**SECURITIES
AND EXCHANGE COMMISSION**
 Washington,
D.C. 20549
 **_____________________**
 **FORM
10-Q**
 
 **(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, 2005**
 
 **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.)
 
 **6805
      Route 202, New Hope, Pennsylvania**
      (Address
      of principal executive offices)
    **18938**
      (Zip
      Code)
 
 **(215)
862-1500**
 (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.
 
 29,847,145
shares of Common Stock, par value of $0.01 per share, were issued and
outstanding as of August 5, 2005.
  
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 
 **Index**
 
 ******Page**PART
      I - FINANCIAL INFORMATIONItem
      1. Financial StatementsConsolidated Statements of Operations - Three and Six Months Ended June
      30, 2005 and 2004 (unaudited)
    2Consolidated
      Balance Sheets - June 30, 2005 and December 31, 2004
      (unaudited)
    3Consolidated
      Statements of Stockholders' Equity - Six Months Ended June 30, 2005
      (unaudited)
    4Consolidated
      Statements of Cash Flows - Six Months Ended June 30, 2005 and 2004
      (unaudited)
    5Notes
      to Consolidated Financial Statements (unaudited)
    6Item
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
      
      Item
      3. Quantitative and Qualitative Disclosures About Market
    Risk
    11
      
      19Item
      4. Controls and Procedures
    20PART
      II - OTHER INFORMATIONItem
      4. Submission of Matters to a Vote of Security Holders
    22Item
      6. Exhibits
    22
  
 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,****2005**
    
    
    **2004**
    
    
    **2005**
    
    
    **2004**Revenue
    
    $
    107,669
    
    $
    115,213
    
    $
    227,504
    
    $
    224,832Costs
      and expenses:Network
      and line costs, excluding depreciation and amortization (see
      below)
    
    
    55,681
    
    
    55,586
    
    
    116,677
    
    
    109,806General
      and administrative expenses
    
    
    18,330
    
    
    15,891
    
    
    36,450
    
    
    31,053Provision
      for doubtful accounts
    
    
    4,806
    
    
    4,905
    
    
    10,394
    
    
    8,326Sales
      and marketing expenses
    
    
    3,773
    
    
    19,204
    
    
    14,041
    
    
    36,488Depreciation
      and amortization
    
    
    9,615
    
    
    5,322
    
    
    19,116
    
    
    10,453Total
      costs and expenses
    
    
    92,205
    
    
    100,908
    
    
    196,678
    
    
    196,126Operating
      income
    
    
    15,464
    
    
    14,305
    
    
    30,826
    
    
    28,706Other
      income (expense):Interest
      income
    
    
    366
    
    
    42
    
    
    674
    
    
    143Interest
      expense
    
    
    (25
    )
    
    (442
    )
    
    (50
    )
    
    (1,259
    )Other
      expense, net
    
    
    (336
    )
    
    --
    
    
    (356
    )
    
    --Income
      before provision for income taxes
    
    
    15,469
    
    
    13,905
    
    
    31,094
    
    
    27,590Provision
      for income taxes
    
    
    6,101
    
    
    5,483
    
    
    12,256
    
    
    10,880Net
      income
    
    $
    9,368
    
    $
    8,422
    
    $
    18,838
    
    $
    16,710Income
      per share - Basic:Net
      income per share
    
    $
    0.34
    
    $
    0.31
    
    $
    0.69
    
    $
    0.63Weighted
      average common shares outstanding
    
    
    27,474
    
    
    26,746
    
    
    27,283
    
    
    26,710Income
      per share - Diluted:Net
      income per share
    
    $
    0.33
    
    $
    0.30
    
    $
    0.67
    
    $
    0.59Weighted
      average common and common equivalent shares outstanding
    
    
    28,218
    
    
    28,039
    
    
    28,021
    
    
    28,090
 
 
 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,**
      **2005**
    
    **December
      31,**
      **2004****Assets**Current
      assets:Cash
      and cash equivalents
    
    $
    69,467
    
    $
    47,492Accounts receivable, trade (net of allowance for uncollectible accounts of
      $15,309 and $17,508 at June 30, 2005 and December
      31, 2004, respectively)
    
    
    38,317
    
    
    48,873Deferred
      income taxes
    
    
    23,228
    
    
    34,815Prepaid
      expenses and other current assets
    
    
    7,330
    
    
    6,888Total
      current assets
    
    
    138,342
    
    
    138,068Property
      and equipment, net
    
    
    78,199
    
    
    65,823Goodwill
    
    
    13,013
    
    
    13,013Intangibles,
      net
    
    
    565
    
    
    1,966Deferred
      income taxes
    
    
    12,234
    
    
    14,291Capitalized
      software and other assets
    
    
    8,808
    
    
    8,567$
    251,161
    
    $
    241,728**Liabilities
      and Stockholders’ Equity**Current
      liabilities:Accounts
      payable and accrued expenses
    
    $
    38,580
    
    $
    38,843Sales,
      use and excise taxes
    
    
    7,543
    
    
    11,179Deferred
      revenue
    
    
    13,382
    
    
    15,321Current
      portion of long-term debt
    
    
    2,552
    
    
    2,529Accrued
      compensation
    
    
    4,764
    
    
    6,690Other
      current liabilities
    
    
    11,068
    
    
    10,022Total
      current liabilities
    
    
    77,889
    
    
    84,584Long-term
      debt
    
    
    993
    
    
    1,717Deferred
      income taxes
    
    
    8,331
    
    
    13,906Commitments
      and contingencies
    
    
    --
    
    
    --Stockholders'
      equity:Preferred
      stock - $.01 par value, 5,000,000 shares authorized; no shares outstanding
    
    
    --
    
    
    --Common
      stock - $.01 par value, 100,000,000 shares authorized; 27,843,150 and
      27,037,096 shares issued and outstanding at
      June 30, 2005 and December 31, 2004, respectively
    
    
    292
    
    
    284Additional paid-in capital
    
    
    359,990
    
    
    356,409Accumulated deficit
    
    
    (191,334
    )
    
    (210,172
    )Treasury stock - $.01 par value, 1,315,789 shares at June 30, 2005 and
      December 31, 2004 , respectively
    
    
    (5,000
    )
    
    (5,000
    )Total stockholders' equity
    
    
    163,948
    
    
    141,521$
    251,161
    
    $
    241,728
 
 See
accompanying notes to consolidated financial statements.
 3
  
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF STOCKHOLDERS' EQUITY**
 **(In
thousands)**
 **(Unaudited)**
 
 **Additional****Common
      Stock**
    
    **Paid-In**
    
    **Accumulated**
    
    **Treasury
      Stock****Shares**
    
    **Amount**
    
    **Capital**
    
    **Deficit**
    
    **Shares**
    
    **Amount**
    
    **Total**Balance,
      December 31, 2004
    
    
    28,353
    
    $
    284
    
    $
    356,409
    
    $
    (210,172
    )
    
    1,316
    
    $
    (5,000
    )
    $
    141,521Net
      income
    
    
    
    
    
    
    
    
    
    
    
    18,838
    
    
    
    
    
    
    
    
    18,838Income
      tax benefit related to exercise of common stock options
    
    
    
    
    
    
    
    
    1,946
    
    
    
    
    
    
    
    
    
    
    
    1,946Exercise
      of common stock options
    
    
    806
    
    
    8
    
    
    1,635
    
    
    
    
    
    
    
    
    
    
    
    1,643Balance,
      June 30, 2005
    
    
    29,159
    
    $
    292
    
    $
    359,990
    
    $
    (191,334
    )
    
    1,316
    
    $
    (5,000
    )
    $
    163,948
 
 
 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,****2005**
    
    
    **2004**Cash
      flows from operating activities:Net
      income
    
    $
    18,838
    
    $
    16,710Adjustments to reconcile net income to net cash provided by operating
      activities:Provision
      for doubtful accounts
    
    
    10,394
    
    
    8,326Depreciation
      and amortization
    
    
    19,115
    
    
    10,453Loss
      on sale, retirement and write-down of assets
    
    
    349
    
    
    --Non-cash
      interest and amortization of accrued interest liabilities
    
    
    --
    
    
    (130
    )Deferred
      income taxes
    
    
    10,015
    
    
    9,534Non-cash
      compensation
    
    
    --
    
    
    9Changes
      in assets and liabilities:Accounts
      receivable, trade
    
    
    162
    
    
    (16,114
    )Prepaid
      expenses and other current assets
    
    
    (442
    )
    
    (1,488
    )Other
      assets
    
    
    (47
    )
    
    (24
    )Accounts
      payable and accrued expenses
    
    
    (8,929
    )
    
    5,888Sales,
      use and excise taxes
    
    
    (3,636
    )
    
    (255
    )Deferred
      revenue
    
    
    (1,939
    )
    
    3,643Accrued
      compensation
    
    
    (1,926
    )
    
    (5,009
    )Other
      current liabilities
    
    
    1,046
    
    
    (748
    )Net
      cash provided by operating activities
    
    
    43,000
    
    
    30,795Cash
      flows from investing activities:Proceeds
      from sale of fixed assets
    
    
    42
    
    
    --Capital
      expenditures
    
    
    (19,986
    )
    
    (3,339
    )Capitalized
      software development costs
    
    
    (2,023
    )
    
    (1,787
    )Net
      cash used in investing activities
    
    
    (21,967
    )
    
    (5,126
    )Cash
      flows from financing activities:Payments
      of borrowings
    
    
    --
    
    
    (30,362
    )Payments
      of capital lease obligations
    
    
    (701
    )
    
    (672
    )Proceeds
      from exercise of options
    
    
    1,643
    
    
    550Net
      cash provided by (used in) financing activities
    
    
    942
    
    
    (30,484
    )Net
      change in cash and cash equivalents
    
    
    21,975
    
    
    (4,815
    )Cash
      and cash equivalents, beginning of period
    
    
    47,492
    
    
    35,242Cash
      and cash equivalents, end of period
    
    $
    69,467
    
    $
    30,427
 
 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, 2005
and for the three and six months ended June 30, 2005 and June 30,
2004  are
unaudited, but in the opinion of management include all adjustments necessary
for a fair statement of the results for the periods presented. The consolidated
balance sheet information for December 31, 2004 was derived from the audited
financial statements included in our Annual Report on Form 10-K for the year
ended December 31, 2004 filed March 16, 2005, as amended by our Form 10-K/A
filed March 30, 2005 (as so amended, “our 2004 Form 10-K”). These interim
financial statements should be read in conjunction with our 2004 Form 10-K. 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
could affect future operating results and cash flows and cause actual results to
vary materially from historical results include, but are not limited to:
 
 ·
    Changes
      in or adverse judicial or administrative interpretations and rulings or
      legislative action relating to government policy, regulation, pricing and
      enforcement including, but not limited to: (i) changes that affect the
      continued availability of the unbundled network element platform for
      existing customers until March 11, 2006, (ii) thereafter, the cost of
      certain elements of the unbundled network element platform of the local
      exchange carriers network, and (iii) thereafter the cost of certain
      unbundled network element platform elements utilized with our
      network.
 ·
    Dependence
      on the availability and functionality of the networks of the incumbent
      local exchange carriers as they relate to the unbundled network element
      platform.
 ·
    Increased
      price competition in local and long distance services, including bundled
      services, and overall competition within the telecommunications industry,
      including, but not limited to, in the State of
Michigan.
 
 Negative
developments in these areas could have a material adverse effect on our
business, financial condition and results of operations.
 
 6
 **(c)
Recent Accounting Pronouncements**
 
 In March
2005, the Financial Accounting Standards Board (“FASB”) issued Interpretation
Number 47, “Accounting for Conditional Asset Retirement Obligations, an
interpretation of FASB Statement No. 143” (“FIN 47”).  FIN 47 clarifies the
term “conditional asset retirement obligation” ** as used
in Statement of Financial Accounting Standards (“SFAS”) No. 143, “Accounting for
Asset Retirement Obligations,” and also clarifies when an entity would have
sufficient information to reasonably estimate the fair value of an asset
retirement.  FIN 47 is effective no later than the end of fiscal years
ending after December 15, 2005.   FIN 47 did not have a material impact on
our financial position, results of operations or cash flows.
 
 In
December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based
Payments” (“SFAS No. 123R”). SFAS No. 123R requires the recognition of the cost
of employee services received in exchange for an award of equity instruments in
the financial statements and measurement based on the grant-date fair value of
the award. It requires the cost to be recognized over the period during which an
employee is required to provide service in exchange for the award. Additionally,
compensation expense will be recognized over the remaining employee service
period for the outstanding portion of any awards for which compensation expense
had not been previously recognized or disclosed under SFAS No. 123, “Accounting
for Stock-Based Compensation” (“SFAS No. 123”).  SFAS No. 123R replaces
SFAS No. 123, and supersedes Accounting Principles Board Opinion No. 25,
“Accounting for Stock Issued to Employees” (“APB No. 25”), and its related
interpretations.   We are currently assessing the implications of the
transition methods allowed and have not determined whether the adoption of FAS
123(R) will result in amounts similar to current pro forma disclosures under FAS
123. We expect the adoption to have an adverse impact on future consolidated
statements of operations.
 
 On April
15, 2005, the Securities and Exchange Commission posted Final Rule Number
33-8568, “Amendment to Rule 4-01(a) of Regulation S-X Regarding the Compliance
Date for Statement of Financial Accounting Standards No. 123 (Revised 2004), *Share-Based
Payment,* ” which
is effective as of April 21, 2005. Under the Commission’s amendment, we are
required to file financial statements that comply with SFAS No. 123R in our
Quarterly Report on Form 10-Q for the first quarter of the first fiscal year
that begins after June 15, 2005, and we are permitted, but not required, to
comply with SFAS No. 123R for periods before the required compliance date. The
requirements will be effective for us beginning with the first quarter of fiscal
2006.
 
 
 7
 **NOTE
2. COMMITMENTS AND CONTINGENCIES**
 
 We are
party to a number of legal actions, purported class actions and proceedings
arising from our provision, marketing and billing of telecommunications
services, as well as certain other legal actions and regulatory matters arising
in the ordinary course of business
 
 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 AT&T agreement
establishes pricing and provides for annual minimum revenue commitments based
upon usage as follows: 2005 - $32 million, 2006 - $32 million and 2007 - $32
million and obligates us to pay 65 percent of the revenue shortfall, if any.
Another separate contract with a different vendor establishes pricing and
provides for annual minimum payments for 2005 of $1.0 million. Despite the
anticipated reduction in our local bundled customer base, we anticipate that we
will not be required to make any shortfall payments under these contracts for
the 2005 commitment period. However, with respect to the 2006 and 2007
commitment periods, we will need to restructure these obligations or experience
significant growth in network minutes as a result of acquisitions or entering
into wholesale arrangements to avoid payments pursuant to the minimum
commitments. To the extent that we do not experience such significant growth or
enter into such wholesale arrangements as will enable us to meet these minimum
usage commitments, and we are unable successfully to restructure these
obligations, we will be required to make these shortfall payments and our costs
of purchasing the services under these agreements will increase.
 
 We have a
contract with our invoice printing company that establishes pricing and provides
for annual minimum payments as follows: 2005 - $1.2 million, 2006 - $1.2
million, 2007 - $1.2 million, and 2008 - $1.3 million. We also agreed to renew
the maintenance agreement associated with a vendor financing agreement we
entered into in May 2004 with a software supplier for an additional two years at
a cost of $1.1 million, which is funded on the anniversary dates of the
agreement.
 
 
 **NOTE
3. 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,****2005**
    
    
    **2004**
    
    
    **2005**
    
    
    **2004**Net
      income as reported
    
    $
    9,368
    
    $
    8,422
    
    $
    18,838
    
    $
    16,710Add:
      Stock-based employee compensation expense included in reported net
      income
    
    
    --
    
    
    --
    
    
    --
    
    
    5Deduct:
      Total stock-based employee compensation expense determined
      under
      fair
      value based method for all options
    
    
    563
    
    
    1,439
    
    
    1,066
    
    
    2,875Pro
      forma net income
    
    $
    8,805
    
    $
    6,983
    
    $
    17,772
    
    $
    13,840
 
 
 **Three
      Months Ended**
      **June
      30,**
    
    **Six
      Months Ended**
      **June
      30,****2005**
    
    
    **2004**
    
    
    **2005**
    
    
    **2004****Basic
      earnings per share:**As
      reported
    
    $
    0.34
    
    $
    0.31
    
    $
    0.69
    
    $
    0.63Pro
      forma
    
    $
    0.32
    
    $
    0.25
    
    $
    0.65
    
    $
    0.50**Diluted
      earnings per share:**As
      reported
    
    $
    0.33
    
    $
    0.30
    
    $
    0.67
    
    $
    0.59Pro
      forma
    
    $
    0.32
    
    $
    0.25
    
    $
    0.65
    
    $
    0.50
 
 
 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
4. 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,****2005**
    
    **2004**
    
    **2005**
    
    **2004**Net
      income used to compute basic earnings per share
    
    $
    9,368
    
    $
    8,422
    
    $
    18,838
    
    $
    16,710Interest
      expense on convertible bonds, net of tax affect
    
    
    --
    
    
    (5
    )
    
    --
    
    
    (11
    )Net
      income used to compute diluted earnings per share
    
    $
    9,368
    
    $
    8,417
    
    $
    18,838
    
    $
    16,699Average
      shares of common stock outstanding used to compute basic
      earnings
      per share
    
    
    27,474
    
    
    26,746
    
    
    27,283
    
    
    26,710Additional
      common shares to be issued assuming exercise of stock options
      and warrants (net of shares assumed reacquired) and conversion of
      convertible bonds *
    
    
    744
    
    
    1,293
    
    
    738
    
    
    1,380Average
      shares of common and common equivalent stock outstanding used
      to compute diluted earnings per share
    
    
    28,218
    
    
    28,039
    
    
    28,021
    
    
    28,090Income
      per share - Basic:Net
      income per share
    
    $
    0.34
    
    $
    0.31
    
    $
    0.69
    
    $
    0.63Weighted
      average common shares outstanding
    
    
    27,474
    
    
    26,746
    
    
    27,283
    
    
    26,710Income
      per share - Diluted:Net
      income per share
    
    $
    0.33
    
    $
    0.30
    
    $
    0.67
    
    $
    0.59Weighted
      average common and common equivalent shares outstanding
    
    
    28,218
    
    
    28,039
    
    
    28,021
    
    
    28,090
 
 * The
diluted share basis for the three and six months ended June 30, 2004 exclude 9
shares associated with certain convertible bonds due to their antidilutive
effect. The diluted share basis for the three months ended June 30, 2005 and
2004 excludes 2,647 and 2,951 shares, respectively, and for the six months ended
June 30, 2005 and 2004 excludes 2,863 and 2,928 shares, respectively, associated
with the options and warrants due to their antidilutive effect.
 
 **NOTE
5. SUBSEQUENT EVENT**
 
 On May
23, 2005, we entered into an Agreement and Plan of Merger (the “Acquisition
Agreement”) with LDMI Telecommunications, Inc., providing for our acquisition of
LDMI. LDMI was privately held and is a facilities-based competitive local
exchange carrier serving business and residential customers primarily in
Michigan and Ohio. Under the terms of the Acquisition Agreement, LDMI became
a wholly owned subsidiary on July 13, 2005, and, in exchange for all of the
stock of LDMI, we paid $24 million in cash and issued 1.8 million shares of our
common stock.
  10
  **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 2004 Form 10-K and
any subsequent filings.
 
 **Cautionary
Note Concerning Forward-Looking Statements**
 
 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," “forecast,”
“guidance” 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, you should see our other reports on Forms 10-K, 10-Q and 8-K subsequently
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.
 
 
 **OVERVIEW**
 
 We offer
a bundle of local and long distance phone services to residential and small
business customers in the United States. We have built a large, profitable base
of bundled phone service customers using the wholesale operating platforms of
the Regional Bell Operating Companies, and have begun and plan to migrate
customers to our own networking platform in Detroit and Grand Rapids, Michigan,
and to further increase our revenues and profitability from those customers
by offering new products and services.
 
 In
December 2004, the FCC issued final rules that effectively eliminated the
requirement that incumbent local exchange companies, such as the Regional Bell
Operating Companies, provide us wholesale services using the unbundled network
element platform and established a 12-month transition plan for implementation.
Beginning on March 11, 2005, we are no longer able to use the unbundled network
element platform to provide service to new customers and 12 months after that
date the limitation will extend to all customers. In addition, during this
12-month period, the wholesale rates that we are charged will increase by $1 per
line per month. At the end of the 12-month period, we will need to service
customers that are not on our own networking platform through a resale or other
wholesale agreement, both of which will have significantly higher costs than
servicing customers through the unbundled network platform. To date, we have not
entered into any wholesale or commercial agreements with the Regional Bell
Operating Companies or any other third party, nor can there be any assurance
that any such agreements will be entered into.
 
 As a
result of (a) significant changes to the FCC rules that previously required the
incumbent local exchange companies to provide on a wholesale basis the unbundled
network elements to us and (b) price increases established by various state
public utility commissions, the rates that we are to be charged by the incumbent
local exchange companies to provide our services increased significantly in 2004
and 2005 and will continue to increase over time. These cost increases have and
will continue to lead us to increase our product pricing, which we believe
inhibits our ability to add new customers and to retain existing customers.
Therefore we have reduced our efforts to increase subscriber growth in markets
other than those areas where we currently have or plan to deploy network
facilities (Detroit and Grand Rapids),  which has
significantly reduced our sales and marketing expenditures from past periods. In
addition to the increases discussed above as a result of these regulatory
actions, we plan to further increase our product pricing for our  customers
located in those areas  where we
do not currently have or plan to deploy network facilities. While these price
increases may increase  our
current revenues from  such
customers, it will adversely affect our ability to retain such customers on our
service and negatively affect our revenues over time.
 
 An
integral element of our business strategy is to develop our own local networking
capacity. Local networking enhances our operating flexibility and provides us
with an alternative to the wholesale operating platforms of the incumbent local
exchange companies. Beginning in 2003, we deployed networking assets in Michigan
and, as of June 30, 2005, we had approximately 80,000 bundled lines on our
Michigan network. We are continuing the expansion of our network by colocating
our networking equipment in the incumbent local exchange companies’ end offices
to provide service over our own network to a larger existing customer base in
Detroit and Grand Rapids, Michigan as well as Chicago, Illinois and Atlanta,
Georgia.
 
 11
 As a
result of the significant changes in the regulatory environment, we have
accelerated our networking initiatives and by December 31, 2005 we expect to
have approximately 255,000 voice line equivalents on our network (including LDMI
lines), although some of the regulatory changes could also impede this
deployment (see “Liquidity and Capital Resources, Other Matters,” below). We
have and continue to improve the automation of 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 exchange companies and provide local telephone services through new,
innovative methods of delivery.  We will be utilizing next generation
networking equipment for the build-out of our network in Grand Rapids and
certain other areas in Michigan, as well as in the Atlanta and Chicago markets.
However, we have not previously developed, deployed or operated a local network
of our own or of this scale and there can be no assurance that we shall be able
successfully to do so and thereafter profitably provide local telephone services
through such a network. In addition, we are dependent upon a variety of vendors
for the provision of equipment necessary for the construction, deployment and
migration of customers to our local network, and failure of these vendors to
deliver the equipment in a timely manner may result in delays in the deployment,
and ultimately, the migration of customers to our network.
 
 Our
future business strategy is to also serve medium-sized businesses, in addition
to residential consumers and small businesses, in those areas where we plan to
deploy network facilities. Expansion into this business market will increase our
addressable market in such areas and will permit us to leverage our investment
in our network facilities due to the complementary telecommunication traffic or
usage patterns of these business customers and our residential customers. On May
23, 2005, we announced the planned acquisition of LDMI Telecommunications, Inc,
a privately held, facilities-based competitive local exchange carrier serving
business and residential customers primarily in Michigan and Ohio. This
acquisition was completed on July 13, 2005 and should significantly accelerate
our entry into the business market.
 
 
 **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,****2005**
    
    **2004**
    
    **2005**
    
    **2004**Revenue
    
    
    100.0
    %
    
    100.0
    %
    
    100.0
    %
    
    100.0
    %Costs
      and expenses:Network
      and line costs
    
    
    51.7
    
    
    48.2
    
    
    51.3
    
    
    48.8General and administrative expenses
    
    
    17.0
    
    
    13.8
    
    
    16.0
    
    
    13.8Provision
      for doubtful accounts
    
    
    4.5
    
    
    4.3
    
    
    4.6
    
    
    3.7Sales
      and marketing expenses
    
    
    3.5
    
    
    16.7
    
    
    6.2
    
    
    16.2Depreciation
      and amortization
    
    
    8.9
    
    
    4.6
    
    
    8.4
    
    
    4.6Total
      costs and expenses
    
    
    85.6
    
    
    87.6
    
    
    86.5
    
    
    87.2Operating
      income
    
    
    14.4
    
    
    12.4
    
    
    13.5
    
    
    12.8Other
      income (expense):Interest
      income
    
    
    0.3
    
    
    --
    
    
    0.4
    
    
    0.1Interest
      expense
    
    
    --
    
    
    (0.3
    )
    
    --
    
    
    (0.6
    )Other,
      net
    
    
    (0.3
    )
    
    --
    
    
    (0.2
    )
    
    --Income
      before income taxes
    
    
    14.4
    
    
    12.1
    
    
    13.7
    
    
    12.3Provision
      for income taxes
    
    
    5.7
    
    
    4.8
    
    
    5.4
    
    
    4.8Net
      income
    
    
    8.7
    %
    
    7.3
    %
    
    8.3
    %
    
    7.5
    %
 
 
 
 12
 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,****2005**
    
    **2004**
    
    **2005**
    
    **2004**Revenue
    
    
    (6.5
    )%
    
    22.7
    %
    
    1.2
    %
    
    23.5
    %Costs
      and expenses:Network
      and line costs
    
    
    0.2
    
    
    28.5
    
    
    6.3
    
    
    26.0General and administrative expenses
    
    
    15.3
    
    
    26.6
    
    
    17.4
    
    
    22.1Provision
      for doubtful accounts
    
    
    (2.0
    )
    
    69.4
    
    
    24.8
    
    
    62.7Sales
      and marketing expenses
    
    
    (80.4
    )
    
    65.1
    
    
    (61.5
    )
    
    73.8Depreciation
      and amortization
    
    
    80.7
    
    
    21.5
    
    
    82.9
    
    
    20.3Total
      costs and expenses
    
    
    (8.6
    )
    
    35.1
    
    
    0.3
    
    
    33.1Operating
      income
    
    
    8.1
    
    
    (25.4
    )
    
    7.4
    
    
    (17.3
    )Other
      income (expense):Interest
      income
    
    
    771.4
    
    
    (77.4
    )
    
    371.3
    
    
    (51.5
    )Interest
      expense
    
    
    (94.3
    )
    
    (78.2
    )
    
    (96.0
    )
    
    (72.1
    )Other,
      net
    
    
    100.0
    
    
    (100.0
    )
    
    100.0
    
    
    (100.0
    )Income
      before income taxes
    
    
    11.2
    
    
    (21.3
    )
    
    12.7
    
    
    (16.3
    )Provision
      for income taxes
    
    
    11.3
    
    
    (20.4
    )
    
    12.6
    
    
    (15.4
    )Net
      income
    
    
    11.2
    %
    
    (21.8
    )%
    
    12.7
    %
    
    (16.9
    )%
 
 
 **SECOND
QUARTER 2005 COMPARED TO SECOND QUARTER 2004**
 
 *Revenue.* The
decrease in revenue for the second quarter 2005 from the second quarter 2004 was
due to the decrease in both bundled revenue and long distance revenue. During
2004 and 2005, we increased certain fees and rates related to our long distance
and bundled products and such changes in rates will adversely impact customer
turnover.
 
 The
decrease in bundled revenue to $96.5 million for the second quarter 2005 from
$99.4 million for the second quarter 2004 was due to lower average bundled lines
in 2005 as compared to 2004, partially offset by higher average monthly revenue
per customer. We ended the second quarter 2005 with 534,000 billed bundled
lines, compared to 672,000 at the end of the second quarter 2004. Approximately
53% of the bundled lines at the end of the second quarter 2005 were in Michigan,
compared to 50% at the end of the second quarter 2004, reflecting our decision
to reduce our efforts to increase subscriber growth in markets other than those
areas where we currently have or plan to deploy network facilities. A
significant increase in the costs we pay for network services from the incumbent
local telephone carriers has caused us to dramatically limit the marketing of
new customers in markets where we do not currently have network facilities and
we expect the decline in bundled revenues to continue in the future.
We expect that this decline in revenues will be offset, in part, by the
acquisition of LDMI on July 13, 2005.
 
 Our long
distance revenue decreased for the second quarter 2005 to $11.2 million from
$15.8 million for the second quarter 2004. 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.* Network
and line costs as a percentage of revenue increased in the second quarter 2005
from 2004 due to inefficient network utilization relating to the advance build
out of our Michigan network, line migration costs and increased unbundled
network element platform costs. These cost increases more than offset the impact
of fewer average bundled lines and long distance customers on network and line
costs and resulted in an increase in network and line costs for the second
quarter 2005 from the second quarter 2004. To date, we have been able to
increase our prices to offset per line increases in network and line cost, but
these increases will increase customer turnover. Network and line costs exclude
depreciation and amortization of $5.3 million for the second quarter 2005 and
$1.3 million for the second quarter 2004.
 
 13
 
 We accrue
expenses for network costs that we believe we have incurred pursuant to our
interconnection agreements with a particular supplier or tariffs but for which
we have not yet been billed. This primarily occurs due to errors and omissions
in billing on the part of our principal suppliers, the Regional Bell Operating
Companies. Accrued expenses are eliminated upon the earlier of actual billing
(including billing for charges appropriately recorded in prior periods but not
invoiced, or “backbilling”) by the Regional Bell Operating Companies or the
expiration of the time period for which we are liable for the charges. In
addition, we accrue for network expense not yet billed in a jurisdiction if we
believe there is a prospect that regulatory or other legal changes in the
jurisdiction will retroactively increase the rates we have charged. In Georgia,
an appeals court overturned a rate reduction by the state public utility
commission and ordered the commission to re-calculate the rates charged to us.
This issue is currently being considered by the state commission on remand from
the court. We believe that the rates charged to us will be in excess of those
previously allowed by the commission and have accrued accordingly.
 
 We seek
to 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 (see "Liquidity and Capital Resources, Other
Matters," below).
 
 We expect
the actions we will take, as a result of the recent regulatory changes, to focus
customer growth in areas where we have our own local network, currently
Michigan, and increase prices on our services, will cause the number of bundled
lines to decline in the future and reduce network and line costs, although the
amount of the reduction may be offset in part by the increased costs we may be
required to pay. In addition, we expect that these declines in bundled lines and
network and line costs will be offset, in part, by customers obtained through
the acquisition of LDMI on July 13, 2005. 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 in the second quarter 2005 from the second
quarter 2004. This increase was attributable to an increase in the number of
information technology and network employees needed to support our local
networking initiatives, partially offset by a reduction in the number of
employees that support our base of bundled customers. In addition, accruals for
incentive compensation in the second quarter 2005 increased from the second
quarter 2004. General and administrative expense as a percentage of revenue
increased from the second quarter 2004 to the second quarter 2005 due to the
inefficiencies of a declining base of revenues relative to certain fixed
operating expenses as well as the overall increase in general and administrative
expenses. We expect that as revenues decline in the future, general and
administrative expense as a percentage of revenues will increase.
 
 *Provision
for Doubtful Accounts* . The
provision for doubtful accounts decreased in the second quarter 2005 from the
second quarter 2004. The decrease was primarily due to a decrease in the average
number of bundled customers.
 
 *Sales
and Marketing Expenses* . Sales
and marketing expense decreased significantly in the second quarter 2005 from
the second quarter 2004. The decreases are attributable to the decrease of sales
and marketing activity related to our bundled product, including decreased
headcount and reduced direct mail and media expenses due to our reduced efforts
to increase subscriber growth in markets other than those areas where we
currently have or plan to deploy network facilities. Included in sales and
marketing expenses are advertising expenses of $0.4 million for the second
quarter 2005 and $2.7 million for the second quarter 2004. We expect sales and
marketing expenses to increase during the second half of 2005 as we expand our
marketing efforts commensurate with the growth of our networking
footprint.
  *Depreciation
and Amortization.* Depreciation and amortization increased in the second quarter 2005 from the
second quarter 2004 primarily due to increased depreciation related to the
reduction in the remaining useful lives of our long distance switches. We expect
depreciation and amortization will remain at these levels for the balance of
2005.
 
 14
 ****
 **YEAR
TO DATE 2005 COMPARED TO YEAR TO DATE 2004**
 
 *Revenue.* The
increase in revenue for the year to date 2005 from the year to date 2004 was due
to the increase in bundled revenue offset by a decline in long distance revenue.
During 2005, we increased certain fees and rates related to our long distance
and bundled products and such changes in rates will adversely impact customer
turnover.
 
 The
increase in bundled revenue to $204.2 million for the year to date 2005 from
$191.4 million for the year to date 2004 was due to higher average monthly
revenue per customer in 2005 as compared to 2004, partially offset by lower
average bundled lines.
 
 Our long
distance revenue decreased for the year to date 2005 to $23.3 million from $33.4
million for the year to date 2004. 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* . Network
and line costs as a percentage of revenue increased for the year to date 2005
from the year to date 2004 due to inefficient network utilization relating to
the advance build out of our Michigan network, line migration costs and
increased unbundled network element platform costs. These cost increases more
than offset the impact of fewer average bundled lines and long distance
customers on network and line costs and resulted in an increase in network and
line costs for the year to date 2005 from the year to date 2004. To date, we
have been able to increase our prices to offset per line increases in network
and line cost, but these increases will increase customer turnover.
 
 During
the year to date 2005, 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 during which we could be backbilled for certain
charges.
 
 *General
and Administrative Expenses* . General
and administrative expenses increased for the year to date 2005 from the year to
date 2004 primarily due to an increase in the number of information technology
and network employees to support our local networking initiatives, partially
offset by a reduction in the number of employees to support our base of bundled
customers. We expect that as revenues decline in the future, general and
administrative expense as a percentage of revenues will increase.
 
 *Provision
for Doubtful Accounts* . The
provision for doubtful accounts increased for the year to date 2005 from the
year to date 2004. The increase was due to an increase in the average number of
bundled customers and revenue as well as an increase in bad debt expense as a
percentage of revenues.
 
 *Sales
and Marketing Expenses* . The
significant decrease in sales and marketing expenses for the year to date 2005
from the year to date 2004 is attributable to the decrease of sales and
marketing activity related to our bundled product, including decreased headcount
and reduced direct mail and media expenses due to our reduced efforts to
increase subscriber growth in markets other than those areas where we currently
have or plan to deploy network facilities. Included in sales and marketing
expenses are advertising expenses of $2.2 million for the year to date 2005 and
$5.1 million for the year to date 2004. We expect sales and marketing expenses
to increase during the second half of 2005 as we expand our marketing efforts
commensurate with the growth of our networking footprint.
 
 *Depreciation
and Amortization.* The
increase in depreciation and amortization for the year to date 2005 from the
year to date 2004 is primarily attributable to increased depreciation related to
the reduction in the remaining useful lives of our long distance switches. We
expect depreciation and amortization will remain at these levels for the balance
of 2005.
 
 *Interest
Expense* . The
decrease in interest expense for the year to date 2005 from the year to date
2004 is primarily attributable to the decrease in outstanding debt balances.
 
 
 15
 
 
 **LIQUIDITY
AND CAPITAL RESOURCES**
 
 Our
management assesses our liquidity in terms of our ability to generate cash to
fund our operations, our capital expenditures and our debt service obligations.
For the years to date 2005 and 2004, our operating activities provided net cash
flow of $43.0 million and $30.8 million, respectively. In the year to date 2005,
approximately half of the net cash flow from operating activities was used to
fund capital expenditures and capitalized software development costs. In the
year to date 2004, the net cash flow from operating activities was used
primarily to reduce our outstanding debt obligations. As of June 30, 2005, we
had $69.5 million in cash and cash equivalents and long-term debt and capital
lease obligations (including current maturities) of $3.5 million, compared to
$47.5 million and $4.2 million, respectively, at December 31, 2004.
 
 Net
cash provided by (used in):
 
 **Year
      to Date**
      **(in
      thousands)**
    
    **Percent****Change****2005**
    
    
    **2004**
    
    
    **2005**
      **vs.**
      **2004**Operating
      activities
    
    $
    43,000
    
    $
    30,795
    
    
    39.6%Investing
      activities
    
    $
    (21,967
    )
    $
    (5,126
    )
    
    328.5%Financing
      activities
    
    $
    942
    
    $
    (30,484
    )
    
    (103.1%)
 
 
 
 *Cash
Provided By Operating Activities.* Cash
generated by operations increased by $12.2 million from the year to date 2004 to
the year to date 2005. The increase was driven by higher cash flow before
changes in working capital and lower investment in working capital. The increase
in cash flow before changes in working capital was primarily driven by higher
revenues, increases in network and line costs and significant reductions in
sales and marketing expense. As revenues are expected to decline in 2005,
accounts receivable are also expected to decline. As operating expenses are
expected to decline in 2005, accounts payable should also be expected to
decline. The application of NOL carryforwards has limited our current payment of
income taxes to cash taxes for alternative minimum taxes and certain state
income taxes. We expect that our NOLs will be substantially utilized during
2007.
 
 *Net
Cash Used in Investing Activities.* Capital
expenditures increased by $16.6 million during the year to date 2005 as compared
to 2004 and capitalized software increased by $0.2 million. In the year to date
2005, approximately $17.7 million of our $20.0 million in capital expenditures
consisted of costs related to our deployment of networking assets (local switch
and colocation equipment) in Michigan.
 
 We expect to
spend between $53 and $58 million in capital expenditures and capitalized
software in 2005, primarily for the build out of the Michigan networking
facilities, as well as the build-out of portions of Chicago and Atlanta. These
capital expenditures include capital expenditures of LDMI from July 13, 2005. We
have not previously developed and deployed a local network of our own or of
this scale and there can be no assurance that we will not encounter
unanticipated costs in acquiring the assets necessary for such networking
capability and its operation or in deploying the new network. In addition, to
the extent we identify other markets to deploy networking facilities, our
capital expenditures will increase accordingly.
 
 In the year
to date 2005, capitalized software development costs totaled $2.0 million as
compared with $1.8 million for the year to date 2004. We expect software
development costs in 2005 to increase from 2004 as we continue to develop the
integrated information systems required to provide local switch-based
service.
 
 The
acquisition of LDMI on July 13, 2005, required the payment of $24 million in
cash and the issuance of 1.8 million shares of our common stock for the purchase
of all of the equity of LDMI and the repayment of $4.7 million in debt. To the
extent that we are successful in identifying and completing additional
acquisitions of either customers, networking assets or businesses, net cash used
in investing activities may increase.
 
 *Net
Cash Provided by (Used in) Financing Activities.* Net cash
provided by financing activities during the year to date 2005 was $0.9 million,
primarily attributable to proceeds from the exercise of stock options. Net cash
used in financing activities during the year to date 2004 was $30.5 million,
primarily attributable to the repayment of outstanding debt. 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. The shares may be
purchased from time to time, in the open market and/or private transactions.
Through June 30, 2005, we had not purchased any shares under this
program.
 
 In recent
years we have been meeting our ongoing cash requirements (including for the
conduct of our operations, acquisitions and capital expenditures) from our
cash-on-hand and from cash generated from operations. However, our continued
growth may require that we seek alternative sources of funding. While we believe
that we would have access to new capital in the public or private markets, 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. 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.
 
 16
 **OTHER
MATTERS**
 
 Our
provision of telecommunications services is subject to government
regulation. **** Before
2005, our local telecommunications services were provided almost exclusively
through the use of unbundled network elements purchased from incumbent local
exchange companies, or ILECs, that were made available to us pursuant to
FCC rules. It has been primarily the availability of cost-based rates for
these unbundled network elements that has enabled us to price our local
telecommunications services competitively.
 
 In
December 2004, the Federal Communications Commission, or FCC, issued final rules
that effectively eliminated the requirement that incumbent local exchange
companies provide us wholesale services using the unbundled network element
platform and established a 12-month transition plan for
implementation:
 
 ·
    Beginning
      on March 11, 2005, we are no longer able to use the unbundled network
      element platforms of the ILECs to provide service to new customers, but
      may continue to do so for our then existing customers. As a result, we are
      unable to add new customers in any area where we do not have our own local
      network, which currently limits us to adding new customers in portions of
      the State of Michigan.
 
 ·
    During
      the 12-month period beginning on March 11, 2005, the wholesale rates that
      we are charged for the unbundled network elements purchased from the ILECs
      was increased by $1 per line per month. Beginning on March 11, 2006, we
      will no longer be able to use the unbundled network element platforms of
      the ILECs to provide service to any of our customers, including
      pre-existing customers. As a result, we will need to service customers
      that are not on our own networking platform through resale or other
      wholesale agreements, which will have significantly higher costs than
      servicing customers using the unbundled network element platforms of the
      ILECs at cost-based rates.
 
 In
December 2004, the FCC also adopted new rules affecting our access to the local
loops facilities and the dedicated transport facilities that we purchase from
the ILECs and that are necessary for the operation of our own network
facilities. The FCC adopted a twelve-month transition plan for competitive
local exchange companies, such as we are, to
transition away from the use of DS1 and DS3 loops and dedicated transport where
there is no impairment, as defined in the FCC’s final rules, and an
eighteen-month transition plan to transition away from dark fiber. The
transition plans apply only to the customer base as it existed on March 11,
2005, and do not permit competitive
local exchange companies, including us, to add
new dedicated transport unbundled
network elements in the
absence of impairment.
 
 The
determination of whether a particular network element is either impaired or
unimpaired in a particular market, as defined in the FCC’s final rules, has a
significant effect on markets where we already have networking facilities and on
our plans for entering a new market. It is difficult to predict which geographic
areas will become unimpaired for network elements because the ILECs are using
non-public information to determine the thresholds for availability; while we
may challenge the ILECs’ threshold assumptions, we may not be successful in such
challenges. If a market is determined to be unimpaired, we may be unable to
cost-effectively offer service in that market.
 
 17
 The
unavailability to us of cost-based transport unbundled network elements could
substantially impair our plans to deploy our own network facilities and we could
be forced to use other means to effect this deployment, including the use of
facilities purchased at higher special access rates or transport services
purchased from other facilities-based competitive local exchange companies. In
either event, our cost of service could rise dramatically and our plans for a
service roll-out using 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.
 
 Furthermore,
we also plan on utilizing enhanced extended links, or EELs, which are a
combination of dedicated interoffice transport and high capacity loops, to
provide T-1 level services to medium-sized businesses. While the FCC did not
explicitly restrict the availability of EELs, the ILECs have taken the position
that EELs are not available in any geographic area where DS1 transport is not
available. Currently, neither the FCC nor any state public utility commission
has ruled on EEL restrictions, but a negative determination on this could
negatively affect our entry into new markets, network rollout and results of
operations.
 
 We are subject to federal, state, local and foreign laws, regulations, and
orders affecting the rates, billing, terms, and conditions of certain of our
service offerings, our costs and other aspects of our operations, including our
relations with other service providers. Regulation varies in each jurisdiction
and may change in response to judicial proceedings, legislative and
administrative proposals, government policies, competition and technological
developments. We cannot predict what impact, if any, such changes or proceedings
may have on our business or results of operations, and we cannot guarantee that
regulatory authorities will not raise material issues regarding our compliance
with applicable regulations. There are
several regulatory factors that could cause our network and line costs as a
percentage of revenue to increase in the future, including without
limitation:
 
 
 ·
    As
      a result of significant changes to the FCC rules that required the
      incumbent local exchange companies, such as the Regional Bell Operating
      Companies that are our principal suppliers, to provide us the unbundled
      network elements of their operating platforms on a wholesale basis, the
      wholesale operating platforms of the incumbent local exchange companies is
      effectively not available to us for our new customers after March 11, 2005
      or for all our customers after March 11, 2006. This determination and
      others 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, will require us either to provide services in these areas through
      other means, including total service resale agreements or commercial
      agreements with incumbent local exchange companies, purchase of
      special access services or network elements from the Regional Bell
      Operating Companies at "just and reasonable" rates under Section 271 of
      the Act, in all cases at significantly increased costs, or to provide
      services over our own switching facilities, if we are able to deploy them.
      As a consequence of these changes, our acquisition of customers from other
      companies who provide service using the unbundled network elements
      platform must be consummated in a manner whereby the transfer of the
      acquired customer is directly provisioned to our own network facilities,
      which, due to the limitations on the number of phone lines the incumbent
      local exchange company is required to “hot cut” over to our network per
      day, may limit or minimize the potential advantages of any such
      acquisition.
   18
 
 ·
    Adverse
      changes to the current pricing methodology, TELRIC, mandated by the FCC
      for use in establishing the prices charged to us by incumbent local
      exchange companies for the use of their unbundled network elements for so
      long as we are permitted to continue to use them, and for the use of
      transport and other services in connection with our local network. 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
      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 exchange 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 exchange companies
      than on the hypothetical network costs that would be incurred when the
      most efficient technology is used.The
      TELRIC methodology still governs our pricing for loops purchased from the
      incumbent local exchange companies in connection with our local network.
      We cannot predict if the FCC will order new TELRIC pricing or if Congress
      will amend the 1996 Act, affecting such pricing or availability.These
      changes could result in material increases in prices charged to us for
      unbundled network elements, including those used in our own local network;
      and
 
 ·
    Determinations
      by state commissions to increase prices for unbundled network elements in
      ongoing state cost dockets.
 
 **CRITICAL
ACCOUNTING POLICIES**
 
 In March
2005, the Financial Accounting Standards Board (“FASB”) issued Interpretation
Number 47, “Accounting for Conditional Asset Retirement Obligations, an
interpretation of FASB Statement No. 143” (“FIN 47”).  FIN 47 clarifies the
term “conditional asset retirement obligation” ** as used
in Statement of Financial Accounting Standards (“SFAS”) No. 143, “Accounting for
Asset Retirement Obligations,” and also clarifies when an entity would have
sufficient information to reasonably estimate the fair value of an asset
retirement.  FIN 47 is effective no later than the end of fiscal years
ending after December 15, 2005. FIN 47 did not have a material impact on our
financial position, results of operations or cash flows.
 
 In
December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based
Payments” (“SFAS No. 123R”). SFAS No. 123R requires the recognition of the cost
of employee services received in exchange for an award of equity instruments in
the financial statements and measurement based on the grant-date fair value of
the award. It requires the cost to be recognized over the period during which an
employee is required to provide service in exchange for the award. Additionally,
compensation expense will be recognized over the remaining employee service
period for the outstanding portion of any awards for which compensation expense
had not been previously recognized or disclosed under SFAS No. 123, “Accounting
for Stock-Based Compensation” (“SFAS No. 123”).  SFAS No. 123R replaces
SFAS No. 123, and supersedes Accounting Principles Board Opinion No. 25,
“Accounting for Stock Issued to Employees” (“APB No. 25”), and its related
interpretations.   We are currently assessing the implications of the
transition methods allowed and have not determined whether the adoption of FAS
123(R) will result in amounts similar to current pro-forma disclosures under FAS
123. We expect the adoption to have an adverse impact on future consolidated
statements of operations
 
 On April
15, 2005, the Securities and Exchange Commission posted Final Rule Number
33-8568, “Amendment to Rule 4-01(a) of Regulation S-X Regarding the Compliance
Date for Statement of Financial Accounting Standards No. 123 (Revised 2004), *Share-Based
Payment,* ” which
is effective as of April 21, 2005. Under the Commission’s amendment, we are
required to file financial statements that comply with SFAS No. 123R in our
Quarterly Report on Form 10-Q for the first quarter of the first fiscal year
that begins after June 15, 2005, and we are permitted, but not required, to
comply with SFAS No. 123R for periods before the required compliance date. The
requirements will be effective for us beginning with the first quarter of fiscal
2006. We are currently assessing the timing and impact of adopting SFAS No.
123R.
 
 
 **Item
3.**   **Quantitative
and Qualitative Disclosure About Market Risk.**
 
 In the
normal course of business, our financial position is subject to a variety of
risks, such as the collectibility of our accounts receivable and the
receivability of the carrying values of our long-term assets. Our long-term
obligations consist primarily of long term debt with fixed interest rates. We do
not presently enter into any transactions involving derivative financial
instruments for risk management or other purposes.
 
 Our
available cash balances are invested on a short-term basis (generally overnight)
and, accordingly, are not subject to significant risks associated with changes
in interest rates. Substantially all of our cash flows are derived from our
operations within the United States and we are not subject to market risk
associated with changes in foreign exchange rates.
 
 
 19
 ******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, 2005. Based upon this
evaluation, and due to the material weaknesses in our internal control over
financial reporting discussed below and as reported in our 2004 Form 10-K, our
CEO and the CFO concluded that our disclosure controls and procedures were not
effective as of June 30, 2005.

In light of
the material weaknesses described below, we performed additional analysis and
other procedures to ensure that our consolidated financial statements were
prepared in accordance with generally accepted accounting principles.
Accordingly, our management believes that the financial statements included in
this report on Form 10-Q fairly present in all material respects our financial
condition, results of operations and cash flows for the periods
presented.

Change in
Internal Control over Financial Reporting - We are responsible for establishing
and maintaining adequate internal control over financial reporting. Our internal
control over financial reporting is a process designed to provide reasonable
assurance regarding the reliability of financial reporting and the preparation
of financial statements in accordance with generally accepted accounting
principles.

Because of
its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.

As of
December 31, 2004, our assessment of the effectiveness of our internal control
over financial reporting identified the following material weaknesses in our
internal control over financial reporting:****
 
 20
 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 the 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.

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.

These
material weaknesses resulted in the restatement of our previously issued
consolidated financial statements for each of the quarters of 2003, the year
ended December 31, 2003, and the first, second and third quarters of 2004 and
certain adjustments to the fourth quarter 2004 financial statements as discussed
in greater detail in our 2004 Form 10-K.

Additionally,
these control deficiencies could result in a material misstatement to annual or
interim financial statements that would not be prevented or
detected.

To
address these material weaknesses, during the first and second quarters of 2005
we took the following remedial actions:


1.
    We
      engaged outside contractors with technical and accounting related
      expertise to assist in the preparation of the income tax provision and
      related work papers. We also implemented 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. During the two
      quarters ending June 30, 2005, there were no complex issues that required
      our retention of outside contractors with technical accounting
      capabilities. We have established processes to identify issues that would
      require such retention of outside
contractors.


3.
    We
      have redesigned the account reconciliation process for sales, use and
      excise tax liabilities. Our Controller performed an in depth review of the
      account reconciliation and our Chief Accounting Officer confirmed the
      review process was completed. The reconciliation and review was performed
      for each of the first and second quarters. Our objective is to complete
      this process on a regular basis each
quarter.

We
believe that, once fully implemented, these remediation actions will correct the
material weaknesses discussed above, provided that management has not yet
completed its assessment of the operational effectiveness of the new
controls.

Except as discussed above, there were no changes in our internal control over
financial reporting during our most recently completed fiscal quarter that have
materially affected or are reasonably likely to materially affect our internal
control over financial reporting, as defined in Rule 13a-15(f) under the
Securities Exchange Act.
  21
  
 **PART
II - OTHER INFORMATION**
 
 **Item
4. Submission of Matters to a Vote of Security Holders**
 
 (a)  Our
Annual Meeting of Stockholders was held on July 25, 2005.  Three proposals
were voted upon at the meeting: (1) the election of two directors, (2) the
ratification of the appointment of PricewaterhouseCoopers LLP as the independent
certified public accountants for 2005, and (3) the ratification and approval of
the 2005 Incentive Plan.
 
 (b)  The votes
in respect of the directors were as follows:
 
 For the election of Mark Fowler as director, there were 23,300,222 votes cast
for, 0 votes cast against and 2,300,784 abstentions and broker non-votes.
 
 For the
election of Robert Korzeniewski as director, there were 23,585,662 votes cast
for, 0 votes cast against and 2,015,344 abstentions and broker non-votes.
 
 The terms of office of the following directors continued after the meeting:
Gabriel Battista, Edward B. Meyercord, III and Ronald Thoma.
 
 (c)  The votes
in respect of the other matters voted upon at the meeting were as
follows:
 
 For the ratification of PricewaterhouseCoopers LLP as independent auditors,
there were 25,447,485 votes cast for, 145,704 votes cast against and 7,817
abstentions and broker non-votes.
 
 For the ratification and approval of the 2005 Incentive Plan, there were
8,759,262 votes cast for, 7,550,731 votes cast against and 23,588 abstentions
and broker non-votes.
 
 **Item
6.**  **Exhibits**
 
 
 2.1
    Agreement
      and Plan of Merger dated as of May 23, 2005, among LDMI
      Telecommunications, Inc., Talk America Holdings, Inc. and Lion Acquisition
      Corp. (incorporated by reference to Exhibit 10.1 to our Current Report on
      Form 8-K filed on May 23, 2005).
 
 2.2
    Escrow
      Agreement dated as of July 13, 2005, among LDMI Telecommunications, Inc.,
      Talk America Holdings, Inc., the Representatives named therein and U.S.
      Bank National Association, as Escrow Agent (incorporated by reference to
      Exhibit 10.2 to our Current Report on Form 8-K filed on July 13,
      2005).
 
 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).
  
 
 22
 
 **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:
      August 8, 2005
    By:/s/ Edward B. Meyercord, III
      Edward
      B. Meyercord, III
      Chief
      Executive OfficerDate:
      August 8, 2005
    By:/s/ David G. Zahka
      David
      G. Zahka
      Chief
      Financial Officer (Principal Financial
Officer)