**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 September 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 XNo____

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

Yes XNo____

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

26,978,275 shares of Common Stock, par value of $0.01 per share,
were issued and outstanding as of November 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 November 9, 2004, for the purpose of restating our
consolidated financial statements for the quarters ended September 30, 2004 and
2003 to reflect corrections of the following errors:

The quarterly results for the four quarters of 2003 and for the first
three 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 three quarters of
2004. These customer fee revenues were $0.4 million for the third quarter
of 2004, $0.2 million for the third quarter of 2003, $1.0 million for the nine
months ended September 30, 2004, $0.7 million for the nine months ended
September 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 three 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 three quarters 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 three quarters 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 three quarters of 2004
is summarized in the following table.


ii

(in
      000s, except per share data)
      (Unaudited)
    
    **2003**
    **2004******
    
    
    **Q1**
    
    
    **Q2**
    
    
    **Q3**
    
    
    **Q4**
    
    
    **Q1**
    
    
    **Q2**
    
    
    **Q3**Revenue:Reported
    
    $
    87,843
    
    $
    93,748
    
    $
    99,929
    
    $
    101,143
    
    $
    109,321
    
    $
    114,881
    
    $
    120,537Adjustments
    
    
    359
    
    
    158
    
    
    249
    
    
    264
    
    
    298
    
    
    332
    
    
    392As Restated
    
    $
    88,202
    
    $
    93,906
    
    $
    100,178
    
    $
    101,407
    
    $
    109,619
    
    $
    115,213
    
    $
    120,929Operating
      Income:Reported
    
    $
    15,179
    
    $
    19,027
    
    $
    17,620
    
    $
    13,432
    
    $
    14,103
    
    $
    13,973
    
    $
    13,864Adjustments
    
    
    359
    
    
    158
    
    
    249
    
    
    264
    
    
    298
    
    
    332
    
    
    392As Restated
    
    $
    15,538
    
    $
    19,185
    
    $
    17,869
    
    $
    13,696
    
    $
    14,401
    
    $
    14,305
    
    $
    14,256Pre-Tax
      Income:Reported
    
    $
    14,961
    
    $
    17,500
    
    $
    16,106
    
    $
    12,197
    
    $
    13,387
    
    $
    13,573
    
    $
    14,486Adjustments
    
    
    358
    
    
    158
    
    
    249
    
    
    264
    
    
    298
    
    
    332
    
    
    392As Restated
    
    $
    15,319
    
    $
    17,658
    
    $
    16,355
    
    $
    12,461
    
    $
    13,685
    
    $
    13,905
    
    $
    14,878Income
      Tax Expense:Reported
    
    $
    5,835
    
    $
    6,825
    
    
    ($35,460
    )
    $
    5,103
    
    $
    5,031
    
    $
    5,025
    
    $
    5,339Adjustments
    
    
    141
    
    
    62
    
    
    (2,287
    )
    
    (243
    )
    
    366
    
    
    458
    
    
    528As Restated
    
    $
    5,976
    
    $
    6,887
    
    
    ($37,747
    )
    $
    4,860
    
    $
    5,397
    
    $
    5,483
    
    $
    5,867Net
      Income:Reported
    
    $
    9,126
    
    $
    10,675
    
    $
    51,566
    
    $
    7,094
    
    $
    8,356
    
    $
    8,548
    
    $
    9,147Adjustments
    
    
    217
    
    
    96
    
    
    2,536
    
    
    507
    
    
    (68
    )
    
    (126
    )
    
    (136
    )As Restated
    
    $
    9,343
    
    $
    10,771
    
    $
    54,102
    
    $
    7,601
    
    $
    8,288
    
    $
    8,422
    
    $
    9,011Basic
      EPS:Reported
    
    $
    0.35
    
    $
    0.41
    
    $
    1.96
    
    $
    0.27
    
    $
    0.31
    
    $
    0.32
    
    $
    0.34Adjustments
    
    
    --
    
    
    --
    
    
    0.09
    
    
    0.02
    
    
    --
    
    
    (0.01
    )
    
    (0.01
    )As Restated
    
    $
    0.35
    
    $
    0.41
    
    $
    2.05
    
    $
    0.29
    
    $
    0.31
    
    $
    0.31
    
    $
    0.33Fully
      Diluted EPS:Reported
    
    $
    0.32
    
    $
    0.37
    
    $
    1.74
    
    $
    0.25
    
    $
    0.29
    
    $
    0.30
    
    $
    0.32Adjustments
    
    
    --
    
    
    --
    
    
    0.14
    
    
    0.02
    
    
    --
    
    
    --
    
    
    --As Restated
    
    $
    0.32
    
    $
    0.37
    
    $
    1.88
    
    $
    0.27
    
    $
    0.29
    
    $
    0.30
    
    $
    0.32Fully
      Diluted Shares:Reported
    
    
    29,940
    
    
    29,563
    
    
    29,761
    
    
    28,884
    
    
    28,862
    
    
    28,694
    
    
    28,212Adjustments
    
    
    --
    
    
    --
    
    
    (884
    )
    
    (777
    )
    
    (732
    )
    
    (655
    )
    
    (475
    )As Restated
    
    
    29,940
    
    
    29,563
    
    
    28,877
    
    
    28,107
    
    
    28,130
    
    
    28,039
    
    
    27,737


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


**At
      September 30, 2004**
    
    
    **As**
      **Originally**
      **Reported**
    
    
    **As Restated**Deferred
      income tax assetsCurrent
    
    $
    27,723
    
    $
    27,723Long-term
    
    
    24,733
    
    
    32,598Goodwill
    
    
    19,503
    
    
    13,013Total
      assets
    
    
    235,831
    
    
    237,206Sales,
      use and excise taxes
    
    
    14,596
    
    
    12,544Deferred
      income taxes
    
    
    19,507
    
    
    19,910Total
      liabilities
    
    
    108,636
    
    
    106,985Accumulated
      deficit
    
    
    (224,289
    )
    
    (221,263
    )Total
      stockholders’ equity
    
    
    127,195
    
    
    130,221

**At
      September 30, 2003***
    
    
    **As**
      **Originally**
      **Reported**
    
    
    **As Restated**Deferred
      income tax assetsCurrent
    
    $
    20,703
    
    $
    24,605Long-term
    
    
    44,112
    
    
    51,725Goodwill
    
    
    19,503
    
    
    13,013Total
      assets
    
    
    237,752
    
    
    245,525Sales,
      use and excise taxes
    
    
    13,803
    
    
    13,037Deferred
      income taxes
    
    
    17,238
    
    
    20,182Total
      liabilities
    
    
    146,476
    
    
    151,400Accumulated
      deficit
    
    
    (257,434
    )
    
    (254,585
    )Total
      stockholders’ equity
    
    
    91,276
    
    
    94,125

*  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 November 9, 2004 of our Quarterly
Report on Form 10-Q for the period ended September 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 Nine Months Ended September 30, 2004
      (restated) and 2003 (restated) (unaudited)
    2Consolidated
      Balance Sheets - September 30, 2004 ( restated), December 31, 2003
      (restated), and September 30, 2003 (restated) (unaudited)
    3Consolidated
      Statements of Stockholders' Equity - Nine Months Ended September 30, 2004
      (restated) (unaudited)
    4Consolidated
      Statements of Cash Flows - Nine Months Ended September 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
    27PART
      II - OTHER INFORMATION
    29Item
      6. Exhibits


1****
**TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
**CONSOLIDATED STATEMENTS OF OPERATIONS**
**(In thousands, except for per share data)**
**(Unaudited)**

**Three
      Months Ended**
      **September,
      30**
    ****
    ****
    ****
    **Nine Months
      Ended**
      **September
      30,**
    ********
    ****
    ****
    **2004**
      **(restated)**
    ****
    ****
    **2003**
      **(restated)**
    ****
    ****
    ****
    **2004**
      **(restated)**
    ****
    ****
    **2003**
      **(restated)**Revenue
    
    $
    120,929
    
    $
    100,178
    
    
    $
    345,761
    
    $
    282,286Costs
      and expenses:Network and line costs, excluding depreciation and amortization (see
      below)
    
    
    60,251
    
    
    46,033
    
    
    
    170,057
    
    
    133,185General and administrative expenses
    
    
    15,934
    
    
    14,236
    
    
    
    46,987
    
    
    39,664Provision for doubtful accounts
    
    
    5,728
    
    
    3,444
    
    
    
    14,054
    
    
    8,561Sales and marketing expenses
    
    
    19,318
    
    
    14,146
    
    
    
    55,806
    
    
    35,146Depreciation and amortization
    
    
    5,442
    
    
    4,450
    
    
    
    15,895
    
    
    13,138Total costs and expenses
    
    
    106,673
    
    
    82,309
    
    
    
    302,799
    
    
    229,694Operating
      income
    
    
    14,256
    
    
    17,869
    
    
    
    42,962
    
    
    52,592Other
      income (expense):Interest income
    
    
    61
    
    
    42
    
    
    
    204
    
    
    337Interest expense
    
    
    561
    
    
    (1,560)
    
    
    
    (698)
    
    
    (6,066)Other income, net
    
    
    --
    
    
    4
    
    
    
    --
    
    
    2,469Income
      before provision for income taxes
    
    
    14,878
    
    
    16,355
    
    
    
    42,468
    
    
    49,332Provision
      (benefit) for income taxes
    
    
    5,867
    
    
    (37,747)
    
    
    
    16,747
    
    
    (24,884)Net
      income
    
    $
    9,011
    
    $
    54,102
    
    
    $
    25,721
    
    $
    74,216Income
      per share - Basic:Net income per share
    
    $
    0.33
    
    $
    2.05
    
    
    $
    0.96
    
    $
    2.82Weighted
      average common shares outstanding
    
    
    26,974
    
    
    26,367
    
    
    
    26,799
    
    
    26,325Income
      per share - Diluted:
    
    $
    0.32
    
    $
    1.88
    
    
    $
    0.92
    
    $
    2.55Net income per shareWeighted
      average common and common equivalent shares outstanding
    
    
    27,737
    
    
    28,877
    
    
    
    27,854
    
    
    29,337

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)**


****
      ****
    
    
    **September
      30, 2004**
      **(restated)**
    
    
    **December
      31,**
      **2003**
      **(restated)**
    ****
      ****
    
    **September 30, 2003**
      **(restated)**
    ****
      ******Assets**Current
      assets:Cash
      and cash equivalents
    
    $
    29,354
    
    $
    35,242
    
    $
    35,132Accounts receivable, trade (net of allowance for uncollectible accounts of
      $14,304, $9,414, and $9,483 at September 30, 2004, December 31, 2003, and
      September 30, 2003, respectively)
    
    
    48,876
    
    
    40,321
    
    
    36,777Deferred
      income taxes
    
    
    27,723
    
    
    24,605
    
    
    24,605Prepaid
      expenses and other current assets
    
    
    7,967
    
    
    5,427
    
    
    5,680Total
      current assets
    
    
    113,920
    
    
    105,595
    
    
    102,194Property
      and equipment, net
    
    
    66,643
    
    
    68,069
    
    
    65,860Goodwill
    
    
    13,013
    
    
    13,013
    
    
    13,013Intangibles,
      net
    
    
    2,533
    
    
    4,666
    
    
    5,245Deferred
      income taxes
    
    
    32,598
    
    
    48,288
    
    
    51,725Other
      assets
    
    
    8,499
    
    
    7,547
    
    
    7,488$
    237,206
    
    $
    247,178
    
    $
    245,525**Liabilities
      and Stockholders’ Equity**Current
      liabilities:Accounts
      payable
    
    $
    43,678
    
    $
    35,296
    
    $
    35,707Sales,
      use and excise taxes
    
    
    12,544
    
    
    13,521
    
    
    13,037Deferred
      revenue
    
    
    15,588
    
    
    10,873
    
    
    9,797Current
      portion of long-term debt
    
    
    3,188
    
    
    16,806
    
    
    42Accrued
      compensation
    
    
    4,658
    
    
    9,888
    
    
    7,913Other
      current liabilities
    
    
    5,067
    
    
    6,851
    
    
    5,237Total
      current liabilities
    
    
    84,723
    
    
    93,235
    
    
    71,733Long-term
      debt
    
    
    2,352
    
    
    31,791
    
    
    59,485Deferred
      income taxes
    
    
    19,910
    
    
    19,009
    
    
    20,182Commitments
      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; 26,976,075
      and 26,662,952, and 26,406,864, issued and outstanding at September 30,
      2004, December 31, 2003 and September 30, 2004,
    respectively
    
    
    283
    
    
    280
    
    
    277Additional
      paid-in capital
    
    
    356,201
    
    
    354,847
    
    
    353,433Accumulated
      deficit
    
    
    (221,263
    )
    
    (246,984
    )
    
    (254,585
    )Treasury stock - $.01 par value, 1,315,789 shares at September 30, 2004
      and December 31, 2003 and September 30, 2003, respectively
    
    
    (5,000
    )
    
    (5,000
    )
    
    (5,000
    )Total
      stockholders' equity
    
    
    130,221
    
    
    103,143
    
    
    94,125$
    237,206
    
    $
    247,178
    
    $
    245,525

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**Balances, December 31, 2003 (restated)
    
    
    27,979
    
    $
    280
    
    $
    354,847
    
    $
    (246,984
    )
    
    1,316
    
    $
    (5,000
    )
    $
    103,143Net income (restated)
    
    
    --
    
    
    --
    
    
    --
    
    
    25,721
    
    
    --
    
    
    --
    
    
    25,721Income
      tax benefit related to exercise of common stock options
    
    
    --
    
    
    --
    
    
    784
    
    
    --
    
    
    --
    
    
    --
    
    
    784Change
      in terms of employee stock options
    
    
    --
    
    
    --
    
    
    9
    
    
    --
    
    
    --
    
    
    --
    
    
    9Exercise
      of common stock options
    
    
    313
    
    
    3
    
    
    561
    
    
    --
    
    
    --
    
    
    --
    
    
    564Balances, September 30, 2004 (restated)
    
    
    28,292
    
    $
    283
    
    $
    356,201
    
    $
    (221,263
    )
    
    1,316
    
    $
    (5,000
    )
    $
    130,221


See accompanying notes to consolidated financial statements.
4**TALK AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
**CONSOLIDATED STATEMENTS OF CASH FLOWS**
**(In thousands)**
**(Unaudited)**

**Nine
      Months Ended September 30,******
      ****
    
    
    **2004**
      **(restated)**
    
    
    **2003**
      **(restated)**
    ****
      ****Cash
      flows from operating activities:Net
      income
    
    $
    25,721
    
    $
    74,216Adjustments to reconcile net income to net cash provided by operating
      activities:Provision
      for doubtful accounts
    
    
    14,054
    
    
    8,561Depreciation
      and amortization
    
    
    15,895
    
    
    13,138Loss
      on sale and retirement of assets
    
    
    --
    
    
    16Non-cash
      compensation
    
    
    9
    
    
    --Non-cash
      interest and amortization of accrued interest liabilities
    
    
    (956
    )
    
    (195
    )Gain
      from extinguishment of debt
    
    
    --
    
    
    (2,476
    )Deferred
      income taxes
    
    
    14,257
    
    
    (26,665
    )Changes
      in assets and liabilities:Accounts
      receivable, trade
    
    
    (22,609
    )
    
    (17,495
    )Prepaid
      expenses and other current assets
    
    
    (1,979
    )
    
    (1,786
    )Other
      assets
    
    
    (17
    )
    
    1,404Accounts
      payable
    
    
    8,382
    
    
    3,555Sales,
      use and excise taxes
    
    
    (977
    )
    
    1,598Deferred
      revenue
    
    
    4,715
    
    
    3,317Accrued
      compensation
    
    
    (5,230
    )
    
    2,304Other
      current liabilities
    
    
    (1,784
    )
    
    (3,776
    )Net
      cash provided by operating activities
    
    
    49,481
    
    
    55,716Cash
      flows from investing activities:Capital
      expenditures
    
    
    (8,053
    )
    
    (9,166
    )Capitalized
      software development costs
    
    
    (2,673
    )
    
    (2,038
    )Net
      cash used in investing activities
    
    
    (10,726
    )
    
    (11,204
    )Cash
      flows from financing activities:Payments
      of borrowings
    
    
    (44,258
    )
    
    (38,672
    )Payments
      of capital lease obligations
    
    
    (949
    )
    
    (46
    )Proceeds
      from exercise of options
    
    
    564
    
    
    750Purchase
      of treasury stock
    
    
    --
    
    
    (5,000
    )Net
      cash used in financing activities
    
    
    (44,643
    )
    
    (42,968
    )Net
      increase (decrease) in cash and cash equivalents
    
    
    (5,888
    )
    
    1,544Cash
      and cash equivalents, beginning of period
    
    
    35,242
    
    
    33,588Cash
      and cash equivalents, end of period
    
    $
    29,354
    
    $
    35,132

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
September 30, 2004 and for the three and nine months ended September 30, 2004
and September 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, as restated by our Form 10-K/A
Amendment No. 2 filed March 28, 20005. 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, 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.Outcomes
  unfavorable to us of the FCC’s rule-making process and of pending litigation
  with regard to the availability and pricing of various network elements and
  bundles thereof.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 telecommunication services, including bundled services of
  local and long distanceUnanticipated
  delays, costs and technical difficulties in developing, deploying and
  operating our own local networking capability, including our potential
  inability to acquire and successfully utilize certain of those technologies
  that will permit us to reduce our reliance on the incumbent local telephone
  companies and profitably provide local telephone services through new methods
  of delivery.
Further negative
developments in these areas would likely have a material adverse effect on our
business prospects, financial condition and results of operations.


6




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

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

****
    
    
    **September
      30, 2004**
    
    
    **December
      31,**
      **2003**
    
    
    **September
      30, 2003**8%
      Secured Convertible Notes Due 2006
    
    $
    --
    
    $
    --
    
    $
    12,45212%
      Senior Subordinated Notes Due 2007
    
    
    --
    
    
    40,730
    
    
    42,5208%
      Convertible Senior Subordinated Notes Due 2007 (1)
    
    
    --
    
    
    3,778
    
    
    3,8435%
      Convertible Subordinated Notes Due 2004
    
    
    670
    
    
    670
    
    
    670Other,
      primarily vendor-financed computer software
    
    
    2,401
    
    
    --
    
    
    --Capital
      lease obligations
    
    
    2,469
    
    
    3,419
    
    
    42Total
      long-term debt and capital lease obligations
    
    
    5,540
    
    
    48,597
    
    
    59,527Less:
      current maturities
    
    
    3,188
    
    
    16,806
    
    
    42Total long-term debt and capital lease obligations, excluding current
      maturities
    
    $
    2,352
    
    $
    31,791
    
    $
    59,485

(1) Includes future accrued interest of $1.0 million as of December
31, 2003.

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

On August 23, 2004, we redeemed the remaining principal amounts of
our 12% Senior Subordinated Notes and our 8% Convertible Senior Subordinated
Notes. The redemption of the 8% Convertible Senior Subordinated Notes prior to
maturity resulted in recording $0.8 million of future accrued interest benefit
as an offset to interest expense.

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

As of September 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.

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

In 2004, we entered
into a vendor-financed computer software purchase agreement for upgrades to our
database management systems. Approximately $2.4 million was outstanding under
this agreement at September 30, 2004. Total assets under this purchase agreement
are approximately $2.9 million as of September 30, 2004, consisting of a
perpetual software license agreement of approximately $2.5 million and a
one-year vendor maintenance agreement of approximately $0.4 million. The
agreement is repayable in 12 quarterly installments through March 2007, 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. Total debt of approximately $2.5 million and
$3.4 million was outstanding under this agreement at September 30, 2004 and
December 31, 2003, respectively. Total assets, net of accumulated depreciation,
under this lease agreement are approximately $2.8 million and $3.4 million as of
September 30, 2004 and December 31, 2003, respectively. The lease is repayable
in monthly installments through December 2006, which includes interest based on
an annual percentage rate of approximately 2%.

7
****
**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 first
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.

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 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. While
we anticipate that we will not be required to make any shortfall payments under
these contracts as a result of the restructuring of these obligations, there can
be no assurances that we will be successful in our efforts. To the extent that
we are unable to meet these minimum commitments, our costs of purchasing the
services under the agreement will correspondingly increase.

**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 September 30,**
    
    **Nine
      Months Ended September 30,******
      ****
    
    
    **2004**
      **(restated)**
    
    
    **2003**
      **(restated)**
    ****
      ****
      ****
    
    **2004**
      **(restated)**
    ****
      ****
      ****
    
    **2003**
      **(restated)**
    ****
      ****
      ********Net
      income as reported
    
    $
    9,011
    
    $
    54,102
    
    $
    25,721
    
    $
    74,216Add:
      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
    
    
    1,424
    
    
    304
    
    
    4,299
    
    
    867Pro
      forma net income
    
    $
    7,587
    
    $
    53,798
    
    $
    21,427
    
    $
    73,349



**Three
      Months Ended September 30,**
    
    **Nine
      Months Ended September 30,******
      ****
    
    
    **2004**
      **(restated)**
    
    
    **2003**
      **(restated)**
    ****
      ****
      ****
    
    **2004**
      **(restated)**
    ****
      ****
      ****
    
    **2003**
      **(restated)**
    ****
      ****
      ******Basic
      earnings per share:**As
      reported
    
    $
    0.33
    
    $
    2.05
    
    $
    0.96
    
    $
    2.82Pro
      forma
    
    $
    0.28
    
    $
    2.04
    
    $
    0.80
    
    $
    2.79**Diluted
      earnings per share:**As
      reported
    
    $
    0.32
    
    $
    1.88
    
    $
    0.92
    
    $
    2.56Pro
      forma
    
    $
    0.28
    
    $
    1.90
    
    $
    0.78
    
    $
    2.63


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.

9
****
**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):

**Three
      Months Ended**
      **September 30,**
    
    **Nine Months
      Ended**
      **September30,******
      ****
    
    
    **2004**
      **(restated)**
    
    
    **2003**
      **(****restated)**
    ****
      ****
      ****
    
    **2004**
      **(restated)**
    ****
      ****
    
    **2003**
      **(restated)**
    ****
      ****Net
      income used to compute basic earnings per share
    
    $
    9,011
    
    $
    54,102
    
    $
    25,721
    
    $
    74,216Interest
      expense on convertible bonds, net of tax affect (See Note 2
      (a))
    
    
    --
    
    
    152
    
    
    --
    
    
    455Net
      income used to compute diluted earnings per share
    
    $
    9,011
    
    $
    54,254
    
    $
    25,721
    
    $
    74,671Average
      shares of common stock outstanding used to compute basic earnings per
      share
    
    
    26,974
    
    
    26,367
    
    
    26,799
    
    
    26,325Additional
      common shares to be issued assuming exercise of stock options and warrants
      (net of shares assumed reacquired) and conversion of convertible bonds
      *
    
    
    763
    
    
    2,510
    
    
    1,055
    
    
    3,012Average
      shares of common and common equivalent stock outstanding used to compute
      diluted earnings per share
    
    
    27,737
    
    
    28,877
    
    
    27,854
    
    
    29,337Income
      per share - Basic:Net
      income per share
    
    $
    0.33
    
    $
    2.05
    
    $
    0.96
    
    $
    2.82Weighted
      average common shares outstanding
    
    
    26,974
    
    
    26,367
    
    
    26,799
    
    
    26,325Income
      per share - Diluted:Net
      income per share
    
    $
    0.32
    
    $
    1.88
    
    $
    0.92
    
    $
    2.55Weighted
      average common and common equivalent shares
      outstanding
    
    
    27,737
    
    
    28,877
    
    
    27,854
    
    
    29,337
* The diluted share basis for both the three and nine months ended
September 30, 2004, excludes 9 shares associated with certain convertible bonds
due to their antidilutive effect. The diluted share basis for the three months
ended September 30, 2004 and 2003 excludes 3,400 and 1,204 shares, respectively,
and for the nine months ended September 30, 2004 and 2003 excludes 2,933 and
1,288 shares, respectively, associated with the options and warrants due to
their antidilutive effect.

10
**NOTE 6. INCOME TAXES**

For the quarter ended September 30, 2003, management evaluated the
deferred tax asset valuation allowance and determined that a portion of the
allowance should be reversed. The evaluation considered the profitability of our
business, the ability to utilize the deferred tax assets in the future and
possible restrictions on use due to provisions of the Internal Revenue Code
Section 382 "Change in Ownership." After consideration of each of these factors,
we concluded certain deferred tax assets would more likely than not be utilized,
and, in the quarter ended September 30, 2003, reversed deferred tax asset
valuation allowances of $50.6 million, recognized a non-cash deferred income tax
benefit of $44.1 million and reduced the amount of goodwill related to the
August, 2000 acquisition of Access One Communications, Inc. by $6.5 million.

As of September 30, 2003, we had a deferred tax asset of $76.3
million, representing the future tax benefit from the application of net
operating loss carryforwards for federal income tax purposes to our future
taxable income, alternative minimum tax credits, and allowance for doubtful
accounts. We also had a deferred tax liability of $20.2 million, representing
the future tax liability attributable to temporary differences between the
financial statement carrying amounts of existing assets and liabilities and
their respective tax bases. There can be no assurance that we will realize the
full benefit of the carryforwards.



**NOTE 7. 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 $0.4 million for the third quarter
      of 2004, $0.2 million for the third quarter of 2003, $1.0 million for the
      nine months ended September 30, 2004, $0.7 million for the nine months
      ended September 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
      three 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 three quarters 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 three quarters
      of 2004 and the third and fourth quarter of 2003 and year end December 31,
      2003.

11

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

****
    
    
    **As**
      **Originally
      Reported**
    
    
    **Adjustments**
    
    
    **As**
      **Restated****Three
      Months Ended September 30, 2004**Revenue
    
    $
    120,537
    
    $
    392
    
    $
    120,929Operating
      income
    
    
    13,864
    
    
    392
    
    
    14,256Provision
      for income taxes
    
    
    5,339
    
    
    528
    
    
    5,867Net
      income
    
    
    9,147
    
    
    (136
    )
    
    9,011Net
      income per share - Basic
    
    
    0.34
    
    
    (0.01
    )
    
    0.33Net
      income per share - Diluted
    
    
    0.32
    
    
    --
    
    
    0.32Weighted
      average common and common equivalent shares outstanding -Diluted
    
    
    28,212
    
    
    (475
    )
    
    27,737**Three
      Months Ended September 30, 2003**Revenue
    
    $
    99,929
    
    $
    249
    
    $
    100,178Operating
      income
    
    
    17,620
    
    
    249
    
    
    17,869Provision
      (benefit) for income taxes
    
    
    (35,460
    )
    
    (2,287
    )
    
    (37,747
    )Net
      income
    
    
    51,566
    
    
    2,536
    
    
    54,102Net
      income per share - Basic
    
    
    1.96
    
    
    0.09
    
    
    2.05Net
      income per share - Diluted
    
    
    1.74
    
    
    0.14
    
    
    1.88Weighted
      average common and common equivalent shares outstanding -Diluted
    
    
    29,761
    
    
    (884
    )
    
    28,877**Nine
      Months Ended September 30, 2004**Revenue
    
    $
    344,739
    
    $
    1,022
    
    $
    345,761Operating
      income
    
    
    41,940
    
    
    1,022
    
    
    42,962Provision
      for income taxes
    
    
    15,395
    
    
    1,352
    
    
    16,747Net
      income
    
    
    26,051
    
    
    (330
    )
    
    25,721Net
      income per share - Basic
    
    
    0.97
    
    
    (0.01
    )
    
    0.96Net
      income per share - Diluted
    
    
    0.91
    
    
    0.01
    
    
    0.92Weighted
      average common and common equivalent shares outstanding -Diluted
    
    
    28,482
    
    
    (628
    )
    
    27,854**Nine
      Months Ended September 30, 2003**Revenue
    
    $
    281,520
    
    $
    766
    
    $
    282,286Operating
      income
    
    
    51,826
    
    
    766
    
    
    52,592Provision
      (benefit) for income taxes
    
    
    (22,801
    )
    
    (2,083
    )
    
    (24,884
    )Net
      income
    
    
    71,367
    
    
    2,849
    
    
    74,216Net
      income per share - Basic
    
    
    2.71
    
    
    0.11
    
    
    2.82Net
      income per share - Diluted
    
    
    2.45
    
    
    0.10
    
    
    2.55Weighted
      average common and common equivalent shares outstanding -Diluted
    
    
    29,337
    
    
    --
    
    
    29,337


12

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

****
      ****
    
    
    **As**
      **Originally
      Reported**
    ****
    ****
    ****
      ****
      **Adjustments**
    ****
    ****
    ****
      **As**
      **Restated****At
      September 30, 2004**Deferred
      income tax assetsCurrent
    
    $
    27,723
    
    $
    --
    
    $
    27,723Long-term
    
    
    24,733
    
    
    7,865
    
    
    32,598Goodwill
    
    
    19,503
    
    
    (6,490
    )
    
    13,013Total
      assets
    
    
    235,831
    
    
    1,375
    
    
    237,206Sales,
      use and excise taxes
    
    
    14,596
    
    
    (2,052
    )
    
    12,544Deferred
      income taxes
    
    
    19,507
    
    
    403
    
    
    19,910Total
      liabilities
    
    
    108,636
    
    
    (1,651
    )
    
    106,985Accumulated
      deficit
    
    
    (224,289
    )
    
    3,026
    
    
    (221,263
    )Total
      stockholders’ equity
    
    
    127,
      195
    
    
    3,026
    
    
    130,221**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
      September 30, 2003***Deferred
      income tax assetsCurrent
    
    $
    20,703
    
    $
    3,902
    
    $
    24,605Long-term
    
    
    44,112
    
    
    7,613
    
    
    51,725Goodwill
    
    
    19,503
    
    
    (6,490
    )
    
    13,013Total
      assets
    
    
    237,752
    
    
    7,773
    
    
    245,525Sales,
      use and excise taxes
    
    
    13,803
    
    
    (766
    )
    
    13,037Deferred
      income taxes
    
    
    17,238
    
    
    2,944
    
    
    20,182Total
      liabilities
    
    
    146,476
    
    
    4,924
    
    
    151,400Accumulated
      deficit
    
    
    (257,434
    )
    
    2,849
    
    
    (254,585
    )Total
      stockholders’ equity
    
    
    91,276
    
    
    2,849
    
    
    94,125

*  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
      September 30, 2004**Cash
      flows from operating activities:Net income
    
    $
    26,051
    
    $
    (330
    )
    $
    25,721Deferred income taxes
    
    
    13,079
    
    
    1,178
    
    
    14,257Changes in assets and liabilities:Sales, use and excise taxes
    
    
    45
    
    
    (1,022
    )
    
    (977
    )Other current liabilities and accrued compensation
    
    
    (7,188
    )
    
    174
    
    
    (7,014
    )Net cash provided by operating activities
    
    
    49,481
    
    
    --
    
    
    49,481**At
      September 30, 2003**Cash
      flows from operating activities:Net income
    
    $
    71,367
    
    $
    2,849
    
    $
    74,216Deferred income taxes
    
    
    (24,224
    )
    
    (2,441
    )
    
    (26,665
    )Changes in assets and liabilities:Sales,
      use and excise taxes
    
    
    2,364
    
    
    (766
    )
    
    1,598Other current liabilities and accrued compensation
    
    
    (1,830
    )
    
    358
    
    
    (1,472
    )Net
      cash provided by operating activities
    
    
    55,716
    
    
    --
    
    
    55,716


**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. We have built a
large, profitable base of bundled phone service customers using the wholesale
operating platforms of the incumbent local telephone companies and plan to
migrate customers to our own networking platform, where feasible, and further
increase our revenues and profitability by offering new products and services to
these customers. As a result of significant changes to the FCC rules that
require incumbent local telephone companies to provide unbundled network
elements to us (discussed under “Other Matters,” below), the wholesale rates
that we are charged in order to provide our services will most likely increase
significantly in 2005 and over time. These cost increases will likely lead to
increases in our product pricing and inhibit our ability to add new customers.
The FCC has established interim rules that make unbundled network elements
available to us on a grandfathered basis until March 2005 and we currently plan
to continue to market our services and to build our base of bundled customers
through such date. However, in the event that either the FCC’s final rules
provide for an earlier date where our pricing from the incumbent local telephone
companies significantly increases, as contemplated in the interim rules, or we
have knowledge regarding such an increase in price, we expect to reduce our
efforts to increase subscriber growth and focus on markets with potential for
networking, as described below.

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. Beginning in
2003, we deployed networking assets in Michigan and, as of September 30, 2004,
we had approximately 10,000 bundled lines on our Michigan network. We are
continuing the expansion of our network by colocating our networking equipment
in the incumbent local telephone companies’ 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. As a result of the significant changes in
the regulatory environment, we have accelerated our networking initiatives and
by the end of 2005 we expect to have 150,000 bundled lines on our network in
Michigan, although some of the regulatory changes could also impede this
deployment (discussed under “Other Matters,” below). We also continue to
automate 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. However, we have not previously developed, deployed or operated a
local network of our own and 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.

We will continue to 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 began testing 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 September 30,**
    
    **Nine
      Months Ended September 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
    
    49.8
    
    46.0
    
    49.2
    
    47.2General and administrative expenses
    
    13.2
    
    14.2
    
    13.6
    
    14.1Provision
      for doubtful accounts
    
    4.7
    
    3.4
    
    4.1
    
    3.0Sales
      and marketing expenses
    
    16.0
    
    14.1
    
    16.2
    
    12.5Depreciation
      and amortization
    
    4.5
    
    4.5
    
    4.6
    
    4.6Total
      costs and expenses
    
    88.2
    
    82.2
    
    87.7
    
    81.4Operating
      income
    
    11.8
    
    17.8
    
    12.3
    
    18.6Other
      income (expense):Interest
      income
    
    0.1
    
    --
    
    0.1
    
    0.1Interest
      expense
    
    0.5
    
    (1.6)
    
    (0.2)
    
    (2.1)Other,
      net
    
    --
    
    --
    
    --
    
    0.9Income
      before income taxes
    
    12.4
    
    16.2
    
    12.2
    
    17.5Provision
      (benefit) for income taxes
    
    4.9
    
    (37.8)
    
    4.8
    
    (8.8)Net
      income
    
    7.5%
    
    54%
    
    7.4%
    
    26.3%

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 September 30,**
    
    **Nine Months
      Ended September 30,****2004**
      **(restated)**
    
    **2003**
      **(restated)**
    
    **2004**
      **(restated)**
    
    **2003**
      **(restated)**Revenue
    
    20.7%
    
    26.6%
    
    22.5%
    
    19.5%Costs
      and expenses:Network
      and line costs
    
    30.9
    
    21.8
    
    27.7
    
    15.2General and administrative expenses
    
    11.9
    
    19.1
    
    18.5
    
    (1.3)Provision
      for doubtful accounts
    
    66.3
    
    57.3
    
    64.2
    
    (4.9)Sales
      and marketing expenses
    
    36.6
    
    107.1
    
    58.8
    
    79.0Depreciation
      and amortization
    
    22.3
    
    (3.5)
    
    21.0
    
    (2.6)Total
      costs and expenses
    
    29.6
    
    29.9
    
    31.8
    
    16.0Operating
      income
    
    (20.2)
    
    13.4
    
    (18.3)
    
    37.3Other
      income (expense):Interest
      income
    
    45.2
    
    (86.0)
    
    (39.5)
    
    (30.1)Interest
      expense
    
    (136.0)
    
    (39.3)
    
    (88.5)
    
    (12.6)Other,
      net
    
    (100.0)
    
    103.8
    
    (100.0)
    
    367.8Income
      before income taxes
    
    (9.0)
    
    22.3
    
    (13.9)
    
    59.5Provision
      for income taxes
    
    115.5
    
    --
    
    167.3
    
    --Net
      income
    
    (83.3)%
    
    304.4%
    
    (65.3)%
    
    140.0%


17
**THIRD QUARTER 2004 COMPARED TO THIRD QUARTER 2003**

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

Bundled revenue increased to $105.6 million for the third quarter
2004 from $72.6 million for the third quarter 2003 due to higher average bundled
lines in 2004 as compared to 2003, partially offset by lower average monthly
revenue per customer. We ended the third quarter 2004 with 683,000 billed
bundled lines, compared to 495,000 at the end of the third quarter 2003 and
672,000 at the end of the second quarter 2004. Approximately 49% of the bundled
lines at the end of the third quarter 2004 were in Michigan, compared to 64.8%
at the end of the third quarter 2003, reflecting our continued efforts to market
into other states. Should there be a significant increase in the costs we pay
for network services from the incumbent local telephone carriers (see discussion
in “Other Matters,” below) we likely will have to (i) dramatically limit the
marketing of new customers in some or all states, resulting in a decline in
revenues in the future, and (ii) raise prices to customers, resulting in our
products being less attractively priced or less competitive when compared to the
incumbents.

Our long distance
revenue decreased for the third quarter 2004 to $15.4 million from $27.5 million
for the third quarter 2003. Our decision in 2000 to invest in building a bundled
customer base, together with customer turnover, contributed to the decline in
the number of long distance customers and the amount of revenue, although the
effect on 2004 and 2003 revenue of the decline in the number of customers was
offset partially by an increase in average monthly revenue per customer due to
price increases. We expect this decline in the number of long distance customers
and the amount of revenues to continue.

*Network and Line Costs.* The increase of network and
line costs for the third quarter 2004 from the third quarter 2003 is primarily
due to the growth in customer lines. As a percentage of revenue, network and
line costs were greater in the third quarter 2004 than the third quarter 2003
due to the shift in customer mix from the lower cost long distance product to
the higher cost bundled product, as well as increases in network cost pricing
and costs of unbundled network elements in certain states. Network and line
costs as a percentage of revenue in the third quarter 2004 reflected the benefit
of a net reduction in accruals for network and line costs of approximately $2
million, primarily due to the expiration of backbilling periods and the
favorable resolution of certain accrued expenses. Network and line costs exclude
depreciation and amortization.

18
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. In addition, 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, purchase of special access services or network elements
  purchased from the Regional Bell Operating Companies at "just and reasonable"
  rates under Section 271 of the Act, 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 switching, other unbundled network
  elements 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 "Other Matters," below.

19
*General and Administrative Expenses*. General and
administrative expenses increased for the third quarter 2004 from the third
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 as a percentage of total revenue increased for the third
quarter 2004 from the third quarter 2003 due to reduced employee collection
hours as a result of several hurricanes near our Florida customer service
centers, changes in the states where we have customers and the decision to test
new credit methodologies in an effort to expand addressable markets.

*Sales and Marketing Expenses*. The increase in sales
and marketing expenses for the third quarter 2004 from the third quarter 2003 is
attributable to increased levels of sales and marketing activity to continue our
bundled line growth. In addition, the cost of acquiring a customer has also
increased in 2004. Currently, substantially all of our sales and marketing
expenses relate to the bundled product. We currently plan to continue to market
our services and to build our base of bundled customers through March 2005 or
until such time as we determine that our pricing from the incumbent local
telephone companies significantly increase, at which point we expect to reduce
our efforts to increase subscriber growth and to focus on markets with potential
for networking. We also expect sales and marketing expense to decline in 2005 as
we limit our customer growth efforts to markets in which we have or expect to
have our own networking facilities.

*Interest Expense*. The decrease in interest expense
for the third quarter 2004 from the third quarter 2003 is primarily attributable
to the decrease in outstanding debt balances. Interest expense in the third
quarter 2004 also included a benefit of $0.8 million 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 third quarter 2004 from the third 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 third 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*. For the quarter ended
September 30, 2003, management evaluated the deferred tax asset valuation
allowance and determined that a portion of the allowance should be reversed. The
evaluation considered the profitability of our business, the ability to utilize
the deferred tax assets in the future and possible restrictions on use due to
provisions of the Internal Revenue Code Section 382 "Change in Ownership." After
consideration of each of these factors, we concluded certain deferred tax assets
would more likely than not be utilized, and, in the quarter ended September 30,
2003, reversed deferred tax asset valuation allowances of $50.6 million,
recognized a non-cash deferred income tax benefit of $44.1 million and reduced
the amount of goodwill related to the August, 2000 acquisition of Access One
Communications, Inc. by $6.5 million. In the quarter ended March 30, 2003, the
tax benefit was partially offset by an income tax expense of $24.1
million.

The effective tax rate for the third quarter 2004 was 39.4%. 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, or NOLs, we currently need only pay accrued
alternative minimum taxes and certain state income taxes.


20
**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 an 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.

Bundled revenue increased to $297.0 million for the year to date 2004
from $201.0 million for the year to date 2003 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 $48.8 million from $81.3 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
the number of long distance customers and the amount of revenue, although the
effect on 2004 and 2003 revenue of the decline in the number of customers was
offset partially by an increase in average monthly revenue per customer due to
price increases.

*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 growth in customer lines. As a percentage of revenue, network and line
costs were greater in the year to date 2004 than the year to date 2003 due to
the shift in customer mix from the lower cost long distance product to the
higher cost bundled product, as well as increases in network cost pricing and
costs of unbundled network elements in certain states. Network and line costs as
a percentage of revenue in the year to date 2004 reflected the benefit of a net
reduction in accruals for network and line costs of approximately $1.0 million
primarily due to the expiration of backbilling periods and the favorable
resolution of certain accrued expenses. Network and line costs exclude
depreciation and amortization.

*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 as a percentage of total revenue increased for the year to
date 2004 from the year to date 2003 due to reduced employee collection hours as
a result of several hurricanes near our Florida customer service centers,
changes in the states where we have customers and the decision to test new
credit methodologies in an effort to expand addressable markets.

*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 in 2004. Currently, substantially all of our sales and marketing
expenses relate to the bundled product.

21
*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.

*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 third
quarters 2004 and 2003, our operating activities provided net cash flow of $18.7
million and $20.6 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
September 30, 2004, we had $29.4 million in cash and cash equivalents and
long-term debt (including current maturities) of $5.5 million, compared to $35.2
million and $48.6 million, respectively, at December 31, 2003.

22
Our contractual obligations as of September 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.:5%
      Convertible Subordinated Notes due 2004
    
    
    670
    
    
    670
    
    
    --
    
    
    --
    
    
    --Talk
      America Inc. and other subsidiaries:Capital
      lease obligations
    
    
    2,469
    
    
    1,127
    
    
    1,342
    
    
    --
    
    
    --Other, primarily vendor-financed computer software
    
    
    2,401
    
    
    1,391
    
    
    1,010
    
    
    --
    
    
    --5,540
    
    
    3,188
    
    
    2,352
    
    
    --
    
    
    --Operating
      leases
    
    
    6,766
    
    
    3,009
    
    
    3,022
    
    
    360
    
    
    375Carrier
      commitments (1)
    
    
    81,650
    
    
    19,250
    
    
    41,600
    
    
    20,800
    
    
    --Total
      Contractual Obligations
    
    $
    93,956
    
    $
    25,447
    
    $
    46,974
    
    $
    21,160
    
    $
    375

(1) 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 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. While
we anticipate that we will not be required to make any shortfall payments under
these contracts as a result of the restructuring of these obligations, there can
be no assurances that we will be successful in our efforts. 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 $49.5 million for the year to date 2004.
The major contributors to the net cash provided by operating activities in this
period were:
Net income of $25.7 million;Increases in accounts payable of $8.4 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 $43.2 million, including utilization of deferred
  tax assets of $14.2 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; anAn increase in deferred revenue of $4.7 million for advance
  customer billings, primarily due to the growth in bundled
  customers.Partially offsetting these contributors to the net 2004 cash provided
by operating activities were:
An increase in accounts receivable of $22.6 million primarily due
  to the growth of our customer base and also due to reduced employee collection
  hours as a result of several hurricanes near our Florida customer service
  centers;A decrease in accrued compensation of $5.2 million due to payment
  of year-end performance bonuses; andA decrease in other current liabilities of $1.8 million primarily
  attributable to a decrease in accrued interest due to both lower debt levels
  and accrued interest payments.
23

For the year to date 2003, the major contributors to the $55.7
million net cash provided by operating activities were:
Net income of $74.2 million;An increase in accounts payable of $3.6 million attributable to an
  increase in network and line costs primarily due to the increase in bundled
  customers;An increase in deferred revenue of $3.3 million for advance
  customer billings, primarily due to the growth in bundled customers; andA decrease in other assets of $1.4 million attributable to
  repayment of a related party loan.Partially offsetting these contributors to the 2003 net cash provided
by operating activities were:
An increase in accounts receivable of $17.5 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;Non-cash items of $5.2 million, primarily consisting of reduction
  of deferred tax asset reserves of $26.6 million; andA decrease in other current liabilities of $3.8 million primarily
  attributable to accrued interest payments.
*Net Cash Used in Investing Activities.* Net cash used
in investing activities was $10.7 million during the year to date 2004,
consisting of capitalized software development costs of $2.7 million and capital
expenditures of $8.0 million, consisting primarily of upgrades to our
information technology capabilities and build-out of our local networking
platform. Net cash used in investing activities was $11.2 million during the
year to date 2003, consisting of capitalized software development costs of $2.0
million and capital expenditures primarily for the purchase of equipment of $9.2
million.

We currently plan to continue to market our services and to build our
base of bundled customers through March 2005 or until such time as we determine
that our pricing from the incumbent local telephone companies significantly
increase, at which point we expect to reduce our efforts to increase subscriber
growth and to focus on markets with potential for networking.

In 2004, we expect to incur capital expenditures of approximately $12
to $15 million for both network and non-network assets. The FCC is considering
whether incumbent local telephone companies should continue to be required to
provide all or some unbundled network elements to competitive carriers, and we
believe that it is likely that the proceeding will result in the elimination of
our existing right to purchase some or all unbundled network elements that we
currently rely upon to provide services to our customers. The FCC has
established interim rules that make unbundled network elements available on a
grandfathered basis until March 2005. If the FCC does not promulgate new rules
prior to the expiration of these interim rules, our cost of service would
increase substantially, and 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. We expect to spend approximately $30
million in 2005 for the buildout of the Michigan networking facilities. However,
we have not previously developed and deployed a local network of our own and 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.

Capitalized software development costs consist of direct development
costs associated with internal-use computer software, including 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. We expect software
development costs in 2005 to be consistent with 2004 as we continue to develop
the integrated information systems required to provide local switch-based
service.


24
*Net Cash Used in Financing Activities.* Net cash used
in financing activities for the year to date 2004 and 2003 was $44.6 million and
$43.0 million, respectively, primarily attributable to debt repayments of $44.3
million and $38.7 million in 2004 and 2003, respectively. In addition, for the
year to date 2003, pursuant to our former 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. The shares may be purchased from time to time, in the open
market and/or private transactions. To date we have not purchased any shares
under this program.

During 2004, we redeemed $40.7 million of our 12% Senior Subordinated
Notes, and $2.8 million of our 8% Convertible Senior Subordinated Notes,
respectively, representing the respective entire principal amounts outstanding
as of December 31, 2003.

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.

**OTHER MATTERS**

Our provision of telecommunications services is subject
to government regulation.****FCC rules that were in effect
until June 15, 2004 required incumbent local telephone companies to provide
to competitive local telephone carriers, such as we are, in most geographic
areas, an unbundled network element platform, which includes all of the network
elements required by a competitor to provide a competitive retail local
telecommunications service, including local switching (for use in serving mass
market customers) and high capacity transport unbundled network elements.

To date, our local telecommunications services have been provided
almost exclusively through the use of unbundled network elements purchased from
incumbent local telephone companies that were made available to us pursuant to
these FCC rules. It is primarily the availability of these unbundled
network elements from the incumbent local telephone companies' facilities
at substantially lower prices than those available for resale through total
service resale agreements that has enabled us to price our local
telecommunications services competitively.

25

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 to
provide telecommunications services was impaired nationwide without access to
the local switching and high capacity transport unbundled network elements, and
that the FCC had erroneously delegated to state commissions decision-making
authority over where particular unbundled network elements must be
provided.  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.

In response to the Court’s decision, the FCC adopted interim rules
that grandfathered competitive carriers, such as we are, and enabled us to
continue until March 2005 to order all unbundled network elements that were
available to us under interconnection agreements that were in effect as of June
15, 2004. After that date, we will not be able to order any of the unbundled
networks elements vacated by the Court unless the FCC adopts replacement rules
creating such a right. The FCC is also currently considering whether to require
the incumbent local telephone companies to continue providing to competitive
carriers the local switching, high capacity loop and high capacity dedicated
transport elements. We cannot predict whether the FCC will complete work on the
proceeding prior to the expiration of its interim rules in March 2005, or if so,
whether the FCC will promulgate rules that would entitle us to continue ordering
the network elements that we currently use.

In addition, the incumbent telephone companies have appealed the
FCC’s interim network element rules, and have petitioned the Court to issue a
mandamus order to set them aside. The Court has held this petition in abeyance,
but invited interested parties to supplement their requests on or before January
4, 2005. Thus, the Court could set aside the interim rules before March
2005.

Should the unbundled network element platform become effectively
unavailable to us, we will be unable to offer our telecommunications services as
we have done in the past and will instead be required to serve customers by
other means, including 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 by purchasing critical unbundled
network elements at "just and reasonable" rates pursuant to Section 271 of the
Act, which presumably will be higher than the rates currently available to
us.  Similarly, should cost-based transport unbundled network elements
become effectively unavailable to us, our plans to deploy our own network
facilities could be substantially impeded, 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 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.

26

**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.

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 our
subsequently filed Quarterly Reports on Form 10-Q, in each case 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 September 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
September 30, 2004.

We have restated our
previously issued consolidated financial statements for the year ended December
31, 2003, the four quarters of 2003, and the first three 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 and the year ended December
31, 2003 and the first, second and third 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, second and third 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 the first three
quarters 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 Notes 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 third quarter of 2004.

27
To address these material weaknesses, subsequent to September 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 September 30, 2004. There were no
changes in our internal control over financial reporting that occurred during
the quarter ended September 30, 2004 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.

28
**PART II - OTHER INFORMATION**

**Item 6.** **Exhibits**

Exhibits

10.1
    Employment
      Agreement with David G. Zahka dated July 30, 2004 (filed herewith).*
      (1)

10.2       
Employment
Agreement with Warren Brasselle dated July 30, 2004 (filed herewith).*
(1)

10.3Employment
Agreement with Jeffrey Earhart dated July 30, 2004 (filed herewith).*
(1)

10.4      
Employment
Agreement with Aloysius T. Lawn, IV dated July 30, 2004 (filed herewith).*
(1)

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

31.2Rule
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).

* Management contract or compensatory plan or arrangement.

(1)
    Previously filed as an exhibit to our Quarterly Report on Form 10-Q for
      the quarter ended September 30, 2004, filed on November 9,
      2004.
****
    ****
      ****
      ****


29

**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 26, 2005
    By:
      /s/ Edward B. Meyercord, III
      Edward
      B. Meyercord, III
      Chief
      Executive Officer