worldwide, excluding U.S. retail customers, including all the largest
U.S.-based long distance carriers.

     The Company believes that the principal reasons its customers select it to
carry their international traffic are (i) the Company's reputation for operating
a state-of-the-art network at rates that are comparable to or lower than its
competitors and (ii) the Company's size, which enables its experienced sales and
operating personnel to tailor cost-effective telecommunications services to meet
customers' needs and to provide highly responsive, flexible customer solutions.

U.S. Wholesale Operations

     The Company's target customer base includes the more than 200 U.S.-based
long distance carriers with annual revenues of $50 million to $2 billion.  The
Company focuses its U.S. wholesale marketing efforts primarily on those large
U.S.-based long distance carriers that originate international traffic but do
not have operating agreements with foreign carriers to terminate the traffic;
however, the Company also 

                                       7
<PAGE>
 
markets its services to small and medium-sized carriers that are unable to
invest in their own international transmission facilities. In addition,
international carriers with operating agreements may use the services of other
international carriers, such as the Company, for overflow traffic or on routes
with smaller traffic volumes.

     In addition, the Company's target customer base includes the foreign
telecommunications carriers with which the Company has, or proposes to have,
operating agreements. The Company's foreign partners include both post telephone
and telegraph companies, commonly known as PTTs, which may be wholly or
partially government-owned, and nondominant carriers that may have recently been
established as a result of the deregulation and privatization of foreign
telecommunications markets ("competitive carriers"). The Company believes that
many of the competitive carriers in developing countries, as well as certain
recently privatized PTTs, are likely to seek alliances, partnerships or joint
ventures with other international carriers to expand their global networks.

     The Company's wholesale carrier services are generally priced at or below
the market price of the other four leading U.S. international facilities-based
carriers.  The Company does not, however, offer a standard discount relative to
any particular carrier's rates, and believes that its ability to obtain traffic
from its customers does not depend upon its pricing alone.

     The Company has 27 marketing and sales professionals dedicated to marketing
and maintaining its relationships with its U.S.-based carrier customers.
Marketing is typically conducted on a personalized basis.  Participation at
industry conferences, referrals from other carriers and long-term relationships
are key factors in establishing the visibility, reputation and personal trust
necessary to obtain and maintain this business.  The Company believes that it
has been able to compete effectively by offering more personalized service than
its competitors and the assurance of ongoing senior-level attention to each
account.

Offshore Operations

     When the Company enters a new foreign market, it typically begins its
marketing efforts by building upon its contacts with U.S.-based carriers that
have operations in that foreign market.  These contacts are generally very
useful in establishing relationships with the carriers in that market.  As its
volume of business in the new market increases, the Company expects to build its
own local sales force.  Currently, 11 sales professionals are dedicated to
marketing to the wholesale and retail markets in the UK, Germany, France,
Russia, Japan, Australia and New Zealand.

Emerging and Value-Added Services

     In providing services to specific ethnic retail customers, the Company
markets to ethnic communities living in the U.S. that generate a high volume of
telephone traffic to their home country.  The Company is able to utilize its
wholesale cost structure and management information systems to take advantage of
the opportunities in these markets.  The Company focused on the U.S.-based
Filipino and Japanese markets in 1998.  During the first quarter of 1999, the
Company has begun to market to the Chinese and Vietnamese communities.  The
Company employs marketing expertise that is relevant to each of these
communities.  The Company expects to begin marketing to additional communities
where the underlying cost structure and the marketing talent is available.

Customers

     The Company sells to long distance international telecommunications
companies, foreign partners and retail customers.  At December 31, 1998, the
Company had approximately 163 worldwide customers, excluding U.S. retail
customers, and 44 operating agreements with foreign partners.  In 1998, no
customer accounted for more than 10% of the Company's revenues.  For further
information regarding customers, see Note (4) entitled "Segment Data" in the
Notes to Consolidated Financial Statements included in Part II, Item 8 of this
10-K.

                                       8
<PAGE>
 
Competition

     The international telecommunications industry is highly competitive and
subject to the introduction of new services facilitated by advances in
technology.  International telecommunications providers compete on the basis of
price, customer service, transmission quality, breadth of service offerings and
value-added services.  The U.S.-based international telecommunications services
market is dominated by AT&T, MCI WorldCom and Sprint.  The Company also competes
with other carriers in certain markets.  As the Company's network expands to
serve a broader range of customers, Pacific Gateway expects to encounter
increasing competition from these and other major domestic and international
communications companies, many of which may have significantly greater resources
and more extensive domestic and international communications networks than the
Company.   Moreover, the Company is likely to be subject to additional
competition as a result of the formation of global alliances and mergers among
the largest telecommunications carriers.  Existing or planned global alliances
or combinations include Global One, AT&T/British Telecommunications plc and
Global Crossing/Frontier.  The Company also faces competition from companies
offering resold international telecommunications services.  The Company expects
that competition from such resellers will increase in the future in tandem with
increasing deregulation of telecommunications markets worldwide.

     The telecommunications industry is in a period of rapid technological
evolution, marked by the introduction of new product and service offerings and
increasing satellite transmission capacity for services similar to those
provided by the Company.  Those technologies being developed or already
introduced include satellite-based systems, such as the proposed Iridium and
GlobalStar systems, utilization of the Internet for international voice and data
communications, digital wireless communication systems such as personal
communications services and broadband multimedia applications.  The Company is
unable to predict which of many possible future products and service offerings
will be important to maintain its competitive position or what expenditures will
be required to develop and provide such products and services.

     Recent regulatory changes also are expected to increase competition in the
telecommunications industry.  In February 1996, the Telecommunications Act of
1996 (the "Telecom Act") was adopted.  The Telecom Act promotes additional
competition in the intrastate, interstate and international telecommunications
markets by both U.S.- based and foreign companies.  The Telecom Act permits the
Regional Bell Operating Companies ("RBOCs") to compete in interstate and
international service.  Although an RBOC currently may not offer international
securities to customers within the region where the RBOC has market power, some
RBOCs have begun to resell international services to customers outside of such
regions or through mobile telephone subsidiaries.  AT&T has obtained relaxed
pricing restrictions and relief from other regulatory constraints that should
make it easier for AT&T to compete with alternative carriers such as the
Company.  In addition, in February 1997, over 60 countries signed a global
agreement on telecommunications under the auspices of the WTO, which agreement
became effective in February 1998.  Under the WTO Agreement, countries committed
to open markets to competition in telecommunications services, improve foreign
investment opportunities in the telecommunications industry and promote pro-
competitive regulatory principles.  The FCC has adopted various rules designed
to implement the principles of the WTO Agreement.  See "--Government
Regulation."  The FCC also adopted streamlined license granting procedures for
carriers from WTO Agreement signatory countries, pursuant to which the FCC
granted more than 200 international applications in the first 90 days after the
streamlined procedures became effective.  There can be no assurance that the
Company will be able to effectively compete in the new regulatory environment or
that these changes or other regulatory developments will not have a material
adverse effect on the Company's business, financial condition or results of
operations.

     The U.S. telecommunications services industry is becoming more concentrated
as a result of mergers, acquisitions and consolidations between and among U.S.
carriers.  Major mergers that have been consummated or are expected to close
soon include WorldCom/MCI, AT&T/TCI, Bell Atlantic/GTE, and

                                       9
<PAGE>
 
SBC/Ameritech. Numerous other, smaller combinations have been announced or
consummated as well. The Company is unable to predict the effect of these
mergers and combinations on competition. The mergers involving WorldCom/MCI
and Bell Atlantic/GTE, which are important U.S. international carriers,
particularly will affect the Company in ways that are not clear. Consolidation
of large U.S. international carriers has the effect generally of reducing the
number of large, facilities-based carriers that compete with the Company,
while making each such competitor stronger, both financially and in the
variety of international routes covered on a facilities basis. This
consolidation could make it more difficult for the Company to compete in
providing facilities-based services. Similarly, the consolidation and
enlargement of the remaining U.S. RBOCs could make these companies more
important competitors to the Company as the RBOCs begin to offer substantially
end-to-end service between the United States and foreign destinations.

International Network

Network Facilities

     The Company has successfully implemented an extensive international
facilities-based network composed of its international gateway switches and
related peripheral equipment and digital undersea fiber optic cable systems, as
well as leased cable and satellite capacity.  The Company is continuing to
expand its considerable investment in telecommunications facilities  so that it
may depend even less upon assets owned by others and be better able to control
quality and costs. Since the beginning of 1997, the Company more than tripled
its network infrastructure by adding switches to various offshore sites, by
expanding the capacity of its New York and Los Angeles switching facility, and
by purchasing additional capacity on undersea fiber optic cables.  The Company
can provide service to any point in the world using a combination of its owned
digital undersea fiber optic network and leased cable and satellite capacity.
The Company's network employs state-of-the-art digital switching and fiber optic
technologies and is supported by comprehensive monitoring and technical
services.  The Company believes that this network is fundamental to its ability
to compete successfully in the international telecommunications market and
regards its network as a significant competitive advantage that would be
expensive and time-consuming for a new entrant to replicate.

     International Gateway and Domestic Switches.  The Company operates
international gateway switches in the U.S in Los Angeles, New York, and Dallas
and offshore in the UK, New Zealand, Russia and Japan. U.S.-originated traffic
to Asia and the Pacific Rim generally is routed via the Los Angeles gateway,
traffic to Europe and Latin America generally is routed via the New York gateway
and traffic to Mexico generally is routed via the Dallas gateway.  During 1997,
the Company installed the international gateway switches in London (to serve the
United Kingdom and Western European markets), Moscow (to serve Eastern European
markets) and Auckland (to serve the Pacific Rim).  During 1998, the Company
installed its switch in Japan (to serve Japan and Asia markets).

     Digital Undersea Fiber Optic Cable Systems.  The Company currently has
investments in 19 digital undersea fiber optic cable systems, with an ownership
interest in each of generally less than 1%.  A digital undersea fiber optic
cable system is typically owned and operated by a consortium of international
service providers that jointly commit to fund the construction and operating
costs of the cables in proportion to their ownership interests.  Typically,
participation in a consortium is limited to those carriers that have the
operating authority to provide direct international service and have obtained
operating agreements with the countries served by the cables.  Capacity is
usually owned by two carriers in two countries, each with ownership to the
theoretical "midpoint" of the cable.  Because digital undersea fiber optic
cables typically take several years to plan and construct, carriers generally
make investments based on a forecast of anticipated traffic.

     In 1998, the Company committed to invest in two new undersea fiber optic
cable construction projects: the Japan-U.S. Cable Network and the TAT-14 Cable
Network, which will connect the United States with the United Kingdom, France,
Germany, the Netherlands and Denmark.  As a result of these 

                                       10
<PAGE>
 
investments the Company will own 240 STM-1's on these systems, increasing to
approximately 480 by 2002 (assuming upgrades), providing the Company with the
equivalent of eight OC-192 or 80 Gps of total capacity on these two systems.
Both cable projects are expected to be in operation in 2000.

     The Company seeks to have ownership positions in digital undersea fiber
optic cable systems over routes where it believes its customers' demand will
justify the investment in those fixed assets.  Although the Company generally
can earn a higher gross margin on traffic routed through its owned fiber optic
cable routes than on traffic routed through its leased routes, it will continue
to buy usage-sensitive transmission capacity on a per-minute basis from other
U.S. facilities-based international carriers on routes where traffic volumes are
relatively low or inconsistent, as well as to manage overflow traffic on busy
routes.

     The Company does not have direct access from its gateway switches to the
digital undersea fiber optic cable heads and currently leases these facilities
from certain of its competitors.

     Satellite Facilities.  The Company uses leased satellite facilities for
traffic to and from countries where digital undersea fiber optic cables are not
available or cost-effective.  The Company also uses leased satellite facilities
for redundancy when digital undersea cable service is temporarily interrupted.
Currently, the Company is evaluating the construction of earth station
facilities based on increasing traffic that may result in such investments being
cost-effective for the Company.

     Network Monitoring and Technical Support.  The Company provides its
customers with service and support, 24-hour network monitoring, trouble
reporting and response procedures, service implementation coordination, billing
assistance and problem resolution.  For each customer, the Company provides a
single point of contact and accepts end-to-end responsibility for installation,
maintenance and problem resolution.

     The Company generally uses redundant, highly automated state-of-the-art
telecommunications equipment in its network and has diverse alternate routes
available in case of component or facility failure.  Back-up power systems and
automatic traffic re-routing enable the Company to provide a high level of
reliability for its customers.  Computerized automatic network monitoring
equipment allows fast and accurate analysis and resolution of network problems.

Operating Agreements

     The Company considers its operating agreements to be as vital a component
of its operations as its network facilities.  The Company has entered into 44
operating agreements that provide for the exchange of traffic with foreign
carriers in 28 countries. International long distance traffic is traditionally
exchanged under switched voice bilateral operating agreements between long
distance carriers in two countries. To terminate a U.S.-originated call in
another country, a U.S.-based international carrier may have an operating
agreement with a carrier in that country or may pay for transmission service
from another carrier that has such an agreement. Typically, operating agreements
provide for the termination of traffic in, and return traffic to, the partners'
respective countries for mutual compensation through negotiated settlement
rates. Operating agreements typically provide that a foreign carrier will return
through the U.S. carrier the same percentage of total U.S. terminating traffic
as it receives from the U.S.-based carrier and also provide for network
coordination and accounting and settlement procedures. The execution of an
operating agreement between two carriers is typically accompanied by an equal
investment by both carriers in digital undersea fiber optic cable between the
two countries. Although operating agreements generally are for an unspecified
term, the Company believes that the common ownership of transmission facilities,
which are expected to have 20-year useful lives, establishes a solid foundation
for long-term relationships among international carriers.

                                       11
<PAGE>
 
Billing and Management Information Systems

     Accurate operation of a management information system is vital to the
Company's operations, given the high volume of transactions and the need to bill
customers accurately.  The Company maintains its own staff of programming and
management information reporting personnel, as well as contract programmers
dedicated to maintaining the Company's management information system.  This
system's functions include reporting on revenues, long distance service costs
and network performance, performing margin analyses and tracking foreign payment
settlements.  As a result of refinements that have occurred in this system, the
Company can monitor its revenues, gross margins and net income on a daily basis.
The Company provides common data access for system users to support its customer
service, accounting and network monitoring functions.

     The Company has developed its own customized billing and management
information system software to meet the needs of its customers and vendors and
to enhance the Company's ability to monitor its operations.  The Company
utilizes an IBM AS400 computer system and continually upgrades and enhances the
system as computer technology advances.  The Company believes these computer
systems are more than adequate to meet the needs of the Company, its customers
and its vendors.

     Furthermore, to support its expansion into retail and value-added services,
the Company is refining its systems to include retail end-user billing and
accounting.  In particular, the Company has recently purchased, and is
integrating into its systems, end-user software that enables the Company to add
sales and use taxes to customers' bills.  Future planned additions include
software that tracks customers' credit and collections and software that would
enable the Company to accept credit-card payments.

     To date, the Company has not experienced any system problem that has led to
significant delays in billing customers or disputes with its customers over
billing. The Company has separately addressed year 2000 issues, see "Risk
Factors--Year 2000 Issue "following and see "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Year 2000 Issue"
included in Part II, Item 7 of this 10-K.

Government Regulation

Overview

     The Company's businesses are heavily regulated.   The FCC exercises
authority over all interstate and international facilities-based and resale
services offered by the Company.  Services that originate and terminate within
the same state, also known as intrastate services, are regulated by state
regulatory commissions.  The Company also may be subject to regulation in
foreign countries in connection with certain business activities.  For example,
the Company's use of transit agreements or arrangements, if any, may be affected
by regulations in either the transited or terminating foreign jurisdiction.

Federal Regulation

     General Requirements.   The Company must comply with the requirements of
common carriage under the Communications Act of 1934 (the "Communications Act"),
as amended by the Telecom Act, including the offering of service on a non-
discriminatory basis at just and reasonable rates, and obtaining FCC approval
prior to most assignments of authorizations or any transfer of de jure or de
facto control of the Company.

     The FCC has established different levels of regulation for dominant and
non-dominant carriers.  The Company is classified as a non-dominant carrier for
both domestic and international service.  Under the Communications Act and the
FCC's rules, all international carriers, including the Company, are 

                                       12
<PAGE>
 
required to obtain authority under Section 214 of the Communications Act prior
to initiating international common carrier services and must file and maintain
tariffs containing the rates, terms and conditions applicable to their
services. The FCC has streamlined its regulation of non-dominant international
carriers to provide that these tariffs and any revisions thereto are effective
upon one day's notice in lieu of the previous 14-day notice period. The
Company has filed international tariffs (for switched and private line
services) with the FCC. Nevertheless, an otherwise non-dominant U.S.-based
carrier may be subject to dominant carrier regulation on a specific
international route if it is affiliated with a foreign carrier with market
power operating at the foreign point. The Company is not subject to dominant
carrier treatment on any route.

     Domestic interstate common carriers such as the Company are not required to
obtain Section 214 or other authority from the FCC for the provision of domestic
interstate telecommunications services.  Domestic interstate carriers must,
however, file and maintain tariffs with the FCC containing the specific rates,
terms and conditions applicable to their services.  These tariffs are effective
upon one day's notice.  The Company has filed a domestic tariff with the FCC.

     In late 1996, the FCC implemented significant changes in its tariff
requirements.  Exercising forbearance authority granted to it by the Telecom
Act, the FCC ruled that interexchange carriers must cancel their tariffs for
domestic interstate interexchange services. In August 1997, the FCC affirmed its
decision to end tariff filing requirements for domestic interstate long distance
services provided by non-dominant carriers.  The FCC also eliminated the
requirement that non-dominant long distance carriers make publicly available
information on rates and terms of their products.  The detariffing order has
been stayed by the U.S.  Court of Appeals for the District of Columbia, and the
order on reconsideration also is stayed until the Court issues a decision.  It
is not known when the Court of Appeals will issue a decision.  On March 18,
1999, the FCC adopted an order that would permit the alternative of posting
rates on the carrier's website.  This order will not become effective until the
Court affirm's the FCC's mandatory detariffing scheme.

     International Services. The Company must have Section 214 facilities-based
authority to offer international services via satellites and undersea fiber
optic cables.   Section 214 resale authority is required to resell international
services.  The Company has obtained global Section 214 facilities-based and
resale authority.

     The Company must  conduct its international business in compliance with the
FCC's international settlements policy.  The international settlements policy
establishes the permissible boundaries for U.S.-based carriers and their foreign
correspondents to exchange traffic and settle the cost of terminating each
other's traffic over their respective networks.  The precise terms of settlement
are established in a correspondent agreement, also referred to as an operating
agreement.  Among other terms, the operating agreement establishes the types of
service covered by the agreement, the division of revenues between the carrier
that bills for the call and the carrier that terminates the call at the other
end, the frequency of settlements (i.e. monthly or quarterly), the currency in
which payments will be made, the formula for calculating traffic flows between
countries, technical standards, procedures for the settlement of disputes, the
effective date of the agreement and the term of the agreement.  The Company may
provide services over international private lines without complying with the
international settlements policy, but only between the United States and
countries specifically approved by the FCC for this activity.

     To promote competition in the international telecommunications market, in
November 1996, the FCC issued a new international settlement order, which
provides international carriers more flexibility in negotiating operating
agreements.  Under the FCC's new international settlement order, U.S.-based
carriers can apply for waivers of the FCC's international settlements policy.
Such waivers, if granted, would allow carriers to negotiate more flexible
operating agreements that, for example, allow them to accept greater than a
proportional share of return traffic.    When it implemented the WTO Agreement,
(see below) the FCC adopted a rebuttable presumption that flexibility is
permitted for WTO member countries.  The FCC has recently proposed to cease
regulation of settlement rates between U.S. carriers and WTO Carriers 

                                       13
<PAGE>
 
(defined below) that do not have market power. Although the Company is unable
to predict exactly how it will affect its international business, the new
international settlements policy may reduce international access costs and
facilitate the Company's international business.

     International telecommunications service providers are required to file
copies of their contracts with other carriers, including operating agreements,
with the FCC within 30 days of execution and to obtain FCC approval of certain
of these contracts.  The FCC's rules also require the Company to file
periodically a variety of reports regarding its international traffic flows and
use of international facilities.  The FCC has also proposed to relax certain
reporting requirements.  In addition, the FCC requires carriers to notify the
Commission 60 days prior to becoming affiliated with a foreign carrier or 30
days after acquiring a 25% or greater noncontrolling interest in a foreign
carrier.  The FCC can impose dominant carrier treatment on affiliates of WTO
Carriers (defined below) with market power or restrict service of affiliates of
non-WTO carriers.

     In February 1997, the United States entered in the WTO Agreement, which
seeks to open markets to competition in telecommunications services, improve
foreign investment opportunities in the telecommunications industry and promote
pro-competitive regulatory principles.  FCC rules implementing the WTO Agreement
became effective February 1998.

     The FCC's rules implementing the WTO Agreement  facilitate the entry of
foreign carriers operating in countries that signed the WTO Agreement ("WTO
Carriers") into the United States telecommunications market.  The rules replace
the effective competitive opportunities test (the "ECO Test") for entry of WTO
Carriers with streamlined procedures that presume entry is pro-competitive.  The
rules similarly relax the equivalency test for WTO Carriers that seek to provide
switched services over private lines between the United States and certain WTO
member countries.  In addition, the rules revise competitive safeguards to
eliminate or reduce various operating conditions and replace them with more
targeted safeguards that enhance the FCC's ability to monitor and detect anti-
competitive behavior in the United States market.  The FCC has retained the
right to issue fines, require additional conditions on a grant of authority and,
if necessary, deny or rescind a grant of authority.  The FCC will continue to
apply the ECO test to affiliates of non-WTO Carriers with market power.

     The FCC also narrowed the "No Special Concessions" rule which generally
provides that United States carriers cannot accept benefits from foreign
carriers to which other United States carriers are not entitled.  This rule
continues to apply to non-WTO Carriers.  The new rule applicable to WTO Carriers
simply prohibits United States carriers from entering into exclusive
arrangements with WTO Carriers that have sufficient market power to affect
competition adversely in the United States market.  To provide more certainty in
the market, the FCC adopted a rebuttable presumption that WTO Carriers with less
than 50% market share in a foreign market lack such market power.  As a result,
United States carriers may enter into exclusive dealings with such WTO Carriers
involving a variety of matters, including operating agreements and
interconnection arrangements.

     In addition, in 1997 the FCC revised the safeguards that apply to United
States carriers classified as dominant due to an affiliation with a foreign
carrier that has market power on the foreign end of an international route.  The
rules rely on reporting requirement, rather than restrictions on carriers'
provision of service, to prevent affiliated carriers from restricting
competition in the United States.  In particular, the rules replace the 14-day
advance notice tariff filing requirement with one-day advance notice requirement
and accords these tariff filings a presumption of lawfulness.  The rules also
remove the prior approval requirement for circuit additions or discontinuances
on the dominant route.  The rules require quarterly reports on traffic and
revenue, provisioning and maintenance, and circuit status for the dominant
carrier in order to monitor and detect anti-competitive behavior.  The rules
also require a limited form of structural separation between United States
carriers and their foreign affiliates with market power.  The FCC adopted a
rebuttable presumption that a foreign carrier with less than 50% market share in
the foreign market lacks market power and, therefore, its United States
affiliate should be presumptively treated as non-dominant.

                                       14
<PAGE>
 
     In August 1997, the FCC adopted mandatory settlement rate benchmarks for
carriers receiving traffic from or sending traffic to the United States.  These
benchmarks are intended to reduce the rates that United States carriers pay
foreign carriers to terminate traffic in their home countries.  The FCC
prohibits a United States carrier affiliated with a foreign carrier from
providing facilities-based service to the foreign carrier's home market until
and unless the foreign carrier has implemented a settlement rate within the
benchmark.  In connection with these rules, the FCC also adopted rules that
liberalize the provision of switched services over private lines to WTO member
countries by allowing such services on routes where 50% or more of United States
billed traffic is being terminated in the foreign country at or below the
applicable settlement rate benchmark, or where the foreign country's rules
concerning the provision of international switched services over private lines
are deemed equivalent to United States rules.

     The Company is unable to predict the full effect on the international
telecommunications market resulting from the WTO Agreement or the rules enacted
to implement its provisions or the establishment of mandatory settlement rate
benchmarks.  These changes are expected to increase competition in the
telecommunications market.  See "--Competition".  These changes may result in
lower costs to the Company; however, the revenues that the Company receives from
inbound international traffic may decrease to a greater degree as a result of
increased competition.  WTO Carriers with market power in their home markets may
be able to more easily offer United States and foreign customers services to the
disadvantage of United States carriers, which may continue to face substantial
obstacles in obtaining from foreign governments and foreign carriers the
authority and facilities to provide such services.  There can be no assurance
that these events would not have a material adverse effect on the Company's
business, financial condition or results of operations.

     Foreign Ownership.   Under the Communications Act, no common carrier radio
license may be held by non-U.S. citizens or their representatives; foreign
governments or corporations organized under the laws of a foreign country; U.S.
corporations with more than 20% of its stock directly owned or voted by non-U.S.
citizens; or more than 25% of its stock indirectly owned or voted by aliens, in
the last instance without first obtaining FCC approval.  For companies from WTO
member countries, the FCC has established an open entry standard, meaning that
the FCC presumptively will approve greater than 25% indirect ownership by a WTO
Carrier of a U.S. common carrier radio licensee subject to certain competitive
safeguards.   The FCC has reserved the right in certain cases to attach
additional conditions to a grant of authority, and to deny the application in
the exceptional case in which an application poses a very high risk to
competition.  For carriers from countries that are not signatory to the WTO
Agreement, the FCC will continue to apply the ECO test in deciding whether to
approve greater than 25% ownership of a radio licensee.

     Federal Legislation and Implementation.  The Telecom Act was adopted in
February 1996 and substantially changed the regulation of telecommunications in
the United States.  The legislation is designed to promote competition in all
telecommunications markets by, among other things, permitting the FCC to relax
regulations for local exchange carriers and other telecommunications carriers
where the public interest and competition warrant.  To the extent such
flexibility is provided, the Company's ability to compete for certain services
may be adversely affected.

     The Telecom Act permits RBOCs to provide domestic and international long
distance services to customers located outside of the RBOCs' home regions;
permits a petitioning RBOC to provide domestic and international long distance
service to customers within its operating area on a state by state basis upon
finding by the FCC that a petitioning RBOC has satisfied certain criteria for
opening up its local exchange network to competition and that provision of long
distance services would further the public interest; and removes existing
barriers to entry into local service markets.  Additionally, there were
significant changes in: the manner by which carrier-to-carrier arrangements are
regulated at the federal and state level; procedure to revise universal service
standards; and penalties for unauthorized switching of customers.  The FCC has
instituted and, in most instances, completed proceedings addressing the
implementation of this legislation.  The Company's business could be adversely
affected by competition from the RBOCs, which typically have greater resources
than the Company.

                                       15
<PAGE>
 
     In implementing the Telecom Act, the FCC established nationwide rules
designed to encourage new entrants to participate in the local services markets
through interconnection with the incumbent local exchange carriers ("ILECs"),
resale of ILECs' retail services, and use of individual and combinations of
unbundled network elements.  These rules set the groundwork for the statutory
criteria governing RBOC entry into the long distance market.  These rules have
been largely upheld on appeal, while certain elements were remanded to the FCC.
The Company cannot predict the ultimate outcome of the FCC's rulemaking and
possible subsequent court challenges, or the eventual effect on its businesses
or the industry in general.

     The FCC has denied applications filed by Ameritech Corporation
("Ameritech"), Southwestern Bell Communications, Inc. ("SBC") and BellSouth
Corporation ("BellSouth") seeking authority to provide in-region, inter-local
access transport area ("interLATA") long distance service to Michigan, Oklahoma,
Louisiana and South Carolina, respectively. In its denial of an Ameritech
application and a BellSouth application, the FCC provided detailed guidance to
applicants regarding the obligations of the applicants, the format of future
applications, the content of future applications, and the review standards that
it will apply in evaluating any future applications. The Company cannot predict
the RBOC's willingness to abide by these FCC guidelines, or the timing or
outcome of future applications submitted to the FCC. Other RBOCs have announced
their intention to file applications at the FCC for authority to provide
interLATA services. The Company cannot predict the outcome of these proceedings.
Both US West and Ameritech entered into a "teaming arrangement" with Qwest
Communications, a domestic U.S. facilities-based carrier whereby the RBOC would
market Qwest's long distance service. AT&T and other IXCs immediately challenged
these arrangements as the unauthorized provision of long distance service by US
West and Ameritech. The FCC first ordered the defendants to cease this
arrangement pending disposition of the IXCs' complaints, and then agreed with
the IXCs and ordered permanent cessation. US West, Ameritech and Qwest have
appealed the FCC's orders. The Company cannot predict the outcome of these
appeals. Once RBOCs are approved to (or de facto) provide in-region interLATA
service, a logical extension of that service might be to also provide
international services. To the extent that the RBOCs enter the international
long distance business, they could become major competitors of the Company. It
is also possible that they could become customers of the Company's wholesale
business although there is no assurance that this would happen.

     The Telecom Act also imposes certain requirements on all telecommunications
carriers to facilitate the entry of new telecommunications providers.  All
carriers must permit interconnection of their networks with other carriers and
may not deploy network features and functions that interfere with
interoperability.  In addition, the Telecom Act requires that all
telecommunications providers contribute equitably to a Universal Service Fund,
although the FCC may exempt an interstate carrier or class of carriers if their
contribution would be minimal.  A substantial portion of the Company's
international revenue may be exempt from the Universal Service Fund payment
base.  There can be no assurance that the Company will be exempt from
contributing to a Universal Service Fund.

     The FCC has issued orders, and is in the process of issuing further orders,
to reform Universal Service Subsidy allocations and adopted various reforms to
the existing rate structure for interstate access services provided by the ILECs
that are designed to reduce access charges, over time, to more economically
efficient levels and rate structures. It also affirmed that information services
providers (including, among others, ISPs should not be subject to existing
access charges ("ISP Exemption"). These FCC orders were upheld on appeal. Also,
several state agencies have started proceedings to address the reallocation of
implicit subsidies contained in access rates and retail service rates to state
universal service funds. Access charges are a principal component of the
Company's telecommunications expense. Pacific Gateway cannot predict whether the
FCC or state proceedings will result in a material impact upon the consolidated
financial position or the Company's profitability.

     In a report to Congress in 1998, the FCC stated that providers of phone-to-
phone Internet telephony might eventually be subject to some sort of common
carrier regulation.  The FCC, however, has 

                                       16
<PAGE>
 
not taken further action in this regard. The Company has explored the use of
Internet telephony in various forms. The Company cannot predict what effect, if
any, such FCC regulation would have, if implemented.

     Certain provisions of the Telecom Act could materially affect the growth
and operation of the telecommunications industry and the services provided by
the Company.  There are numerous rulemakings undertaken or to be undertaken by
the FCC which will interpret and implement the Telecom Act.  Further, certain of
the Telecom Act's provisions have been and likely will be challenged in the
courts.  The Company is unable to predict the outcome of such rulemakings or
litigation or the substantive effect (financial or otherwise) on the Company of
the legislation and rulemakings.  There can be no assurance that current laws
and FCC and other regulation will not be amended or modified.  Any such
amendment or modification could have a material adverse effect on the Company's
business, financial condition or results of operations.

State and Local Regulation

     In addition to regulation by the FCC, the Company is subject to varying
degrees of state regulation relating to its provision of intrastate long
distance telecommunications services.  While the FCC exercises jurisdiction over
all facilities and services of telecommunications common carriers to the extent
those facilities are used to provide domestic interstate or international
communications, state regulatory commissions retain jurisdiction over the same
facilities and services to the extent they are used to provide intrastate
communications.  Most states require certification or other authorization and
the filing of tariffs to offer intrastate long distance services, and require
that common carriers use just and reasonable rates and not discriminate among
similarly situated customers.  States may also require the filing of periodic
reports, the payment of various regulatory fees and surcharges, and compliance
with service standards and consumer protection rules.  The Company may be
required by certain states to obtain prior approval from or notify the state
commission of any transfer of control, sale of assets, corporate reorganization,
issuance of stock or debt instrument and related transactions.  The Company is
in the process of obtaining and has pending applications for authority to
provide intrastate long distance telecommunications services in all 50 states.
The Company would also be subject to regulation by local governments if it
installs and operates networks.  Many of the regulations issued by these
regulatory bodies may change, the results of which the Company is unable to
predict.

Effect of U.S. and Foreign Laws on Certain Arrangements

     Certain subsidiaries of the Company have entered into, and expect to
continue to enter into, certain termination or origination arrangements in
foreign countries that rely on private lines for the termination of U.S.
originated traffic into, or the origination of foreign-based traffic from
foreign countries. These arrangements may be viewed by foreign regulatory
agencies as "international simple resale" arrangements. The Company believes
that foreign telecommunications regulations are being liberalized and that such
arrangements are permitted in some instances and may be expressly approved by
foreign regulatory agencies in other instances. Nevertheless, at this time the
FCC or a foreign regulatory agency in a particular country may take the view
that such arrangements are not in compliance with current regulatory policies.
If the FCC finds that such arrangements violate FCC rules, the FCC could impose
a variety of sanctions on the Company or its subsidiaries, possibly including
rescission of the Company's Section 214 License.

     In addition, the counterparties in these arrangements that compete with the
PTT, and their operations may not be permitted by foreign regulatory agencies
and the PTT may act unilaterally to cancel or eliminate the private line service
on which the foreign company depends.  Regulatory authorities in Hong Kong and
the PTT in Mexico have acted against such arrangements.    The  foreign
companies with whom the Company's subsidiaries enter into such arrangements, and
perhaps the Company or its subsidiaries, could be subject to a variety of
penalties in connection with such arrangements under foreign or U.S. law,
including without limitation orders to cease operations or to limit future
operations, loss of licenses or of license opportunities, fines, seizure of
equipment and, in certain foreign jurisdictions, criminal prosecution. The

                                       17
<PAGE>
 
revenue and/or profit generated under such arrangements may have become a
significant portion of the overall revenue and/or profit of the Company at the
time such arrangements are discovered and curtailed. Moreover, the discovery
of the existence of such arrangements by foreign PTTs could adversely affect
the Company's business relationships with such foreign PTTs. Any of the
developments described above (i.e., the imposition of penalties, the loss of
revenue and/or profit generated by such arrangements (whether as a result of
regulatory problems or otherwise) or the discovery of the existence of such
arrangements by foreign PTTs) could have a material adverse effect on the
Company's business, financial condition or results of operations.

Employees

     As of December 31, 1998, Pacific Gateway's wholly-owned subsidiaries had
165 full-time employees, of which 18 were engaged in international relations, 69
in operations, engineering and information systems, 48 in sales, customer
support and business development and 30 in administration.  The Russian
subsidiary, of which the Company owns a majority interest, has 34 employees.
The Company expects to continue to add personnel as the Company continues to
expand its operations and diversify its services.

Financial Information About Foreign And Domestic Operations And Export Sales

     The Company has offshore operations in the United Kingdom, New Zealand,
Russia, Bermuda, Japan and Cyprus.  For information regarding revenues by
country see Note (4) entitled "Segment Data" in the Notes to the Consolidated
Financial Statements included in Part II, Item 8 of this 10-K.

Financial Information About Industry Segments

     The Company adopted Statement of Financial Accounting Standard No.131,
Disclosures about Segments of an Enterprise and Related Information (SFAS No.
131) effective January 1, 1998.  SFAS No. 131 requires disclosures of a
Company's operating segments, which is defined as a segment whose operating
results are distinguishable and regularly reviewed by the Company's decision
makers.  Prior to the adoption of SFAS No. 131, the Company classified all
operations under one segment, Telecommunications.  By utilizing a combination of
factors, principally services provided and geographic areas, the Company has
identified three operating segments:  U.S. wholesale, offshore and value-added
services.  The operating results of these segments are regularly reviewed by and
integral to the Company's management and its decision-making process.  Financial
information on the Company's operating segments is included in Note (4) entitled
"Segment Data" in the Notes to the Consolidated Financial Statements included in
Part II Item 8 of this 10-K.

                                       18
<PAGE>
 
Risk Factors

Dependence On Operating Agreements With Foreign Partners

     The Company relies on operating agreements with foreign partners to
terminate traffic in, and receive return traffic from, foreign countries.  The
operating agreements are generally for an unspecified term in accordance with
industry practice, although many of the Company's foreign partners have mutual
investments with the Company in digital undersea fiber optic cable to assure
long-term telecommunications access between their respective countries and the
United States.  While the Company has been successful in negotiating and
maintaining operating agreements, the trend toward deregulation of telephone
communications in many countries and a significant reduction in outgoing traffic
carried by Pacific Gateway, among other things, could cause foreign partners to
terminate their operating agreements or could cause such operating agreements to
have substantially less value to the Company.  Such termination by certain of
the Company's foreign partners could have a material adverse effect on the
Company's business, financial condition or results of operations.   Moreover,
there can be no assurance that the Company will be able to enter into additional
operating agreements in the future.  In certain countries with either a monopoly
carrier or with very few competing carriers, it may be difficult for the Company
to negotiate operating agreements for the termination of traffic on reasonable
terms and at acceptable rates, if at all.  In addition, when there are very few
carriers available to terminate traffic in a given country, the transmission
quality provided by any such carrier may be of such low quality as to be
unacceptable to the Company, in which case the Company will be required to find
other carriers willing to terminate traffic.  The failure to enter into
additional operating agreements could limit the Company's ability to increase
its revenues on a profitable basis.

Managing Rapid Growth and Diversification

     The Company is experiencing a period of rapid growth and diversification,
which is expected to continue to place a significant strain on the Company's
management, operational and financial resources.  In order to manage its growth
effectively, the Company must continue to implement and improve its operational
and financial systems and controls, and to expand, train and manage its employee
base.  Inaccuracies in the Company's forecasts of traffic could result in
insufficient or excessive transmission facilities and disproportionate fixed
expenses.  The Company's overflow traffic is handled by other international
carriers to which the Company pays per minute usage fees.  The Company is not
able to assure that the quality of these services is commensurate with the
transmission quality provided by the Company.  Finally, the Company has entered
into a phase of rapid diversification.  The Company is changing from an
international carrier that measured its revenue essentially according to the
number of "minutes" of phone traffic it terminated to a far more diverse
supplier of "bandwidth" services that expects to enter developing new areas such
as Internet services. Although these diversification efforts promise significant
returns for the Company and its shareholders, these efforts necessarily result
in the assumption of risks, such as greater demands on management time,
investment risks associated with capital expenditures for new lines of business
and increased pressures upon the Company's operations and financial systems.  
The inability to attract and retain additional qualified personnel could 
materially and adversely affect the Company. The Company expects that its 
expansion and diversification will lead to increased financial and 
administrative demands, such as increased operational complexity associated 
with, expanded network facilities, administrative burdens associated with 
managing an increasing number of foreign subsidiaries and relationships with
foreign partner. The Company's accounting systems and policies have been
developed as the Company has experienced significant growth. There can be no
assurance that they will be adequate to support the Company's future operations.
If the Company is not able to manage its growth effectively, maintain the
quality of its service or diversify its services quickly and effectively, the
future development of the Company's business may be adversely affected.

Risks Associated with Growth of Telecommunications Network Customer Base

      Although the Company's strategy is to seek to establish significant
traffic volumes prior to investing in fixed-cost facilities, the development of
such facilities entails significant costs and prior planning, which are based in
part on the Company's expectations concerning future revenue growth and market
developments. As the Company expands its network and the volume of its network
traffic, its cost of revenues will increasingly consist of fixed costs arising
from the ownership and maintenance of its switches and undersea fiber optic
cables. While the Company believes that in the long-term these investments will
allow it to reduce its cost of service and to enhance its service offerings, in
the short-term, costs increases and a decrease in the Company's operating
margins may occur. If the Company's traffic volume were to decrease, or fail to
increase to the extent expected or necessary to make efficient use of its
network, the Company's costs as a percentage of revenue could increase
significantly, which could have a material adverse effect on the Company's
business, financial condition or results of operations.

                                      19
<PAGE>
 
Risks Of International Telecommunications Business

     The Company generates a significant portion of its revenues by providing
international wholesale telecommunications services to its customers.  The
international nature of its operations subject the Company to certain risks,
such as changes in foreign government regulations and telecommunications
standards, licensing requirements, tariffs, taxes and other trade barriers, as
well as political and economic instability.  The Company's revenues and cost of
long distance services are sensitive to changes in international settlement
rates, changes in the ratios between outgoing and incoming traffic, foreign
currency fluctuations, and import and export regulations.  In addition, the
Company's business could be adversely affected by a reversal in the current
trend toward deregulation of government-owned telecommunications carriers.  In
the event of any dispute arising from foreign operations, the Company may be
subject to the exclusive jurisdiction of foreign courts and may not be
successful in subjecting foreign persons or entities to the jurisdiction of the
courts in the United States.  The Company also may be hindered or prevented from
enforcing its rights with respect to foreign governments because of the doctrine
of sovereign immunity.  There can be no assurance that the laws, regulations or
administrative practices of foreign countries relating to the Company's ability
to do business in that country will not change.  Any such change could have a
material adverse effect on the Company's business, financial condition or
results of operations.  The Company will be increasingly subject to these risks
to the extent that it proceeds with the planned expansion of its international
operations.

     International rates charged to customers are likely to decrease in the
future for a variety of reasons, including increased competition between
existing carriers, new entrants into niche markets and the consummation of joint
ventures among large international carriers that facilitate targeted pricing and
cost reductions.  The rates that the Company can charge its customers for
international services also may decrease in the future due to the widespread
resale of international private lines to provide switched voice services, the
provision of international services via non-traditional means (including the
Internet) and the rapid growth of international circuit capacity due to the
deployment of new undersea fiber optic cables and new high capacity satellite
systems in the Atlantic, Pacific and Indian Ocean regions. There can be no
assurance that the Company will be able to increase its traffic volume or reduce
its operating costs sufficiently to offset any resulting rate decreases.

     Certain subsidiaries of the Company have entered into, and expect to
continue to enter into, certain termination arrangements or origination
arrangements in foreign countries that rely on private lines for the termination
of U.S. originated traffic into, or the origination of foreign-based traffic
from foreign countries. These arrangements may be viewed by foreign regulatory
agencies as "international simple resale" arrangements. The Company believes
that foreign telecommunications regulations are being liberalized, and that in
the future such arrangements may be expressly approved by foreign regulatory
agencies. Nevertheless, the FCC or a foreign regulatory agency in a particular
country may take the view that such arrangements are not in compliance with
current regulatory policies relating to private line resale. If the FCC finds
that such arrangements violate FCC rules, the FCC could impose a variety of
sanctions on the Company, including rescission of the Company's authority to
provide international telecommunication services. In addition, the
counterparties in these arrangements compete with the PTT and their operations
may not be permitted by foreign regulatory agencies. The PTT may act
unilaterally to cancel or eliminate the private line service on which the
foreign company depends. In 1997, regulatory authorities in Hong Kong and the
PTT in Mexico have acted against such arrangements. The foreign companies with
whom the Company's subsidiaries enter into such arrangements, and perhaps the
Company or its subsidiaries, could be subject to a variety of penalties in
connection with such arrangements under foreign or U.S. law, including without
limitation orders to cease operations or to limit future operations, loss of
licenses or of license opportunities, fines, seizure of equipment and, in
certain foreign jurisdictions, criminal prosecution. The revenue and/or profit
generated under such arrangements may have become a significant portion of the
overall revenue and/or profit of the Company at the time such arrangements are
discovered and curtailed. Moreover, the discovery of the existence of such
arrangements by foreign PTTs could adversely affect the Company's business
relationships with such foreign PTTs. Any of the developments described above
(i.e., the imposition of penalties, the loss of revenue and/or profit generated
by such arrangements (whether as a result of regulatory problems or

                                       20
<PAGE>
 
otherwise) or the discovery of the existence of such arrangements by foreign
PTTs) could have a material adverse effect on the Company's business,
financial condition or results of operations.

Dependence On Availability Of Transmission Facilities

     The future profitability of the Company will depend in part on its ability
to obtain transmission facilities on a cost-effective basis. Because digital
undersea fiber optic cables typically take several years to plan and construct,
carriers generally make investments based on a forecast of anticipated traffic.
Therefore, the Company's operations are subject to the risk that it will not
adequately anticipate the amount of traffic over its network and may not procure
sufficient capacity to ensure the cost-effective transmission of customer
traffic. The Company has not controlled the planning or construction of digital
undersea fiber optic transmission facilities and the Company seeks access to
such facilities through partial ownership positions. If ownership positions are
not available, the Company must seek access to such facilities through lease
arrangements on negotiated terms that may vary with industry and market
conditions. The Company currently has partial ownership interests in 19 digital
undersea fiber optic cable systems. In addition, unlike AT&T, Sprint and MCI
Worldcom, the Company does not have direct access from it's gateway switches to
the digital undersea fiber optic cable heads and will be required either to
build its own "backhaul" facilities or to lease these facilities from these
competitors of the Company.

     The Company has applied to obtain partial ownership interests in new
undersea fiber optic cables, which are currently under construction. These
cables are subject to regulation by the FCC, for the U.S. portion, and by
foreign authorities, for overseas termination points. Each new cable system that
lands in the United States must be approved by the FCC before the system may be
activated. The FCC has provided or will provide opportunity for public comment
on each such application. The application of at least one of the cables in which
the Company seeks an interest has been opposed by a private party pursuant to
the FCC notice and comment procedure. There is no guarantee that the FCC or
responsible foreign authorities will take favorable action with respect to the
undersea fiber optic cables in which the Company seeks an interest. In addition,
the FCC approval process may delay the date that a cable system is ready for
service. Regulatory delays regarding the commencement of the operation of a
cable could have material adverse effect on the Company's business, results of
operations, or financial conditions. There can be no assurance of continued
availability of transmission facilities or access to digital undersea fiber
optic cable heads on economically viable terms.

Competition

     The international telecommunications industry is highly competitive and
subject to the introduction of new services facilitated by advances in
technology.  International telecommunications providers compete on the basis of
price, customer service, transmission quality, breadth of service offerings and
value-added services.  The U.S.-based international telecommunications services
market is dominated by AT&T, MCI WorldCom and Sprint.  The Company also competes
with other carriers in certain markets.  As the Company's network expands to
serve a broader range of customers, Pacific Gateway expects to encounter
increasing competition from these and other major domestic and international
communications companies, many of which may have significantly greater resources
and more extensive domestic and international communications networks than the
Company.  Moreover, the Company is likely to be subject to additional
competition as a result of the formation of global alliances and mergers among
the largest telecommunications carriers.  Existing or planned global alliances
or combinations include Global One, AT&T/British Telecommunications plc and
Global Crossing/Frontier.  The Company also faces competition from companies
offering resold international telecommunications services.  The Company expects
that competition from such resellers will increase in the future in tandem with
increasing deregulation of telecommunications markets worldwide.

     The telecommunications industry is in a period of rapid technological
evolution, marked by the introduction of new product and service offerings and
increasing satellite transmission capacity for services similar to those
provided by the Company.  Those technologies being developed or already
introduced include satellite-based systems, such as the proposed Iridium and
GlobalStar systems, utilization of the Internet for international voice and data
communications,  digital wireless communication systems such as personal
communications services and broadband multimedia applications.  The Company is
unable to 

                                       21
<PAGE>
 
predict which of many possible future products and service offerings will be
important to maintain its competitive position or what expenditures will be
required to develop and provide such products and services.

     Recent regulatory changes also are expected to increase competition in the
telecommunications industry.  In February 1996, the Telecom Act was adopted.
The Telecom Act promotes additional competition in the intrastate, interstate
and international telecommunications markets by both U.S.-based and foreign
companies.  The Telecom Act permits the RBOCs to compete in interstate and
international service.  Although an RBOC currently may not offer international
services to customers within the region where the RBOC has market power, some
RBOCs have begun to resell international services to customers outside of such
regions or through mobile telephone subsidiaries.  AT&T has obtained relaxed
pricing restrictions and relief from other regulatory constraints that should
make it easier for AT&T to compete with alternative carriers such as the
Company.  In addition, in February 1997, over 60 countries signed a global
agreement on telecommunications under the auspices of the WTO, which agreement
became effective in February 1998.  Under the WTO Agreement, countries committed
to open markets to competition in telecommunications services, improve foreign
investment opportunities in the telecommunications industry and promote pro-
competitive regulatory principles.  The FCC has adopted various rules designed
to implement the principles of the WTO Agreements.  See "--Government
Regulation."  The FCC also adopted streamlined license granting procedures for
carriers from WTO Agreement signatory countries, pursuant to which the FCC
granted more than 200 international applications in the first 90 days after the
streamlined procedures became effective.  There can be no assurance that the
Company will be able to effectively compete in the new regulatory environment or
that these changes or other regulatory developments will not have a material
adverse effect on the Company's business, financial condition or results of
operations.

     The U.S. telecommunications services industry is becoming more concentrated
as a result of mergers, acquisitions and consolidations between and among U.S.
carriers.  Major mergers that have been consummated or are expected to close
soon include WorldCom/MCI, AT&T/TCI, Bell Atlantic/GTE and SBC/Ameritech.
Numerous other, smaller combinations have been announced or consummated as well,
such as Global Grossing/Frontier.  The Company is unable to predict the effect
of these mergers and combinations on competition.  The mergers involving
WorldCom/MCI and Bell Atlantic/GTE, which are important U.S. international
carriers, particularly will affect the Company in ways that are not clear.
Consolidation of large U.S. international carriers has the effect generally of
reducing the number of large, facilities-based carriers that compete with the
Company, while making each such competitor stronger, both financially and in the
variety of international routes covered on a facilities basis.  This
consolidation could make it more difficult for the Company to compete in
providing facilities-based services.  Similarly, the consolidation and
enlargement of the remaining U.S. RBOCs could make these companies more
important competitors to the Company as the RBOCs begin to offer substantially
end-to-end service between the United States and foreign destinations.

                                       22
<PAGE>
 
Risks Related to Bandwidth Capacity Investments

     The Company's ability to achieve its strategic objectives will depend in
large part upon the successful, timely and cost-effective completion of the
cable projects in which the Company is investing, as well as on achieving
capacity sales on the Company's portion of these systems once they become
operational, the construction or leasing of necessary "backhaul" facilities, and
the deployment of a fiber optic network of significant capacity within the
United States and foreign countries. There can be no assurance that these new
systems will be completed at all, let alone at the cost or in the time frame
currently estimated. Furthermore, there can be no assurance that the Company
will be able to sell capacity on the new cable systems in which it is investing
at optimal prices. The Company's commitment to cable investments reflects the
Company's belief in rapid growth of the demand for international
telecommunication capacity. There can be no assurance that such anticipated
demand growth will occur. The domestic fiber optic capacity, as well as undersea
fiber optic cable transmission systems, have experienced significant per circuit
price declines resulting from technological advances in fiber optic technology.
Recent technological advances have created even greater per circuit pricing
pressure in the industry. In addition, the introduction of new products or the
emergence of new technologies may enable competitors to install competing
systems at a lower per-circuit cost on routes currently targeted by the Company
or to expand capacity on existing competitive systems, potentially rendering the
Company's systems not cost competitive. The Company's cable investment also will
be subject to the risks inherent in a large-scale, complex undersea fiber optic
telecommunications system employing advanced technology, including operations,
administration, maintenance and repair. There can be no assurance of the actual
useful life of any of the systems that the Company uses and failure of any such
systems could have a material adverse effect on the Company's business,
financial condition or results of operations.

Risk from Proposed Internet Operations

     The Company's success in launching Internet operations will depend on 
several factors including finding the right personnel to manage the operations; 
the Company's ability to compete successfully in the Internet marketplace where 
competition already is intense; the Company's ability to win customers from 
established vendors; and growth in the Internet in accordance with the Company's
expectations. There can be no assurances that the Company will be able to
successfully enter the Internet marketplace. Failure of the Company to do so
could have a material adverse effect on the Company's diversification strategy,
as well as on its business, financial condition or result of operations.

Dependence On Key Personnel

     The Company is dependent on the efforts of certain key personnel to
successfully operate its business.  These personnel include Howard A.
Neckowitz, Chairman of the Board, President and Chief Executive Officer; Gail E.
Granton, Executive Vice President, International Business Development and
Secretary; Ronald D.  Anderson, Vice President, Operations and Engineering;
Robert F. Craver, Senior Vice President, International Relations; Fred A.
Weismiller, Executive Vice President, International Marketing; Thomas J. Murphy,
Executive Vice President of Global Networks and Multimedia Services and Sandra
D. Grey, Chief Financial Officer and Vice President, Finance, as well as a group
of employees with long-standing industry relationships and technical knowledge
of the Company's operations.  The loss of the services of one or more of these
individuals could materially and adversely affect the business of the Company
and its future prospects.  The Company does have employment agreements with
certain of these personnel but does not maintain key person life insurance on
any of its officers or employees.  The Company's future success will also depend
on its ability to attract and retain additional management, technical and sales
personnel required in connection with the growth and development of its
business.

                                       23
<PAGE>
 
Capital Expenditures; Potential Need For Additional Financing

     The facilities-based telecommunications industry requires substantial
capital investment in switching and peripheral equipment and digital undersea
fiber optic cables.  Growth in the number of minutes transmitted, international
locations and customers served by the Company will require additional investment
in equipment and facilities.  Moreover, the Company's diversification strategy
will significantly increase the Company's capital requirements.  In particular,
in 1998, the Company incurred commitments of approximately  $168 million to
purchase interests in the Japan-U.S. and TAT-14 undersea cable systems.  To
fully exploit the potential of these investments, the Company is planning
additional investments in related "backhaul" facilities and bandwidth capacity
located in the United States and Europe.  The Company has obtained a commitment
letter from Salomon Brothers Holding Company, Inc. and Goldman Sachs Credit
Partners L.P. for a $200 million credit facility, with the ability to add an
additional $100 million of bank debt.  While the Company believes that its
existing and anticipated sources of liquidity should be sufficient to fund the
capital requirements of its current business for the foreseeable future, certain
events may occur that would require the Company to obtain additional financing
which could take the form of the public sale of debt or equity securities.  Such
events could include acquisitions, the decision to expand investment in
facilities, faster than expected growth or lower than anticipated funds
generated from operations.  There can be no assurance that the Company will be
able to raise additional financing, or, if raised, that the terms of such
financing will be favorable to the Company.

Risks Associated With Joint Ventures, Direct Investments and Acquisitions

     An important component in the Company's business strategy is to expand
through joint ventures, investments and acquisitions.  This growth strategy is
dependent on the continued availability of suitable strategic opportunities and
subjects the Company to certain risks.  Pursuing these transactions could place
significant demands on the Company's financial and management resources and
potentially disrupt the Company's ongoing business.  Transactions also may
require integration of financial and call routing systems, network and other
physical facilities and personnel.  Difficulties in integration could cause
system degradation, added costs and loss of employees and customers.  There can
be no assurance that the Company will be successful in overcoming these risks or
other problems in connection with future transactions.  In addition, any such
transactions materially adversely affect the Company's operating results due to
dilutive issuances of securities and the incurrence of additional debt.

Government Regulation

     The Company's business is heavily regulated, which in turn imposes certain
risks on the Company.  See "Business-Government Regulation."  The Company's
interstate and international facilities-based and resale services are subject to
regulation by the FCC, and regulations promulgated by the FCC are subject to
change in the future. The Company is also subject to regulation in foreign
countries in connection with certain of its business activities. For example,
the Company has obtained licenses in certain countries, including the United
Kingdom, Germany, France, Japan, Australia, New Zealand and Canada, and
anticipates becoming licensed in others. In addition, the Company's use of
transit agreements or arrangements, if any, may be affected by laws or
regulations in either the transited or terminating foreign jurisdiction. There
can be no assurance that foreign countries will not adopt laws or regulatory
requirements that could adversely affect the Company, or that the Company will
be able to obtain and keep required licenses and obtain reasonably-priced access
to certain markets. There can be no assurance that future regulatory, judicial
and legislative changes will not have a material adverse effect on the Company's
business, financial condition or results of operations or that regulators or
third parties will not raise issues or take enforcement actions with regard to
the Company's compliance with applicable regulations.

     The telecommunications industry has recently experienced significant
regulatory changes designed to open markets to competition in telecommunications
services, improve foreign investment opportunities in the telecommunications
industry and promote pro-competitive regulatory principles. See "Business--
Government Regulation."  The Company is unable to predict the full effect of
these changes on the international telecommunications market.  These changes are
expected to increase competition in the 

                                       24
<PAGE>
 
telecommunications market. See "--Competition." These changes may result in
lower costs to the Company; however, the revenues that the Company receives
may decrease to a greater degree as a result of increased competition. For
example, WTO Carriers with market power in their home markets may be able to
more easily offer United States and foreign customers services to the
disadvantage of United States carriers, which may continue to face substantial
obstacles in obtaining from foreign governments and foreign carriers the
authority and facilities to provide such services. There can be no assurance
that these events would not have a material adverse effect on the Company's
business, financial condition or results of operations.

Foreign Ownership

     Under the Communications Act, no common carrier radio license may be held
by non-U.S. citizens or their representatives; foreign governments or
corporations organized under the laws of a foreign country; U.S. corporations
with more than 20% of its stock directly owned or voted by non-U.S. citizens; or
more than 25% of its stock indirectly owned or voted by aliens, in the last
instance without first obtaining FCC approval.  For WTO entities, the FCC has
established an open entry standard, meaning that the FCC presumptively will
approve greater than 25% indirect ownership by a WTO Carrier of a U.S. common
carrier radio licensee, subject to certain competitive safeguards.   The FCC has
reserved the right in certain cases to attach additional conditions to a grant
of authority, and to deny the application in the exceptional case in which an
application poses a very high risk to competition.  For carriers from countries
that are not signatory to the WTO Agreement, the FCC will continue to apply the
ECO test in deciding whether to approve greater than 25% ownership of an
international radio licensee.

     The FCC also requires a carrier to notify the Commission if it becomes
affiliated with a foreign carrier, if it acquires greater than 25% interest in a
foreign carrier or if a foreign carrier acquires a greater than 25% interest in
the Company.

Federal Legislation and Implementation

     The Telecom Act was adopted in February 1996 and substantially changed the
regulation of telecommunications in the United States.  The Telecom Act permits
RBOCs to provide domestic and international long distance services to customers
located outside of the RBOCs' home regions; permits a petitioning RBOC to
provide domestic and international long distance service to customers within its
operating area on a state by state basis upon finding by the FCC that a
petitioning RBOC has satisfied certain criteria for opening up its local
exchange network to competition and that provision of long distance services
would further the public interest; and removes existing barriers to entry into
local service markets.  Additionally, there were significant changes in: the
manner by which carrier-to-carrier arrangements are regulated at the federal and
state level; procedure to revise universal service standards; and penalties for
unauthorized switching of customers.  The FCC has instituted and, in most
instances completed, proceedings addressing the implementation of this
legislation.

     In implementing the Telecom Act, the FCC established nationwide rules
designed to encourage new entrants to participate in the local services markets
through interconnection with the incumbent local exchange carriers ("ILECs"),
resale of ILECs' retail services, and use of individual and combinations of
unbundled network elements.  These rules set the groundwork for the statutory
criteria governing RBOC entry into the long distance market.  These rules have
been largely upheld on appeal, while certain elements were remanded to the FCC.
The Company cannot predict the ultimate outcome of the FCC's rulemaking and
possible subsequent court challenges, or the eventual effect on its businesses
or the industry in general.

     The FCC has denied applications filed by Ameritech,  SBC and BellSouth
seeking authority to provide in-region, interLATA long distance service to
Michigan, Oklahoma, Louisiana and South Carolina, respectively.   In its denial
of an Ameritech application and a BellSouth application, the FCC provided
detailed guidance to applicants regarding the obligations of the applicants, the
format and content of future 

                                       25
<PAGE>
 
applications and the review standards that it will apply in evaluating any
future applications. The Company cannot predict the RBOC's willingness to
abide by these FCC guidelines, or the timing or outcome of future applications
submitted to the FCC. Other RBOCs have announced their intention to file
applications at the FCC for authority to provide interLATA services. The
Company cannot predict the outcome of these proceedings. Both US West and
Ameritech entered into a "teaming arrangement" with Qwest Communications, a
domestic U.S. facilities-based carrier whereby the RBOC would market Qwest's
long distance service. AT&T and other IXCs immediately challenged these
arrangements as the unauthorized provision of long distance service by US West
and Ameritech. The FCC first ordered the defendants to cease this arrangement
pending disposition of the IXCs' complaints, and then agreed with the IXCs and
ordered permanent cessation. US West, Ameritech and Qwest have appealed the
FCC's orders. The Company cannot predict the outcome of these appeals. Once
RBOCs are approved to (or de facto) provide in-region interLATA service, a
logical extension of that service might be to also provide international
services. To the extent that the RBOCs enter the international long distance
business, they could become major competitors of the Company. It is also
possible that they could become customers of the Company's wholesale business,
although there is no assurance that this would happen.

     The Company is subject to access charges and may be subject to Universal
Service Fund contributions on some of its reserves.  See "Business--Government
Regulation."  The FCC has issued orders to reform Universal Service Subsidy
allocations and adopted various reforms to the existing rate structure for
interstate access services provided by the ILECs that are designed to reduce
access charges, over time, to more economically efficient levels and rate
structures.  It also affirmed that information services providers including,
among others, ISPs should not be subject to existing access charges. These FCC
orders were upheld on appeal. Also, several state agencies have started
proceedings to address the reallocation of implicit subsidies contained in
access rates and retail service rates to state universal service funds. Access
charges are a principal component of the Company's telecommunications expense.
Pacific Gateway cannot predict whether the FCC or state proceedings will result
in a material impact upon the consolidated financial position or the Company's
profitability.

     In a report to Congress last year, the FCC stated that providers of phone-
to-phone Internet telephony might eventually be subject to some sort of common
carrier regulation.  The FCC, however, has not taken further action in this
regard.  The Company has explored the use of Internet telephony in various
forms.  The Company cannot predict what effect, if any, such FCC regulation
would have, if implemented.

     In February 1997, over 60 countries signed a global agreement on
telecommunications under the auspices of the WTO.  The WTO Agreement, which
became effective on February 5, 1998, seeks to open markets to competition in
telecommunications services, improve foreign investment opportunities in the
telecommunications industry and promote pro-competitive regulatory principles.
The Company is unable to predict the effect the WTO Agreement will have on the
Company.

     In sum, there can be no assurance that current laws and FCC and other
regulations will not be amended or modified.  Any such amendment or modification
could have a material adverse effect on the Company's business, financial
condition or results of operations.

Effects of Natural Disasters and Other Catastrophic Events; Risks of Network 
Failure

     The Company's business is susceptible to natural disasters and catastrophic
events such as earthquakes, fire, power outages, terrorism and war.  Any system 
or network failure that causes interruptions in the Company's operations could 
have a material adverse effect on its business, financial condition or results 
of operations. The Company's operations are dependent on its ability to 
successfully expand its network and integrate new and emerging technologies and 
equipment into its network, which are likely to increase the risk of system 
failure and to cause strain upon the network. The Company's operations also are 
dependent on the Company's protection of its hardware and other equipment from 
damage from natural disasters such as fires, floods, hurricanes and earthquakes,
other catastrophic events such as civil unrest, terrorism and war and other
sources of power loss and telecommunication failures. Although the Company has
taken a number of steps to prevent its network from being affected by natural
disasters, such as building redundant systems for power supply to the switching
equipment, there can be no assurance that any such systems will prevent the
Company's switches from becoming disabled in the event of a natural disaster or
catastrophic event. The failure of the Company's network, or a significant
decrease in telephone traffic resulting from effects of a natural disaster or
catastrophic event, could have a material adverse effect on the Company's
relationship with its customers and the Company's business, financial condition
or results of operations.

                                      26
<PAGE>
 
Concentration Of Credit Risk

     The Company's customer base includes domestic and international companies
in the telecommunications industry.  The Company performs ongoing credit
evaluations of its customers but generally does not require collateral to
support accounts receivable from its customers.  The Company's allowance for
doubtful accounts is based on current market conditions.  Losses on
uncollectible accounts have consistently been insignificant and within
management's expectations.   However, the failure of any of the Company's large
customers to remit payments to the Company due to bankruptcy or otherwise could
have a material adverse effect on the Company's business, financial condition or
results of operations.

Anti-Takeover Provisions

     The Company's Board of Directors has the authority to issue up to 5,000,000
shares of preferred stock (the "Preferred Stock") and to determine the price,
rights, preferences and privileges of those shares without any further vote or
actions by the stockholders.  The rights of the holders of Common Stock will be
subject to, and may be adversely affected by, the rights of the holders of any
Preferred Stock that may be issued in the future.  The issuance of shares of
Preferred Stock, while potentially providing desirable flexibility in connection
with possible acquisitions and serving other corporate purposes, could have the
effect of making it more difficult for a third party to acquire, or may
discourage a third party from attempting to acquire, a majority of the
outstanding voting stock of the Company.  The Company is subject to the anti-
takeover provisions of Section 203 of the Delaware General Corporation Law,
which prohibits the Company from engaging in a "business combination" with an
"interested stockholder" for a period of three years after the date of the
transaction in which the person became an interested stockholder unless the
business combination is approved in a prescribed manner.  The application of
Section 203 could have the effect of delaying or preventing a change of control
of the Company.  Furthermore, certain provisions of the Company's bylaws,
including provisions that provide that the exact number of directors shall be
determined by a majority of the Board of Directors, that vacancies on the Board
of Directors may be filled only by a majority vote of the directors then in
office, though less than a quorum, and that stockholder meetings may only be
called by the Board of Directors or the Chairman of the Board, may have the
effect of delaying or preventing a change in control of the Company, which could
adversely affect the market price of the Company's Common Stock.  In addition,
the Company adopted a stockholders rights plan (the "Stockholders Rights Plan")
in November 1997 and, in connection therewith, entered into a Rights Agreement
between the Company and Norwest Bank Minnesota N.A., as Rights Agent, dated as
of November 17, 1997, which will cause substantial dilution to a person or group
that attempts to acquire the Company on terms not approved by the Company's
Board of Directors.  These provisions, along with the adoption of the
Stockholders Rights Plan, may discourage takeover bids for the Company.  See
Note (9) in the Notes to the Consolidated Financial Statements included in Part
II, Item 8 of this 10-K for further information on the Stockholders' Rights
Plan.

Operating Results Subject to Significant Fluctuations

     The Company's quarterly operating results are difficult to forecast with 
any degree of accuracy because a number of factors subject these results to 
significant fluctuations. As a result, the Company believes that 
period-to-period comparisons of these operating results are not necessarily 
meaningful and should not be relied upon as indications of future performance. 

     The Company's financial results include many variable factors and as such 
the Company's revenues, costs and expenses have fluctuated in the past and are 
likely to continue to fluctuate in the future as a result of numerous factors. 
The Company's revenues in any given period can vary due to factors such as call 
volume fluctuations, particularly in regions with relatively high per-minute 
rates; the addition or loss of large customers, whether through competition, 
merger, consolidation or otherwise; the loss of economically beneficial routing 
options for the termination of the Company's traffic; financial difficulties of 
large customers; pricing pressure resulting from increased competition; delays 
or difficulties in the development of new products or programs or in the 
integration of new management personnel and technical difficulties with or 
failures of portions of the Company's network that impact the Company's ability 
to provide service to or bill its customers. The Company's cost of services and 
operating expenses in any given period can vary due to factors such as 
fluctuation in rates charged by carriers to terminate the Company's traffic; 
increases in bad debt expense and reserves; the timing of capital expenditures, 
and other costs associated with acquiring or obtaining other rights to switching
and other transmission facilities; changes in the Company's sales incentive 
plans; and costs associated with changes in staffing levels of sales, marketing,
technical support and administrative personnel. In addition, the Company's 
operating results can vary due to factors such as changes in routing due to 
variations in the quality of vendor transmission capability; loss of favorable 
routing options; the amount of, and the accounting policy for, return traffic 
under operating agreements; actions by domestic or foreign regulatory entities; 
the level, timing and pace of the Company's expansion in international and 
commercial markets; and general domestic and international economic and 
political conditions. Further, a substantial portion of transmission capacity 
used by the Company is obtained on a variable, per minute and short-term basis, 
subjecting the Company to the possibility of unanticipated price increases and 
service cancellations. Since the Company does not generally have long term 
arrangements for the purchase of resale of long distance services, and since 
rates fluctuate significantly over short periods of time, the Company's gross 
margins also may be negatively impacted in the longer term by competitive 
pricing pressures.

Possible Volatility of Stock Price

     Historically, the market prices for securities of emerging companies in the
telecommunications industry have been highly volatile.  Future announcements
concerning the Company or its competitors, including results of operations,
technological innovations, government regulations, proprietary rights or
significant litigation, may have a significant impact on the market price of the
Company's Common Stock.  Quarterly results may vary substantially from previous
or corresponding periods, causing the Company to fall short of expectations of
public market analysts and investors for such quarter, which could have a
material adverse effect on the market price of the Company's Common Stock.

                                       27
<PAGE>
 
Dividend Policy

     The Company has never paid cash dividends on its Common Stock and has no
plans to do so in the foreseeable future.  The Company intends to retain
earnings to develop and expand its business.

Year 2000 Issue

     The "Year 2000" issue affects  computer systems, network elements, software
applications and other business systems that have time-sensitive programs that
may not properly reflect or recognize the year 2000.  Because many computers and
computer applications define dates by the last two digits of the year, "00" may
not be properly identified as the year 2000.  This error could result in
miscalculations or system failures.  The Year 2000 issue may also affect the
systems and applications of the Company's vendors and customers.  The costs
associated with testing Year 2000 readiness of the Company's internal
information systems and with testing and upgrading of equipment to ensure Year
2000 readiness are not expected to be material to the Company's business,
financial condition or results of operations.  A number of the computers of the
Company's customers and vendors that interface with the Company's systems may
run on programs that are not Year 2000 ready and may disrupt the Company's
billing, credit and tracking systems.  In the event that any of the Company's
significant vendors and customers do not successfully and timely achieve Year
2000 readiness and the Company is unable to replace them with new and/or
alternative vendors and customers, the Company's business or operations could be
adversely affected.  See "Management's Discussion and Analysis of Financial
Condition and Results of Operations" included in Part II, Item 7 of this 10-K.

ITEM 2.  PROPERTIES

     The principal offices of the Company are located in 36,400 square feet of
space in Burlingame, California.  The Company leases this space under agreements
which expires in April 1999 and December 2003.  The Company also leases a total
of approximately 40,000 square feet in the U.S. in the cities of New York, Los
Angeles and Dallas and in the United Kingdom, New Zealand, Russia, Japan and
Australia as sites for its switching facilities.  In addition, the Company
leases a total of approximately 3,000 square feet of office space in Houston,
Texas, Tarzana, California and Riverside, California for its operations. The
Company believes that its facilities are adequate to support its current needs
and that suitable additional facilities will be available, when needed, on
commercially reasonable terms.

ITEM 3.  LEGAL PROCEEDINGS

     The Company is not currently subject to any material legal proceedings.

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

     No matters were submitted to a vote of shareholders of the Company during
the fourth fiscal quarter of the fiscal year ended December 31, 1998.

                                       28
<PAGE>
 
EXECUTIVE OFFICERS

     Set forth below are the names, ages, positions and certain other
information concerning the current executive officers and other key members of
management of the Company.

     The executive officers of the Company are as follows:
<TABLE>
<CAPTION>
 
NAME                          AGE     POSITION
<S>                           <C>     <C>
                                  
Howard A.  Neckowitz           45     President and Chief Executive Officer
                                  
Gail E.  Granton               43     Executive Vice President,  International Business
                                      Development and Secretary        

Ronald D.  Anderson            42     Senior Vice President, Operations and Engineering
                                  
Robert F.  Craver              56     Senior Vice President, International Relations
                                  
Fred A.  Weismiller            57     Executive Vice President, International Marketing
                                  
Thomas J.  Murphy              47     Executive Vice President of Global  Networks and
                                      Multimedia Services              
                                  
Sandra D.  Grey                32     Chief Financial Officer and Vice President, Finance
 
</TABLE>

MR. HOWARD A.  NECKOWITZ has served as President, Chief Executive Officer and
Chairman of the Board of the Company since its inception in August 1991.  Mr.
Neckowitz previously served as a consultant to major U.S.  and overseas
telecommunications companies with respect to valuation and due diligence
processes for the acquisition of ongoing foreign telecommunications operations
and the start-up of competitive carrier operations for international, long
distance, local and cellular operations in various countries.  Prior to his
consulting experience, Mr. Neckowitz served from 1982 to 1986 as Director,
International Services, at GTE Sprint, where he founded and developed GTE
Sprint's international services operation.  In this position, he was responsible
for feasibility analyses supporting GTE Sprint's entrance into the international
switch service market.  From 1977 to 1982, Mr. Neckowitz worked at AT&T in its
Overseas Department.

MS. GAIL E. GRANTON has served as Executive Vice President, International
Business Development, Secretary and a member of the Board of Directors of the
Company since its inception in August 1991.  From August 1991 to August 1996,
she served as Chief Financial Officer of the Company.  From 1986 to August 1991,
Ms. Granton served as a consultant to major U.S. and overseas telecommunications
companies, focusing on the valuation and due diligence process for the
acquisition of ongoing foreign telecommunication operations and the start-up of
competitive carrier operations for international, long distance, local and
cellular operation in various countries.  From 1982 to 1986, Ms. Granton worked
in the International Department of GTE Sprint as a Manager, International
Business Development, reporting to Mr. Neckowitz.

MR. RONALD D. ANDERSON has served as Senior Vice President, Operations and
Engineering of the Company since December 1992.  From 1986 to 1992, Mr. Anderson
served in a similar position with TRT International, Inc., an international
telecommunications carrier that has since been acquired by WorldCom.  Mr.
Anderson has more than 16 years of experience in domestic and international
telecommunications engineering and operations, with significant experience in
international signaling and transmission for cable and satellite, PTT technical
interface and bilateral technical negotiations.

                                       29
<PAGE>
 
MR. ROBERT F. CRAVER has served as Senior Vice President, International
Relations of the Company since February 1994.  Prior to joining the Company, Mr.
Craver worked at GTE Hawaiian Telephone Co., Inc. from 1987 to 1994.  While at
GTE Hawaiian Telephone, Mr. Craver directed that company's international program
as Director of International Services.  Mr. Craver has also held international
positions at Sprint and AT&T, for a total of more than 21 years of experience in
the international telecommunications industry.  Mr. Craver has extensive
experience in international negotiations with foreign partners and has served as
an officer of the Pacific Telecommunications Council.

MR. FRED A.  WEISMILLER joined the Company in November 1994 as Executive Vice
President, International Marketing.  Mr. Weismiller's responsibilities include
developing the valued-added long distance services, which can be sold to U.S.
carriers and to carriers in developing overseas markets.  From 1991 to 1994, Mr.
Weismiller served as Managing Director and Executive Director, Sales and
Marketing at Telecom New Zealand.  Mr. Weismiller has 26 years of experience in
international and domestic telecommunications management, including 20 years
with AT&T, where his final assignment was in Hong Kong as the Managing Director
of the AT&T Regional Technical Center from 1989 to 1990.

MR. THOMAS J. MURPHY joined the Company in August 1998 as Executive Vice
President, Global Networks and Multimedia Services.  From 1993 to 1998, Mr.
Murphy worked at Cable and Wireless U.S., a telecommunications company
exclusively servicing the U.S. business market, where he served as the Chief
Operating Officer.  Mr. Murphy has extensive experience in telecommunications
operational activities including facilities management, technical operations,
network operations, project management and network planning.  Mr. Murphy has
worked in the telecommunications industry for over 20 years.

MS. SANDRA D. GREY has served as Chief Financial Officer of the Company since
1996.  From 1989 to 1996, Ms. Grey worked for Telecom New Zealand, the primary
provider of telecommunications services in New Zealand, where she was Chief
Financial Officer of the international subsidiary.  Ms. Grey has more than 8
years experience in international telecommunications.

                                       30
<PAGE>
 
                                    PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED
STOCKHOLDER MATTERS

     The Common Shares were initially offered to the public on July 19, 1996 at
a price of $12.00 per share.  The Common Shares are quoted on the NASDAQ
National Market under the symbol "PGEX."

     The following table sets forth, for the periods indicated, the high and low
sales prices for the Common Shares as reported by the NASDAQ National Market.
Such prices reflect inter-dealer prices, without retail mark-up, mark-down or
commission, and do not necessarily represent actual transactions.

<TABLE>
<CAPTION>
                                               High      Low
                                              -------  -------
<S>                                           <C>      <C>
          Quarter ended March 31, 1997        $39.250  $22.500
          Quarter ended June 30, 1997         $29.000  $21.750
          Quarter ended September 30, 1997    $39.375  $27.000
          Quarter ended December 31, 1997     $55.125  $33.000
 
          Quarter ended March 31, 1998        $57.875  $43.188
          Quarter ended June 30, 1998         $60.750  $38.875
          Quarter ended September 30, 1998    $46.750  $26.500
          Quarter ended December 31, 1998     $49.250  $23.250
</TABLE>

     As of March 17, 1999 there were 99 holders of record of the Common Shares
of the Company.
 
     The Company has never paid cash dividends on its Common Stock and has no
plans to do so in the foreseeable future.  The Company intends to retain
earnings to develop and expand its business.


ITEM 6.  SELECTED FINANCIAL DATA

     The following selected consolidated financial data as of and for each of
the five years in the period ended December 31, 1998 have been derived from the
audited consolidated financial statements of the Company.  The following data
should be read in conjunction with the consolidated financial statements and the
notes thereto and "Management's Discussion and Analysis of Financial Condition
and Results of Operations" included herein.

<TABLE>
<CAPTION>
                                                                              Year Ended December 31,                         
                                                     -------------------------------------------------------------------------
                                                          1998           1997            1996            1995          1994   
                                                     -----------     ----------      ----------      ----------    ----------- 
Statement of Operations Data:                                       (In thousands except per share amounts)
<S>                                                  <C>             <C>             <C>             <C>           <C>
   Revenues                                             $466,291       $298,609        $162,426         $76,416        $20,913
   Cost of long distance                                 393,640        254,076         140,340          66,346         17,196
                                                     -----------     ----------      ----------      ----------    -----------
      Gross margin                                        72,651         44,533          22,086          10,070          3,717
   Selling, general and administrative expenses           36,791         21,416          11,113           5,467          2,273
   Depreciation and amortization                           8,713          5,417           2,044           1,124            410
                                                     -----------     ----------      ----------      ----------    -----------
      Operating income                                    27,147         17,700           8,929           3,479          1,034
   Other (income) expense, net                            (1,132)          (126)            129               -              -
   Interest (income) expense, net                         (2,292)        (2,009)           (885)            538            193
                                                     -----------     ----------      ----------      ----------    -----------
      Income before income taxes                          30,571         19,835           9,685           2,941            841
   Provision for income taxes                             10,635          7,338           3,877           1,155            205
                                                     -----------     ----------      ----------      ----------    -----------
      Net income                                        $ 19,936       $ 12,497        $  5,808         $ 1,786        $   636
                                                     ===========     ==========      ==========      ==========    ===========
   Net income per share - diluted                          $0.97          $0.64           $0.34           $0.12          $0.04
                                                     ===========     ==========      ==========      ==========    ===========
   Weighted average number of common               
     shares outstanding-diluted                           20,495         19,497          16,872          14,535         14,300
                                                     ===========     ==========      ==========      ==========    ===========
</TABLE>

                                       31
<PAGE>
 
<TABLE>
<CAPTION>
                                                                              Year Ended December 31,                         
                                                     -------------------------------------------------------------------------
                                                          1998           1997            1996            1995          1994   
                                                     -----------     ----------      ----------      ----------    ----------- 
                                                               (In thousands except revenues per minute of use amounts)
<S>                                                  <C>            <C>              <C>             <C>           <C>
   Other Operating Data:
      EBITDA/(1)/                                     $   35,860     $   23,117        $ 10,973        $  4,603        $ 1,444
      Capital expenditures                            $   49,611     $   36,725        $ 18,669        $  7,233        $ 3,745
      Minutes of use                                   1,635,285      1,025,649         563,495         252,925         61,690
      Revenues per minute use                              $0.29          $0.29           $0.29           $0.30          $0.34
</TABLE>                 
                      
<TABLE>
<CAPTION>
                                                                                  As of December 31,
                                                     -------------------------------------------------------------------------
                                                         1998            1997           1996            1995           1994
                                                     -----------     ----------      ----------      ----------    ----------- 
                                                                                   (In thousands)
<S>                                                  <C>            <C>              <C>             <C>           <C>
   Balance Sheet  Data:
      Cash and cash equivalents                       $   30,041     $   43,850        $ 45,563        $  1,792        $     9
      Working capital (deficit)                       $   (8,953)    $   14,541        $ 35,051        $ (6,412)       $   242
      Total assets                                    $  235,637     $  171,617        $103,816        $ 29,976        $12,301
      Stockholders' equity                            $  100,639     $   76,573        $ 62,472        $  2,891        $ 1,104
</TABLE>

_______________

/(1)/  EBITDA represents earnings before interest expense, income taxes,
       depreciation and amortization expense. EBITDA does not represent cash
       flows as defined by generally accepted accounting principles and does not
       necessarily indicate that cash flows are sufficient to fund all of the
       Company's cash needs. EBITDA is a financial measure commonly used in the
       Company's industry and should not be considered in isolation or as a
       substitute for net income, cash from operating activities or other
       measures of liquidity determined in accordance with generally accepted
       accounting principles.


ITEM 7.   MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

Note on forward-looking statements

     This Annual Report contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended.  Forward-looking
statements are statements other than historical information or statements of
current condition.  Some forward-looking statements may be identified by use of
terms such as "believes," "anticipates," "plans," "intends" or "expects." These
forward-looking statements relate to the plans, objectives and expectations of
Pacific Gateway Exchange, Inc. ("Pacific Gateway" or the "Company") regarding
its future operations or financial performance or related to the Company's
expectations regarding the telecommunications industry.  In light of the
inherent risks and uncertainties of any forward-looking statement, the inclusion
of forward-looking statements in this report should not be regarded as a
representation by the Company or any other person that the forward-looking
statements will come true.  The revenues and results of operations of the
Company, and future developments in the telecommunications industry, are
difficult to forecast and could differ materially from those projected in the
forward-looking statements as a result of numerous factors, including the
following: (i) changes in international settlement rates; (ii) changes in the
ratios between outgoing and incoming traffic and changes in expected future
revenue from delayed proportional return traffic from foreign partners pursuant
to certain operating agreements; (iii) foreign currency fluctuations; (iv)
termination of certain operating agreements or inability to enter into
additional operating agreements; (v) inaccuracies in the Company's forecasts of
traffic; (vi) changes in or developments under domestic or foreign laws,
regulations, licensing requirements or telecommunications standards; (vii)
foreign political or economic instability; (viii) changes in the availability of
transmission facilities such as domestic, international and undersea fiber optic
cable facilities or in the feasibility and expense of building or leasing such
facilities; (ix) loss of the services of key officers, such as Howard A.
Neckowitz, Chairman of the Board, President and Chief Executive Officer or Gail
E. Granton, Executive Vice President, International Business Development and
Secretary; (x) loss of a customer which provides significant revenues to the
Company; (xi) highly competitive market conditions in the industry and rapid
technological change; (xii) future management decisions regarding, for example,
acquisitions, capital expenditures or financings;  (xiii) concentration of
credit risk; (xiv) natural disasters 

                                       32
<PAGE>
 
and catastrophic events, including network outages or failures; (xv)
opportunities for (and problems relating to) the acquisition of other companies
or offshore facilities; (xvi) difficulties that maybe encountered in the
development of bandwidth services; including construction delays, regulatory
obstacles and the availability of opportunities for additional bandwidth
services; (xvii) uncertainties in the development of ethnic marketing programs
and new business lines, such as the Company's commencement of Internet
operations and sales to switchless resellers relating, for example, to the
difficulty of hiring appropriate personnel and competitive conditions; (xviii)
Internet growth at slower rates than expected due to market conditions or (xix)
any failure of our computer systems or the computer systems of third parties
that are material to our operations (such as the computer systems of service
providers, suppliers and brokers) to process correctly information relating to
dates in and after the year 2000. See "Risk Factors" included in Part I of this
10-K for additional reasons why the forward-looking statements may not be
realized. The foregoing review of important factors, including those discussed
in detail below, should not be construed as exhaustive; the Company undertakes
no obligation to release publicly the results of any future revisions it may
make to forward-looking statements to reflect events or circumstances after the
date hereof or to reflect the occurrence of unanticipated events.

Overview

     Pacific Gateway was founded in August 1991 to capitalize on the significant
growth opportunities in the international telecommunications services market.
The Company operates an international network consisting of international and
domestic switching facilities in the U.S in New York, Los Angeles and Dallas and
offshore in the United Kingdom, New Zealand, Russia and Japan.  The Company has
partial ownership interests in 19 digital undersea fiber optic cable systems in
the Atlantic, Pacific and Caribbean regions and operating agreements with
foreign carriers that provide for the exchange of telecommunications traffic. In
1998, the Company committed to invest in two significant undersea fiber optic
cable construction projects: the Japan-U.S. Cable network for $86 million and
the TAT-14 Cable Network for $70 million, which will connect the United States
with the UK, France, Germany, the Netherlands and Denmark.  Both cables are
planned to be placed into operation in 2000.   As of December 31, 1998, along
with many varied options for termination, the Company had 44 operating
agreements in 28 countries around the world, which provide for the exchange of
telecommunications traffic with these carriers.

     The Company has focused its efforts in 1998 towards expanding its
operations offshore and diversifying its operations to provide value-added
services.  In 1998, the Company began operations in Japan and began the
licensing, construction and pre-sales activities in offshore locations of
Germany, France and Australia.  Additional offshore locations are expected to be
developed in 1999.   To diversify its operations, the Company has initiated
ethnic marketing programs for the Filipino and Japanese ethnic markets to
provide international long distance services.  The Company expects to continue
to diversify its markets and service offerings in 1999.

     The Company's revenues are derived from three operating segments: U.S.
wholesale, offshore and value-added services. The Company's U.S. wholesale
segment provides international telecommunications services at low cost and high
quality to its target base of U.S.based carriers that originate international
traffic but do not have operating agreements with foreign carriers to terminate
the traffic.   The U.S. wholesale segment also provides service to U.S.-based
international carriers, terminating their overflow telecommunications traffic or
on routes with smaller traffic volumes.   The offshore segment consists
primarily of traffic originated through the Company's operations in the UK,
Germany, France, Russia, Japan, Australia and New Zealand.   The Company is
diversifying its operations to include a variety of emerging and value-added
services.  Revenues generated by this operating segment are from providing
international long distance services to certain ethnic retail markets,
principally the Filipino-American and Japanese-American communities. In the
first quarter of 1999, the Company expanded its ethnic retail marketing to
include the Chinese and Vietnamese communities.  The Company plans to expand
its ethnic marketing program to additional ethnic communities in 1999.

     The majority of the Company's costs are variable and consist of payments to
foreign partners for the termination of traffic, payments to other providers of
long distance services for transmission services, payments to domestic carriers
for the termination of overseas-originated traffic in the United States where
the Company does not 

                                       33
<PAGE>
 
have its own domestic network and payments to local exchange companies for
access charges for originating and terminating international and domestic
traffic. The Company enters new markets by establishing operating agreements
with foreign partners, by gaining termination arrangements with U.S. carriers or
those carriers in offshore markets who are able to terminate traffic on the
Company's behalf and through innovative termination arrangements. The Company
seeks to have ownership positions in cable systems where it believes its
customers' demand will justify the investment in those fixed assets. Although
the Company is generally able to earn a higher gross margin on traffic routed
through its owned circuits relative to leased routes, Pacific Gateway will
continue to buy usage-sensitive transmission capacity on a per minute basis from
other U.S. facilities-based international carriers on routes where traffic
volumes are relatively low or inconsistent, as well as to manage overflow
traffic on busy routes.

     Under the FCC mandated operating agreement regime, the Company
traditionally agrees to send U.S.-originated traffic to its foreign partners and
its foreign partners agree to send a proportionate amount of return traffic via
the Company's network at negotiated rates. These agreements contractually
obligate the foreign partners to adhere to the policy of the FCC, whereby
traffic from the foreign country is routed to U.S.-based international carriers,
such as the Company, in the same proportion as traffic carried into the foreign
country. The Company and its foreign partners typically settle the amounts owed
to each other in cash on a net basis, subsequent to the receipt of return
traffic. The Company records the amount due to the foreign partners as an
expense in the period the Company's traffic is delivered. Where the offshore
markets have begun to liberalize, the Company has experienced the traditional
environment changing to a more cost-based termination arrangement.


 
     The following table sets forth income statement data as a percentage of
revenues for the period indicated.

<TABLE>
<CAPTION>
                                                           Year Ended December 31,
                                                      ---------------------------------------
                                                          1998           1997          1996
                                                      ----------      ---------     ---------
                                                  
<S>                                                   <C>             <C>           <C>
 Revenues                                                  100.0%         100.0%        100.0%
 Cost of long distance services                             84.4%          85.1%         86.4%
                                                      ----------      ---------     ---------
            Gross margin                                    15.6%          14.9%         13.6%
 Selling, general and administrative expenses                7.9%           7.2%          6.8%
 Depreciation and amortization                               1.9%           1.8%          1.3%
                                                      ----------      ---------     ---------
            Total operating expenses                         9.8%           9.0%          8.1%
                                                      ----------      ---------     ---------
            Operating income                                 5.8%           5.9%          5.5%
 Other (income) expense, net                                (0.2)%          0.0%          0.0%
 Interest income                                            (0.6)%         (0.7)%        (0.5)%
                                                      ----------      ---------     ---------
    Income before income taxes                               6.6%           6.6%          6.0%
 Provision for income taxes                                  2.3%           2.4%          2.4%
                                                      ----------      ---------     ---------
            Net income                                       4.3%           4.2%          3.6%
                                                      ==========      =========     =========
</TABLE>

Year Ended December 31, 1998 Compared to Year Ended December 31, 1997.

     Revenues:   Total revenues in 1998 increased 56.2% to $466.3 million from
$298.6 million in 1997.  The increase was primarily the result of growth in each
of the Company's three operating segments: U.S. wholesale, offshore and value-
added.  U.S. wholesale revenues grew from $279.8 million in 1997 to $390.6
million in 1998.  This growth is attributed to an increase in volume of traffic
in the U.S. market and an increase in number of U.S. wholesale customers to 102
at December 31, 1998 from 90 at December 31, 1997.  The Company's offshore
operations in the UK, Russia, New Zealand and Japan generated $55.7 million in
revenue for the year ended December 31, 1998 compared to $17.7 million for the
year ended December 31, 1997.  Offshore operations began in 1997 with 35
customers at December 31, 1997 and grew to 61 customers at December 31, 1998.
Value-added 

                                       34
<PAGE>
 
services, which primarily provide international long distance services to
certain ethnic markets, contributed $20 million to revenue in 1998 compared to
$1.1 million in 1997. As a result of the growth in all three operating segments,
total minutes increased 59% from 1997 while the average price per minute charged
to customers remained unchanged at 29 cents. During 1998, the Company
experienced price declines in all operating segments; however, the Company's
average price per minute remained unchanged from 1997 because the Company was
able to expand its operations in the offshore markets and diversify its
operations to include value-added services, both of which generally offer higher
prices. The change in the terminating country mix with significantly different
rates per minute, the reduction in the rates received for the traffic
terminating in and transiting the United States and the increase in the
incidental United States domestic terminating traffic are additional factors
influencing the average price per minute.

     Gross margin: Gross margin as a percentage of revenues increased from 14.9%
in 1997 to 15.6% in 1998, primarily due to the expansion of operations to
include additional offshore markets and the diversification of operations to
include value-added services. The offshore and value-added services segments
contribute to gross margin by maintaining higher prices while utilizing the
existing U.S. wholesale low-cost network and back-office systems. In addition,
in the U.S. wholesale segment, the Company generally paid lower access rates to
carriers terminating its traffic than it paid in 1997. The Company continues to
experience pressure on gross margin across all operating segments. The Company
expects its expansion and diversification plans will offset this erosion over
the long-term. The cost of long distance service increased to $393.6 million for
the year ended December 31, 1998 from $254.1 million at December 31, 1997.

     Selling, general and administrative expenses: As a percentage of revenues,
selling, general and administrative expenses increased from 7.2% in 1997 to 7.9%
in 1998 and the actual expenses increased 71.8% to $36.8 million from $21.4
million.  This increase was due primarily to increased personnel as the number
of employees at the Company's wholly owned subsidiaries grew to 165 from 90 at
December 31, 1997. In addition, the Company incurred increased sales commission
expenses payable to its joint venture, PinTouch Telecom, who markets the
Company's value-added services to the Filipino-American ethnic market.

     Depreciation and amortization: Depreciation and amortization increased
60.9% to $8.7 million in 1998 from $5.4 million in 1997 representing 1.9% of
1998 total revenues. The increase in the dollar amount was primarily due to
depreciation of the additional transmission facilities acquired in the U.S.
wholesale and offshore operating segments during 1998.

     Interest income: Interest income increased 14.1% to $2.3 million in 1998
from $2.0 million in 1997. The increase was primarily due to the Company having
on average $34 million in cash or cash equivalents during 1998 as compared to on
average $30 million in cash or cash equivalents during 1997.

     Other (income) expense, net: Other income was $1.1 million in 1998 compared
to $0.1 million in 1997. The increase is related to the equity in the earnings
of the Company's unconsolidated joint venture, PinTouch Telecom.

     Income tax: Income taxes increased to $10.6 million from $7.3 million,
primarily due to increased operating income. The effective tax rate was 34.8% in
1998 and 37% in 1997. The decrease in the effective tax rate was attributable to
earnings of certain non-U.S. subsidiaries, a portion of which are intended to be
reinvested indefinitely in operations outside the U.S.

Year Ended December 31, 1997 Compared to Year Ended December 31, 1996.

     Revenues: Total revenues in 1997 increased 83.8% to $298.6 million from
$162.4 million in 1996. The increase was primarily the result of an active U.S.
market and growth of the Company's offshore sites in the UK, Russia and New
Zealand. Sales to existing customers increased as the number of operating
agreements grew to 43 at December 31, 1997 from 30 at December 31, 1996. The
total number of customers worldwide increased to 125 at December 31, 1997 from
75 at December 31, 1996. As a result, total minutes increased 82% from 1996
while the 

                                       35
<PAGE>
 
average price per minute charged to customers remained unchanged at 29 cents.
During 1997, prices generally declined in the markets in which the Company
principally operates and may decline further in the future. However, the
Company's average price per minute remained unchanged from 1996 because the
Company was able to increase traffic to markets offering higher prices. The
change in the terminating country mix with significantly different rates per
minute, the reduction in the rates received for the traffic terminating in and
transiting the United States and the increase in the incidental United States
domestic terminating traffic are factors influencing the average customer price
per minute.

     Gross margin: Gross margin as a percentage of revenues increased from 13.6%
in 1996 to 14.9% in 1997, primarily because the Company generally paid lower
access rates to foreign carriers than it paid in 1996 and because in certain
countries the competition for call termination has intensified and resulted in
lower termination costs for Pacific Gateway and similar companies. Because the
same rate is charged by the foreign carrier to terminate calls in its country as
the Company charges to terminate calls in the United States, declining rates
have an adverse effect on revenue. However, because the Company sends more
minutes to foreign partners than it receives from them, declining rates improve
the Company's gross margin received on its transactions with such foreign
carriers. Gross margin was 17.0% for the first half of 1997 and was 13.6% for
the second half of 1997.

     Gross margin as a percentage of revenues was lower during the second half
of 1997 primarily because the Company's revenues increased significantly from
$114.6 million for the first half of 1997 to $184.0 million for the second half
of 1997. Significant revenue increases generally reduce the Company's short-term
gross margin for two reasons, which again took effect in the second half of
1997. First, to terminate the additional traffic efficiently, the Company incurs
the expense of building new facilities and reconfiguring its U.S. network.
Second, until this can be achieved, the Company has no choice but to terminate
the additional traffic over less efficient, higher cost routes. The cost of long
distance service increased to $254.1 million for the year ended December 31,
1997 from $140.3 million at December 31, 1996.

     Selling, general and administrative expenses: As a percentage of revenues,
selling, general and administrative expenses increased from 6.8% in 1996 to 7.2%
in 1997 and the actual expenses increased 92.7% to $21.4 million from $11.1
million. This increase was due primarily to increased personnel as the number of
employees at the Company's wholly-owned subsidiaries grew to 90 and to 30 at its
majority owned Russian subsidiary at December 31, 1997 from 49 at December 31,
1996. In addition, the Company incurred higher sales commission expenses due to
increased revenues.

     Depreciation and amortization: Depreciation and amortization increased 165%
to $5.4 million in 1997 from $2.0 million in 1996, representing 1.8% of 1997
total revenues. The increase in the dollar amount was primarily due to
depreciation of additional transmission facilities acquired during 1997.

     Interest income: Interest income increased 127% to $2.0 million in 1997
from $0.9 million in 1996. The increase was primarily due to the Company having
on average $30 million in cash or cash equivalents during 1997 as compared to on
average $15 million in cash or cash equivalents during 1996.

     Income tax: Income taxes increased to $7.3 million from $3.9 million,
primarily due to increased operating income. The effective tax rate was 37% in
1997 and 40% in 1996. The decrease in the effective tax rate was attributable to
earnings of certain non-U.S. subsidiaries.

Liquidity and Capital Resources

     The Company has financed its rapid growth, including its capital
expenditures, through funds provided by operations and the funds from the public
offering completed in the third quarter of 1996. Due to the timing differences
in the international settlements, the Company's accounts receivable turnover
varies from its accounts payable turnover. The length of these turnovers is a
function of different timing requirements in the Company's agreements with
foreign partners. For example, the length of the Company's accounts payable
turnover is partially 

                                       36
<PAGE>
 
due to its accounts payable with foreign partners, which generally have 180 day
terms as a result of the six-month lag in the international settlement process.

     Net cash provided by operating activities was $28.9 million for the year
ended December 31, 1998, compared to $34.2 million for the same period in 1997
and $13.9 million in 1996. The decrease in cash provided by operating activities
in 1998 was caused by cash outflows for payments of accounts payable, which were
greater due to the relative shortening of the payment process and income taxes
payable. This decrease was partially offset by greater cash generating net
income. The increase from 1996 to 1997 was primarily a result of an increase in
net income and accounts payable, which were greater than the increase in
accounts receivable.

     Net cash used in investing activities increased to $52.9 million in 1998,
from $36.5 million in 1997 and $18.4 million in 1996. The 1998 expenditures were
primarily for additional transmission equipment for the U.S. wholesale domestic
switches in New York and Los Angeles as well as for the acquisition of partial
ownership interests in international fiber optic cable transmission systems.
Capital expenditures in 1997 and 1996 were also for the acquisition of ownership
interests in international fiber optic cable transmission systems and related
equipment.

     Net cash provided by financing activities was $10.2 million in 1998, $0.5
million in 1997 and $48.3 million in 1996. In the fourth quarter of 1998, the
Company entered into an uncollateralized 1-year revolving line of credit of up
to $30 million with Bank of America, NT&SA and NationsBanc Montgomery LLC ("1998
Facility") and borrowed $8.7 million pursuant to this line of credit. The
proceeds were used to fund outstanding cable commitments. During the third
quarter of 1996, the Company completed an initial public offering of 6,057,050
shares of Common Stock, which provided the Company with net proceeds of
approximately $54.1 million.

     At December 31, 1998, the Company had outstanding commitments of $159
million for the acquisition of additional ownership in digital undersea fiber
optic cables and network equipment. This includes the commitment to purchase
undersea fiber optic cables in the Japan-U.S. cable network for $86 million and
in the TAT-14 cable system for $70 million. The Company has used its revolving
line of credit to fund its first installment payments for these cable systems.
In addition, in the first quarter of 1999, the Company's wholly owned
subsidiary, Pacific Gateway Exchange (Bermuda) Limited, obtained a commitment
letter from Salomon Brothers Holding Company, Inc. and Goldman Sachs Credit
Partners L.P. for a $200 million credit facility, with the ability to layer an
additional $100 million of bank debt. This facility is expected to replace the
1998 facility. The proceeds will be used to fund the $156 million in cable
commitments as well as additional global network expansion and general corporate
purposes. The Company believes that existing cash balances, cash provided by
operating activities, existing lines of credit and debt commitments will be
sufficient to meet its outstanding capital commitments, current capital
expenditures and working capital needs for its expected growth in 1999.

Year 2000 Issue

     The "Year 2000" issue affects the computer systems, network elements,
software applications and other business systems that have time-sensitive
programs that may not properly reflect or recognize the year 2000. Because many
computers and computer applications define dates by the last two digits of the
year, "00" may not be properly identified as the year 2000. This error could
result in miscalculations or system failures.

     The Company has identified its Year 2000 risk in three categories: internal
information systems; other internal systems; and external vendor and customer
systems.

     Internal information systems. The Company's internal information systems
were initially designed to be Year 2000 ready. These systems, such as the
Company's billing system, have been tested in a simulated Year 2000 environment
and were preliminarily determined to be Year 2000 ready. Additional tests will
be conducted for final determination of Year 2000 readiness by April 30, 1999.
The costs associated with testing Year 2000 readiness are not expected to be
material to the Company's business, financial condition or results of
operations.

                                       37
<PAGE>
 
     Other internal systems. The Company has assessed the impact of the Year
2000 on its other internal systems, primarily its telecommunications switching
equipment in the U.S. in Dallas, Los Angeles and New York and offshore in the
UK, New Zealand, Russia and Japan, and has conducted tests on such systems.
Software and hardware upgrades have been ordered for all switching equipment
that was found to be non-compliant and is expected to be in place and fully
functional by April 30, 1999. The costs associated with testing and upgrading
equipment to ensure Year 2000 readiness are not expected to be material to the
Company's business, financial condition or results of operations. The Company is
in the process of identifying and evaluating other operational systems and
applications, which we believe are not mission-critical, such as building
operations and individual personal computers used by the Company personnel.

     Vendor and customer systems. The Company has sent letters and
questionnaires to its significant vendors and customers requesting a response
from those third parties on their Year 2000 readiness with respect to
information systems used by those entities which could impact business with the
Company. To the extent that responses to Year 2000 readiness are unsatisfactory,
the Company intends to identify alternative and/or new vendors and customers who
have demonstrated Year 2000 readiness. We are still awaiting responses from our
most significant vendors and customers. There is no assurance, however, that
full Year 2000 readiness will be achieved by such third parties or that the
Company will receive assurances from such third parties. In the event that any
of the Company's significant vendors and customers do not successfully and
timely achieve Year 2000 readiness, and the Company is unable to replace them
with new and/or alternative vendors and customers, the Company's business or
operations could be adversely affected.

     As part of the Company's Year 2000 risk program, the Company is evaluating
scenarios that may occur as a result of the century change and anticipates
completing contingency and business continuity plans targeted at mitigating the
effects of any significant Year 2000 noncompliance by mid-1999.

Quarterly Results of Operations

     The following tables set forth statement of operations data for each of the
Company's last eight calendar quarters and the percentage of the Company's
revenues represented by each line item reflected therein. This information has
been prepared on the same basis as the audited financial statements contained
herein and, in management's opinion, reflects all adjustments, consisting only
of normal recurring adjustments, necessary for a fair presentation of the
information for the periods presented. The operating results for any quarter are
not necessarily indicative of results for any future period.

<TABLE>
<CAPTION>
                                                                              Quarter Ended:
                                        -------------------------------------------------------------------------------------------
                                         Dec. 31,   Sept. 30,   June 30,   March 31,   Dec. 31,   Sept. 30,   June 30,   March 31,
                                           1998       1998        1998       1998        1997        1997       1997       1997
                                        ---------  ----------  ---------  ----------  ---------  ----------  ---------  ---------- 
                                                                     (In thousands except per share amounts)
<S>                                     <C>        <C>         <C>        <C>         <C>        <C>         <C>        <C>
Revenues                                 $126,414    $124,853   $109,952    $105,072   $103,975     $79,997    $63,186     $51,451
Cost of long distance services            106,804     104,644     92,951      89,241     90,869      68,099     51,967      43,141
                                        ---------  ----------  ---------  ----------  ---------  ----------  ---------  ---------- 
   Gross margin                            19,610      20,209     17,001      15,831     13,106      11,898     11,219       8,310
Selling, general and          
   administrative expenses                 10,327      11,612      7,290       7,562      6,386       5,587      5,618       3,825
Depreciation and amortization               2,395       2,209      2,146       1,963      1,702       1,595      1,267         853
                                        ---------  ----------  ---------  ----------  ---------  ----------  ---------  ---------- 
   Operating income                         6,888       6,388      7,565       6,306      5,018       4,716      4,334       3,632
Other (income) expense, net                   (14)     (1,712)       496          98        204        (162)      (168)          -
Interest income                              (591)       (532)      (556)       (613)      (617)       (377)      (527)       (488)
                                        ---------  ----------  ---------  ----------  ---------  ----------  ---------  ---------- 
   Income before income taxes               7,493       8,632      7,625       6,821      5,431       5,255      5,029       4,120
Provision for income taxes                  2,470       2,980      2,740       2,445      1,728       1,965      1,987       1,658
                                        ---------  ----------  ---------  ----------  ---------  ----------  ---------  ---------- 
   Net income                            $  5,023    $  5,652   $  4,885    $  4,376   $  3,703     $ 3,290    $ 3,042     $ 2,462
                                        =========  ==========  =========  ==========  =========  ==========  =========  ========== 
   Net income per                
       share - diluted                      $0.25       $0.29      $0.25       $0.22      $0.19       $0.17      $0.16       $0.13
                                        =========  ==========  =========  ==========  =========  ==========  =========  ========== 
</TABLE>

                                       38
<PAGE>
 
<TABLE>
<CAPTION>
                                                            As a Percentage of Revenues for the Quarter Ended:
                                        -------------------------------------------------------------------------------------------
                                         Dec. 31,   Sept. 30,   June 30,   March 31,   Dec. 31,   Sept. 30,   June 30,   March 31,
                                           1998       1998        1998       1998        1997        1997       1997       1997
                                        ---------  ----------  ---------  ----------  ---------  ----------  ---------  ---------- 
<S>                                     <C>        <C>         <C>        <C>         <C>        <C>         <C>        <C>
Revenues                                  100.0 %     100.0 %    100.0 %     100.0 %    100.0 %     100.0 %    100.0 %     100.0 %
Cost of long distance services             84.5 %      83.8 %     84.5 %      84.9 %     87.4 %      85.1 %     82.2 %      83.8 %
                                        ---------  ----------  ---------  ----------  ---------  ----------  ---------  ---------- 
   Gross margin                            15.5 %      16.2 %     15.5 %      15.1 %     12.6 %      14.9 %     17.8 %      16.2 %
Selling, general and                    
   administrative expenses                  8.2 %       9.3 %      6.6 %       7.2 %      6.1 %       7.0 %      8.9 %       7.4 %
Depreciation and amortization               1.9 %       1.8 %      2.0 %       1.9 %      1.6 %       2.0 %      2.0 %       1.7 %
                                        ---------  ----------  ---------  ----------  ---------  ----------  ---------  ---------- 
   Operating income                         5.4 %       5.1 %      6.9 %       6.0 %      4.9 %       5.9 %      6.9 %       7.1 %
                                        
Other (income) expense, net                   - %      (1.4)%      0.5 %       0.1 %      0.2 %      (0.2)%     (0.3)%         - %
Interest income                            (0.5)%      (0.4)%     (0.5)%      (0.6)%     (0.6)%      (0.5)%     (0.8)%      (0.9)%
                                        ---------  ----------  ---------  ----------  ---------  ----------  ---------  ---------- 
   Income before income taxes               5.9 %       6.9 %      6.9 %       6.5 %      5.3 %       6.6 %      8.0 %       8.0 %
Provision for income taxes                  2.0 %       2.4 %      2.5 %       2.3 %      1.7 %       2.5 %      3.2 %       3.2 %
                                        ---------  ----------  ---------  ----------  ---------  ----------  ---------  ---------- 
   Net income                               3.9 %       4.5 %      4.4 %       4.2 %      3.6 %       4.1 %      4.8 %       4.8 %
                                        =========  ==========  =========  ==========  =========  ==========  =========  ========== 
</TABLE>

ITEM 7A.   QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The Company has not entered into any market risk sensitive instruments for
the years ended December 31, 1998 and 1997.

                                       39
<PAGE>
 
ITEM 8.  FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA


                       REPORT OF INDEPENDENT ACCOUNTANTS


February 19, 1999, except for Note 10, as to which the date is March 2, 1999


To the Board of Directors and Stockholders
of Pacific Gateway Exchange, Inc.


     In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of operations, cash flows and changes in
stockholders' equity present fairly, in all material respects, the financial
position of Pacific Gateway Exchange, Inc. and subsidiaries as of December 31,
1998 and 1997 and the results of their operations and their cash flows for each
of the three years in the period ended December 31, 1998, in conformity with
generally accepted accounting principles.  In addition, in our opinion, the
financial statement schedule listed in Item 14(a) of the Form 10-K presents
fairly, in all material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements.  These financial
statements and financial statement schedule are the responsibility of the
Company's management: our responsibility is to express an opinion on these
financial statements and financial statement schedule based on our audits.  We
conducted our audits of these statements in accordance with generally accepted
auditing standards which 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, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation.  We believe that our
audits provide a reasonable basis for the opinion expressed above.

 

/s/   PricewaterhouseCoopers LLP



San Francisco, California

                                      40
<PAGE>
                        PACIFIC GATEWAY EXCHANGE, INC.
                          CONSOLIDATED BALANCE SHEETS
                                (in thousands)
                                    ASSETS
<TABLE>
<CAPTION>
                                                                                               December 31,
                                                                             ------------------------------------------------
                                                                                     1998                      1997
                                                                             ----------------------   -----------------------
<S>                                                                          <C>                      <C>
Current Assets:
Cash and cash equivalents                                                                 $ 30,041                  $ 43,850
Accounts receivable, net of allowance for doubtful accounts
       of $4,312 in 1998 and $2,230 in 1997.                                                87,725                    62,313
Prepaids                                                                                     1,244                       511
Income taxes recoverable                                                                     1,358                         -
Deferred income tax                                                                          2,207                     1,096
Other current assets                                                                         1,408                       673
                                                                             ----------------------   -----------------------
               Total current assets                                                        123,983                   108,443

Property and Equipment:
Undersea fiber optic cables                                                                 34,663                    31,144
Long distance communications equipment                                                      48,710                    30,535
Computers and office equipment                                                               9,352                     6,343
Leasehold improvements                                                                       2,004                       702
Construction in progress                                                                    13,587                       966
Cable construction in progress                                                              12,066                       883
                                                                             ----------------------   -----------------------
                                                                                           120,382                    70,573
Less accumulated depreciation                                                               17,335                     9,140
                                                                             ----------------------   -----------------------
               Total property and equipment, net                                           103,047                    61,433
Deferred income tax                                                                             78                         -
Deposits and other assets                                                                    8,529                     1,741
                                                                             ----------------------   -----------------------
               Total assets                                                              $ 235,637                 $ 171,617
                                                                             ======================   =======================

                         LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable                                                                         $ 118,303                  $ 87,949
Accrued liabilities                                                                          4,193                     3,733
Income taxes payable                                                                             -                     1,491
Line of credit                                                                               8,700                         -
Current portion of capitalized lease obligations                                               436                       216
Other liabilities                                                                            1,304                       513
                                                                             ----------------------   -----------------------
               Total current liabilities                                                   132,936                    93,902
Long-term portion of capitalized lease obligations                                              99                       185
Deferred income tax                                                                          1,963                       957
                                                                             ----------------------   -----------------------
               Total liabilities                                                           134,998                    95,044

Commitments and contingencies (Note 5).

Stockholders' Equity:
Preferred stock, $.0001 par value, authorized
       5,000,000 shares, no shares issued                                                        -                         -
Common stock, $.0001 par value, authorized 70,000,000,
       issued 19,363,777, outstanding 19,220,217 shares
       in 1998; and issued 19,216,710, outstanding
       19,073,150 shares in 1997.                                                                2                         2
Additional paid in capital                                                                  65,431                    60,849
Deferred compensation - restricted stock                                                    (4,618)                   (4,134)
Foreign currency translation                                                                    34                         2
Retained earnings                                                                           40,190                    20,254
Cost of common stock held in treasury,
       143,560 shares in 1998 and 1997                                                        (400)                     (400)
                                                                             ----------------------   -----------------------
               Total stockholders' equity                                                  100,639                    76,573
                                                                             ----------------------   -----------------------
               Total liabilities and stockholders' equity                                $ 235,637                 $ 171,617
                                                                             ======================   =======================
</TABLE>

         See accompanying Notes to Consolidated Financial Statements.

                                       41
<PAGE>
 
                        PACIFIC GATEWAY EXCHANGE, INC.
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                     (in thousands, except per share data)

<TABLE> 
<CAPTION> 
                                                                     Year Ended December 31,
                                                   -------------------------------------------------------------
                                                          1998                 1997                  1996
                                                   -------------------    ----------------     -----------------
<S>                                                <C>                    <C>                  <C> 
 Revenues                                                   $ 466,291           $ 298,609             $ 141,912
 Revenues - related party                                           -                   -                20,514
                                                   -------------------    ----------------     -----------------
            Total revenues                                    466,291             298,609               162,426
 Cost of long distance services                               393,640             254,076               140,340
                                                   -------------------    ----------------     -----------------
            Gross margin                                       72,651              44,533                22,086
 Selling, general and administrative expenses                  36,791              21,416                11,113
 Depreciation and amortization                                  8,713               5,417                 2,044
                                                   -------------------    ----------------     -----------------
            Total operating expenses                           45,504              26,833                13,157
                                                   -------------------    ----------------     -----------------
            Operating income                                   27,147              17,700                 8,929
 Interest income                                               (2,292)             (2,009)                 (885)
 Other (income) expense, net                                   (1,132)               (126)                  129
                                                   -------------------    ----------------     -----------------
            Income before income taxes                         30,571              19,835                 9,685
 Provision for income taxes                                    10,635               7,338                 3,877
                                                   -------------------    ----------------     -----------------
            Net income                                       $ 19,936            $ 12,497               $ 5,808
                                                   ===================    ================     =================
            Net income per share - basic                       $ 1.05              $ 0.66                $ 0.36
                                                   ===================    ================     =================
            Net income per share - diluted                     $ 0.97              $ 0.64                $ 0.34
                                                   ===================    ================     =================
 Weighted average number of common shares
 outstanding - basic                                           19,071              18,960                16,234
                                                   ===================    ================     =================
 Weighted average number of common shares
 outstanding - diluted                                         20,495             19,497                 16,872
                                                   ===================    ================     =================

</TABLE> 

        See accompanying Notes to Consolidated Financial Statements.

                                       42
<PAGE>
 
                       PACIFIC GATEWAY EXCHANGE, INC.
                    CONSOLIDATED STATEMENTS OF CASH FLOWS
                               (in thousands)

<TABLE> 
<CAPTION> 
                                                                                 Year Ended December 31,
                                                               ------------------------------------------------------------
                                                                      1998                 1997                1996
                                                               --------------------   ----------------  -------------------
<S>                                                            <C>                    <C>               <C> 
Operating Activities:
Net income                                                                $ 19,936           $ 12,497              $ 5,808
Adjustments to net income:
      Depreciation and amortization                                          8,713              5,417                2,044
      Loss on sale of stock                                                      -                  -                  129
      Stock compensation expense                                               674                146                   85
      Bad debt provision                                                     2,146              2,173                  855
      Equity in earnings of affiliated companies                            (1,499)                 -                    -
      Changes in operating assets and liabilities:
         Accounts receivable                                               (27,558)           (38,681)             (13,421)
         Accounts receivable, related party                                      -              3,066                  196
         Notes and advances receivable                                           -                  -                  175
         Prepaid expenses                                                     (733)               306                 (729)
         Deferred tax asset                                                 (1,189)                88                 (816)
         Deposits and other assets                                          (1,830)            (1,430)                (107)
         Accounts payable                                                   30,322             48,309               17,053
         Accrued liabilities                                                   460              2,429                  532
         Federal income taxes recoverable                                     (834)                 -                    -
         Federal income taxes payable                                       (1,491)              (462)               1,758
         Other liabilities                                                     791                150                 (152)
         Deferred tax liability                                              1,006                249                  488
                                                               --------------------   ----------------  -------------------
Net cash provided by operating activities                                   28,914             34,257               13,898
                                                               --------------------   ----------------  -------------------

Investing Activities:
Purchase of property and equipment                                         (49,611)           (36,725)             (18,669)
Investment in subsidiaries and affiliates                                   (3,314)               222                    -
Other investing activities                                                       -                  -                  274
                                                               --------------------   ----------------  -------------------
Net cash used in investing activities                                      (52,925)           (36,503)             (18,395)
                                                               --------------------   ----------------  -------------------

Financing Activities:
Borrowings on revolving lines of credit                                      8,700                  -                6,200
Repayments on revolving lines of credit                                          -                  -              (11,620)
Repayments on capital lease obligations                                       (498)              (209)                   -
Proceeds from issuance of common stock                                       1,157                742               55,130
Payment of issuance costs                                                      (57)                 -               (1,042)
Payment to acquire treasury stock                                                -                  -                 (400)
Dividends received from affiliated company                                     900                  -                    -
                                                               --------------------   ----------------  -------------------
Net cash provided by financing activities                                   10,202                533               48,268
                                                               --------------------   ----------------  -------------------

Net (decrease) increase in cash and cash equivalents                       (13,809)            (1,713)              43,771
Cash and cash equivalents at beginning of the period                        43,850             45,563                1,792
                                                               --------------------   ----------------  -------------------
Cash and cash equivalents at end of the period                            $ 30,041           $ 43,850             $ 45,563
                                                               ====================   ================  ===================

Supplementary Information:
Interest paid during period                                               $      -            $     -              $   276
Income taxes paid during period                                           $ 12,067            $ 7,841              $ 2,447

</TABLE> 

         See accompanying Notes to Consolidated Financial Statements.

                                       43
<PAGE>
                        PACIFIC GATEWAY EXCHANGE, INC.
          CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
                                (in thousands)


<TABLE>
<CAPTION>
                                                                                           
                                            Common Stock    Additional    Deferred         Foreign              
                                           --------------    Paid-in    Compensation -    Currency     Retained  
                                           Shares  Amount    Capital   Restricted Stock  Translation   Earnings  
<S>                                       <C>      <C>     <C>         <C>                <C>          <C>
Balance December 31, 1995                  14,100  $    1    $    941       $         -     $      -    $  1,949   
   Repurchase of common stock                   -       -           -                 -            -           -   
   Issuance of common stock,                                                                                    
      net of $1,042 issuance                                                                                    
      costs                                 4,940       1      54,087                 -            -           -   
   Stock compensation expense                   -       -          85                 -            -           -   
   Net income                                   -       -           -                 -            -       5,808   
                                          -------- -------- ---------- ----------------- ------------ -----------
Balance December 31, 1996                  19,040       2      55,113                 -            -       7,757   
   Stock options exercised                    102       -         742                 -            -           -   
   Stock compensation expense                   -       -         146                 -            -           -   
   Tax effect of stock options exercised        -       -         714                 -            -           -   
   Issuance of restricted stock                75       -       4,134            (4,134)           -           -   
   Foreign currency translation                 -       -           -                 -            2           -   
   Net income                                   -       -           -                 -            -      12,497   
                                          -------- -------- ---------- ----------------- ------------ -----------
Balance December 31, 1997                  19,217       2      60,849            (4,134)           2      20,254   
   Stock options exercised                     89       -       1,100                 -            -           -   
   Stock compensation expense                   -       -         194               480            -           -   
   Tax effect of stock options exercised        -       -         524                 -            -           -   
   Issuance of restricted stock                25       -         964              (964)           -           -   
   Issuance of common stock,                                                                                   
       for investment in company               33       -       1,800                 -            -           -   
   Foreign currency translation                 -       -           -                 -           32           -   
   Net income                                   -       -           -                 -            -      19,936   
                                          -------- -------- ---------- ----------------- ------------ -----------
Balance December 31, 1998                  19,364  $    2    $ 65,431       $    (4,618)    $     34   $  40,190   
                                          ======== ======== ========== ================= ============ ===========
                                          
<CAPTION>
                                            Treasury Stock                 
                                         ----------------------            
                                           Shares     Amount       Total    
<S>                                       <C>         <C>          <C>                       
Balance December 31, 1995                      -        $ -         $ 2,891 
   Repurchase of common stock               (144)      (400)           (400)
   Issuance of common stock,                                                  
      net of $1,042 issuance                                                  
      costs                                    -          -          54,088  
   Stock compensation expense                  -          -              85 
   Net income                                  -          -           5,808 
                                        --------- ---------- --------------
Balance December 31, 1996                   (144)      (400)         62,472 
   Stock options exercised                     -          -             742 
   Stock compensation expense                  -          -             146 
   Tax effect of stock options exercised       -          -             714 
   Issuance of restricted stock                -          -               - 
  Foreign currency translation                 -          -               2 
  Net income                                   -          -          12,497 
                                        --------- ---------- ---------------
Balance December 31, 1997                   (144)      (400)         76,573 
   Stock options exercised                     -          -           1,100 
   Stock compensation expense                  -          -             674 
   Tax effect of stock options exercised       -          -             524 
   Issuance of restricted stock                -          -               - 
   Issuance of common stock,                                                  
       for investment in company               -          -           1,800 
  Foreign currency translation                 -          -              32 
  Net income                                   -          -          19,936 
                                        --------- ---------- ---------------
Balance December 31, 1998                   (144)    $ (400)      $ 100,639 
                                        ========= ========== =============== 
</TABLE>
         See accompanying Notes to Consolidated Financial Statements. 

                                       44
<PAGE>
 
                        PACIFIC GATEWAY EXCHANGE, INC
                 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
                                        


(1)  The Company and Significant Accounting Policies

 Description of Business and Organization:

     Pacific Gateway Exchange, Inc. ("Pacific Gateway" or the "Company"), a
Delaware corporation, owns and operates an international switched and domestic
switched telecommunications network.  The operations of Pacific Gateway have
grown significantly as the result of entering into additional operating
agreements with foreign partners and marketing to certain long distance
companies in the United States which do not have their own international
network.  In addition, the Company provides international long distance services
to certain ethnic retail markets, principally the Filipino-American and
Japanese-American communities.

     The Company is subject to various risks in connection with the operation of
its business.  These risks include, but are not limited to, changes in
government regulation, dependence on transmission facilities-based carriers and
suppliers, price competition and competition from larger industry participants.

 Principles of Consolidation:

     Consolidated Financial Statements include the accounts of Pacific Gateway
and majority-owned and controlled subsidiaries principally in Bermuda, the
United Kingdom, Russia, New Zealand, Australia, Japan and Cyprus.  Investments
in 20% to 50%-owned companies and partnerships are accounted for on the equity
method.  Intercompany transactions have been eliminated.

 Foreign Currency Translation:

     Assets and liabilities of operations outside the United States, for which
the functional currency is not U.S. dollars, are translated into U.S. dollars
using the exchange rate in effect at each period end.  Revenues and expenses are
translated at the average exchange rate prevailing during the period.  The
effects of foreign currency translation adjustments arising from differences in
exchange rates from period to period are deferred and included as a component of
"Stockholders' Equity".

     For operations in highly-inflationary economies, principally in Russia,
assets and liabilities are maintained in the reporting currency, U.S. dollars.

      The effects of foreign currency transactions, and of remeasuring the
financial position and results of operations in the functional currency, are
included in "Selling, general and administrative expenses."

 Estimates:

     The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the dates of the financial
statements and reported amounts of revenues and expenses during the reported
periods.  Actual results could differ from those estimates.

 Cash and Cash Equivalents:

     Cash equivalents consist primarily of money market accounts and called
bonds with original maturities of three months or less.  The carrying amounts
reported in the accompanying balance sheets approximate fair market value.

 

                                       45
<PAGE>
 
 Property and Equipment:

     Property and equipment are stated at cost. Maintenance and repairs are
expensed as incurred.  Replacements and betterments are capitalized.  Costs
incurred in connection with the construction of new property and equipment are
capitalized until the property and equipment becomes operational.  The cost and
related accumulated depreciation of assets sold or retired are removed from the
account balance, and any resulting gain or loss is reflected in results of
operations.  Depreciation is provided for financial reporting purposes using the
straight-line method over the following estimated useful lives:

<TABLE>
     <S>                                       <C>
     Undersea fiber optic cables                     20 years
     Long distance communications equipment         5-7 years
     Computers and office equipment                 4-7 years
     Leasehold improvements                     term of lease
</TABLE>

The Company invests in undersea fiber optic cable systems through the purchase
of indefeasible rights of user ("IRU's") or through an ownership interest in
cable construction consortia.

 Long-Lived Assets:

     Statement of Financial Accounting Standards ("SFAS") No. 121, Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed
of, requires that long-lived assets and certain intangible assets be reviewed
for impairment whenever events or changes in circumstances indicate that the
carrying amount may not be recoverable.  If undiscounted expected future cash
flows are less than the carrying value of the assets, an impairment loss is to
be recognized based on the fair value of the assets.  No impairment losses have
been recognized to date.
 
 Income Taxes:

     The Company accounts for income taxes in accordance with SFAS No. 109,
Accounting for Income Taxes.  SFAS No. 109 has as its basic objective the
recognition of current and deferred income tax assets and liabilities based upon
all events that have been recognized in the financial statements as measured by
the provisions of the enacted tax laws.

     Valuation allowances are established when necessary to reduce deferred tax
assets to the estimated amount to be realized.  Income tax expense represents
the tax payable for the current period and the change during the period in the
deferred tax assets and liabilities.
 
 Revenue Recognition:

     Revenues for telecommunications services provided to customers are
recognized as services are rendered.  Revenues for return traffic received
according to the terms of the Company's operating agreements with its foreign
partners are recognized as revenue as the return traffic is received.

 Accounting for International Long Distance Traffic:

     The Company has entered into operating agreements with 44
telecommunications carriers in 28 countries under which international long
distance traffic is both delivered and received.  Under these agreements, the
foreign carriers are contractually obligated to adhere to the policy of the
Federal Communications Commission (the "FCC"), whereby traffic from the foreign
country is routed to international carriers, such as the Company, in the same
proportion as traffic carried into the country.  Mutually exchanged traffic
between the Company and foreign carriers is settled through a formal settlement
policy that generally extends over a six-month period at an agreed upon rate.
The Company records the amount due to the foreign partner as an expense in the
period the traffic is delivered.  Of the 44 agreements the Company had at
December 31, 1998, 18 agreements provided that the Company generally must wait
up to six months before it actually receives the proportional return traffic. In
circumstances where the Company does not receive the return traffic due from the
foreign partner at the end of the agreed-upon delayed return period, the Company
and the foreign partner may agree to a settlement which compensates the Company
for the return traffic not received, through greater return traffic in future
periods, or a reduction to the Company's current accounts payable balance.

 

                                       46
<PAGE>
 
 Fair Value of Financial Instruments:

     The fair value of financial instruments, consisting of investments in cash,
cash equivalents, receivables, accounts payable and line of credit, is based on
interest rates available to the Company and comparisons to quoted prices. At
December 31, 1998 and 1997, the fair value of these financial instruments
approximates carrying value.

 Concentration of Credit Risk:

     Financial instruments that potentially subject the Company to concentration
of credit risk consist of cash and cash equivalents and accounts receivable.
At December 31, 1998 and 1997, the Company had bank deposits in excess of
federally insured limits of $22,891,000 and $43,650,000, respectively.  The
Company's customer base includes domestic and international companies in the
telecommunications industry.  The Company performs ongoing credit evaluations of
its customers but generally does not require collateral to support customer
receivables.  The Company's allowance for doubtful accounts is based on current
market conditions.  Losses on uncollectible accounts have consistently been
within management's expectations.

 Earnings Per Share:

     The Company adopted SFAS No. 128, Earnings Per Share, effective December
31, 1997.  In accordance with SFAS No. 128, basic earnings per share is
calculated by dividing net income by the weighted-average number of shares
outstanding for the period.  Diluted earnings per share is calculated by
dividing net income by the weighted average number of shares outstanding during
the period plus the dilutive effect of stock options determined using the
treasury stock method.

     There were no adjustments to net income in the calculation of basic and
diluted earnings per share for the years ended December 31, 1998, 1997 and 1996,
respectively.  The reconciliation of the weighted average shares outstanding
used in calculating basic and diluted earnings per share is as follows:

<TABLE>
<CAPTION>
------------------------------------------------------------------------------------------------------------ 
                                                          Income               Shares           Per-Share
(in thousands, except per share amounts)                (Numerator)        (Denominator)          Amount
------------------------------------------------------------------------------------------------------------ 
<S>                                                     <C>                <C>                 <C>
1998
Basic EPS:
Income available to common stockholders                  $19,936                19,071            $1.05
Effect of dilutive stock options                                                 1,424
                                                     ------------------------------------------------------- 
Diluted EPS                                              $19,936                20,495            $0.97
 
1997
Basic EPS:
Income available to common stockholders                  $12,497                18,960            $0.66
Effect of dilutive stock options                                                   537
                                                     -------------------------------------------------------  
Diluted EPS                                              $12,497                19,497            $0.64
 
1996
Basic EPS:
Income available to common stockholders                  $ 5,808                16,234            $0.36
Effect of dilutive stock options                                                   638
                                                     ------------------------------------------------------- 
Diluted EPS                                              $ 5,808                16,872            $0.34
------------------------------------------------------------------------------------------------------------ 
</TABLE>

 Comprehensive Income:

     In June 1997, the FASB issued SFAS No. 130, Reporting Comprehensive Income.
SFAS No. 130 establishes standards for reporting and display of comprehensive
income and its components in a financial statement that is displayed with the
same prominence as other financial statements. Comprehensive income includes all
changes in equity (net assets) during a period from non-owner sources. This
includes net income and other comprehensive income. Examples of items to be
included in other comprehensive income, which are excluded from net income,
include foreign currency translation adjustments. The Company adopted SFAS No.
130 for the year ended December 31, 1998. Total other comprehensive income
consisted of foreign currency translation gains, which were not material for all
years presented.

                                       47
<PAGE>
 
 Financial Statement Classifications:

     Certain prior-year amounts have been reclassified to conform to the 1998
financial statement presentation.  Such reclassifications have no effect on net
income as previously reported.

(2) Income Taxes

     The provision for income taxes is comprised of the following:

<TABLE>
<CAPTION>
                                                              Year Ended December 31,
                                 ------------------------------------------------------------------------------
(in thousands)                             1998                         1997                        1996
                                 ---------------------        ----------------------      ---------------------
<S>                                <C>                          <C>                         <C>
Current tax expense:
  Federal                                      $ 7,318                        $5,737                     $3,364
  State and local                                1,664                           986                        841
  Foreign                                        1,835                           279                          -
                                 ---------------------        ----------------------      ---------------------
  Total current                                $10,817                        $7,002                     $4,205
Deferred tax expense:
  Federal                                      $  (242)                       $  265                     $ (262)
  State and local                                 (146)                           71                        (66)
  Foreign                                          206                             -                          -
                                 ---------------------        ----------------------      ---------------------
  Total deferred                               $  (182)                       $  336                     $ (328)
                                 ---------------------        ----------------------      ---------------------
Total provision                                $10,635                        $7,338                     $3,877
                                 =====================        ======================      =====================
</TABLE>

     Undistributed earnings intended to be reinvested indefinitely in operations
outside the United States were approximately $15,349,000.

     The provision for income taxes differs from the amount computed by applying
the statutory federal income tax rates as follows:

<TABLE>
<CAPTION>
                                                               Year Ended December 31,
                                 -------------------------------------------------------------------------------
                                           1998                         1997                         1996
                                 ---------------------        ----------------------       ---------------------
 
<S>                                <C>                          <C>                          <C>
Expected statutory amount                        35.0%                         35.0%                       34.0%
State income taxes, net of                            
 federal benefit                                  3.2%                          3.8%                        5.3%
Tax exempt interest                                 -%                         (0.5)%                      (0.4)%
Undistributed earnings of
 certain subsidiaries                            (5.0)%                        (2.5)%                         -%
 
Other                                             1.6%                          1.2%                        1.1%
                                 ---------------------        ----------------------       ---------------------
                                                 34.8%                         37.0%                       40.0%
                                 =====================        ======================       =====================
</TABLE>
 
     Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and amounts used for income tax purposes and the impact of available
net operating loss carryforwards.

                                       48
<PAGE>
 
     The tax effect of significant temporary differences, which comprise the
deferred tax assets and liabilities, are as follows:

<TABLE>
<CAPTION>
                                             December 31,
                                  ---------------------------------
(in thousands)                         1998               1997
                                  --------------    ---------------
<S>                                 <C>               <C> 
Deferred tax assets:                                      
  Allowance for doubtful accounts         $1,483             $  697
  State taxes                                581                316
  Accrued compensation                       139                 83
  Other                                      276                  -
                                   -------------     --------------   
Total gross deferred tax assets           $2,479             $1,096
                                                          
Deferred liabilities:                                     
  Depreciation                            $2,029             $  870
  Other                                      128                 87
                                   -------------     --------------   
Total gross deferred tax                                            
 liabilities                              $2,157             $  957 
                                  --------------    ---------------
                                                          
Net deferred tax assets                   $  322             $  139
                                  ==============    ===============
</TABLE>

(3) Acquisitions and Investments

     In 1997, the Company acquired a controlling interest in Rustelnet, a
provider of enhanced telecommunications services to the Russian market.  The
acquisition was accounted for by the purchase method, and accordingly, the
results of operations of the acquired business have been included in the
accompanying consolidated financial statements from the date of acquisition.
The price was $36,000 with Rustelnet having cash balances of $257,000 at the
time.  The fair value of net liabilities acquired in the acquisition was
$158,000.  The excess of purchase price over the estimated fair market value of
$627,000 has been allocated to goodwill.  Goodwill is being amortized on a
straight-line basis over a 10-year period.  In connection with the acquisition
of Rustelnet, the Company purchased Rustelnet shares from individual
shareholders who are members of Pacific Gateway's management.  A total of 690
Rustelnet shares were sold by management to the Company for $13,000.

     In 1997, the Company and Globe Telecom, a company operating in the
Philippines, formed a joint venture, PinTouch Telecom, to market long distance
services to the Filipino-American community. In accordance with the joint
venture agreement, the Company receives 47.5% of PinTouch's net earnings, for
which the Company has recognized equity in earnings of $1,665,000 and $131,000
for the years ended December 31, 1998 and 1997, respectively.

     In February 1998, the Company purchased 16.6% of the common stock of Ekonom
S.A. de C.V., a Mexican multimedia company, for $3,300,000 in cash and
$1,800,000 in the Company's common stock. The Company's investment in Ekonom is
accounted for under the cost method.

(4)  Segment Data

     The Company adopted SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information effective January 1, 1998. SFAS No. 131
requires disclosures of a Company's operating segments, which is defined as a
segment whose operating results are distinguishable and regularly reviewed by
the Company's decision makers. Prior to the adoption of SFAS No. 131, the
Company classified all operations under one segment, Telecommunications. By
utilizing a combination of factors, principally services provided and geographic
areas, the Company has identified three operating segments: U.S. wholesale,
offshore and value-added services. The operating results of these segments are
regularly reviewed by the Company's management and are integral to their
decision-making process.

     U.S. wholesale provides international telecommunications services to its
target base of U.S.based carriers that originate international traffic but do
not have operating agreements with foreign carriers to terminate the traffic.
U.S. wholesale also provides service to customers who are existing international
carriers, terminating their overflow telecommunications traffic or on routes
with smaller traffic volumes.

     The offshore segment consists primarily of the operating subsidiaries in
the UK, New Zealand, Russia and Japan.   The Company has established
telecommunications switching facilities in each location and provides services
similar to U.S. wholesale to its country-specific customers.

                                       49
<PAGE>
 
     The Company's third segment includes a variety of emerging and value-added
services.  Presently, this operating segment primarily provides international
long distance services to certain ethnic retail markets, principally the
Filipino-American and Japanese-American communities.

     The results of operations for the Company's operating segments for each of
the three years ended December 31, 1998 are as follows:

<TABLE>
<CAPTION>
 
(in thousands)                                    U.S.                         Value-   Total Operating
1998                                            Wholesale      Offshore        Added       Segments
------------------------------------------------------------------------------------------------------
<S>                                        <C>            <C>            <C>            <C>
Sales to unaffiliated customers                 $390,619        $55,714        $19,958        $466,291
Sales and transfers between segments              36,405         19,879              -          56,284
                                                ------------------------------------------------------ 
Total sales                                     $427,024        $75,593        $19,958        $522,575
Depreciation and amortization                   $  7,031        $ 1,682        $     -        $  8,713
Operating income                                $ 16,730        $ 6,677        $ 3,740        $ 27,147
Total assets                                    $151,491        $34,831        $ 5,857        $192,179
------------------------------------------------------------------------------------------------------
                                                                                           
1997                                                                                       
Sales to unaffiliated customers                 $279,750        $17,739        $ 1,120        $298,609
Sales and transfers between segments              13,186         12,005              -          25,191
                                                ------------------------------------------------------ 
Total sales                                     $292,936        $29,744        $ 1,120        $323,800
Depreciation and amortization                   $  4,632        $   785        $     -        $  5,417
Operating income                                $ 16,398        $ 1,219        $    83        $ 17,700
Total assets                                    $105,057        $18,542        $ 1,071        $124,670
------------------------------------------------------------------------------------------------------
                                               
1996                                           
Sales to unaffiliated customers                 $162,426        $     -        $     -        $162,426
Depreciation and amortization                   $  2,044        $     -        $     -        $  2,044
Operating income                                $  8,929        $     -        $     -        $  8,929
Total assets                                    $ 55,847        $     -        $     -        $ 55,847
======================================================================================================
</TABLE>

     The reconciliations from the Company's operating segments to the
consolidated totals on the Company's balance sheets and statements of operations
for each of the three years ended December 31, 1998 are as follows:
 
<TABLE>
<CAPTION>
(in thousands)
1998
--------------------------------------------------------------
<S>                                             <C>
Total sales for operating segments                    $522,575
Elimination of sales between segments                  (56,284)
                                                      -------- 
Total consolidated sales                              $466,291
 
Total assets for operating segments                   $192,179
Assets not allocated to operating segments              43,458 
                                                      -------- 
Total consolidated assets                             $235,637
==============================================================
 
1997
Total sales for operating segments                    $323,800
Elimination of sales between segments                  (25,191)
                                                      --------  
Total consolidated sales                              $298,609
 
Total assets for operating segments                   $124,670
Assets not allocated to operating segments              46,947 
                                                      --------  
Total consolidated assets                             $171,617
==============================================================
 
1996
Total sales for operating segments                    $162,426
Elimination of sales between segments                        -
                                                      --------  
  Total consolidated sales                            $162,426
 
Total assets for operating segments                   $ 55,847
Assets not allocated to operating segments              47,969 
                                                      --------  
Total consolidated assets                             $103,816
==============================================================
</TABLE>

                                       50
<PAGE>
 
     The Company sells to long distance international telecommunications
companies, foreign partners and to retail customers. At December 31, 1998, the
Company had 44 operating agreements with foreign partners and approximately 163
worldwide customers excluding U.S. retail customers. Total revenues from
external customers including U.S. retail customers by country for each of the
three years ended December 31, 1998 were as follows:

<TABLE>
<CAPTION>
                                                              Year Ended December 31,
                                   -----------------------------------------------------------------------
(in thousands)                                1998                      1997                   1996
                                   ------------------------    --------------------   -------------------- 
<S>                                  <C>                         <C>                    <C>
United States                                      $334,746                $216,286               $116,735
United Kingdom                                       51,378                  21,625                  4,245
Russia                                               11,877                   6,733                  5,630
Australia                                            10,988                   6,377                  8,771
New Zealand                                           7,681                   2,222                  1,767
Japan                                                 5,369                   4,678                  5,518
Other                                                44,252                  40,688                 19,760
                                   ------------------------    --------------------   -------------------- 
Total revenues                                     $466,291                $298,609               $162,426
                                   ========================    ====================   ====================
</TABLE>

     Revenues are attributed to countries based on the location of customer.
Other includes revenues from customers located in countries that individually
represented less than 2% of total revenues.

     For the year ended December 31, 1998, there were no major customers that
comprised ten percent or more of the Company's revenues.   For the year ended
December 31, 1997, 10.4% of the Company's revenues were derived from Frontier
Communications, Inc. of $30,996,000.  Matrix Telecom, Inc. derived 12.6% of the
Company's revenues for the year ended December 31, 1996 with revenues of
$20,514,000.


(5) Commitments and Contingencies

 Litigation

     The Company is not currently subject to any legal proceedings that
management believes will have a material impact on the Company's financial
position or results of operations.

 Leases

     The Company leases office space and equipment under noncancelable operating
leases.  Rental expenses for 1998, 1997 and 1996 were approximately $1,274,000,
$965,000 and $255,000, respectively. The Company leases certain computer
equipment under an agreement that is classified as a capital lease.  The lease
has a term of three years with a minimum purchase price at the end of the lease.
Leased capital assets included in property and equipment at December 31, 1998
were $1,241,000.

     Future minimum lease payments under noncancelable operating and capital
leases as of December 31, 1998 are as follows:
<TABLE>
<CAPTION>
 
(in thousands)                                          Operating leases  Capital leases
                                                        ----------------  --------------
<S>                                                     <C>               <C>             
             1999                                                 $  812            $436
             2000                                                    742             112
             2001                                                    702               -
             2002                                                    672               -  
             2003                                                    582               - 
             Thereafter                                            1,355               -
                                                                  ------            ----
             Total minimum lease payments                         $4,865            $548
                                                                  ======
               Amount representing interest                                           13
                                                                                    ----
               Present value of net minimum payments                                $535
                                                                                    ----
               Current portion                                                      $436
                                                                                    ====
</TABLE>

                                       51
<PAGE>
 
 Employment Agreements

     The Company has entered into employment agreements with certain employees
that provide that, in the event of a change in control, each of these employees
would be entitled to severance following their resignation from the Company.
Should such an event occur, the Company's aggregate obligation for severance
would be approximately $4,764,000.  Upon any such change in control, each of
these individuals would also receive full vesting of any outstanding stock
options.

 Commitments

     At December 31, 1998, the Company had outstanding commitments of $159
million for the acquisition of additional ownership in digital undersea fiber
optic cables and network equipment. This includes the commitment to purchase
undersea fiber optic cable in the Japan-U.S. cable network for $86 million and
in TAT-14 cable system for $70 million.

 Line of Credit

     During October 1998, the Company entered into an uncollateralized 1-year
revolving line of credit of up to $30 million with an interest rate of LIBOR
plus 1.125% with Bank of America, NT&SA and NationsBanc Montgomery LLC.  As of
December 31, 1998, the Company had $8.7 million outstanding and $21.3 million
available under this line of credit with an interest rate of 7.75%. The line of
credit, which expires December 17, 1999, has financial covenants, which require
a maximum ratio of debt to annualized operating cash flow of 3 to 1 and a
minimum interest coverage ratio (ratio of operating cash flow to net interest
expense) of 2.5 to 1.  The Company was in compliance with these covenants at
December 31, 1998.

(6) Employee Benefit Plans

     In September 1995, the Company established an Employee Stock Purchase Plan
(the "Purchase Plan") which is intended to qualify under section 423 of the
Internal Revenue Code.  The Purchase Plan was not active for the years ended
December 31, 1998, 1997 or 1996.  Under the Purchase Plan, the Company reserved
up to 400,000 shares of common stock for purchase by employees who meet certain
eligibility requirements.  Eligible employees may contribute up to 10% of their
compensation to the Purchase Plan to purchase shares at 85% of the fair market
value of the stock on the first or last day of each six-month offering period as
defined in the Purchase Plan.

     In 1996, the Company adopted a 401(k) plan pursuant to which eligible
employees may accumulate savings on a tax-deferred basis.  Each year the Company
may make a discretionary profit sharing contribution to the 401(k) plan which
will be allocated to the accounts of eligible employees who are employed on the
last day of the year.  The profit sharing allocation is made on a pro rata basis
in proportion to the compensation of the eligible employees.  The Company did
not make a contribution in 1998, 1997 or 1996.

(7) Stock Option Plan

     On September 30, 1995, the Company adopted the 1995 Stock Option Plan (the
"1995 Plan").  The 1995 Plan provides for the granting of nonqualified and
incentive stock options to purchase up to 1,200,000 shares of common stock.
Options granted under the 1995 Plan generally vest over four years.  The maximum
term of options granted is ten years.  The Company granted options to purchase
883,411 shares of common stock under the 1995 Plan.

     On February 17, 1997, the Company adopted the 1997 Long-Term Incentive Plan
(the "1997 Plan"), replacing the 1995 Plan.  The 1997 Plan provides for the
granting of awards of nonqualified and incentive stock options, stock
appreciation rights, stock grants or stock-based performance units.  Awards may
be made under the 1997 Plan with respect to 4,000,000 shares of common stock and
with respect to stock option and stock appreciation right awards, no more than
500,000 shares may be awarded to any one individual in any one-year period.  The
remaining terms of the 1997 Plan are similar to those described in the 1995
Plan.

     On September 18, 1998, the Company repriced 768,500 options to purchase the
Company's common stock granted under the 1997 plan to $27.688 per share, the
fair market value of the Company's common stock on September 18, 1998.

                                       52
<PAGE>
 
     SFAS No. 123, Accounting for Stock-Based Compensation, encourages adoption
of a fair value-based method for valuing the cost of stock-based compensation.
However, it allows companies to continue to use the intrinsic value method
prescribed under Accounting Principles Board Opinion ("APB") No. 25, Accounting
for Stock Options Issued to Employees, for options granted to employees and
disclose pro forma net income and earnings per share in accordance with SFAS No.
123.  Had compensation cost for the Company's stock-based compensation plans
been determined consistent with SFAS No. 123, the Company's net income and
earnings per share would have been as follows:

<TABLE>
<CAPTION>
                                                                  Year Ended December 31,
                                       ------------------------------------------------------------------------
(in thousands, except per share                  1998                      1997                     1996
    amounts)                           -----------------------   ----------------------    -------------------- 
<S>                                      <C>                       <C>                       <C>
Net income - as reported                                $19,936                  $12,497                  $5,808
Net income - pro forma                                  $14,308                  $11,469                  $5,244
 
Earnings per share - basic as reported                  $  1.05                  $  0.66                  $ 0.36
Earnings per share - basic pro forma                    $  0.75                  $  0.60                  $ 0.32
 
Earnings per share - diluted as reported                $  0.97                  $  0.64                  $ 0.34
Earnings per share - diluted pro forma                  $  0.70                  $  0.59                  $ 0.31
</TABLE>

     The fair value of the options granted by the Company is estimated at $56.5
million on the date of the grant using the Black-Scholes Model for those options
issued after the Company's initial public offering and the Minimum Value
methodology for those options granted prior to the offering.  The assumptions
used in the Black- Scholes model are as follows:

<TABLE>
<CAPTION>
                                                                 Year Ended December 31,
                                       -------------------------------------------------------------------------
                                                 1998                      1997                      1996
                                       ----------------------    ----------------------     --------------------
<S>                                      <C>                       <C>                        <C>
Dividend yield                                     0.0%                      0.0%                     0.0%
Volatility                                        49.4%                     40.9%                    30.5%
Risk-free interest rate                            4.5%                      5.8%                     6.7%
Assumed forfeiture rate                            0.0%                      0.0%                     0.0%
Expected life                                      5 years                   5 years                  5 years
</TABLE>

     SFAS No. 123 requires that stock-based compensation granted to non-
employees be accounted for based on the fair value-based method described above.
It also requires that restricted stock granted to employees be recognized as
compensation expense over the vesting period, measured at the fair market value
on the grant date. In 1998 and 1997, the Company granted 25,000 and 75,000
shares, respectively, of restricted stock under the 1997 Plan.  The Company
recorded deferred compensation of approximately $963,000 and $4,134,000 for the
years ended December 31, 1998 and 1997, respectively.  This amount was recorded
as a reduction of stockholders' equity and is being amortized as an expense to
operations over the applicable vesting periods.  For the years ended December
31, 1998, 1997 and 1996, $674,000, $146,000 and $85,000, respectively, was
recognized as compensation expense for restricted stock and stock options
granted to non-employees.

                                       53
<PAGE>
 
     Stock Option Awards were:

<TABLE>
<CAPTION>
                                                             Year Ended December 31,
                                   1998                                1997                                 1996
                      ---------------------------------   --------------------------------     --------------------------------
                                             Weighted-                         Weighted-                            Weighted-
                                             Average                            Average                              Average
                           Option            Exercise        Option            Exercise            Option           Exercise
                           Shares             Price          Shares             Price              Shares             Price
                      --------------     --------------   -------------     --------------     --------------    --------------  
<S>                     <C>              <C>              <C>               <C>                <C>               <C> 
Options outstanding,                                                                                             
    Beginning of year      2,296,065             $32.14         883,411             $ 9.77            509,170            $ 8.23
Options granted            2,608,800              32.50       1,610,000              41.60            374,241             12.58
Options exercised            (88,887)             13.02        (101,660)              7.30                  -                 -
Options forfeited /                                                                                              
 cancelled                  (824,907)             39.12         (95,686)             11.08                  -                 -
                      --------------     --------------   -------------     --------------     --------------    --------------
Options outstanding,                                                                                             
    End of year            3,991,071             $31.36       2,296,065             $32.14            883,411            $ 9.77
                      ==============     ==============   =============     ==============     ==============    ============== 
Option price range at    $  8.500 to                        $  8.500 to                           $  4.400 to     
   End of year               $53.125                            $50.188                              $ 29.500    
                                                                                                                 
Option shares available                                                                                          
for grant at end of          
 year                        621,107                          2,405,000                               316,589
                      ==============                      =============                        ==============
</TABLE>

     The following table summarizes information concerning currently outstanding
and exercisable options:

<TABLE>
<CAPTION>
                                                 Options                                          Options
                                               Outstanding                                      Exercisable
                         -------------------------------------------------------      ---------------------------------
                                                  Weighted
                                                  Average            Weighted                               Weighted
                                                 Remaining           Average                                 Average
     Range of                  Number           Contractual          Exercise              Number           Exercise
  Exercise Prices           Outstanding             Life              Price             Exercisable           Price
                         ----------------     --------------    ----------------      --------------    ---------------
<S>                        <C>                  <C>               <C>                   <C>               <C>
$  8.500 - $14.000                566,146               0.98              $ 9.21             411,120             $ 9.08
$ 24.750 - $29.500              2,149,925               3.32               27.87             235,750              27.60
$ 38.500 - $53.125              1,275,000               3.38               47.08             186,250              46.54
                         ----------------     --------------    ----------------      --------------    ---------------
$  8.500 - $53.125              3,991,071               3.01              $31.36             833,120             $22.69
                         ================     ==============    ================      ==============    ===============
</TABLE>


(8) Capital Stock

     On July 19, 1996, the Company completed an initial public offering of
6,057,050 shares of common stock of which 4,940,050 were offered by the Company
and 1,116,550 shares were offered by certain selling shareholders. The net
proceeds to the Company (after deducting underwriting discounts and estimated
offering expenses) from the sale of the shares was approximately $54.1 million.

 
(9) Stockholders' Rights Plan

     On November 17, 1997, the Board of Directors of the Company declared a
dividend of one preferred share purchase right (a "Right") for each outstanding
share of Common Stock.  Subject to certain exceptions, each Right, when
exercisable, entitles the registered holder to purchase from the Company one
one-thousandth of a share of Series A Junior Participating Preferred Stock, par
value $0.0001 per share (the "Preferred Stock"), of the Company at a price of
$200, subject to adjustment (the "Purchase Price").

     The Rights generally will only be exercisable (i) ten days following a
public announcement that a person or group of affiliated or associated persons
(an "Acquiring Person") has acquired, or obtained the right to acquire, 15% or
more of the outstanding shares of the Company's Common Stock or (ii) 15 business
days following 

                                       54
<PAGE>
 
commencement of (or an announcement of an intention to make) a tender or
exchange offer for 15% or more of the outstanding shares of the Common Stock.
The Rights will expire, if not previously exercised, exchanged or redeemed, on
December 1, 2007.

     If any person or group generally acquires 15% or more of the Company's
outstanding Common Stock, each Right, except those held by such an Acquiring
Person, would entitle each holder of a Right to acquire, upon exercise at the
then current exercise price of the Right, Common Stock having a value equal to
two times the exercise price of the Right.

     At anytime after a person or group generally acquires more than 15% of the
outstanding Common Stock and prior to their acquisition of 50% or more of the
outstanding Common Stock, each Right, except those held by such an Acquiring
Person, may be exchanged by the Board of Directors for one share of Common
Stock.

     If the Company is acquired in a merger or other business combination
transaction or 50% or more of the Company's assets or earnings power is sold,
each Right will entitle the holder thereof (except for the Acquiring Person) to
receive, upon exercise at the then current exercise price of the Right, common
stock of the acquiring or surviving company having a value equal to two times
the exercise price of the Right.

At any time prior to the time an Acquiring Person becomes such, the Board of
Directors may redeem the Rights in whole, but not in part, at a price of $.01
per Right (the "Redemption Price").

(10) Subsequent Event

     On March 2, 1999, the Company signed a commitment letter for a $200 million
senior secured credit facility with Salomon Brothers Holding Company, Inc. and
Goldman Sachs Credit Partners L.P.   The facility may be increased in the future
of up to $100 million if additional commitments are received from lenders.   The
completion of the financing is subject to the execution of definitive loan
documents and customary conditions for this type of facility.  The Company plans
to use the facility to finance its undersea fiber optic cable investments and
its expansion into the U.S. and Western Europe domestic markets.

                                       55
<PAGE>
 
ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND 
FINANCIAL DISCLOSURE

None.

                                    PART III
                                        
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS

     The information concerning directors required by this item is incorporated
by reference to the information contained under the captions "Election of
Directors", "Meetings and Committees of the Board" and "Section 16(a) Beneficial
Ownership Reporting Compliance" in the Company's Proxy Statement for the 1999
Annual Meeting of Stockholders.

ITEM 11. EXECUTIVE COMPENSATION

     The information required by this item is incorporated by reference to the
information contained under the caption "Compensation of Directors and Executive
Officers" in the Company's Proxy Statement for the 1999 Annual Meeting of
Stockholders.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

     The information required by this item is incorporated by reference to the
information contained under the caption "Ownership of the Capital Stock of the
Company" in the Company's Proxy Statement for the 1999 Annual Meeting of
Stockholders.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

     The information required by this item is incorporated by reference to the
information contained under the caption "Certain Relationships and Related
Transactions" in the Company's Proxy Statement for the 1999 Annual Meeting of
Stockholders.

                                    PART IV
                                        
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K

(a) 1. Financial Statements*

       Consolidated Balance Sheets as of December 31, 1998 and 1997

       Consolidated Statements of Operations for the Years Ended December 31,
       1998, 1997 and 1996

       Consolidated Statements of Cash Flows for the Years Ended December 31,
       1998, 1997 and 1996

       Consolidated Statements of Changes in Stockholders' Equity for the Years
       Ended December 31, 1998, 1997 and 1996

       Notes to Consolidated Financial Statements


*      Included in Item 8 of this 10-K

                                       56
<PAGE>
 
(a) 2. Financial Statement Schedule

       Schedule II Valuation and Qualifying Accounts
 
(a) 3. Exhibits

<TABLE>
<CAPTION>
Exhibit    Description                                                Method of Filing
Number
--------
<C>        <S>                                                        <C>
3.1.1      Amended and Restated Certificate of Incorporation, as      Incorporated by reference to Quarterly
           Amended May 20, 1997                                       Report on Form 10-Q for the quarter ended
                                                                      June 30, 1997 (No. 000-21043)

3.1.2      Certificate of Amendment of Amended and Restated           Filed with this document 
           Certificate of Incorporation as amended June 19, 1998
 
3.2        Amended and Restated  Bylaws, as amended October 23,       Incorporated by reference to Quarterly
           1998                                                       Report on Form 10-Q for the quarter ended
                                                                      September 30 1998 (No. 000-21043)

4.1        Specimen Certificate for Common Stock                      Incorporated by reference to Registration
                                                                      Statement on Form S-1 (No. 33-80191)

4.2.1      Amended and Restated Certificate of Incorporation, as      Incorporated by reference to Quarterly
           Amended May 20, 1997                                       Report on Form 10-Q for the quarter ended
                                                                      June 30, 1997 (No. 000-21043)
 
4.2.2      Certificate of Amendment of Amended and Restated           Refer to exhibit 3.1.2 
           Certificate of Incorporation as amended June 19, 1998

4.3        Rights Agreement dated as of November 17, 1997, between    Incorporated by reference to Form 8-K
           the Company and Norwest Bank Minnesota, N.A. as Rights     filed November 21, 1997 (No. 000-21043)
           Agent

10.1       Form of Indemnification Agreement for directors and        Incorporated by reference to Form 10-K for
           officers                                                   the year ended December 31, 1997 (No.
                                                                      000-21043)

10.2       1997 Long-Term Incentive Plan                              Incorporated by reference to Quarterly
                                                                      Report on Form 10-Q for the quarter ended
                                                                      June 30, 1997 (No. 000-21043)

10.3       Employee Stock Purchase Plan                               Incorporated by reference to Registration
                                                                      Statement on Form S-1 (No. 33-80191)

10.4.1     Proxy dated December 10, 1994 by Julie J. Jensen           Incorporated by reference to Registration
                                                                      Statement on Form S-1 (No. 33-80191)

10.4.2     Proxy dated December 10, 1994 by Jeffrey J. Jensen         Incorporated by reference to Registration
                                                                      Statement on Form S-1 (No. 33-80191)

10.4.3     Proxy dated December 10, 1994 by Janet Jensen Kreiger      Incorporated by reference to Registration
                                                                      Statement on Form S-1 (No. 33-80191)

10.4.4     Proxy dated December 10, 1994 by James J. Jensen           Incorporated by reference to Registration
                                                                      Statement on Form S-1 (No. 33-80191)

10.4.5     Proxy dated December 10, 1994 by Jami J. Jensen            Incorporated by reference to Registration
                                                                      Statement on Form S-1 (No. 33-80191)

10.4.6     Proxy dated April 30, 1998 by Gail E. Granton              Incorporated by reference to Quarterly
           individually and as trustee of the The Granton Foundation  Report on Form 10-Q for the quarter ended
                                                                      June 30, 1998 ( No. 000-21043)
</TABLE> 

                                       57
<PAGE>
 
<TABLE> 
<CAPTION> 
Exhibit    Description                                                Method of Filing
Number
---------
<C>        <S>                                                        <C> 
10.4.7     Proxy dated June 10, 1996 Ronald L. Jensen                 Incorporated by reference to Registration
                                                                      Statement on Form S-1 (No. 33-80191)

10.5.1     Employment Agreement dated as of January 1, 1998 between   Incorporated by reference to Quarterly
           Howard A. Neckowitz and Pacific Gateway Exchange, Inc.     Report on Form 10-Q for the quarter ended
                                                                      June 30, 1998 ( No. 000-21043)

10.5.2     Employment Agreement dated as of January 1, 1998 between   Incorporated by reference to Quarterly
           Gail E. Granton and Pacific Gateway Exchange, Inc.         Report on Form 10-Q for the quarter ended
                                                                      June 30, 1998 ( No. 000-21043)

10.5.3     Employment Agreement dated as of January 1, 1998 between   Incorporated by reference to Quarterly
           Ronald D. Anderson and Pacific Gateway Exchange,Inc.       Report on Form 10-Q for the quarter ended
                                                                      June 30, 1998 ( No. 000-21043)

10.5.4     Employment Agreement dated October 1, 1995 between         Incorporated by reference to Quarterly
           Robert F. Craver and Pacific Gateway Exchange, Inc.        Report on Form 10-Q for the quarter ended
                                                                      June 30, 1998 ( No. 000-21043)
 
10.5.5     Employment Agreement dated October 1, 1995 between         Incorporated by reference to Quarterly
           Fred A. Weismiller and Pacific Gateway Exchange, Inc.      Report on Form 10-Q for the quarter ended
                                                                      June 30, 1998 ( No. 000-21043)
 
10.5.6     Restricted Stock Award Agreement dated December 30,1997    Incorporated by reference to Form 10-K for
           between Howard A. Neckowitz and Pacific Gateway            the year ended December 31, 1997 (No.
           Exchange, Inc.                                             000-21043)

10.5.7     Employment Agreement dated September 3, 1998 between       Filed with this document
           Thomas J. Murphy and Pacific Gateway Exchange, Inc. 

10.6       Telephone Service dated May 1, 1995 between Matrix         Incorporated by reference to Registration
           Telecom, Inc. and Pacific Gateway Exchange, Inc.           Statement on Form S-1 (No. 33-80191)

10.7       Agreement for Billing Services dated November 24, 1995     Incorporated by reference to Registration
           Between Matrix Telecom, Inc. and Pacific Gateway           Statement on Form S-1 (No. 33-80191)
           Exchange, Inc.
 
10.8       Credit Agreement among Pacific Gateway Exchange, Inc.      Filed with this document
           and Bank of America, NT & SA and NationsBanc Montgomery
           Securities LLC dated December 18, 1998

21.1       Subsidiaries                                               Filed with this document

23.1       Consent of Independent Accountants                         Filed with this document

27.1       Financial Data Schedule                                    Filed with this document
</TABLE>

  (b)  Reports on Form 8-K

       None.

                                       58
<PAGE>
 
                                   SIGNATURES
                                        
     Pursuant to the requirements of section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized, in
Burlingame, California, on the 30th day of March, 1999.

                                     Pacific Gateway Exchange, Inc.

                                     
                                 By: /s/  Howard A. Neckowitz
                                     ------------------------------
                                          Howard A. Neckowitz
                                     President, Chief Executive Officer and
                                          Chairman of the Board

   Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, this report has been signed by the following persons on behalf of the
Registrant and in the capacities indicated and on the 30th day of March, 1999.

<TABLE> 
<CAPTION> 
        Signature                         Title
        ---------                         -----
<S>                                  <C>     

     /s/  Howard A. Neckowitz        President, Chief Executive Officer and
----------------------------------   Chairman of the Board
     Howard A. Neckowitz             (Principal Executive Officer)


     /s/  Gail E. Granton            Executive Vice President,
----------------------------------   International Business Development,
     Gail E. Granton                 Secretary and Director


                                     Chief Financial Officer, and
     /s/  Sandra D. Grey             Vice President, Finance
----------------------------------   (Principal Financial Officer)
     Sandra D. Grey                  (Principal Accounting Officer)


     /s/  Robert C. Calafell           Director
----------------------------------
     Robert C. Calafell


     /s/  Charles M. Dalfen          Director
----------------------------------
     Charles M. Dalfen


     /s/  James J. Junewicz          Director
----------------------------------
     James J. Junewicz


     /s/  Barry J. Volante            Director
----------------------------------
     Barry J. Volante

</TABLE> 

                                       59