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                                 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

                 For the fiscal year ended December 31, 1996.

                                      OR

   [_]     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
                        SECURITIES EXCHANGE ACT OF 1934
                      For the Transition period from to

                       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                (I.R.S. EMPLOYER
  INCORPORATION OR ORGANIZATION)               IDENTIFICATION NO.)

        533 AIRPORT BOULEVARD, SUITE 505, BURLINGAME, CALIFORNIA 94010
                   (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

                        TELEPHONE NUMBER: 415-375-6700
             (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

          SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:

                   COMMON SHARES, PAR VALUE $.0001 PER SHARE
                               (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. [X]  Yes  [_] No

  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K ((S) 229.405 of this chapter) 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. [_] (Amended by Exch
Act Rel No. 28869, eff. 5/1/91.)

  The aggregate market value of the shares of all classes of voting stock of
the registrant held by non-affiliates of the registrant on March 27, 1997 was
approximately $175,000,000, 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 27, 1997, there were outstanding 18,896,490 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 1997
Annual General Meeting of Shareholders.

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                         PACIFIC GATEWAY EXCHANGE, INC.

                               TABLE OF CONTENTS

<TABLE>
<CAPTION>
                                                                           PAGE
 ITEM                                                                     NUMBER
 ----                                                                     ------
                                     PART I

 <C>  <S>                                                                 <C>
  1.  Business.........................................................      1
  2.  Properties.......................................................     23
  3.  Legal Proceedings................................................     23
  4.  Submission of Matters to a Vote of Security Holders..............     23
      Executive Officers and Key Members of Management.................     23

                                    PART II

      Market for the Registrant's Common Stock and Related Stockholder
  5.  Matters..........................................................     25
  6.  Selected Financial Data..........................................     26
      Management's Discussion and Analysis of Financial Condition and
  7.  Results of Operations............................................     27
  8.  Financial Statements and Supplementary Data......................     33
      Changes in and Disagreements with Accountants on Accounting and
  9.  Financial Disclosure.............................................     46

                                    PART III

 10.  Directors and Executive Officers.................................     46
 11.  Executive Compensation...........................................     46
 12.  Security Ownership of Certain Beneficial Owners and Management...     46
 13.  Certain Relationships and Related Transactions...................     46

                                    PART IV

 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K.     46
</TABLE>

                                       i
<PAGE>

                                    PART I

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, including statements
regarding expected future revenue from delayed proportional return traffic
from foreign partners pursuant to certain operating agreements. 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," "intends," or
"expects." These forward-looking statements relate to the plans, objectives
and expectations of Pacific Gateway Exchange, Inc. ("Pacific Gateway" or the
"Company") for future operations. In light of the risks and uncertainties
inherent in all future projections, 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 objectives or plans of the Company will
be achieved. The Company's revenues and results of operation 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; (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; (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; or (xii) concentration of credit risk. The foregoing review of
important factors 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.

ITEM 1. BUSINESS

OVERVIEW

  Pacific Gateway is a facilities-based international telecommunications
carrier which provides international telecommunications services primarily to
its target customer base of long distance service providers worldwide. The
Company was incorporated in Delaware and commenced operations on August 8,
1991. As a "facilities-based" carrier, the Company primarily owns or leases
its international network facilities rather than reselling time provided by
another facilities-based carrier. The Company operates an international
network consisting of international and domestic switching facilities in Los
Angeles, New York, and Dallas, partial ownership interest in 14 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.

  As of December 31, 1996, Pacific Gateway had operating agreements with 30
foreign carriers in 24 countries around the world, which countries
collectively represent approximately 53.3% of U.S.-originated international
traffic. The Company is currently negotiating operating agreements with
several prospective foreign partners. The Company's foreign partners include
both telecommunications carriers that have been dominant in their home markets
which may be wholly or partially government-owned (often referred to as post
telephone and telegraph companies or "PTTs") and nondominant carriers that may
have been recently established as a result of the deregulation of foreign
telecommunications markets ("Competitive Carriers").

  On July 25, 1996, the Company and certain stockholders of the Company (the
"Selling Stockholders") consummated an initial public offering of 6,057,050
Common Shares (the "Offering"). Of these shares, 4,940,050 were sold by the
Company and 1,116,550 by the Selling Stockholders. The net proceeds to the
Company (after deducting underwriting discounts and estimated offering
expenses) from the sale of the shares
<PAGE>

was approximately $54.1 million. The Company used $3.3 million of the net
proceeds to repay indebtedness. The Company has used approximately $5.2
million to purchase international network facilities on existing routes. The
remaining $45.6 million will be used to finance the expansion of its
international network facilities on new and existing routes and the remaining
proceeds are expected to be invested in joint ventures, strategic alliances or
acquisitions and used for working capital and general corporate purposes. In
connection with the Offering, KDD America, Inc. ("KDD America"), a subsidiary
of Kokusai Denshin Denwa, an international telecommunications carrier based in
Japan ("KDD Japan") purchased 1,800,000 shares and, as a result, owns
approximately 9.5% of the Company's outstanding Common Shares.

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. Services offered by
international long distance carriers fall into three primary categories:
international switched services, switch-based value-added services and
international private line services.

  Bilateral operating agreements between international long distance carriers
in different countries are key components of the international long distance
telecommunications market. Under an operating agreement, each carrier agrees
to terminate traffic in its country and provide proportional return traffic to
its partner carrier. The implementation of a high quality international
network, including the acquisition and utilization of digital undersea fiber
optic cable and adherence to the technical recommendations of the
International Telegraph and Telephone Consultative Committee (the "CCITT") of
the International Telephone Union (the "ITU") for signalling, protocol and
transmission, is an important element in enabling a carrier to compete
effectively in the international long distance telecommunications market.

  The international long distance telecommunications market has experienced
rapid growth in recent years. During 1995, according to the Federal
Communications Commission (the "FCC"), the U.S.-Originated Market grew at an
annual rate of 19.5% from $13.3 billion to $15.9 billion. The Company believes
that the international telecommunications market will continue to experience
strong growth for the foreseeable future as a result of the following trends:

  . the opening of overseas telecommunications markets due to deregulation
    and the privatization of government-owned monopoly carriers, permitting
    the emergence of new carriers;

  . the reduction of international outbound long distance rates, driven by
    competition and technological advancements, which is making international
    calling available to a much larger customer base and stimulating
    increasing traffic volumes;

  . the increased availability and quality of digital undersea fiber optic
    cable in the place of satellite- and analog coaxial cable-based
    transmission networks, which have enabled long distance carriers to
    improve the quality of their services and reduce their cost structures;

  . the dramatic increases in the availability of telephones and the number
    of access lines in service around the world, stimulated by economic
    growth, government mandates and technological advancements;

  . the worldwide proliferation of new communications devices such as
    cellular telephones, facsimile machines and other forms of data
    communications equipment;

  . the rapidly increasing globalization of commerce, trade and travel; and

  . the rapidly increasing demand for bandwidth-intensive data transmission
    services, including the Internet.

  Many of the world's developing countries are committing significant
resources to build telecommunications infrastructures in order to increase the
number and quality of telephone lines in their countries. The Company believes
that increasing investment in telecommunications infrastructure will stimulate
increasing demand for

                                       2
<PAGE>

international telecommunications services. Certain countries have opened their
telecommunications markets to competition in order to increase the level of
private investment and the rate of infrastructure development. Deregulation of
telecommunications services in the United States began in 1984 with the AT&T
Communications, Inc. ("AT&T") divestiture. The Company believes that the trend
of new international Competitive Carriers emerging in international markets
outside of the United States creates numerous opportunities for U.S.-based
carriers, such as Pacific Gateway, to increase their access to developing
telecommunications markets and to increase their market share in both the
U.S.-Originated Market and the Overseas-Originated Market. The Company
believes that many of the emerging carriers in developing countries, as well
as certain recently privatized PTTs, are likely to seek alliances, mergers,
partnerships or joint ventures with other international carriers to expand
their global networks. Recent examples include AT&T's alliance with Unisource,
known as "Uniworld," MCI Telecommunications Corporation's ("MCI") merger with
British Telecom and Sprint Corporation's ("Sprint") alliance with Deutsche
Telekom and France Telecom, known as "Global One."

  Despite the growth and general deregulatory trends in the global
telecommunications market, the pace of change and emergence of competition in
many countries remains slow, with domestic and international traffic still
dominated by government-controlled monopoly carriers. The Company believes
that U.S.-based international carriers, such as Pacific Gateway, which have
already established, or are in negotiations to establish, operating agreements
with government-controlled monopoly carriers in many such countries will be
well-positioned to capture the benefits of increasing traffic flows as the
telecommunications infrastructure in these countries is expanded.

 Markets

  U.S.-Originated Market. In 1995, the U.S.-Originated Market was $14.0
billion in aggregate revenues from international switched services traffic,
according to statistics published by the FCC. Based on 1995 FCC statistics,
the U.S.-Originated Market is dominated by AT&T with a 62% market share,
followed by MCI with a 26.8% market share, and Sprint with a 8.2% market
share. The balance of this market currently is divided among WorldCom, Inc.
("WorldCom"), Pacific Gateway and a number of specialized carriers. U.S.-based
carriers that originate international traffic but do not have operating
agreements with foreign carriers utilize the services of a carrier which has
the appropriate facilities and operating agreements to terminate this traffic.
In addition, international carriers with operating agreements may use the
services of other international carriers for overflow traffic or on routes
with smaller traffic volumes. Approximately $1.7 billion of the 1995 U.S.-
Originated Market traffic, which aggregated $14.0 billion in revenues, was
terminated under an operating agreement held by a carrier other than the
originating carrier. The Company's marketing efforts to U.S.-based carriers
are primarily directed at this segment of the U.S.-Originated Market.

  Overseas-Originated Market. Although the Company's extensive international
network enables it to compete in the entire Overseas-Originated Market,
Pacific Gateway is focusing its strategy on developing a significant presence
in a defined set of geographical routes 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.

 Services

  International Switched Services. International switched services represent
the largest component of international telecommunications traffic. These
services are provided through transmission facilities employing switches that
automatically route calls to available circuits. As shown in the diagram
below, a typical international telephone call which originates in a U.S.
business or residence 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 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

                                       3
<PAGE>

gateway switch operated by an international carrier in the country of
destination. 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}

  Switch-Based Value-Added Services. Switch-based value-added services include
800 service, international directory assistance with the option of call
completion, travel card services, enhanced facsimile services and
videoconferencing, among others. The provision of such value-added services
offers carriers attractive opportunities to increase operating margins and
offer a more competitive service to their customers.

  International Private Line Services. International private line services
provide a dedicated point-to-point connection between two locations without
using a public switched network. A typical private line would connect the New
York and London branches of an international bank. Customers of this service
are typically multinational corporations or government agencies which have
substantial communications volume between two or more international locations.

 Operating Agreements

  International long distance traffic is traditionally exchanged under
switched voice bilateral operating agreements between long distance carriers
in two countries. In order 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 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

                                       4
<PAGE>

digital undersea fiber optic cable between the two countries. While 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.

COMPANY STRATEGY

The Company's objective is to strengthen its position as a facilities-based
international telecommunications services provider by increasing its customer
base in the United States and abroad and positioning itself for continued
growth in revenues and profitability. The Company's strategy for achieving
this objective consists of the following key elements:

 Secure Additional Operating Agreements

  Pacific Gateway actively seeks to enter into additional operating agreements
to expand the geographical scope of its international network and to attract
new domestic and foreign customers. Pacific Gateway is able to increase the
revenues generated by its existing customer base by providing direct service
for these customers to additional countries.

  Pacific Gateway targets prospective partners for new operating agreements by
evaluating customer demand, the relative long-term economic attractiveness of
offering direct service to a particular country and the availability of fiber
optic or satellite transmission capacity to that country. Currently, the
Company is focusing its resources on establishing additional routes primarily
to Asia, the Pacific Rim, Eastern Europe and Latin America. The Company
believes that these markets, and, in the near future, the Middle East and
Africa, offer opportunities for the Company to attain significant market
share, improve gross margins, and gain other strategic advantages. In
addition, the Company is seeking increased access to more competitive high
traffic routes, such as to Western Europe, through strategic relationships
with well-established international carriers that offer opportunities to
achieve significant revenue growth at relatively low cost. Pacific Gateway
believes that the experience, relationships and knowledge of its management
team have played, and will continue to play, a key role in enabling the
Company to negotiate additional operating agreements in selected markets. The
Company also believes that as specific telecommunications markets become less
regulated, its management team will be able to use its experience and
knowledge to augment existing operating agreements, including by the
deployment of telecommunications equipment in foreign countries, resulting in
a more efficient world-wide network.

 Expand and Enhance Network Facilities

  To support additional operating agreements and the growth of traffic on its
existing direct routes, the Company intends to continue to acquire partial
ownership positions in new and existing digital undersea fiber optic cables.
The Company is generally able to increase its gross profit margin and provide
greater assurance of the quality and reliability of transmission by routing
traffic over its owned international facilities. The Company also intends to
expand its switching and international gateway facilities in the United States
and to invest in network operations in certain foreign locations in order to
originate and terminate customer traffic more cost effectively and support the
development of a targeted commercial sales development program. The Company
utilizes state-of-the-art equipment and technologies that conform to relevant
operating standards to ensure high quality, cost-effective transmission
service.

 Increase Overseas-Originated Traffic Through International Alliances, Joint
Ventures and Acquisitions

  The Company believes that alliances and direct investments with foreign
partners have the potential to increase the Company's opportunities to
increase traffic in the most rapidly growing segments of the international
telecommunications market. In July 1996, the Company and KDD Japan entered
into a seven-year cooperation agreement that contemplates joint projects in
the communication field, including joint product development in new services,
such as video teleconferencing, imaging and Internet services together with
related technical support and assistance; joint marketing arrangements to
promote small and medium-size business and retail and ethnic marketing
programs; continuing exchange of traffic, assistance by KDD Japan to the
Company with respect to the Company's business in Asia; and sharing of
information by Pacific Gateway and KDD Japan

                                       5
<PAGE>

regarding the telecommunications market and industry in the United States and
Japan, respectively. During 1996, the Company made net payments to KDD Japan,
reduced by amounts owed to the Company by KDD Japan, of approximately $5.9
million in connection with exchanging traffic.

  The Company is currently evaluating several other potential alliances,
investment opportunities and acquisitions, including equity positions and
operating roles with both established and emerging international
telecommunications carriers with operations in Asia, the Pacific Rim, Eastern
Europe, Western Europe and Latin America. The Company currently is discussing
with potential U.S. and foreign partners the terms of possible business
relationships and other strategic alliances which could provide that the
partner would acquire a minority ownership interest in the Company. There can
be no assurance that any of these discussions will result in the formation of
an alliance or that any such alliance, if formed, would be successful. The
Company is pursuing these opportunities to stimulate traffic from foreign
markets, to leverage its foreign partners' knowledge of their local markets
and to expand into new emerging markets. In many of the regions targeted by
the Company, the provision of telecommunications services is being
deregulated, providing numerous opportunities either to provide wholesale
services to other competitive carriers operating in the region or to service
the end-user market directly. Additionally, many of the switch-based value-
added services currently offered by the Company in the United States
(discussed below) can be provided abroad through such alliances, creating
opportunities to generate additional revenues through available technology.

  The Company has recently expanded its operations into the United Kingdom.
Along with its full service operating agreement with a major carrier in the
United Kingdom, the Company has obtained both an international facilities
license and an international simple resale license through its wholly owned
United Kingdom subsidiary. These licenses place the Company in a position to
market service in both the United Kingdom and the United States. The Company
is currently installing a switch site in London for use in its United Kingdom
operations. The Company is augmenting its capacity and is currently
investigating purchasing and leasing fully owned circuit capacity that will
enable it to provide service to and from the United Kingdom.

 Expand Product Line

  The Company intends to expand the range of products and services that it
offers to its customers to include international 800 service, prepaid services
such as debit and travel cards, international directory assistance with the
option of call completion service, enhanced facsimile service and virtual
private network services. The Company believes that leveraging its existing
network by offering additional value-added services will increase the loyalty
of its existing customer base and help attract new customers. These services
will enable Pacific Gateway's carrier customers to provide 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.

 Expand Customer Segments

  Pacific Gateway intends to leverage its existing network and low-cost
structure by marketing international long distance services directly to the
retail market, including selected corporate customers that have significant
expenditures on international telecommunications services and are located
within geographic proximity to the Company's switching facilities. The Company
also intends to market its services to targeted customers which have large
concentrations of international telecommunications traffic to specific
countries where the Company believes that it can offer the combined advantages
of competitive prices, high transmission quality and service diversity. The
Company expects that traffic generated by retail customers will result in
higher gross margins than the Company's wholesale traffic with anticipated
higher selling, general and administrative costs directly related to the
provision of these services. To develop this aspect of its business more
rapidly, the Company, in addition, may seek to acquire a marketing
organization with an existing corporate customer base located within
geographic proximity to the Company's switching facilities.

                                       6
<PAGE>

 Maintain Efficient Low-Cost Operations

  The Company believes it is important to maintain efficient, low-cost
operations in order to be competitive in the international wholesale
telecommunications services market. Through continuous monitoring of its
network, the Company optimizes the routing of calls to decrease transmission
costs and obtain the highest possible transmission quality and reliability.
The Company pursues a disciplined, incremental approach to the costs of
expansion. When Pacific Gateway initially expands sales and services into a
region, the Company typically arranges to provide services for that area on a
usage-sensitive (variable cost) basis. As volume grows, the Company typically
reprovisions its network by acquiring fixed-cost facilities with greater
capacity. In addition, the Company closely controls selling, general and
administrative costs at levels that it believes are among the lowest in the
industry. The Company intends to maintain a small corporate staff and to
continue investing in network technology and information systems that will
preserve and enhance its position as a low-cost international
telecommunications service provider.

SERVICES

  The Company provides four categories of services: international switched
services, domestic switched services, switch-based value-added services and
international private line services. Substantially all the Company's current
revenues are generated by the sale of international switched services and
domestic switched services.

  International Switched Services. The Company's international switched
services revenues are generated from outgoing and incoming international
traffic carried through its international network. Revenues from international
switched services are derived from country-specific, usage-sensitive rates
charged to its customers and return traffic from Pacific Gateway's foreign
partners.

  As of December 31, 1996, the Company had 30 operating agreements with
foreign carriers in 24 countries under which it carries traffic through its
network of switching facilities and digital undersea fiber optic cables, as
well as through leased satellite circuits. Through its network and its
arrangements with U.S. and foreign carriers, the Company is able to deliver
traffic to or between all countries in the world that have direct dial service
with the United States. International switched services represented
approximately 91.6%, 88.1% and 85.6% of the Company's revenues in 1996, 1995
and 1994, respectively.

  Domestic Switched Services. The Company provides both originating and
terminating switched long distance services 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). As the Company expands its switching network to include the United
Kingdom and other strategic locations, its originating network may be expanded
to the major metropolitan areas in those regions. The Company provides
domestic switched services as a cost-effective means to terminate its return
traffic in the U.S. and to offer services to U.S.-based long distance
resellers that do not own or lease switching facilities ("switchless
resellers"). Currently, the Company provides domestic switched services only
to Matrix. Domestic switched services accounted for approximately 7.4%, 11.7%
and 12.4% of the Company's total revenues in 1996, 1995 and 1994,
respectively.

  Switch-Based Value-Added Services. The Company currently offers directory
assistance, international 800 service and prepaid services such as debit and
travel cards on a limited basis to its U.S.-based wholesale carrier customers
that do not provide such services directly to their customers. Pacific Gateway
intends to expand the range of its value-added services to include
international directory assistance with the option of call completion
services. In the aggregate, these services accounted for less than 1% of the
Company's revenues in each of 1996, 1995 and 1994.

                                       7
<PAGE>

  International Private Line Services. Pacific Gateway provides dedicated
international point-to-point connections on a selective basis to customers
requiring special dedicated services for high-traffic voice and data routes
between two locations. International private line services represented less
than 1% of the Company's revenues in each of 1996, 1995 and 1994.

INTERNATIONAL NETWORK

  Since its inception in 1991, the Company has successfully implemented an
extensive international facilities-based network comprised 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 map below illustrates the Company's international network,
including cable projects that are currently in the planning stages. The
Company is able to 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. The Company regards its extensive international
network as a significant competitive advantage which would be expensive and
time-consuming for a new entrant to replicate.

                          [INTERNATIONAL NETWORK MAP]

                                       8
<PAGE>

 International Gateway and Domestic Switches

  The Company operates international gateway switches in Los Angeles, New York
and Dallas. The gateway switches were manufactured by Northern Telecom and
conform to international signalling and transmission standards provided for in
CCITT recommendations. Traffic to Asia and the Pacific Rim is generally routed
via the Company's Los Angeles gateway, traffic to Europe and Latin America is
routed via the Company's New York gateway and traffic to Mexico will be routed
via the Company's Dallas gateway. In addition, the Company operates domestic
switches in Los Angeles, New York and Dallas to support origination and
termination of its customer traffic and to provide domestic and international
switched service to Matrix. The Company expects to implement an international
switch in the United Kingdom in the second quarter of 1997 to serve the United
Kingdom and Western European markets and, in the future, may implement other
international gateway and domestic switches in other strategic locations. The
Company expects to expand its originating network to the Pacific Rim, Asia and
Latin America through alliances or direct investments.

 Digital Undersea Fiber Optic Cable Systems

  The Company currently has investments in 14 digital undersea fiber optic
cable systems with an ownership interest in each of generally less than 1%.
Digital undersea fiber optic cables are typically owned and operated by
consortia of international service providers which jointly commit to fund the
construction and operating costs of the cables in proportion to their equity
positions in the cables. Typically, participation in a consortium is limited
to those carriers which 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 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.

  The Company seeks to have ownership positions in digital undersea fiber
optic 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 fiber optic
cable routes 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.

  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 utilizes leased satellite facilities for traffic to and from
countries where digital undersea fiber optic cables are not available or cost-
effective. Leased satellite facilities are also used for redundancy when
digital undersea cable service is temporarily interrupted. The Company is
currently 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 customer service and support, 24-hour network
monitoring, trouble reporting and response procedures, service implementation
coordination, billing assistance and problem resolution. The Company provides
a single point of contact for each customer and accepts end-to-end
responsibility for installation, maintenance and problem resolution.

  Pacific Gateway generally utilizes redundant, highly automated state-of-the-
art telecommunications equipment in its network and has diverse alternate
routes available in cases 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.

                                       9
<PAGE>

OPERATING AGREEMENTS

  As of December 31, 1996, the Company had 30 operating agreements with
foreign carriers in 24 countries as reflected in the table below.

<TABLE>
<CAPTION>
           NUMBER OF                                               CUMULATIVE % OF
              NEW               COUNTRY OR COUNTRIES OF            U.S.-ORIGINATED
      YEAR AGREEMENTS              FOREIGN CARRIER(S)                 MINUTES(1)
      ---- ----------           -----------------------            ---------------
      <C>  <C>        <S>                                          <C>
      1991     1      Guam                                               0.2%
      1992     2      Japan(2), Philippines                              5.7%
      1993     4      Australia, Canada, New Zealand, Russia            26.9%
      1994     5      Netherlands, Sweden, Switzerland                  29.3%
      1995     9      Chile, Dominican Republic, Japan, Spain,
                      United Kingdom(2), Venezuela                      40.3%
      1996     9      Germany, Israel, South Korea, Malaysia,
                      Hong Kong, Taiwan, Vietnam, Indonesia,
                      Thailand                                          53.3%
</TABLE>
--------
(1) Percentage of total U.S.-originated international minutes going to
    countries in which the Company has entered into operating agreements,
    excluding private lines, based on 1995 FCC statistics.
(2) Private line only in 1995. Expanded to full-service agreement in 1996.

  These agreements enable the Company to terminate traffic in a foreign
country directly to its foreign carrier's network and entitle the Company to
receive a proportionate amount of return traffic from the foreign partner.
Although the Company's 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.
Currently, Pacific Gateway is engaged in various stages of negotiation with
respect to operating agreements with several carriers in in a number of
countries in addition to those reflected in the table above.

CUSTOMERS

  As of December 31, 1996, the Company provided its services to approximately
75 U.S.-based long distance carriers, up from 44 carriers as of December 31,
1995 and 15 carriers as of December 31, 1994. The Company's customers include
U.S.-based carriers who have their own international networks. In the United
States, the Company has identified more than 200 long distance carriers as its
target customer base. The Company also regards the 30 foreign carriers with
which it has operating agreements as existing customers and as potential
customers for the Company's anticipated switch-based value-added services. In
1996 and 1995, only Matrix, with 12.6% and 22%, respectively, accounted for
more than 10% of the Company's revenues. In 1994, Matrix, Wiltel, Inc. (now
WorldCom) and Optus Communications Pty Limited accounted for 44%, 12% and 11%
of the Company's revenues, respectively.

  Matrix is a U.S.-based switchless long distance carrier which provides
domestic and international long distance services to its domestic retail
customers through Pacific Gateway and another United States facilities-based
international telecommunications carrier. It targets principally the small
business market, utilizing telemarketing services, direct mail and direct
sales. Pursuant to an agreement dated as of May 1, 1995, as amended, Matrix
agreed to send substantially all its international telecommunications traffic
and its domestic telecommunications traffic in the Northeast, California and
Hawaii through Pacific Gateway's network until November 1996 subject to
earlier termination if the Company did not match a bona fide competitive
pricing offer Matrix may have received from a third party. The term of the
agreement automatically extends on a month-to-month basis. Either party may
terminate the agreement by giving the other 30 days' notice of termination.
The Company expects that the relative portion of its revenues derived through
its relationship with Matrix will continue to decline if the Company continues
to be successful in obtaining additional U.S. and foreign customers and
increasing traffic from its existing customers. In the fourth quarter of 1996,
Matrix accounted for 9.7% of the Company's revenues.

                                      10
<PAGE>

SALES AND MARKETING

  The Company believes that the principal reasons its customers select Pacific
Gateway 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, (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 service and (iii) the fact that Pacific Gateway
is the only significant U.S. facilities-based international carrier that
generally does not compete for end-user customers in the domestic long
distance market.

 Wholesale Carrier Services

  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
AT&T or any other carrier's rates, and believes that its ability to obtain
traffic from its customers is not dependent upon its pricing alone.

  Pacific Gateway has nine sales professionals dedicated to marketing and
maintaining the Company's 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.

 Commercial Services

  Pacific Gateway is developing a commercial program targeted at selected
businesses with substantial international calling volume located in geographic
proximity to the Company's international gateway switches in New York, Los
Angeles and Dallas. The primary service offerings will be switched services,
as well as international private line services. The Company believes it can
reach this customer base at low marginal cost through a focused sales force.
To develop this aspect of its business more rapidly, the Company may seek to
acquire a marketing organization with an existing corporate customer base
located within geographic proximity to the Company's switching facilities. The
Company is not currently negotiating any such acquisition.

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. To date, the Company has not experienced any system
problem which has led to significant delays in billing customers or in
disputes with its customers over billing.

  The Company maintains its own staff of programming and management
information reporting personnel, as well as contract programmers dedicated to
the maintenance of the Company's management information system. This system
includes reporting on revenues, cost of long distance services, margin
analysis, foreign settlement systems and network performance reporting. The
Company provides common data access for system users to support its customer
service, accounting and network monitoring functions.

  Matrix provided call processing, rating and bill rendering services to the
Company until May 1996 when these functions were taken over by the Company. It
is not anticipated that Matrix will provide any of these services in the
future. The Company has developed its own customized billing and management
information system software to meet the needs of its customers and vendors and
enhance the Company's ability to monitor its operations. The Company purchased
an IBM AS400 computer system in November 1995 and an IBM AS405 and an IBM
AS535 in February 1997. The Company believes these computer systems are more
than adequate to meet the needs of the Company, its customers and its vendors.

                                      11
<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 and Sprint. The Company also
competes with WorldCom and 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. Recent examples include
AT&T's alliance with Unisource, known as "Uniworld," MCI's merger with British
Telecom, and Sprint's alliance with Deutsche Telekom and France Telecom, known
as "Global One." 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, and digital wireless communication systems such as PCS.
The Company is unable to predict which of many possible future product 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.

  After the FCC reclassified AT&T as a non-dominant carrier in the domestic
interstate market, only certain domestic local exchange carriers continue to
be classified as dominant carriers. AT&T has also been classified as a non-
dominant carrier in the international market. As a consequence of its
classifications, AT&T has obtained relaxed pricing restrictions and relief
from other regulatory constraints, including reduced tariff notice
requirements, which should make it easier for AT&T to compete with alternative
carriers such as the Company in the interstate, domestic interexchange and
international markets. As a consequence of its non-dominant status, AT&T is
permitted to file tariffs for its international services on one day's notice
instead of 45 days, without economic or cost support data, and will no longer
be required to comply with price cap regulation for its residential IMTS. In
addition, AT&T is relieved from Section 214 licensing requirements imposed on
dominant carriers, such as obtaining FCC approval prior to terminating service
to a particular point. AT&T remains subject to the Section 214 requirements of
non-dominant U.S. international carriers, and the generally applicable common
carrier requirements, including to provide international services at
reasonable and nondiscriminatory rates, terms, and conditions. However, the
removal of dominant carrier regulation makes it easier for AT&T to compete
with the Company.

  The 1996 Telecommunications Act substantially revises the Communications Act
and is designed to promote additional competition in the intrastate,
interstate and international telecommunications markets by both U.S.-based and
foreign companies, including the Regional Bell Operating Companies ("RBOCs").
On an interim basis pending the outcome of the FCC interexchange proceeding,
the FCC has removed dominant carrier regulation for RBOC out-of-region,
interstate, domestic and international interexchange service when offered
through an affiliate. RBOCs, among other existing or potential competitors of
the Company, have significantly more resources than the Company. See "--
Government Regulation."

  In February of 1997, over 60 countries signed a global agreement on
telecommunications under the auspices of the World Trade Organization (the
"WTO"). The agreement, which must be ratified by the signatories before taking
effect on January 1, 1998, seeks to open markets to competition in
telecommunications services, improve

                                      12
<PAGE>

foreign investment opportunities in the telecommunications industry and to
adopt pro-competitive regulatory principles. Although the Company is unable to
predict the exact effects this new agreement will have, it believes the WTO
agreement will provide the Company with lower access cost and an expanded
market potential.

GOVERNMENT REGULATION

 Overview

  The Company's services 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.
There can be no assurance that foreign countries will not adopt or apply
regulatory requirements that could have a material adverse effect on the
Company.

 Federal Regulation

  General Requirements. The Company must comply with the requirements of
common carriage under the Communications Act, including the offering of
service on a non-discriminatory basis at just and reasonable rates, and
obtaining FCC approval prior to any assignment 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 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 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 has no affiliations that
would subject it 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 took a major step to reduce tariff requirements.
Exercising its forbearance authority granted by the Telecommunications Act,
the FCC ruled that non-dominant interexchange carriers are no longer required
to file tariffs for their domestic services. However, in January 1997 the US
Court of Appeals of the District of Columbia issued a stay that prevented this
ruling from taking effect. A decision is not likely before the last quarter of
1997. If the FCC's ruling is upheld, the Company's regulatory burden would be
reduced.

  International Services. With respect to international services, the Company
must obtain facilities-based Section 214 authorization to operate its channels
of communication via satellites and undersea fiber optic cables, although the
FCC recently reduced the filing requirements for facilities-based
authorizations. Section 214 resale authority is required to resell
international services. The Company has obtained all required authorizations
from the FCC to use its various transmission media for the provision of
international switched services and international private line services.


                                      13
<PAGE>

  While the FCC permits the resale of international switched services, the
resale of international private lines for the provision of services
interconnected to the public switched network, generally referred to as
"private line resale," is permitted only on those routes where the FCC has
found that equivalent resale opportunities are provided to U.S.-based carriers
(for example, on routes to Canada, the United Kingdom, New Zealand and
Sweden). The FCC is considering these and other international service issues
in the context of several policy rulemaking proceedings and in response to
specific petitions and applications filed by other international carriers. In
one recent proceeding, the FCC reduced regulatory requirements of
international telecommunications service providers such as the Company. In
addition to reducing the filing period for non-dominant carriers'
international tariffed rates from 14 days to one day, the FCC streamlined
other international service rules. In particular, the FCC now permits
resellers to resell services of any authorized facilities-based carrier except
U.S. facilities-based affiliates that are regulated as dominant carriers on
routes the reseller seeks to serve. The FCC's resolution of some of these
issues in other proceedings either may facilitate the Company's international
business (by, for example, streamlining the regulatory requirement to acquire
additional international facilities capacity), or adversely affect the
Company's international business (by, for example, permitting larger carriers
to take advantage of accounting rate discounts for high traffic volumes). The
Company is unable to predict how the FCC will resolve the pending
international policy issues or how such resolution will affect its
international business.

  The Company must also conduct its international business in compliance with
the FCC's international settlements policy ("ISP"). The ISP establishes the
permissible boundaries for U.S.-based carriers and their foreign
correspondents to 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 amount of payments (the "settlement rate") is determined by the
negotiated accounting rate specified in the operating agreement. Under the
ISP, unless prior approval is obtained, the settlement rate generally must be
one-half of the accounting rate. Carriers must obtain waivers of the FCC's
rules if they wish to use an accounting rate that differs from the prevailing
rate or vary the settlement rate from one-half of the accounting rate. As a
result of the FCC's pro-competition policies, the recent trend has been to
reduce accounting rates.

  As a U.S.-based international carrier, the Company is also subject to the
FCC's "uniform settlements policy" designed to eliminate foreign carriers'
incentives and opportunities to discriminate in their operating agreements
among different U.S.-based carriers through "whipsawing." Whipsawing refers to
the practice of a foreign carrier to vary the accounting and/or settlement
rate offered to different U.S.-based carriers for the benefit of the foreign
carrier, which could secure various incentives by favoring one U.S.-based
carrier over another. Under the uniform settlements policy, U.S.-based
carriers can only enter into operating agreements that contain the same
accounting rate offered to all U.S.-based carriers. Another feature of this
policy is the principle of proportionate return to assure that competing U.S.-
based carriers have roughly equitable opportunities to receive the return
traffic that reduces the marginal cost of providing international service.

  To promote competition in the international telecommunications market, the
FCC recently (November, 1996) issued a new international settlement order
which will likely provide international carriers more flexibility in
negotiating operating agreements. Under the FCC's new international settlement
order, U.S.-based carriers can apply for waivers to the FCC's uniform
settlement policy and the FCC's proportionate return policy. Such waivers if
granted, would allow carriers to negotiate more flexible operating agreements.
Before granting a waiver to its ISP, the FCC must find that the relevant
foreign country has a competitive telecommunications market. While only the
United Kingdom and Canadian markets currently appear to qualify as such, the
FCC may also consider waivers for arrangements with non-dominant carriers from
countries in the process of becoming competitive. International access costs
represent a significant component of the Company's total costs. Although the
Company is unable to predict exactly how this new FCC order will effect its
international business, the new ISP may reduce international access costs and
facilitate the Company's international business.

                                      14
<PAGE>

  Additionally, 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. The Company
has filed each of its operating agreements with the FCC. 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.

  Foreign Ownership. The Communications Act limits the ownership of an entity
holding a common carrier radio license by non-U.S. citizens, foreign
corporations and foreign governments. The Company does not currently hold any
radio licenses. Through its Foreign Market Entry Order of November 1995, the
FCC expanded foreign ownership limitation to certain investments in holders of
international Section 214 authorizations. An investment of 25% or more by a
foreign carrier with market power, such as the traditional foreign public
operating companies, would be approved by the FCC only if the foreign market
provides similar competitive economic opportunities to US companies or if
other US public interests would be served by the approval. Foreign investments
by foreign carriers without market power or investments significantly below
25% would not trigger the FCC's additional screening. The FCC has recently
begun to review its Foreign Market Entry Order after the United States and
other countries agreed in the context of the WTO in February 1997 to open
their telecommunications markets to foreign investments by 1998. The effect on
the Company of the FCC's foreign ownership rules cannot be determined.

  Federal Legislation. The recently-enacted Telecommunications Act, among
other things, is intended to establish competition with local exchange
carriers ("LECs") as a national policy by preempting state and local laws that
prohibit competition in the local exchange market and by the establishment of
certain requirements, including interconnection requirements, the offering of
local network elements on an unbundled basis and other LEC requirements with
respect to resale, number portability, dialing parity, access to rights-of-way
and mutual compensation. The Telecommunications Act authorizes the FCC to
provide regulatory flexibility for LECs and other telecommunications companies
for which regulation is no longer necessary, the Telecommunications Act also
provides specific guidelines under which RBOCs can provide in-region long
distance services. Upon enactment, RBOCs have been authorized to provide out-
of-region long distance services permitting them to compete with the Company
in the provision of domestic long distance services. As long as these services
are provided by affiliates of the RBOCs, and not directly by them, the FCC
does not apply dominant carrier regulation. The Telecommunications Act also
contains provisions that permit the FCC to forbear from applying certain
provisions of the Telecommunications Act and common carrier regulations to
non-dominant carriers. Such FCC action could reduce some of the Company's
regulatory requirements, such as filing specific rates for its domestic
interstate services. The forebearing of filing tariffs provided for by an FCC
ruling in late 1996 is still uncertain providing the outcome of a legal
challenge before the U.S. Court of Appeals in the District of Columbia. The
Telecommunications 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. Again, the FCC's rule--"interconnection
order"--implementing the Act has been challenged in court, with the outcome
uncertain and not expected before summer 1997. In addition, the
Telecommunications Act requires all telecommunications providers to 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.

  Certain provisions of the Telecommunications Act could materially affect the
growth and operation of the telecommunications industry and the services
provided by the Company. There are currently numerous rulemakings being
undertaken by the FCC which interpret and implement the Telecommunications
Act's provisions. Certain rules have been, and likely will continue to be,
judicially challenged. The Company is unable to predict the outcome of such
rulemakings or litigation or the substantive effect (financial or otherwise)
of the new legislation and the rulemakings on the Company.

  Effect of Foreign Laws of Certain Termination Arrangements. The Company has
entered into and expects to continue to enter into certain termination
arrangements with alternative foreign carriers that are not the dominant
carriers in their respective foreign countries. These arrangements involve the
termination of U.S. originated traffic over private leased lines into foreign
countries and may be viewed by foreign regulatory

                                      15
<PAGE>

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, 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 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 Section 214 License. In addition, the operations of alternative
carriers like the Company's partners, who compete with the PTT, may not be
permitted by foreign regulatory agencies. The alternative foreign carriers
with whom the Company enters into such arrangements, and perhaps the Company
itself, 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, 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 otherwise) or the discovery of the existence of such
arrangements by foreign PTTs) could have a material adverse effect on the
Company's business, operating results and financial condition.

RISK FACTORS

  An investment in the Common Stock of the Company involves a high degree of
risk. Prospective investors should consider carefully the following risk
factors, together with the other information contained in this Annual Report,
in evaluating the Company and its business before purchasing shares of Common
Stock. In particular, prospective investors should note that this Annual
Report contains 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, and actual results could differ materially
from those projected in the forward-looking statements as a result of numerous
factors, including changes in international settlement rates, changes in the
ratios between outgoing and incoming traffic, foreign currency fluctuations,
termination of certain operating agreements, and other factors set forth below
and elsewhere in this report.

DEPENDENCE ON OPERATING AGREEMENTS WITH FOREIGN PARTNERS

  Pacific Gateway's strategy is based on its ability to enter into operating
agreements with foreign carriers, which the Company refers to as foreign
partners, in each of the foreign countries it has targeted so it can terminate
traffic in, and receive return traffic from, that country. The Company
believes that it would not be able to serve its customers at competitive
prices without such operating agreements. 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, none of which has been terminated to date, 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. Moreover, there can be no assurance that the Company will be able to
enter into additional operating agreements in the future. The failure to enter
into additional operating agreements could limit the Company's ability to
increase its revenues on a profitable basis. See "Business--Industry
Background--Operating Agreements" and "Business--Operating Agreements."

MANAGING RAPID GROWTH

  The Company is experiencing a period of rapid growth 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

                                      16
<PAGE>

controls, to purchase and utilize more digital undersea fiber optic cable and
other transmission facilities 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. If the Company is not able to
manage its growth effectively or maintain the quality of its service, the
Company's business may be adversely affected.

RISKS OF INTERNATIONAL TELECOMMUNICATIONS BUSINESS

  The Company generates substantially all its revenues by providing
international wholesale telecommunications services to its customers. The
Company's operations are subject 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 and foreign currency fluctuations.
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. In addition, the Company's business could be adversely
affected by a reversal in the current trend toward deregulation of government-
owned telecommunications carriers. 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.

  The Company has entered into and expects to continue to enter into certain
termination arrangements with alternative foreign carriers that are not the
dominant carriers in their respective foreign countries. These arrangements
involve the termination of U.S. originated traffic over private leased lines
into foreign countries and 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 Section 214 License. In
addition, the operations of alternative carriers like the Company's partners,
who compete with the PTT, may not be permitted by foreign regulatory agencies.
The alternative foreign carriers with whom the Company enters into such
arrangements, and perhaps the Company itself, 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, 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 otherwise) or the
discovery of the existence of such arrangements by foreign PTTs) could have a
material adverse effect on the Company's business, operating results and
financial condition.

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.
The Company does not control the planning or construction of digital undersea
fiber optic transmission facilities and must seek 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

                                       17
<PAGE>

market conditions. The Company currently has partial ownership interests in 14
digital undersea fiber optic cable systems. In addition, unlike AT&T, MCI,
Sprint and WorldCom, the Company does not have direct access from its gateway
switches to the digital undersea fiber optic cable heads, and is required to
lease these facilities from these competitors of the Company. The cost of
leasing access from the gateway switches to the digital undersea fiber optic
cable heads is currently approximately 0.3% of the Company's revenue. There
can be no assurance of continued availability of transmission facilities or
access to digital undersea fiber optic cable heads on economically viable
terms. See "Business--International Network."

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 and Sprint. The Company also
competes with WorldCom and 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 among
the largest telecommunications carriers. 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. Such technologies include satellite-based systems,
such as the proposed Iridium and GlobalStar systems, utilization of the
Internet for international voice and data communications and digital wireless
communication systems such as personal communications services ("PCS"). The
Company is unable to predict which of many possible future product 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. There can be no assurance that the Company will be able to maintain
its competitive position in the future.

  As a consequence of its classification, as a non-dominant carrier in the
domestic interstate and international markets, AT&T has obtained relaxed
pricing restrictions and relief from other regulatory constraints, including
reduced tariff notice requirements, which should make it easier for AT&T to
compete with alternative carriers such as the Company in the interstate,
domestic interexchange market as well as the international market. AT&T's
reclassification as a non-dominant carrier for international services could
have an adverse effect on the Company because certain regulations, such as the
price cap regulation and extended tariff notice periods, applicable to AT&T as
a dominant carrier no longer apply. These reduced regulatory requirements
could make it easier for AT&T to compete with the Company.

  The recently enacted Telecommunications Act permits and is designed to
promote additional competition in the intrastate, interstate and international
telecommunications markets by both U.S.-based and foreign companies, including
the RBOCs. RBOCs have begun to enter the international telecommunications
market via resale to customers residing out of the RBOCs' region. Among other
existing or potential competitors of the Company, the RBOCs, have
significantly more resources than the Company. See "Business--Competition" and
"Business--Government Regulation."

DEPENDENCE ON KEY PERSONNEL

  The Company is dependent on the efforts of Howard A. Neckowitz, Chairman of
the Board, President and Chief Executive Officer; Gail E. Granton, Executive
Vice President, International Business Development and

                                      18
<PAGE>

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 and Sandra D.
Grey, Chief Financial Officer, 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 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. See "Executive Officers and Key Members of Management."

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. While the Company believes that its
existing and anticipated sources of liquidity, should be sufficient to fund
its capital requirements for the foreseeable future, certain events may occur
that would require the Company to obtain additional financing. Such events
could include 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.

GOVERNMENT REGULATION

  The Company's business is subject to various federal laws, regulations,
regulatory actions and court decisions which may have negative effects on the
Company. 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 may
also be subject to regulation in foreign countries in connection with certain
of its business activities. For example, 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. There can be no
assurance that future regulatory, judicial and legislative changes will not
have a material adverse effect on the Company or that regulators or third
parties will not raise material, including taking enforcement actions, issues
with regard to the Company's compliance with applicable regulations.

  The FCC recently further streamlined its regulation of non-dominant
international carriers to provide that their 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. The Company has also filed a domestic tariff with
the FCC. With respect to international services, the Company has obtained
facilities-based Section 214 authorizations to operate its channels of
communication via satellites and undersea fiber optic cables. The FCC recently
reduced the filing requirements for facilities-based authorizations. Section
214 resale authority is also required to resell international services. The
Company has obtained all required authorizations from the FCC to use its
various transmission media for the provision of international switched
services and international private line services. In addition, the FCC is
presently considering certain international policy issues in other rulemaking
proceedings either upon the Commission's own initiative or in response to
specific applications and petitions filed by other telecommunications
carriers. The resolution of these proceedings could have an adverse effect on
the Company's business.

  The Company is also required to conduct its international business in
compliance with the FCC's international settlements policy ("ISP"). The ISP
establishes the permissible boundaries for U.S.-based carriers and their
foreign counterparts to settle the cost of terminating each other's traffic
over their respective networks. At the end of 1996 the FCC initiated a
rulemaking proceeding directed at reducing the settlement rates U.S.

                                      19
<PAGE>

carriers pay foreign carriers for terminating U.S. calls overseas. While the
outcome of this rulemaking may have beneficial effects on the Company, there
can be no assurance that it will not have a material adverse effect on the
Company's business in the end.

  The FCC also issued a new international settlement order, under it U.S.-
based carriers can apply for waivers to the FCC's uniform settlement policy
and the FCC's proportionate return policy. Such waivers if granted, would
allow carriers to negotiate more flexible operating agreements. Before
granting a waiver to its ISP, the FCC must find that the relevant foreign
country has a competitive telecommunications market. While only the United
Kingdom and Canadian markets currently appear to qualify as such, the FCC may
also consider waivers for arrangements with non-dominate carriers from
countries in the process of becoming competitive. The Company is unable to
predict how the FCC's new international settlement order will affect the
Company's business.

FOREIGN OWNERSHIP

  The Communications Act limits the ownership of an entity holding a common
carrier radio license by non-U.S. citizens, foreign corporations and foreign
governments. The Company does not currently hold any radio licenses. Through
its Foreign Market Entry Order of November 1995, the FCC expanded foreign
ownership limitation to certain investments in holders of international
Section 214 authorizations. An investment of 25% or more by a foreign carrier
with market power, such as the traditional foreign public operating companies,
would be approved by the FCC only if the foreign market provides similar
competitive economic opportunities to US companies or if other US public
interests would be served by the approval. Foreign investments by foreign
carriers without market power or investments significantly below 25% would not
trigger the FCC's additional screening. The FCC has recently begun to review
its Foreign Market Entry Order after the United States and other countries
agreed in the context of the WTO in February 1997 to open their
telecommunications markets to foreign investments by 1998. The effect on the
Company of the FCC's foreign ownership rules cannot be determined.

FEDERAL LEGISLATION

  The 1996 Telecommunications Act substantially revises the Communications
Act. 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 legislation also provides specific guidelines
under which the RBOCs can provide in-region long distance services. Under the
Telecommunications Act, RBOCs are authorized to provide out-of-region
services, which permit the RBOCs and other carriers to provide domestic and
international long distance services. The FCC has proposed rules to govern the
entry of RBOCs into the out-of-region interstate, interexchange market. Among
other things, the FCC has proposed to allow affiliates of RBOCs that provide
out-of-region interstate, interexchange service to be regulated as non-
dominant carriers, under certain circumstances. The Company's business could
be adversely affected by competition from the RBOCs, which typically have
greater resources than the Company, and from other carriers that have expanded
opportunities to provide domestic and international services.

  The Telecommunications 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. The FCC Interconnection Order, which
implements the statutory provisions, has not taken effect pending a court
challenge brought by certain RBOCs. In addition, the Telecommunications Act
requires all telecommunications providers to 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. There can be no
assurance that the Company would be exempt from contributing to a Universal
Service Fund.


                                      20
<PAGE>

  Certain provisions of the Telecommunications 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
Telecommunications Act's provisions. Further, certain of the
Telecommunications Act's provisions have been, and likely will continue to be,
judicially challenged. The Company is unable to predict the outcome of such
rulemakings or litigation or the substantive effect (financial or otherwise)
of the new legislation and the rulemakings on the Company.

  In February of 1997, over 60 countries signed a global agreement on
telecommunications under the auspices of the World Trade Organization (the
"WTO"). The agreement, which still needs ratification by the signatories
before entering into effect on January 1, 1998, seeks to open markets to
competition in telecommunications services, improve foreign investment
opportunities in the telecommunications industry and to adopt pro-competitive
regulatory principles. The Company is unable to predict the effect this
agreement will have on the Company.

  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
an adverse effect on the Company's business.

RELATIONSHIP WITH MATRIX

  Revenues from Matrix accounted for approximately 12.6%, 22% and 44% of the
Company's revenues in 1996, 1995 and 1994, respectively. The Company expects
revenues from Matrix to continue to decline as a percentage of total revenue
although there is no assurance that this trend will continue. Matrix is
currently one of Pacific Gateway's largest customers, accounting for
approximately 9.7% of the Company's revenues for the fourth quarter of 1996.
The loss of Matrix as a customer could have an immediate and material adverse
effect on the Company's business. The largest shareholders of Matrix--Mr.
Jensen, members of his family, Mr. Neckowitz and Ms. Granton--are also the
majority shareholders of Pacific Gateway. Due to their ownership interests in
Matrix and the close connection between the business of the Company and the
operations of Matrix, the interests of Mr. Jensen, Mr. Neckowitz and Ms.
Granton may conflict with the Company's interest in certain circumstances.
Pursuant to an agreement dated May 1, 1995, as amended, Matrix agreed to send
substantially all its international telecommunications traffic and its
domestic telecommunications traffic in the Northeast and California through
the Company's network until November 1996, subject to earlier termination if
the Company did not match a bona fide competitive pricing offer Matrix may
have received from a third party. The term of the agreement automatically
extends on a month-to-month basis. Either party may terminate the agreement by
giving the other 30 days' notice of termination. There can be no assurance
whether or on what terms such agreement will be continued. See "Business--
Customers."

CONCENTRATION OF CREDIT RISK

  Seven of the Company's customers accounted for approximately 52% and 55% of
gross accounts receivable as of December 31, 1996 and December 31, 1995,
respectively. 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 expectation.

ANTI-TAKEOVER PROVISIONS

  The Company's Board of Directors has the authority to issue up to 1,000,000
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 number of authorized shares of Preferred
Stock will be increased to 5,000,000, and the number of authorized shares of
Common Stock will be increased from 25,000,000 to 50,000,000, if the Company's
stockholders approve the proposed amendment to the Company's Certificate of
Incorporation at the 1997 annual meeting. The rights of the holders of Common
Stock will be subject to, and

                                      21
<PAGE>

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 has no present intention to issue shares of
Preferred Stock. In addition, the Company is subject to the anti-takeover
provisions of Section 203 of the Delaware General Corporation Law, which will
prohibit 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 also 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 the
vacancies on the Board of Directors may be filled by a majority vote of the
directors then in office, though less than a quorum, may have the effect of
delaying or preventing changes in control or management of the Company, which
could adversely affect the market price of the Company's Common Stock. See
"Executive Officers and Members of Management".

CONTROL OF COMPANY BY PRE-INITIAL PUBLIC OFFERING SHAREHOLDERS

  Stockholders of the Company who owned shares of Common Stock prior to the
Company's initial public offering ("Original Stockholders") in the aggregate
own and control approximately 67% of the outstanding shares of Common Stock.
As a result of their ownership of shares of Common Stock, these stockholders
of the Company, acting together, have the power to control the management and
policies of the Company. Mr. Neckowitz has proxies to vote a total of
8,245,820 shares of Common Stock held by members of the Jensen family and a
proxy to vote a total of 1,020,414 shares held by Ms. Granton. These proxies,
combined with the shares owned by Mr. Neckowitz, give him the right to vote
approximately 60% of the outstanding shares of Common Stock of the Company.

SHARES ELIGIBLE FOR FUTURE SALE

  Future sales of Common Stock in the public market by the Original
Stockholders of the Company could adversely affect the market price for the
Common Stock. As of March 27, 1997 there were 18,896,490 shares of Common
Stock outstanding that could be sold in the public market, subject to
limitations contained in Rule 144 under the Securities Act of 1933, as
amended. The volume limitations of Rule 144 will apply to the sale of these
shares as long as the shares are held by affiliates of the Company. Sales of
substantial amounts of shares of Common Stock in the public market, or even
the potential for such sales, could adversely affect the prevailing market
price of the Common Stock and impair the Company's ability to raise capital
through the sale of equity securities.

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.

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, if any, to develop and expand its business.

                                      22
<PAGE>

EMPLOYEES

  As of December 31, 1996, Pacific Gateway had 49 full-time employees, of
which 6 were engaged in international relations, 22 in operations,
engineering, and information systems, 12 in sales, customer support and
business development and 9 in administration.

ITEM 2. PROPERTIES

  The principal offices of the Company are located in 8444 square feet of
space in Burlingame, California. The Company leases this space under an
agreement which expires in April 1999. The Company also leases a total of
approximately 19,600 square feet in New York, Los Angeles and Dallas as sites
for its switching facilities. In addition, the Company leases approximately
3,000 square feet of office space in Houston, 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, at 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, 1996.

               EXECUTIVE OFFICERS AND KEY MEMBERS OF MANAGEMENT

  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.............  43 President and Chief Executive Officer
      Gail E. Granton.................  41 Executive Vice President,
                                            International Business
                                            Development and Secretary
      Sandra D. Grey..................  30 Chief Financial Officer
      Ronald D. Anderson..............  40 Senior Vice President,
                                            Operations and Engineering
      Robert F. Craver................  54 Senior Vice President,
                                            International Relations
      Fred A. Weismiller..............  55 Executive Vice President,
                                            International Marketing

  Other key members of management of the Company are as follows:

<CAPTION>
      NAME                             AGE POSITION
      ----                             --- --------
      <S>                              <C> <C>
      Katherine A. Chapman............  30 Director, Customer Programs
      William R. Haner................  43 Vice President, International Sales
      Joyce R. Hewins.................  33 Vice President, Carrier Marketing
</TABLE>


                                      23
<PAGE>

  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.

  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 7 years experience in international telecommunications.

  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 15 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.

  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 20 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 25 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.

  MS. KATHERINE A. CHAPMAN has served as Director, Customer Programs for the
Company since April 1995. From 1989 to April 1995, Ms. Chapman served in
various positions with Cable & Wireless of North America. While at Cable &
Wireless, Ms. Chapman had various responsibilities including sales, marketing,
and customer support for commercial customers, managing and maintaining a
wholesale customer base, and developing the marketing strategy for dedicated
access customers. Ms. Chapman has over seven years of experience in the
telecommunications industry.

                                      24
<PAGE>

  MR. WILLIAM R. HANER has served as Vice President, International Sales, of
the Company since January 1995. From 1993 to 1994, Mr. Haner served in a
similar position with IDB Communications Group, Inc., an international
telecommunications company which has since been acquired by WorldCom. From
1985 to 1993, Mr. Haner was a Director of Sales for TRT International, Inc.,
where he was responsible for international data services and implementing
enhanced facsimile services. Mr. Haner has more than 14 years of sales
experience with long distance carriers and commercial customers.

  MS. JOYCE R. HEWINS joined the Company in December 1993 as Vice President,
Carrier Marketing, to develop a U.S. carrier marketing program for the
Company. Prior to joining the Company, Ms. Hewins was Director, Carrier
Services, at West Coast Communications, where she was responsible for carrier
marketing from 1992 to 1993. Ms. Hewins was also Director, Carrier Services at
Com System, Inc., a domestic long distance telecommunications company, where
she was responsible for developing the carrier marketing program from 1984 to
1992. Ms. Hewins has more than 11 years of experience in the
telecommunications industry.

                                    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
sale 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 September 30, 1996 (from July 19, 1996).... $ 31.00 $ 12.00
      Quarter ended December 31, 1996.......................... $37.125 $25.875
</TABLE>

  As of March 27, 1997, there were 109 holders of record of the Common Shares.

                                      25
<PAGE>

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, 1996 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,
                                     -----------------------------------------
                                       1996     1995     1994    1993    1992
                                     --------  -------  ------- ------  ------
                                       (IN THOUSANDS EXCEPT PER SHARE AND
                                      REVENUES PER MINUTE OF USE AMOUNTS)
<S>                                  <C>       <C>      <C>     <C>     <C>
STATEMENT OF OPERATIONS DATA:
  Revenues.......................... $162,426  $76,416  $20,913 $5,048  $  800
  Cost of long distance services....  140,340   66,346   17,196  4,036     587
                                     --------  -------  ------- ------  ------
    Gross margin....................   22,086   10,070    3,717  1,012     213
  Selling, general and
   administrative expenses..........   11,113    5,467    2,273  1,008     531
  Depreciation......................    2,044    1,124      410    104      17
                                     --------  -------  ------- ------  ------
    Operating income (loss).........    8,929    3,479    1,034   (100)   (335)
  Interest expense/(income), net....     (885)     538      193     12     --
  Other expenses....................      129      --       --     --      --
                                     --------  -------  ------- ------  ------
    Income (loss) before income
     taxes..........................    9,685    2,941      841   (112)   (335)
  Provision for income taxes........    3,877    1,155      205    --      --
                                     --------  -------  ------- ------  ------
    Net income (loss)............... $  5,808  $ 1,786  $   636 $ (112) $ (335)
                                     ========  =======  ======= ======  ======
  Net income (loss) per share--
   primary.......................... $   0.35  $  0.12  $  0.04 $(0.01) $(0.03)
                                     ========  =======  ======= ======  ======
  Weighted average shares
   outstanding......................   16,737   14,300   14,300 14,300  11,128
OTHER OPERATING DATA:
  EBITDA (1)........................ $ 10,973  $ 4,603  $ 1,444 $    4  $ (318)
  Capital Expenditures.............. $ 18,669  $ 7,233  $ 3,745 $1,542  $   66
  Minutes of use....................  563,495  252,925   61,690 13,580     N/A
  Revenues per minute use........... $   0.29  $  0.30  $  0.34 $ 0.37     N/A
  Estimated return traffic revenue
   backlog (2)...................... $ 13,719  $ 6,142  $   986 $  158     --
<CAPTION>
                                               AS OF DECEMBER 31,
                                     -----------------------------------------
                                       1996     1995     1994    1993    1992
                                     --------  -------  ------- ------  ------
<S>                                  <C>       <C>      <C>     <C>     <C>
BALANCE SHEET DATA
  Cash and cash equivalents......... $ 45,563  $ 1,792  $     9 $   63  $  129
  Working capital (deficit).........   35,051   (6,412)     242   (865)     37
  Total assets......................  103,816   29,756   12,301  4,130   1,007
  Revolving line of credit..........      --     3,000      --     --      --
  Revolving line of credit, related
   party............................      --     2,420    4,488    718     --
  Stockholders' equity..............   62,472    2,891    1,104    468     580
</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.
(2) Represents management's estimates of the revenue to be received from
    delayed proportional return traffic that are based on the anticipated
    ratios between outgoing and incoming traffic and the anticipated
    settlement rates. See "Management's Discussion and Analysis of Financial
    Condition and Results of Operations--Overview."


                                      26
<PAGE>

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

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 Los Angeles, New York and Dallas, partial
ownership interests in 14 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. As of
December 31, 1996, the Company had operating agreements with 30 foreign
carriers in 24 countries around the world, which provide for the exchange of
telecommunications traffic with these carriers. The Company's revenues are
derived primarily from the sale of international telecommunications services
to U.S.-based carriers on a wholesale basis and from the traffic received by
the Company under operating agreements with its foreign partners.
Substantially all the Company's remaining revenues are derived from the sale
of domestic switched services to Matrix. As of December 31, 1996, the Company
provided its services to approximately 75 U.S.-based long distance carriers.

  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 to countries where the
Company does not have operating agreements, payments to domestic carriers for
the termination of overseas-originated traffic in the United States where the
Company does not have its own domestic network and payments to local exchange
companies for access charges for originating and terminating international and
domestic traffic where the Company has its own domestic network. The Company
generally enters new markets by establishing operating agreements with foreign
partners and by investing in or leasing digital undersea fiber optic cable in
order to cost-effectively carry and terminate traffic. The Company seeks to
have partial 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 its operating agreements, the Company typically 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 partner as an expense in the period the
Company's traffic is delivered.

  Of the Company's operating agreements currently in service, eleven provide
that the Company generally must wait up to six months before it actually
receives the proportional return traffic. The delay period between the
Company's delivery of U.S.-originated traffic and the receipt of the
proportional return traffic enables the carriers to determine the appropriate
traffic exchange ratio based on the Company's relative market share on a
particular route. As a result, the Company delivers outbound traffic and
generally recognizes a loss in the period in which it sells to its customers
because amounts due to foreign partners generally exceed revenues from
customers on outbound traffic. The Company then recognizes revenues with
minimal associated cost on the associated return traffic on a six month
delayed basis. The rates that the Company charges its customers are
established at a level such that the Company expects to recognize a gross
profit on the combined transactions.

  The Company's selling, general and administrative expenses consist primarily
of personnel costs and selling commissions related to its U.S. wholesale
business. The Company has developed its own customized billing and management
information system. See "Business--Billing and Management Information
Systems."

                                      27
<PAGE>

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

<TABLE>
<CAPTION>
                                                           YEAR ENDED DECEMBER
                                                                   31,
                                                           ---------------------
                                                            1996    1995   1994
                                                           ------  ------ ------
      <S>                                                  <C>     <C>    <C>
      Revenues............................................ 100.0%  100.0% 100.0%
      Cost of long distance services......................  86.4%   86.8%  82.2%
                                                           ------  ------ ------
          Gross margin....................................  13.6%   13.2%  17.8%
      Selling, general and administrative expenses........   6.8%    7.2%  10.9%
      Depreciation........................................   1.3%    1.5%   2.0%
                                                           ------  ------ ------
          Total operating expenses........................   8.1%    8.7%  12.9%
                                                           ------  ------ ------
          Operating income................................   5.5%    4.5%   4.9%
      Interest expense/(income), net......................  (0.5%)   0.7%   0.9%
      Other expenses......................................   0.0%    0.0%   0.0%
                                                           ------  ------ ------
        Income before income taxes........................   6.0%    3.8%   4.0%
      Provision for income taxes..........................   2.4%    1.5%   1.0%
                                                           ------  ------ ------
          Net income......................................   3.6%    2.3%   3.0%
                                                           ======  ====== ======
</TABLE>

 Year Ended December 31, 1996 Compared to Year Ended December 31, 1995

  Revenues: Total revenues in 1996 increased 113% to $162.4 million from $76.4
million in 1995. The increase was primarily the result of both increased sales
to existing customers, due to an increase in the number of operating
agreements to 30 at December 31, 1996 from 21 at December 31, 1995 and a 70%
increase in the number of wholesale carrier customers to 75 at December 31,
1996 from 44 at December 31, 1995. As a result, total minutes have increased
123% from last year while the average price per minute charged to customers
has slightly declined to 29 cents compared to 30 cents last year. 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. During the year (as in all previous years) Pacific Gateway
sent more minutes out than it received under its operating agreements. Because
the same rate is charged by the foreign carrier to terminate calls in their
country as Pacific Gateway charges to terminate calls in the United States,
declining rates have an adverse effect on revenue and estimated return traffic
revenue backlog, but, as a result of sending more calls out than the Company
receives, declining rates improve the gross margin received on the entire
transaction of a minute delivered with such foreign carriers. The revenue from
Matrix increased to $20.5 million, or 12.6% of revenue, in 1996 from $17.2
million, or 22.5% of revenue, in 1995. The Company expects Matrix to continue
to decline as a percentage of total revenue with the fourth quarter of 1996
being 9.7%.

  Gross Margin: Gross margin increased 119.3% to $22.1 million in 1996 from
$10.1 million in 1995. As a percentage of revenue, gross margin increased from
13.2% in the prior year to 13.6% in the current year. This increase resulted
from savings derived from a reduction in the transit or resale rates on the
routes in which the Company does not have a direct operating agreement, a
reduction in the foreign access charges on the routes in which the Company has
a direct operating agreement and a reduction in the domestic termination rates
in the United States. These savings were offset by the effects of an increase
in the estimated return traffic revenue backlog which adversely effects the
current gross margin. The cost of long distance service increased to $140.3
million for the year ended December 31, 1996 from $66.3 million at December
31, 1995. This increase in costs represents growth in outbound traffic on new
and existing routes in advance of receiving proportional return traffic,
resulting in an increase in the estimated delayed proportional return traffic
backlog amount at December 31, 1996.

  Selling, General and Administrative Expenses: As a percentage of revenues,
selling, general and administrative expenses decreased from 7.2% in the prior
year to 6.8% in the current year and the actual expenses

                                      28
<PAGE>

increased 103.3% to $11.1 million from $5.5 million. This increase was due
primarily to increased personnel and sales commission expenses. The increase
in personnel expenses was directly related to the increase in employees to 49
at December 31, 1996 from 28 at December 31, 1995. The increase in sales
commission expenses was primarily due to increased revenues.

  Depreciation: Depreciation increased 82% to $2.0 million in 1996 from $1.1
million in 1995. As a percentage of revenues, depreciation was 1.3% of revenue
for the year ended December 31, 1996, and 1.5% in 1995. The increase in the
dollar amount was primarily due to depreciation of additional transmission
facilities acquired during 1996.

  Interest: The Company had interest revenue of $885 thousand in 1996 compared
to interest expense of $538 thousand in 1995. This was due to the successful
completion of the initial public offering in July 1996 resulting in the
Company having $45.6 million in cash or cash equivalents and no line of credit
outstanding at December 31, 1996 compared to $1.8 million of cash and $5.5
million owing under the lines of credit available to the Company at December
31, 1995.

  Income Tax: Income taxes increased to $3.9 million from $1.2 million,
primarily due to increased operating income. The effective tax rate was 40% in
1996 and 39.3% in 1995.

 Year Ended December 31, 1995 Compared to Year Ended December 31, 1994

  Revenues: Total revenues in 1995 increased 266% to $76.4 million from $20.9
million in 1994. The increase was primarily the result of both increased sales
to existing customers, due to an increase in the number of operating
agreements to 21 at December 31, 1995 from 12 at December 31, 1994, and a 193%
increase in the number of wholesale carrier customers to 44 at December 31,
1995 from 15 at December 31, 1994. In addition to an increase in the revenue
from Matrix to $17.2 million in 1995 from $9.2 million in 1994, the Company
also received more return traffic from its foreign partners during 1995 with
return traffic revenue increasing to $4.5 million in 1995 from $412 thousand
in 1994.

  Gross Margin: Gross margin increased 173% to $10.1 million from $3.7 million
primarily due to increased revenues. As a percentage of revenues, gross margin
decreased from 17.8% in 1994 to 13.2% in 1995. This decrease was primarily the
result of increased traffic on direct routes where the Company must generally
wait up to six months for the return traffic. The amount of costs associated
with operating agreements that provide for delayed proportional return traffic
during the year increased to $17.7 million in 1995 from $1.2 million in 1994.
This increase in costs represents growth in outbound traffic on new and
existing routes in advance of proportional return traffic, and is expected to
result in increased delayed proportional return traffic in the following six
months.

  Selling, General and Administrative Expenses: Selling general and
administrative expenses increased 139% to $5.5 million from $2.3 million. This
increase was due primarily to increased personnel and sales commission
expenses. The increase in personnel expenses was directly related to the
increase in employees to 28 as of December 31, 1995 from 15 as of December 31,
1994. The increase in sales commission expenses was primarily due to increased
revenues. Matrix provided certain data processing services to the Company for
which the Company incurred expenses of $166 thousand and $35 thousand in 1995
and 1994, respectively. As a percentage of revenues, selling, general and
administrative expenses decreased from 10.9% in the prior period to 7.2% in
the current period.

  Depreciation: Depreciation increased 168% to $1.1 million from $410
thousand. As a percentage of revenues, depreciation decreased to 1.5% in the
current period from 2.0% in the prior period. The increase in dollar amount
was primarily due to depreciation of additional transmission facilities
acquired in 1995.

  Interest Expense: Interest Expense increased 179% to $538 thousand from $193
thousand. This increase was a result of increased borrowings under the
Company's revolving credit facility with a principal stockholder of the
Company, which borrowings were used to finance the acquisition of long
distance communications equipment and ownership interests in digital undersea
fiber optic cables.

                                      29
<PAGE>

  Income Taxes: Income taxes increased to $1.2 million from $205 thousand
primarily due to increased operating income and a change in the effective tax
rate. The effective tax rate was 39.3% in 1995 and 24.4% in 1994. The lower
rate reflects utilization of certain net operating loss carryforwards.

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,
                            1996      1996      1996     1996      1995     1995      1995     1995
                          --------  --------- -------- --------- -------- --------- -------- ---------
                                            (IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
<S>                       <C>       <C>       <C>      <C>       <C>      <C>       <C>      <C>
Revenues................  $49,204    $44,249  $36,733   $32,240  $25,339   $21,392  $17,560   $12,125
                          -------    -------  -------   -------  -------   -------  -------   -------
Cost of long distance
 services...............   41,113     37,449   32,649    29,130   22,247    18,904   15,154    10,041
                          -------    -------  -------   -------  -------   -------  -------   -------
 Gross margin...........    8,091      6,800    4,084     3,110    3,092     2,488    2,406     2,084
Selling, general and
 administrative
 expenses...............    3,854      3,054    2,250     1,956    1,643     1,536    1,295       993
Depreciation............      634        547      478       385      414       300      221       189
                          -------    -------  -------   -------  -------   -------  -------   -------
 Operating income.......    3,603      3,199    1,356       769    1,035       652      890       902
Interest
 expense/(income), net .     (643)      (488)      94       152      157       153      117       111
Other expenses..........       56         73      --        --       --        --       --        --
                          -------    -------  -------   -------  -------   -------  -------   -------
   Income before income
    taxes...............    4,190      3,614    1,262       617      878       499      773       791
Provision for income
 taxes..................    1,680      1,446      500       250      345       196      303       311
                          -------    -------  -------   -------  -------   -------  -------   -------
   Net income...........  $ 2,510    $ 2,168  $   762   $   367  $   533   $   303  $   470   $   480
                          =======    =======  =======   =======  =======   =======  =======   =======
   Net income per
    share--primary......  $  0.13    $  0.12  $  0.05   $  0.03  $  0.04   $  0.02  $  0.03   $  0.03
                          =======    =======  =======   =======  =======   =======  =======   =======
Other Operating Data:
 Revenues from delayed
  return traffic(1).....  $ 5,683    $ 4,535  $ 3,100   $ 3,042  $ 2,216   $ 1,260  $   792   $   194
                          =======    =======  =======   =======  =======   =======  =======   =======
Estimated return traffic
 revenue backlog(2).....  $13,719    $11,812  $10,946   $ 8,400  $ 6,142   $ 5,258  $ 3,476   $ 2,052
                          =======    =======  =======   =======  =======   =======  =======   =======
</TABLE>


<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,
                           1996     1996      1996     1996      1995     1995      1995     1995
                         -------- --------- -------- --------- -------- --------- -------- ---------
<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...............   83.6      84.6     88.9      90.3     87.8      88.4     86.3      82.8
                          -----     -----    -----     -----    -----     -----    -----     -----
 Gross margin...........   16.4      15.4     11.1       9.7     12.2      11.6     13.7      17.2
Selling, general and
 administrative
 expenses...............    7.8       6.9      6.1       6.1      6.5       7.2      7.4       8.2
Depreciation............    1.3       1.2      1.3       1.2      1.6       1.4      1.3       1.6
                          -----     -----    -----     -----    -----     -----    -----     -----
 Operating income.......    7.3       7.2      3.7       2.4      4.1       3.0      5.0       7.4
Interest
 expense/(income), net..   (1.3)     (1.1)     0.3       0.5      0.6       0.7      0.7       0.9
Other expenses..........    0.1       0.2      --        --       --        --       --        --
                          -----     -----    -----     -----    -----     -----    -----     -----
   Income before income
    taxes...............    8.5       8.2      3.4       1.9      3.5       2.3      4.3       6.5
Provision for income
 taxes..................    3.4       3.3      1.4       0.9      1.4       0.9      1.7       2.6
                          -----     -----    -----     -----    -----     -----    -----     -----
   Net income...........    5.1%      4.9%     2.1%      1.1%     2.1%      1.4%     2.6%      3.9%
                          =====     =====    =====     =====    =====     =====    =====     =====
</TABLE>
--------
(1) Represents revenue from proportional return traffic under certain of the
    Company's operating agreements which require the Company to wait up to six
    months to receive the return traffic. The substantial majority of the
    direct costs associated with such revenue is recognized up to six months
    in advance of the receipt of the revenue.
(2) Represents management's estimates of the revenue to be received from
    delayed proportional return traffic that are based on the anticipated
    ratios between outgoing and incoming traffic and the anticipated
    settlement rates. See "Management's Discussion and Analysis of Financial
    Condition and Results of Operations--Overview."

                                      30
<PAGE>

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 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 $13.9 million for the year
ended December 31, 1996, $7.4 million for the year ended December 31, 1995 and
($78 thousand) for the year ended December 31, 1994. The increases in 1996 and
1995 were primarily a result of an increase in net income and accounts payable
which exceeded the increases in accounts receivable. The decrease in 1994 was
primarily the result of the increase in accounts receivable and notes
receivable exceeding the increase in accounts payable.

  Net cash used in investing activities was $18.4 million for the year ended
December 31, 1996 compared with $6.5 million for the year ended December 31,
1995 and $3.7 million for the year ended December 31, 1994. The expenditures
in 1996, 1995, and 1994 were primarily for the acquisition of partial
ownership interests in international fiber optic cable transmission systems
and related equipment.

  Net cash provided by financing activities was $48.3 million for the year
ended December 31, 1996, $933 thousand for the year ended December 31, 1995
and $3.8 million for the year ended December 31, 1994. During the third
quarter of 1996, the Company completed an initial public offering of 6,057,050
shares, of which 4,940,050 shares were offered by the Company, which provided
the Company with net proceeds of approximately $54.1 million. The Company used
$3.3 million to repay an outstanding line of credit with a major shareholder
of the Company. The cash balance at December 31, 1996, of $45.6 million, will
be used to finance investment in international network facilities, working
capital and offshore ventures, alliances or acquisitions. In 1994, the Company
established a revolving credit facility with a major shareholder of the
Company and in 1995 the Company established a revolving credit facility with a
commercial lender. These lines of credit were repaid in the second and third
quarters of 1996.

  The deficit in working capital excluding cash at December 31, 1996 is $10.5
million compared to a deficit of $7.7 million at December 31, 1995. This is
due to the significant delay that occurs in both paying and receiving the
actual cash for the minutes sent and received from overseas. This is offset by
the estimated return traffic revenue backlog of $13.7 million at December 31,
1996 and $6.1 million at December 31, 1995.

  At December 31, 1996, the Company had outstanding commitments of $27,910,360
million for the acquisition of additional ownership in digital undersea fiber
optic cables and network equipment. The Company believes that net proceeds
from the public offering in the third quarter of 1996, together with cash
provided by operating activities and other sources of liquidity, will be
sufficient to meet its outstanding capital commitments, current capital
expenditures and working capital needs through the end of 1997. However, the
Company may raise additional funds through an equity offering or other
financing arrangements to fund growth potential to the extent management
identifies opportunities that are beneficial for the Company.

                                      31
<PAGE>

OTHER OPERATING DATA

  The information set forth below illustrates management's estimate of the
amount of revenue derived from the proportional delayed return traffic which
certain carriers are contractually obligated to provide to the Company within
six months of the Company delivering certain outbound calls. See Note 2 to the
Notes to the Financial Statements. The estimated delayed return traffic
revenue is based on the anticipated ratios between the outgoing and incoming
traffic and anticipated settlement rates. The information concerning estimated
delayed return traffic revenue backlog contains "forward looking statements"
within the meaning of Section 27A of the Securities Act of 1933 and 21E of the
Securities Exchange Act of 1934. The actual results and actual amounts of
delayed return traffic revenue could differ materially from the estimated
amounts reflected herein as a result of numerous factors, including, but not
limited to, changes in international settlement rates, changes in ratios
between outgoing and incoming traffic, foreign currency fluctuations,
termination of certain operating agreements and changes in US tax law.

<TABLE>
<CAPTION>
                                                      YEAR ENDED DECEMBER
                                                              31,
                                                      ----------------------
                                                       1996    1995     1994
                                                      ------- ------    ----
      <S>                                             <C>     <C>       <C>
      Revenues received in current period from
       delayed return traffic(1)..................... $16,360 $4,462    $412
      Estimated delayed return traffic revenue
       backlog at end of period(2)...................  13,719  6,142(5)  986(5)
      Estimated delayed return traffic revenue
       backlog at end of preceding period(3).........   6,142    986      --
      Increase in estimated revenues from delayed
       return traffic(4).............................   7,577  5,156     986
</TABLE>
--------
(1) Represents revenue recorded in the current period from certain of the
    Company's operating agreements which require the Company to wait up to six
    months to receive the return traffic. See Note 2 of the Notes to the
    Financial Statements.
(2) For the year ended December 31, 1995 and 1994 the amount reflects the
    revenue actually received by the Company from delayed return traffic for
    the six months following the end of such period. The amount as of December
    31, 1996 reflects management's estimate of the revenue to be received by
    the Company from delayed return traffic during the six months ending June
    30, 1997, such estimate being based on the anticipated ratios between
    outgoing and incoming traffic and anticipated settlement rates.
(3) To reflect the increase (decrease in delayed return traffic revenue for
    each respective period, the information presented reflects, for the
    purpose of computing such increase/(decrease), the amount of the estimated
    return traffic revenue for the preceding period. For example, the amount
    set forth for the year ended December 31, 1996 is the amount of return
    traffic revenue backlog for the prior periods.
(4) The increase in the amount of estimated delayed return traffic revenue
    earned during year ended December 31, 1996, 1995 and 1994, is (1) for the
    period ending December 31, 1996, the difference between the amount of
    estimated delayed return traffic revenue backlog at December 31, 1996 and
    December 31, 1995, (2) for the period ending December 31, 1995, the
    difference between the amount of estimated delayed return traffic revenue
    backlog at December 31, 1995 and December 31, 1994 and (3) for the period
    ending December 31, 1994, the difference between the amount of estimated
    delayed return traffic revenue backlog at December 31, 1994 and December
    31, 1993. The amount of the increase reflects management's estimate of
    such revenue earned in the particular six month period, although not
    reported on the Company's financial statements until up to six months
    later, under the operating agreements which require the Company to wait up
    to six months before such revenue is actually received pursuant to the
    contractual obligation of foreign carriers to deliver such return traffic.
    Historically the Company has realized an after tax net margin of
    approximately 50% on the amount of such revenues when these are received.
(5) At the end of each quarter, the Company determines the actual amount of
    delayed return traffic revenue received for each preceding six month
    period and uses this actual amount as the "estimated" return traffic
    backlog for the period ending six months earlier. As a result, in each
    current quarter and the immediately preceding quarter, the amounts
    represent estimates. However, in the preceding comparison period, the
    delayed return backlog represents the amount that the Company actually
    received in the ensuing six months.

                                      32
<PAGE>

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

                       REPORT OF INDEPENDENT ACCOUNTANTS

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

  We have audited accompanying consolidated balance sheets of Pacific Gateway
Exchange, Inc. and subsidiaries as of December 31, 1996 and 1995, and the
related statements of operations, cash flows and changes in stockholders'
equity for each of the three years in the period ended December 31, 1996. We
have also audited the financial statement schedule listed in Item 14(a) of the
Form 10-K. 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 in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.

  In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Pacific
Gateway Exchange, Inc. and subsidiaries as of December 31, 1996 and 1995, and
the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 1996, in conformity with
generally accepted accounting principles. In addition, in our opinion, the
financial statement schedule referred to above, when considered in relation to
the basic financial statements taken as a whole, present fairly, in all
material respects, the information required to be included therein.

                                          /s/ Coopers & Lybrand L.L.P.

San Francisco, California
February 19, 1997

                                      33
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.

                          CONSOLIDATED BALANCE SHEETS

                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                  DECEMBER 31,
                                                                ----------------
                                                                  1996    1995
                                                                -------- -------
                            ASSETS
                            ------
<S>                                                             <C>      <C>
CURRENT ASSETS:
Cash and cash equivalents.....................................  $ 45,563 $ 1,792
Accounts receivable, net of allowance for doubtful accounts of
 $1,679 in 1996
 and $824 in 1995.............................................    25,145  12,916
Accounts receivable, related party............................     3,066   3,262
Advances receivable, related party............................        --     175
Prepaids......................................................       729      --
Deferred income tax...........................................     1,184     368
                                                                -------- -------
    Total current assets......................................    75,687  18,513
PROPERTY AND EQUIPMENT:
Undersea fiber optic cables...................................    13,393   5,826
Long distance communications equipment........................    13,744   6,092
Computers and office equipment................................     1,362     749
Construction in progress......................................     2,837      --
                                                                -------- -------
                                                                  31,336  12,667
Less accumulated depreciation.................................     3,700   1,656
                                                                -------- -------
    Total property and equipment, net.........................    27,636  11,011
Deposits and other assets.....................................       493     452
                                                                -------- -------
    Total assets..............................................  $103,816 $29,976
                                                                ======== =======
<CAPTION>
             LIABILITIES AND STOCKHOLDERS' EQUITY
             ------------------------------------
<S>                                                             <C>      <C>
CURRENT LIABILITIES:
Accounts payable..............................................  $ 36,472 $19,419
Accrued liabilities...........................................     1,304     772
Income taxes payable..........................................     2,493     735
Revolving line of credit......................................        --   3,000
Other liabilities.............................................       367     519
                                                                -------- -------
    Total current liabilities.................................    40,636  24,445
Deferred income tax...........................................       708     220
Revolving line of credit, related party.......................        --   2,420
                                                                -------- -------
    Total liabilities.........................................    41,344  27,085
Commitments and contingencies (Note 8)
STOCKHOLDERS' EQUITY:
Preferred stock, $.0001 par value, authorized 1,000,000
 shares, no shares issued.....................................        --      --
Common stock, $.0001 par value, authorized 25,000,000, issued
 19,040,050, outstanding 18,896,490 shares in 1996 and issued
 and outstanding 14,100,000 shares in 1995....................         2       1
Additional paid in capital....................................    55,113     941
Retained earnings.............................................     7,757   1,949
Less cost of common stock held in treasury, 143,560 shares in
 1996.........................................................       400      --
                                                                -------- -------
    Total stockholders' equity................................    62,472   2,891
                                                                -------- -------
    Total liabilities and stockholders' equity................  $103,816 $29,976
                                                                ======== =======
</TABLE>

          See Accompanying Notes to Consolidated Financial Statements.

                                       34
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.

                     CONSOLIDATED STATEMENTS OF OPERATIONS

                     (IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
                                                      YEAR ENDED DECEMBER 31,
                                                      -------------------------
                                                        1996     1995    1994
                                                      --------  ------- -------
<S>                                                   <C>       <C>     <C>
Revenues............................................. $141,912  $59,250 $11,702
Revenues--related party..............................   20,514   17,166   9,211
                                                      --------  ------- -------
    Total revenues...................................  162,426   76,416  20,913
Cost of long distance services.......................  140,340   66,346  17,196
                                                      --------  ------- -------
    Gross margin.....................................   22,086   10,070   3,717
Selling, general and administrative expenses.........   11,113    5,467   2,273
Depreciation.........................................    2,044    1,124     410
                                                      --------  ------- -------
    Total operating expenses.........................   13,157    6,591   2,683
                                                      --------  ------- -------
    Operating income.................................    8,929    3,479   1,034
Interest expense (income), net.......................     (885)     538     193
Other expenses.......................................      129       --      --
                                                      --------  ------- -------
  Income before income taxes.........................    9,685    2,941     841
Provision for income taxes...........................    3,877    1,155     205
                                                      --------  ------- -------
    Net income....................................... $  5,808  $ 1,786 $   636
                                                      ========  ======= =======
    Net income per share--primary.................... $   0.35  $  0.12 $  0.04
                                                      ========  ======= =======
    Net income per share--fully diluted.............. $   0.34  $  0.12 $  0.04
                                                      ========  ======= =======
Weighted average number of common shares
 outstanding--primary................................   16,737   14,300  14,300
                                                      ========  ======= =======
Weighted average number of common shares
 outstanding--fully diluted..........................   16,944   14,300  14,300
                                                      ========  ======= =======
</TABLE>


          See Accompanying Notes to Consolidated Financial Statements.

                                       35
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.

                      CONSOLIDATED STATEMENT OF CASH FLOWS

                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                    YEAR ENDED DECEMBER 31,
                                                    --------------------------
                                                      1996     1995     1994
                                                    --------  -------  -------
<S>                                                 <C>       <C>      <C>
OPERATING ACTIVITIES:
Net income......................................... $  5,808  $ 1,786  $   636
Adjustments to net income:
  Depreciation.....................................    2,044    1,124      410
  Loss on sale of stock............................      129
  Compensation expense.............................       85
  Bad debts provision..............................      855      687      117
  Changes in operating assets and liabilities:
    Accounts receivable............................  (13,421)  (9,436)  (3,979)
    Accounts receivable, related party.............      196   (1,059)  (1,008)
    Notes and advances receivable..................      175     (175)     195
    Prepaid expenses...............................     (729)      --       --
    Deferred tax asset.............................     (816)    (314)     (53)
    Deposits and other assets......................     (107)    (243)    (106)
    Accounts payable...............................   17,053   12,782    3,693
    Accrued liabilities............................      532      700       72
    Other liabilities..............................     (152)     519       --
    Deferred tax liability.........................      488      220       --
    Federal income taxes payable (recoverable).....    1,758      790      (55)
                                                    --------  -------  -------
  Net cash provided by (used in) operating
   activities......................................   13,898    7,381      (78)
                                                    --------  -------  -------
INVESTING ACTIVITIES:
Purchase of property and equipment.................  (18,669)  (7,233)  (3,745)
Sale of stock (accepted as payment for accounts
 receivable) to related party......................       --      702       --
Sale of stock (accepted as payment for accounts
 receivable).......................................      274       --       --
                                                    --------  -------  -------
                                                     (18,395)  (6,531)  (3,745)
                                                    --------  -------  -------
FINANCING ACTIVITIES:
Proceeds from issuance of common stock.............   55,130       --       --
Payment of issuance costs..........................   (1,042)      --       --
Payment to acquire treasury stock..................     (400)      --       --
Borrowings on revolving lines of credit............    3,200    4,000    3,930
Repayments on revolving lines of credit............   (6,200)  (3,067)    (160)
Borrowings on revolving lines of credit, related
 party.............................................    3,000       --       --
Repayments on revolving lines of credit, related
 party.............................................   (5,420)      --       --
                                                    --------  -------  -------
Net cash provided by financing activities..........   48,268      933    3,770
                                                    --------  -------  -------
Net increase in cash and cash equivalents..........   43,771    1,783      (53)
Cash and cash equivalents at beginning of the
 period............................................    1,792       10       63
                                                    --------  -------  -------
Cash and cash equivalents at end of the period..... $ 45,563  $ 1,792  $    10
                                                    ========  =======  =======
SUPPLEMENTARY INFORMATION:
Interest paid during period........................ $    276  $   576  $   103
Income taxes paid during period.................... $  2,447  $   683  $   313
</TABLE>

          See Accompanying Notes to Consolidated Financial Statements.

                                       36
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.

           CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY

                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                            STOCK                                        TREASURY
                          COMMITTED COMMON STOCK  ADDITIONAL RETAINED      STOCK
                            TO BE   -------------  PAID-IN   EARNINGS  -------------
                           ISSUED   SHARES AMOUNT  CAPITAL   (DEFICIT) SHARES AMOUNT   TOTAL
                          --------- ------ ------ ---------- --------- ------ ------  -------
<S>                       <C>       <C>    <C>    <C>        <C>       <C>    <C>     <C>
Balance January 1, 1994.     850         4  $ 0    $    92    $ (473)     --     --   $   469
  Issuance of Common
   Stock................    (850)       11    0        850        --      --     --        --
  Net Income............      --        --   --         --       636      --     --       636
                            ----    ------  ---    -------    ------    ----  -----   -------
Balance December 31,
 1994...................      --        15    0        942       163      --     --     1,105
  940 to 1 stock split..      --    14,085    1         (1)       --      --     --        --
  Net Income............      --        --   --         --     1,786      --     --     1,786
                            ----    ------  ---    -------    ------    ----  -----   -------
Balance December 31,
 1995...................      --    14,100    1        941     1,949      --     --     2,891
  Repurchase of Common
   Stock................      --        --   --         --        --    (144) $(400)     (400)
  Issuance of Common
   Stock, net of $1,042
   issuance costs.......      --     4,940    1     54,087        --      --     --    54,088
  Stock option
   compensation expense.      --        --   --         85        --      --     --        85
  Net Income............      --        --   --         --     5,808      --     --     5,808
                            ----    ------  ---    -------    ------    ----  -----   -------
Balance December 31,
 1996...................      --    19,040  $ 2    $55,113    $7,757    (144) $(400)  $62,472
                            ====    ======  ===    =======    ======    ====  =====   =======
</TABLE>


          See Accompanying Notes to Consolidated Financial Statements.

                                       37
<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.

 Principals of Consolidation:

  Consolidated Financial Statements include the accounts of Pacific Gateway and
majority-owned and controlled subsidiaries. Investments in 20% to 50%-owned
affiliates are accounted for on the equity method. Intercompany transactions
have been eliminated.

 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 maturities of three months or less. The carrying amount reported in the
accompanying balance sheets approximates fair market value.

 Property and Equipment:

  Property and equipment are stated at cost. 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
</TABLE>

  Maintenance and repairs are expensed as incurred. Replacements and
betterments are capitalized. 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.

 Income Taxes:

  The Company accounts for income taxes in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 109, "Accounting for Income Taxes."
SFAS 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.

                                       38
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

 Earnings Per Share:

  Earnings per share are calculated based on the weighted average number of
shares outstanding during the period plus the dilutive effect of stock
committed to be issued and stock options determined using the treasury stock
method. The earnings per share calculation has been adjusted for all periods
presented to reflect the 940 to 1 stock split effected October 20, 1995.
Additionally, this calculation treats stock options granted prior to the
Company's initial public offering as if they were common stock equivalents for
all periods presented.

 Financial Statement Classifications:

  Certain amounts on the accompanying financial statements for 1995 have been
reclassified to conform to the 1996 presentation. Such reclassifications have
no effect on net income as previously reported.

 Fair Value of Financial Instruments:

  The carrying amounts for accounts receivable and accounts payable approximate
their fair value. The revolving lines of credit had an interest rate which
varied with the prime rate and approximates the current interest rate for
similar financial instruments as of December 31, 1995. Therefore, the recorded
amount of the revolving lines of credit as of December 31, 1995, approximated
fair market 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, 1996 and 1995 the Company had bank deposits in excess of
federally insured limits of $45,381,000 and $1,592,000, respectively. Seven of
the Company's customers accounted for approximately 52% and 55% of gross
accounts receivable as of December 31, 1996 and 1995, respectively. 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.

(2) ACCOUNTING FOR INTERNATIONAL LONG DISTANCE TRAFFIC

  The Company has entered into operating agreements with 30 telecommunications
carriers in 24 different 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 30 agreements the Company had at
December 31, 1996, 11 agreements provided that the company generally must wait
up to six months before it actually receives the proportional return traffic.
For these agreements, the Company recognizes a loss in the period in which it
sells to a customer because the amount due to the foreign partner generally
exceeds the amount the Company charges its customers. As a result, a
significant increase in traffic with one or more of the carriers with which the
Company must wait up to six months to receive return traffic may cause the
Company to report a net loss in the accounting period in which such increase
occurred. Historically, when the return traffic is received in the future
period, the Company generally realizes a gross margin on the return traffic
that, when combined with the prior period loss on the outbound traffic, results
in a gross profit on the total transaction. As the Company has historically
been a net outpayer to these foreign companies it does not actually pay its
accounts payable balance until it receives the

                                       39
<PAGE>

                        PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
return traffic that it is owed. Although the Company can reasonably estimate
the revenue it will receive under the FCC's proportional share policy, there
is no guarantee that there will be traffic delivered back to the United States
or what impact changes in future settlement rates will have on net payments
made and revenue received.

(3) INCOME TAXES

  The provision for income taxes is comprised of the following:

<TABLE>
<CAPTION>
                                                  YEAR ENDED DECEMBER 31,
                                               --------------------------------
                                                  1996        1995       1994
                                               ----------  ----------  --------
      <S>                                      <C>         <C>         <C>
      CURRENT TAX EXPENSE
      U.S. Federal............................ $3,364,342  $  999,950  $206,647
      State and local.........................    841,085  $  249,988  $ 51,662
                                               ----------  ----------  --------
      Total current........................... $4,205,427  $1,249,938  $258,309
                                               ----------  ----------  --------
      DEFERRED TAX EXPENSE
      U.S. Federal............................   (262,558)    (75,950)  (42,647)
      State and local.........................    (65,640)    (18,988)  (10,662)
                                               ----------  ----------  --------
      Total deferred..........................   (328,198)    (94,938)  (53,309)
                                               ----------  ----------  --------
      Total provision......................... $3,877,229  $1,155,000  $205,000
                                               ==========  ==========  ========
</TABLE>

  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,
                                                            ------------------
                                                            1996   1995  1994
                                                            ----   ----  -----
      <S>                                                   <C>    <C>   <C>
      Expected statutory rate.............................. 34.0 % 34.0%  34.0 %
      Release of valuation allowance.......................   --     --  (15.1)%
      State income taxes, net of federal benefit...........  5.3 %  5.3%   5.5 %
      Tax exempt interest.................................. (0.4)%   --     --
      Other................................................  1.1 %   --     --
                                                            ----   ----  -----
                                                            40.0 % 39.3%  24.4 %
                                                            ====   ====  =====
</TABLE>

  As a result of operating losses in 1992 and 1993 and the fact that the
Company had a limited operating history, a valuation allowance equal to the
deferred tax asset was recorded at December 31, 1993. The Company was
profitable for the first time in 1994 which allowed it to release the
previously recorded deferred tax asset valuation allowance.

  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.

                                      40
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

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

<TABLE>
<CAPTION>
                                                      YEAR ENDED DECEMBER 31,
                                                    ---------------------------
                                                       1996      1995    1994
                                                    ---------- -------- -------
      <S>                                           <C>        <C>      <C>
      Deferred tax assets:
        Allowance for doubtful accounts............ $  861,768 $325,613 $54,040
        State taxes................................    210,647
        Other......................................    111,548   42,185  61,412
                                                    ---------- -------- -------
          Total gross deferred tax assets..........  1,183,963  367,798 115,452
      Deferred tax liabilities:
        Depreciation...............................    707,518  219,551  62,143
                                                    ---------- -------- -------
          Net deferred tax assets.................. $  476,445 $148,247 $53,309
                                                    ========== ======== =======
</TABLE>

(4) REVOLVING LINES OF CREDIT

  At December 31, 1995, the Company had a revolving line of credit with Ronald
L. Jensen, a principal stockholder of the Company, which matured on the
completion of the initial public offering in July 1996. Interest was payable
monthly at prime (8.25% at June 30, 1996, 8.75% at December 31, 1995 and 9.0%
at December 31, 1994) plus 2%. The outstanding balance under this line of
credit of $3,301,890 was repaid on July 24, 1996. The amount outstanding under
this line, which was subordinated to the amount due the commercial lender, was
$2,420,339 and $4,487,724 at December 31, 1995, and December 31, 1994,
respectively.

  In 1995, the Company entered into an additional revolving line of credit with
a commercial lender under which it was able to borrow the lesser of $3,000,000
or 70% of certain of the Company's accounts receivable. Interest was payable at
the lenders prime rate plus 0.875%. This line of credit was paid down on June
6, 1996 and expired in September, 1996. The amount outstanding under this line
at December 31, 1995, was $3,000,000.

(5) RELATED PARTY TRANSACTIONS

  The Company provides certain domestic and international switched
telecommunications services to Matrix Telecom, Inc. ("Matrix"), which is a
switchless reseller. Ronald L. Jensen and his five adult children, as a group,
own a controlling interest in Matrix and also own a significant, but not
controlling interest in the Company. Revenues recorded from providing these
services were $20,514,040, 17,165,995 and $9,211,000 for the years ended
December 31, 1996, 1995, and 1994 respectively. Matrix also provided certain
data processing services to the Company for which the Company incurred expenses
of $246,221, $166,000, and $35,000 in 1996, 1995 and 1994 respectively. These
functions were taken over by the company in June 1996 and it is not anticipated
that Matrix will provide any of these services in the future. The amount
receivable from Matrix was $3,065,846, $3,261,849 and $2,203,000 at December
31, 1996, 1995, and 1994 respectively.

  In February 1995, the Company accepted certain shares of common stock, with a
fair market value of approximately $702,000, of a customer as payment for
accounts receivable totaling $702,000. The Company then sold this stock to
Ronald L. Jensen for $702,000. Mr. Jensen subsequently sold the stock over a
period of several months for a total of $730,000.

  At December 31, 1995, the Company had advances receivable from the officers
of the Company totaling $175,000. These advances were due on demand and were
repaid in the first quarter of 1996.

                                       41
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

(6) SEGMENT DATA

  The Company classifies its operations into one industry segment,
telecommunications services. Export sales were $46,522,000, $17,619,000 and
$4,572,000 for the years ended December 31, 1996, 1995 and 1994 respectively.
Export sales by geographic area were as follows:

<TABLE>
<CAPTION>
                                                   YEAR ENDED DECEMBER 31,
                                              ----------------------------------
                                                 1996        1995        1994
                                              ----------- ----------- ----------
      <S>                                     <C>         <C>         <C>
      Pacific Rim............................ $20,653,000 $10,066,000 $2,908,000
      Europe.................................  17,134,000   4,798,000    812,000
      Canada.................................   6,449,000   2,418,000    852,000
      Other..................................   2,286,000     337,000         --
                                              ----------- ----------- ----------
                                              $46,522,000 $17,619,000 $4,572,000
                                              =========== =========== ==========
</TABLE>

  To date the Company's international operating agreements have been with
entities operating in countries where management does not expect political or
economic forces to cause disruption in telecommunications traffic to or from
these countries.

  The Company sells to the long distance companies in the United States which
do not have their own international network and to its foreign partners. At
December 31, 1996, the Company had 30 operating agreements and approximately 75
United States customers. Because it has a small number of large customers, 10%
or more of the Company's revenues have been derived from the following
customers.

<TABLE>
<CAPTION>
                                                  YEAR ENDED DECEMBER 31,
                                             ----------------------------------
                                                1996        1995        1994
                                             ----------- ----------- ----------
      <S>                                    <C>         <C>         <C>
      Matrix Telecom, Inc. (See Note 5)..... $20,514,040 $17,165,995 $9,211,000
      Wiltel, Inc...........................     (A)         (A)      2,599,000
      Optus Communications Pty Limited......     (A)         (A)      2,209,000
</TABLE>
--------
(A) Sales were less than 10% of total sales.

(7) EMPLOYEE BENEFIT PLANS

  In September 1995, the Company established an Employee Stock Purchase Plan
(the "Purchase Plan") which is meant to qualify under section 423 of the
Internal Revenue Code. The Purchase Plan will become effective during 1997.
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.

(8) COMMITMENTS AND CONTINGENCIES

 Litigation

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

                                       42
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

 Leases

  The Company leases office space and equipment under noncancelable operating
leases. Rental expenses for 1996, 1995 and 1994 were $255,000, $142,000 and,
$92,000, respectively. Future minimum lease payments under these leases as of
December 31, 1996 are as follows:

<TABLE>
      <S>                                                            <C>
      1997.......................................................... $  390,193
      1998..........................................................    485,815
      1999..........................................................    403,633
      2000..........................................................    341,068
      2001..........................................................    301,036
      Thereafter....................................................  1,660,005
                                                                     ----------
        Total minimum lease payments................................ $3,581,691
                                                                     ==========
</TABLE>

 Employment Agreements

  The Company has entered into employment agreements with each of Howard
Neckowitz, President, Chief Executive Officer and Chairman of the Board, Gail
Granton, Executive Vice President, International Business Development and
Secretary, Ronald Anderson, Vice President, Operations and Engineering, Robert
Craver, Senior Vice President, International Relations and Fred Weismiller,
Executive Vice President, International Marketing. The agreement with Mr.
Neckowitz is for a term of four years, the agreements with Ms. Granton and Mr.
Anderson are for a term of three years and the agreement with Mr. Craver and
Mr. Weismiller is for a term of two years. The agreements provide for severance
payments in amount equal to base salary to the end of the term or, if greater,
two years of base salary for Mr. Neckowitz and one year base salary for Ms.
Granton, Mr. Anderson, Mr. Craver and Mr. Weismiller in the event of
termination without cause or termination following a change of control of the
Company. In the event of a change of control, each of such employees would be
entitled to severance following their resignation from the Company resulting
from diminution of their duties. Should such an event occur, the Company's
obligation for severance could range from $1,209,000 to $1,559,000. Upon any
such payment of severance, the individual would also receive full vesting of
any outstanding stock options.

 Commitments

  At December 31, 1996 the Company had outstanding commitments of $27,910,360
for the acquisition of additional ownership interests in digital undersea fiber
optic cables and the expansion of the existing switch sites.

(9) STOCK OPTION PLAN

  On September 30, 1995, the Company adopted the 1995 Stock Option Plan (the
"Plan"). The 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 Plan generally vest over four years and must be exercised within five
years. The maximum term of options granted is ten years. The Company applies
Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations in accounting for its plans. Had
compensation cost for the Company's stock option plans been determined based
upon the fair value at the grant date for awards under these plans consistent
with the methodology prescribed under Statement of Financial Accounting
Standards No. 123, Accounting for Stock-Based Compensation, the Company's net
income and net income per share would have been reduced to the pro forma
amounts indicated below:

<TABLE>
<CAPTION>
                                                                    1996   1995
                                                                   ($000) ($000)
                                                                   ------ ------
      <S>                                                          <C>    <C>
      Net Income--as reported..................................... 5,808  1,786
      Net Income--pro forma....................................... 5,244  1,636
      Net Income per share--primary--as reported..................  0.35   0.12
      Net Income per share--primary--pro forma....................  0.31   0.11
</TABLE>

                                       43
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  The fair value of the options granted by the Company is estimated at $2.69
million for 1996 and $1,287,159 for 1995 on the date of the grant using the
Black Scholes Model for those options granted after the Company filed its
registration statement on form S-1 on December 8, 1995 and the Minimum Value
methodology for those options granted prior to that date. The assumptions used
in the Black Scholes model are: dividend yield 0%, volatility 30.5%, risk free
interest rate of 6.7%, assumed forfeiture rate of 0% and an expected life of 5
years. The assumptions used in the Minimum Value model are: dividend yield 0%,
risk free interest rate 6.58%, assumed forfeiture rate of 17% and an expected
life of 5 years.

  Stock Option Awards were:

<TABLE>
<CAPTION>
                                                 YEAR ENDED DECEMBER 31,
                                          -------------------------------------
                                                 1996               1995
                                          ------------------ ------------------
                                                   WEIGHTED-          WEIGHTED-
                                                    AVERAGE            AVERAGE
                                                   EXERCISE           EXERCISE
                                          OPTIONS    PRICE   OPTIONS    PRICE
                                          -------- --------- -------- ---------
      <S>                                 <C>      <C>       <C>      <C>
      Options outstanding, beginning of
       year..............................  509,170    8.23         --     --
      Options exercised..................       --                 --     --
      Options granted....................  374,241   12.58    509,170   8.23
      Options outstanding, end of year...  883,411    9.77    509,170   8.23
                                          ========           ========   ====
      Option price range at end of year.. $4.40 to           $4.40 to     --
                                            $29.50              $9.00
      Options available for grant at end
       of year...........................  316,589            690,830     --
                                          ========           ========   ====
</TABLE>

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

<TABLE>
<CAPTION>
                                          OPTIONS OUTSTANDING          OPTIONS EXERCISABLE
                                 ------------------------------------- --------------------
                                                              WEIGHTED             WEIGHTED
                                             WEIGHTED AVERAGE AVERAGE              AVERAGE
                                   NUMBER       REMAINING     EXERCISE   NUMBER    EXERCISE
      RANGE OF EXERCISE PRICES   OUTSTANDING CONTRACTUAL LIFE  PRICE   EXERCISABLE  PRICE
      ------------------------   ----------- ---------------- -------- ----------- --------
      <S>                        <C>         <C>              <C>      <C>         <C>
      $4.40-$9.00.............     609,661         3.79        $ 8.28    182,908    $7.60
      $9.50-$11.50............     233,750         4.41         10.29         --       --
      $29.50..................      40,000         4.96         29.50         --       --
                                   -------         ----        ------    -------    -----
      $4.40-$29.50............     883,411         4.01        $ 9.77    182,908    $7.60
                                   =======         ====        ======    =======    =====
</TABLE>

(10) CAPITAL STOCK

  In 1992, the Company entered into an agreement whereby it received $850,000
in cash and agreed to issue stock of the Company representing approximately 73%
of the Company. In 1994, the Company issued 11,020 (pre-split) shares of its
common stock to fulfill its commitment under this agreement. The earnings per
share calculation treats these shares as common stock equivalents prior to the
issuance of the shares for all periods presented.

  On September 30, 1995, the Company's Board of Directors authorized management
to file a registration statement with the Securities and Exchange Commission to
permit the Company to sell shares of its common stock to the public. On
September 30, 1995, the Company's Board of Directors authorized an amendment to
the Certificate of Incorporation which was approved by the shareholders on the
same date. The amendment effected a 940 to 1 split of the Company's Common
Stock and adjusted the authorized shares to 25,000,000 shares of common stock,
$.0001 par value per share, and 1,000,000 shares of Preferred Stock, $.0001 par
value per share. The 940 to 1 split was effective October 20, 1995. The rights,
preferences and limitations of the Preferred Stock may be designated by the
Company's Board of Directors at any time.

                                       44
<PAGE>

                        PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  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. In connection with the Offering, the US affiliate of Kokusau
Denshin, Denwa ("KDD"), one of Japan's leading international
telecommunications carriers, purchased 1,800,000 shares and, as a result, owns
approximately 9.5% of the Company's outstanding common stock.

(11) NEW ACCOUNTING PRONOUNCEMENTS

  In December, 1996, the FASB issued SFAS No. 128, "Earnings per Share," which
is effective for both interim periods and annual periods ending after December
15, 1997. SFAS 128 establishes standards for computing and presenting earnings
per share (EPS). This statement replaces the presentation of primary EPS with
a presentation of basic EPS. It also requires dual presentation of basic and
diluted EPS on the face of the income statement for all entities with complex
capital structures and requires a reconciliation of the numerator and
denominator of the basic EPS computation to the numerator and denominator of
the diluted EPS computation. The Company does not expect the impact on the
financial statements to be material.

                                      45
<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 for 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 Annual Meeting of Stockholders.

ITEM 11. EXECUTIVE COMPENSATION

  The information required for 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 Annual Meeting of
Stockholders.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

  The information required for 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 Annual Meeting of
Stockholders.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

  The information required for 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 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, 1996 and 1995

    Consolidated Statements of Operations for the Years Ended December 31,
    1996, 1995 and 1994

    Consolidated Statements of Cash Flows for the Years Ended December 31,
    1996, 1995 and 1994

    Consolidated Statements of Changes in Stockholders' Equity for the
    Years Ended December 31, 1996, 1995 and 1994

    Notes to Consolidated Financial Statements

  (a) 2. FINANCIAL STATEMENT SCHEDULE

    Schedule II Valuation and Qualifying Accounts

  (a) 3. EXHIBITS

*Included in Item 8


                                      46
<PAGE>

<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER         DESCRIPTION                      METHOD OF FILING
 -------        -----------                      ----------------
 <C>     <S>                         <C>
  3.1    Amended and Restated        Incorporated by reference to Registration
         Certificate of              Statement on Form S-1 (No. 33-80191)
         Incorporation
  3.2    Amended and Restated        Incorporated by reference to Registration
         Bylaws                      Statement on Form S-1 (No. 33-80191)
  4.1    Specimen Certificate for    Incorporated by reference to Registration
         Common Stock                Statement on Form S-1 (No. 33-80191)
  4.2    Amended and Restated        Incorporated by reference to Registration
         Certificate of              Statement on Form S-1 (No. 33-80191)
         Incorporation
  4.3    Amended and Restated        Incorporated by reference to Registration
         Bylaws                      Statement on Form S-1 (No. 33-80191)
 10.1    Form of Indemnification     Incorporated by reference to Registration
         Agreement for directors     Statement on Form S-1 (No. 33-80191)
         and officers*
 10.2    Stock Option Plan and       Incorporated by reference to Registration
         forms of agreements         Statement on Form S-1 (No. 33-80191)
         thereunder*
 10.3    Employee Stock Purchase     Incorporated by reference to Registration
         Plan*                       Statement on Form S-1 (No. 33-80191)
 10.4.1  Proxy dated December 10,    Incorporated by reference to Registration
         1994 by Julie J. Jensen     Statement on Form S-1 (No. 33-80191)
 10.4.2  Proxy dated December 10,    Incorporated by reference to Registration
         1994 by Jeffrey J. Jensen   Statement on Form S-1 (No. 33-80191)
 10.4.3  Proxy dated December 10,    Incorporated by reference to Registration
         1994 by Janet Jensen        Statement on Form S-1 (No. 33-80191)
         Kreiger
 10.4.4  Proxy dated December 10,    Incorporated by reference to Registration
         1994 by James J. Jensen     Statement on Form S-1 (No. 33-80191)
 10.4.5  Proxy dated December 10,    Incorporated by reference to Registration
         1994 by Jami J. Jensen      Statement on Form S-1 (No. 33-80191)
 10.4.6  Proxy dated May 10, 1996    Incorporated by reference to Registration
         by Gail E. Granton          Statement on Form S-1 (No. 33-80191)
 10.4.7  Proxy dated June 10, 1996   Incorporated by reference to Registration
         by Ronald L. Jensen         Statement on Form S-1 (No. 33-80191)
 10.5.1  Employment Agreement        Incorporated by reference to Registration
         dated October 1, 1995       Statement on Form S-1 (No. 33-80191)
         between Howard A.
         Neckowitz and Pacific
         Gateway Exchange, Inc.*
 10.5.2  Employment Agreement        Incorporated by reference to Registration
         dated October 1, 1995       Statement on Form S-1 (No. 33-80191)
         between Gail E. Granton
         and Pacific Gateway
         Exchange, Inc.*
 10.5.3  Employment Agreement        Incorporated by reference to Registration
         dated October 1, 1995       Statement on Form S-1 (No. 33-80191)
         between Ronald D.
         Anderson and Pacific
         Gateway Exchange, Inc.*
 10.5.4  Employment Agreement        Incorporated by reference to Registration
         dated October 1, 1995       Statement on Form S-1 (No. 33-80191)
         between Robert F. Craver
         and Pacific Gateway
         Exchange, Inc.*
 10.5.5  Employment Agreement        Filed with this document
         dated October 1, 1996
         between Fred A.
         Weismiller and Pacific
         Gateway Exchange, Inc.*
</TABLE>

                                       47
<PAGE>

<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER         DESCRIPTION                      METHOD OF FILING
 -------        -----------                      ----------------
 <C>     <S>                         <C>
 10.6    Telephone Service dated     Incorporated by reference to Registration
         May 1, 1995 between         Statement on Form S-1 (No. 33-80191)
         Matrix Telecom, Inc. and
         Pacific Gateway Exchange,
         Inc.
 10.7    Agreement for Billing       Incorporated by reference to Registration
         Services dated November     Statement on Form S-1 (No. 33-80191)
         24, 1995 between Matrix
         Telecom, Inc. and Pacific
         Gateway Exchange, Inc.
 10.8    Business Loan Agreement     Incorporated by reference to Registration
         (Receivables) and           Statement on Form S-1 (No. 33-80191)
         Security Agreement
         (Receivables) dated
         December 19, 1995 between
         Bank of America, NT&SA
         and Pacific Gateway
         Exchange, Inc.
 10.9    Form of Stock Purchase      Incorporated by reference to Registration
         Agreement with KDD          Statement on Form S-1 (No. 33-80191)
 11.1    Statement regarding         Incorporated by reference to Registration
         computation of per share    Statement on Form S-1 (No. 33-80191)
         income (loss)
 21.1    Subsidiaries                Filed with this document
 24.1    Power of Attorney           Incorporated by reference to Registration
                                     Statement on Form S-1 (No. 33-80191)
 27.1    Financial Data Schedule     Filed with this document
</TABLE>

  (b) REPORTS ON FORM 8-K

    No reports on Form 8-K were filed during the fourth fiscal quarter
    ended December 31, 1996.
--------
*Management contract or compensatory plan.

                                       48
<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 27TH DAY OF MARCH, 1997.

                                          Pacific Gateway Exchange, Inc.

                                                /s/ Howard A. Neckowitz
                                          By: _________________________________
                                                   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 27TH DAY OF MARCH, 1997.

<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                 and Director

           /s/ Sandra D. Grey               Chief Financial Officer
___________________________________________   (Principal Financial Officer)
              Sandra D. Grey                  (Principal Accounting Officer)

                                            Director
___________________________________________
             Ronald L. Jensen

          /s/ Charles M. Dalfen             Director
___________________________________________
             Charles M. Dalfen

          /s/ James J. Junewicz             Director
___________________________________________
             James J. Junewicz
</TABLE>

                                      49
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.

                                  SCHEDULE II

                       VALUATION AND QUALIFYING ACCOUNTS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                           ADDITIONS
                                BALANCE AT CHARGED TO               DEDUCTIONS
                                BEGINNING  COSTS AND   BALANCE AT   ACCOUNTS--
        DESCRIPTION             OF PERIOD   EXPENSES  END OF PERIOD WRITTEN OFF
        -----------             ---------- ---------- ------------- -----------
<S>                             <C>        <C>        <C>           <C>
Allowance for doubtful
 accounts:
  1996.........................    $824      $1,355       $500        $1,679
  1995.........................     137         687        --            824
  1994.........................      20         117        --            137
</TABLE>

                                      S-1
<PAGE>

                               INDEX TO EXHIBITS

<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER          DESCRIPTION                      METHOD OF FILING
 -------         -----------                      ----------------
 <C>     <S>                          <C>
  3.1    Amended and Restated         Incorporated by reference to Registration
         Certificate of               Statement on Form S-1 (No. 33-80191)
         Incorporation
  3.2    Amended and Restated         Incorporated by reference to Registration
         Bylaws                       Statement on Form S-1 (No. 33-80191)
  4.1    Specimen Certificate for     Incorporated by reference to Registration
         Common Stock                 Statement on Form S-1 (No. 33-80191)
  4.2    Amended and Restated         Incorporated by reference to Registration
         Certificate of               Statement on Form S-1 (No. 33-80191)
         Incorporation
  4.3    Amended and Restated         Incorporated by reference to Registration
         Bylaws                       Statement on Form S-1 (No. 33-80191)
 10.1    Form of Indemnification      Incorporated by reference to Registration
         Agreement for directors      Statement on Form S-1 (No. 33-80191)
         and officers*
 10.2    Stock Option Plan and        Incorporated by reference to Registration
         forms of agreements          Statement on Form S-1 (No. 33-80191)
         thereunder*
 10.3    Employee Stock Purchase      Incorporated by reference to Registration
         Plan*                        Statement on Form S-1 (No. 33-80191)
 10.4.1  Proxy dated December 10,     Incorporated by reference to Registration
         1994 by Julie J. Jensen      Statement on Form S-1 (No. 33-80191)
 10.4.2  Proxy dated December 10,     Incorporated by reference to Registration
         1994 by Jeffrey J. Jensen    Statement on Form S-1 (No. 33-80191)
 10.4.3  Proxy dated December 10,     Incorporated by reference to Registration
         1994 by Janet Jensen         Statement on Form S-1 (No. 33-80191)
         Kreiger
 10.4.4  Proxy dated December 10,     Incorporated by reference to Registration
         1994 by James J. Jensen      Statement on Form S-1 (No. 33-80191)
 10.4.5  Proxy dated December 10,     Incorporated by reference to Registration
         1994 by Jami J. Jensen       Statement on Form S-1 (No. 33-80191)
 10.4.6  Proxy dated May 10, 1996     Incorporated by reference to Registration
         by Gail E. Granton           Statement on Form S-1 (No. 33-80191)
 10.4.7  Proxy dated June 10, 1996    Incorporated by reference to Registration
         by Ronald L. Jensen          Statement on Form S-1 (No. 33-80191)
 10.5.1  Employment Agreement dated   Incorporated by reference to Registration
         October 1, 1995 between      Statement on Form S-1 (No. 33-80191)
         Howard A. Neckowitz and
         Pacific Gateway Exchange,
         Inc.*
 10.5.2  Employment Agreement dated   Incorporated by reference to Registration
         October 1, 1995 between      Statement on Form S-1 (No. 33-80191)
         Gail E. Granton and
         Pacific Gateway Exchange,
         Inc.*
 10.5.3  Employment Agreement dated   Incorporated by reference to Registration
         October 1, 1995 between      Statement on Form S-1 (No. 33-80191)
         Ronald D. Anderson and
         Pacific Gateway Exchange,
         Inc.*
</TABLE>

<PAGE>

<TABLE>
<CAPTION>
 EXHIBIT
 NUMBER         DESCRIPTION                      METHOD OF FILING
 -------        -----------                      ----------------
 <C>     <S>                         <C>
 10.5.4  Employment Agreement        Incorporated by reference to Registration
         dated October 1, 1995       Statement on Form S-1 (No. 33-80191)
         between Robert F. Craver
         and Pacific Gateway
         Exchange, Inc.*
 10.5.5  Employment Agreement        Filed with this document
         dated October 1, 1996
         between Fred A.
         Weismiller and Pacific
         Gateway Exchange, Inc.*
 10.6    Telephone Service dated     Incorporated by reference to Registration
         May 1, 1995 between         Statement on Form S-1 (No. 33-80191)
         Matrix Telecom, Inc. and
         Pacific Gateway Exchange,
         Inc.
 10.7    Agreement for Billing       Incorporated by reference to Registration
         Services dated November     Statement on Form S-1 (No. 33-80191)
         24, 1995 between Matrix
         Telecom, Inc. and Pacific
         Gateway Exchange, Inc.
 10.8    Business Loan Agreement     Incorporated by reference to Registration
         (Receivables) and           Statement on Form S-1 (No. 33-80191)
         Security Agreement
         (Receivables) dated
         December 19, 1995 between
         Bank of America, NT&SA
         and Pacific Gateway
         Exchange, Inc.
 10.9    Form of Stock Purchase      Incorporated by reference to Registration
         Agreement with KDD          Statement on Form S-1 (No. 33-80191)
 11.1    Statement regarding         Incorporated by reference to Registration
         computation of per share    Statement on Form S-1 (No. 33-80191)
         income (loss)
 21.1    Subsidiaries                Filed with this document
 24.1    Power of Attorney           Incorporated by reference to Registration
                                     Statement on Form S-1 (No. 33-80191)
 27.1    Financial Data Schedule     Filed with this document
</TABLE>
--------
*Management contract or compensatory plan.