<PAGE>

================================================================================

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

                                   FORM 10-K

(MARK ONE)
(X) ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
    ACT OF 1934 [NO FEE REQUIRED]

                  FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997

                                      OR

( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
    EXCHANGE ACT OF 1934 [NO FEE REQUIRED]

                       COMMISSION FILE NUMBER 000-21043

                        PACIFIC GATEWAY EXCHANGE, INC.
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)


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


        533 AIRPORT BOULEVARD, SUITE 505, BURLINGAME, CALIFORNIA 94010
                   (Address of principal executive offices)

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

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

                   COMMON SHARES, PAR VALUE $.0001 PER SHARE
          PREFERRED SHARE PURCHASE RIGHTS, PAR VALUE $.0001 PER SHARE
                               (Title of class)

  Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X]  No [_]

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

  The aggregate market value of voting stock held by non-affiliates of the
registrant on March 18, 1998, was approximately $839,000,000, 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 18, 1998, there were outstanding 19,113,955 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 1998
   Annual General Meeting of Shareholders.

================================================================================
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.

                               TABLE OF CONTENTS

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

  1.  Business.........................................................      1
  2.  Properties.......................................................     21
  3.  Legal Proceedings................................................     21
  4.  Submission of Matters to a Vote of Security Holders..............     21
      Executive Officers...............................................     21

                                   PART II

      Market for the Registrants Common Stock and Related Stockholder
  5.  Matters..........................................................     23
  6.  Selected Financial Data..........................................     24
      Management's Discussion and Analysis of Financial Condition and
  7.  Results of Operations............................................     25
  8.  Financial Statements and Supplementary Data......................     31
      Changes in and Disagreements with Accountants on Accounting and
  9.  Financial Disclosure.............................................     47

                                   PART III

 10.  Directors and Executive Officers.................................     47
 11.  Executive Compensation...........................................     47
 12.  Security Ownership of Certain Beneficial Owners and Management...     47
 13.  Certain Relationships and Related Transactions...................     47

                                   PART IV

 14.  Exhibits, Financial Statement Schedules, and Reports on Form 8-K.     47
</TABLE>
<PAGE>

                                    PART I

ITEM 1. BUSINESS

NOTE ON FORWARD-LOOKING STATEMENTS

  This Annual Report contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended, 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," "plans,"
"intends" or "expects." These forward-looking statements relate to the plans,
objectives and expectations of Pacific Gateway Exchange, Inc. ("Pacific
Gateway" or the "Company") regarding its future operations or financial
performance or related to the Company's expectations regarding the
telecommunciations industry. In light of the inherent risks and uncertainties
of any forward-looking statement, the inclusion of forward-looking statements
in this report should not be regarded as a representation by the Company or
any other person that the forward-looking statements will come true. The
revenues and results of operations of the Company, and future developments in
the telecommunications industry, are difficult to forecast and could differ
materially from those projected in the forward-looking statements as a result
of numerous factors, including the following: (i) changes in international
settlement rates; (ii) changes in the ratios between outgoing and incoming
traffic; (iii) foreign currency fluctuations; (iv) termination of certain
operating agreements or inability to enter into additional operating
agreements; (v) inaccuracies in the Company's forecasts of traffic; (vi)
changes in or developments under domestic or foreign laws, regulations,
licensing requirements or telecommunications standards; (vii) foreign
political or economic instability; (viii) changes in the availability of
transmission facilities, such as undersea fiber optic cable; (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; (xii) future management
decisions regarding, for example, acquisitions, capital expenditures or
financings: (xiii) concentration of credit risk; or (xiv) natural disasters
and catastrophic events. The foregoing review of important factors including
those discussed in detail below should not be construed as exhaustive; the
Company undertakes no obligation to release publicly the results of any future
revisions it may make to forward-looking statements to reflect events or
circumstances after the date hereof or to reflect the occurrence of
unanticipated events.

(a) GENERAL DEVELOPMENT OF BUSINESS

  Pacific Gateway is a facilities-based international telecommunications
carrier, which provides international telecommunications services to its
target customer base of long distance service providers worldwide as well as
retail customers. The Company is incorporated in Delaware and commenced
operations on August 8, 1991. On July 25, 1996, the Company and certain
stockholders of the Company consummated an initial public offering of
6,057,050 shares of the Company's Common Stock. As a "facilities-based"
carrier, the Company owns or leases its international network facilities
including: digital undersea fiber optic cable, international switching
facilities and operating agreements with foreign carriers. The Company
operates an international network consisting of international and domestic
switching facilities in the U.S. in Los Angeles, New York, and Dallas, and
offshore in the United Kingdom, New Zealand and Russia. The Company has
partial ownership interests in 17 digital undersea fiber optic cable systems
in the Atlantic, Pacific and Caribbean regions and operating agreements that
provide for the exchange of traffic with foreign carriers.

  In 1997, the Company began to provide international long distance services
to retail customers through its existing network. In particular, the Company
and GMCR Inc. ("Globe Telecom"), a company operating in the Philippines,
formed a joint venture called "Pintouch" to market international long distance
services to the Filipino-American community.


                                       1
<PAGE>

  As of December 31, 1997, Pacific Gateway had 43 operating agreements with
foreign carriers in 28 countries around the world, which countries
collectively represent approximately 54.3% of U.S.-originated international
traffic according to Federal Communications Commission ("FCC") 1996
statistics. 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 non-dominant carriers that may have been recently
established as a result of the deregulation of foreign telecommunications
markets ("Competitive Carriers").

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:
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 signaling, 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 1996, according to the FCC, the U.S.-
Originated Market grew at an annual rate of 20.7% from $15.9 billion to $19.2
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 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

                                       2
<PAGE>

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. 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.

  In February 1997, over 60 countries signed a global agreement on
telecommunications under the auspices of the World Trade Organization (the
"WTO"), which became effective February 5, 1998. The agreement seeks to open
markets to competition in telecommunications services, improve 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.

Markets

  U.S.-Wholesale Market. The U.S. wholesale market provides international
telecommunications services to its target customer base of long distance
service providers worldwide. The Company's U.S. wholesale marketing efforts
are primarily directed to U.S.-based carriers that originate international
traffic but do not have operating agreements with foreign carriers to
terminate the traffic. In addition, international carriers with operating
agreements may use the services of other international carriers, such as
Pacific Gateway, for overflow traffic or on routes with smaller traffic
volumes.

  Offshore Market. Although the Company's extensive international network
enables it to compete in the entire international market outside the U.S.,
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. The Company's services in this market are predominantly
wholesale.

  Emerging and Value-Added Services Market. The Company is broadening its
focus to include a variety of emerging and value-added services. The Company
is utilizing its existing network to provide international long distance
services to certain ethnic retail markets. In addition, the Company intends to
expand the range of products and services that it offers to include
international 800, travel and debit cards, multimedia and internet services
and is in the beginning stage of doing so in some respects.

Services

  Switched Services. Switched services represent the largest component of
telecommunications traffic. These services are provided through transmission
facilities employing switches that automatically route calls to available
circuits. As shown in the following diagram, 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 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.

                                       3
<PAGE>




                    [INTERNATIONAL SWITCHED SERVICES CHART]

  Value-Added Services. Value-added services include 800 service,
international directory assistance with the option of call completion, travel
card services, enhanced facsimile services, videoconferencing and internet
access, 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. For example, 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 through the U.S. carrier the same percentage of total U.S.
terminating traffic as it receives from the U.S.-based carrier and also
provide for network coordination and accounting and settlement procedures. The
execution of an operating agreement between two carriers is typically
accompanied by an equal investment by both carriers in digital undersea fiber
optic cable between the two countries. 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:


                                       4
<PAGE>

Expand and Enhance Network Facilities

  To support the expected growth in data and voice traffic, the Company
intends to expand its investment in new and existing digital undersea fiber
optic cables. The Company is generally able to provide greater assurance of
the quality and reliability of transmission at a cost-effective rate 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
although there can be no assurance the Company will be successful in this
expansion. 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 Kokusai Denshin Denwa
("KDD Japan") entered into a seven-year cooperation agreement that
contemplates joint projects in the communications field, including joint
product development of enhanced services, such as imaging and internet
services.

  In February 1998, the Company acquired 16.66% of the stock of Ekonom S.A. de
C.V. ("Ekonom"), a Mexican multimedia and internet telecom provider. The
Company intends to use Ekonom's expertise to help it provide a portfolio of
multimedia and internet services to its customers. In addition, in conjunction
with the acquisition, the Company and Ekonom agreed to enter into an ethnic
retail marketing joint venture in order to market telecommunication services
to certain ethnic communities although the terms of the joint venture have not
yet been finalized.

  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. 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 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. In 1997, the Company
expanded its operations offshore to include the United Kingdom, Russia, and
New Zealand. The Company is currently expanding to 4 new offshore locations.
In each location the Company is in the process of obtaining the appropriate
licenses, and undergoing construction and pre-sales activities. There can be
no assurance that the Company will be successful in the expansion to these new
locations.

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 and is in the beginning stages of doing so in some
respects. 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.


                                       5
<PAGE>

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 Customer Segments

  Pacific Gateway intends to leverage its existing network by marketing
international long distance services directly to the retail market, including
ethnic marketing. 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 however, selling, general and administrative costs directly related to
the provision of these services are also anticipated to increase. To develop
this aspect of its business more rapidly, the Company may enter into
partnerships or alliances with companies which have an existing customer base
that Pacific Gateway intends to target. Examples of this include the October
1997 formation of the Pintouch joint venture between the Company and Globe
Telecom to market international long distance services to the Filipino-
American community. In addition, in conjunction with the February 1998
acquisition of 16.66% of Ekonom, the Company and Ekonom agreed to enter into
an ethnic retail marketing joint venture.

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

                                       6
<PAGE>

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.

(B) FINANCIAL INFORMATION ABOUT INDUSTRY SEGMENTS

  The Company classifies its operations into one industry segment,
telecommunications services.

(C) NARRATIVE DESCRIPTION OF BUSINESS

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 and domestic switched
services.

International Switched Services

  The Company's international switched service revenues are generated from
outgoing and incoming international traffic carried through its international
network including switching facilities in the United Kingdom, New Zealand and
Russia. Revenues from international switched services are derived from
country-specific, usage-sensitive rates charged to its customers, return
traffic from Pacific Gateway's foreign partners, and terminating traffic in
its international switching facilities.

  As of December 31, 1997, the Company had 43 operating agreements with
foreign carriers in 28 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 96.4%, 91.6% and 88.1% of the Company's revenues in 1997, 1996
and 1995, 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). The Company provides switched services as a
cost-effective means to terminate its return traffic in the mentioned areas
and for the U.S., to offer services to U.S.-based long distance resellers that
do not own or lease switching facilities ("switchless resellers"). Domestic
switched services accounted for approximately 2.6%, 7.4% and 11.7% of the
Company's total revenues in 1997, 1996 and 1995 , respectively.

Emerging and Value-Added Services

  The Company is broadening its focus to include a variety of emerging and
value-added services. The Company is utilizing its existing network to provide
international long distance services to certain ethnic retail markets. In
particular, the Company and Globe Telecom formed a joint venture called
"Pintouch" to market international long distance services to the Filipino-
American community. In addition, the Company intends to expand the range of
products and services that it offers to include a variety of value-added
services including directory assistance, prepaid services such as debit and
travel cards, multimedia and internet services to its U.S.-based wholesale
carrier customers that do not provide such services directly to their
customers. The Company also has international 800 service available in 7
countries. The Company intends to enter the multimedia services

                                       7
<PAGE>

market utilizing its relationship with Ekonom, a Mexican multimedia and
internet telecom provider in which the Company acquired a minority equity
interest in February 1998. In the aggregate, these services accounted for less
than 1% of the Company's revenues in each of 1997, 1996 and 1995.

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 1997, 1996 and 1995.

CUSTOMERS

  The Company sells its services to long distance international
telecommunications companies, foreign partners and retail customers. At
December 31, 1997, the Company had 43 operating agreements and approximately
125 customers worldwide. In 1997, Frontier Communications, Inc. accounted for
10.4% of the Company's revenues. For further information regarding significant
customers see Note (6) entitled "Segment Data" in the Notes to Consolidated
Financial Statements included in Part II, Item 8 of this 10-K.

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. 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
personal communications services. The Company is unable to predict which of
many possible future products and service offerings will be important to
maintain its competitive position or what expenditures will be required to
develop and provide such products and services.

  Recent regulatory changes also are expected to increase competition in the
telecommunications industry. In February 1996, the Telecommunications Act of
1996 (the "Telecom Act") was adopted. The Telecom Act promotes additional
competition in the intrastate, interstate and international telecommunications
markets by both U.S.- based and foreign companies. The Telecom Act permits the
Regional Bell Operating Companies ("RBOCs") to compete in interstate and
international service. Some RBOCs have begun to resell international services.
AT&T has obtained relaxed pricing restrictions and relief from other
regulatory constraints that should make it easier for AT&T to compete with
alternative carriers such as the Company. In addition, in February 1997, over
60 countries signed a global agreement on telecommunications under the
auspices of the World Trade

                                       8
<PAGE>

Organization (the "WTO"), which agreement became effective in February 1998.
This agreement (the "WTO Agreement") seeks to open markets to competition in
telecommunications services, improve foreign investment opportunities in the
telecommunications industry and promote pro-competitive regulatory principles.
The FCC has adopted various rules designed to implement the principles of the
WTO Agreements. See "- Government Regulation." There can be no assurance that
the Company will be able to effectively compete in the new regulatory
environment or that these changes or other regulatory developments will not
have a material adverse effect on the Company's business, financial condition
or results of operations.

GOVERNMENT REGULATION

Overview

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

Federal Regulation

  General Requirements. The Company must comply with the requirements of
common carriage under the Communications Act of 1934, as amended (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 has streamlined its regulation of non-dominant international
carriers to provide that these tariffs and any revisions thereto are effective
upon one day's notice in lieu of the previous 14-day notice period. The
Company has filed international tariffs (for switched and private line
services) with the FCC. Nevertheless, an otherwise non-dominant U.S.-based
carrier may be subject to dominant carrier regulation on a specific
international route if it is affiliated with a foreign carrier with market
power operating at the foreign point. The Company is not subject to dominant
carrier treatment on any route.

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

  In late 1996, the FCC implemented significant changes in its tariff
requirements. Exercising forbearance authority granted to it by the Telecom
Act, the FCC ruled that non-dominant interexchange carriers are no longer
required to file tariffs for domestic services. In August 1997, the FCC
affirmed its decision to end tariff filing requirements for domestic
interstate long distance services provided by non-dominant carriers. The FCC
also eliminated the requirement that non-dominant long distance carriers make
publicly available information on rates and terms of their products. The
detariffing order has been stayed by the U.S. Court of Appeals for the
District of Columbia and the order on reconsideration also is stayed until the
Court issues a decision. It is not known when the Court of Appeals will issue
a decision.


                                       9
<PAGE>

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

  The Company must conduct its international business in compliance with the
FCC's international settlements policy ("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.

  To promote competition in the international telecommunications market, in
November 1996, the FCC 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. Under
the new order, the FCC will no longer apply the ECO Test (defined below) as a
threshold for determining when to permit accounting rate flexibility with
carriers from WTO member countries. Instead, the FCC adopted a rebuttable
presumption that flexibility is permitted for WTO member countries. Although
the Company is unable to predict exactly how this new FCC order will affect
its international business, the new ISP may reduce international access costs
and facilitate the Company's international business.

  International telecommunications service providers are required to file
copies of their contracts with other carriers, including operating agreements,
with the FCC within 30 days of execution. 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.

  In February 1997, the United States entered in the WTO Agreement, which
seeks to open markets to competition in telecommunications services, improve
foreign investment opportunities in the telecommunications industry and
promote pro-competitive regulatory principles. In June 1997, the FCC proposed
to implement new rules in order to comply with the WTO Agreement. These new
rules were adopted by the FCC in November 1997 and became effective in
February 1998.

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

  The FCC also narrowed the "No Special Concessions" rule, which generally
provides that United States carriers cannot accept benefits from foreign
carriers to which other United States carriers are not entitled. This rule
continues to apply to non-WTO Carriers. The new rule applicable to WTO
Carriers simply prohibits United States carriers from entering into exclusive
arrangements with WTO Carriers that have sufficient market power to affect
competition adversely in the United States market. To provide more certainty
in the market, the

                                      10
<PAGE>

FCC adopted a rebuttable presumption that WTO Carriers with less than 50%
market share in foreign market lack such market power. As a result, United
States carriers may enter into exclusive dealings with WTO Carriers involving
a variety of matters, including operating agreements and interconnection
arrangements.

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

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

  The Company is unable to predict the full effect on the international
telecommunications market resulting from the WTO Agreement or the rules
enacted to implement its provisions or the establishment of mandatory
settlement rate benchmarks. These changes are expected to increase competition
in the telecommunications market. See "--Competition". These changes may
result in lower costs to the Company, however, the revenues that the Company
receives from inbound international traffic may decrease to a greater degree
as a result of increased competition. WTO Carriers with market power in their
home markets may be able to more easily offer United States and foreign
customers services to the disadvantage of United States carriers, which may
continue to face substantial obstacles in obtaining from foreign governments
and foreign carriers the authority and facilities to provide such services. In
addition, many foreign carriers are currently challenging the enforceability
against such carriers of the FCC's order adopting mandatory settlement rate
benchmarks. A finding that this order was unenforceable against such carriers
could accelerate the entry of foreign carriers into the United States market
by making it easier for foreign carriers to route international traffic to the
United States at low, cost-based termination rates, while United States
carriers would continue to have to route international traffic into most
foreign countries at much higher settlements rates. There can be no assurance
that these events would not have a material adverse effect on the Company's
business, financial condition or results of operations.

  Foreign Ownership. Under the Communications Act, non-U.S. citizens, foreign
governments or corporations organized under the laws of a foreign country that
is not WTO member country may not (i) directly or indirectly own greater than
25% of an international Section 214 licensee or (ii) indirectly own greater
than 25% of a radio licensee, in each case without first obtaining FCC
approval after satisfying the ECO Test. For WTO Carriers, the FCC has replaced
the ECO Test in favor of an open entry standard, provided that certain
competitive safeguards will continue to apply. The FCC has reserved the right
in certain cases to attach additional conditions to a grant of authority, and
to deny the application in the exceptional case in which an application poses
a very high risk to competition.


                                      11
<PAGE>

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

  In implementing the Telecom Act, the FCC established nationwide rules
designed to encourage new entrants to participate in the local services
markets through interconnection with the incumbent local exchange carriers
("ILECs"), resale of ILECs' retail services, and use of individual and
combinations of unbundled network elements. These rules set the groundwork for
the statutory criteria governing RBOC entry into the long distance market.
Appeals of the FCC Order adopting those rules were consolidated before the
United States Court of Appeals for the Eighth Circuit (the "Eighth Circuit").
The Eighth Circuit upheld challenges to certain practices implementing cost
provisions of the Telecom Act that were ordered by certain state public
utility commissions to be premature, but vacated significant portions of the
FCC's nationwide pricing rules, and vacated an FCC rule requiring that
unbundled network elements be provided on a combined basis. The Solicitor
General, on behalf of the FCC, and certain other parties, sought certiorari in
the United States Supreme Court, which was granted. Certain RBOCs have also
raised constitutional challenges to provisions of the Telecom Act restricting
RBOC provision of long distance services, manufacturing of telecommunications
equipment, electronic publishing and alarm monitoring services. On December
31, 1997, the United States District Court for the Northern District of Texas
ruled that these restrictions violate the Bill of Attainder Clause of the U.S.
Constitution. Currently, this decision only applies to SBC Corporation
("SBC"), US West Communications Group ("US WEST") and Bell Atlantic
Corporation ("Bell Atlantic"). AT&T, MCI, the U.S. Department of Justice and
the FCC announced that they will appeal the decision and sought a stay of the
ruling. The Company cannot predict either the ultimate outcome of these or
future challenges of the Telecom Act, any related appeals of regulatory or
court decisions, or the eventual effect on its businesses or the industry in
general.

  The FCC has denied applications filed by Ameritech Corporation
("Ameritech"), SBC and BellSouth Corporation ("BellSouth") seeking authority
to provide inter-local access transport area ("interLATA") long distance
service to Michigan, Oklahoma and South Carolina, respectively. SBC has
appealed the FCC's denial of its application to the Eighth Circuit. In its
denial of an Ameritech application and a BellSouth application, the FCC
provided detailed guidance to applicants regarding the obligations of the
applicants, the format of future applications, the content of future
applications, and the review standards that it will apply in evaluating any
future applications. The National Association of Regulatory Utility
Commissioners and several state regulatory commissions have appealed
jurisdictional aspects of the Ameritech application denial to the Eighth
Circuit. The Company cannot predict either the outcome of these appeals, of
the RBOC's willingness to abide by these FCC guidelines, or the timing or
outcome of future applications submitted to the FCC. Other RBOCs have
announced their intention to file applications at the FCC for authority to
provide inter LATA services. The Company cannot predict the outcome of these
proceedings. To the extent that the RBOC's are permitted to enter the
international long-distance business, they could become major competitors of
the Company. It is also possible that they could become customers of the
Company's wholesale business although there is no assurance that this would
happen.

  On May 7, 1997, the FCC announced that it will issue a series or orders that
will reform Universal Service Subsidy allocations and adopted various reforms
to the existing rate structure for interstate access services provided by the
ILECs that are designed to reduce access charges, over time, to more
economically efficient levels and rate structures. It also affirmed that
information services providers (including, among others, internet service
providers ("ISPs") should not be subject to existing access charges ("ISP
Exemption"). Petitions for

                                      12
<PAGE>

reconsideration of, among other things, the access service and ISP Exemption
related actions were filed before the FCC and appeals taken to various United
States Courts of Appeals. On reconsideration, the FCC, in significant part,
affirmed the access charge and ISP Exemption actions, and the court appeals
have been consolidated before the Eighth Circuit. Also, several state agencies
have started proceedings to address the reallocation of implicit subsidies
contained in access rates and retail service rates to state universal service
funds. Access charges are a principal component of the Company's
telecommunications expense. Pacific Gateway cannot predict either the outcome
of these appeals or whether or not the result(s) will have a material impact
upon the consolidated financial position or the Company's results of
operations.

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 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, which compete with the PTT, may not be permitted by foreign
regulatory agencies or the PTT may act unilaterally to cancel or eliminate the
private line service on which the alternative carrier depends. In 1997,
regulatory authorities in Hong Kong and the PTT in Mexico have acted against
such arrangements. 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, loss of licenses or of license opportunities,
fines, seizure of equipment and, in certain foreign jurisdictions, criminal
prosecution. The revenue and/or profit generated under such arrangements may
have become a significant portion of the overall revenue and/or profit of the
Company at the time such arrangements are discovered and curtailed. Moreover,
the discovery of the existence of such arrangements by foreign PTTs could
adversely affect the Company's business relationships with such foreign PTTs.
Any of the developments described above (i.e., the imposition of penalties,
the loss of revenue and/or profit generated by such arrangements (whether as a
result of regulatory problems or 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.

EMPLOYEES

  As of December 31, 1997, Pacific Gateway's wholly-owned subsidiaries had 90
full-time employees, of which 10 were engaged in international relations, 39
in operations, engineering and information systems, 20 in sales, customer
support and business development, 21 in administration. The Russian subsidiary
of which the company owns a majority interest has 30 employees.

(D) FINANCIAL INFORMATION ABOUT FOREIGN AND DOMESTIC OPERATIONS AND EXPORT
SALES

  During 1997, the company developed and acquired offshore subsidiaries in the
United Kingdom, New Zealand, Russia, Bermuda and Cyprus. For information
regarding foreign and domestic operations and export sales from the U.S. see
Note (6) entitled "Segment Data" in the Notes to the Consolidated Financial
Statements included in Part II, Item 8 of this 10-K.

RISK FACTORS

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

                                      13
<PAGE>

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.

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 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 a significant portion of 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, foreign currency
fluctuations, and import and export regulations. 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. Furthermore, in
the event of any dispute arising from foreign operations, the Company may be
subject to the exclusive jurisdiction of foreign courts and may not be
successful in subjecting foreign persons or entities to the jurisdiction of
the courts in the United States. The Company may also be hindered or prevented
from enforcing their rights with respect to foreign governments because of the
doctrine of sovereign immunity. There can be no assurance that the laws,
regulations or administrative practices of foreign countries relating to the
Company's ability to do business in that country will not change. Any such
change could have a material adverse effect on the business and financial
condition of the Company.

  In addition, the Company's business could be adversely affected by a
reversal in the current trend toward deregulation of government-owned
telecommunications carriers. The rates that the Company can charge its
customers for international services may also decrease in the future due to
the widespread resale of international private lines to provide switched voice
services, the provision of international services via non-traditional means
including Internet and the rapid growth of international circuit capacity due
to the deployment of new undersea fiber optic cables and new high capacity
satellite systems in the Atlantic, Pacific and Indian Ocean regions. There can
be no assurance that the Company will be able to increase its traffic volume
or reduce its operating costs sufficiently to offset any resulting rate
decreases.


                                      14
<PAGE>

  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
in 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 which compete
with the PTT, may not be permitted by foreign regulatory agencies or the PTT
may act unilaterally to cancel or eliminate the private line service on which
the alternative carrier depends. In 1997, regulatory authorities in Hong Kong
and the PTT in Mexico have acted against such arrangements. 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, loss of
licenses or of license opportunities, fines, seizure of equipment and, in
certain foreign jurisdictions, criminal prosecution. The revenue and/or profit
generated under such arrangements may have become a significant portion of the
overall revenue and/or profit of the Company at the time such arrangements are
discovered and curtailed. Moreover, the discovery of the existence of such
arrangements by foreign PTTs could adversely affect the Company's business
relationships with such foreign PTTs. Any of the developments described above
(i.e., the imposition of penalties, the loss of revenue and/or profit
generated by such arrangements (whether as a result of regulatory problems or
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 has not controlled the planning or
construction of digital undersea fiber optic transmission facilities. The
Company seeks access to such facilities through partial ownership positions.
If ownership positions are not available, the Company must seek access to such
facilities through lease arrangements on negotiated terms that may vary with
industry and market conditions. The Company currently has partial ownership
interests in 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 competitors of the Company. The
cost of leasing access from the Company's gateway switches to the digital
undersea fiber optic cable heads is currently approximately less than 1% 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.

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

                                      15
<PAGE>

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. 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.

  Recent regulatory changes also are expected to increase competition in the
telecommunications industry. In February 1996, the Telecom Act was adopted.
The Telecom Act promotes additional competition in the intrastate, interstate
and international telecommunications markets by both U.S.-based and foreign
companies. The Telecom Act permits the RBOCs to compete in interstate and
international service. Some RBOCs have begun to resell international services.
AT&T has obtained relaxed pricing restrictions and relief from other
regulatory constraints that should make it easier for AT&T to compete with
alternative carriers such as the Company. In addition, in February 1997, over
60 countries signed a global agreement on telecommunications under the
auspices of the WTO, which agreement became effective in February 1998. The
WTO Agreement seeks to open markets to competition in telecommunications
services, improve foreign investment opportunities in the telecommunications
industry and promote pro-competitive regulatory principles. The FCC has
adopted various rules designed to implement the principles of the WTO
Agreements See "Business--Government Regulation." There can be no assurance
that the Company will be able to effectively compete in the new regulatory
environment or that these changes or other regulatory developments will not
have a material adverse effect on the Company's business, financial condition
or results of operations.

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 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
and Vice President, Finance, as well as a group of employees with long-
standing industry relationships and technical knowledge of the Company's
operations. The loss of the services of one or more of these individuals could
materially and adversely affect the business of the Company and its future
prospects. The Company does 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.

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 the
capital requirements of its current business for the foreseeable future,
certain events may occur that would require the Company to obtain additional
financing, which could take the form of the public sale of debt or equity
securities. Such events could include acquisitions, the decision to expand
investment in facilities, faster than expected growth, or lower than
anticipated funds generated from operations. There can be no assurance that
the Company will be able to raise additional financing, or, if raised, that
the terms of such financing will be favorable to the Company.


                                      16
<PAGE>

Government Regulation

  The Company's business is heavily regulated. See "Business--Government
Regulation". The Company's interstate and international facilities-based and
resale services are subject to regulation by the FCC, and regulations
promulgated by the FCC are subject to change in the future. The Company 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's business, financial condition
or results or operation or that regulators or third parties will not raise
issues or take enforcement actions with regard to the Company's compliance
with applicable regulations.

  The telecommunications industry has recently experienced significant
regulatory changes designed to open markets to competition in
telecommunications services, improve foreign investment opportunities in the
telecommunications industry and promote pro-competitive regulatory principles.
See "Business--Government Regulation." The Company is unable to predict the
full effect of these changes on the international telecommunications market.
These changes are expected to increase competition in the telecommunications
market. See "--Competition." These changes may result in lower costs to the
Company, however, the revenues that the Company receives from inbound
international traffic may decrease to a greater degree as a result of
increased competition. WTO Carriers with market power in their home markets
may be able to more easily offer United States and foreign customers services
to the disadvantage of United States carriers, which may continue to face
substantial obstacles in obtaining from foreign governments and foreign
carriers the authority and facilities to provide such services. In addition,
many foreign carriers are currently challenging the enforceability against
such carriers of the FCC's order adopting mandatory settlement rate
benchmarks. A finding that this order was unenforceable against such carriers
could accelerate the entry of foreign carriers into United States market by
making it easier for foreign carriers to route international traffic to the
United States at low, cost-based termination rates, while United States
carriers would continue to have to route international traffic into most
foreign countries at much higher settlement rates. There can be no assurance
that these events would not have a material adverse effect on the Company's
business, financial condition or results of operations.

Foreign Ownership

  Under the Communications Act, non-U.S. citizens, foreign governments or
corporations organized under the laws of a foreign country that is not WTO
member country may not (i) directly or indirectly own greater than 25% of an
international Section 214 licensee or (ii) indirectly own greater than 25% of
a radio licensee, in each case without first obtaining FCC approval after
satisfying the ECO Test. For WTO Carriers, the FCC has recently replaced the
ECO Test in favor of an open entry standard, provided, that certain
competitive safeguards will continue to apply. See "Business--Government
Regulation." This new standard is expected to increase competition in the
telecommunications market. See "--Competition." In addition, this standard may
make it easier for foreign competitors to acquire customers of the Company,
which may result in the migration of those customers from the Company's
network and onto the competitors' networks.

Federal Legislation and Implementation

  The Telecom 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 Telecom 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

                                      17
<PAGE>

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 Telecom Act also imposes certain requirements on all telecommunications
carriers to facilitate the entry of new telecommunications providers. All
carriers must permit interconnection of their networks with other carriers and
may not deploy network features and functions that interfere with
interoperability. The FCC Interconnection Order, which implements the
statutory provisions, has not taken effect pending a court challenge brought
by certain RBOCs. In addition, the Telecom 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.

  Certain provisions of the Telecom Act could materially affect the growth and
operation of the telecommunications industry and the services provided by the
Company. There are numerous rulemakings undertaken or to be undertaken by the
FCC which will interpret and implement the Telecom Act's provisions. Further,
certain of the Telecom 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 implementing the Telecom Act, the FCC established nationwide rules
designed to encourage new entrants to participate in the local services
markets through interconnection with the ILECs, resale of ILECs' retail
services, and use of individual and combinations of unbundled network
elements. These rules set the groundwork for the statutory criteria governing
RBOC entry into the long distance market. Appeals of the FCC Order adopting
those rules were consolidated before the Eighth Circuit. The Eighth Circuit
upheld constitutional challenges to certain practices implementing cost
provisions of the Telecom Act that were ordered by certain state public
utility commissions to be premature, but vacated significant portions of the
FCC's nationwide pricing rules, and vacated an FCC rule requiring that
unbundled network elements be provided on a combined basis. The Solicitor
General, on behalf of the FCC, and certain other parties, sought certiorari in
the United States Supreme Court, which was granted. Certain RBOCs have also
raised constitutional challenges to provisions of the Telecom Act restricting
RBOC provision of long distance services, manufacturing of telecommunications
equipment, electronic publishing and alarm monitoring services. On December
31, 1997, the United States District Court for the Northern District of Texas
ruled that these restrictions violate the Bill of Attainder Clause of the U.S.
Constitution. Currently, this decision only applies to SBC, US WEST and Bell
Atlantic. AT&T, MCI, the U.S. Department of Justice and the FCC announced that
they will appeal the decision and sought a stay of the ruling. The Company
cannot predict either the ultimate outcome of these or future challenges of
the Telecom Act, any related appeals of regulatory or court decisions, or the
eventual effect on its businesses or the industry in general.

  The FCC has denied applications filed by Ameritech, SBC and BellSouth
seeking authority to provide interLATA long distance service to Michigan,
Oklahoma and South Carolina, respectively. SBC has appealed the FCC's denial
of its application to the Eighth Circuit. In its denial of an Ameritech
application and a BellSouth application, the FCC provided detailed guidance to
applicants regarding the obligations of the applicants, the format of future
applications, the content of future applications, and the review standards
that it will apply in evaluating any future applications. The National
Association of Regulatory Utility Commissioners and several state regulatory
commissions have appealed jurisdictional aspects of the Ameritech application
denial to the Eighth Circuit. The Company cannot predict either the outcome of
these appeals, of the RBOC's willingness to abide by these FCC guidelines, or
the timing or outcome of future applications submitted to the FCC. Other RBOCs
have announced their intention to file applications at the FCC for authority
to provide inter LATA services. The Company cannot predict the outcome of
these proceedings. To the extend that the RBOC's are permitted to enter the
international long-distance business, they could become major competitors of
the Company. It is also possible that they could become customers of the
Company's wholesale business, although there is no assurance that this would
happen.


                                      18
<PAGE>

  On May 7, 1997, the FCC announced that it will issue a series or orders that
will reform Universal Service Subsidy allocations and adopted various reforms
to the existing rate structure for interstate access services provided by the
ILECs that are designed to reduce access charges, over time, to more
economically efficient levels and rate structures. It also affirmed that
information services providers (including, among others, ISPs) should not be
subject to existing access charges. Petitions for reconsideration of, among
other things, the access service and ISP Exemption related actions were filed
before the FCC and appeals taken to various United States Courts of Appeals.
On reconsideration, the FCC, in significant part, affirmed the access charge
and ISP Exemption actions, and the court appeals have been consolidated before
the Eighth Circuit. Also, several state agencies have started proceedings to
address the reallocation of implicit subsidies contained in access rates and
retail service rates to state universal service funds. Access charges are a
principal component of the Company's telecommunications expense. Pacific
Gateway cannot predict either the outcome of these appeals or whether or not
the result(s) will have a material impact upon the consolidated financial
position or the Company's results of operations.

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

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

Effects of Natural Disasters and Other Catastrophic Events

  The Company's business is susceptible to natural disasters and catastrophic
events such as earthquakes, fire, terrorism and war. Although the Company has
taken a number of steps to prevent its network from being affected by natural
disasters such as building redundant systems for power supply to the switching
equipment, there can be no assurance that any such systems will prevent the
Company's switches from becoming disabled in the event of an earthquake, power
outage or otherwise. The failure of the Company's network, or a significant
decrease in telephone traffic resulting from effects of a natural or man-made
disaster, could have a material adverse effect on the Company's relationship
with its customers and the Company's business, results of operations and
financial condition.

Concentration Of Credit Risk

  Seven of the Company's customers accounted for approximately 40% and 52% of
gross accounts receivable as of December 31, 1997 and December 31, 1996,
respectively. One customer accounted for 10.4% of the Company's 1997 revenues.
The Company performs ongoing credit evaluations of its customers but generally
does not require collateral to support accounts receivable from its customers.
The Company's allowance for doubtful accounts is based on current market
conditions. Losses on uncollectible accounts have consistently been
insignificant and within management's expectations. However, the failure of
any of the Company's large customers to remit payments to the Company due to
bankruptcy or otherwise could have a material adverse effect on the Company's
business, financial condition and results of operations.

Anti-Takeover Provisions

  The Company's Board of Directors has the authority to issue up to 5,000,000
shares of preferred stock (the "Preferred Stock") and to determine the price,
rights, preferences and privileges of those shares without any further vote or
actions by the stockholders. The rights of the holders of Common Stock will be
subject to, and may be adversely affected by, the rights of the holders of any
Preferred Stock that may be issued in the future. The issuance of shares of
Preferred Stock, while potentially providing desirable flexibility in
connection with possible acquisitions and serving other corporate purposes,
could have the effect of making it more difficult for a third party to
acquire, or may discourage a third party from attempting to acquire, a
majority of the outstanding

                                      19
<PAGE>

voting stock of the Company. In addition, the Company is subject to the anti-
takeover provisions of Section 203 of the Delaware General Corporation Law,
which prohibits the Company from engaging in a "business combination" with an
"interested stockholder" for a period of three years after the date of the
transaction in which the person became an interested stockholder unless the
business combination is approved in a prescribed manner. The application of
Section 203 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 and that 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 a change in control of the Company, which could adversely affect
the market price of the Company's Common Stock. In addition, the Company
adopted a stockholders rights plan (the "Stockholders Rights Plan") in
November 1997 and in connection therewith entered into a Rights Agreement
between the Company and Norwest Bank Minnesota N.A., as Rights Agent, dated as
of November 17, 1997, which will cause substantial dilution to a person or
group that attempts to acquire the Company on terms not approved by the
Company's Board of Directors. These provisions, along with the adoption of the
Stockholders Rights Plan, may discourage takeover bids for the Company. See
Note (11) in the Notes to the Consolidated Financial Statements included in
Part II, Item 8 of this 10-K for further information on the Stockholders'
Rights Plan.

Influence 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
still own and control a significant portion of the outstanding shares of
Common Stock although, as a result of sales pursuant to Rule 144, their
collective ownership has been reduced during 1997. As a result of their
ownership of shares of Common Stock, these stockholders of the Company, to the
extent acting together, may influence the management and policies of the
Company. Through direct ownership of shares owned and proxies to vote, Mr.
Neckowitz has the right to vote a substantial percentage 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 18, 1998, there were 19,113,955 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 or in the
case of Original Stockholders who are not affiliates, until the requisite
holding period under Rule 144 has been met. 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 to develop and expand its business.


                                      20
<PAGE>

ITEM 2. PROPERTIES

  The principal offices of the Company are located in 12,950 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 40,000 square feet in the U.S. in the cities of New York, Los
Angeles and Dallas and in the United Kingdom, New Zealand and Russia as sites
for its switching facilities. In addition, the Company leases a total of
approximately 3,000 square feet of office space in Houston, Texas, Tarzana,
California and Riverside, California for its operations. The Company believes
that its facilities are adequate to support its current needs and that
suitable additional facilities will be available, when needed, on commercially
reasonable terms.

ITEM 3. LEGAL PROCEEDINGS

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

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

  No matters were submitted to a vote of shareholders of the Company during
the fourth fiscal quarter of the fiscal year ended December 31, 1997.

EXECUTIVE OFFICERS

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

  The executive officers of the Company are as follows:

<TABLE>
<CAPTION>
 NAME                          AGE POSITION
 ----                          --- --------
 <C>                           <C> <S>
 Howard A. Neckowitz.........  44  President and Chief Executive Officer
 Gail E. Granton.............  42  Executive Vice President, International
                                    Business Development and Secretary
 Sandra D. Grey..............  31  Chief Financial Officer and Vice President,
                                   Finance
 Ronald D. Anderson..........  41  Senior Vice President, Operations and
                                   Engineering
 Robert F. Craver............  55  Senior Vice President, International
                                   Relations
 Fred A. Weismiller..........  56  Executive Vice President, International
                                   Marketing
</TABLE>

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

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


                                      21
<PAGE>

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

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

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

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


                                      22
<PAGE>

                                    PART II

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

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

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

<TABLE>
<CAPTION>
                                                                 HIGH     LOW
                                                                ------- -------
      <S>                                                       <C>     <C>
      Quarter ended September 30, 1996 (from July 19, 1996).... $31.000 $12.000
      Quarter ended December 31, 1996.......................... $37.125 $25.875
      Quarter ended March 31, 1997............................. $39.250 $22.500
      Quarter ended June 30, 1997.............................. $29.000 $21.750
      Quarter ended September 30, 1997......................... $39.375 $27.000
      Quarter ended December 31, 1997.......................... $55.125 $33.000
</TABLE>

  As of March 18, 1998 there were 97 holders of record of the Common Shares of
the Company.

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

                                      23
<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, 1997 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,
                                   --------------------------------------------
                                    1993    1994    1995      1996      1997
                                   ------  ------- -------  --------  ---------
                                    (IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
<S>                                <C>     <C>     <C>      <C>       <C>
STATEMENT OF OPERATIONS DATA:
Revenues.........................  $5,048  $20,913 $76,416  $162,426  $ 298,609
Cost of long distance services...   4,036   17,196  66,346   140,340    254,076
                                   ------  ------- -------  --------  ---------
 Gross margin....................   1,012    3,717  10,070    22,086     44,533
Selling, general and administra-
 tive expenses...................   1,008    2,273   5,467    11,113     21,416
Depreciation.....................     104      410   1,124     2,044      5,417
                                   ------  ------- -------  --------  ---------
 Operating income (loss).........    (100)   1,034   3,479     8,929     17,700
Other expense/(income), net......      --       --      --       129       (126)
Interest expense/(income), net...      12      193     538      (885)    (2,009)
                                   ------  ------- -------  --------  ---------
 Income (loss) before income tax-
  es.............................    (112)     841   2,941     9,685     19,835
Provision for income taxes.......      --      205   1,155     3,877      7,338
                                   ------  ------- -------  --------  ---------
 Net income (loss)...............  ($ 112) $   636 $ 1,786  $  5,808  $  12,497
                                   ======  ======= =======  ========  =========
Net income (loss) per share--di-
 luted...........................  ($0.01) $  0.04 $  0.12  $   0.34  $    0.64
                                   ======  ======= =======  ========  =========
Weighted average shares outstand-
 ing--diluted....................  14,300   14,300  14,535    16,872     19,497
                                   ======  ======= =======  ========  =========
<CAPTION>
                                            YEAR ENDED DECEMBER 31,
                                   --------------------------------------------
                                    1993    1994    1995      1996      1997
                                   ------  ------- -------  --------  ---------
                                   (IN THOUSANDS EXCEPT REVENUES PER MINUTE
                                                OF USE AMOUNTS)
<S>                                <C>     <C>     <C>      <C>       <C>
OTHER OPERATING DATA:
 EBITDA (1)......................  $    4  $ 1,444 $ 4,603  $ 10,973  $  23,117
 Capital Expenditures............  $1,542  $ 3,745 $ 7,233  $ 18,669  $  36,725
 Minutes of use..................  13,580   61,690 252,925   563,495  1,025,649
 Revenues per minute use.........  $ 0.37  $  0.34 $  0.30  $   0.29  $    0.29
 Estimated return traffic revenue
  backlog (2)....................  $  158  $   986 $ 6,142  $ 13,719  $  10,685
<CAPTION>
                                              AS OF DECEMBER 31,
                                   --------------------------------------------
                                    1993    1994    1995      1996      1997
                                   ------  ------- -------  --------  ---------
<S>                                <C>     <C>     <C>      <C>       <C>
BALANCE SHEET DATA
 Cash and cash equivalents.......  $   63  $     9 $ 1,792  $ 45,563  $  43,850
 Working capital (deficit).......    (865)     242  (6,412)   35,051    (14,541)
 Total assets....................   4,130   12,301  29,976   103,816    171,617
 Revolving line of credit........      --       --   3,000        --         --
 Revolving line of credit, re-
  lated party....................     718    4,488   2,420        --         --
 Stockholders' equity............     468    1,104   2,891    62,472     76,573
</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."

                                      24
<PAGE>

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

NOTE ON FORWARD-LOOKING STATEMENTS

  This Annual Report contains certain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended, 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," "plans,"
"intends" or "expects." These forward-looking statements relate to the plans,
objectives and expectations of Pacific Gateway regarding its future operations
or financial performance or related to the Company's expectations regarding
the telecommunications industry. In light of the inherent risks and
uncertainties of any forward-looking statement, the inclusion of forward-
looking statements in this report should not be regarded as a representation
by the Company or any other person that the forward-looking statements will
come true. The revenues and results of operations of the Company, and the
future developments in the telecommunications industry are difficult to
forecast and could differ materially from those projected in the forward-
looking statements as a result of numerous factors, including the following:
(i) changes in international settlement rates; (ii) changes in the ratios
between outgoing and incoming traffic; (iii) foreign currency fluctuations;
(iv) termination of certain operating agreements or inability to enter into
additional operating agreements; (v) inaccuracies in the Company's forecasts
of traffic; (vi) changes in or developments under domestic or foreign laws,
regulations, licensing requirements or telecommunications standards; (vii)
foreign political or economic instability; (viii) changes in the availability
of transmission facilities, such as undersea fiber optic cable; (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; (xii) future management
decisions regarding, for example, acquisitions, capital expenditures or
financings (xiii) concentration of credit risk or (xiv) natural disasters and
catastrophic events. The foregoing review of important factors including those
discussed in detail below should not be construed as exhaustive; the Company
undertakes no obligation to release publicly the results of any future
revisions it may make to forward-looking statements to reflect events or
circumstances after the date hereof or to reflect the occurrence of
unanticipated events.

OVERVIEW

  Pacific Gateway was founded in August 1991 to capitalize on the significant
growth opportunities in the international telecommunications services market.
The Company operates an international network consisting of international and
domestic switching facilities in the U.S in New York, Los Angeles, and Dallas
and offshore in the United Kingdom, New Zealand and Russia. The Company has
partial ownership interests in 17 digital undersea fiber optic cables 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, 1997, the Company had 43 operating agreements in 28
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. In addition,
the Company has begun to recognize revenue from retail customers generated by
Pintouch the Company's joint venture with Globe Telecom.

  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

                                      25
<PAGE>

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 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 partners as an expense in the period the
Company's traffic is delivered.

  Of the Company's operating agreements in service as of December 31, 1997, 18
agreements provide that the Company 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 following table sets forth income statement data as a percentage of
revenues for the period indicated.

<TABLE>
<CAPTION>
                                                             YEAR ENDED
                                                            DECEMBER 31,
                                                          ---------------------
                                                          1997    1996    1995
                                                          -----   -----   -----
     <S>                                                  <C>     <C>     <C>
     Total revenues...................................... 100.0%  100.0%  100.0%
     Cost of long distance services......................  85.1%   86.4%   86.8%
                                                          -----   -----   -----
       Gross margin......................................  14.9%   13.6%   13.2%
     Selling, general and administrative expenses........   7.2%    6.8%    7.2%
     Depreciation........................................   1.8%    1.3%    1.5%
                                                          -----   -----   -----
       Total operating expenses..........................   9.0%    8.1%    8.7%
                                                          -----   -----   -----
       Operating income..................................   5.9%    5.5%    4.5%
     Other (income)/expenses, net........................   0.0%    0.0%    0.0%
     Interest (income)/expense, net......................  (0.7%)  (0.5%)   0.7%
                                                          -----   -----   -----
       Income before income taxes........................   6.6%    6.0%    3.8%
     Provision for income taxes..........................   2.4%    2.4%    1.5%
                                                          -----   -----   -----
       Net income........................................   4.2%    3.6%    2.3%
                                                          =====   =====   =====
</TABLE>

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

  Revenues: Total revenues in 1997 increased 83.8% to $298.6 million from
$162.4 million in 1996. The increase was primarily the result of an active
U.S. market and growth of the Company's offshore sites in the U.K., Russia and
New Zealand. Sales to existing customers increased as the number of operating
agreements

                                      26
<PAGE>

grew to 43 at December 31, 1997 from 30 at December 31, 1996. The total number
of customers worldwide increased to 125 at December 31, 1997 from 75 at
December 31, 1996. As a result, total minutes have increased 82% from last
year while the average price per minute charged to customers remained
unchanged at 29 cents. During 1997 prices generally declined in the markets in
which the Company principally operates and may decline further in the future.
However, the Company's average price per minute remained unchanged from 1996
because the company was able to increase traffic to markets offering higher
prices. The change in the terminating country mix with significantly different
rates per minute, the reduction in the rates received for the traffic
terminating in and transiting the United States and the increase in the
incidental United States domestic terminating traffic, are factors influencing
the average customer price per minute.

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

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

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

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

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

  Income Tax: Income taxes increased to $7.3 million from $3.9 million,
primarily due to increased operating income. The effective tax rate was 37% in
1997 and 40% in 1996. The decrease in the effective tax rate was attributable
to earnings of certain non-U.S. subsidiaries. A portion of these earnings are
intended to be reinvested indefinitely in operations outside the U.S.

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

                                      27
<PAGE>

number of wholesale carrier customers to 75 at December 31, 1996 from 44 at
December 31, 1995. As a result, total minutes increased 123% from 1995 while
the average price per minute charged to customers slightly declined to 29
cents compared to 30 cents in 1995. 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. See Note (5) in the Notes to Consolidated Financial Statements
included in Part II, Item 8 of this 10-K for further information regarding the
Company's transactions with Matrix.

  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 1995 to 13.6% in 1996. This increase resulted from savings derived
from a reduction in the transit or resale rates on the routes in which the
Company did not have a direct operating agreement, a reduction in the foreign
access charges on the routes in which the Company had 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 represented 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 1995 to
6.8% in 1996 and the actual expenses 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 (income) expense, net: The Company had interest income of $0.9
million in 1996 compared to interest expense of $0.5 million in 1995. This was
due to the successful completion of the initial public offering in July 1996
resulting in the Company having $45.5 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.

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 increased to $34.2 million for the
year ended December 31, 1997, from $13.9 million and $7.4 million for the
years ended December 31, 1996 and 1995. The increases in 1997 and 1996 were
primarily a result of an increase in net income as well as accounts payable,
which exceeded the increases in accounts receivable.


                                      28
<PAGE>

  Net cash used in investing activities increased to $36.5 million in 1997,
from $18.4 million in 1996 and $6.5 million in 1995. The expenditures in all
three years 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 $0.5 million in 1997, $48.3
million in 1996 and $0.9 million in 1995. During the third quarter of 1996,
the Company completed an initial public offering of 6,057,050 shares of Common
Stock, 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 of the proceeds to repay an outstanding line of credit with a
major shareholder of the Company.

  The deficit in working capital excluding cash at December 31, 1997 was $29.3
compared to a deficit of $10.5 million at December 31, 1996 and $7.7 million
at December 31, 1995. This is due to the significant delay that occurs in both
paying and receiving cash for the minutes sent and received from overseas.
This is partially offset by the estimated return traffic revenue backlog of
$10.7 million at December 31,1997, compared to $13.7 million at December 31,
1996 and $6.1 million at December 31, 1995.

  At December 31, 1997, the Company had outstanding commitments of $11.8
million for the acquisition of additional ownership in digital undersea fiber
optic cables and network equipment. The Company believes that existing cash
balances, 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 1998. However, the Company may raise additional funds through
offerings of equity or debt securities or other financing arrangements to fund
growth opportunities that management believes are beneficial to the Company.

IMPACT OF THE YEAR 2000

  The Company has assigned resources to review all systems and selected
computer applications to access their ability to process transactions in the
Year 2000. The Company is still in the process of determining the extent of
systems modifications and/or computer software upgrades needed to ensure the
systems will properly utilize dates beyond December 31, 1999. The Company has
not yet determined the total cost of such modifications and/or upgrades.

                                      29
<PAGE>

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:
                         ------------------------------------------------------------------------------
                         MARCH 31, JUNE 30,  SEPT. 30, DEC. 31,  MARCH 31, JUNE 30,  SEPT. 30, DEC. 31,
                           1996      1996      1996      1996      1997      1997      1997      1997
                         --------- --------  --------- --------  --------- --------  --------- --------
                                           (IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
<S>                      <C>       <C>       <C>       <C>       <C>       <C>       <C>       <C>
Revenues................  $32,240  $36,733    $44,249  $49,204    $51,451  $63,186    $79,997  $103,975
                          -------  -------    -------  -------    -------  -------    -------  --------
Cost of long distance
 Services...............   29,130   32,649     37,449   41,113     43,141   51,967     68,099    90,869
                          -------  -------    -------  -------    -------  -------    -------  --------
Gross margin............    3,110    4,084      6,800    8,091      8,310   11,219     11,898    13,106
Selling, general and
 Administrative
 expenses...............    1,956    2,250      3,054    3,854      3,825    5,618      5,587     6,386
Depreciation............      385      478        547      634        853    1,267      1,595     1,702
                          -------  -------    -------  -------    -------  -------    -------  --------
Operating income........      769    1,356      3,199    3,603      3,632    4,334      4,716     5,018
Other expense/(income)..       --       --         73       56         --     (168)      (162)      204
Interest
 expense/(income).......      152       94       (488)    (643)      (488)    (527)      (377)     (617)
                          -------  -------    -------  -------    -------  -------    -------  --------
Income before income
 taxes..................      617    1,262      3,614    4,190      4,120    5,029      5,255     5,431
Provision for income
 taxes..................      250      500      1,446    1,680      1,658    1,987      1,965     1,728
                          -------  -------    -------  -------    -------  -------    -------  --------
Net income..............  $   367  $   762    $ 2,168  $ 2,510    $ 2,462  $ 3,042    $ 3,290  $  3,703
                          =======  =======    =======  =======    =======  =======    =======  ========
Net income per share--
 diluted................  $  0.03  $  0.03    $  0.02  $  0.04    $  0.13  $  0.16    $  0.17  $   0.19
                          =======  =======    =======  =======    =======  =======    =======  ========
<CAPTION>
                                     AS A PERCENTAGE OF REVENUES FOR THE QUARTER ENDED:
                         ------------------------------------------------------------------------------
                         MARCH 31, JUNE 30,  SEPT. 30, DEC. 31,  MARCH 31, JUNE 30,  SEPT. 30, DEC. 31,
                           1996      1996      1996      1996      1997      1997      1997      1997
                         --------- --------  --------- --------  --------- --------  --------- --------
<S>                      <C>       <C>       <C>       <C>       <C>       <C>       <C>       <C>
Revenues................    100.0%   100.0%     100.0%   100.0%     100.0%   100.0%     100.0%    100.0%
Cost of long distance
 Services...............     90.3     88.9       84.6     83.6       83.8     82.2       85.1      87.4
                          -------  -------    -------  -------    -------  -------    -------  --------
Gross margin............      9.7     11.1       15.4     16.4       16.2     17.8       14.9      12.6
Selling, general and
 Administrative
 expenses...............      6.1      6.1        6.9      7.8        7.4      8.9        7.0       6.1
Depreciation............      1.2      1.3        1.2      1.3        1.7      2.0        2.0       1.6
                          -------  -------    -------  -------    -------  -------    -------  --------
Operating income........      2.4      3.7        7.2      7.3        7.1      6.9        5.9       4.9
Other expense...........       --       --        0.2      0.1         --     (0.3)      (0.2)      0.2
Interest
 expense/(income).......      0.5      0.3       (1.1)    (1.3)      (0.9)    (0.8)      (0.5)     (0.6)
                          -------  -------    -------  -------    -------  -------    -------  --------
Income before income
 taxes..................      1.9      3.4        8.2      8.5        8.0      8.0        6.6       5.3
Provision for income
 taxes..................      0.9      1.4        3.3      3.4        3.2      3.2        2.5       1.7
                          -------  -------    -------  -------    -------  -------    -------  --------
Net income..............      1.1%     2.1%       4.9%     5.1%       4.8%     4.8%       4.1%      3.6%
                          =======  =======    =======  =======    =======  =======    =======  ========
</TABLE>

                                      30
<PAGE>

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTAL DATA

                       REPORT OF INDEPENDENT ACCOUNTANTS

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

  We have audited the accompanying consolidated balance sheets of Pacific
Gateway Exchange, Inc. and subsidiaries as of December 31, 1997 and 1996, 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, 1997. We
have also audited the financial statement schedule listed in Item 14(a) of the
Form 10-K. These financial statements and financial 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, 1997 and 1996, and
the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 1997, 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 16, 1998

                                      31
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.
                          CONSOLIDATED BALANCE SHEETS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                               DECEMBER 31,
                                                             ------------------
                                                               1997      1996
                                                             --------  --------
<S>                                                          <C>       <C>
                          ASSETS
CURRENT ASSETS:
Cash and cash equivalents..................................  $ 43,850  $ 45,563
Accounts receivable, net of allowance for doubtful accounts
 of $2,230 in 1997 and $1,679 in 1996......................    62,313    25,145
Accounts receivable, related party.........................       --      3,066
Prepaids...................................................       511       729
Deferred income tax........................................     1,096     1,184
Other current assets.......................................       673       --
                                                             --------  --------
    Total current assets...................................   108,443    75,687
PROPERTY AND EQUIPMENT:
Undersea fiber optic cables................................    31,144    13,393
Long distance communications equipment.....................    30,535    13,744
Computers and office equipment.............................     6,343     1,317
Leasehold improvements.....................................       702        45
Construction in progress...................................     1,849     2,837
                                                             --------  --------
                                                               70,573    31,336
Less accumulated depreciation                                   9,140     3,700
                                                             --------  --------
    Total property and equipment, net......................    61,433    27,636
Deposits and other assets..................................     1,741       493
                                                             --------  --------
    Total assets...........................................  $171,617  $103,816
                                                             ========  ========
           LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable...........................................  $ 87,949  $ 36,472
Accrued liabilities........................................     3,733     1,304
Income taxes payable.......................................     1,491     2,493
Current portion of capitalized lease obligations...........       216       --
Other liabilities..........................................       513       367
                                                             --------  --------
    Total current liabilities..............................    93,902    40,636
Long-term portion of capitalized lease obligations.........       185       --
Deferred income tax........................................       957       708
                                                             --------  --------
    Total liabilities......................................    95,044    41,344
Commitments and contingencies (Note 7).
STOCKHOLDERS' EQUITY:
Preferred stock, $.0001 par value, authorized 5,000,000
 shares, no shares issued..................................       --        --
Common stock, $.0001 par value, authorized 50,000,000,
 issued 19,216,710, outstanding 19,073,150 shares in 1997;
 and issued 19,040,050, outstanding 18,896,490 shares in
 1996......................................................         2         2
Additional paid in capital.................................    60,849    55,113
Deferred compensation--restricted stock....................    (4,134)      --
Foreign currency translation...............................         2       --
Retained earnings..........................................    20,254     7,757
Cost of common stock held in treasury, 143,560 shares in
 1997 and 1996.............................................      (400)     (400)
                                                             --------  --------
    Total stockholders' equity.............................    76,573    62,472
                                                             --------  --------
  Total liabilities and stockholders' equity                 $171,617  $103,816
                                                             ========  ========
</TABLE>

          See Accompanying Notes to Consolidated Financial Statements.

                                       32
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.
                       CONSOLIDATED STATEMENTS OF INCOME
                     (IN THOUSANDS, EXCEPT PER SHARE DATA)

<TABLE>
<CAPTION>
                                                     YEAR ENDED DECEMBER 31,
                                                    ---------------------------
                                                      1997      1996     1995
                                                    --------  --------  -------
<S>                                                 <C>       <C>       <C>
Revenues........................................... $298,609  $141,912  $59,250
Revenues--related party............................      --     20,514   17,166
                                                    --------  --------  -------
    Total revenues.................................  298,609   162,426   76,416
Cost of long distance services.....................  254,076   140,340   66,346
                                                    --------  --------  -------
    Gross margin...................................   44,533    22,086   10,070
Selling, general and administrative expenses.......   21,416    11,113    5,467
Depreciation.......................................    5,417     2,044    1,124
                                                    --------  --------  -------
    Total operating expenses.......................   26,833    13,157    6,591
                                                    --------  --------  -------
    Operating income...............................   17,700     8,929    3,479
Interest (income) expense, net.....................   (2,009)     (885)     538
Other (income) expense, net........................     (126)      129      --
                                                    --------  --------  -------
  Income before income taxes.......................   19,835     9,685    2,941
Provision for income taxes.........................    7,338     3,877    1,155
                                                    --------  --------  -------
    Net income..................................... $ 12,497  $  5,808  $ 1,786
                                                    --------  --------  -------
    Net income per share--basic.................... $   0.66  $   0.36  $  0.13
                                                    --------  --------  -------
    Net income per share--diluted.................. $   0.64  $   0.34  $  0.12
                                                    --------  --------  -------
Weighted average number of common shares
 outstanding--basic................................   18,960    16,234   14,100
                                                    --------  --------  -------
Weighted average number of common shares
 outstanding--diluted..............................   19,497    16,872   14,535
                                                    ========  ========  =======
</TABLE>

          See Accompanying Notes to Consolidated Financial Statements.

                                       33
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.
                      CONSOLIDATED STATEMENT OF CASH FLOWS
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                    YEAR ENDED DECEMBER 31,
                                                   ---------------------------
                                                     1997      1996     1995
                                                   --------  --------  -------
<S>                                                <C>       <C>       <C>
OPERATING ACTIVITIES:
  Net income...................................... $ 12,497  $  5,808  $ 1,786
Adjustments to net income:
 Depreciation.....................................    5,417     2,044    1,124
 Loss on sale of stock............................      --        129      --
 Stock compensation expense.......................      146        85      --
 Bad debts provision..............................    2,173       855      687
 Changes in operating assets and liabilities:
  Accounts receivable.............................  (38,681)  (13,421)  (9,436)
  Accounts receivable, related party..............    3,066       196   (1,059)
  Notes and advances receivable...................      --        175     (175)
  Prepaid expenses................................      306      (729)     --
  Deferred tax asset..............................       88      (816)    (314)
  Deposits and other assets.......................   (1,430)     (107)    (243)
  Accounts payable................................   48,309    17,053   12,782
  Accrued liabilities.............................    2,429       532      700
  Federal income taxes payable (recoverable)......     (462)    1,758      790
  Other liabilities...............................      150      (152)     519
  Deferred tax liability..........................      249       488      220
                                                   --------  --------  -------
 Net cash provided by operating activities........   34,257    13,898    7,381
                                                   --------  --------  -------
INVESTING ACTIVITIES:
Purchase of property and equipment................  (36,725)  (18,669)  (7,233)
Other investing activities........................      222       274      702
                                                   --------  --------  -------
Net cash used in investing activities.............  (36,503)  (18,395)  (6,531)
                                                   --------  --------  -------
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
Repayments on revolving lines of credit...........      --     (6,200)  (3,067)
Borrowings on revolving lines of credit, related
 party............................................      --      3,000      --
Repayments on revolving lines of credit, related
 party............................................      --     (5,420)     --
Exercise of stock options.........................      742       --       --
Repayments on capital lease obligations...........     (209)      --       --
                                                   --------  --------  -------
Net cash provided by financing activities.........      533    48,268      933
                                                   ========  ========  =======
Net increase in cash and cash equivalents.........   (1,713)   43,771    1,783
Cash and cash equivalents at beginning of the pe-
 riod.............................................   45,563     1,792       10
                                                   --------  --------  -------
Cash and cash equivalents at end of the period.... $ 43,850  $ 45,563  $ 1,792
                                                   ========  ========  =======
SUPPLEMENTARY INFORMATION:
Interest paid during period....................... $    --   $    276  $   576
Income taxes paid during period................... $  7,841  $  2,447  $   683
</TABLE>

          See Accompanying Notes to Consolidated Financial Statements.

                                       34
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.
           CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
                                 (IN THOUSANDS)

<TABLE>
<CAPTION>
                                                                                           TREASURY
                          COMMON STOCK  ADDITIONAL     DEFERRED       FOREIGN                STOCK
                          -------------  PAID-IN    COMPENSATION-    CURRENCY   RETAINED -------------
                          SHARES AMOUNT  CAPITAL   RESTRICTED STOCK TRANSLATION EARNINGS SHARES AMOUNT   TOTAL
                          ------ ------ ---------- ---------------- ----------- -------- ------ ------  -------
<S>                       <C>    <C>    <C>        <C>              <C>         <C>      <C>    <C>     <C>
BALANCE DECEMBER 31,
 1994...................      15  $--    $   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
Stock options exercised.     102   --        742            --          --          --     --     --        742
Stock option
 compensation expense...     --    --        146            --          --          --     --     --        146
Tax effect on stock
 option exercise........     --    --        714            --          --          --     --     --        714
Restricted stock
 compensation expense...     --    --      4,134            --          --          --     --     --      4,134
Deferred compensation -
 restricted stock.......      75   --        --          (4,134)        --          --     --     --     (4,134)
Foreign currency
 translation............     --    --                       --            2         --     --     --          2
Net income..............     --    --        --             --          --       12,497    --     --     12,497
                          ------  ----   -------       --------        ----     -------   ----  -----   -------
BALANCE DECEMBER 31,
 1997...................  19,217  $  2   $60,849       $ (4,134)       $  2     $20,254   (144) $(400)  $76,573
                          ======  ====   =======       ========        ====     =======   ====  =====   =======
</TABLE>

          See Accompanying Notes to Consolidated Financial Statements.

                                       35
<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.

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

 Principles of Consolidation:

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

 Foreign Currency Translation:

  Assets and liabilities of operations outside the United States, except for
operations in highly inflationary economies (principally in Russia) are
translated into U.S. dollars using the exchange rate in effect at each period
end. Revenues and expenses are translated at the average exchange rate
prevailing during the period. The effects of foreign currency translation
adjustments arising from differences in exchange rates from period to period
are deferred and included as a component of "Stockholders' Equity". The
effects of foreign currency transactions, and of remeasuring the financial
position and results of operations in the functional currency, are included in
"Selling general and administrative expenses." Operations in highly
inflationary economies are maintained in the reporting currency, U.S. dollars.

 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 sheet 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
     Leasehold improvements....................................... term of lease
</TABLE>

                                      36
<PAGE>

                        PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)

  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 No. 109 has as its basic objective the recognition of current and
deferred income tax assets and liabilities based upon all events that have
been recognized in the financial statements as measured by the provisions of
the enacted tax laws.

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

 Revenue Recognition:

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

 Earnings Per Share:

  The Company adopted SFAS No. 128 "Earnings Per Share" effective December 31,
1997. In accordance with SFAS No. 128, basic earnings per share is calculated
by dividing net income by the weighted-average number of shares outstanding
for the period. Diluted earnings per share is calculated by dividing net
income by the weighted average number of shares outstanding during the period
plus the dilutive effect of stock options determined using the treasury stock
method. The earnings per share calculation has been adjusted for all periods
presented to reflect the 940 to 1 stock split effected October 20, 1995.

  There were no adjustments to net income in the calculation of basic and
diluted earnings per share for the years ended December 31, 1997, 1996 and
1995, respectively. The reconciliation of the weighted average shares
outstanding used in calculating basic and diluted earnings per share is as
follows:

<TABLE>
<CAPTION>
                                              INCOME       SHARES     PER-SHARE
                                            (NUMERATOR) (DENOMINATOR)  AMOUNT
                                            ----------- ------------  ---------
     <S>                                    <C>         <C>           <C>
     1997
     BASIC EPS:
     Income available to common stockhold-
      ers.................................. $12,497,000  18,960,000     $0.66
     Effect of dilutive stock options......                 537,000
                                            -----------  ----------     -----
     DILUTED EPS........................... $12,497,000  19,497,000     $0.64
     1996
     BASIC EPS:
     Income available to common stockhold-
      ers.................................. $ 5,808,000  16,234,000     $0.36
     Effect of dilutive stock options......                 638,000
                                            -----------  ----------     -----
     DILUTED EPS........................... $ 5,808,000  16,872,000     $0.34
     1995
     BASIC EPS:
     Income available to common stockhold-
      ers.................................. $ 1,786,000  14,100,000     $0.13
     Effect of dilutive stock options......                 435,000
                                            -----------  ----------     -----
     DILUTED EPS........................... $ 1,786,000  14,535,000     $0.12
                                            ===========  ==========     =====
</TABLE>

                                      37
<PAGE>

                        PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


 Fair Value of Financial Instruments:

  The carrying amounts for accounts receivable and accounts payable
approximate their fair 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, 1997 and 1996, the Company had bank deposits in excess of
federally insured limits of $43,650,000 and $45,381,000, respectively. Seven
of the Company's customers accounted for approximately 40% and 52% of gross
accounts receivable as of December 31, 1997 and 1996, 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.

 Financial Statement Classifications:

  Certain prior-year amounts have been reclassified to conform to the 1997
financial statement presentation. Such reclassifications have no effect on net
income as previously reported.

(2) ACCOUNTING FOR INTERNATIONAL LONG DISTANCE TRAFFIC

  The Company has entered into operating agreements with 43 telecommunications
carriers in 28 countries under which international long distance traffic is
both delivered and received. Under these agreements, the foreign carriers are
contractually obligated to adhere to the policy of the Federal Communications
Commission (the "FCC"), whereby traffic from the foreign country is routed to
international carriers, such as the Company, in the same proportion as traffic
carried into the country. Mutually exchanged traffic between the Company and
foreign carriers is settled through a formal settlement policy that generally
extends over a six-month period at an agreed upon rate. The Company records
the amount due to the foreign partner as an expense in the period the traffic
is delivered. Of the 43 agreements the Company had at December 31, 1997, 18
agreements provided that the Company generally must wait up to six months
before it actually receives the proportional return traffic. Under these
agreements, the Company recognizes a loss in the period in which it originates
a call from 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. In circumstances where the
Company does not receive the return traffic due from the foreign partner at
the end of the agreed-upon delayed return period, the Company and the foreign
partner may agree to a settlement which compensates the Company for the return
traffic not received, through greater return traffic in future periods, or a
reduction to the Company's current accounts payable balance. 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.

                                      38
<PAGE>

                        PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


(3) INCOME TAXES

  The provision for income taxes is comprised of the following:

<TABLE>
<CAPTION>
                                                  YEAR ENDED DECEMBER 31,
                                              ---------------------------------
                                                 1997       1996        1995
                                              ---------- ----------  ----------
     <S>                                      <C>        <C>         <C>
     CURRENT TAX EXPENSE:
      Federal................................ $5,736,898 $3,364,342  $  999,950
      State and local........................    985,411    841,085     249,988
      Foreign................................    279,392         --          --
                                              ---------- ----------  ----------
      Total current.......................... $7,001,701 $4,205,427  $1,249,938
     DEFERRED TAX EXPENSE:
      Federal................................ $  265,217 $ (262,558) $  (75,950)
      State and local........................     71,113    (65,640)    (18,988)
      Foreign................................         --         --          --
                                              ---------- ----------  ----------
      Total deferred......................... $  336,330 $ (328,198) $  (94,938)
                                              ---------- ----------  ----------
     TOTAL PROVISION......................... $7,338,031 $3,877,229  $1,155,000
                                              ========== ==========  ==========
</TABLE>

  The Company has not recognized income taxes on undistributed earnings in
operations outside the United States of approximately $1,417,000 at December
31, 1997. These earnings are intended to be reinvested indefinitely.

  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,
                                                   ---------------------------
                                                    1997      1996      1995
                                                   -------   -------   -------
     <S>                                           <C>       <C>       <C>
     Expected statutory amount....................    35.0%     34.0%     34.0%
     State income taxes, net of federal benefit...     3.8%      5.3%      5.3%
     Tax exempt interest..........................    (0.5)%    (0.4)%      --%
     Undistributed earnings of certain
      subsidiaries................................    (2.5)%      --%       --%
     Other........................................     1.2%      1.1%       --%
                                                   -------   -------   -------
                                                      37.0%     40.0%     39.3%
                                                   =======   =======   =======
</TABLE>
  Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and amounts used for income tax purposes and the impact of available
net operating loss carryforwards.

                                      39
<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,
                                                  ------------------------------
                                                     1997       1996      1995
                                                  ---------- ---------- --------
     <S>                                          <C>        <C>        <C>
     Deferred tax assets:
      Allowance for doubtful accounts............ $  696,831 $  861,768 $325,613
      State taxes................................    316,574    210,647       --
      Other......................................     83,088    111,548   42,185
                                                  ---------- ---------- --------
      Total gross deferred tax assets............ $1,096,492 $1,183,963 $367,798
     Deferred liabilities:
      Depreciation............................... $  870,566 $  707,518 $219,551
      Other......................................     85,811         --       --
                                                  ---------- ---------- --------
      Total gross deferred tax liabilities....... $  956,377 $  707,518 $219,551
                                                  ========== ========== ========
      Net deferred tax assets.................... $  140,115 $  476,445 $148,247
                                                  ========== ========== ========
</TABLE>

(4) ACQUISITION OF RUSTELNET

  In 1997, the Company acquired a majority interest in Rustelnet, a provider
of enhanced telecommunications services to the Russian market. The acquisition
was accounted for by the purchase method and accordingly the results of
operations of the acquired business have been included in the accompanying
consolidated financial statements from the date of acquisition. The price was
$36,000 with Rustelnet having cash balances of $257,000 at the time. The fair
value of net liabilities acquired in the acquisition was $158,000. The excess
of purchase price over the estimated fair market value of $627,000 has been
allocated to goodwill. Goodwill is being amortized on a straight-line basis
over a 10-year period.

(5) RELATED PARTY TRANSACTIONS

  The Company provides certain domestic and international switched
telecommunications services to Matrix Telecom, Inc. ("Matrix"), which is a
switchless reseller. In 1996 and 1995, a significant (greater than 10%)
shareholder in the Company also owned a controlling interest in Matrix. See
Note 6 for the amount of revenues recorded from providing these services for
the years ended December 31, 1996 and 1995. In 1997, the shareholder sold
shares of the Company's common stock and currently owns less than 10%.
Accordingly, ongoing transactions with Matrix are no longer disclosed as
related party transactions.

  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 a
significant shareholder for $702,000. The shareholder subsequently sold the
stock over a period of several months for a total of $730,000.

  In connection with the acquisition of Rustelnet (see Note 4), the Company
purchased Rustelnet shares from individual shareholders who are members of
Pacific Gateway's management. A total of 690 Rustelnet shares were sold by
management to the Company for $13,000.


                                      40
<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 $83,875,000, $46,522,000, and
$17,619,000 for the years ended December 31, 1997, 1996 and 1995 respectively.
Export sales by geographic area were as follows:

<TABLE>
<CAPTION>
                                                   YEAR ENDED DECEMBER 31,
                                             -----------------------------------
                                                1997        1996        1995
                                             ----------- ----------- -----------
     <S>                                     <C>         <C>         <C>
     Pacific Rim............................ $22,577,000 $20,653,000 $10,066,000
     Europe.................................  44,292,000  17,134,000   4,798,000
     Canada.................................  11,015,000   6,449,000   2,418,000
     Other..................................   5,991,000   2,286,000     337,000
                                             ----------- ----------- -----------
     Total export sales..................... $83,875,000 $46,522,000 $17,619,000
                                             =========== =========== ===========
</TABLE>

  The Company's domestic and foreign operations are as follows:

<TABLE>
<CAPTION>
                                                      CORPORATE &
                            UNITED STATES    OTHER    ELIMINATIONS  CONSOLIDATED
                            ------------- ----------- ------------  ------------
<S>                         <C>           <C>         <C>           <C>
1997
Sales to unaffiliated cus-
 tomers...................  $280,870,000  $17,739,000 $         --  $298,609,000
Sales and transfers be-
 tween geographic areas...    12,066,000   12,005,000  (24,071,000)           --
                            ------------  ----------- ------------  ------------
Total sales...............  $292,936,000  $29,744,000 $(24,071,000) $298,609,000
Operating income..........  $ 15,720,000  $ 1,193,000 $    (42,000) $ 16,871,000
Identifiable assets.......  $183,312,000  $32,542,000 $(36,869,000) $178,985,000
                            ============  =========== ============  ============
1996
Sales to unaffiliated cus-
 tomers...................  $141,912,000  $        -- $         --  $141,912,000
Sales and transfers be-
 tween geographic areas...            --           --           --            --
                            ------------  ----------- ------------  ------------
Total sales...............  $141,912,000  $        -- $         --  $141,912,000
Operating income..........  $  8,929,000  $        -- $         --  $  8,929,000
Identifiable assets.......  $103,816,000  $        -- $         --  $103,816,000
                            ============  =========== ============  ============
1995
Sales to unaffiliated cus-
 tomers...................  $ 59,250,000  $        -- $         --  $ 59,250,000
Sales and transfers be-
 tween geographic areas...            --           --           --            --
                            ------------  ----------- ------------  ------------
Total sales...............  $ 59,250,000  $        -- $         --  $ 59,250,000
Operating income..........  $  3,479,000  $        -- $         --  $  3,479,000
Identifiable assets.......  $ 29,976,000  $        -- $         --  $ 29,976,000
                            ============  =========== ============  ============
</TABLE>

  Other includes operating subsidiaries located in the United Kingdom, Russia,
New Zealand and Cyprus. United States includes all remaining operations of the
Company. Transfers between geographic areas are accounted for at cost plus a
reasonable profit. Identifiable assets are those assets identified in the
operations in each area or segment, including goodwill.

                                      41
<PAGE>

                        PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


  The Company sells to long distance international telecommunications
companies, to foreign partners and to retail customers. At December 31, 1997,
the Company had 43 operating agreements and approximately 125 worldwide
customers. Ten percent or more of the Company's revenues have been derived
from the following customers.

<TABLE>
<CAPTION>
                                              YEAR ENDED DECEMBER 31,
                                           1997        1996        1995
                                        ----------- ----------- -----------
     <S>                                <C>         <C>         <C>
     Frontier Communications, Inc.      $30,996,068     (A)         (A)
     Matrix Telecom, Inc. (See Note 5)      (A)     $20,514,040 $17,165,995
</TABLE>
--------
(A) Sales were less than 10% of total sales.

(6) 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.

 Leases

  The Company leases office space and equipment under noncancelable operating
leases. Rental expenses for 1997, 1996 and 1995 were $965,000, $255,000 and
$142,000, respectively. The Company leases certain computer equipment under an
agreement that is classified as a capital lease. The lease has a term of three
years with a minimum purchase price at the end of the lease. Leased capital
assets included in property and equipment at December 31, 1997 were $610,000.

  Future minimum lease payments under operating and capital leases as of
December 31, 1997 are as follows:

<TABLE>
<CAPTION>
                                                            OPERATING  CAPITAL
                                                              LEASES    LEASES
                                                            ---------- --------
     <S>                                                    <C>        <C>
     1998.................................................. $1,040,000 $216,000
     1999..................................................    603,000  216,000
     2000..................................................    507,000    8,000
     2001..................................................    467,000       --
     2002..................................................    437,000       --
     Thereafter............................................  2,200,000       --
                                                            ---------- --------
     Total minimum lease payments.......................... $5,254,000 $440,000
                                                            ==========
     Amount representing interest..........................              39,000
                                                                       --------
     Present value of net minimum payments.................            $401,000
                                                                       --------
     Current portion.......................................            $216,000
                                                                       ========
</TABLE>

 Employment Agreements

  The Company has entered into employment agreements with certain employees
which provide that in the event of a change in control each of such employees
would be entitled to severance following their resignation from the Company.
Should such an event occur, the Company's aggregate obligation for severance
would be $1,173,000. Upon any such change in control, each individual would
also receive full vesting of any outstanding stock options. In 1998, the
Company entered into new agreements with certain employees which would
increase the Company's aggregate obligation for severance by approximately
$1,603,000.

 Commitments

  At December 31, 1997 the Company had outstanding commitments of $11,800,000
for the acquisition of additional ownership interests in digital undersea
fiber optic cables and the expansion of existing switch sites.

                                      42
<PAGE>

                        PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


(8) 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. It is intended for the Purchase Plan to become
effective during 1998. Under the Purchase Plan, the Company reserved up to
400,000 shares of common stock for purchase by employees who meet certain
eligibility requirements. Eligible employees may contribute up to 10% of their
compensation to the Purchase Plan to purchase shares at 85% of the fair market
value of the stock on the first or last day of each six-month offering period
as defined in the Purchase Plan.

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

(9) STOCK OPTION PLAN

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

  On February 17, 1997, the Company adopted the 1997 Long-Term Incentive Plan
(the "1997 Plan"), replacing the 1995 Plan. The 1997 Plan provides for the
granting of awards of nonqualified and incentive stock options, stock
appreciation rights, stock grants or stock-based performance units. Awards may
be made under the 1997 Plan with respect to 4,000,000 shares of common stock
and with respect to stock option and stock appreciation right awards, no more
than 500,000 shares may be awarded to any one individual in any one-year
period. The remaining terms of the 1997 Plan are similar to those described in
the 1995 Plan. The Company granted options to purchase 1,610,000 shares of
common stock in 1997 under the 1997 plan.

  The Company applies Accounting Principles Board Opinion No. 25, "Accounting
for Stock Issued to Employees", and related interpretations in accounting for
its stock-based compensation plans. Accordingly, no compensation expense has
been recognized 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 SFAS
No. 123, "Accounting for Stock-Based Compensation", the Company's earnings per
share would have been reduced to the pro forma amounts indicated below:

<TABLE>
<CAPTION>
                                                    YEAR ENDED DECEMBER 31,
                                               ---------------------------------
                                                  1997        1996       1995
                                               ----------- ---------- ----------
     <S>                                       <C>         <C>        <C>
     Net income--as reported.................  $12,497,000 $5,808,000 $1,786,000
     Net income--pro forma...................  $11,469,000 $5,244,000 $1,636,000
     Earnings per share--basic as reported...  $      0.66 $     0.36 $     0.13
     Earnings per share--basic pro forma.....  $      0.60 $     0.32 $     0.12
     Earnings per share--diluted as reported.  $      0.64 $     0.34 $     0.12
     Earnings per share--diluted pro forma...  $      0.59 $     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 $30.7
million on the date of the grant using the Black-Scholes Model for those
options issued after the Company's initial public offering and the Minimum
Value methodology for those options granted prior to the offering. The
assumptions used in the Black Scholes model are: dividend yield 0%, volatility
40.9%, risk free interest rate of 5.8%, assumed forfeiture rate of 0% and an
expected life of 5 years.

  During 1997, 75,000 shares of restricted stock were granted under the 1997
Plan. The fair value of $4,134,375 will be recognized as compensation expense
over the 10-year vesting period. For the year ended December 31,1997, $146,000
was recognized as compensation expense for restricted stock and stock options
granted to non-employees.

  Stock Option Awards were:

<TABLE>
<CAPTION>
                                           YEAR ENDED DECEMBER 31,
                         ------------------------------------------------------------
                                1997                 1996                1995
                         -------------------- ------------------- -------------------
                                    WEIGHTED-           WEIGHTED-           WEIGHTED-
                                     AVERAGE             AVERAGE             AVERAGE
                          OPTION    EXERCISE   OPTION   EXERCISE   OPTION   EXERCISE
                          SHARES      PRICE    SHARES     PRICE    SHARES     PRICE
                         ---------  --------- --------- --------- --------- ---------
<S>                      <C>        <C>       <C>       <C>       <C>       <C>
Options outstanding,
 Beginning of year......   883,411   $ 9.77     509,170  $ 8.23          --   $  --
Options granted......... 1,610,000    41.60     374,241   12.58     509,170    8.23
Options exercised.......  (101,660)    7.30          --      --          --      --
Options forfeited.......   (95,686)   11.08          --      --          --      --
                         ---------   ------   ---------  ------   ---------   -----
Options outstanding,
 End of year............ 2,296,065   $32.14     883,411  $ 9.77     509,170   $8.23
                         =========   ======   =========  ======   =========   =====
Option price range at    $8.500 to            $4.400 to           $4.400 to
 End of year............ $  50.188            $  29.500           $   9.000
Option shares available
 for grant
 at end of year......... 2,405,000              316,589             690,830
                         =========            =========           =========
</TABLE>

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

<TABLE>
<CAPTION>
                                      OPTIONS OUTSTANDING        OPTIONS EXERCISABLE
                                -------------------------------- --------------------
                                             WEIGHTED
                                              AVERAGE   WEIGHTED             WEIGHTED
                                             REMAINING  AVERAGE              AVERAGE
                                  NUMBER    CONTRACTUAL EXERCISE   NUMBER    EXERCISE
                                OUTSTANDING    LIFE      PRICE   EXERCISABLE  PRICE
     RANGE OF EXERCISE PRICES   ----------- ----------- -------- ----------- --------
     <S>                        <C>         <C>         <C>      <C>         <C>
     $ 8.500--$14.000........      671,065     1.99      $ 9.18    323,785    $ 9.02
     $ 24.750--$29.500.......      170,500     3.23       26.27     10,000     29.50
     $ 38.500--$50.188.......    1,454,500     3.92       43.42         --        --
                                 ---------     ----      ------    -------    ------
     $ 8.500--$50.188........    2,296,065     3.31      $32.14    333,785    $ 9.63
                                 =========     ====      ======    =======    ======
</TABLE>

                                      44
<PAGE>

                        PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


(10) CAPITAL STOCK

  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.

  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.

(11) STOCKHOLDERS' RIGHTS PLAN

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

  The Rights generally will only be exercisable (i) ten days following a
public announcement that a person or group of affiliated or associated persons
(an "Acquiring Person") has acquired, or obtained the right to acquire, 15% or
more of the outstanding shares of the Company's Common Stock or (ii) 15
business days following commencement of (or an announcement of an intention to
make) a tender or exchange offer for 15% or more of the outstanding shares of
the Common Stock. The Rights will expire, if not previously exercised,
exchanged or redeemed, on December 1, 2007.

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

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

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

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

                                      45
<PAGE>

                        PACIFIC GATEWAY EXCHANGE, INC.

            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)


(12) NEW ACCOUNTING PRONOUNCEMENTS

  In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income". SFAS No. 130 establishes standards for reporting and display of
comprehensive income and its components in a financial statement that is
displayed with the same prominence as other financial statements.
Comprehensive income as defined includes all changes in equity (net assets)
during a period from nonowner sources. Examples of items to be included in
comprehensive income, which are excluded from net income, include foreign
currency translation adjustments. Management is currently evaluating the
financial statement and disclosure impact of the adoption of SFAS No. 130. The
disclosures prescribed by SFAS No. 130 must be made beginning with the quarter
ended March 31, 1998

  In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprises and Related Information". This statement establishes standards
for the way companies report information about operating segments in annual
financial statements. It also establishes standards for related disclosures
about products and services, geographic areas, and major customers. The
Company is in the process of evaluating the disclosure impact of adopting this
new standard. The disclosures prescribed by SFAS No. 131 must be made for the
year ended December 31, 1998.

(13) SUBSEQUENT EVENT

  On February 13, 1998, the Company purchased of 16.6% of Ekonom S.A. de C.V.,
a Mexican multimedia company existing under the laws of the United Mexican
States, for $3,600,000 in cash and $1,800,000 in Pacific Gateway's stock. The
Company's investment in Ekonom will be accounted for the under the cost method
in 1998.

                                      46
<PAGE>

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
        FINANCIAL DISCLOSURE

  None.

                                   PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS

  The information concerning directors required by this item is incorporated
by reference to the information contained under the captions "Election of
Directors", "Meetings and Committees of the Board" and "Section 16(a)
Beneficial Ownership Reporting Compliance" in the Company's Proxy Statement
for the 1998 Annual Meeting of Stockholders.

ITEM 11. EXECUTIVE COMPENSATION

  The information required by this item is incorporated by reference to the
information contained under the caption "Compensation of Directors and
Executive Officers" in the Company's Proxy Statement for the 1998 Annual
Meeting of Stockholders.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

  The information required by this item is incorporated by reference to the
information contained under the caption "Ownership of the Capital Stock of the
Company" in the Company's Proxy Statement for the 1998 Annual Meeting of
Stockholders.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

  The information required by this item is incorporated by reference to the
information contained under the caption "Certain Relationships and Related
Transactions" in the Company's Proxy Statement for the 1998 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, 1997 and 1996

    Consolidated Statements of Operations for the Years Ended December 31,
    1997, 1996 and 1995

    Consolidated Statements of Cash Flows for the Years Ended December 31,
    1997, 1996 and 1995

    Consolidated Statements of Changes in Stockholders' Equity for the
    Years Ended December 31, 1997, 1996 and 1995

    Notes to Consolidated Financial Statements

  * Included in Item 8 of this 10-K

                                      47
<PAGE>

  (a)2. FINANCIAL STATEMENT SCHEDULE

    Schedule II Valuation and Qualifying Accounts

  3. EXHIBITS

<TABLE>
<CAPTION>
EXHIBIT
NUMBER                     DESCRIPTION                             METHOD OF FILING
-------                    -----------                             ----------------
<S>      <C>                                              <C>
3.1      Amended and Restated Certificate of              Incorporated by reference to
         Incorporation, as amended May 20, 1997           Quarterly Report on Form 10-Q for
                                                          the quarter ended June 30, 1997
                                                          (No. 000-21043)

3.2      Amended and Restated Bylaws, as amended December Filed with this document
         30, 1997

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

4.2      Amended and Restated Certificate of              Incorporated by reference to
         Incorporation, as amended May 20, 1997           Quarterly Report on Form 10-Q for
                                                          the quarter ended June 30, 1997
                                                          (No. 000-21043)

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

10.1     Form of Indemnification Agreement for directors  Filed with this document
         and officers

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

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

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

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

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

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

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

10.4.6   Proxy dated May 10, 1996 by Gail E. Granton      Incorporated by reference to
                                                          Registration Statement on Form S-
                                                          1 (No. 33-80191)

10.4.7   Proxy dated June 10, 1996 Ronald L. Jensen       Incorporated by reference to
                                                          Registration Statement on Form S-
                                                          1 (No. 33-80191)

10.5.1   Employment Agreement dated October 1, 1995       Incorporated by reference to
         between Howard A. Neckowitz and Pacific Gateway  Registration Statement on Form S-
         Exchange, Inc.                                   1 (No. 33-80191)
</TABLE>

                                       48
<PAGE>

<TABLE>
<CAPTION>
EXHIBIT
NUMBER                     DESCRIPTION                             METHOD OF FILING
-------                    -----------                             ----------------
<S>      <C>                                              <C>
10.5.2   Employment Agreement dated October 1, 1995       Incorporated by reference to
         between Gail E. Granton and Pacific Gateway      Registration Statement on Form S-
         Exchange, Inc.                                   1 (No. 33-80191)

10.5.3   Employment Agreement dated as of October 1, 1995 Incorporated by reference to
         between Ronald D. Anderson and Pacific Gateway   Registration Statement on Form S-
         Exchange,Inc.                                    1 (No. 33-80191)

10.5.4   Employment Agreement dated October 1, 1995       Incorporated by reference to
         between Robert F. Craver and Pacific Gateway     Registration Statement on Form S-
         Exchange, Inc.                                   1 (No. 33-80191)

10.5.5   Employment Agreement dated October 1, 1995       Incorporated by reference to
         between Fred A. Weismiller and Pacific Gateway   Annual Report on Form 10-K for
         Exchange, Inc.                                   the year ended December 31, 1996
                                                          (No. 000-21043)

10.5.6   Restricted Stock Award Agreement dated December  Filed with this document
         30,1997 between Howard A. Neckowitz and Pacific
         Gateway Exchange, Inc.

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

10.7     Agreement for Billing Services dated November    Incorporated by reference to
         24, 1995 Between Matrix Telecom, Inc. and        Registration Statement on Form S-
         Pacific Gateway Exchange, Inc.                   1 (No. 33-80191)

10.8     Form of Stock Purchase Agreement with KDD        Incorporated by reference to
                                                          Registration Statement on Form S-
                                                          1 (No. 33-80191)

21.1     Subsidiaries                                     Filed with this document

23.1     Consent of Independent Accountants               Filed with this document

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

  (b) REPORTS ON FORM 8-K

  Stockholders Rights Plan filed on Form 8-K November 21, 1997.

                                       49
<PAGE>

                                  SIGNATURES

  Pursuant to the requirements of section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the registrant has duly caused this report
to be signed on its behalf by the undersigned, thereunto duly authorized, in
Burlingame, California, on the 30th day of March, 1998.

                                          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 30th day of March, 1998.

               SIGNATURE                                TITLE


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

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

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

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

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

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

                                      50
<PAGE>

                         PACIFIC GATEWAY EXCHANGE, INC.

                                  SCHEDULE II

                       VALUATION AND QUALIFYING ACCOUNTS

<TABLE>
<CAPTION>
                                          ADDITIONS
                               BALANCE AT CHARGED TO DEDUCTIONS-
                               BEGINNING  COSTS AND   ACCOUNTS    BALANCE AT
         DESCRIPTION           OF PERIOD   EXPENSES  WRITTEN OFF END OF PERIOD
         -----------           ---------- ---------- ----------- -------------
<S>                            <C>        <C>        <C>         <C>
Allowance for doubtful
 accounts:
  1997........................   $1,679     $2,173     $1,622       $2,230
  1996........................      824      1,355        500        1,679
  1995........................      137        687        --           824
</TABLE>

                                      S-1