**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 March 31, 2004**
 
 **OR**
 
 **[
      ]**
    **TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**
 
 **For
the transition period from _____** **to
_____**
 
 **Commission
file number 000 - 26728**
 
 **Talk
America Holdings, Inc.**
 (Exact
name of registrant as specified in its charter)
 
 **Delaware**
      (State
      of incorporation)
    **23-2827736**
      (I.R.S.
      Employer Identification No.)
 
 **12020
      Sunrise Valley Drive, Suite 250, Reston, Virginia**
      (Address
      of principal executive offices)
    **20191**
      (Zip
      Code)
 
 **(703)
391-7500**
 (Registrant's
telephone number, including area code)
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.
 
 Yes X No____
 
 Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
 
 Yes X No____
 
 Indicate
the number of shares outstanding of each of the issuer's classes of common
stock, as of the latest practicable date.
 
 26,686,205
shares of Common Stock, par value of $0.01 per share, were issued and
outstanding as of May 6, 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 May 7, 2004, for the purpose of restating
our consolidated financial statements for the quarters ended March 31, 2004 and
2003 to reflect corrections of the following errors:
 
 The
quarterly results for the four quarters of 2003 and for the first quarter 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 quarter of 2004. These customer fee revenues were
$0.3 million for the first quarter of 2004, $0.4 million for the first quarter
2003 and $1.0 million for the full year 2003. These customer fees have now been
appropriately recorded to revenues in the consolidated statement of operations
for the year ended December 31, 2003 and in the unaudited quarterly periods for
the first quarter 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 those periods; 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 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 quarter of 2004 and the third and fourth
quarter of 2003 and year end December 31, 2003.
 
 (d) In
connection with the release of the valuation allowance in the third quarter
2003, $6.5 million of deferred tax assets associated with acquired net operating
loss carryforwards were realizable and should have been recorded as a deferred
tax asset. Originally, we believed this deferred tax asset was limited due to
provisions of the Internal Revenue Code Section 382. This error resulted in
deferred tax assets being understated and goodwill being overstated in each of
the periods beginning in the third quarter 2003. As a result, we have restated
the first quarter of 2004 and the third and fourth quarter of 2003 and year end
December 31, 2003.
 
 The
effect of these items are reflected in our consolidated financial statements
contained in Item 1 of this Amendment, with corresponding changes reflected in
Item 2, Management’s Discussion and Analysis of Financial Condition and Results
of Operations and Item 4, Controls and Procedures. The effect of these items on
our consolidated statement of operations for the four quarters of 2003, the year
ended December 31, 2003 and for the first quarter of 2004 is summarized in the
following table.
 
  i
 (in
      000s, except per share data)
      (Unaudited)
    
    **2003**
    **2004******
    
    
    **Q1**
    
    
    **Q2**
    
    
    **Q3**
    
    
    **Q4**
    
    
    **Q1**Revenue:Reported
    
    $
    87,843
    
    $
    93,748
    
    $
    99,929
    
    $
    101,143
    
    $
    109,321Adjustments
    
    
    359
    
    
    158
    
    
    249
    
    
    264
    
    
    298As Restated
    
    $
    88,202
    
    $
    93,906
    
    $
    100,178
    
    $
    101,407
    
    $
    109,619Operating
      Income:Reported
    
    $
    15,179
    
    $
    19,027
    
    $
    17,620
    
    $
    13,432
    
    $
    14,103Adjustments
    
    
    359
    
    
    158
    
    
    249
    
    
    264
    
    
    298As Restated
    
    $
    15,538
    
    $
    19,185
    
    $
    17,869
    
    $
    13,696
    
    $
    14,401Pre-Tax
      Income:Reported
    
    $
    14,961
    
    $
    17,500
    
    $
    16,106
    
    $
    12,197
    
    $
    13,387Adjustments
    
    
    358
    
    
    158
    
    
    249
    
    
    264
    
    
    298As Restated
    
    $
    15,319
    
    $
    17,658
    
    $
    16,355
    
    $
    12,461
    
    $
    13,685Income
      Tax Expense:Reported
    
    $
    5,835
    
    $
    6,825
    
    
    ($35,460
    )
    $
    5,103
    
    $
    5,031Adjustments
    
    
    141
    
    
    62
    
    
    (2,287
    )
    
    (243
    )
    
    366As Restated
    
    $
    5,976
    
    $
    6,887
    
    
    ($37,747
    )
    $
    4,860
    
    $
    5,397Net
      Income:Reported
    
    $
    9,126
    
    $
    10,675
    
    $
    51,566
    
    $
    7,094
    
    $
    8,356Adjustments
    
    
    217
    
    
    96
    
    
    2,536
    
    
    507
    
    
    (68
    )As Restated
    
    $
    9,343
    
    $
    10,771
    
    $
    54,102
    
    $
    7,601
    
    $
    8,288Basic
      EPS:Reported
    
    $
    0.35
    
    $
    0.41
    
    $
    1.96
    
    $
    0.27
    
    $
    0.31Adjustments
    
    
    --
    
    
    --
    
    
    0.09
    
    
    0.02
    
    
    --As Restated
    
    $
    0.35
    
    $
    0.41
    
    $
    2.05
    
    $
    0.29
    
    $
    0.31Fully
      Diluted EPS:Reported
    
    $
    0.32
    
    $
    0.37
    
    $
    1.74
    
    $
    0.25
    
    $
    0.29Adjustments
    
    
    --
    
    
    --
    
    
    0.14
    
    
    0.02
    
    
    --As Restated
    
    $
    0.32
    
    $
    0.37
    
    $
    1.88
    
    $
    0.27
    
    $
    0.29Fully
      Diluted Shares:Reported
    
    
    29,940
    
    
    29,563
    
    
    29,761
    
    
    28,884
    
    
    28,862Adjustments
    
    
    --
    
    
    --
    
    
    (884
    )
    
    (777
    )
    
    (732
    )As Restated
    
    
    29,940
    
    
    29,563
    
    
    28,877
    
    
    28,107
    
    
    28,130
 
 ii
 
 
 The
consolidated balance sheets for the first quarters of 2004 and 2003 as
originally reported have been restated as follows (in
thousands):
 **At
      March 31, 2004**
    
    
    **As
      Originally**
      **Reported**
    
    
    **As
      Restated**Deferred
      income tax assetsCurrent
    
    $
    24,568
    
    $
    24,568Long-term
    
    
    36,528
    
    
    45,093Goodwill
    
    
    19,503
    
    
    13,013Total
      assets
    
    
    236,144
    
    
    238,219Sales,
      use and excise taxes
    
    
    14,131
    
    
    12,802Deferred
      income taxes
    
    
    19,920
    
    
    20,038Total
      liabilities
    
    
    127,942
    
    
    126,729Accumulated
      deficit
    
    
    (241,984
    )
    
    (238,696
    )Total
      stockholders’ equity
    
    
    108,202
    
    
    111,490**At
      March 31, 2003***
    
    
    **As
      Originally**
      **Reported**
    
    
    **As
      Restated**Deferred
      income tax assetsCurrent
    
    $
    16,765
    
    $
    16,623Long-term
    
    
    --
    
    
    --Goodwill
    
    
    19,503
    
    
    19,503Total
      assets
    
    
    178,051
    
    
    180,053Sales,
      use and excise taxes
    
    
    11,772
    
    
    11,412Deferred
      income taxes
    
    
    --
    
    
    --Total
      liabilities
    
    
    150,448
    
    
    152,233Accumulated
      deficit
    
    
    (319,675
    )
    
    (319,458
    )Total
      stockholders’ equity
    
    
    27,603
    
    
    27,820
 
 * 
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 May 7, 2004 of our Quarterly Report on Form 10-Q
for the period ended March 31, 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.
 
 iii
 
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 
 **Index**
 
 ******Page**PART
      I - FINANCIAL INFORMATIONItem
      1. Consolidated Financial StatementsConsolidated
      Statements of Operations - Three Months Ended March 31, 2004 (restated)
      and 2003 (restated) (unaudited)
    2Consolidated
      Balance Sheets - March 31, 2004 (restated), December 31, 2003 (restated),
      and March 31, 2003 (restated) (unaudited)
    3Consolidated
      Statements of Cash Flows - Three Months Ended March 31, 2004 (restated)
      and 2003 (restated) (unaudited)
    4Notes
      to Consolidated Financial Statements (unaudited)
    5Item
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
    12Item
      4. Controls and Procedures
    19PART
      II - OTHER INFORMATIONItem
      6. Exhibits and Reports on Form 8-K(a) Exhibits
    21(b)
      Reports on Form 8-K
    21
 
  1
 
 ****
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF OPERATIONS**
 **(In
thousands, except for per share data)**
 **(Unaudited)**
 
 
 ****
      ****
    
    **Three
      Months Ended March 31,****2004**
      **(restated)**
    
    
    **2003**
      **(restated)**
    ****
      ****Revenue
    
    $
    109,619
    
    $
    88,202Costs
      and expenses:Network and line costs
    
    
    54,220
    
    
    43,884General
      and administrative expenses
    
    
    15,162
    
    
    12,879Provision
      for doubtful accounts
    
    
    3,421
    
    
    2,223Sales
      and marketing expenses
    
    
    17,284
    
    
    9,371Depreciation
      and amortization
    
    
    5,131
    
    
    4,307Total
      costs and expenses
    
    
    95,218
    
    
    72,664Operating
      income
    
    
    14,401
    
    
    15,538Other
      income (expense):Interest
      income
    
    
    101
    
    
    109Interest
      expense
    
    
    (817
    )
    
    (2,479
    )Other
      income, net
    
    
    --
    
    
    2,151Income
      before provision for income taxes
    
    
    13,685
    
    
    15,319Provision
      for income taxes
    
    
    5,397
    
    
    5,976Net
      income
    
    $
    8,288
    
    $
    9,343Income
      per share - Basic:Net
      income per share
    
    $
    0.31
    
    $
    0.35Weighted
      average common shares outstanding
    
    
    26,674
    
    
    26,376Income
      per share - Diluted:Net
      income per share
    
    $
    0.29
    
    $
    0.32Weighted
      average common and common equivalentshares
      outstanding
    
    
    28,130
    
    
    29,940
 
 
 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)**
 
 
 ****
      ****
    
    
    **March****31, 2004**
      **(restated)**
    
    
    **December
      31, 2003**
      **(restated)**
    ****
      ****
    
    **March
      31, 2003**
      **(restated)**
    ****
      ******Assets**Current
      assets:Cash
      and cash equivalents
    
    $
    29,749
    
    $
    35,242
    
    $
    29,046Accounts receivable, trade (net of allowance for uncollectible accounts of
      $10,032, $9,414, and $7,349 at March 31, 2004, December 31, 2003, and
      March 31, 2003, respectively)
    
    
    42,660
    
    
    40,321
    
    
    30,963Deferred
      income taxes
    
    
    24,568
    
    
    24,605
    
    
    16,623Prepaid
      expenses and other current assets
    
    
    5,941
    
    
    5,427
    
    
    3,954Total
      current assets
    
    
    102,918
    
    
    105,595
    
    
    80,586Property
      and equipment, net
    
    
    65,390
    
    
    68,069
    
    
    66,277Goodwill
    
    
    13,013
    
    
    13,013
    
    
    19,503Intangibles,
      net
    
    
    3,955
    
    
    4,666
    
    
    6,667Deferred
      income taxes
    
    
    45,093
    
    
    48,288
    
    
    --Other
      assets
    
    
    7,850
    
    
    7,547
    
    
    7,020$
    238,219
    
    $
    247,178
    
    $
    180,053**Liabilities
      and Stockholders’ Equity**Current
      liabilities:Accounts
      payable
    
    $
    39,470
    
    $
    35,296
    
    $
    35,476Sales,
      use and excise taxes
    
    
    12,802
    
    
    13,521
    
    
    11,412Deferred
      revenueLegal settlements
    
    
    12,599
    
    
    10,873
    
    
    7,634Current
      portion of long-term debt
    
    
    16,797
    
    
    16,806
    
    
    62Accrued
      compensation
    
    
    2,905
    
    
    9,888
    
    
    3,358Other
      current liabilities
    
    
    5,767
    
    
    6,851
    
    
    6,465Total
      current liabilities
    
    
    90,340
    
    
    93,235
    
    
    64,407Long-term
      debt
    
    
    16,351
    
    
    31,791
    
    
    87,826Deferred
      income taxes
    
    
    20,038
    
    
    19,009
    
    
    --Commitments
      and contingenciesStockholders'
      equity:Preferred
      stock - $.01 par value, 5,000,000 shares authorized; no shares outstanding
    
    
    --
    
    
    --
    
    
    --Common
      stock - $.01 par value, 100,000,000 shares authorized; 26,683,094,
      26,662,952, and 26,161,437 issued and outstanding at March 31, 2004, and
      December 31, 2003 and March 31, 2003, respectively
    
    
    280
    
    
    280
    
    
    275Additional
      paid-in capital
    
    
    354,906
    
    
    354,847
    
    
    352,003Accumulated
      deficit
    
    
    (238,696
    )
    
    (246,984
    )
    
    (319,458
    )Treasury stock - $.01 par value, 1,315,789 shares at March 31, 2004,
      December 31, 2003 and March 31, 2003, respectively
    
    
    (5,000
    )
    
    (5,000
    )
    
    (5,000
    )Total
      stockholders' equity
    
    
    111,490
    
    
    103,143
    
    
    27,820$
    238,219
    
    $
    247,178
    
    $
    180,053
 
 See
accompanying notes to consolidated financial statements.
 3
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF CASH FLOWS**
 **(In
thousands)**
 **(Unaudited)**
 
 ****
    
    **Three
      Months Ended March 31,******
    
    
    **2004**
      **(restated)**
    
    
    **2003**
      **(restated)**
    ****
      ****Cash
      flows from operating activities:Net
      income
    
    $
    8,288
    
    $
    9,343Adjustments to reconcile net income to net cash provided by operating
      activities:Provision
      for doubtful accounts
    
    
    3,421
    
    
    2,223Depreciation
      and amortization
    
    
    5,131
    
    
    4,307Non-cash
      compensation
    
    
    9
    
    
    --Non-cash
      interest and amortization of accrued interest liabilities
    
    
    (65
    )
    
    (65
    )Gain
      from extinguishment of debt
    
    
    --
    
    
    (2,154
    )Deferred
      income taxes
    
    
    4,261
    
    
    5,676Changes
      in assets and liabilities:Accounts
      receivable, trade
    
    
    (5,760
    )
    
    (5,343
    )Prepaid
      expenses and other current assets
    
    
    (514
    )
    
    (145
    )Other
      assets
    
    
    (13
    )
    
    1,114Accounts
      payable
    
    
    4,174
    
    
    3,325Sales,
      use and excise taxes
    
    
    (719
    )
    
    (27
    )Deferred
      revenue
    
    
    1,726
    
    
    1,154Accrued
      compensation
    
    
    (6,983
    )
    
    (2,251
    )Other
      current liabilities
    
    
    (1,084
    )
    
    (2,548
    )Net
      cash provided by operating activities
    
    
    11,872
    
    
    14,609Cash
      flows from investing activities:Capital
      expenditures
    
    
    (1,220
    )
    
    (2,691
    )Capitalized
      software development costs
    
    
    (811
    )
    
    (663
    )Net
      cash used in investing activities
    
    
    (2,031
    )
    
    (3,354
    )Cash
      flows from financing activities:Payments
      of borrowings
    
    
    (15,000
    )
    
    (10,793
    )Payments
      of capital lease obligations
    
    
    (384
    )
    
    (16
    )Proceeds
      from exercise of options and warrants
    
    
    50
    
    
    12Purchase
      of treasury stock
    
    
    --
    
    
    (5,000
    )Net
      cash used in financing activities
    
    
    (15,334
    )
    
    (15,797
    )Net
      decrease in cash and cash equivalents
    
    
    (5,493
    )
    
    (4,542
    )Cash
      and cash equivalents, beginning of period
    
    
    35,242
    
    
    33,588Cash
      and cash equivalents, end of period
    
    $
    29,749
    
    $
    29,046
 
 See
accompanying notes to consolidated financial statements.
 
 4
 **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 March 31, 2004
and for the three months ended March 31, 2004 and March 31, 2003 are presented
as unaudited, but in the opinion of management include all adjustments necessary
to present fairly the information set forth therein. The consolidated balance
sheet information for December 31, 2003 was derived from the audited financial
statements included in our Annual Report on Form 10-K for the year ended
December 31, 2003 filed March 12, 2004, as
amended by our Form 10-K/A filed May 7, 2004, and as restated by our Form 10-K/A
Amendment No. 2 filed March 28, 2005 . These
interim financial statements should be read in conjunction with our Annual
Report on Form 10-K for the year ended December 31, 2003, as amended by our Form
10-K/A , and as
restated by our Form 10-K/A Amendment No. 2 . The
interim results are not necessarily indicative of the results for any future
periods. Certain prior year amounts have been reclassified for comparative
purposes.
 
 **(b)
Risks and Uncertainties**
 
 Future
results of operations involve a number of risks and uncertainties. Factors that
could affect future operating results and cash flows and cause actual results to
vary materially from historical results include, but are not limited to:
 
 ·
    Changes
      in government policy, regulation and enforcement or adverse judicial or
      administrative interpretations and rulings or legislative action relating
      to regulations, enforcement and pricing, including, but not limited to,
      changes that affect the continued availability of the unbundled network
      element platform of the local exchange carriers network and the costs
      associated therewith
 ·
    Dependence
      on the availability and functionality of the networks of the incumbent
      local exchange carriers as they relate to the unbundled network element
      platform
 ·
    Increased
      price competition in local and long distance services, including bundled
      services, and overall competition within the telecommunications industry,
      including, but not limited to, in the State of
Michigan
 ·
    Adverse
      determinations in certain litigation
matters
 
 Negative
developments in these areas could have a material adverse effect on our
business, financial condition and results of operations.
 
 **NOTE
2. DEBT AND CAPITAL LEASE OBLIGATIONS**
 
 The
following is a summary of our debt and capital lease obligations (in
thousands):
 
 ****
    
    
    **March
      31, 2004**
    
    
    **December
      31, 2003**
    
    
    **March
      31, 2003**8% Secured Covnertible Notes Due 2006
    
    $
    --
    
    $
    --
    
    $
    26,55212%
      Senior Subordinated Notes Due 2007
    
    
    25,730
    
    
    40,730
    
    
    56,6208%
      Convertible Senior Subordinated Notes Due 2007 (1)
    
    
    3,713
    
    
    3,778
    
    
    3,9735%
      Convertible Subordinated Notes Due 2004
    
    
    670
    
    
    670
    
    
    670Capital
      lease obligations
    
    
    3,035
    
    
    3,419
    
    
    73Total
      long-term debt and capital lease obligations
    
    
    33,148
    
    
    48,597
    
    
    87,888Less:
      current maturities (2)
    
    
    16,797
    
    
    16,806
    
    
    62Total long-term debt and capital lease obligations, excluding current
      maturities
    
    $
    16,351
    
    $
    31,791
    
    $
    87,826
 
 
 
 5
  (1)
Includes future accrued interest or $0.9 million as of March 31, 2004 and $1.0
million as of December 31, 2003.
 
 (2)
Reflects our February 19, 2004 notice and commitment to redeem $15 million
principal amount of these 12% Senior Subordinated Notes on April 20, 2004 and
resulting change in the maturity of such principal amount to the noticed
redemption date.
 
 **(a)**  **12%
Senior Subordinated Notes Due 2007 and 8% Convertible Senior Subordinated Notes
Due 2007**
 
 Effective
April 4, 2002, we completed the exchange of $57.9 million of the $61.8 million
outstanding principal balance of our 4-1/2% Convertible Subordinated Notes due
December 15, 2002 ("4-1/2% Convertible Subordinated Notes") for $53.2 million
principal amount of our new 12% Senior Subordinated PIK Notes due August 2007
("12% Senior Subordinated Notes") and $2.8 million principal amount of our new
8% Convertible Senior Subordinated Notes due August 2007 ("8% Convertible Senior
Subordinated Notes") and cash paid of $0.5 million. In addition, we exchanged
$17.4 million of the $18.1 million outstanding principal balance of our 5%
Convertible Subordinated Notes ("5% Convertible Subordinated Notes") that mature
on December 15, 2004 for $17.4 million principal amount of the 12% Senior
Subordinated Notes.
 
 The 12%
Senior Subordinated Notes accrue interest at a rate of 12% per year on the
principal amount, payable semiannually on February 15 and August 15, beginning
on August 15, 2002. Interest is payable in cash, except that we may, at our
option, pay up to one-third of the interest due on any interest payment date
through and including the August 15, 2004 interest payment date in additional
12% Senior Subordinated Notes. The 8% Convertible Senior Subordinated Notes
accrue interest at a rate of 8% per year on the principal amount, also payable
semiannually on February 15 and August 15, and are convertible, at the option of
the holder, into common stock at $15.00 per share. The 12% Senior Subordinated
Notes and 8% Convertible Senior Subordinated Notes are redeemable at any time at
our option at par value plus accrued interest to the redemption date.
 
 In
accordance with SFAS No. 15, "Accounting by Debtors and Creditors for Troubled
Debt Restructurings," we accounted for the exchange of the 4-1/2% Convertible
Subordinated Notes for $53.2 million of the 12% Senior Subordinated Notes and
$2.8 million of the 8% Convertible Senior Subordinated Notes as a troubled debt
restructuring. Since the total liability of $57.4 million ($57.9 million of
principal as of the exchange date, less cash payments of $0.5 million) was less
than the future cash flows to holders of 8% Convertible Senior Subordinated
Notes and 12% Senior Subordinated Notes of $91.5 million (representing the $56.0
million of principal and $35.5 million of future interest expense), the
liability remained on our balance sheet at $57.4 million as long-term debt. We
recognized the difference of $1.4 million between principal and the carrying
amount as a reduction of interest expense over the life of the new notes.
 
 **(b)**  **5% Convertible Subordinated Notes Due 2004**
 
 As of
March 31, 2004, we had $0.7 million principal amount outstanding of our 5%
Convertible Subordinated Notes that mature on December 15, 2004. Interest on
these notes is due and payable semiannually on June 15 and December 15. 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)**  **Capital
Leases**
 
 During
2003, we entered into a non-cancelable capital lease agreement for upgrades to
our customer data storage equipment. Approximately $3.0 million was outstanding
under this agreement at December 31, 2003. Total assets under this lease
agreement are approximately $3.4 million as of March 31, 2004 and December 31,
2003. The lease is repayable in 36 monthly installments, which includes interest
based on an annual percentage rate of approximately 2%.
  6
 ****
 **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, as well as certain legal actions
and regulatory matters arising in the ordinary course of business. During the
second quarter of 2003, we were made aware that AOL agreed to settle a class
action case for approximately $10 million; the claims in the case allegedly
relate to marketing activities conducted pursuant to the former
telecommunications marketing agreement, between us and AOL. At the time of the
settlement agreement, AOL asserted that we are required to indemnify AOL in this
matter under the terms of the marketing agreement and advised that it will seek
such indemnification from us. We believe that we do not have an obligation to
indemnify AOL in this matter and that any claim by AOL for this indemnification
would be without merit. We have received no further information regarding this
matter and it is our intention, if AOL initiates a claim for indemnification
under the marketing agreement, to defend against the claim vigorously. We
believe that the ultimate outcome of the foregoing actions will not result in a
liability that would have a material adverse effect on our financial condition
or results of operations.
 
 **NOTE
4. STOCK-BASED COMPENSATION**
 
 We
account for our stock option awards under the intrinsic value based method of
accounting prescribed by APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations, including FASB Interpretation No. 44
"Accounting for Certain Transactions Including Stock Compensation," an
interpretation of APB Opinion No. 25. Under the intrinsic value based method,
compensation cost is the excess, if any, of the quoted market price of the stock
at grant date or other measurement date over the amount an employee must pay to
acquire the stock. We make pro forma disclosures of net income and earnings per
share as if the fair value based method of accounting had been applied as
required by SFAS No. 123, "Accounting for Stock-Based Compensation" and SFAS
148, “ Accounting
for Stock-Based Compensation - Transition and Disclosure - an amendment of SFAS
123” . The
following disclosure complies with the adoption of this statement and includes
pro forma net income as if the fair value based method of accounting had been
applied (in thousands except for per share data):
 
 ****
    
    **Three
      Months Ended**
      **March
      31,****2004**
      **(restated)**
    
    
    **2003**
      **(restated)**
    ****
      ****Net
      income as reported
    
    $
    8,288
    
    $
    9,343Add:
      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
    
    
    (1,453
    )
    
    (222
    )Pro
      forma net income
    
    $
    6,840
    
    $
    9,121
 
 
 ****
      ****
    
    **Three
      Months Ended March 31,******
    
    
    **2004(restated)**
    
    
    **2003      
      (restated)****Basic
      earnings per share:**As
      reported
    
    $
    0.31
    
    $
    0.35Pro
      forma
    
    $
    0.26
    
    $
    0.34**Diluted
      earnings per share:**As
      reported
    
    $
    0.29
    
    $
    0.32Pro
      forma
    
    $
    0.25
    
    $
    0.33
 
 
 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.
 7
 ****
 **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 March 31,******
      ****
    
    
    **2004**
      **(restated)**
    
    
    **2003**
      **(restated)**
    ****
      ****Net
      income used to compute basic earnings per share
    
    $
    8,288
    
    $
    9,343Interest
      expense on convertible bonds, net of tax affect
    
    
    (5
    )
    
    319Net
      income used to compute diluted earnings per share
    
    $
    8,283
    
    $
    9,662Average
      shares of common stock outstanding used to compute basic earnings per
      share
    
    
    26,674
    
    
    26,376Additional
      common shares to be issued assuming exercise of stock options and warrants
      (net of shares assumed reacquired) and conversion of convertible bonds
      *
    
    
    1,456
    
    
    3,564Average
      shares of common and common equivalent stock outstanding used to compute
      diluted earnings per share
    
    
    28,130
    
    
    29,940Income
      per share - Basic:Net
      income per share
    
    $
    0.31
    
    $
    0.35Weighted
      average common shares outstanding
    
    
    26,674
    
    
    26,376Income
      per share - Diluted:Net
      income per share
    
    $
    0.29
    
    $
    0.32Weighted
      average common and common equivalent shares outstanding
    
    
    28,130
    
    
    29,940
 
 * The
diluted share basis for the three months ended March 31, 2004 and 2003,
respectively, excludes 9 shares associated with certain convertible bonds due to
their antidilutive effect. The diluted share basis for the three months ended
March 31, 2004 and 2003 excludes 2,889 and 2,184 shares, respectively,
associated with the options and warrants due to their antidilutive
effect.
 
  **NOTE
6. SUBSEQUENT EVENT**
  On
February 19, 2004, we noticed and committed to redeem $15 million principal
amount of our 12% Senior Subordinated Notes on April 20, 2004, with the
resulting change in the maturity of such principal amount to the noticed
redemption date. We redeemed the $15 million of 12% Senior Subordinated Notes on
April 20, 2004, leaving $10.7 million principal amount of the 12% Senior
Subordinated Notes then outstanding.
 
 8
 
 **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 quarter of 2004. These
      customer fee revenues were $0.3 million for the first quarter of 2004,
      $0.4 million for the first quarter 2003 and aggregated $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 quarter 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 quarter of 2004 and
      the third and fourth quarter of 2003 and year end December 31,
      2003.
 (d)
    In
      connection with the release of the valuation allowance in the third
      quarter 2003, $6.5 million of deferred tax assets associated with acquired
      net operating loss carryforwards were realizable and should have been
      recorded as a deferred tax asset. Originally, we believed this deferred
      tax asset was limited due to provisions of the Internal Revenue Code
      Section 382. This error resulted in deferred tax assets being understated
      and goodwill being overstated in each of the periods beginning in the
      third quarter 2003. As a result, we have restated the first quarter of
      2004 and the third and fourth quarter of 2003 and year end December 31,
      2003.
 
 As a
result of these restatements, certain originally reported amounts in the
consolidated statements of operations for the quarters ended March 31, 2004 and
2003 have been restated as follows (in thousands, except per share
data):
 9
 ****
    
    
    **As**
      **Originally
      Reported**
    
    
    **Adjustments**
    
    
    **As**
      **Restated****Three
      Months Ended March 31, 2004**Revenue
    
    $
    109,321
    
    $
    298
    
    $
    109,619Operating
      income
    
    
    14,103
    
    
    298
    
    
    14,401Provision
      for income taxes
    
    
    5,031
    
    
    366
    
    
    5,397Net
      income
    
    
    8,356
    
    
    (68
    )
    
    8,288Net
      income per share - Basic
    
    
    0.31
    
    
    --
    
    
    0.31Net
      income per share - Diluted
    
    
    0.29
    
    
    --
    
    
    0.29Weighted
      average common and common equivalent shares outstanding -Diluted
    
    
    28,862
    
    
    (732
    )
    
    28,130**Three
      Months Ended March 31, 2003**Revenue
    
    $
    87,843
    
    $
    359
    
    $
    88,202Operating
      income
    
    
    15,179
    
    
    359
    
    
    15,538Provision
      for income taxes
    
    
    5,835
    
    
    141
    
    
    5,976Net
      income
    
    
    9,126
    
    
    217
    
    
    9,343Net
      income per share - Basic
    
    
    0.35
    
    
    --
    
    
    0.35Net
      income per share - Diluted
    
    
    0.32
    
    
    --
    
    
    0.32Weighted
      average common and common equivalent shares outstanding -Diluted
    
    
    29,940
    
    
    --
    
    
    29,940
 
  10
 
 As a
result of these restatements, certain originally reported amounts in the
consolidated balance sheets at March 31, 2004, December 31, 2003 and March
31, 2003 have been restated as follows (in thousands):
  ****
    
    
    **As**
      **Originally
      Reported**
    
    
    **Adjustments**
    
    
    **As**
      **Restated****At
      March 31, 2004**Deferred
      income tax assetsCurrent
    
    $
    24,568
    
    $
    --
    
    $
    24,568Long-term
    
    
    36,528
    
    
    8,565
    
    
    45,093Goodwill
    
    
    19,503
    
    
    (6,490
    )
    
    13,013Total
      assets
    
    
    236,144
    
    
    2,075
    
    
    238,219Sales,
      use and excise taxes
    
    
    14,131
    
    
    (1,329
    )
    
    12,802Deferred
      income taxes
    
    
    19,920
    
    
    118
    
    
    20,038Total
      liabilities
    
    
    127,942
    
    
    (1,213
    )
    
    126,729Accumulated
      deficit
    
    
    (241,984
    )
    
    3,288
    
    
    (238,696
    )Total
      stockholders’ equity
    
    
    108,202
    
    
    3,288
    
    
    111,490**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
      March 31, 2003***Deferred
      income tax assetsCurrent
    
    $
    16,765
    
    $
    (142
    )
    $
    16,623Long-term
    
    
    --
    
    
    --
    
    
    --Goodwill
    
    
    19,503
    
    
    --
    
    
    19,503Total
      assets
    
    
    178,051
    
    
    2,002
    
    
    180,053Sales,
      use and excise taxes
    
    
    11,772
    
    
    (360
    )
    
    11,412Deferred
      income taxes
    
    
    --
    
    
    --
    
    
    --Total
      liabilities
    
    
    150,448
    
    
    1,785
    
    
    152,233Accumulated
      deficit
    
    
    (319,675
    )
    
    217
    
    
    (319,458
    )Total
      stockholders’ equity
    
    
    27,603
    
    
    217
    
    
    27,820
 
 *  Certain amounts reflected herein for 2003 have
been reclassified to reflect the 2004 presentation.
 11
  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
      March 31, 2004**Cash
      flows from operating activities:Net
      income
    
    $
    8,356
    
    $
    (68
    )
    $
    8,288Deferred
      income taxes
    
    
    4,068
    
    
    193
    
    
    4,261Changes
      in assets and liabilities:Sales,
      use and excise taxes
    
    
    (420
    )
    
    (299
    )
    
    (719
    )Other
      current liabilities and accrued compensation
    
    
    (8,241
    )
    
    174
    
    
    (8,067
    )Net
      cash provided by operating activities
    
    
    11,872
    
    
    --
    
    
    11,872**At
      March 31, 2003**Cash
      flows from operating activities:Net
      income
    
    $
    9,126
    
    $
    217
    
    $
    9,343Deferred
      income taxes
    
    
    5,835
    
    
    (159
    )
    
    5,676Changes
      in assets and liabilities:Sales,
      use and excise taxes
    
    
    332
    
    
    (359
    )
    
    (27
    )Other
      current liabilities and accrued compensation
    
    
    (5,100
    )
    
    301
    
    
    (4,799
    )Net
      cash provided by operating activities
    
    
    14,609
    
    
    --
    
    
    14,609
 
 **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 , and 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.
  12
 **OVERVIEW**
 
 We offer
a bundle of local and long distance phone services to residential and small
business customers in the United States. Our business strategy is to build a
large, profitable base of bundled phone service customers using the wholesale
operating platforms of the incumbent local exchange companies and then to
migrate customers to our own networking platform and further increase our
revenues and profitability by offering new products and services to these
customers. We refer to this strategy as our “customer first”
strategy.
 
 In 2000,
we decided to expand beyond our historical long distance service offerings and
utilize the unbundled network element platform to enter the large local
telecommunications market and diversify our product portfolio through the
bundling of local service with our core long distance service offerings. We
ended the first quarter 2004 with 623,000 billed bundled lines. We expect our
existing base of long distance customers to continue to decline in 2004 through
attrition due to our decision to focus our marketing efforts on the sale of our
bundled product.
 
 An
integral element of our business strategy is to develop our own local networking
capability. If successful, local networking will enhance our operating
flexibility and provide us with an alternative to the wholesale operating
platforms of the incumbent local exchange companies. As the first step in
enabling us to implement this stage of our business strategy, during 2003, we
deployed networking assets in Michigan and currently have provisioned over 1,500
customers to our switch. We are in the process of automating the business
processes required to provide local network-based services. We are also adding
new services and enhancing our existing service and product offerings, as
available, to increase our revenues and profitability from our customers. We
have installed a new voicemail platform and expect to launch a new dial-up
internet service and digital subscriber line, or DSL, service in
2004.
 
 **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 March 31,******
    
    
    **2004**
      **(restated)**
    
    
    **2003**
      **(restated)**
    ****
      ****Revenue
    
    
    100.0
    %
    
    100.0
    %Costs
      and expenses:Network
      and line costs
    
    
    49.5
    
    
    49.8General
      and administrative expenses
    
    
    13.8
    
    
    14.6Provision
      for doubtful accounts
    
    
    3.1
    
    
    2.5Sales
      and marketing expenses
    
    
    15.8
    
    
    10.6Depreciation
      and amortization
    
    
    4.7
    
    
    4.9Total
      costs and expenses
    
    
    86.9
    
    
    82.4Operating
      income
    
    
    13.1
    
    
    17.6Other
      income (expense):Interest
      income
    
    
    0.1
    
    
    0.1Interest
      expense
    
    
    (0.7
    )
    
    (2.8
    )Other,
      net
    
    
    --
    
    
    2.5Income
      before income taxes
    
    
    12.5
    
    
    17.4Provision
      for income taxes
    
    
    4.9
    
    
    6.8Net
      income
    
    
    7.6
    %
    
    10.6
    %
 
 
 13
 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
preceding fiscal period:
 
 
 **Three
      Months Ended March 31,****2004**
      **(restated)**
    
    **2003**
      **(restated)**Revenue
    24.3%
    
    11.0%Costs
      and expenses:Network
      and line costs
    23.6
    
    9.1General and administrative expenses
    17.7
    
    (11.6)Provision
      for doubtful accounts
    53.9
    
    (44.5)Sales
      and marketing expenses
    84.4
    
    59.0Depreciation
      and amortization
    19.1
    
    (3.1)Total
      costs and expenses
    31.0
    
    5.1Operating
      income
    (7.3)
    
    50.5Other
      income (expense):Interest
      income
    (8.2)
    
    23.6Interest
      expense
    (67.0)
    
    68.2Other,
      net
    (100.0)
    
    366.5Income
      before income taxes
    (10.7)
    
    88.4Provision
      for income taxes
    (9.7)
    
    --Net
      income
    (11.3)%
    
    14.9%
 
 
 *Revenue.* The
increase in revenue for the first quarter 2004 from the first quarter 2003 was
due to the increase in bundled revenue offset by a decline in long distance
revenue. During 2004, we increased certain fees and rates related to our long
distance and bundled products and such changes in rates may adversely impact
customer turnover.
 
 The
increase in bundled revenue to $92.0 million for the first quarter 2004 from
$60.5 million for the first quarter 2003 was due to higher average bundled lines
in 2004 as compared to 2003, partially offset by lower average monthly revenue
per customer. We ended the first quarter 2004 with 623,000 billed bundled lines,
compared to 402,000 at the end of first quarter 2003. Approximately 54% of the
bundled lines in the first quarter 2004 were in Michigan, compared to 67% at the
end of first quarter 2003, reflecting our continued efforts to market into new
states in the first quarter 2004, increasing our penetration of New York and New
Jersey and adding Alabama, Pennsylvania and Maryland as productive states. Continued growth in
revenues will depend upon our ability to develop and scale various marketing
programs in additional states or areas and to maintain or reduce the current
level of customer turnover.
 
 Our long
distance revenue decreased for the first quarter 2004 to $17.6 million from
$27.7 million for the first quarter 2003. Our decision in 2000 to invest in
building a bundled customer base, together with customer turnover, contributed
to the decline in long distance customers and revenue, although the effect on
revenue of the decline in customers was offset partially by an increase in
average monthly revenue per customer due to price increases. We expect this
decline in long distance customers and revenues to continue.
 
 *Network
and Line Costs* . The
increase of network and line costs for the first quarter 2004 from the first
quarter 2003 is primarily due to the increase in bundled customers, partially
offset by the decrease in long distance customers. The lower total network and
line costs as a percentage of revenue were due primarily to lower network costs
as a percentage of revenue for both the bundled and long distance products. This
decrease was partially offset by a shift in our customer base to the higher cost
bundled product from the lower cost long distance product and increases in
network cost pricing and costs of unbundled network elements in certain states.
 
 Bundled
network and line costs were $47.3 million for the first quarter 2004, as
compared to $32.1 million for the first quarter 2003. Long distance network and
line costs were $6.9 million for the first quarter 2004, as compared to $11.8
million for the first quarter 2003. As a percentage of bundled revenue, bundled
and network line costs were 51.4% for the first quarter 2004, as compared to
53.0% for the first quarter 2003. Long distance network and line costs as a
percentage of long distance revenue were 39.2% for the first quarter 2004, as
compared to 42.6% for the first quarter 2003. During the first quarter 2004, we
recorded a liability for network and line costs of $1.2 million related to
retroactive cost increases pending the resolution of a rate proceeding in the
State of Georgia. The increase in these liabilities was offset by a
reduction  in
accruals for network and line costs due  to the
expiration of the period to backbill us certain charges.
 
 14
 We
structure and price our products in order to maintain network and line costs as
a percentage of revenue at certain targeted levels. While the control of the
structure and pricing of our products assists us in mitigating risks of
increases in network and line costs, the telecommunications industry is highly
competitive and there can be no assurances that we will be able to effectively
market these higher priced products. There are several factors that could cause
our network and line costs as a percentage of revenue to increase in the future,
including without limitation:
 
 ·  determinations
by the FCC, courts, or state commission(s) that make unbundled local switching
and/or combinations of unbundled network elements effectively unavailable to us
in some or all of our geographic service areas, requiring us to provide services
in these areas through total service resale agreements with incumbent local
exchange companies, through network elements purchased from the Regional Bell
Operating Companies at "just and reasonable" rates under Section 271 of the Act
or through the switching facilities of other non-incumbent carriers, in any case
at significantly increased costs, or to provide services over our own switching
facilities, if they have been deployed. The Court of Appeals, on March 2, 2004,
issued an order that reversed the FCC’s Triennial Review Order in part and
remanded to the FCC with instructions to revise the Order in material ways that
may make unbundled local switching and/or combinations of unbundled network
elements effectively unavailable to us in some or all of our geographic service
areas (see our discussion under "Liquidity and Capital Resources, Other
Matters," below);
  ·  adverse
changes to the current pricing methodology mandated by the FCC for use in
establishing the prices charged to us by incumbent local telephone companies for
the use of their unbundled network elements. The FCC’s 2003 Triennial Review
Order, which was reversed in part and remanded to the FCC with instructions to
revise the Order in material ways, (see our discussion under "Liquidity and
Capital Resources, Other Matters," below) clarified several aspects of these
pricing principles related to depreciation, fill factors (i.e. network
utilization) and cost of capital, which could enable incumbent local telephone
companies to increase the prices for unbundled network elements. In addition,
the FCC released a Notice of Proposed Rulemaking on December 15, 2003, which
initiated a proceeding to consider making additional changes to its unbundled
network element pricing methodology, including reforms that would base prices
more on the actual network costs incurred by incumbent local exchange 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; and
  ·  determinations
by state commissions to increase prices for unbundled network elements in
ongoing state cost dockets.
  Changes
in the pricing of our service plans could also cause network and line costs as a
percentage of revenue to change in the future. See our discussion under
"Liquidity and Capital Resources, Other Matters," below.
 
 *General
and Administrative Expenses* . General
and administrative expenses increased for the first quarter ended 2004 from the
first 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
during the first quarter 2004.
 
 While we
expect general and administrative expense as a percentage of revenue to continue
to decline as the customer base grows, realization of such efficiencies will be
dependent on the ability of management to continue to control personnel costs in
areas such as customer service and collections. There can be no assurances that
we will be able to realize these efficiencies.
 
 *Provision
for Doubtful Accounts* . The
provision for doubtful accounts increased for the first quarter 2004 from the
first quarter 2003. The increase in bad debt expense is primarily attributable
to the increase in bundled revenue, both in total and as a percentage of total
revenue.
  
 15
 *Sales
and Marketing Expenses* . The
increase in sales and marketing expenses for the first quarter 2004 from the
first quarter 2003 is primarily attributable to increased levels of sales and
marketing activity to continue our bundled sales growth. Currently,
substantially all of our sales and marketing expenses relate to the bundled
product. We expect sales and marketing expenses in total and as a percentage of
sales to continue to increase in 2004 as we continue to target growth in the
bundled product and invest in the development of our marketing programs.
 
 *Interest
Expense* . The
decrease in interest expense for the first quarter 2004 from the first quarter
2003 is primarily attributable to a decrease in outstanding debt balances
through repurchases of our 12% Senior Subordinated Notes during 2003 and the
first quarter 2004, and our 8% Secured Convertible Notes during
2003.
 
 *Depreciation
and Amortization.* The
increase in depreciation and amortization for the first quarter 2004 from the
first 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 first quarter 2003 consists of gains from our repurchase of a
portion of our 12% Senior Subordinated Notes at a discount to par.
 
 *Provision
for Income Taxes* . The
effective tax rate for the first quarter 2004 was 39.4%. The increase in the
effective tax rate from 39% in 2003 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
first quarters 2004 and 2003, our operating activities provided net cash flow of
$11.9 million and $14.6 million, respectively, which was used in each year by
us, along with existing cash and cash equivalents, to reduce our outstanding
debt obligations and fund capital expenditures and capitalized software
development costs. For the first quarter 2003, we also utilized cash to
repurchase shares of our common stock. As of March 31, 2004, we had $29.7
million in cash and cash equivalents and long-term debt (including current
maturities) of $33.1 million, compared to $35.2 million and $48.6 million,
respectively, at December 31, 2003.
 
 Our
contractual obligations as of March 31, 2004 are summarized by years to maturity
as follows (in thousands):
 
 Contractual
      Obligations
    
    
    Total
    
    
    1
      year or
      less
    
    
    2 -
      3
      Years
    
    
    4 -
      5
      Years
    
    
    ThereafterTalk
      America Holdings, Inc.:12%
      Senior Subordinated Notes due 2007 (1)
    
    $
    25,730
    
    $
    15,000
    
    $
    --
    
    $
    10,730
    
    $
    --8%
      Convertible Senior Subordinated Notes due 2007 (2)
    
    
    3,713
    
    
    --
    
    
    --
    
    
    3,713
    
    
    --5%
      Convertible Subordinated Notes due 2004
    
    
    670
    
    
    670
    
    
    --
    
    
    --
    
    
    --Talk
      America Inc. and other subsidiaries:Capital
      lease obligations
    
    
    3,035
    
    
    1,127
    
    
    1,908
    
    
    --
    
    
    --$
    33,148
    
    $
    16,797
    
    $
    1,908
    
    $
    14,443
    
    $
    --Operating
      leases
    
    $
    7,508
    
    $
    2,844
    
    $
    3,773
    
    $
    446
    
    $
    445Carrier
      commitments (3)
    
    
    81,650
    
    
    19,250
    
    
    41,600
    
    
    20,800
    
    
    --Total
      Contractual Obligations
    
    $
    122,306
    
    $
    38,891
    
    $
    47,281
    
    $
    35,689
    
    $
    445
 
 
 16
 (1)
Reflects our February 19, 2004 notice and commitment to redeem $15 million
principal amount of these 12% Senior Subordinated Notes on April 20, 2004 and
resulting change in the maturity of such principal amount to the noticed
redemption date. Since the first quarter 2004 and through May 10, 2004, we have
redeemed the $15 million of these 12% Senior Subordinated Notes that we so
noticed for redemption.
 
 (2) The
amount of the 8% Convertible Senior Subordinated Notes include $2.8 million of
principal and $0.9 million of future accrued interest.
 
 (3) In
December 2003, we entered into a new four-year master carrier agreement with
AT&T. The agreement provides us with a variety of services, including
transmission facilities to connect our network switches as well as services for
international calls, local traffic, international calling cards, overflow
traffic and operator assisted calls. The agreement also provides that, subject
to certain terms and conditions, we will purchase these services exclusively
from AT&T during the term of the agreement, provided, however, that we are
not obligated to purchase exclusively in certain cases, including if such
purchases would result in a breach of any contract with another carrier that was
in place when we entered into the AT&T agreement, or if vendor diversity is
required. Certain of our network service agreements, including the AT&T
agreement, contain certain minimum usage commitments. Our contract with AT&T
establishes pricing and provides for annual minimum revenue commitments based
upon usage as follows: 2004 - $25 million, 2005 - $32 million, 2006 - $32
million and 2007 - $32 million and obligates us to pay 65 percent of the revenue
shortfall, if any. A separate contract with a different vendor establishes
pricing and provides for annual minimum payments for 2004 of $3.0 million. While
we believe we will meet these annual minimum revenue commitments, and that we
will not have to pay the shortfalls, there can be no assurances of this, and, if
we are required to pay any of the shortfall amounts under one of these
agreements, our costs of purchasing the services under the agreement will
correspondingly increase.
 
 *Cash
Provided By Operating Activities.* Net cash
provided by operating activities was $11.9 million and $14.6 million for the
quarters ended March 31, 2004 and 2003, respectively. For the quarter ended
March 31, 2004, the major contributors to the net cash provided by operating
activities were:
 ·  Net
income of $8.3 million;
 ·  Increases
in accounts payable of $4.2 million, primarily due to increased levels of sales
and marketing activity to continue our bundled sales growth, and an increase in
network and line costs primarily due to the increase in bundled
customers;
 ·  Non-cash
items of $12.8 million, primarily consisting of utilization of deferred tax
assets of $4.3 million. The application of NOL carryforwards have 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 by the end of
2007;
 ·  An
increase in deferred revenue of $1.7 million for advance customer billings,
primarily due to the growth in bundled customers.
 
 Partially
offsetting these contributors to the net cash provided by operating activities
were:
 ·  An
increase in accounts receivable of $5.8 million due to the growth of our
customer base. We generally do not have a significant concentration of credit
risk with respect to net trade accounts receivable, due to the large number of
end-users comprising our customer base;
 ·  A
decrease in accrued compensation of $7.0 million due to payment of year-end
performance bonuses;
 ·  A
decrease in other current liabilities of $1.1 million primarily attributable to
a decrease in accrued interest due to both lower debt levels and accrued
interest payments.
 
 For the
quarter ended March 31, 2003, the major contributors to the net cash provided by
operating activities were:
 ·  Net
income of $9.3 million;
 ·  An
increase in accounts payable of $3.3 million attributable to an
increase in network and line costs primarily due to the increase in bundled
customers;
 ·  An
increase in deferred revenue of $1.2 million for advance customer billings,
primarily due to the growth in bundled customers;
 ·  A
decrease in other assets of $1.1 million attributable to repayment of a related
party loan.
 
 Partially
offsetting these contributors to the net cash provided by operating activities
were:
 ·  An
increase in accounts receivable of $5.3 million, primarily due to the continued
shift in our customer base from long distance customers to local bundled
customers with higher average monthly revenue per customer.
 ·  A
decrease in accrued compensation of $2.3 million primarily due to payment of
year-end performance bonuses;
 ·  A
decrease in other current liabilities of $2.5 million primarily attributable to
accrued interest payments.
 
 17
 
 *Net
Cash Used in Investing Activities.* Net cash
used in investing activities was $2.0 million during the quarter ended March 31,
2004, consisting of capitalized software development costs of $0.8 million and
capital expenditures of $1.2 million, consisting primarily of upgrades to our
information technology capabilities.
 
 In 2004,
we plan to add six additional colocations to our existing local network and to
continue migrating local bundled customers over to our network, and expect to
incur capital expenditures of approximately $12 to $15 million for both network
and non-network assets. As we pursue our "customer first" strategy of building a
large, profitable base of bundled service customers using the wholesale
operating platforms of the incumbent local exchange companies and then migrate
those customers to our own networking platform and offer new products and
services to these customers, our capital expenditures are expected to increase
significantly.
 
 Capitalized
software development costs consist of direct development costs associated with
internal-use computer software, including external direct costs of material and
services and payroll costs for employees devoting time to the software projects.
In 2003, capitalized software development costs totaled $2.7 million and were
primarily related to the development of customer relations management software.
In 2004, we expect software development costs to increase moderately as we
continue to develop the integrated information systems required to provide local
switch-based service.
 
 Net cash
used in investing activities was $3.4 million during the quarter ended March 31,
2003, consisting of capitalized software development costs of $0.7 million and
capital expenditures primarily for the purchase of equipment of $2.7 million.
 
 *Net
Cash Used in Financing Activities.* Net cash
used in financing activities for the quarters ended March 31, 2004 and 2003 was
$15.3 and $15.8 million, primarily attributable to debt repayment of $15.0 and
$10.8 million, respectively. In addition, for the quarter ended March 31, 2003,
pursuant to our share buyback program announced in January 2003, we purchased
1,315,789 shares for a purchase price of $5.0 million. Under the buyback
program, we are authorized to spend up to $10.0 million for share purchases,
with a cap of 2.5 million shares.
 
 In the
second quarter of 2004 through May 10, 2004, we have redeemed the $15 million of
12% Senior Subordinated Notes for which we had given notice in February 2004,
leaving $10.7 million principal amount of the 12% Senior Subordinated Notes
currently outstanding. In 2004, we will continue to evaluate opportunities to
purchase our debt prior to maturity, as well as to consider acquiring shares
under the balance of our share buyback program. The remaining shares authorized
under the program may be purchased, from time to time, in the open market and/or
in private transactions.
 
 While we
believe that we have access to new capital in the public or private markets to
fund our ongoing cash requirements, there can be no assurance as to the timing,
amounts, terms or conditions of any such new capital or whether it could be
obtained on terms acceptable to us. We anticipate that our cash requirements
will generally be met from our cash-on-hand and from cash generated from
operations. Based on our current projections for operations, we believe that our
cash-on-hand and our cash flow from operations will be sufficient to fund our
currently contemplated capital expenditures, our debt service obligations, and
the expenses of conducting our operations for at least the next twelve months.
However, there can be no assurance that we will be able to realize our projected
cash flows from operations, which is subject to the risks and uncertainties
discussed in this report, or that we will not be required to consider capital
expenditures in excess of those currently contemplated, as discussed in this
report.
 
 18
 **OTHER
MATTERS**
 
 Our
provision of telecommunication services is subject to government regulation.
Changes in existing regulations could have a material adverse effect on us. Our
local telecommunication services are provided almost exclusively through the use
of unbundled network elements purchased from incumbent local telephone
companies, and it is primarily the availability of cost-based unbundled network
element rates that enables us to price our local telecommunications services
competitively. The FCC currently requires incumbent local telephone companies to
provide an unbundled network element platform, that includes all of the network
elements required by a competitor to provide a retail telecommunications
service, in most geographic areas. Through the use of such unbundled network
element platforms we are able to provide retail local services entirely through
the use of the incumbent local telephone company’s facilities at lower prices
than those available for local resale through total resale service agreements.
In its UNE Triennial Review proceeding, the FCC sought to identify, among other
issues, which if any network elements the incumbent local telephone companies
should no longer be required to offer on an unbundled basis. The FCC also
analyzed the issue of which elements must be unbundled in response to a remand
of its previous rules by the U.S. Court of Appeals for the District of Columbia
Circuit. In the FCC’s UNE Triennial Review Order, released August 21, 2003 and
effective as of October 2, 2003, the Commission determined that certain network
elements will no longer be subject to unbundling, while other elements must
continue to be offered subject to further, more detailed review by the state
public utility commissions. The Order was subject to numerous federal judicial
appeals, which were consolidated in the U.S. Court of Appeals for the District
of Columbia Circuit. The Court, on March 2, 2004, issued an order that reversed
the FCC’s Order in part and remanded to the FCC with instructions to revise the
Order in material ways. The Court stayed its decision until the denial of any
petitions for rehearing or for a 60-day period (i.e., until May 1, 2004),
whichever is later. In April 2004 the Court extended its stay to June 15, 2004.
As directed by the FCC in early April 2004, we have agreed to negotiate in good
faith new commercial contracts for the receipt of wholesale phone services from
the incumbent local exchange carriers. To date no agreements have been reached
nor can any assurance be given that any agreements will be reached.
 
 Should
the local circuit switching unbundled network element become effectively
unavailable due to this adverse decision or otherwise, we would be unable to
offer services on an unbundled network element platform basis and would instead
have to serve customers through total service resale agreements with the
incumbent local exchange companies, through network elements purchased from the
Regional Bell Operating Companies at "just and reasonable" rates under Section
271 of the Act or through our own facilities or the switching facilities of
other non-incumbent carriers. Our transition from providing telecommunications
services on an unbundled network element platform basis could delay our service
roll-out in some markets, increase our costs and have a material adverse effect
on our business, prospects, operating margins, results of operations, cash flows
and financial condition.
  **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.
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 Item 7, "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.
 
 19
 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 March 31, 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 March 31, 2004.
 
 We have
restated our previously issued consolidated financial statements for the year
ended December 31, 2003, the four quarters of 2003. This restatement was
primarily the result of the following material weaknesses:
 
 1. We did
not maintain effective controls over the application of generally accepted
accounting principles related to the financial reporting process for complex
transactions. Specifically, we did not have personnel who possess sufficient
depth, skills and experience in accounting for and review of complex
transactions in the financial reporting process to ensure that complex
transactions were accounted for in accordance with generally accepted accounting
principles. This control deficiency resulted in the restatement of our financial
statements for the third and fourth quarters of 2003, the year ended December
31, 2003 and the first quarter 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 quarter of 2004.
 
 The
restatements, described above, were for matters related to (a) the recognition
in revenue in the four quarters 2003, the year ended December 31, 2003 and for
the first quarter of 2004 of certain customer fees previously recorded in those
periods as increases in current liabilities; (b) the calculation of outstanding
diluted weighted average common and common equivalent shares since the third
quarter 2003 to reflect the  inclusion
of assumed tax benefits in the proceeds used to repurchase shares in the
application of the treasury stock method of accounting for outstanding options;
(c) for the third and fourth quarters 2003 and the year ended December 31, 2003,
a correction in the calculation of net operating losses utilized in 2003 and in
the calculation of state deferred tax assets; and (d) the recording, beginning
in the third quarter 2003 and for the year ended December 31, 2003, of a
deferred tax asset associated with acquired net operating loss carryforwards.
Refer to Note 7 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 first
quarter of 2004.
 
 To
address these material weaknesses, subsequent to March 31, 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 March 31, 2004. There were no changes in our internal
control over financial reporting that occurred during the quarter ended March
31, 2004 that have materially affected, or are reasonably likely to materially
affect, our internal control over financial reporting.
 
 
 20
  **PART
II - OTHER INFORMATION**
 
 
 **Item
6.**  **Exhibits
and Reports on Form 8-K**
 
 (a)  Exhibits
 
 
 31.1
    Rule
      13a-14(a) Certifications of Edward B. Meyercord, III (filed
      herewith).
 
 31.2
    Rule
      13a-14(a) Certifications of David G. Zahka (filed
    herewith).
 
 32.1
    Certification
      of Edward B. Meyercord, III Pursuant to 18 U.S.C. Section 1350, as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished to
      the Commission herewith).
 
 32.2
    Certification
      of David G. Zahka Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
      to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished to the
      Commission herewith).
 
 (b)
Reports on Form 8-K.
 
 No
Current Reports on Form 8-K were filed by us during the three months ended March
31, 2004.
 
 21
 **SIGNATURES**
 
 Pursuant
to the requirements of the Securities Exchange Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
 
 **TALK
AMERICA HOLDINGS, INC.**
 
 
 
 Date:
      April 25, 2005
    By:/s/ Edward B. Meyercord, III
      Edward
      B. Meyercord, III
      Chief
      Executive Officer