**SECURITIES
AND EXCHANGE COMMISSION**
 Washington,
D.C. 20549
 **_____________________**
 **FORM
10-Q**
 
 **(Mark
One)**
 
 **[X]**
    **QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**
 
 **For
the quarterly period ended March 31, 2005**
 
 **OR**
 
 **[  
      ]**
    **TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**
 
 **For
the transition period from____to _____**
 
 **Commission
file number 000 - 26728**
 
 **Talk
America Holdings, Inc.**
 (Exact
name of registrant as specified in its charter)
 
 **Delaware**
      (State
      of incorporation)
    **23-2827736**
      (I.R.S.
      Employer Identification No.)
 
 **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.
 
 27,234,811
shares of Common Stock, par value of $0.01 per share, were issued and
outstanding as of May 4, 2005.
 
 
 
 
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 
 **Index**
 
 ******Page**PART
      I - FINANCIAL INFORMATIONItem
      1. Consolidated Financial StatementsConsolidated
      Statements of Operations - Three Months Ended March 31, 2005 and 2004
      (unaudited)
    3Consolidated
      Balance Sheets - March 31, 2005 and December 31, 2004
      (unaudited)
    4Consolidated
      Statements of Cash Flows - Three Months Ended March 31, 2005 and 2004
      (unaudited)
    5Consolidated
      Statements of Stockholders’ Equity - Three Months EndedMarch
      31,2005 (unaudited)
    6Notes
      to Consolidated Financial Statements (unaudited)
    7Item
      2. Management’s Discussion and Analysis of Financial Condition and Results
      of Operations
    10Item
      4. Controls and Procedures
    21PART
      II - OTHER INFORMATIONItem
      6. Exhibits and Reports on Form 8-K
    23(a)
      Exhibits
 
 
 
 
 2
 
 **PART
I. FINANCIAL INFORMATION**
 
 **Item
1. Consolidated Financial Statements.**
 
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF OPERATIONS**
 **(In
thousands, except for per share data)**
 **(Unaudited)**
 
 
 **Three
      Months Ended March 31,****2005**
    
    
    **2004**Revenue
    
    $
    119,835
    
    $
    109,619Costs
      and expenses:Network
      and line costs (excluding depreciation and
      amortization
      shown below)
    
    
    60,996
    
    
    52,512General
      and administrative expenses
    
    
    18,120
    
    
    16,870Provision
      for doubtful accounts
    
    
    5,588
    
    
    3,421Sales
      and marketing expenses
    
    
    10,268
    
    
    17,284Depreciation
      and amortization
    
    
    9,501
    
    
    5,131Total
      costs and expenses
    
    
    104,473
    
    
    95,218Operating
      income
    
    
    15,362
    
    
    14,401Other
      income (expense):Interest
      income
    
    
    308
    
    
    101Interest
      expense
    
    
    (25
    )
    
    (817
    )Other
      expense, net
    
    
    (20
    )
    
    --Income
      before provision for income taxes
    
    
    15,625
    
    
    13,685Provision
      for income taxes
    
    
    6,155
    
    
    5,397Net
      income
    
    $
    9,470
    
    $
    8,288Income
      per share - Basic:Net
      income per share
    
    $
    0.35
    
    $
    0.31Weighted
      average common shares outstanding
    
    
    27,086
    
    
    26,674Income
      per share - Diluted:Net
      income per share
    
    $
    0.34
    
    $
    0.29Weighted
      average common and common equivalentshares
      outstanding
    
    
    27,813
    
    
    28,130
 
 
 See
accompanying notes to consolidated financial statements.
 
  3
 
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
BALANCE SHEETS**
 **(In
thousands, except for share and per share data)**
 **(Unaudited)**
 
 
 **March
      31,**
      **2005**
    
    **December
      31,**
      **2004****Assets**Current
      assets:Cash
      and cash equivalents
    
    $
    57,183
    
    $
    47,492Accounts
      receivable, trade (net of allowance for uncollectible accounts of $16,840
      and $17,508 at March 31, 2005 and
      December
      31, 2004, respectively)
    
    
    43,083
    
    
    48,873Deferred
      income taxes
    
    
    27,782
    
    
    34,815Prepaid
      expenses and other current assets
    
    
    6,236
    
    
    6,888Total
      current assets
    
    
    134,284
    
    
    138,068Property
      and equipment, net
    
    
    69,877
    
    
    65,823Goodwill
    
    
    13,013
    
    
    13,013Intangible
      assets, net
    
    
    1,266
    
    
    1,966Deferred
      income taxes
    
    
    12,896
    
    
    14,291Capitalized
      software and other assets
    
    
    8,873
    
    
    8,567$
    240,209
    
    $
    241,728**Liabilities
      and Stockholders’ Equity**Current
      liabilities:Accounts
      payable
    
    $
    43,693
    
    $
    43,439Sales,
      use and excise taxes
    
    
    9,588
    
    
    11,179Deferred
      revenueLegal settlements
    
    
    14,272
    
    
    15,321Current
      portion of long-term debt and capitalized lease
obligations
    
    
    2,541
    
    
    2,529Accrued
      compensation
    
    
    1,843
    
    
    6,690Other
      current liabilities
    
    
    5,575
    
    
    5,426Total
      current liabilities
    
    
    77,512
    
    
    84,584Long-term
      debt and capitalized lease obligations
    
    
    1,076
    
    
    1,717Deferred
      income taxes
    
    
    9,963
    
    
    13,906Commitments
      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; 27,212,160 and
      27,037,096 shares issued and outstanding at
      March
      31, 2005 and December 31, 2005, respectively
    
    
    285
    
    
    284Additional paid-in capital
    
    
    357,075
    
    
    356,409Accumulated deficit
    
    
    (200,702
    )
    
    (210,172
    )Treasury stock - at cost, 1,315,789 shares at March 31, 2005 and December
      31, 2004
    
    
    (5,000
    )
    
    (5,000
    )Total
      stockholders' equity
    
    
    151,658
    
    
    141,521$
    240,209
    
    $
    241,728
 
 See
accompanying notes to consolidated financial statements.
 4
  
 **TALK
AMERICA HOLDINGS, INC. AND SUBSIDIARIES**
 **CONSOLIDATED
STATEMENTS OF CASH FLOWS**
 **(In
thousands)**
 **(Unaudited)**
 
 
 **Three
      Months Ended**
      **March
      31,****2005**
    
    
    **2004**Cash
      flows from operating activities:Net
      income
    
    $
    9,470
    
    $
    8,288Adjustments
      to reconcile net income to net cash provided by operating
      activities:Provision
      for doubtful accounts
    
    
    5,588
    
    
    3,421Depreciation
      and amortization
    
    
    9,501
    
    
    5,131Non-cash
      compensation
    
    
    --
    
    
    9Non-cash
      interest and amortization of accrued interest liabilities
    
    
    --
    
    
    (65
    )Loss
      on sale and retirement of assets
    
    
    20
    
    
    --Deferred
      income taxes
    
    
    4,484
    
    
    4,261Changes
      in assets and liabilities:Accounts
      receivable, trade
    
    
    202
    
    
    (5,760
    )Prepaid
      expenses and other current assets
    
    
    652
    
    
    (514
    )Other
      assets
    
    
    9
    
    
    (13
    )Accounts
      payable
    
    
    254
    
    
    4,174Sales,
      use and excise taxes
    
    
    (1,591
    )
    
    (719
    )Deferred
      revenue
    
    
    (1,049
    )
    
    1,726Accrued
      compensation
    
    
    (4,847
    )
    
    (6,983
    )Other
      current liabilities
    
    
    149
    
    
    (1,084
    )Net
      cash provided by operating activities
    
    
    22,842
    
    
    11,872Cash
      flows from investing activities:Capital
      expenditures
    
    
    (12,221
    )
    
    (1,220
    )Capitalized
      software development costs
    
    
    (1,010
    )
    
    (811
    )Proceeds
      from sale of property and equipment
    
    
    42
    
    
    --Net
      cash used in investing activities
    
    
    (13,189
    )
    
    (2,031
    )Cash
      flows from financing activities:Payments
      of borrowings
    
    
    --
    
    
    (15,000
    )Payments
      of capital lease obligations
    
    
    (629
    )
    
    (384
    )Proceeds
      from exercise of options
    
    
    667
    
    
    50Net
      cash provided by (used in) financing activities
    
    
    38
    
    
    (15,334
    )Net
      increase (decrease) in cash and cash equivalents
    
    
    9,691
    
    
    (5,493
    )Cash
      and cash equivalents, beginning of period
    
    
    47,492
    
    
    35,242Cash
      and cash equivalents, end of period
    
    $
    57,183
    
    $
    29,749
 
 See
accompanying notes to consolidated financial statements.
 
 5
 ****
 **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, 2004
    
    
    28,353
    
    $
    284
    
    $
    356,409
    
    $
    (210,172
    )
    
    1,316
    
    $
    (5,000
    )
    $
    141,521Net
      income
    
    
    --
    
    
    --
    
    
    --
    
    
    9,470
    
    
    --
    
    
    --
    
    
    9,470Income
      tax benefit related to exercise of common stock options
    
    
    --
    
    
    --
    
    
    358
    
    
    --
    
    
    --
    
    
    --
    
    
    358Exercise
      of common stock options
    
    
    175
    
    
    1
    
    
    308
    
    
    --
    
    
    --
    
    
    --
    
    
    309Balances,
      March 31, 2005
    
    
    28,528
    
    $
    285
    
    $
    357,075
    
    $
    (200,702
    )
    
    1,316
    
    $
    (5,000
    )
    $
    151,658
 
 
 See
accompanying notes to consolidated financial statements.
  
 6
 ****
 **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, 2005
and for the three months ended March 31, 2005 and March 31, 2004 are unaudited,
but in the opinion of management include all adjustments necessary for a fair
statement of the results for the periods presented. The consolidated balance
sheet information for December 31, 2004 was derived from the audited financial
statements included in our Annual Report on Form 10-K for the year ended
December 31, 2004 filed March 16, 2005, as amended by our Form 10-K/A filed
March 30, 2005 (as so amended, “our 2004 Form 10-K”). These interim financial
statements should be read in conjunction with our 2004 Form 10-K. The interim
results are not necessarily indicative of the results for any future periods.
Certain prior year amounts have been reclassified for comparative
purposes.
 
 **(b)
Risks and Uncertainties**
 
 Future
results of operations involve a number of risks and uncertainties. Factors that
could affect future operating results and cash flows and cause actual results to
vary materially from historical results include, but are not limited to:
 
 ·
    Changes
      in 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 until March 11, 2006 and,
      thereafter, the cost of certain elements of the unbundled network element
      platform of the local exchange carriers network and the costs associated
      therewith and thereafter the cost of certain unbundled network element
      platform elements utilized with our
network.
 ·
    Dependence
      on the availability and functionality of the networks of the incumbent
      local exchange carriers as they relate to the unbundled network element
      platform.
 ·
    Increased
      price competition in local and long distance services, including bundled
      services, and overall competition within the telecommunications industry,
      including, but not limited to, in the State of
Michigan.
 
 Negative
developments in these areas could have a material adverse effect on our
business, financial condition and results of operations.
 
 **(c)
Recent Accounting Pronouncements**
 
 In March
2005, the Financial Accounting Standards Board (“FASB”) issued Interpretation
Number 47, “Accounting for Conditional Asset Retirement Obligations, an
interpretation of FASB Statement No. 143” (“FIN 47”).  FIN 47 clarifies the
term “conditional asset retirement obligation” ** as used
in Statement of Financial Accounting Standards (“SFAS”) No. 143, “Accounting for
Asset Retirement Obligations,” and also clarifies when an entity would have
sufficient information to reasonably estimate the fair value of an asset
retirement.  FIN 47 is effective no later than the end of fiscal years
ending after December 15, 2005.  We are evaluating the implementation of
FIN 47 and whether it will have a material impact on our financial position,
results of operations or cash flows.
 
 7
 
 In
December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based
Payments” (“SFAS No. 123R”). SFAS No. 123R requires the recognition of the cost
of employee services received in exchange for an award of equity instruments in
the financial statements and measurement based on the grant-date fair value of
the award. It requires the cost to be recognized over the period during which an
employee is required to provide service in exchange for the award. Additionally,
compensation expense will be recognized over the remaining employee service
period for the outstanding portion of any awards for which compensation expense
had not been previously recognized or disclosed under SFAS No. 123, “Accounting
for Stock-Based Compensation” (“SFAS No. 123”).  SFAS No. 123R replaces
SFAS No. 123, and supersedes Accounting Principles Board Opinion No. 25,
“Accounting for Stock Issued to Employees” (“APB No. 25”), and its related
interpretations.
 
 On April
15, 2005, the Securities and Exchange Commission posted Final Rule Number
33-8568, “Amendment to Rule 4-01(a) of Regulation S-X Regarding the Compliance
Date for Statement of Financial Accounting Standards No. 123 (Revised 2004), *Share-Based
Payment,* ” which
is effective as of April 21, 2005. Under the Commission’s amendment, we are
required to file financial statements that comply with SFAS No. 123R in our
Quarterly Report on Form 10-Q for the first quarter of the first fiscal year
that begins after June 15, 2005, and we are permitted, but not required, to
comply with SFAS No. 123R for periods before the required compliance date. The
requirements will be effective for us beginning with the first quarter of fiscal
2006. We are currently assessing the timing and impact of adopting SFAS No.
123R.
  **** **NOTE
2. 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.
 
 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: 2005 - $32 million, 2006 - $32 million and 2007 - $32 million and
obligates us to pay 65 percent of the revenue shortfall, if any. Another
separate contract with a different vendor establishes pricing and provides for
annual minimum payments for 2005 of $1.0 million. Despite the anticipated
reduction in our local bundled customer base, we anticipate that we will not be
required to make any shortfall payments under these contracts as a result of the
restructuring of these obligations or the growth in network minutes as a result
of acquisitions, but there can be no assurances that we will be successful in
this restructuring or acquisition. To the extent that we are unable to meet
these minimum commitments, our costs of purchasing the services under the
agreement will correspondingly increase.
 
 We have a
contract with our invoice printing company that establishes pricing and provides
for annual minimum payments as follows: 2005 - $1.2 million, 2006 - $1.2
million, 2007 - $1.2 million, and 2008 - $1.3 million. We also agreed to renew
the maintenance agreement associated with a vendor financing agreement we
entered into in May 2004 with a software supplier for an additional two years at
a cost of $1.1 million, which is funded on the anniversary dates of the
agreement.
 
 8
 **NOTE
3. STOCK-BASED COMPENSATION**
 
 We
account for our stock option awards under the intrinsic value based method of
accounting prescribed by APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations, including FASB Interpretation No. 44
"Accounting for Certain Transactions Including Stock Compensation," an
interpretation of APB Opinion No. 25. Under the intrinsic value based method,
compensation cost is the excess, if any, of the quoted market price of the stock
at grant date or other measurement date over the amount an employee must pay to
acquire the stock. We make pro forma disclosures of net income and earnings per
share as if the fair value based method of accounting had been applied as
required by SFAS No. 123, "Accounting for Stock-Based Compensation" and SFAS
148, “Accounting for Stock-Based Compensation - Transition and Disclosure - an
amendment of SFAS 123”. The following disclosure complies with the adoption of
this statement and includes pro forma net income as if the fair value based
method of accounting had been applied (in thousands except for per share
data):
 
 **Three
      Months Ended March 31,****2005**
    
    
    **2004**Net
      income as reported
    
    $
    9,470
    
    $
    8,288Add:
      Stock-based employee compensation
      expense
      included in reported net income,
      net
      of tax effect
    
    
    --
    
    
    5Deduct:
      Total stock-based employee
      compensation
      expense determined under
      fair
      value based method for all options, net
      of
      tax effect
    
    
    (503
    )
    
    (1,453
    )Pro
      forma net income
    
    $
    8,967
    
    $
    6,840
 
 
 **Three
      Months Ended March 31**,**2005**
    
    
    **2004****Basic
      earnings per share:**As
      reported
    
    $
    0.35
    
    $
    0.31Pro
      forma
    
    $
    0.33
    
    $
    0.26**Diluted
      earnings per share:**As
      reported
    
    $
    0.34
    
    $
    0.29Pro
      forma
    
    $
    0.33
    
    $
    0.25
 
 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
4. PER SHARE DATA**
 
 Basic
earnings per common share for a fiscal period is calculated by dividing net
income by the weighted average number of common shares outstanding during the
fiscal period. Diluted earnings per common share is calculated by adjusting the
weighted average number of common shares outstanding and the net income during
the fiscal period for the assumed conversion of all potentially dilutive stock
options, warrants and convertible bonds (and assuming that the proceeds
hypothetically received from the exercise of dilutive stock options and warrants
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,****2005**
    
    **2004**Net
      income used to compute basic earnings per share
    
    $
    9,470
    
    $
    8,288Interest
      expense on convertible bonds, net of tax affect
    
    
    --
    
    
    (5
    )Net
      income used to compute diluted earnings per share
    
    $
    9,470
    
    $
    8,283Average
      shares of common stock outstanding used to compute basic earnings per
      share
    
    
    27,086
    
    
    26,674Additional
      common shares to be issued assuming exercise of stock options and warrants
      (net of shares assumed reacquired) and
      conversion
      of convertible bonds *
    
    
    727
    
    
    1,456Average
      shares of common and common equivalent stock outstanding used to compute
      diluted earnings per share
    
    
    27,813
    
    
    28,130Income
      per share - Basic:Net
      income per share
    
    $
    0.35
    
    $
    0.31Weighted
      average common shares outstanding
    
    
    27,086
    
    
    26,674Income
      per share - Diluted:Net
      income per share
    
    $
    0.34
    
    $
    0.29Weighted
      average common and common equivalent shares outstanding
    
    
    27,813
    
    
    28,130
 
 * The
diluted share basis for the three months ended March 31, 2004 excludes nine
shares associated with certain convertible bonds due to their antidilutive
effect. The diluted share basis for the three months ended March 31, 2005 and
2004 excludes 3,234 and 2,889 shares, respectively, associated with the options
and warrants due to their antidilutive effect.
 
 
 **Item
2. Management’s Discussion and Analysis of Financial Condition and Results of
Operations.**
  You
should read the following discussion in conjunction with our Consolidated
Financial Statements included elsewhere in this Form 10-Q and in our 2004 Form
10-K and any subsequent filings.
 
 10
 ****
 **Cautionary
Note Concerning Forward-Looking Statements**
 
 Certain
of the statements contained herein may be considered "forward-looking
statements" for purposes of the securities laws. From time to time, oral or
written forward-looking statements may also be included in other materials
released to the public. These forward-looking statements are intended to provide
our management’s current expectations or plans for our future operating and
financial performance, based on our current expectations and assumptions
currently believed to be valid. For these statements, we claim protection of the
safe harbor for forward-looking statements provided by the Private Securities
Litigation Reform Act of 1995. These forward-looking statements can be
identified by the use of forward-looking words or phrases, including, but not
limited to, "believes," "estimates," "expects," "expected," "anticipates,"
"anticipated," "plans," "strategy," "target," "prospects," “forecast,”
“guidance” and other words of similar meaning in connection with a discussion of
future operating or financial performance. Although we believe that the
expectations reflected in such forward-looking statements are reasonable, there
can be no assurance that such expectations will prove to have been
correct.
 
 All
forward-looking statements involve risks and uncertainties that may cause our
actual results to differ materially from those expressed or implied in the
forward-looking statements. In addition to those factors discussed in this Form
10-Q, you should see our other reports on Forms 10-K, 10-Q and 8-K subsequently
filed with the Securities and Exchange Commission from time to time for
information identifying factors that may cause actual results to differ
materially from those expressed or implied in the forward-looking
statements.
 
 **OVERVIEW**
 
 We offer
a bundle of local and long distance phone services to residential and small
business customers in the United States. We have built a large, profitable base
of bundled phone service customers using the wholesale operating platforms of
the incumbent local exchange companies, such as the Regional Bell Operating
Companies, and have begun and plan to migrate customers to our own networking
platform in Detroit and Grand Rapids, Michigan, and further increase our
revenues and profitability from those customers by offering new products and
services.
 
 In
December 2004, the FCC issued final rules that effectively eliminated the
requirement that incumbent local exchange companies provide us wholesale
services using the unbundled network element platform and established a 12-month
transition plan for implementation. Beginning on March 11, 2005, we are no
longer able to use the unbundled network element platform to provide service to
new customers and 12 months after that date the limitation will extend to all
customers. In addition, during this 12-month period, the wholesale rates that we
are charged will increase by $1 per line per month. At the end of the 12-month
period, we will need to service customers that are not on our own networking
platform through a resale or other wholesale agreement, both of which will have
significantly higher costs than servicing customers through the unbundled
network platform. As a result of (a) significant changes to the FCC rules that
previously required the incumbent local exchange companies to provide on a
wholesale basis the unbundled network elements to us and (b) price increases
established by various state public utility commissions, the rates that we are
to be charged by the incumbent local exchange companies to provide our services
increased significantly in 2004 and the first quarter of 2005 and will continue
to increase over time. These cost increases have and will continue to lead us to
increase our product pricing, which we believe inhibits our ability to add new
customers and to retain existing customers. Therefore we have reduced our
efforts to increase subscriber growth in markets other than those areas where we
currently have or plan to deploy network facilities (Detroit and Grand Rapids),
which will significantly reduce our sales and marketing expenditures from past
periods. In addition to the increases discussed above as a result of these
regulatory actions, we plan to further increase our product pricing for our
customers located in those areas where we do not currently have or plan to
deploy network facilities. These cost increases will increase our revenue for
such customers; however, it will likely adversely affect our ability to retain
such customers on our service.
 
 11
 An
integral element of our business strategy is to develop our own local networking
capacity. Local networking would enhance our operating flexibility and provide
us with an alternative to the wholesale operating platforms of the incumbent
local exchange companies. Beginning in 2003, we deployed networking assets in
Michigan and, as of March 31, 2005, we had approximately 28,000 bundled lines on
our Michigan network. We are continuing the expansion of our network by
colocating our networking equipment in the incumbent local exchange companies’
end offices to provide service over our own network to a larger existing
customer base in Detroit and Grand Rapids, Michigan. As a result of the
significant changes in the regulatory environment, we have accelerated our
networking initiatives and by December 31, 2005 we expect to have approximately
175,000 bundled lines on our network in Michigan, although some of the
regulatory changes could also impede this deployment (see “Liquidity and Capital
Resources, Other Matters,” below). We have and continue to improve the
automation of the business processes required to provide local network-based
services. In addition, we are actively exploring next generation networking
opportunities with a variety of vendors in order to decrease our cost of
delivering service, reduce our reliance upon the incumbent local exchange
companies and provide local telephone services through new, innovative methods
of delivery.  However, we have not previously developed, deployed or
operated a local network of our own or of this scale and there can be no
assurance that we shall be able successfully to do so and thereafter profitably
provide local telephone services through such a network. In addition, we are
dependent upon a variety of vendors for the provision of equipment necessary for
the construction, deployment and migration of customers to our local network,
and failure of these vendors to deliver the equipment in a timely manner may
result in delays in the deployment, and ultimately, the migration of customers
to our network.
 
 Our
future business strategy is to also serve medium sized businesses, in addition
to residential consumers and small businesses, in those areas where we plan to
deploy network facilities. Expansion into this business market will increase our
addressable market in such areas and will permit us to leverage our investment
in our network facilities due to the complementary telecommunication traffic or
usage patterns of these business customers and our residential and small
business customers. We will consider and pursue the acquisition of customers or
networking assets to enter the business market, complement existing networking
plans or to supplement customer density where there is a potential for
deployment of network facilities. We are currently targeting the fourth quarter
of 2005 for our entry into the medium sized business market in Michigan.
 
 12
  **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,****2005**
    
    
    **2004**Revenue
    
    
    100.0
    %
    
    100.0
    %Costs
      and expenses:Network
      and line costs
    
    
    50.9
    
    
    47.9General
      and administrative expenses
    
    
    15.1
    
    
    15.4Provision
      for doubtful accounts
    
    
    4.7
    
    
    3.1Sales
      and marketing expenses
    
    
    8.6
    
    
    15.8Depreciation
      and amortization
    
    
    8.0
    
    
    4.7Total
      costs and expenses
    
    
    87.3
    
    
    86.9Operating
      income
    
    
    12.7
    
    
    13.1Other
      income (expense):Interest
      income
    
    
    0.3
    
    
    0.1Interest
      expense
    
    
    --
    
    
    (0.7
    )Income
      before income taxes
    
    
    13.0
    
    
    12.5Provision
      for income taxes
    
    
    5.1
    
    
    4.9Net
      income
    
    
    7.9
    %
    
    7.6
    %
 
 
 The
following table sets forth for certain items of our financial data for the
period indicated the percentage increase or (decrease) in such item from the
prior year comparable fiscal period:
 
 **Three
      Months   Ended**
      **March
      31, 2005**Revenue
    
    
    9.3
    %Costs
      and expenses:Network
      and line costs
    
    
    16.2General
      and administrative expenses
    
    
    7.4Provision
      for doubtful accounts
    
    
    63.3Sales
      and marketing expenses
    
    
    (40.6
    )Depreciation
      and amortization
    
    
    85.2Total
      costs and expenses
    
    
    9.7Operating
      income
    
    
    6.7Other
      income (expense):
    
    
    100.0Interest
      income
    
    
    205.0Interest
      expense
    
    
    (96.9
    )Income
      before income taxes
    
    
    14.2Provision
      for income taxes
    
    
    14.0Net
      income
    
    
    14.3
    %
 
 
 13
 *Revenue.* The
increase in revenue for the first
quarter 2005
from the first quarter 2004 was due to an increase in bundled revenue offset by
a decline in long distance revenue. During 2004 and the first quarter 2005, we
increased certain fees and rates related to our long distance and bundled
products. Additional increases in fees and rates related to our long distance
and bundled products continued and are expected to continue to adversely affect
customer turnover.
 
 Bundled
revenue increased to $107.7 million for the first quarter 2005 from $92.0
million for the first quarter 2004 due primarily to higher average revenue per
bundled line and higher average bundled lines in 2005 as compared to 2004. We
ended the first quarter 2005 with 624,000 billed bundled lines, compared to
623,000 in the first quarter 2004. Approximately 49% of the bundled lines in
March 2005 were in Michigan, compared to 54% in March 2004. We expect the
actions we will take, as a result of the recent regulatory changes, to focus
customer growth on areas where we have our own local network and increase prices
on our services where we do not have or plan to deploy network facilities will
cause the number of bundled lines and revenues to decline in the future and will
significantly increase the percentage of our bundled lines in
Michigan.
 
 Our long
distance revenue decreased in the first quarter 2005 to $12.1 million from $17.6
million in the first quarter 2004. Our decision in 2000 to invest in building a
bundled customer base, together with customer turnover, contributed to the
decline in long distance customers and revenue, although the effect on revenue
of the decline in customers was offset partially by an increase in average
monthly revenue per customer due to price increases. We expect this decline in
long distance customers and revenues to continue.
 
 *Network
and Line Costs* . The
increase in network and line costs in the first quarter 2005 from 2004 was
primarily due to the increase in average bundled lines, partially offset by the
decrease in long distance customers. Network and line costs as a percentage of
revenue increased in the first quarter 2005 from 2004 due to inefficient
utilization relating to the advanced build out of our Michigan network,
migration costs and increased unbundled network element platform costs. To date,
we have been able to increase our prices to offset per line increases in network
and line cost, but these increases will increase customer turnover. Network and
line costs exclude depreciation and amortization of $5.6 million for the first
quarter 2005 and $1.2 million for the first quarter 2004.
 
 We accrue
expenses for network costs that we believe we have incurred pursuant to our
interconnection agreements with a particular supplier or tariffs but for which
we have not yet been billed. This primarily occurs due to errors and omissions
in billing on the part of our principal suppliers, the Regional Bell Operating
Companies. Accrued expenses are eliminated upon the earlier of actual billing
(including billing for charges appropriately recorded in prior periods but not
invoiced, or “backbilling”) by the Regional Bell Operating Companies or the
expiration of the time period for which we are liable for the charges. In
addition, we accrue for network expense not yet billed in a jurisdiction if we
believe there is a prospect that regulatory or other legal changes in the
jurisdiction will retroactively increase the rates we have charged. In Georgia,
an appeals court overturned a recent rate reduction by the state public utility
commission and ordered the commission to re-calculate our rates. This issue is
currently being considered by the state commission on remand from the court and
we expect that the issue will be resolved during 2005. We believe that these
rates will be in excess of those previously allowed and have accrued
accordingly.
 
 14
 
 We seek
to structure and price our products in order to maintain network and line costs
as a percentage of revenue at certain targeted levels. While the control of the
structure and pricing of our products assists us in mitigating risks of
increases in network and line costs, the telecommunications industry is highly
competitive and there can be no assurances that we will be able to effectively
market these higher priced products (see "Liquidity and Capital Resources, Other
Matters," below).
 
 We expect
the actions we will take, as a result of the recent regulatory changes, to focus
customer growth in areas where we have our own local network, currently
Michigan, and increase prices on our services, will cause the number of bundled
lines to decline in the future and reduce network and line costs, although the
amount of the reduction may be offset in part by the increased costs we may be
required to pay. Changes in the pricing of our service plans could also cause
network and line costs as a percentage of revenue to change in the future. See
our discussion under "Liquidity and Capital Resources, Other Matters,"
below.
 
 *General
and Administrative Expenses* . General
and administrative expenses increased in the first quarter 2005 from the first
quarter 2004. The 2005 increase was attributable to the period-to-period
increases in the number of employees to support our base of bundled customers
and our deployment of our local facilities. General and administrative expense
as a percentage of revenue decreased from the first quarter 2004 to the first
quarter 2005 due to the efficiencies of a growing base of revenues relative to
certain fixed operating expenses. We expect that as revenues decline in the
future, as we anticipate, general and administrative expense as a percentage of
revenues will increase.
 
 *Provision
for Doubtful Accounts* . The
provision for doubtful accounts increased in the first quarter 2005 from the
first quarter 2004. The increase was due to an increase in the average number of
bundled customers and revenue as well as an increase in bad debt expense as a
percentage of revenues. Bad debt
has increased as a percentage of revenue across all states. In addition, w e
increased market share outside of Michigan from the first quarter of 2004 to the
first quarter of 2005 into states where we have experienced generally higher
levels of bad debt.
 
 15
 *Sales
and Marketing Expenses* . Sales
and marketing expense decreased in the first quarter 2005 from the first quarter
2004. The decreases are primarily attributable to the decrease of sales and
marketing activity related to our bundled product, including decreased headcount
and reduced direct mail and media expenses due to our reduced efforts to
increase subscriber growth in markets other than those areas where we currently
have or plan to deploy network facilities. Included in sales and marketing
expenses are advertising expenses of $1.8 million for the first quarter 2005 and
$2.4 million for the first quarter 2004. We expect sales and marketing expenses
to decrease further during 2005 as we focus our marketing efforts only on
markets with potential for networking.
 
 *Interest
Expense* . The
decrease in interest expense for the first quarter 2005 from the first quarter
2004 is primarily attributable to the decreases in, and the retirement in 2004
of the balance of, the outstanding debt balances.
 
 *Depreciation
and Amortization.* Depreciation and amortization increased in the first quarter 2005 from the first
quarter 2004 primarily due to increased depreciation related to the reduction in
the remaining useful lives of our long distance switches. We expect depreciation
and amortization will remain at these levels for the balance of
2005.
 
 
 **LIQUIDITY
AND CAPITAL RESOURCES**
 
 Our
management assesses our liquidity in terms of our ability to generate cash to
fund our operations, our capital expenditures and our debt service obligations.
For the first quarters 2005 and 2004, our operating activities provided net cash
flow of $22.8 million and $11.9 million, respectively. In the first quarter
2005, more than half of the net cash flow from operating activities was used to
fund capital expenditures and capitalized software development costs. In the
first quarter 2004, the net cash flow from operating activities was used
primarily to reduce our outstanding debt obligations. As of March 31, 2005, we
had $57.2 million in cash and cash equivalents and long-term debt and capital
lease obligations (including current maturities) of $3.6 million, compared to
$29.7 million and $33.1 million, respectively, at March 31, 2004.
 
 Net cash
provided by (used in):
 ****
 ****
    
    **First
      Quarter**
      **(in thousands)**
    
    **Percent
      Change****2005**
    
    
    **2004**
    
    
    **2005
      vs. 2004**Operating
      activities
    
    $
    22,842
    
    $
    11,872
    
    
    92.4
    %Investing
      activities
    
    
    (13,189
    )
    
    (2,031
    )
    
    549.4Financing
      activities
    
    
    38
    
    
    (15,334
    )
    
    100.2
 
 
 *Cash
Provided By Operating Activities.* Cash
generated by operations increased by $11.0 million from the first quarter 2004
to the first quarter 2005. The increase was driven by higher cash flow before
changes in working capital and lower investment in working capital. The increase
in cash flow before changes in working capital was primarily driven by growth in
revenues, increases in network and line costs and significant reductions in
sales and marketing expense. As revenues are expected to decline in 2005, net
accounts receivable are also expected to decline. As operating expenses are
expected to decline in 2005, accounts payable should also be expected to
decline. The application of NOL carryforwards has limited our current payment of
income taxes to cash taxes for alternative minimum taxes and certain state
income taxes. We expect that our NOLs will be substantially utilized during
2007.
 
 16
 *Net
Cash Used in Investing Activities.* Capital
expenditures increased by $11.0 million during the first quarter 2005 as
compared to 2004 and capitalized software increased by $0.2 million. In the
first quarter 2005, approximately $11.2 million of our $12.2 million in capital
expenditures consisted of costs related to our deployment of networking assets
(local switch and colocation equipment) in Michigan.
 
 We expect
to spend between $43 and $47 million in capital expenditures and capitalized
software in 2005, primarily for the build out of the Michigan networking
facilities. We have not, however, previously developed and deployed a local
network of our own or of this scale and there can be no assurance that we
will not encounter unanticipated costs in acquiring the assets necessary for
such networking capability and its operation or in deploying the new network. In
addition, to the extent we identify other markets to deploy networking
facilities, our capital expenditures will increase accordingly.
 
 In the
first quarter 2005, capitalized software development costs totaled $1.0 million.
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.
 
 To the
extent that we are successful in identifying and completing acquisitions of
either customers, networking assets or businesses, net cash used in investing
activities may increase.
 
 *Net
Cash Used in Financing Activities.* Net cash
used in financing activities during the first quarter 2004 was $15.3 million,
primarily attributable to the payment of outstanding debt in the first quarter
2004. On June 1, 2004, we announced that our Board of Directors had authorized a
share buyback program for us to purchase up to $50 million of our outstanding
shares. The shares may be purchased from time to time, in the open market and/or
private transactions. Through March 31, 2005, we had not purchased any shares
under this program.
 
 While we
believe that we may have access to new capital in the public or private markets
to fund our ongoing cash requirements (including any acquisitions), 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.
 
 17
 **Other
Matters**
 
 Our
provision of telecommunications services is subject to government
regulation. **** To date,
our local telecommunications services have been provided almost exclusively
through the use of unbundled network elements purchased from incumbent local
exchange companies that were made available to us pursuant to FCC rules. It has
been primarily the availability of these unbundled network elements from
the incumbent local exchange 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.  As a result of the FCC’s final rules, since March 11, 2005,
the unbundled network element platform is no longer available to us for adding
new customers. Further, as of March 11, 2005 there is a $1 increase in the cost
per line, per month for us to continue providing service to our existing
customers that are on the unbundled network element platform. In addition, for
both local loops and dedicated transport, the FCC adopted a twelve-month
transition plan for competitive
local exchange companies, such as us, to
transition away from the use of DS1 and DS3 loops and dedicated transport where
there is no impairment, as defined in the FCC’s final rules, and an
eighteen-month transition plan to transition away from dark fiber. The
transition plans apply only to the customer base as it exists on March 11, 2005,
and do not permit competitive
local exchange companies to add
new dedicated transport unbundled
network elements in the
absence of impairment. The FCC’s final rules have been appealed by several
parties and we cannot predict the likelihood of success of such appeal or what
affect a successful appeal would have on our financial results.
 
 As a
result of the FCC’s final rules, we will be forced by March 11, 2006, to
transition our customers from the unbundled network element platform to our own
network facilities or to service our local customers through resale agreements
or through elements purchased through commercial agreements that we may enter
into with the incumbent local exchange companies. In 2003, we began deploying
networking assets in Michigan and, as of March 31, 2005, we had approximately
28,000 bundled lines on our Michigan network. We are continuing the expansion of
our network by colocating our networking equipment in the incumbent local
exchange companies’ end offices to provide service over our own network to a
larger existing customer base in geographic regions where we have a high density
of customers. We are also considering other ways of expanding our network
capacity and customer base, including by acquisition of capacity and customers
from other companies, both directly and by acquisition of such companies. By
December 31, 2005 we expect to have 175,000 bundled lines on our network in
Michigan, and we are actively exploring network opportunities in areas outside
of Michigan. However, 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.
 
 Furthermore, we are
subject to federal, state, local and foreign laws, regulations, and orders
affecting the rates, billing, terms, and conditions of certain of our service
offerings, our costs and other aspects of our operations, including our
relations with other service providers. Regulation varies in each jurisdiction
and may change in response to judicial proceedings, legislative and
administrative proposals, government policies, competition and technological
developments. We cannot predict what impact, if any, such changes or proceedings
may have on our business or results of operations, and we cannot guarantee that
regulatory authorities will not raise material issues regarding our compliance
with applicable regulations. There are
several regulatory factors that could cause our network and line costs as a
percentage of revenue to increase in the future, including without
limitation:
 
 
 18
 ·
    As
      a result of significant changes to the FCC rules that required the
      incumbent local exchange companies, such as the Regional Bell Operating
      Companies that are our principal suppliers, to provide us the unbundled
      network elements of their operating platforms on a wholesale basis, the
      wholesale operating platforms of the incumbent local exchange companies is
      effectively not available to us for our new customers after March 11, 2005
      or for all our customers after March 11, 2006. This determination and
      others by the FCC, courts, or state commission(s) that make unbundled
      local switching and/or combinations of unbundled network elements
      effectively unavailable to us in some or all of our geographic service
      areas, will require us either to provide services in these areas through
      other means, including total service resale agreements or commercial
      agreements with incumbent local exchange companies, purchase of
      special access services or network elements purchased from the Regional
      Bell Operating Companies at "just and reasonable" rates under Section 271
      of the Act, in all cases at significantly increased costs, or to provide
      services over our own switching facilities, if we are able to deploy them.
      As a consequence of these changes, our acquisition of customers from other
      companies who provide service using the unbundled network elements
      platform must be consummated in a manner whereby the transfer of the
      acquired customer is directly provisioned to our own network facilities,
      which, due to the limitations on the number of phone lines the incumbent
      local exchange company is required to “hot cut” over to our network per
      day, may limit or minimize the potential advantages of any such
      acquisition. However, we have not recently made any such acquisitions of
      customers, networking assets or businesses and there can be no assurances
      that we will be able to do so successfully.
 
 ·
    Adverse
      changes to the current pricing methodology, TELRIC, mandated by the FCC
      for use in establishing the prices charged to us by incumbent local
      exchange companies for the use of their unbundled network elements for so
      long as we are permitted to continue to use them, and for the use of
      transport and other services in connection with our local network. The
      FCC’s 2003 Triennial Review Order, which was reversed in part and remanded
      to the FCC with instructions to revise the Order in material ways
      clarified several aspects of these pricing principles related to
      depreciation, fill factors (i.e. network utilization) and cost of capital,
      which could enable incumbent local exchange companies to increase the
      prices for unbundled network elements. In addition, the FCC released a
      Notice of Proposed Rulemaking on December 15, 2003, which initiated a
      proceeding to consider making additional changes to its unbundled network
      element pricing methodology, including reforms that would base prices more
      on the actual network costs incurred by incumbent local exchange companies
      than on the hypothetical network costs that would be incurred when the
      most efficient technology is used.The
      TELRIC methodology still governs our pricing for loops purchased from the
      incumbent local exchange companies in connection with our local network.
      We cannot predict if the FCC will order new TELRIC pricing or if Congress
      will amend the 1996 Act, affecting such pricing or availability.These
      changes could result in material increases in prices charged to us for
      unbundled network elements, including those used in our own local network;
      and
 
 ·
    Determinations
      by state commissions to increase prices for unbundled network elements in
      ongoing state cost dockets.
 
 **Critical
Accounting Policies**
 
 In March
2005, the Financial Accounting Standards Board (“FASB”) issued Interpretation
Number 47, “Accounting for Conditional Asset Retirement Obligations, an
interpretation of FASB Statement No. 143” (“FIN 47”).  FIN 47 clarifies the
term “conditional asset retirement obligation” ** as used
in Statement of Financial Accounting Standards (“SFAS”) No. 143, “Accounting for
Asset Retirement Obligations,” and also clarifies when an entity would have
sufficient information to reasonably estimate the fair value of an asset
retirement.  FIN 47 is effective no later than the end of fiscal years
ending after December 15, 2005.  We are evaluating the implementation of
FIN 47 and whether it will have a material impact on our financial position,
results of operations or cash flows.
 
 19
 In
December 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based
Payments” (“SFAS No. 123R”). SFAS No. 123R requires the recognition of the cost
of employee services received in exchange for an award of equity instruments in
the financial statements and measurement based on the grant-date fair value of
the award. It requires the cost to be recognized over the period during which an
employee is required to provide service in exchange for the award. Additionally,
compensation expense will be recognized over the remaining employee service
period for the outstanding portion of any awards for which compensation expense
had not been previously recognized or disclosed under SFAS No. 123, “Accounting
for Stock-Based Compensation” (“SFAS No. 123”).  SFAS No. 123R replaces
SFAS No. 123, and supersedes Accounting Principles Board Opinion No. 25,
“Accounting for Stock Issued to Employees” (“APB No. 25”), and its related
interpretations.   We are currently assessing the implications of the
transition methods allowed and have not determined whether the adoption of FAS
123(R) will result in amounts similar to current pro-forma disclosures under FAS
123. We expect the adoption to have an adverse impact on future consolidated
statements of operations
 
 On April
15, 2005, the Securities and Exchange Commission posted Final Rule Number
33-8568, “Amendment to Rule 4-01(a) of Regulation S-X Regarding the Compliance
Date for Statement of Financial Accounting Standards No. 123 (Revised 2004), *Share-Based
Payment,* ” which
is effective as of April 21, 2005. Under the Commission’s amendment, we are
required to file financial statements that comply with SFAS No. 123R in our
Quarterly Report on Form 10-Q for the first quarter of the first fiscal year
that begins after June 15, 2005, and we are permitted, but not required, to
comply with SFAS No. 123R for periods before the required compliance date. The
requirements will be effective for us beginning with the first quarter of fiscal
2006. We are currently assessing the timing and impact of adopting SFAS No.
123R.
 
 **Item
3.**   **Quantitative
and Qualitative Disclosure about Market Risk.**
 
 In the
normal course of business, our financial position is subject to a variety of
risks, such as the collectibility of our accounts receivable and the
receivability of the carrying values of our long-term assets. Our long-term
obligations consist primarily of long term debt with fixed interest rates. We do
not presently enter into any transactions involving derivative financial
instruments for risk management or other purposes.
 
 Our
available cash balances are invested on a short-term basis (generally overnight)
and, accordingly, are not subject to significant risks associated with changes
in interest rates. Substantially all of our cash flows are derived from our
operations within the United States and we are not subject to market risk
associated with changes in foreign exchange rates.
 
 
 20
 **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 March 31, 2005. Based upon this
evaluation, and due to the material weaknesses in our internal control over
financial reporting discussed below and as reported in our 2004 Form 10-K, our
CEO and the CFO concluded that our disclosure controls and procedures were not
effective as of March 31, 2005.

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

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

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

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

1.
We did not maintain effective controls over the application of generally
accepted accounting principles related to the financial reporting process for
complex transactions. Specifically, we did not have personnel who possess
sufficient depth, skills and experience in the accounting for and review of
complex transactions in the financial reporting process to ensure that complex
transactions were accounted for in accordance with generally accepted accounting
principles.

2.
We did not maintain effective controls over sales, use and excise tax
liabilities. Specifically, our reconciliation and review procedures with respect
to sales, use and excise tax liability that we collect and remit did not
identify that certain customer fee revenue had been incorrectly recorded in the
sales, use and excise tax general ledger account.**
 21
 
 These
material weaknesses resulted in the restatement of our previously issued
consolidated financial statements for each of the quarters of 2003, the year
ended December 31, 2003, and the first, second and third quarters of 2004 and
certain adjustments to the fourth quarter 2004 financial statements as discussed
in greater detail in our 2004 Form 10-K.

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

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


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

2.
    Outside
      contractors with technical accounting capabilities have been and will be
      retained to the extent an issue is sufficiently complex and outside the
      technical accounting capabilities of our personnel. During the quarter
      there were no complex issues that required our retention of outside
      contractors with technical accounting capabilities. We have established
      processes to identify issues that would require such retention of outside
      contractors.

3.
    We
      have redesigned the account reconciliation process for sales, use and
      excise tax liabilities. Our Controller performed an in depth review of the
      account reconciliation and our
      Chief Accounting Officer confirmed the review process was completed. The
      reconciliation and review was performed for the quarter. Our objective is
      to complete thisprocess
      on a regular basis each quarter.
We believe that,
once fully implemented, these remediation actions will correct the material
weaknesses discussed above, provided, management has not yet completed its
assessment of the operational effectiveness of the new controls.

Except as discussed
above, there were no changes in our internal control over financial reporting
during our most recently completed fiscal quarter that have materially affected
or are reasonably likely to materially affect our internal control over
financial reporting, as defined in Rule 13a-15(f) under the Securities Exchange
Act.
 22
 **PART
II - OTHER INFORMATION**
 
 **Item
5.**  **Other
Information.**
 
 Effective
as of May 9, 2005, we entered into a three-year employment agreement with Thomas
Walsh. Under the contract, Mr. Walsh is entitled to a minimum annual base salary
of $200,000 and certain other perquisites made generally available to our senior
executive officers.
 
 **Item
6.**  **Exhibits.**
 
 (a)  Exhibits
 
 10.1
    Employment
      Agreement between Talk America Holdings, Inc. and Thomas M. Walsh, dated
      as of May 9, 2005. *
 
 31.1
    Rule
      13a-14(a) Certifications of Edward B. Meyercord, III (filed
      herewith).
 
 31.2
    Rule
      13a-14(a) Certifications of David G. Zahka (filed
    herewith).
 
 32.1
    Certification
      of Edward B. Meyercord, III Pursuant to 18 U.S.C. Section 1350, as Adopted
      Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished to
      the Commission herewith).
 
 32.2
    Certification
      of David G. Zahka Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant
      to Section 906 of the Sarbanes-Oxley Act of 2002 (furnished to the
      Commission herewith).
 
 *
Management contract or compensation plan or arrangement.
  23
 
 **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:
      May 9, 2005
    By:/s/ Edward B. Meyercord, III
      Edward
      B. Meyercord, III
      Chief
      Executive OfficerDate:
      May 9, 2005
    By:/s/ David G. Zahka
      David
      G. Zahka
      Chief
      Financial Officer (Principal Financial
Officer)