**SECURITIES
AND EXCHANGE COMMISSION**


Washington,
D.C. 20549


**_____________________**


**FORM
10-Q/A**


**(Amendment
No.1)**


**(Mark
One)**





**[X]**
    **QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**





**For
the quarterly period ended June 30, 2004**





**OR**





**[
      ]**
    **TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**





**For
the transition period from** **** **to _____**





**Commission
file number 000 - 26728**





**Talk
America Holdings, Inc.**


(Exact
name of registrant as specified in its charter)





**Delaware**
      (State
      of incorporation)
    **23-2827736**
      (I.R.S.
      Employer Identification No.)





**12020
      Sunrise Valley Drive, Suite 250, Reston, Virginia**
      (Address
      of principal executive offices)
    **20191**
      (Zip
      Code)





**(703)
391-7500**


(Registrant's
telephone number, including area code)





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 whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Act).





Yes X No____





Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date.





26,972,408
shares of Common Stock, par value of $0.01 per share, were issued and
outstanding as of August 2, 2004.





****


**Explanatory
Note**





Talk
America Holdings, Inc. is filing this Amendment No. 1 on Form 10-Q/A (“Amendment
No. 1”) to our Quarterly Report on Form 10-Q originally filed with the
Securities and Exchange Commission on August 4, 2004, for the purpose of
restating our consolidated financial statements for the quarter ended June 30,
2004 and 2003 to reflect corrections of the following errors:





The
quarterly results for the four quarters of 2003 and for the first and second
quarters of 2004 have been adjusted to reflect the restatement of our previously
reported consolidated financial statements for those periods and for the year
ended December 31, 2003 as detailed below.





We have
revised our consolidated financial statements for these periods to correct for
the following errors:





(a)  Due to a
classification error in our general ledger, we incorrectly recorded certain
customer fee revenues as sales, use and excise tax liability to the consolidated
balance sheets for the four quarters of 2003, for the year ended December 31,
2003 and for the first and second quarters of 2004.  These
customer fee revenues were $0.3 million for the second quarter of 2004, $0.1
million for the second quarter 2003, $0.6 million for the six months ended June
30, 2004, $0.5 million for the six months ended June 30, 2003, and $1.0 million
for the full year 2003. These customer fees have now been appropriately recorded
to revenues in the consolidated statement of operations for the year ended
December 31, 2003 and in the unaudited quarterly periods for the first and
second quarters 2004 and 2003;





(b) We
determined that in our calculations of earnings per share since the third
quarter of 2003 we had not incorporated the tax benefits associated with the
assumed exercise of employee stock options. As a result, fully diluted shares
outstanding were over-reported and income per fully diluted share was
understated in the periods subsequent to third quarter 2003; and





(c) We
identified errors in the computation of the deferred tax assets recognized in
the third quarter of 2003 as follows: (i) failure to deduct state income tax
expense from federal taxable income resulted in the deferred tax benefit as
originally reported for the year ended December 31, 2003 and the unaudited third
quarter 2003 being understated by $0.9 million and (ii) failure to complete the
appropriately detailed analysis of our deferred tax assets relating to state net
operating loss carryforwards resulted in the deferred tax benefit as originally
reported for the year ended December 31, 2003 and the unaudited third quarter
2003 being understated by $1.7 million. In February 2005, we determined that we
improperly corrected for the errors in the deferred tax computations through an
adjustment to the effective tax rate for 2004 rather than through the
restatement of our prior period financial statements. As a result, we have
restated the first and second quarter of 2004 and the third and fourth quarter
of 2003 and year end December 31, 2003.





(d) In
connection with the release of the valuation allowance in the third quarter
2003, $6.5 million of deferred tax assets associated with acquired net operating
loss carryforwards were realizable and should have been recorded as a deferred
tax asset. Originally, we believed this deferred tax asset was limited due to
provisions of the Internal Revenue Code Section 382. This error resulted in
deferred tax assets being understated and goodwill being overstated in each of
the periods beginning in the third quarter 2003. As a result, we have restated
the first and second quarter of 2004 and the third and fourth quarter of 2003
and year end December 31, 2003.





The
effect of these items are reflected in our consolidated financial statements
contained in Item 1 of this Amendment, with corresponding changes reflected in
Item 2, Management’s Discussion and Analysis of Financial Condition and Results
of Operations and Item 4, Controls and Procedures. The effect of these items on
our consolidated statement of operations for the four quarters of 2003, the year
ended December 31, 2003 and for the first and second quarter of 2004 is
summarized in the following table.











ii








(in
      000s, except per share data)
      (Unaudited)
    
    **2003**
    **2004******
    
    
    **Q1**
    
    
    **Q2**
    
    
    **Q3**
    
    
    **Q4**
    
    **Q1**
    **Q2**Revenue:Reported
    
    $
    87,843
    
    $
    93,748
    
    $
    99,929
    
    $
    101,143
    
    
    
    $
    109,321
    
    $
    114,881Adjustments
    
    
    359
    
    
    158
    
    
    249
    
    
    264
    
    
    
    
    298
    
    
    332As Restated
    
    $
    88,202
    
    $
    93,906
    
    $
    100,178
    
    $
    101,407
    
    
    
    $
    109,619
    
    $
    115,213Operating
      Income:Reported
    
    $
    15,179
    
    $
    19,027
    
    $
    17,620
    
    $
    13,432
    
    
    
    $
    14,103
    
    $
    13,973Adjustments
    
    
    359
    
    
    158
    
    
    249
    
    
    264
    
    
    
    
    298
    
    
    332As Restated
    
    $
    15,538
    
    $
    19,185
    
    $
    17,869
    
    $
    13,696
    
    
    
    $
    14,401
    
    $
    14,305Pre-Tax
      Income:Reported
    
    $
    14,961
    
    $
    17,500
    
    $
    16,106
    
    $
    12,197
    
    
    
    $
    13,387
    
    $
    13,573Adjustments
    
    
    358
    
    
    158
    
    
    249
    
    
    264
    
    
    
    
    298
    
    
    332As Restated
    
    $
    15,319
    
    $
    17,658
    
    $
    16,355
    
    $
    12,461
    
    
    
    $
    13,685
    
    $
    13,905Income
      Tax Expense:Reported
    
    $
    5,835
    
    $
    6,825
    
    
    ($35,460
    )
    $
    5,103
    
    
    
    $
    5,031
    
    $
    5,025Adjustments
    
    
    141
    
    
    62
    
    
    (2,287
    )
    
    (243
    )
    
    
    
    366
    
    
    458As Restated
    
    $
    5,976
    
    $
    6,887
    
    
    ($37,747
    )
    $
    4,860
    
    
    
    $
    5,397
    
    $
    5,483Net
      Income:Reported
    
    $
    9,126
    
    $
    10,675
    
    $
    51,566
    
    $
    7,094
    
    
    
    $
    8,356
    
    $
    8,548Adjustments
    
    
    217
    
    
    96
    
    
    2,536
    
    
    507
    
    
    
    
    (68
    )
    
    (126
    )As Restated
    
    $
    9,343
    
    $
    10,771
    
    $
    54,102
    
    $
    7,601
    
    
    
    $
    8,288
    
    $
    8,422Basic
      EPS:Reported
    
    $
    0.35
    
    $
    0.41
    
    $
    1.96
    
    $
    0.27
    
    
    
    $
    0.31
    
    $
    0.32Adjustments
    
    
    --
    
    
    --
    
    
    0.09
    
    
    0.02
    
    
    
    
    --
    
    
    (0.1
    )As Restated
    
    $
    0.35
    
    $
    0.41
    
    $
    2.05
    
    $
    0.29
    
    
    
    $
    0.31
    
    $
    0.31Fully
      Diluted EPS:Reported
    
    $
    0.32
    
    $
    0.37
    
    $
    1.74
    
    $
    0.25
    
    
    
    $
    0.29
    
    $
    0.30Adjustments
    
    
    --
    
    
    --
    
    
    0.14
    
    
    0.02
    
    
    
    
    --
    
    
    --As Restated
    
    $
    0.32
    
    $
    0.37
    
    $
    1.88
    
    $
    0.27
    
    
    
    $
    0.29
    
    $
    0.30Fully
      Diluted Shares:Reported
    
    
    29,940
    
    
    29,563
    
    
    29,761
    
    
    28,884
    
    
    
    
    28,862
    
    
    28,694Adjustments
    
    
    --
    
    
    --
    
    
    (884
    )
    
    (777
    )
    
    
    
    (732
    )
    
    (655
    )As Restated
    
    
    29,940
    
    
    29,563
    
    
    28,877
    
    
    28,107
    
    
    
    
    28,130
    
    
    28,039








iii








The
consolidated balance sheets for the second quarter of 2004 and 2003 as
originally reported have been restated as follows (in thousands):








**At
      June 30, 2004**
    
    
    **As
      Originally**
      **Reported**
    
    
    **As
      Restated**Deferred
      income tax assetsCurrent
    
    $
    26,338
    
    $
    26,338Long-term
    
    
    30,619
    
    
    38,857Goodwill
    
    
    19,503
    
    
    13,013Total
      assets
    
    
    239,996
    
    
    241,744Sales,
      use and excise taxes
    
    
    14,926
    
    
    13,266Deferred
      income taxes
    
    
    19,840
    
    
    20,088Total
      liabilities
    
    
    121,989
    
    
    120,575Accumulated
      deficit
    
    
    (233,436
    )
    
    (230,274
    )Total
      stockholders’ equity
    
    
    118,007
    
    
    121,169





**At
      June 30, 2003***
    
    
    **As
      Originally**
      **Reported**
    
    
    **As**
      **Restated**Deferred
      income tax assetsCurrent
    
    $
    10,653
    
    $
    10,447Long-term
    
    
    --
    
    
    --Goodwill
    
    
    19,503
    
    
    19,503Total
      assets
    
    
    169,318
    
    
    171,572Sales,
      use and excise taxes
    
    
    12,794
    
    
    12,276Deferred
      income taxes
    
    
    --
    
    
    --Total
      liabilities
    
    
    130,554
    
    
    132,495Accumulated
      deficit
    
    
    (309,000
    )
    
    (308,687
    )Total
      stockholders’ equity
    
    
    38,764
    
    
    39,077




* 
Certain amounts reflected herein for 2003 have been reclassified to reflect the
2004 presentation.





Unless
otherwise expressly stated, this Amendment No. 1 does not reflect events
occurring after the filing on August 4, 2004 of our Quarterly Report on Form
10-Q for the period ended June 30, 2004, nor does it modify or update in any way
disclosures contained in our Form 10-Q other than to reflect the restatement
discussed above.









iv








**TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**





**Index**





******Page**PART
      I - FINANCIAL INFORMATIONItem
      1. Consolidated Financial StatementsConsolidated
      Statements of Operations - Three and Six Months Ended June 30, 2004
      (restated) and 2003 (restated) (unaudited)
    2Consolidated
      Balance Sheets - June 30, 2004 (restated), December 31, 2003 (restated),
      and June 30, 2003 (restated) (unaudited)
    3Consolidated
      Statements of Stockholders' Equity - Six Months Ended June 30, 2004
      (restated) (unaudited)
    4Consolidated
      Statements of Cash Flows - Three and Six Months Ended June 30, 2004
      (restated) and 2003 (restated) (unaudited)
    5Notes
      to Consolidated Financial Statements (unaudited)
    6Item
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
    14Item
      4. Controls and Procedures
    25PART
      II - OTHER INFORMATION
    27Item
      6. Exhibits and Reports on Form 8-K
    27(a) Exhibits(b)
      Reports on Form 8-K






1





**TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
STATEMENTS OF OPERATIONS**


**(In
thousands, except for per share data)**


**(Unaudited)**








**Three
      Months Ended**
      **June
      30,**
    
    **Six
      Months Ended**
      **June
      30,******
    
    
    **2004**
      **(restated)**
    
    
    **2003**
      **(restated)**
    ****
      ****
    
    **2004**
      **(restated)**
    ****
      ****
    
    ****
      **2003**
      **(restated**)
    ****
      ****
      ****Revenue
    
    $
    115,213
    
    $
    93,906
    
    $
    224,832
    
    $
    182,108Costs
      and expenses:Network and line costs, excluding depreciation and amortization (see
      below)
    
    
    55,586
    
    
    43,268
    
    
    109,806
    
    
    87,152General
      and administrative expenses
    
    
    15,891
    
    
    12,549
    
    
    31,053
    
    
    25,428Provision
      for doubtful accounts
    
    
    4,905
    
    
    2,895
    
    
    8,326
    
    
    5,117Sales
      and marketing expenses
    
    
    19,204
    
    
    11,629
    
    
    36,488
    
    
    21,000Depreciation
      and amortization
    
    
    5,322
    
    
    4,380
    
    
    10,453
    
    
    8,688Total
      costs and expenses
    
    
    100,908
    
    
    74,721
    
    
    196,126
    
    
    147,385Operating
      income
    
    
    14,305
    
    
    19,185
    
    
    28,706
    
    
    34,723Other
      income (expense):Interest
      income
    
    
    42
    
    
    186
    
    
    143
    
    
    295Interest
      expense
    
    
    (442
    )
    
    (2,027
    )
    
    (1,259
    )
    
    (4,506
    )Other
      income, net
    
    
    --
    
    
    314
    
    
    --
    
    
    2,465Income
      before provision for income taxes
    
    
    13,905
    
    
    17,658
    
    
    27,590
    
    
    32,977Provision
      for income taxes
    
    
    5,483
    
    
    6,887
    
    
    10,880
    
    
    12,863Net
      income
    
    $
    8,422
    
    $
    10,771
    
    $
    16,710
    
    $
    20,114Income
      per share - Basic:Net
      income per share
    
    $
    0.31
    
    $
    0.41
    
    $
    0.63
    
    $
    0.76Weighted
      average common shares outstanding
    
    
    26,746
    
    
    26,226
    
    
    26,710
    
    
    26,300Income
      per share - Diluted:Net
      income per share
    
    $
    0.30
    
    $
    0.37
    
    $
    0.59
    
    $
    0.70Weighted
      average common and common equivalent shares outstanding
    
    
    28,039
    
    
    29,563
    
    
    28,090
    
    
    29,349








See
accompanying notes to consolidated financial statements.





2


**TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
BALANCE SHEETS**


**(In
thousands, except for share and per share data)**


**(Unaudited)**








**June
      30,**
      **2004**
      **(restated)**
    
    **December
      31,**
      **2003**
      **(restated)**
    
    **June
      30,**
      **2003**
      **(restated)****Assets**Current
      assets:Cash
      and cash equivalents
    
    $
    30,427
    
    $
    35,242
    
    $
    25,858Accounts receivable, trade (net of allowance for uncollectible accounts of
      $12,227, $9,414 and $7,954 at June 30, 2004, December 31, 2003 and June 30
      2003, respectively)
    
    
    48,109
    
    
    40,321
    
    
    33,905Deferred
      income taxes
    
    
    26,338
    
    
    24,605
    
    
    10,447Prepaid
      expenses and other current assets
    
    
    7,476
    
    
    5,427
    
    
    4,417Total
      current assets
    
    
    112,350
    
    
    105,595
    
    
    74,627Property
      and equipment, net
    
    
    66,016
    
    
    68,069
    
    
    64,383Goodwill
    
    
    13,013
    
    
    13,013
    
    
    19,503Intangibles,
      net
    
    
    3,244
    
    
    4,666
    
    
    5,956Deferred
      income taxes
    
    
    38,857
    
    
    48,288
    
    
    --Other
      assets
    
    
    8,264
    
    
    7,547
    
    
    7,103$
    241,744
    
    $
    247,178
    
    $
    171,572**Liabilities
      and Stockholders’ Equity**Current
      liabilities:Accounts
      payable
    
    $
    43,039
    
    $
    35,296
    
    $
    34,469Sales,
      use and excise taxes
    
    
    13,266
    
    
    13,521
    
    
    12,276Deferred
      revenueLegal settlements
    
    
    14,516
    
    
    10,873
    
    
    8,707Current
      portion of long-term debt
    
    
    17,554
    
    
    16,806
    
    
    58Accrued
      compensation
    
    
    4,941
    
    
    9,888
    
    
    4,264Other
      current liabilities
    
    
    4,186
    
    
    6,851
    
    
    7,171Total
      current liabilities
    
    
    97,502
    
    
    93,235
    
    
    66,945Long-term
      debt
    
    
    2,985
    
    
    31,791
    
    
    65,550Deferred
      income taxes
    
    
    20,088
    
    
    19,009
    
    
    --Commitments
      and contingenciesStockholders'
      equity:Preferred
      stock - $.01 par value, 5,000,000 shares authorized; no shares outstanding
    
    
    --
    
    
    --
    
    
    --Common
      stock - $.01 par value, 100,000,000 shares authorized; 26,966,743,
      26,662,952 and 26,351,070, issued and outstanding at June 30, 2004,
      December 31, 2003 and June 30, 2003, respectively
    
    
    283
    
    
    280
    
    
    277Additional
      paid-in capital
    
    
    356,160
    
    
    354,847
    
    
    352,487Accumulated
      deficit
    
    
    (230,274
    )
    
    (246,984
    )
    
    (308,687
    )Treasury
      stock - $.01 par value, 1,315,789 shares at June 30, 2004 and December 31,
      2003 and June 30, 2003 respectively
    
    
    (5,000
    )
    
    (5,000
    )
    
    (5,000
    )Total
      stockholders' equity
    
    
    121,169
    
    
    103,143
    
    
    39,077$
    241,744
    
    $
    247,178
    
    $
    171,572





See
accompanying notes to consolidated financial statements.





3


**TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
STATEMENTS OF STOCKHOLDERS' EQUITY**


**(In
thousands)**


**(Unaudited)**





********
      ****
    
    **Common
      Stock**
    
    **Additional**
      **Paid-In**
    
    
    **Accumulated**
    
    **Treasury
      Stock******
    
    
    **Shares**
    
    
    **Amount**
    
    
    **Capital**
    
    
    **Deficit**
    
    
    **Shares**
    
    
    **Amount**
    
    
    **Total**Balance, December 31, 2003 (restated)
    
    
    27,979
    
    $
    280
    
    $
    354,847
    
    $
    (246,984
    )
    
    1,316
    
    $
    (5,000
    )
    $
    103,143Net income (restated)
    
    
    --
    
    
    --
    
    
    --
    
    
    16,710
    
    
    --
    
    
    --
    
    
    16,710Income
      tax benefit related to exercise of common stock options
    
    
    --
    
    
    --
    
    
    757
    
    
    --
    
    
    --
    
    
    --
    
    
    757Change
      in terms of employee stock options
    
    
    --
    
    
    --
    
    
    9
    
    
    --
    
    
    --
    
    
    --
    
    
    9Exercise
      of common stock options
    
    
    304
    
    
    3
    
    
    547
    
    
    --
    
    
    --
    
    
    --
    
    
    550Balance, June 30, 2004 (restated)
    
    
    28,283
    
    $
    283
    
    $
    356,160
    
    $
    (230,274
    )
    
    1,316
    
    $
    (5,000
    )
    $
    121,169








See
accompanying notes to consolidated financial statements.





4


**TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**


**CONSOLIDATED
STATEMENTS OF CASH FLOWS**


**(In
thousands)**


**(Unaudited)**





****
      ****
    
    **Six
      Months Ended June 30,******
      ****
    
    
    **2004**
      **(restated)**
    
    
    **2003**
      **(restated)**
    ****
      ****Cash
      flows from operating activities:Net
      income
    
    $
    16,710
    
    $
    20,114Adjustments to reconcile net income to net cash provided by operating
      activities:Provision
      for doubtful accounts
    
    
    8,326
    
    
    5,117Depreciation
      and amortization
    
    
    10,453
    
    
    8,688Loss
      on sale and retirement of assets
    
    
    --
    
    
    16Non-cash
      interest and amortization of accrued interest liabilities
    
    
    (130
    )
    
    (131
    )Gain
      from extinguishment of debt
    
    
    --
    
    
    (2,471
    )Deferred
      income taxes
    
    
    9,534
    
    
    11,851Non-cash
      compensation
    
    
    9
    
    
    --Changes
      in assets and liabilities:Accounts
      receivable, trade
    
    
    (16,114
    )
    
    (11,180
    )Prepaid
      expenses and other current assets
    
    
    (1,488
    )
    
    (551
    )Other
      assets
    
    
    (24
    )
    
    1,435Accounts
      payable
    
    
    7,743
    
    
    2,321Sales,
      use and excise taxes
    
    
    (255
    )
    
    837Deferred
      revenue
    
    
    3,643
    
    
    2,227Accrued
      compensation
    
    
    (4,947
    )
    
    (1,345
    )Other
      current liabilities
    
    
    (2,665
    )
    
    (1,843
    )Net
      cash provided by operating activities
    
    
    30,795
    
    
    35,084Cash
      flows from investing activities:Capital
      expenditures
    
    
    (3,339
    )
    
    (4,217
    )Capitalized
      software development costs
    
    
    (1,787
    )
    
    (1,388
    )Net
      cash used in investing activities
    
    
    (5,126
    )
    
    (5,605
    )Cash
      flows from financing activities:Payments
      of borrowings
    
    
    (30,362
    )
    
    (32,676
    )Payments
      of capital lease obligations
    
    
    (672
    )
    
    (31
    )Proceeds
      from exercise of options
    
    
    550
    
    
    498Purchase
      of treasury stock
    
    
    --
    
    
    (5,000
    )Net
      cash used in financing activities
    
    
    (30,484
    )
    
    (37,209
    )Net
      decrease in cash and cash equivalents
    
    
    (4,815
    )
    
    (7,730
    )Cash
      and cash equivalents, beginning of period
    
    
    35,242
    
    
    33,588Cash
      and cash equivalents, end of period
    
    $
    30,427
    
    $
    25,858





See
accompanying notes to consolidated financial statements.





****
 
 5
 ****
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**


**NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS**


**(Unaudited)**





**NOTE
1. ACCOUNTING POLICIES**





**(a)
Basis of Financial Statements Presentation**





The
consolidated financial statements include the accounts of Talk America Holdings,
Inc. and its wholly-owned subsidiaries (collectively, "Talk America," "we,"
"our" and "us"). All intercompany balances and transactions have been
eliminated.





The
consolidated financial statements and related notes thereto as of June 30, 2004
and for the three and six months ended June 30, 2004 and June 30, 2003 are
presented as unaudited, but in the opinion of management include all adjustments
necessary to present fairly the information set forth therein. The consolidated
balance sheet information for December 31, 2003 was derived from the audited
financial statements included in our Annual Report on Form 10-K for the year
ended December 31, 2003 filed March 12, 2004, as
amended by our Form 10-K/A filed May 7, 2004, and as restated by our Form 10-K/A
Amendment No. 2 filed March 28, 2005 . These
interim financial statements should be read in conjunction with our Annual
Report on Form 10-K for the year ended December 31, 2003, as amended by our Form
10-K/A , and as
restated by our Form 10-K/A Amendment No. 2 . The
interim results are not necessarily indicative of the results for any future
periods. Certain prior year amounts have been reclassified for comparative
purposes.





**(b)
Risks and Uncertainties**





Future
results of operations involve a number of risks and uncertainties. Factors that
would likely negatively affect future operating results and cash flows and cause
actual results to vary materially from historical results include, but are not
limited to:


·
    Dependence
      on the availability and functionality of the networks of the incumbent
      local telephone carriers as they relate to the unbundled network element
      platform


·
    The
      FCC is expected to pronounce interim and eventually final rules with
      respect thereto, which are expected to adversely affect availability and
      pricing of various network elements and bundles thereof. Such rules may
      also affect or limit our ability to pursue our current “customer first”
      strategy of acquiring a base of bundled phone service customers, building
      our own network platform and the migrating those customers to our own
      network platform.


·
    Additional
      changes in government policy, regulation and enforcement or adverse
      judicial or administrative interpretations and rulings or legislative
      action relating to regulations, enforcement and
pricing.


·
    Increased
      price competition in local and long distance services, including bundled
      services, and overall competition within the telecommunications
      industry.





Further
negative developments in these areas would likely have a material adverse effect
on our business prospects, financial condition and results of operations. See
“Other Matters.”





6


**NOTE
2. DEBT AND CAPITAL LEASE OBLIGATIONS**





The
following is a summary of our debt and capital lease obligations (in
thousands):





****
      ****
    
    
    **June
      30, 2004**
    
    
    **December
      31, 2003**
    
    
    **June
      31, 2003**8%
      Secured Convertible Notes Due 2006
    
    $
    --
    
    $
    --
    
    $
    15,45212%
      Senior Subordinated Notes Due 2007
    
    
    10,730
    
    
    40,730
    
    
    45,5208%
      Convertible Senior Subordinated Notes Due 2007 (1)
    
    
    3,648
    
    
    3,778
    
    
    3,9085%
      Convertible Subordinated Notes Due 2004
    
    
    670
    
    
    670
    
    
    670Other,
      primarily vendor-financed computer software
    
    
    2,744
    
    
    --
    
    
    --Capital
      lease obligations
    
    
    2,747
    
    
    3,419
    
    
    58Total
      long-term debt and capital lease obligations
    
    
    20,539
    
    
    48,597
    
    
    65,608Less:
      current maturities (2)
    
    
    17,554
    
    
    16,806
    
    
    58Total
      long-term debt and capital lease obligations, excluding current
      maturities
    
    $
    2,985
    
    $
    31,791
    
    $
    65,550








(1)
Includes future accrued interest of $0.8 million as of June 30, 2004 and $1.0
million as of December 31, 2003.





(2)
Reflects our June 21, 2004, notice and commitment to redeem remaining principal
amounts of our 12% Senior Subordinated Notes and our 8% Convertible Senior
Subordinated Notes, respectively, on August 23, 2004, and resulting change in
the maturity of such principal amount to the noticed redemption date.





**(a)**  **12%
Senior Subordinated Notes Due 2007 and 8% Convertible Senior Subordinated Notes
Due 2007**





Effective
April 4, 2002, we completed the exchange of $57.9 million of the $61.8 million
outstanding principal balance of our 4-1/2% Convertible Subordinated Notes due
December 15, 2002 ("4-1/2% Convertible Subordinated Notes") for $53.2 million
principal amount of our new 12% Senior Subordinated PIK Notes due August 2007
("12% Senior Subordinated Notes") and $2.8 million principal amount of our new
8% Convertible Senior Subordinated Notes due August 2007 ("8% Convertible Senior
Subordinated Notes") and cash paid of $0.5 million. In addition, we exchanged
$17.4 million of the $18.1 million outstanding principal balance of our 5%
Convertible Subordinated Notes ("5% Convertible Subordinated Notes") that mature
on December 15, 2004 for $17.4 million principal amount of the 12% Senior
Subordinated Notes.





On June
21, 2004, we provided a notice and commitment to redeem the remaining principal
amounts of our 12% Senior Subordinated Notes and our 8% Convertible Senior
Subordinated Notes on August 23, 2004. The 12% Senior Subordinated Notes and 8%
Convertible Senior Subordinated Notes are redeemable at any time at our option
at par value plus accrued interest to the redemption date.





In
accordance with SFAS No. 15, "Accounting by Debtors and Creditors for Troubled
Debt Restructurings," we accounted for the exchange of the 4-1/2% Convertible
Subordinated Notes for $53.2 million of the 12% Senior Subordinated Notes and
$2.8 million of the 8% Convertible Senior Subordinated Notes as a troubled debt
restructuring. Since the total liability of $57.4 million ($57.9 million of
principal as of the exchange date, less cash payments of $0.5 million) was less
than the future cash flows to holders of 8% Convertible Senior Subordinated
Notes and 12% Senior Subordinated Notes of $91.5 million (representing the $56.0
million of principal and $35.5 million of future interest expense), the
liability remained on our balance sheet at $57.4 million as long-term debt. We
recognized the difference of $1.4 million between principal and the carrying
amount as a reduction of interest expense over the life of the new notes. The
redemption of the 8% Convertible Senior Subordinated Notes prior to maturity
will cause $0.8 million of future accrued interest benefit to be recorded as an
offset to interest expense upon redemption.





**(b)**  **5% Convertible Subordinated Notes Due 2004**





As of
June 30, 2004, we had $0.7 million principal amount outstanding of our 5%
Convertible Subordinated Notes that mature on December 15, 2004. The notes are
convertible, at the option of the holder, at a conversion price of $76.14 per
share. The 5% Convertible Subordinated Notes are redeemable, in whole or in part
at our option, at 100.71% of par.








7





**(c)**  **Other**





During
the second quarter 2004, we entered into a vendor-financed computer software
purchase agreement for upgrades to our database management systems.
Approximately $2.7 million was outstanding under this agreement at June 30,
2004. Total assets under this purchase agreement are approximately $3.4 million
as of June 30, 2004, consisting of a perpetual software license agreement of
approximately $2.9 million and a one-year vendor maintenance agreement of
approximately $0.5 million. The agreement is repayable in 12 quarterly
installments, which includes interest based on an annual percentage rate of
approximately 3% and annual maintenance agreement renewals.





**(d)**  **Capital
Leases**





During
2003, we entered into a non-cancelable capital lease agreement for upgrades to
our customer data storage equipment. Approximately $2.7 million and $3.4 million
was outstanding under this agreement at June 30, 2004 and December 31, 2003,
respectively. Total assets under this lease agreement are approximately $3.4
million as of June 30, 2004 and December 31, 2003. The lease is repayable in
monthly installments through December 2006, which includes interest based on an
annual percentage rate of approximately 2%.





**NOTE
3. COMMITMENTS AND CONTINGENCIES**





We are
party to a number of legal actions and proceedings arising from our provision
and marketing of telecommunications services (including matters involving do not
call regulations), as well as certain legal actions and regulatory matters
arising in the ordinary course of business. During the second quarter of 2003,
we were made aware that AOL agreed to settle a class action case for
approximately $10 million; the claims in the case allegedly relate to marketing
activities conducted pursuant to the former telecommunications marketing
agreement, between us and AOL. At the time of the settlement agreement, AOL
asserted that we are required to indemnify AOL in this matter under the terms of
the marketing agreement and advised that it will seek such indemnification from
us. We believe that we do not have an obligation to indemnify AOL in this matter
and that any claim by AOL for this indemnification would be without merit. We
have received no further information regarding this matter and it is our
intention, if AOL initiates a claim for indemnification under the marketing
agreement, to defend against the claim vigorously. We believe that the ultimate
outcome of the foregoing actions will not result in a liability that would have
a material adverse effect on our financial condition or results of operations.





**NOTE
4. STOCK-BASED COMPENSATION**





We
account for our stock option awards under the intrinsic value based method of
accounting prescribed by APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations, including FASB Interpretation No. 44
"Accounting for Certain Transactions Including Stock Compensation," an
interpretation of APB Opinion No. 25. Under the intrinsic value based method,
compensation cost is the excess, if any, of the quoted market price of the stock
at grant date or other measurement date over the amount an employee must pay to
acquire the stock. We make pro forma disclosures of net income and earnings per
share as if the fair value based method of accounting had been applied as
required by SFAS No. 123, "Accounting for Stock-Based Compensation" and SFAS
148, “ Accounting
for Stock-Based Compensation - Transition and Disclosure - an amendment of SFAS
123.” The
following disclosure complies with the adoption of this statement and includes
pro forma net income as if the fair value based method of accounting had been
applied (in thousands except for per share data):





8






****
    
    **Three
      Months Ended June 30,**
    
    **Six
      Months Ended June 30,****2004**
      **(restated)**
    
    
    **2003**
      **(restated)**
    ****
      ****
    
    **2004**
      **(restated)**
    ****
    
    **2003**
      **(restated)**
    ****Net
      income as reported
    
    $
    8,422
    
    $
    10,771
    
    $
    16,710
    
    $
    20,114Add:
      Stock-based employee compensation expense included in reported net income
    
    
    --
    
    
    --
    
    
    5
    
    
    --Deduct:
      Total stock-based employee compensation expense determined under fair
      value based method for all options
    
    
    1,439
    
    
    340
    
    
    2,875
    
    
    562Pro
      forma net income
    
    $
    6,983
    
    $
    10,431
    
    $
    13,840
    
    $
    19,552











**Three
      Months Ended June 30,**
    
    **Six
      Months Ended June 30,****2004**
      **(restated)**
    
    **2003**
      **(****restated)**
    
    **2004**
      **(****restated)**
    
    **2003**
      **(restated)****Basic
      earnings per share:**As
      reported
    
    $
      0.31
    
    $
      0.41
    
    $
      0.63
    
    $
      0.76Pro
      forma
    
    $
      0.25
    
    $
      0.37
    
    $
      0.50
    
    $
      0.71**Diluted
      earnings per share:**As
      reported
    
    $
      0.30
    
    $
      0.37
    
    $
      0.59
    
    $
      0.70Pro
      forma
    
    $
      0.25
    
    $
      0.36
    
    $
      0.50
    
    $
      0.69








For
purposes of pro forma disclosures under SFAS 123, the estimated fair value of
the options is assumed to be amortized to expense over the options' vesting
period. The fair value of the options granted has been estimated at the various
dates of the grants using the Black-Scholes option-pricing model with the
following assumptions:





· Fair
market value based on our closing common stock price on the date the option is
granted;


· Risk-free
interest rate based on the weighted averaged 5 year U.S. treasury note strip
rates;


·
    Volatility
      based on the historical stock price over the expected term (5
      years);


·
    No
      expected dividend yield based on future dividend payment
      plans.





**NOTE
5. PER SHARE DATA**





Basic
earnings per common share for a fiscal period is calculated by dividing net
income by the weighted average number of common shares outstanding during the
fiscal period. Diluted earnings per common share is calculated by adjusting the
weighted average number of common shares outstanding and the net income during
the fiscal period for the assumed conversion of all potentially dilutive stock
options, warrants and convertible bonds (and assuming that the proceeds
hypothetically received from the exercise of dilutive stock options are used to
repurchase our common stock at the average share price during the fiscal
period). For the diluted earnings calculation, we also adjust the net income by
the interest expense on the convertible bonds assumed to be converted. Income
per share is computed as follows (in thousands except per share
data):







9







**Three
      Months Ended**
      **June
      30,**
    
    **Six
      Months Ended**
      **June
      30,******
      ****
    
    
    **2004**
      **(restated)**
    
    
    **2003**
      **(****restated)**
    ****
      ****
    
    **2004**
      **(restated)**
    ****
      ****
    
    **2003**
      **(restated)**
    ****
      ****Net
      income used to compute basic earnings per share
    
    $
    8,422
    
    $
    10,771
    
    $
    16,710
    
    $
    20,114Interest
      expense on convertible bonds, net of tax affect (See Note 2
      (a))
    
    
    (5
    )
    
    183
    
    
    (11
    )
    
    366Net
      income used to compute diluted earnings per share
    
    $
    8,417
    
    $
    10,954
    
    $
    16,699
    
    $
    20,480Average
      shares of common stock outstanding used to compute basic earnings per
      share
    
    
    26,746
    
    
    26,226
    
    
    26,710
    
    
    26,300Additional
      common shares to be issued assuming exercise of stock options and warrants
      (net of shares assumed reacquired) and conversion of convertible bonds
      *
    
    
    1,293
    
    
    3,337
    
    
    1,380
    
    
    3,045Average
      shares of common and common equivalent stock outstanding used to compute
      diluted earnings per share
    
    
    28,039
    
    
    29,563
    
    
    28,090
    
    
    29,345Income
      per share - Basic:Net
      income per share
    
    $
    0.31
    
    $
    0.41
    
    $
    0.63
    
    $
    0.76Weighted
      average common shares outstanding
    
    
    26,746
    
    
    26,226
    
    
    26,710
    
    
    26,300Income
      per share - Diluted:Net
      income per share
    
    $
    0.30
    
    $
    0.37
    
    $
    0.59
    
    $
    0.70Weighted
      average common and common equivalent shares outstanding
    
    
    28,039
    
    
    29,563
    
    
    28,090
    
    
    29,345





* The
diluted share basis for the three and six months ended June 30, 2004 and 2003
both exclude 9 shares associated with certain convertible bonds due to their
antidilutive effect. The diluted share basis for the three months ended June 30,
2004 and 2003 excludes 2,951 and 1,305 shares, respectively, and for the six
months ended June 30, 2004 and 2003 excludes 2,928 and 1,595 shares,
respectively, associated with the options and warrants due to their antidilutive
effect.





10


**NOTE
6. RESTATEMENT**





Our
consolidated financial statements have been revised to reflect the correction
for the following errors:





(a)
    Due
      to a classification error in our general ledger, we incorrectly recorded
      certain customer fee revenues as sales, use and excise tax liability to
      the consolidated balance sheets for the four quarters of 2003, for the
      year ended December 31, 2003 and for the first and second quarters of
      2004. These customer fee revenues were $0.3 million for the second quarter
      of 2004, $0.1 million for the second quarter of 2003, $0.6 million for the
      six months ended June 30, 2004, $0.5 million for the six months ended June
      30, 2003, and an aggregate of $1.0 million for the full year 2003. These
      customer fees have now been appropriately recorded to revenues in the
      consolidated statement of operations for the year ended December 31, 2003
      and in the unaudited quarterly periods for the first and second quarters
      2004 and 2003.


(b)
    We
      determined that in our calculations since the third quarter of 2003 we had
      not incorporated the tax benefits associated with the assumed exercise of
      employee stock options. As a result, fully diluted shares outstanding were
      over-reported and income per fully diluted share was understated in those
      periods.


(c)
    We
      identified errors in the computation of the deferred tax assets recognized
      in the third quarter of 2003 as follows: (i) failure to deduct state
      income tax expense from federal taxable income resulted in the deferred
      tax benefit as originally reported for the year ended December 31, 2003
      and the unaudited third quarter of 2003 being understated by $0.9 million
      and (ii) failure to complete the appropriately detailed analysis of our
      deferred tax assets relating to state net operating loss carryforwards
      resulted in the deferred tax benefit as originally reported for the year
      ended December 31, 2003 and the unaudited third quarter of 2003 being
      understated by $1.7 million. In February 2005, we determined that we
      improperly corrected for the errors in the deferred tax computations
      through an adjustment to the effective tax rate for 2004 rather than
      through the restatement of our prior period financial statements. As a
      result, we have restated the first and second quarter of 2004 and the
      third and fourth quarter of 2003 and year end December 31,
      2003.


(d)
    In
      connection with the release of the valuation allowance in the third
      quarter 2003, $6.5 million of deferred tax assets associated with acquired
      net operating loss carryforwards were realizable and should have been
      recorded as a deferred tax asset. Originally, we believed this deferred
      tax asset was limited due to provisions of the Internal Revenue Code
      Section 382. This error resulted in deferred tax assets being understated
      and goodwill being overstated in each of the periods beginning in the
      third quarter 2003.As
      a result, we have restated the first and second quarter of 2004 and the
      third and fourth quarter of 2003 and year end December 31,
      2003.





As a
result of these restatements, certain originally reported amounts in the
consolidated statements of operations for the three months and six months ended
June 30, 2004 and 2003 have been restated as follows (in thousands, except per
share data):





11








****
      ****
    
    
    **As**
      **Originally
      Reported**
    
    
    **Adjustments**
    
    
    **As**
      **Restated****Three
      Months Ended June 30, 2004**Revenue
    
    $
    114,881
    
    $
    332
    
    $
    115,213Operating
      income
    
    
    13,973
    
    
    332
    
    
    14,305Provision
      for income taxes
    
    
    5,025
    
    
    458
    
    
    5,483Net
      income
    
    
    8,548
    
    
    (126
    )
    
    8,422Net
      income per share - Basic
    
    
    0.32
    
    
    (0.01
    )
    
    0.31Net
      income per share - Diluted
    
    
    0.30
    
    
    --
    
    
    0.30Weighted
      average common and commonequivalent
      shares outstanding -Diluted
    
    
    28,694
    
    
    (655
    )
    
    28,039**Three
      Months Ended June 30, 2003**Revenue
    
    $
    93,748
    
    $
    158
    
    $
    93,906Operating
      income
    
    
    19,027
    
    
    158
    
    
    19,185Provision
      for income taxes
    
    
    6,825
    
    
    62
    
    
    6,887Net
      income
    
    
    10,675
    
    
    96
    
    
    10,771Net
      income per share - Basic
    
    
    0.41
    
    
    --
    
    
    0.41Net
      income per share - Diluted
    
    
    0.37
    
    
    --
    
    
    0.37Weighted
      average common and common equivalent shares outstanding -Diluted
    
    
    29,563
    
    
    --
    
    
    29,563**Six
      Months Ended June 30, 2004**Revenue
    
    $
    224,202
    
    $
    630
    
    $
    224,832Operating
      income
    
    
    28,076
    
    
    630
    
    
    28,706Provision
      for income taxes
    
    
    10,056
    
    
    824
    
    
    10,880Net
      income
    
    
    16,904
    
    
    (194
    )
    
    16,710Net
      income per share - Basic
    
    
    0.63
    
    
    --
    
    
    0.63Net
      income per share - Diluted
    
    
    0.59
    
    
    --
    
    
    0.59Weighted
      average common and common equivalent shares outstanding -Diluted
    
    
    28,787
    
    
    (697
    )
    
    28,090**Six
      Months Ended June 30, 2003**Revenue
    
    $
    181,591
    
    $
    517
    
    $
    182,108Operating
      income
    
    
    34,206
    
    
    517
    
    
    34,723Provision
      (benefit) for income taxes
    
    
    12,659
    
    
    204
    
    
    12,863Net
      income
    
    
    19,801
    
    
    313
    
    
    20,114Net
      income per share - Basic
    
    
    0.75
    
    
    0.01
    
    
    0.76Net
      income per share - Diluted
    
    
    0.69
    
    
    0.01
    
    
    0.70Weighted
      average common and common equivalent shares outstanding -Diluted
    
    
    29,345
    
    
    4
    
    
    29,349





As a
result of these restatements, certain originally reported amounts in the
consolidated balance sheets at June 30, 2004, December 31, 2003 and June 30,
2004 have been restated as follows (in thousands):





12








****
      ****
    
    
    **As**
      **Originally
      Reported**
    
    
    **Adjustments**
    
    
    **As**
      **Restated****At
      June 30, 2004**Deferred
      income tax assetsCurrent
    
    $
    26,338
    
    $
    --
    
    $
    26,338Long-term
    
    
    30,619
    
    
    8,238
    
    
    38,857Goodwill
    
    
    19,503
    
    
    (6,490
    )
    
    13,013Total
      assets
    
    
    239,996
    
    
    1,748
    
    
    241,744Sales,
      use and excise taxes
    
    
    14,926
    
    
    (1,660
    )
    
    13,266Deferred
      income taxes
    
    
    19,840
    
    
    248
    
    
    20,088Total
      liabilities
    
    
    121,989
    
    
    (1,414
    )
    
    120,575Accumulated
      deficit
    
    
    (233,436
    )
    
    3,162
    
    
    (230,274
    )Total
      stockholders’ equity
    
    
    118,007
    
    
    3,162
    
    
    121,169**At
      December 31, 2003**Deferred
      income tax assetsCurrent
    
    $
    24,605
    
    $
    --
    
    $
    24,605Long-term
    
    
    40,543
    
    
    7,745
    
    
    48,288Goodwill
    
    
    19,503
    
    
    (6,490
    )
    
    13,013Total
      assets
    
    
    245,923
    
    
    1,255
    
    
    247,178Sales,
      use and excise taxes
    
    
    14,551
    
    
    (1,030
    )
    
    13,521Deferred
      income taxes
    
    
    19,904
    
    
    (895
    )
    
    19,009Total
      liabilities
    
    
    146,136
    
    
    (2,101
    )
    
    144,035Accumulated
      deficit
    
    
    (250,340
    )
    
    3,356
    
    
    (246,984
    )Total
      stockholders’ equity
    
    
    99,787
    
    
    3,356
    
    
    103,143**At
      June 30, 2003***Deferred
      income tax assetsCurrent
    
    $
    10,653
    
    $
    (206
    )
    $
    10,447Long-term
    
    
    --
    
    
    --
    
    
    --Goodwill
    
    
    19,503
    
    
    --
    
    
    19,503Total
      assets
    
    
    169,318
    
    
    2,254
    
    
    171,572Sales,
      use and excise taxes
    
    
    12,794
    
    
    (518
    )
    
    12,276Deferred
      income taxes
    
    
    --
    
    
    --
    
    
    --Total
      liabilities
    
    
    130,554
    
    
    1,941
    
    
    132,495Accumulated
      deficit
    
    
    (309,000
    )
    
    313
    
    
    (308,687
    )Total
      stockholders’ equity
    
    
    38,764
    
    
    313
    
    
    39,077


* 
Certain amounts reflected herein for 2003 have been reclassified to reflect the
2004 presentation.





13


As a
result of these restatements, certain originally reported amounts for cash flows
from operating activities in the consolidated statement of cash flows have been
adjusted as follows (in thousands):





****
      ****
    
    
    **As**
      **Originally
      Reported**
    ****
    ****
    ****
      ****
      **Adjustments**
    ****
    ****
    ****
      **As**
      **Restated****At
      June 30, 2004**Cash
      flows from operating activities:Net income
    
    $
    16,904
    
    $
    (194
    )
    $
    16,710Deferred income taxes
    
    
    8,884
    
    
    650
    
    
    9,534Changes in assets and liabilities:Sales, use and excise taxes
    
    
    375
    
    
    (630
    )
    
    (255
    )Other current liabilities and accrued compensation
    
    
    (7,786
    )
    
    174
    
    
    (7,612
    )Net cash provided by operating activities
    
    
    30,795
    
    
    --
    
    
    30,795**At
      June 30, 2003**Cash
      flows from operating activities:Net income
    
    $
    19,801
    
    $
    313
    
    $
    20,114Deferred income taxes
    
    
    11,647
    
    
    204
    
    
    11,851Changes in assets and liabilities:Sales,
      use and excise taxes
    
    
    1,354
    
    
    (517
    )
    
    837Other
      current liabilities and accrued compensation
    
    
    (3,188
    )
    
    --
    
    
    (3,188
    )Net
      cash provided by operating activities
    
    
    35,084
    
    
    --
    
    
    35,084






**Item
2. Management’s Discussion and Analysis of Financial Condition and Results of
Operations**





You
should read the following discussion in conjunction with our Consolidated
Financial Statements included elsewhere in this Form 10-Q and in our Annual
Report on Form 10-K filed March 12, 2004, as amended by our Form 10-K/A filed
May 7, 2004, as restated by our Form 10-K/A Amendment No. 2 filed March 28, 2005
and any subsequent filings. Certain of the statements contained herein may be
considered “forward-looking statements” for purposes of the securities laws.
From time to time, oral or written forward-looking statements may also be
included in other materials released to the public. These forward-looking
statements are intended to provide our management’s current expectations or
plans for our future operating and financial performance, based on our current
expectations and assumptions currently believed to be valid. For these
statements, we claim protection of the safe harbor for forward-looking
statements provided by the Private Securities Litigation Reform Act of 1995.
These forward-looking statements can be identified by the use of forward-looking
words or phrases, including, but not limited to, “believes,” "estimates,"
"expects," "expected," "anticipates," "anticipated," “plans,” “strategy,”
“target,” “prospects” and other words of similar meaning in connection with a
discussion of future operating or financial performance. Although we believe
that the expectations reflected in such forward-looking statements are
reasonable, there can be no assurance that such expectations will prove to have
been correct.





All
forward-looking statements involve risks and uncertainties that may cause our
actual results to differ materially from those expressed or implied in the
forward-looking statements. In addition to those factors discussed in this Form
10-Q Report, you should see our other reports on Forms 10-K, 10-Q and 8-K filed
with the Securities and Exchange Commission from time to time for information
identifying factors that may cause actual results to differ materially from
those expressed or implied in the forward-looking statements.







14





**OVERVIEW**





We offer
a bundle of local and long distance phone services to residential and small
business customers in the United States. Our current business strategy is to
build a large, profitable base of bundled phone service customers using the
wholesale operating platforms of the incumbent local telephone companies and to
then migrate customers to our own networking platform and further increase our
revenues and profitability by offering new products and services to these
customers. As a result of the decision earlier this year by the U.S. Court of
Appeals for the District of Columbia (discussed under “Other Matters”, below)
that reversed important portions of the FCC’s orders requiring incumbent local
telephone companies to provide unbundled network elements by the U.S. Court of
Appeals for the District of Columbia, the FCC is in the process of creating
interim and eventually final rules that govern the manner in which we purchase
services from the incumbent local telephone carriers, including the unbundled
network element platform. The FCC expects to complete final rules within six
months of announcing interim rules. As of the date of this report, the FCC has
not issued the interim rules. While the content of the interim and final rules
are not known, they are likely to contain provisions that would cause our costs
to significantly increase over time. These cost increases will have a negative
impact on our product pricing and our ability to add new customers and thus may
affect our current business strategy.





An
integral element of our current business strategy is to develop our own local
networking capability. Local networking would enhance our operating flexibility
and provide us with an alternative to the wholesale operating platforms of the
incumbent local telephone companies. During 2003, we deployed networking assets
in Michigan and have provisioned over 3,500 customers to our switch from our
colocation site in Southfield, Michigan as of June 30, 2004. We are currently in
the process of expanding our presence in the incumbent local telephone
companies’ end offices by collocating our networking equipment in these end
offices to provide service over our own network to a larger existing customer
base in geographic regions where we have a high density of customers. We expect
to have equipment collocated and operating in at least 18 different sites by the
end of 2004 or the beginning of 2005. We are in the process of automating the
business processes required to provide local network-based services. In
addition, we are actively exploring next generation networking opportunities
with a variety of vendors in order to decrease our cost of delivering service,
reduce our reliance upon the incumbent local telephone companies and provide
local telephone services through new, innovative methods of
delivery.





In
addition, we will add new services and enhance our existing service and product
offerings, as available. We believe that the addition of these new services and
of enhanced services will increase our revenues and gross margins from our
customers while also meeting the needs and demands of our customers and reducing
our customer turnover. We launched a new dial-up internet service in June 2004,
and expect to test digital subscriber line, or DSL, service in the third quarter
2004.








15


**RESULTS
OF OPERATIONS**





The
following table sets forth for the periods indicated certain of our financial
data as a percentage of revenue:





**Three
      Months Ended June 30,**
    
    **Six
      Months Ended June 30,******
      ****
    
    
    **2004**
      **(restated)**
    
    
    **2003**
      **(restated)**
    ****
      ****
    
    **2004**
      **(restated)**
    ****
      ****
    
    **2003**
      **(restated)**
    ****
      ****Revenue
    
    
    100.0
    %
    
    100.0
    %
    
    100.0
    %
    
    100.0
    %Costs
      and expenses:Network
      and line costs
    
    
    48.2
    
    
    46.1
    
    
    48.8
    
    
    47.9General
      and administrative expenses
    
    
    13.8
    
    
    13.4
    
    
    13.8
    
    
    13.9Provision
      for doubtful accounts
    
    
    4.3
    
    
    3.1
    
    
    3.7
    
    
    2.8Sales
      and marketing expenses
    
    
    16.7
    
    
    12.4
    
    
    16.2
    
    
    11.5Depreciation
      and amortization
    
    
    4.6
    
    
    4.6
    
    
    4.6
    
    
    4.8Total
      costs and expenses
    
    
    87.6
    
    
    79.6
    
    
    87.2
    
    
    80.9Operating
      income
    
    
    12.4
    
    
    20.4
    
    
    12.8
    
    
    19.1Other
      income (expense):Interest
      income
    
    
    --
    
    
    0.2
    
    
    0.1
    
    
    0.2Interest
      expense
    
    
    (0.3
    )
    
    (2.2
    )
    
    (0.6
    )
    
    (2.5
    )Other,
      net
    
    
    --
    
    
    0.4
    
    
    --
    
    
    1.3Income
      before income taxes
    
    
    12.1
    
    
    18.8
    
    
    12.3
    
    
    18.1Provision
      for income taxes
    
    
    4.8
    
    
    7.3
    
    
    4.8
    
    
    7.1Net
      income
    
    
    7.3
    %
    
    11.5
    %
    
    7.5
    %
    
    11.0
    %











16


The
following table sets forth for certain items of our financial data for the
periods indicated the percentage increase or (decrease) in such item from the
prior year comparable fiscal period:





****


**Three
      Months Ended June 30,**
    
    **Six
      Months Ended June 30,****2004**
      **(restated)**
    
    **2003**
      **(****restated)**
    
    **2004**
      **(restated)**
    
    **2003**
      **(restated)**Revenue
    
    22.7%
    
    20.9%
    
    23.5%
    
    15.9%Costs
      and expenses:Network
      and line costs
    
    28.5
    
    14.9
    
    26.0
    
    11.9General and administrative expenses
    
    26.6
    
    (8.0)
    
    22.1
    
    (9.9)Provision
      for doubtful accounts
    
    69.4
    
    3.4
    
    62.7
    
    (24.8)Sales
      and marketing expenses
    
    65.1
    
    68.2
    
    73.8
    
    64.0Depreciation
      and amortization
    
    21.5
    
    (1.1)
    
    20.3
    
    (2.1)Total costs and expenses
    
    35.1
    
    14.2
    
    33.1
    
    9.5Operating
      income
    
    (25.4)
    
    56.8
    
    (17.3)
    
    54.0Other
      income (expense):Interest
      income
    
    (77.4)
    
    97.9
    
    (51.5)
    
    61.7Interest
      expense
    
    (78.2)
    
    (30.1)
    
    (72.1)
    
    3.0Other,
      net
    
    (100.0)
    
    3588.9
    
    (100.0)
    
    (402.1)Income
      before income taxes
    
    (21.3)
    
    87.5
    
    (16.3)
    
    87.9Provision
      for income taxes
    
    (20.4)
    
    N/A
    
    (15.4)
    
    N/ANet
      income
    
    (21.8)%
    
    14.4%
    
    (16.9)
    
    14.6%














17








**SECOND
QUARTER 2004 COMPARED TO SECOND QUARTER 2003**





*Revenue.* The
increase in revenue for the second quarter 2004 from the second quarter 2003 was
due to the increase in bundled revenue offset by a decline in long distance
revenue. During 2004, we increased certain fees and rates related to our long
distance and bundled products and such changes in rates may adversely impact
customer turnover.





The
increase in bundled revenue to $99.4 million for the second quarter 2004 from
$67.8 million for the second quarter 2003 was due to higher average bundled
lines in 2004 as compared to 2003, partially offset by lower average monthly
revenue per customer. We ended the second quarter 2004 with 672,000 billed
bundled lines, compared to 443,000 at the end of the second quarter 2003 and
623,000 at the end of the first quarter 2004. Approximately 50% of the bundled
lines at the end of the second quarter 2004 were in Michigan, compared to 68% at
the end of the second quarter 2003, reflecting our continued efforts to market
into new states. A significant increase in the costs we pay for network services
from the incumbent local telephone carriers may cause us to dramatically limit
the marketing of new customers in some or all states, resulting in a decline in
revenues in the future.





Our long
distance revenue decreased for the second quarter 2004 to $15.8 million from
$26.0 million for the second quarter 2003. Our decision in 2000 to invest in
building a bundled customer base, together with customer turnover, contributed
to the decline in long distance customers and revenue, although the effect on
revenue of the decline in customers was offset partially by an increase in
average monthly revenue per customer due to price increases. We expect this
decline in long distance customers and revenues to continue.





*Network
and Line Costs* The
increase of network and line costs for the second quarter 2004 from the second
quarter 2003 is primarily due to the increase in bundled customers, partially
offset by the decrease in long distance customers. The lower total network and
line costs as a percentage of revenue were due primarily to lower network costs
as a percentage of revenue for both the bundled and long distance products. This
decrease was partially offset by a shift in our customer base to the higher cost
bundled product from the lower cost long distance product and increases in
network cost pricing and costs of unbundled network elements in certain states.
Network and line costs exclude depreciation and amortization.





Bundled
network and line costs were $49.7 million for the second quarter 2004, as
compared to $32.0 million for the second quarter 2003. Long distance network and
line costs were $5.8 million for the second quarter 2004, as compared to $11.2
million for the second quarter 2003. As a percentage of bundled revenue, bundled
and network line costs were 50.1% for the second quarter 2004, as compared to
47.2% for the second quarter 2003. Long distance network and line costs as a
percentage of long distance revenue were 36.8% for the second quarter 2004, as
compared to 43.1% for the second quarter 2003. During the second quarter 2004,
we recorded liabilities for network and line costs related to retroactive cost
increases pending the resolution of a rate proceeding in the State of Georgia
and other matters. The increase in these liabilities was partially offset by a
reduction  in
accruals for network and line costs due  to the
expiration of the period to backbill us certain charges. In addition during the
second quarter 2004, we received a credit of $1.3 million related to a
retroactive reduction in certain switching costs for Bell South.





18


We
structure and price our products in order to maintain network and line costs as
a percentage of revenue at certain targeted levels. While the control of the
structure and pricing of our products assists us in mitigating risks of
increases in network and line costs, the telecommunications industry is highly
competitive and there can be no assurances that we will be able to effectively
market these higher priced products. There are several factors that could cause
our network and line costs as a percentage of revenue to increase in the future,
including without limitation:





·  Determinations
by the FCC, courts, or state commission(s) that make unbundled local switching
and/or combinations of unbundled network elements effectively unavailable to us
in some or all of our geographic service areas, requiring us to provide services
in these areas through other means, including total service resale agreements
with incumbent local telephone companies, network elements purchased from the
Regional Bell Operating Companies at "just and reasonable" rates under Section
271 of the Act and the switching facilities of other non-incumbent carriers, in
any case at significantly increased costs, or to provide services over our own
switching facilities, if we are able to deploy them. The U.S. Court of Appeals
for the District of Columbia, on March 2, 2004, issued an order that reversed
the FCC’s Triennial Review Order in part and remanded to the FCC with
instructions to revise the Order in material ways that may make unbundled local
switching and/or combinations of unbundled
network elements effectively unavailable to us in some or all of our geographic
service areas (see our discussion under "Liquidity and Capital Resources, Other
Matters," below).




·  Adverse
changes to the current pricing methodology mandated by the FCC for use in
establishing the prices charged to us by incumbent local telephone companies for
the use of their unbundled network elements. The FCC’s 2003 Triennial Review
Order, which was reversed in part and remanded to the FCC with instructions to
revise the Order in material ways, (see our discussion under "Liquidity and
Capital Resources, Other Matters," below), clarified several aspects of these
pricing principles related to depreciation, fill factors (i.e. network
utilization) and cost of capital, which could enable incumbent local telephone
companies to increase the prices for unbundled network elements. In addition,
the FCC released a Notice of Proposed Rulemaking on December 15, 2003, which
initiated a proceeding to consider making additional changes to its unbundled
network element pricing methodology, including reforms that would base prices
more on the actual network costs incurred by incumbent local telephone companies
than on the hypothetical network costs that would be incurred when the most
efficient technology is used. These changes could result in material increases
in prices charged to us for unbundled network elements.




·  Determinations
by state commissions to increase prices for unbundled network elements in
ongoing state cost dockets.




Changes
in the pricing of our service plans could also cause network and line costs as a
percentage of revenue to change in the future. See our discussion under
"Liquidity and Capital Resources, Other Matters," below.





*General
and Administrative Expenses* . General
and administrative expenses increased for the second quarter 2004 from the
second quarter 2003 primarily due to an increase in the number of employees for
customer service, information technology and our local networking initiatives to
support our expanding base of bundled customers. The increase was also
attributable to a new operating lease for information technology
equipment.





*Provision
for Doubtful Accounts* . The
provision for doubtful accounts increased for the second quarter 2004 from the
second quarter 2003. The increase in bad debt expense is primarily attributable
to the increase in bundled revenue, both in total and as a percentage of total
revenue. In addition, the provision for doubtful accounts as a percentage of
revenues increased in the second quarter 2004 due to an insufficient number of
collections personnel.





*Sales
and Marketing Expenses* . The
increase in sales and marketing expenses for the second quarter 2004 from the
second quarter 2003 is primarily attributable to increased levels of sales and
marketing activity to continue our bundled sales growth. The cost of acquiring a
customer has also increased. Currently, substantially all of our sales and
marketing expenses relate to the bundled product.





19





*Interest
Expense* . The
decrease in interest expense for the second quarter 2004 from the second quarter
2003 is primarily attributable to the decrease in outstanding debt balances
through repurchases of our 12% Senior Subordinated Notes during 2003 and the
first quarter 2004, and our 8% Secured Convertible Notes during 2003. Interest
expense in the third quarter 2004 will include an $0.8 million benefit related
to the redemption of the 8% Convertible Senior Subordinated Notes prior to
maturity.





*Depreciation
and Amortization.* The
increase in depreciation and amortization for the second quarter 2004 from the
second quarter 2003 is primarily attributable to depreciation on costs incurred
in 2003 related to our deployment of networking assets (our local switch and
colocation equipment) in Michigan, and amortization of capitalized software
projects completed during 2003 primarily related to the development of customer
relations management software.





*Other
Income, Net* . Other
income for the second quarter 2003 consists of gains from our repurchase of a
portion of our 12% Senior Subordinated Notes at a discount to par.





*Provision
for Income Taxes* . The
effective tax rate for the second quarter 2004 was 39.4%. The increase in the
effective tax rate reflects the impact of income tax returns filed during the
first quarter 2004 for the 2003 tax year. The effective tax rate is expected to
be approximately 39.4% for fiscal 2004 and approximately 39.8% for fiscal 2005.
As a result of the application of net operating loss carryforwards, we currently
need only pay accrued alternative
minimum taxes and state income taxes; we expect net-operating losses will be
fully utilized during 2007. During the second half of 2004, we expect to resolve
certain tax benefits related to net operating loss carryforwards not previously
recognized.








**YEAR
TO DATE 2004 COMPARED TO YEAR TO DATE 2003**





*Revenue.* The
increase in revenue for the year to date 2004 from the year to date 2003 was due
to the increase in bundled revenue offset by a decline in long distance revenue.
During 2004, we increased certain fees and rates related to our long distance
and bundled products and such changes in rates may adversely impact customer
turnover.





The
increase in bundled revenue to $191.4 million for the year to date 2004 from
$128.4 million for the year to date 2003 was due to higher average bundled lines
in 2004 as compared to 2003, partially offset by lower average monthly revenue
per customer.





Our long
distance revenue decreased for the year to date 2004 to $33.4 million from $53.8
million for the year to date 2003. Our decision in 2000 to invest in building a
bundled customer base, together with customer turnover, contributed to the
decline in long distance customers and revenue, although the effect on revenue
of the decline in customers was offset partially by an increase in average
monthly revenue per customer due to price increases. We expect this decline in
long distance customers and revenues to continue.





*Network
and Line Costs* . The
increase of network and line costs for the year to date 2004 from the year to
date 2003 is primarily due to the increase in bundled customers, partially
offset by the decrease in long distance customers. The lower total network and
line costs as a percentage of revenue were due primarily to lower network costs
as a percentage of revenue for both the bundled and long distance products. This
decrease was partially offset by a shift in our customer base to the higher cost
bundled product from the lower cost long distance product and increases in
network cost pricing and costs of unbundled network elements in certain states.





Bundled
network and line costs were $97.1 million for the year to date 2004, as compared
to $64.1 million for the year to date 2003. Long distance network and line costs
were $12.7 million for the year to date 2004, as compared to $23.0 million for
the year to date 2003. As a percentage of bundled revenue, bundled and network
line costs were 50.7% for the year to date 2004, as compared to 50.0% for the
year to date 2003. Long distance network and line costs as a percentage of long
distance revenue were 38.1% for the year to date 2004, as compared to 42.8% for
the year to date 2003. During the year to date 2004, we recorded liabilities for
network and line costs related to retroactive cost increases pending the
resolution of a rate proceeding in the State of Georgia and other matters. The
increase in these liabilities was partially offset by a reduction  in
accruals for network and line costs due  to the
expiration of the period to backbill us certain charges. In addition during the
second quarter 2004, we received a credit of $1.3 million related to a
retroactive reduction in certain switching costs for Bell South.





20


*General
and Administrative Expenses* . General
and administrative expenses increased for the year to date 2004 from the year to
date 2003 primarily due to an increase in the number of employees for customer
service, information technology and our local networking initiatives to support
our expanding base of bundled customers. The increase was also attributable to a
new operating lease for information technology equipment.





*Provision
for Doubtful Accounts* . The
provision for doubtful accounts increased for the year to date 2004 from the
year to date 2003. The increase in bad debt expense is primarily attributable to
the increase in bundled revenue, both in total and as a percentage of total
revenue. In addition, the provision for doubtful accounts as a percentage of
revenues increased in the second quarter 2004 due to an insufficient number of
collections personnel.





*Sales
and Marketing Expenses* . The
increase in sales and marketing expenses for the year to date 2004 from the year
to date 2003 is primarily attributable to increased levels of sales and
marketing activity to continue our bundled sales growth. The cost of acquiring a
customer has also increased. Currently, substantially all of our sales and
marketing expenses relate to the bundled product.





*Interest
Expense* . The
decrease in interest expense for the year to date 2004 from the year to date
2003 is primarily attributable to the decrease in outstanding debt balances
through repurchases of our 12% Senior Subordinated Notes during 2003 and 2004,
and our 8% Secured Convertible Notes during 2003.




*Depreciation
and Amortization.* The
increase in depreciation and amortization for the year to date 2004 from the
year to date 2003 is primarily attributable to depreciation on costs incurred in
2003 related to our deployment of networking assets (our local switch and
colocation equipment) in Michigan, and amortization of capitalized software
projects completed during 2003 primarily related to the development of customer
relations management software.





*Other
Income, Net* . Other
income for the year to date 2003 consists of gains from our repurchase of a
portion of our 12% Senior Subordinated Notes at a discount to par.





*Provision
for Income Taxes* . The
effective tax rate for the year to date 2004 was 39.4%. The increase in the
effective tax rate reflects the impact of income tax returns filed during the
first quarter 2004 for the 2003 tax year. The effective tax rate is expected to
be approximately 39.4% for fiscal 2004. As a result of the application of net
operating loss carryforwards, we currently need only pay accrued alternative
minimum taxes and state income taxes; we expect net operating losses will be
fully utilized by the end of 2007.








**LIQUIDITY
AND CAPITAL RESOURCES**





Our
management assesses our liquidity in terms of our ability to generate cash to
fund our operations, capital expenditures and debt service obligations. For the
second quarters 2004 and 2003, our operating activities provided net cash flow
of $18.9 million and $20.5 million, respectively, which was used by us along
with existing cash and cash equivalents, to reduce our outstanding debt
obligations and fund capital expenditures and capitalized software development
costs. As of June 30, 2004, we had $30.4 million in cash and cash equivalents
and long-term debt (including current maturities) of $20.5 million, compared to
$35.2 million and $48.6 million, respectively, at December 31, 2003.








21


Our
contractual obligations as of June 30, 2004 are summarized by years to maturity
as follows (in thousands):








Contractual
      Obligations
    
    Total
    
    1
      year or
      less
    
    2 -
      3
      Years
    
    4 -
      5
      Years
    
    ThereafterTalk
      America Holdings, Inc.:12%
      Senior Subordinated Notes due 2007 (1)
    
    $
    10,730
    
    $
    10,730
    
    $
    --
    
    $
    --
    
    $
    --8%
      Convertible Senior Subordinated Notes due 2007 (2)
    
    
    3,648
    
    
    3,648
    
    
    --
    
    
    --
    
    
    --5%
      Convertible Subordinated Notes due 2004
    
    
    670
    
    
    670
    
    
    --
    
    
    --
    
    
    --Talk
      America Inc. and other subsidiaries:Capital lease obligations
    
    
    2,747
    
    
    1,121
    
    
    1,626
    
    
    --
    
    
    --Other,
      primarily vendor-financed computer software
    
    
    2,744
    
    
    1,385
    
    
    1,359
    
    
    --
    
    
    --20,539
    
    
    17,554
    
    
    2,985
    
    
    --
    
    
    --Operating
      leases
    
    
    6,848
    
    
    2,781
    
    
    3,267
    
    
    390
    
    
    410Carrier
      commitments (3)
    
    
    81,650
    
    
    19,250
    
    
    41,600
    
    
    20,800
    
    
    --Total
      Contractual Obligations
    
    $
    109,037
    
    $
    39,585
    
    $
    47,852
    
    $
    21,190
    
    $
    410





(1)
Reflects our June 21, 2004, notice and commitment to redeem entire remaining
principal amount of these 12% Senior Subordinated Notes on August 23, 2004, and
resulting change in the maturity of such principal amount to the noticed
redemption date.





(2) The
amount of the 8% Convertible Senior Subordinated Notes include $2.8 million of
principal and $0.8 million of future accrued interest, and reflects our June 21,
2004, notice and commitment to redeem entire remaining principal amount of these
notes on August 23, 2004, and resulting change in the maturity of such principal
amount to the noticed redemption date.





(3) In
December 2003, we entered into a new four-year master carrier agreement with
AT&T. The agreement provides us with a variety of services, including
transmission facilities to connect our network switches as well as services for
international calls, local traffic, international calling cards, overflow
traffic and operator assisted calls. The agreement also provides that, subject
to certain terms and conditions, we will purchase these services exclusively
from AT&T during the term of the agreement, provided, however, that we are
not obligated to purchase exclusively in certain cases, including if such
purchases would result in a breach of any contract with another carrier that was
in place when we entered into the AT&T agreement, or if vendor diversity is
required. Certain of our network service agreements, including the AT&T
agreement, contain certain minimum usage commitments. Our contract with AT&T
establishes pricing and provides for annual minimum revenue commitments based
upon usage as follows: 2004 - $25 million, 2005 - $32 million, 2006 - $32
million and 2007 - $32 million and obligates us to pay 65 percent of the revenue
shortfall, if any. A separate contract with a different vendor establishes
pricing and provides for annual minimum payments for 2004 of $3.0 million. To
the extent that we are unable to meet these minimum commitments, our costs of
purchasing the services under the agreement will correspondingly
increase.





*Cash
Provided By Operating Activities.* Net cash
provided by operating activities was $30.8 for the year to date 2004. The major
contributors to the net cash provided by operating activities in this period
were:


·  Net
income of $16.7 million;


·  Increases
in accounts payable of $7.7 million, primarily due to increased levels of sales
and marketing activity, and an increase in network and line costs primarily due
to the increase in bundled customers;


·  Non-cash
items of $25.2 million, including utilization of deferred tax assets of $9.5
million. The application of NOL carryforwards has limited our current payment of
income taxes to cash taxes for alternative minimum taxes and state income taxes.
We expect that our NOLs will be fully utilized during 2007;


·  An
increase in deferred revenue of $3.6 million for advance customer billings,
primarily due to the growth in bundled customers.





22





Partially
offsetting these contributors to the net cash provided by operating activities
were:


·  An
increase in accounts receivable of $16.1 million due to the growth of our
customer base. We generally do not have a significant concentration of credit
risk with respect to net trade accounts receivable, due to the large number of
end-users comprising our customer base;


·  A
decrease in accrued compensation of $4.9 million due to payment of year-end
performance bonuses;


·  A
decrease in other current liabilities of $2.6 million primarily attributable to
a decrease in accrued interest due to both lower debt levels and accrued
interest payments.





For the
year to date 2003, the major contributors to the net cash provided by operating
activities were:


·  Net
income of $20.1 million;


·  An
increase in accounts payable of $2.3 million attributable to an increase in
network and line costs primarily due to the increase in bundled
customers;


Non-cash items of $22.9 million, primarily consisting of utilization
      of deferred tax assets of $11.8 million;


·  An
increase in deferred revenue of $2.2 million for advance customer billings,
primarily due to the growth in bundled customers;


·  A
decrease in other assets of $1.4 million attributable to repayment of a related
party loan.





Partially
offsetting these contributors to the net cash provided by operating activities
were:


·  An
increase in accounts receivable of $11.2 million, primarily due to the continued
shift in our customer base from long distance customers to local bundled
customers with higher average monthly revenue per customer.


·  A
decrease in accrued compensation of $1.3 million primarily due to payment of
year-end performance bonuses;


·  A
decrease in other current liabilities of $1.8 million primarily attributable to
accrued interest payments.








*Net
Cash Used in Investing Activities.* Net cash
used in investing activities was $5.1 million during the year to date 2004,
consisting of capitalized software development costs of $1.8 million and capital
expenditures of $3.3 million, consisting primarily of upgrades to our
information technology capabilities and build-out of our local networking
platform.





In 2004,
we have made application for and we plan to have equipment collocated and
operating in a total of eighteen colocations by the end of 2004 and the
beginning of 2005 and to continue migrating local bundled customers over to our
network. In 2004, we expect to incur capital expenditures of approximately $20
to $25 million for both network and non-network assets. As a result of the FCC’s
expected pronouncement of interim and final rules that are expected to adversely
affect availability and pricing of various network elements and bundles thereof,
including the unbundled network element platform of the local telephone carriers
network, we may need to further accelerate our plans for 2005 to migrate those
customers to our own networking platform and our capital expenditures would
increase significantly, although there can be no assurance that we will be
successful in such efforts.





Capitalized
software development costs consist of direct development costs associated with
internal-use computer software, including external direct costs of material and
services and payroll costs for employees devoting time to the software projects.
In 2003, capitalized software development costs totaled $2.7 million and were
primarily related to the development of customer relations management software.
In 2004, we expect software development costs to increase moderately as we
continue to develop the integrated information systems required to provide local
switch-based service.





Net cash
used in investing activities was $5.6 million during the year to date 2003,
consisting of capitalized software development costs of $1.4 million and capital
expenditures primarily for the purchase of equipment of $4.2 million.





*Net
Cash Used in Financing Activities.* Net cash
used in financing activities for the second quarters 2004 and 2003 was $30.5 and
$37.2 million, primarily attributable to debt repayment of $30.4 and $32.7
million, respectively. In addition, for the year to date 2003, pursuant to our
share buyback program announced in January 2003, we purchased 1,315,789 shares
for a purchase price of $5.0 million. On June 1, 2004, we announced that our
Board of Directors had authorized a share buyback program for us to purchase up
to $ 50 million of our outstanding shares. To date we have not purchased any
shares under the program.





During
the first half of 2004, we redeemed the $15 million of 12% Senior Subordinated
Notes for which we had given notice in February 2004. On June 21, 2004, we
noticed and committed to redeem all of the approximately $10.7 million remaining
principal amount of our 12% Senior Subordinated Notes and $2.8 million remaining
principal amount of our 8% Convertible Senior Subordinated Notes on August 23,
2004, with the resulting change in the maturity of such principal amounts to the
noticed redemption date. In addition, in June 2004, we announced a new share
buyback program to purchase up to $50 million of our outstanding shares. The
shares may be purchased from time to time, in the open market and/or private
transactions.





While we
believe that we have access to new capital in the public or private markets to
fund our ongoing cash requirements, there can be no assurance as to the timing,
amounts, terms or conditions of any such new capital or whether it could be
obtained on terms acceptable to us. We anticipate that our cash requirements
will generally be met from our cash-on-hand and from cash generated from
operations. Based on our current projections for operations, we believe that our
cash-on-hand and our cash flow from operations will be sufficient to fund our
currently contemplated capital expenditures, our debt service obligations, and
the expenses of conducting our operations for at least the next twelve months.
However, there can be no assurance that we will be able to realize our projected
cash flows from operations, which is subject to the risks and uncertainties
discussed in this report, or that we will not be required to consider capital
expenditures in excess of those currently contemplated, as discussed in this
report.





23





**OTHER
MATTERS**




Our
provision of telecommunications services is subject to government
regulation.  Recent changes in these regulations are likely to have a
material adverse effect on us.  Our local telecommunications services are
provided almost exclusively through the use of unbundled network elements
purchased from incumbent local telephone companies, and it is primarily the
availability of unbundled network elements priced by regulators at cost-based
rates that has enabled us to price our local telecommunications services
competitively.  FCC rules that were in effect until June 15, 2004
required incumbent local telephone companies to provide an unbundled
network element platform, that includes all of the network elements required by
a competitor to provide a competitive retail local telecommunications service,
in most geographic areas.




Through
the use of unbundled network element platforms of the incumbent local telephone
company, we have been able to provide retail local telecommunications services
entirely through the use of the incumbent local telephone
companies' facilities at substantially lower prices than those available
for resale through total service resale agreements.  However, on March 2,
2004, the U.S. Court of Appeals for the District of Columbia reversed the FCC
order that adopted the rules requiring incumbent local telephone companies to
provide unbundled network elements in important respects.  Among other
things, the Court ruled that the FCC had improperly determined that the ability
of competitive local telephone carriers such as us was impaired nationwide
without access to the local switching and high capacity transport unbundled
network elements, and that the FCC had erroneously delegated decision-making
authority over where particular unbundled network elements must be provided to
state commissions.  Accordingly, the Court of Appeals vacated important
portions of the FCC's orders relating to the provision of unbundled network
elements effective as of June 15, 2004, including the portions that required
incumbent local telephone carriers to provide critical components of the
unbundled network element platform.  Thus, although we and other carriers
have appealed the Court's ruling to the U.S. Supreme Court, as of the date of
this report there are no effective FCC rules that require incumbent local
telephone carriers to provide the unbundled network element platform that we
currently rely upon to provide our local telecommunications services and there
are no rules in place requiring incumbent local telephone carriers to provide
the high capacity transport unbundled network elements that we have intended to
use to deploy our own switching facilities in the future.





Should
the unbundled network element platform become effectively unavailable to us due
to this adverse judicial ruling or otherwise, we will be unable to offer our
telecommunications services as we have done in the past and will instead be
required to serve customers through total service resale agreements with the
incumbent local telephone companies, through the use of our own network
facilities, by migrating customers onto the networks of other facilities-based
competitive local telephone companies, or perhaps by purchasing critical
unbundled network elements at presumably higher "just and reasonable" rates
pursuant to Section 271 of the Act.  Similarly, should cost-based transport
unbundled network elements become effectively unavailable to us due to this
adverse judicial ruling or otherwise, our plans to deploy our own network
facilities could be substantially impeded, and we could be forced to substitute
the use of facilities purchased at higher special access rates or transport
services purchased from other facilities-based competitive local telephone
carriers.   In either event, our cost of service could rise
dramatically and our plans for a service roll-out for use of our own network
facilities could be delayed substantially or derailed entirely.  This would
have a material adverse effect on our business, prospects, operating margins,
results of operations, cash flows and financial condition.





The
regional Bell telephone companies all have announced plans to continue to
provide all of the unbundled network element platform until late 2004. 
These announcements are non-binding, do not in all cases include high capacity
transport facilities, and do not extend beyond late 2004.  In addition, FCC
officials have publicly stated an intention to require incumbent local telephone
companies to provide all unbundled network elements through the end of 2004, but
there is no assurance that they will issue such an order or that the courts will
permit it to take effect.  Even if the FCC took such action, unbundled
network elements would be available to us in 2005 only at substantially higher
rates, if at all, unless the FCC takes additional action to promulgate new
permanent rules requiring incumbent local telephone companies to provide
unbundled network elements at cost-based rates.





24


**CRITICAL
ACCOUNTING POLICIES**





Our
discussion and analysis of our financial condition and results of operations are
based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
Certain amounts for 2003 have been reclassified to conform to the current year
presentation. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosure of contingent assets and
liabilities. On an on-going basis, we evaluate our estimates, including those
related to bad debt, goodwill and intangible assets, income taxes, sales taxes,
network and line costs, contingencies and litigation. We base our estimates and
judgments on historical experience and on various other assumptions that are
believed to be reasonable under the circumstances, the results of which form the
basis for making judgments about the carrying values of assets and liabilities
that are not readily apparent from other sources. Actual results may differ from
these estimates under different assumptions or conditions.





In March
2004, the Emerging Issues Task Force ("EITF") issued EITF 03-6, “Participating
Securities and the Two-Class Method Under FASB Statement No. 128, Earnings per
Share” This issue addresses the computation of earnings per share ("EPS") by
companies that have issued securities other than common stock that contractually
entitle the holder to participate in dividends and earnings of the company when,
and if, it declares dividends on its common stock. The provisions of EITF 03-6
are not expected to have a material effect on the Company’s method and
presentation with respect to earnings per share .





Additional
information about these critical accounting policies may by found in our Annual
Report on Form 10-K for the year ended December 31, 2003 filed March 12, 2004,
as amended by our Form 10-K/A filed May 7, 2004, as restated by our form 10-K/A
Amendment No. 2 filed March 28, 2005 and in Management's Discussion and Analysis
of Financial Condition and Results of Operations, under the heading Critical
Accounting Policies.





**Item
4. Controls and Procedures**





*Disclosure
Controls and Procedures* —We
maintain disclosure controls and procedures that are designed to ensure that
information required to be disclosed in our reports under the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), is recorded, processed,
summarized and reported within the time periods specified in the SEC's rules and
forms, and that such information is accumulated and communicated to management,
including our Chief Executive Officer ("CEO") and Chief Financial Officer
("CFO"), as appropriate, to allow timely decisions regarding required
disclosure.





We
carried out an evaluation under the supervision and with the participation of
our management, including the CEO and CFO, of the effectiveness of the design
and operation of our disclosure controls and procedures (as defined in Rule
13a-15(e) under the Exchange Act) as of June 30, 2004. Based upon this
evaluation, our CEO and the CFO concluded that, for the reasons described below,
our disclosure controls and procedures were not effective as of June 30, 2004.





25


We have
restated our previously issued consolidated financial statements for the year
ended December 31, 2003, the four quarters of 2003, the first and second
quarters of 2004. This restatement was primarily the result of the following
material weaknesses:





1. We did
not maintain effective controls over the application of generally accepted
accounting principles related to the financial reporting process for complex
transactions. Specifically, we did not have personnel who possess sufficient
depth, skills and experience in accounting for and review of complex
transactions in the financial reporting process to ensure that complex
transactions were accounted for in accordance with generally accepted accounting
principles. This control deficiency resulted in the restatement of our financial
statements for the third and fourth quarters of 2003, the year ended December
31, 2003 and the first and second quarters of 2004.





2. We did
not maintain effective controls over sales, use and excise tax liabilities.
Specifically, our reconciliation and review procedures with respect to sales,
use and excise tax liability that we collect and remit did not identify that
certain customer fee revenue had been incorrectly recorded in the sales, use and
excise tax general ledger account. This control deficiency resulted in the
restatement of our revenues and sales, use and excise tax liability for each of
the quarters in 2003, the year ended December 31, 2003 and the first and second
quarters of 2004.





The
restatements, described above, were for matters related to (a) the recognition
in revenue in the four quarters 2003, the year ended December 31, 2003 and for
the first and second quarter of 2004 of certain customer fees previously
recorded in those periods as increases in current liabilities; (b) the
calculation of outstanding diluted weighted average common and common equivalent
shares since the third quarter 2003 to reflect the  inclusion
of assumed tax benefits in the proceeds used to repurchase shares in the
application of the treasury stock method of accounting for outstanding options;
(c) for the third and fourth quarters 2003 and the year ended December 31, 2003,
a correction in the calculation of net operating losses utilized in 2003 and in
the calculation of state deferred tax assets; and (d) the recording, beginning
in the third quarter 2003 and for the year ended December 31, 2003, of a
deferred tax asset associated with acquired net operating loss carryforwards.
Refer to Note 6 to the Consolidated Financial Statements for further information
regarding this restatement, including the effect of the restatement for each of
the four quarters of 2003, the year ended December 31, 2003 and the second
quarter of 2004.




To
address these material weaknesses, subsequent to June 30, 2004, we have taken
the following actions:




1.
    Engaging
      outside contractors with technical and accounting related expertise to
      assist in the preparation of the income tax provision and related work
      papers. We are also implementing controls to assure accurate data is
      provided to, and that we review and agree with the conclusions of, outside
      contractors.




2.
    Outside
      contractors with technical accounting capabilities have been and will be
      retained to the extent an issue is sufficiently complex and outside the
      technical accounting capabilities of our
personnel.




3.
    We
      have redesigned the account reconciliation process for sales, use and
      excise tax liabilities. Our Controller will increase the depth of review
      of the account reconciliation and our Chief Accounting Officer will
      confirm that established review processes are being adhered
      to.


We are in
the process of developing procedures for the testing of these controls to
determine if the material weaknesses have been remediated. We will continue the
implementation of policies, processes and procedures regarding the review of
complex transactions. Management believes that our controls and procedures will
continue to improve as a result of the further implementation of these
measures.





The
changes to internal control over financial reporting were implemented subsequent
to the quarter ended June 30, 2004. There were no changes in our internal
control over financial reporting that occurred during the quarter ended June 30,
2004 that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.





26





**PART
II - OTHER INFORMATION**





**Item
4. Submission of Matters to a Vote of Security Holders**





The
Annual Meeting of Stockholders was held on May 19, 2004.  Two proposals
were voted upon at the meeting: (1) the election of two directors and (2) the
ratification of the appointment of PricewaterhouseCoopers LLP as the independent
certified public accountants for 2004.  The votes for each proposal were as
follows:





For the election of Gabriel Battista as director, there were 17,597,685 votes
cast for, 0 votes cast against and 4,150,601 abstentions and broker non-votes.





For the
election of Ronald R. Thoma as director, there were 20,835,661 votes cast for, 0
votes cast against and 912,625 abstentions and broker non-votes.





For the
ratification of PricewaterhouseCoopers LLP as independent auditors, there were
21,636,442 votes cast for, 85,924 votes cast against and 25,920 abstentions and
broker non-votes.





**Item
6.**  **Exhibits
and Reports on Form 8-K**





(a)  Exhibits





31.1
    Rule
      13a-14(a) Certifications of Edward B. Meyercord, III (filed
      herewith).





31.2
    Rule
      13a-14(a) Certifications of David G. Zahka (filed
    herewith).





32.1
    Certification
      of Edward B. Meyercord, III Pursuant to 18 U.S.C. Section 1350, as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished to
      the Commission herewith).





32.2
    Certification
      of David G. Zahka Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
      to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished to the
      Commission herewith).





(b)          
Reports on Form 8-K.





The
following Current Reports on Form 8-K were filed by us during the three months
ended June 30, 2004:





1.  Current
Report on Form 8-K dated June 1, 2004, reporting the authorization of our share
buyback program of $50 million.





27


**SIGNATURES**





Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.





**TALK
AMERICA HOLDINGS, INC.**











Date:
      April 25, 2005
    By:/s/ Edward B. Meyercord, III
      Edward
      B. Meyercord, III
      Chief
      Executive Officer