**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549-0001**

 

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**FORM 10-Q**

**(MARK ONE)**

**x****                             ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For thequarterly period ended June 30, 2006**

**OR**

**o****                                ****TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**Commission File Number 000-50706**

 

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**ESCHELON TELECOM, INC.**

(Exact name ofregistrant as specified in its charter)

| **Delaware**                              |   | **41-1843131**       |
|-------------------------------------------|--------|----------------------|
| (State or other  jurisdiction of          |   | (I.R.S. Employer     |
| incorporation or  organization)           |   | Identification  No.) |
|                                      |   |                 |
| **730  Second Avenue**                    |   |                 |
| **Minneapolis,  MN**                      |   | **55402**            |
| (Address of  principal executive offices) |   | (Zip Code)           |

 

Registrant’s telephonenumber, including area code: **(612) 376-4400**

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to the filing requirements for the past90 days.  Yes  x   No  o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.  See definition of“accelerated filer and large accelerated filer” in Rule 12b-2 of the ExchangeAct.
| Large accelerated filer o |   | Accelerated filer o |   | Non-accelerated filer x |
|---------------------------|--------|--------------------------|--------|-------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).Yes  o   No  x

As of July 31, 2006, the number of outstanding sharesof the Registrant’s Common Stock, par value $.01 per share, was 17,906,802shares.

 

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**ESCHELONTELECOM, INC.****INDEX TO FORM 10-Q**
| **PART I. FINANCIAL INFORMATION** |                                                                                                              |
|-----------------------------------|-------------------------------------------------------------------------------------------------------------------|
| ** **                        |                                                                                                              |
| Item 1.                           | Financial Statements:                                                                                             |   |
|                              |                                                                                                              |   |
|                              | Consolidated Balance  Sheets – December 31, 2005 and June 30, 2006 (Unaudited)                               |   |
|                              |                                                                                                              |   |
|                              | Unaudited  Consolidated Statements of Operations – Three months and six months ended  June 30, 2005 and 2006 |   |
|                              |                                                                                                              |   |
|                              | Unaudited  Consolidated Statements of Cash Flows – Six months ended June 30, 2005 and  2006                  |   |
|                              |                                                                                                              |   |
|                              | Notes to Consolidated  Financial Statements                                                                       |   |
|                              |                                                                                                              |   |
| Item 2.                           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                       |   |
|                              |                                                                                                              |   |
| Item 3.                           | Quantitative  and Qualitative Disclosures About Market Risk                                                       |   |
|                              |                                                                                                              |   |
| Item 4.                           | Controls and  Procedures                                                                                          |   |
|                              |                                                                                                              |   |
| **PART II. OTHER  INFORMATION**   |                                                                                                              |
| ** **                        |                                                                                                              |
| Item 1.                           | Legal Proceedings                                                                                                 |   |
|                              |                                                                                                              |   |
| Item  1A.                         | Risk  Factors                                                                                                     |   |
|                              |                                                                                                              |   |
| Item 2.                           | Unregistered  Sales of Equity Securities and Use of Proceeds                                                      |   |
|                              |                                                                                                              |   |
| Item 3.                           | Defaults  Upon Senior Securities                                                                                  |   |
|                              |                                                                                                              |   |
| Item 4.                           | Submission  of Matters to a Vote of Security Holders                                                              |   |
|                              |                                                                                                              |   |
| Item 5.                           | Other Information                                                                                                 |   |
|                              |                                                                                                              |   |
| Item  6.                          | Exhibits                                                                                                          |   |
|                              |                                                                                                              |   |
| Signature                         |                                                                                                              |   |

 

2

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**PARTI.  FINANCIAL INFORMATION**

 

## **Item1.  Financial Statements**

**Eschelon Telecom, Inc.**

**ConsolidatedBalance Sheets**

**(InThousands, Except Share and Per Share Amounts)**
| ** **                                                                                                                                                                              | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                                                                                                                                                              | ** ** | **2005**              | ** ** | **2006**          | ** ** |
| ** **                                                                                                                                                                              | ** ** | ** **            | ** ** | **(Unaudited)**   | ** ** |
| **Assets**                                                                                                                                                                              | ** ** | ** **            | ** ** | ** **        | ** ** |
| Current assets:                                                                                                                                                                         |       |                  |       |              |       |
| Cash and cash  equivalents                                                                                                                                                              |       | $                     | 26,062     |              | $          | 27,006 |   |
| Restricted cash                                                                                                                                                                         |       | 996                   |       | 680               |       |
| Available-for-sale  securities                                                                                                                                                          |       | 4,760                 |       | 64,190            |       |
| Accounts  receivable, net of allowance for doubtful accounts of $492 and $823,  respectively                                                                                            |       | 22,996                |       | 23,960            |       |
| Other  receivables                                                                                                                                                                      |       | 3,052                 |       | 3,972             |       |
| Inventories                                                                                                                                                                             |       | 2,927                 |       | 3,342             |       |
| Prepaid expenses                                                                                                                                                                        |       | 2,294                 |       | 2,407             |       |
| Total current assets                                                                                                                                                                    |       | 63,087                |       | 125,557           |       |
|                                                                                                                                                                                    |       |                  |       |              |       |
| Property and equipment,  net                                                                                                                                                            |       | 126,452               |       | 126,428           |       |
|                                                                                                                                                                                    |       |                  |       |              |       |
| Other assets                                                                                                                                                                            |       | 1,506                 |       | 1,540             |       |
| Goodwill                                                                                                                                                                                |       | 7,168                 |       | 27,585            |       |
| Intangible assets, net                                                                                                                                                                  |       | 33,333                |       | 35,229            |       |
| Total assets                                                                                                                                                                            |       | $                     | 231,546    |              | $          | 316,339 |   |
|                                                                                                                                                                                    |       |                  |       |              |       |
| **Liabilities and stockholders’  equity**                                                                                                                                          | ** ** | ** **            | ** ** | ** **        | ** ** |
| Current liabilities:                                                                                                                                                                    |       |                  |       |              |       |
| Accounts payable                                                                                                                                                                        |       | $                     | 16,400     |              | $          | 12,845 |   |
| Accrued  telecommunication costs                                                                                                                                                        |       | 4,227                 |       | 3,217             |       |
| Accrued office  rent                                                                                                                                                                    |       | 2,035                 |       | 1,759             |       |
| Accrued interest  expense                                                                                                                                                               |       | 2,646                 |       | 3,830             |       |
| Other accrued  expenses                                                                                                                                                                 |       | 5,485                 |       | 7,032             |       |
| Deferred revenue                                                                                                                                                                        |       | 7,921                 |       | 8,928             |       |
| Accrued  compensation expenses                                                                                                                                                          |       | 2,809                 |       | 3,117             |       |
| Capital lease  obligations, current maturities                                                                                                                                          |       | 2,430                 |       | 1,382             |       |
| Total current  liabilities                                                                                                                                                              |       | 43,953                |       | 42,110            |       |
|                                                                                                                                                                                    |       |                  |       |              |       |
| Long-term liabilities:                                                                                                                                                                  |       |                  |       |              |       |
| Commitments and  contingencies                                                                                                                                                          |       |                  |       |              |       |
| Other long-term  liabilities                                                                                                                                                            |       | 251                   |       | 352               |       |
| Capital lease  obligations, less current maturities                                                                                                                                     |       | 2,964                 |       | 3,755             |       |
| Notes payable                                                                                                                                                                           |       | 92,125                |       | 139,281           |       |
| Total liabilities                                                                                                                                                                       |       | 139,293               |       | 185,498           |       |
|                                                                                                                                                                                    |       |                  |       |              |       |
| Stockholders’ equity:                                                                                                                                                              |       |                  |       |              |       |
| Preferred stock,  $0.01 par value per share; 125,000,000 shares authorized; no shares issued  and outstanding                                                                           |       | —                |       | —            |       |
| Common stock,  $0.01 par value per share; 200,000,000 shares authorized; issued and  outstanding shares – 14,634,279 shares at December 31, 2005; and 17,902,633  at June 30, 2006 |       | 146                   |       | 175               |       |
| Additional  paid-in capital                                                                                                                                                             |       | 248,199               |       | 287,974           |       |
| Accumulated  other comprehensive income (loss)                                                                                                                                          |       | 56                    |       | (79               | )          |
| Accumulated  deficit                                                                                                                                                                    |       | (155,047              | )          | (157,229          | )          |
| Deferred  compensation                                                                                                                                                                  |       | (1,101                | )          | —            |       |
| Total stockholders’  equity                                                                                                                                                        |       | 92,253                |       | 130,841           |       |
| Total liabilities and  stockholders’ equity                                                                                                                                        |       | $                     | 231,546    |              | $          | 316,339 |   |

 

*See accompanying notes.*

3

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**Eschelon Telecom, Inc.**

**UnauditedConsolidated Statements of Operations**

**(InThousands, Except Share and Per Share Amounts)**
| ** **                                                          | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                          | ** ** | **2005**                                        | ** ** | **2006**                                      | ** ** | **2005** | ** ** | **2006** | ** ** |
| Revenue:                                                            |       |                                            |       |                                          |       |   |   |   |   |
| Network services                                                    |       | $                                               | 50,095     |                                          | $          | 60,920 |   | $ | 98,763 |   | $ | 113,705 |   |
| Business telephone systems                                          |       | 6,826                                           |       | 7,330                                         |       | 12,691 |   | 14,271 |   |
| Total revenue                                                       |       | 56,921                                          |       | 68,250                                        |       | 111,454 |   | 127,976 |   |
|                                                                |       |                                            |       |                                          |       |   |   |   |   |
| Costs and  expenses:                                                |       |                                            |       |                                          |       |   |   |   |   |
| Network services expense (excluding depreciation and  amortization) |       | 24,901                                          |       | 24,780                                        |       | 44,902 |   | 45,543 |   |
| Business telephone systems cost of revenue                          |       | 4,191                                           |       | 4,414                                         |       | 7,821 |   | 8,967 |   |
| Sales, general and administrative                                   |       | 23,080                                          |       | 25,973                                        |       | 45,445 |   | 48,672 |   |
| Depreciation and amortization                                       |       | 8,707                                           |       | 9,795                                         |       | 17,281 |   | 19,971 |   |
| Operating income  (loss)                                            |       | (3,958                                          | )          | 3,288                                         |       | (3,995 | ) | 4,823 |   |
|                                                                |       |                                            |       |                                          |       |   |   |   |   |
| Other income  (expense):                                            |       |                                            |       |                                          |       |   |   |   |   |
| Interest income                                                     |       | 102                                             |       | 759                                           |       | 233 |   | 992 |   |
| Interest expense                                                    |       | (4,952                                          | )          | (4,654                                        | )          | (9,814 | ) | (8,054 | ) |
| Other income, net of other expense                                  |       | 54                                              |       | 8                                             |       | 54 |   | 57 |   |
| Loss before  taxes                                                  |       | (8,754                                          | )          | (599                                          | )          | (13,522 | ) | (2,182 | ) |
| Income taxes                                                        |       | —                                          |       | —                                        |       | — |   | — |   |
| Net loss before  discontinued operation                             |       | (8,754                                          | )          | (599                                          | )          | (13,522 | ) | (2,182 | ) |
| Income from  discontinued operation                                 |       | 111                                             |       | —                                        |       | 111 |   | — |   |
| Net loss                                                            |       | (8,643                                          | )          | (599                                          | )          | (13,411 | ) | (2,182 | ) |
| Less preferred  stock dividends                                     |       | (1,088                                          | )          | —                                        |       | (2,167 | ) | — |   |
| Net loss  applicable to common stockholders                         |       | $                                               | (9,731     | )                                             | $          | (599 | ) | $ | (15,578 | ) | $ | (2,182 | ) |
|                                                                |       |                                            |       |                                          |       |   |   |   |   |
| Basic and  diluted income (loss) per share:                         |       |                                            |       |                                          |       |   |   |   |   |
| Continuing operations                                               |       | $                                               | (26.62     | )                                             | $          | (0.04 | ) | $ | (42.56 | ) | $ | (0.14 | ) |
| Discontinued operation                                              |       | 0.30                                            |       | —                                        |       | 0.30 |   | — |   |
| Net loss                                                            |       | $                                               | (26.32     | )                                             | $          | (0.04 | ) | $ | (42.26 | ) | $ | (0.14 | ) |
|                                                                |       |                                            |       |                                          |       |   |   |   |   |
| Weighted average  number of shares outstanding:                     |       |                                            |       |                                          |       |   |   |   |   |
| Basic and  diluted                                                  |       | 369,743                                         |       | 16,065,330                                    |       | 368,631 |   | 15,376,909 |   |

 

*See accompanying notes.*

4

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**Eschelon Telecom, Inc.**

**UnauditedConsolidated Statements of Cash Flows**

**(InThousands)**
| ** **                                                                            | ** ** | **Six months ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                            | ** ** | **June 30,**              | ** ** |
| ** **                                                                            | ** ** | **2005**                       | ** ** | **2006** | ** ** |
| **Operating  activities**                                                             | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net loss                                                                              |       | $                              | (13,411    | ) | $ | (2,182 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities:      |       |                           |       |   |   |
| Depreciation and amortization expense                                                 |       | 17,281                         |       | 19,971 |   |
| Other non-cash items                                                                  |       | 3,406                          |       | 3,447 |   |
| Changes in operating assets and liabilities:                                          |       |                           |       |   |   |
| Restricted cash                                                                       |       | (153                           | )          | 316 |   |
| Accounts receivable                                                                   |       | (2,457                         | )          | 1,004 |   |
| Inventories                                                                           |       | (120                           | )          | (415 | ) |
| Prepaid expenses and other assets                                                     |       | 520                            |       | (893 | ) |
| Discontinued assets held for sale, net of  liabilities                                |       | 810                            |       | — |   |
| Accounts payable and accrued expenses                                                 |       | (1,838                         | )          | (5,024 | ) |
| Deferred revenue                                                                      |       | 373                            |       | 215 |   |
| Accrued compensation expense                                                          |       | 1,230                          |       | 181 |   |
| Net cash  provided by operating activities                                            |       | 5,641                          |       | 16,620 |   |
|                                                                                  |       |                           |       |   |   |
| **Investing  activities**                                                             | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Purchase of  subsidiaries, net of cash acquired                                       |       | —                         |       | (19,956 | ) |
| Purchase of  assets held for sale, net of liabilities                                 |       | (216                           | )          | — |   |
| Purchases of  available-for-sale securities                                           |       | (18,637                        | )          | (68,268 | ) |
| Proceeds from  sales of available-for-sale securities                                 |       | 13,218                         |       | 8,800 |   |
| Purchases of  property and equipment                                                  |       | (9,253                         | )          | (12,023 | ) |
| Cash paid for  customer installation costs                                            |       | (6,640                         | )          | (7,579 | ) |
| Proceeds from  sales of assets                                                        |       | 6                              |       | 72 |   |
| Net cash used in  investing activities                                                |       | (21,522                        | )          | (98,954 | ) |
|                                                                                  |       |                           |       |   |   |
| **Financing  activities**                                                             | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Proceeds from  issuance of notes payable                                              |       | —                         |       | 45,600 |   |
| Payments made on  notes and capital lease obligations                                 |       | (1,028                         | )          | (1,278 | ) |
| Proceeds from  issuance of stock, net of fees                                         |       | 200                            |       | 40,267 |   |
| Increase in debt  issuance costs                                                      |       | (347                           | )          | (1,311 | ) |
| Net cash  provided by (used in) financing activities                                  |       | (1,175                         | )          | 83,278 |   |
|                                                                                  |       |                           |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                 |       | (17,056                        | )          | 944 |   |
| Cash and cash  equivalents at beginning of period                                     |       | 26,435                         |       | 26,062 |   |
| Cash and cash  equivalents at end of period                                           |       | $                              | 9,379      |   | $ | 27,006 |   |
|                                                                                  |       |                           |       |   |   |
| **Supplemental  cash flow information**                                               | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Cash paid for  interest                                                               |       | $                              | 7,323      |   | $ | 6,010 |   |
|                                                                                  |       |                           |       |   |   |
| **Supplemental  noncash activities**                                                  | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Equipment  purchases under capital leases                                             |       | $                              | 2,473      |   | $ | 1,021 |   |
| Value of common stock  issued to management and certain members of board of directors |       | $                              | 24         |   | $ | 6,045 |   |

 

*See accompanying notes.*

 

 

5

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**Eschelon Telecom, Inc.**

**Notes toConsolidated Financial Statements**

**(In Thousands, Except Share andPer Share Amounts)**

**(Unaudited)**

**1.)****          Summary of SignificantAccounting Policies**

**Basis of Presentation**

The accompanyingunaudited consolidated financial statements of Eschelon Telecom, Inc. and itssubsidiaries (the “Company”) have been prepared in accordance with accountingprinciples generally accepted in the United States of America for interimfinancial information and the instructions to Form 10-Q and Article 10 ofRegulation S-X promulgated by the United States Securities and ExchangeCommission (the “SEC”).  Accordingly,they do not include all of the information and notes required by accountingprinciples generally accepted in the United States of America for completefinancial statements.  In the opinion ofmanagement, all adjustments (consisting of normal and recurring adjustments andaccruals) considered necessary for a fair presentation for the periodsindicated have been included.  Operatingresults for the three and six month periods ended June 30, 2006 are notnecessarily indicative of the results that may be expected for the year endingDecember 31, 2006.  The consolidatedbalance sheet at December 31, 2005 has been derived from the audited consolidatedfinancial statements at that date but does not include all of the informationand footnotes required by generally accepted accounting principles for completefinancial statements.  These financialstatements should be read in conjunction with the Company’s audited financialstatements and related notes thereto for the year ended December 31, 2005included in the Eschelon Telecom, Inc. Form 10-K filed with the SEC on March17, 2006.

## **Principlesof Consolidation**

The consolidatedfinancial statements include the accounts of the Company and its wholly ownedsubsidiaries.  All intercompany balancesand transactions have been eliminated in consolidation.

## **Available-for-SaleSecurities**

Investments are comprisedof corporate, municipal and United States government debt securities andauction-rate securities with maturities of more than three months.  Because all investments in securitiesrepresent the investment of cash available for current operations, the Companyclassifies all investments as short-term. In accordance with Statement of Financial Accounting Standards (SFAS)No. 115, *Accounting for Certain Investments in Debt andEquity Securities*, and based on the Company’s intentions regardingthese instruments, all investments in debt securities are classified asavailable-for-sale and accounted for at fair value.  Fair value is determined by quoted marketprices, with unrealized gains and losses reported as a separate component ofstockholders’ equity.  The Company usesthe specific identification of securities sold method to recognize realizedgains and losses in earnings.

The cost basis,unrealized holding gains, unrealized holding losses and fair value of theinvestment securities available-for-sale as of December 31, 2005 and June 30,2006, are as follows:
| ** **                | ** ** | **December 31, 2005** | ** ** | **June 30, 2006** | ** ** |
|---------------------------|------------|---------------------------------|------------|-----------------------------|------------|
| ** **                | ** ** | ** **                      | ** ** | **Unrealized**              | ** ** | ** ** | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** |
| ** **                | ** ** | **Amortized**                   | ** ** | **Holding**                 | ** ** | ** ** | ** ** | **Amortized** | ** ** | **Holding** | ** ** | ** ** | ** ** |
| ** **                | ** ** | **Cost Basis**             | ** ** | **Gains**                   | ** ** | **Fair Value** | ** ** | **Cost Basis** | ** ** | **Losses** | ** ** | **Fair Value** | ** ** |
|                      |       |                            |       |                        |       |   |   |   |   |   |   |   |   |
| U.S. government  agencies |       | $                               | 1,961      |                        | $          | 26 |   | $ | 1,987 |   | $ | 8,014 |   | $ | (31 | ) | $ | 7 ,983 |   |
| Corporate  obligations    |       | 2,743                           |       | 30                          |       | 2,773 |   | 19,055 |   | (48 | ) | 19,007 |   |
| Auction rate  securities  |       | —                          |       | —                      |       | — |   | 37,200 |   | — |   | 37,200 |   |
| Total                     |       | $                               | 4,704      |                        | $          | 56 |   | $ | 4,760 |   | 64,269 |   | $ | (79 | ) | $ | 64,190 |   |
|                           |            |                                 |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

As of June 30, 2006, theavailable-for-sale securities have maturities that range from four months totwo years.

6

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**Property and Equipment**

Property and equipment,including leasehold improvements, are stated at cost.  Depreciation is provided using thestraight-line method over the estimated useful lives of the assets.  Leasehold improvements are amortized over theshorter of the related lease term or the estimated useful life of the asset.

All internal costsdirectly related to the construction of the switches and operating and supportsystems, including compensation of certain employees, are capitalized.

Property and equipmentconsist of the following:
|                                            | ** ** | **December 31,** | ** ** | **June 30,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|-------------------|------------|
| ** **                                 | ** ** | **2005**              | ** ** | **2006**          | ** ** |
|                                       |       |                  |       |              |       |
| Vehicles                                   |       | $                     | 1,375      |              | $          | 1,883 |   |
| Office furniture  and equipment            |       | 18,229                |       | 19,593            |       |
| Computer equipment  and software           |       | 41,897                |       | 44,795            |       |
| Leasehold  improvements                    |       | 23,765                |       | 25,172            |       |
| Switching and  data equipment and software |       | 134,661               |       | 141,919           |       |
|                                       |       | 219,927               |       | 233,362           |       |
| Less accumulated  depreciation             |       | (93,475               | )          | (106,934          | )          |
| Property and equipment,  net               |       | $                     | 126,452    |              | $          | 126,428 |   |

 

## **Goodwilland Other Intangible Assets**

Goodwill represents theexcess of cost over the fair value of net assets acquired.
| Goodwill at December 31,  2005       |   | $      | 7,168  |   |
|--------------------------------------|--------|--------|--------|--------|
| Acquisition of  Oregon Telecom, Inc. |   | 20,417 |   |
| Impairment  charges                  |   | — |   |
| Goodwill at June 30,  2006           |   | $      | 27,585 |   |

 

The Company allocated thepurchase price for Oregon Telecom, Inc. on a preliminary basis using theinformation available.  The allocation ofthe purchase price will be finalized in 2006. Upon completion of the final purchase price allocation, an additionalportion of the excess purchase price may be allocated to certain intangiblesthat are separable from goodwill.

Intangibles consist ofcustomer installation costs, debt issuance costs, customer relationships, non-competeagreements and developed technology.  Thecustomer installation costs are being amortized over a period of 48 months,which approximates the average life of a customer contract.  Debt issuance costs are being amortized overthe term of the respective debt obligation. Non-compete agreement costs represent costs associated with anon-compete agreement with a former employee. These costs are being amortized over the term of the agreement.  Customer relationships and developedtechnology are being amortized over four and three years, respectively.

Intangible assets consistof the following:
| ** **                   | ** ** | ** **       | ** ** | **December 31, 2005** | ** ** | **June 30, 2006**   | ** ** |
|------------------------------|------------|------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                   | ** ** | **Useful  Life** | ** ** | **Gross  Carrying  Amount**     | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** | **Gross  Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net** | ** ** |
| ** **                   | ** ** | **(years)**      | ** ** | ** **                      | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Customer  installation costs |       | 4                |       | $                               | 77,650     |                          | $          | 52,034 |   | $ | 25,616 |   | $ | 85,232 |   | $ | 57,998 |   | $ | 27,234 |   |
| Debt issuance  costs         |       | 4-6              |       | 5,666                           |       | 1,077                         |       | 4,589 |   | 6,976 |   | 1,566 |   | 5,410 |   |
| Customer  relationships      |       | 4                |       | 3,820                           |       | 955                           |       | 2,865 |   | 3,820 |   | 1,432 |   | 2,388 |   |
| Non-compete  agreements      |       | 3                |       | 300                             |       | 100                           |       | 200 |   | 300 |   | 150 |   | 150 |   |
| Developed  technology        |       | 3                |       | 94                              |       | 31                            |       | 63 |   | 94 |   | 47 |   | 47 |   |
| Total                        |       |             |       | $                               | 87,530     |                          | $          | 54,197 |   | $ | 33,333 |   | $ | 96,422 |   | $ | 61,193 |   | $ | 35,229 |   |

 

7

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**Stock-Based Compensation**

*Stock Option Plan*

A total of 1,632,414shares of the Company’s common stock have been authorized for issuance underthe Eschelon Telecom, Inc. Stock Option Plan of 2002 (the “2002 Plan”).  The 2002 Plan provides for grants ofincentive stock options, non-statutory stock options, stock appreciationrights, restricted or unrestricted stock awards, phantom stock, performanceawards and other stock-based awards to our employees, former employees,officers, directors and consultants.  The2002 Plan is administered by the Compensation Committee of the Board of Directorswith all grants subject to the approval by the Board of Directors.  The Compensation Committee has delegated themanagement of the 2002 Plan to the Company’s Executive Council.  The purpose of the 2002 Plan is to enable theCompany to attract, retain and reward the best-available persons, to provideparticipants with incentives to improve stockholder value and to contribute tothe growth and financial success of the Company through their future serviceswith the Company.  All of the Company’semployees, former employees, officers and directors are eligible to participatein the 2002 Plan.

The exercise price ofincentive stock options may not be less than the fair market value of the stockon the date of grant and the options are exercisable for a period not to exceedten years from the date of the grant. Options and restricted stock awards are typically subject to one of thefollowing vesting schedules:  (1) 20%upon the initial grant and 20% per year over four years from the date of grant,(2) 20% per year over five years from the date of grant, or (3) 33 1/3% uponthe initial grant and 33 1/3% per year over two years from the date ofgrant.  Awards granted may be subject toother vesting terms as determined by the Compensation Committee.

*Stock Options*

EffectiveJanuary 1, 2006, the Company adopted the provisions of SFAS No. 123R (SFAS123R), *Share Based Payment: an amendment of FASB StatementNo. 123 and FASB Statement No. 95,* which requires the measurementand recognition of compensation expense for all share-based payment awards toemployees and directors based on estimated fair values.  Prior to the adoption of SFAS 123R, theCompany accounted for its stock-based compensation under the recognition andmeasurement principles of Accounting Principles Board Opinion No. 25 (APB 25), *Accounting for Stock Issued to Employees,* and relatedinterpretations.  The Company recordedstock-based compensation expense under SFAS 123R for stock option awards of$225 and $561 for the three and six months ended June 30, 2006,respectively.  As a result of adoptingSFAS 123R on January 1, 2006, the Company’s net loss for the three and sixmonths ended June 30, 2006 is $86 and $283 greater, respectively, than if ithad continued to account for share-based compensation under APB 25.  As of June 30, 2006, there was $882 ofunrecognized compensation expense related to unvested options granted under theCompany’s share-based payment plans.  Theexpense is expected to be recognized over a weighted-average period of 1.2 years.

The Company adopted SFAS123R using the modified prospective transition method and the straight-lineattribution method for recognizing compensation expense.  Under the modified prospective transitionmethod, compensation expense recognized during the three and six months endedJune 30, 2006, included:  (a) thequarterly prorated portion of compensation expense for all share-based awardsgranted prior to January 1, 2006, but not yet vested, based on the grant datefair value estimated in accordance with the original provisions of SFAS 123,and (b) the quarterly prorated portion of compensation expense for allshare-based awards granted subsequent to adoption of SFAS 123R, based on thegrant date fair value estimated in accordance with the provisions of SFAS123R.  In accordance with the modifiedprospective transition method, the Company’s consolidated financial statementsfor periods prior to the adoption of SFAS 123R have not been restated toreflect the impact of the provisions of SFAS 123R.

The Company recordscompensation expense for employee stock options based on the estimated fairvalue of the options on the date of grant using assumptions required by SFAS123R.  Due to insufficient historyrelated to options, the Company uses the short-cut method accepted by the SECto determine the expected life of options. The Company expects to continue using the short-cut method for optionsgranted through December 31, 2007, after which the use of the short-cut methodis not permitted by the SEC.  Volatilityis estimated based on an exchange-traded telecommunications fund using datathat corresponds to the expected term of the options granted.  The risk-free interest rate is based on theFederal Reserve rate for U.S. government securities with a term that correspondsto the expected term of the options granted.  The Company uses historical data and other factors to estimate theexpected forfeiture rate.

8

----

The following tablesummarizes the assumptions used to estimate the fair value of options grantedduring the three and six-month periods ended June 30, 2005 and 2006 using theBlack-Scholes option-pricing model:
| ** **                       | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                       | ** ** | **2005**                                            | ** ** | **2006**                                          | ** ** | **2005** | ** ** | **2006** | ** ** |
| Expected  dividend yield         |       | —                                              |       | —                                            |       | — |   | — |   |
| Expected stock  price volatility |       | 25                                                  | %          | 26                                                | %          | 25 | % | 26 | % |
| Risk-free  interest rate         |       | 3.83%-4.24                                          | %          | 4.95                                              | %          | 3.71%-4.24 | % | 4.56%-4.95 | % |
| Expected life of  options        |       | 5 years                                             |       | 6 – 6.5 years                                |       | 5 years |   | 6 – 6.5 years |   |

 

Pro forma informationregarding net loss and net loss per share is required by SFAS 123, and has beendetermined as if the Company had accounted for its employee stock options underthe fair value method of SFAS 123.  Thefollowing table illustrates the effect on net loss per share for the three andsix months ended June 30, 2005, if the Company had applied the fair valuerecognition provision of SFAS 123, *Accounting for Stock-BasedCompensation,*to stock-based employee compensation:
| ** **                                                                                                         | ** ** | **Three months**       | ** ** | **Six months**         | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                         | ** ** | **ended**                   | ** ** | **ended**                   | ** ** |
| ** **                                                                                                         | ** ** | **June 30, 2005** | ** ** | **June 30, 2005** | ** ** |
| Net loss  applicable to common stockholders, as reported                                                           |       | $                           | (9,731     | )                           | $          | (15,578 | ) |
| Add: Stock-based  employee compensation expense included in reported net loss                                      |       | 636                         |       | 648                         |       |
| Deduct: Total  stock-based employee compensation expense determined under fair value-based  methods for all awards |       | (272                        | )          | (289                        | )          |
| Pro forma net  loss applicable to common stockholders                                                              |       | $                           | (9,367     | )                           | $          | (15,219 | ) |
|                                                                                                               |       |                        |       |                        |       |
| Net loss per  share:                                                                                               |       |                        |       |                        |       |
| Basic and diluted - as reported                                                                                    |       | $                           | (26.32     | )                           | $          | (42.26 | ) |
| Basic and  diluted - pro forma                                                                                     |       | $                           | (25.33     | )                           | $          | (41.28 | ) |

 

The following tablesummarizes the option activity under the 2002 Plan:
| ** **                        | ** ** | **Number of   Options** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|-----------------------------------|------------|-----------------------------------|------------|---------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------|------------|
|                              |       |                              |       |                                        |       |                                                 |       |                                |       |
| Outstanding at  December 31, 2005 |       | 1,167,490                         |       | $                                           | 4.12       |                                                 |       |                                |       |   |
| Granted                           |       | 33,607                            |       | 14.08                                       |       |                                                 |       |                                |       |
| Canceled                          |       | (15,696                           | )          | 7.82                                        |       |                                                 |       |                                |       |
| Exercised                         |       | (328,355                          | )          | 0.76                                        |       |                                                 |       |                                |       |
| Outstanding at  June 30, 2006     |       | 857,046                           |       | $                                           | 5.72       |                                                 | 8.20       |                                | $          | 8,353 |   |
|                              |       |                              |       |                                        |       |                                                 |       |                                |       |
| Exercisable at June 30,  2006     |       | 418,560                           |       | $                                           | 4.32       |                                                 | 7.92       |                                | $          | 4,667 |   |

 

The weighted-averagegrant-date fair value of options granted during the three months ended June 30,2005 and 2006, was $6.19 and $5.75, respectively.  The weighted-average grant-date fair value ofoptions granted during the six months ended June 30, 2005 and 2006, was $6.90and $5.18, respectively.  The totalintrinsic value for options exercised during the three months ended June 30,2005 and 2006, was $105 and $1,655, respectively. The total intrinsic value foroptions exercised during the six months ended June 30, 2005 and 2006, was $110and $4,362, respectively.

Cash received from optionexercises for the three months ended June 30, 2005 and 2006, was $43 and $97,respectively, and for the six months ended June 30, 2005 and 2006 cash receivedwas $44 and $250, respectively.

9

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*Restricted and UnrestrictedCommon Stock*

In 2003, the Companygranted 183,399 shares of restricted common stock to certain of its directorsand members of management.  The Companyrecords compensation expense as the restrictions are removed from the stock.  In 2005, the Company granted 9,350 shares ofunrestricted common stock to certain directors. In 2006, the Company granted 390,000 shares of restricted common stockto certain of its members of management. Total compensation expense related to restricted and unrestricted commonstock for the six months ended June 30, 2005 and 2006, was $36 and $78,respectively.

The following tablesummarizes the activity of the Company’s unvested restricted common shares forthe six months ended June 30, 2006:
|                                | ** ** | **Number of   Shares** | ** ** | **Weighted  Average Grant-  Date Fair Value** | ** ** |
|--------------------------------|------------|----------------------------------|------------|--------------------------------------------------------------|------------|
|                           |       |                             |       |                                                         |       |
| Unvested at  December 31, 2005 |       | 31,686                           |       | $                                                            | 0.68       |   |
| Granted                        |       | 390,000                          |       | 15.50                                                        |       |
| Vested                         |       | (15,842                          | )          | 0.68                                                         |       |
| Forfeited                      |       | —                           |       | —                                                       |       |
| Unvested at June 30,  2006     |       | 405,844                          |       | $                                                            | 14.92      |   |

 

## **NetIncome (Loss) Per Share**

Basic earnings per shareis computed based on the weighted average number of common sharesoutstanding.  Diluted earnings per shareis computed based on the weighted average number of common shares outstandingadjusted by the number of additional shares that would have been outstandinghad potentially dilutive common shares been issued.  Potentially dilutive shares of common stockinclude unexercised stock options and unvested restricted stock grants.  The Company does not have any potentiallydilutive shares because net losses were reported in all periods presented.

**2.)****          Acquisitions**

***Oregon Telecom, Inc.***

On April 1, 2006, theCompany completed its acquisition of Oregon Telecom, Inc. (“OTI”), aprivately-held competitive services provider based in Salem, Oregon.  The Company paid approximately $20,268 incash to acquire OTI.  The results of OTIhave been included in the consolidated financial statements since the date ofacquisition.  As a result of theacquisition, the Company strengthened its presence in the Oregon market andcreated opportunities for cost savings and increased profitability.

The Company allocated thepurchase price on a preliminary basis using the information thenavailable.  The allocation of thepurchase price will be finalized in 2006. Upon completion of the final purchase price allocation, an additionalportion of the excess purchase price may be allocated to certain intangiblesthat are separable from goodwill.
| Cash                    |   | $      | 312    |   |
|-------------------------|--------|--------|--------|--------|
| Other current  assets   |   | 2,986  |   |
| Property and  equipment |   | 529    |   |
| Other assets            |   | 72     |   |
| Goodwill                |   | 20,417 |   |
| Current  liabilities    |   | (3,834 | )      |
| Long-term  liabilities  |   | (214   | )      |
| Total purchase price    |   | $      | 20,268 |   |

 

10

----

The Company accrued $934in acquisition related expenses, which include severance benefits, relocationcosts and contract termination fees.  AtJune 30, 2006, the balance in the acquisition reserve was as follows:
| Balance at April 1, 2006  |   | $  | 934 |   |
|---------------------------|--------|----|-----|--------|
| Payments                  |   | (7 | )   |
| Balance at June 30,  2006 |   | $  | 927 |   |

 

**3.)****          Notes Payable**

On March 29, 2006, theCompany completed an offering of $48,000 of 8 3/8% senior second secured notes(“notes”) due 2010 at a discount resulting in a 9.92% yield.  The notes were entered into under a fourthsupplemental indenture to the original indenture dated March 17, 2004, and havethe same terms and conditions of the original indenture.  The Company received net proceeds ofapproximately $44,289 after deducting fees and expenses associated with theoffering.  The Company’s acquisition ofOregon Telecom, Inc. on April 1, 2006, was financed with approximately $20,268of the proceeds from the offering.  Theremaining proceeds will be used for general corporate purposes and potentialfuture acquisitions.

**4.)****          Benefit ContributionPlan**

The Company has a definedcontribution salary deferral plan covering substantially all employees underSection 401(k) of the Internal Revenue Code. The Company contributes an amount equal to 45 cents for each dollarcontributed by each employee up to a maximum of 6% of each employee’scompensation.  The Company recognizedexpense for contributions to the plan for the three months ended June 30, 2005and 2006 of $242 and $267, respectively, and for the six months ended June 30,2005 and 2006 of $469 and $497, respectively.

**5.)****          Capital Stock**

**PreferredStock**

As a result of theCompany’s initial public offering of common stock in August 2005, all of theCompany’s then-outstanding shares of convertible preferred stock andaccumulated dividends were automatically converted to common stock.

After the conversion, theCompany has 125,000,000 of undesignated preferred shares authorized and noshares of preferred stock outstanding.

Prior to the conversion,under the terms of the Company’s Series A Convertible Preferred Stock andSeries B Convertible Preferred Stock (collectively, “Preferred Stock”), theholders were entitled to receive, when and if declared by the Board ofDirectors, cumulative dividends on each share of Preferred Stock at the rate of8% per year which accrued daily and, to the extent not paid, accumulatedquarterly in arrears.  At June 30, 2005,dividends in arrears were $10,944.

## **CommonStock**

On May 19, 2006, theCompany completed an offering of 2,550,000 shares of the Company’s common stockat $15.70 per share.  After deductingfees and expenses related to the offering, the Company received net proceeds ofapproximately $40,017, which will be used to fund potential futureacquisitions.

**6.)****          Condensed ConsolidatingFinancial Information**

The Company’s 8 3/8%senior second secured notes due 2010 issued by Eschelon Operating Company arefully and unconditionally guaranteed jointly and severally by the Company andall existing subsidiaries and the indenture governing the notes requires thatany future subsidiaries that are organized in the United States must alsoguarantee the notes on the same basis.

The following tablespresent condensed consolidating balance sheets at December 31, 2005 and June30, 2006; condensed consolidating statements of operations for the three andsix-month periods ended June 30, 2005 and 2006; and condensed consolidatingstatements of cash flows for the six-month periods ended June 30, 2005 and2006.

11

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**Unaudited Condensed ConsolidatingBalance Sheets**

**As of December 31, 2005**

**(InThousands)**
| ** **                                                 | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Assets**                                                 | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                            |       |                   |       |          |       |             |       |             |       |             |       |
| Cash and cash equivalents                                  |       | $                      | 25,070     |          | $          | —           |       | $                | 992        |             | $          | — |   | $ | 26,062 |   |
| Restricted cash                                            |       | 996                    |       | —        |       | —           |       | —           |       | 996              |       |
| Available-for-sale securities                              |       | 4,760                  |       | —        |       | —           |       | —           |       | 4,760            |       |
| Accounts receivable                                        |       | —                 |       | —        |       | 22,996           |       | —           |       | 22,996           |       |
| Other receivables                                          |       | —                 |       | —        |       | 3,052            |       | —           |       | 3,052            |       |
| Inventories                                                |       | —                 |       | —        |       | 2,927            |       | —           |       | 2,927            |       |
| Prepaid expenses                                           |       | 1,149                  |       | —        |       | 1,145            |       | —           |       | 2,294            |       |
| Total current  assets                                      |       | 31,975                 |       | —        |       | 31,112           |       | —           |       | 63,087           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Property and  equipment, net                               |       | 82,840                 |       | —        |       | 43,612           |       | —           |       | 126,452          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Investment in  affiliates                                  |       | 59,046                 |       | —        |       | —           |       | (59,046          | )          | —           |       |
| Other assets                                               |       | 507                    |       | —        |       | 999              |       | —           |       | 1,506            |       |
| Goodwill                                                   |       | —                 |       | —        |       | 7,168            |       | —           |       | 7,168            |       |
| Intangible  assets, net                                    |       | 13,695                 |       | 4,588         |       | 15,050           |       | —           |       | 33,333           |       |
| Total assets                                               |       | $                      | 188,063    |          | $          | 4,588            |       | $                | 97,941     |             | $          | (59,046 | ) | $ | 231,546 |   |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Liabilities  and stockholders’ equity (deficit)**   | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current  liabilities:                                      |       |                   |       |          |       |             |       |             |       |             |       |
| Accounts payable                                           |       | $                      | 14,602     |          | $          | —           |       | $                | 1,798      |             | $          | — |   | $ | 16,400 |   |
| Accrued telecommunication costs                            |       | —                 |       | —        |       | 4,227            |       | —           |       | 4,227            |       |
| Accrued office rent                                        |       | 1,485                  |       | —        |       | 550              |       | —           |       | 2,035            |       |
| Accrued interest expense                                   |       | —                 |       | 2,645         |       | 1                |       | —           |       | 2,646            |       |
| Other accrued expenses                                     |       | 944                    |       | —        |       | 4,541            |       | —           |       | 5,485            |       |
| Deferred revenue                                           |       | —                 |       | —        |       | 7,921            |       | —           |       | 7,921            |       |
| Accrued compensation expenses                              |       | 1,623                  |       | —        |       | 1,186            |       | —           |       | 2,809            |       |
| Capital lease obligations, current maturities              |       | 2,320                  |       | —        |       | 110              |       | —           |       | 2,430            |       |
| Total current  liabilities                                 |       | 20,974                 |       | 2,645         |       | 20,334           |       | —           |       | 43,953           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Long-term  liabilities:                                    |       |                   |       |          |       |             |       |             |       |             |       |
| Other long-term liabilities                                |       | 251                    |       | —        |       | —           |       | —           |       | 251              |       |
| Capital lease obligations, less current maturities         |       | 2,857                  |       | —        |       | 107              |       | —           |       | 2,964            |       |
| Notes payable                                              |       | —                 |       | 92,125        |       | —           |       | —           |       | 92,125           |       |
| Due to (from) affiliates                                   |       | 213,724                |       | (106,099      | )          | (107,625         | )          | —           |       | —           |       |
| Total liabilities                                          |       | 237,806                |       | (11,329       | )          | (87,184          | )          | —           |       | 139,293          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Convertible  preferred stock                               |       | —                 |       | —        |       | —           |       | —           |       | —           |       |
| Stockholders’  equity (deficit)                       |       | (49,743                | )          | 15,917        |       | 185,125          |       | (59,046          | )          | 92,253           |       |
| Total liabilities and  stockholders’ equity (deficit) |       | $                      | 188,063    |          | $          | 4,588            |       | $                | 97,941     |             | $          | (59,046 | ) | $ | 231,546 |   |

 

12

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**UnauditedCondensed Consolidating Balance Sheets**

**As ofJune 30, 2006**

**(InThousands)**
| ** **                                                 | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Assets**                                                 | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                            |       |                   |       |          |       |             |       |             |       |             |       |
| Cash and cash equivalents                                  |       | $                      | 26,235     |          | $          | —           |       | $                | 771        |             | $          | — |   | $ | 27,006 |   |
| Restricted cash                                            |       | 680                    |       | —        |       | —           |       | —           |       | 680              |       |
| Available-for-sale securities                              |       | 64,190                 |       | —        |       | —           |       | —           |       | 64,190           |       |
| Accounts receivable                                        |       | —                 |       | —        |       | 23,960           |       | —           |       | 23,960           |       |
| Other receivables                                          |       | 386                    |       | —        |       | 3,586            |       | —           |       | 3,972            |       |
| Inventories                                                |       | —                 |       | —        |       | 3,342            |       | —           |       | 3,342            |       |
| Prepaid expenses                                           |       | 1,110                  |       | —        |       | 1,297            |       | —           |       | 2,407            |       |
| Total current  assets                                      |       | 92,601                 |       | —        |       | 32,956           |       | —           |       | 125,557          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Property and  equipment, net                               |       | 85,660                 |       | —        |       | 40,768           |       | —           |       | 126,428          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Investment in  affiliates                                  |       | 79,314                 |       | —        |       | —           |       | (79,314          | )          | —           |       |
| Other assets                                               |       | 530                    |       | —        |       | 1,010            |       | —           |       | 1,540            |       |
| Goodwill                                                   |       | —                 |       | —        |       | 27,585           |       | —           |       | 27,585           |       |
| Intangible  assets, net                                    |       | 15,206                 |       | 5,411         |       | 14,612           |       | —           |       | 35,229           |       |
| Total assets                                               |       | $                      | 273,311    |          | $          | 5,411            |       | $                | 116,931    |             | $          | (79,314 | ) | $ | 316,339 |   |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Liabilities  and stockholders’ equity (deficit)**   | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current  liabilities:                                      |       |                   |       |          |       |             |       |             |       |             |       |
| Accounts payable                                           |       | $                      | 10,542     |          | $          | —           |       | $                | 2,303      |             | $          | — |   | $ | 12,845 |   |
| Accrued telecommunication costs                            |       | —                 |       | —        |       | 3,217            |       | —           |       | 3,217            |       |
| Accrued office rent                                        |       | 988                    |       | —        |       | 771              |       | —           |       | 1,759            |       |
| Accrued interest expense                                   |       | —                 |       | 3,828         |       | 2                |       | —           |       | 3,830            |       |
| Other accrued expenses                                     |       | 1,552                  |       | —        |       | 5,480            |       | —           |       | 7,032            |       |
| Deferred revenue                                           |       | —                 |       | —        |       | 8,928            |       | —           |       | 8,928            |       |
| Accrued compensation expenses                              |       | 1,779                  |       | —        |       | 1,338            |       | —           |       | 3,117            |       |
| Capital lease obligations, current maturities              |       | 1,269                  |       | —        |       | 113              |       | —           |       | 1,382            |       |
| Total current  liabilities                                 |       | 16,130                 |       | 3,828         |       | 22,152           |       | —           |       | 42,110           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Long-term  liabilities:                                    |       |                   |       |          |       |             |       |             |       |             |       |
| Other long-term liabilities                                |       | 352                    |       | —        |       | —           |       | —           |       | 352              |       |
| Capital lease obligations, less current maturities         |       | 3,706                  |       | —        |       | 49               |       | —           |       | 3,755            |       |
| Notes payable                                              |       | —                 |       | 139,281       |       | —           |       | —           |       | 139,281          |       |
| Due to (from) affiliates                                   |       | 298,718                |       | (145,896      | )          | (152,822         | )          | —           |       | —           |       |
| Total  liabilities                                         |       | 318,906                |       | (2,787        | )          | (130,621         | )          | —           |       | 185,498          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Convertible  preferred stock                               |       | —                 |       | —        |       | —           |       | —           |       | —           |       |
| Stockholders’  equity (deficit)                       |       | (45,595                | )          | 8,198         |       | 247,552          |       | (79,314          | )          | 130,841          |       |
| Total liabilities and  stockholders’ equity (deficit) |       | $                      | 273,311    |          | $          | 5,411            |       | $                | 116,931    |             | $          | (79,314 | ) | $ | 316,339 |   |

 

13

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**Unaudited Condensed ConsolidatingStatement of Operations**

**For the Three Months Ended June30, 2005**

**(InThousands)**
| ** **                                                          | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                          | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                          | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Revenue:                                                            |       |                   |       |          |       |             |       |             |       |
| Network services                                                    |       | $                      | —     |          | $          | —           |       | $                | 50,095     |   | $ | 50,095 |   |
| Business telephone systems                                          |       | —                 |       | —        |       | 6,826            |       | 6,826            |       |
| Total revenue                                                       |       | —                 |       | —        |       | 56,921           |       | 56,921           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Costs and  expenses:                                                |       |                   |       |          |       |             |       |             |       |
| Network services expense (excluding depreciation and  amortization) |       | —                 |       | —        |       | 24,901           |       | 24,901           |       |
| Business telephone systems cost of revenue                          |       | —                 |       | —        |       | 4,191            |       | 4,191            |       |
| Sales, general and administrative                                   |       | 10,652                 |       | —        |       | 12,428           |       | 23,080           |       |
| Depreciation and amortization                                       |       | 5,416                  |       | —        |       | 3,291            |       | 8,707            |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Operating income  (loss)                                            |       | (16,068                | )          | —        |       | 12,110           |       | (3,958           | )          |
| Other income  (expense)                                             |       | (92                    | )          | (4,723        | )          | 19               |       | (4,796           | )          |
| Income (loss)  before income taxes                                  |       | (16,160                | )          | (4,723        | )          | 12,129           |       | (8,754           | )          |
| Income taxes                                                        |       | —                 |       | —        |       | —           |       | —           |       |
| Net income  (loss) before discontinued operation                    |       | (16,160                | )          | (4,723        | )          | 12,129           |       | (8,754           | )          |
| Income from  discontinued operation, net of tax                     |       | —                 |       | —        |       | 111              |       | 111              |       |
| Net income (loss)                                                   |       | $                      | (16,160    | )             | $          | (4,723           | )          | $                | 12,240     |   | $ | (8,643 | ) |

 

14

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**Unaudited Condensed ConsolidatingStatement of Operations**

**For the Three Months Ended June30, 2006**

**(InThousands)**
| ** **                                                          | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                          | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                          | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Revenue:                                                            |       |                   |       |          |       |             |       |             |       |
| Network services                                                    |       | $                      | —     |          | $          | —           |       | $                | 60,920     |   | $ | 60,920 |   |
| Business telephone systems                                          |       | —                 |       | —        |       | 7,330            |       | 7,330            |       |
| Total revenue                                                       |       | —                 |       | —        |       | 68,250           |       | 68,250           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Costs and  expenses:                                                |       |                   |       |          |       |             |       |             |       |
| Network services expense (excluding depreciation and  amortization) |       | —                 |       | —        |       | 24,780           |       | 24,780           |       |
| Business telephone systems cost of revenue                          |       | —                 |       | —        |       | 4,414            |       | 4,414            |       |
| Sales, general and administrative                                   |       | 13,411                 |       | —        |       | 12,562           |       | 25,973           |       |
| Depreciation and amortization                                       |       | 5,617                  |       | —        |       | 4,178            |       | 9,795            |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Operating income  (loss)                                            |       | (19,028                | )          | —        |       | 22,316           |       | 3,288            |       |
| Other income  (expense)                                             |       | 492                    |       | (4,380        | )          | 1                |       | (3,887           | )          |
| Income (loss)  before income taxes                                  |       | (18,536                | )          | (4,380        | )          | 22,317           |       | (599             | )          |
| Income taxes                                                        |       | —                 |       | —        |       | —           |       | —           |       |
| Net income (loss)                                                   |       | $                      | (18,536    | )             | $          | (4,380           | )          | $                | 22,317     |   | $ | (599 | ) |

 

15

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**Unaudited Condensed ConsolidatingStatement of Operations**

**For the Six Months Ended June 30,2005**

**(InThousands)**
| ** **                                                          | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                          | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                          | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Revenue:                                                            |       |                   |       |          |       |             |       |             |       |
| Network services                                                    |       | $                      | —     |          | $          | —           |       | $                | 98,763     |   | $ | 98,763 |   |
| Business telephone systems                                          |       | —                 |       | —        |       | 12,691           |       | 12,691           |       |
| Total revenue                                                       |       | —                 |       | —        |       | 111,454          |       | 111,454          |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Costs and  expenses:                                                |       |                   |       |          |       |             |       |             |       |
| Network services expense (excluding depreciation and  amortization) |       | —                 |       | —        |       | 44,902           |       | 44,902           |       |
| Business telephone systems cost of revenue                          |       | —                 |       | —        |       | 7,821            |       | 7,821            |       |
| Sales, general and administrative                                   |       | 21,125                 |       | —        |       | 24,320           |       | 45,445           |       |
| Depreciation and amortization                                       |       | 10,688                 |       | —        |       | 6,593            |       | 17,281           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Operating income  (loss)                                            |       | (31,813                | )          | —        |       | 27,818           |       | (3,995           | )          |
| Other income  (expense)                                             |       | (159                   | )          | (9,397        | )          | 29               |       | (9,527           | )          |
| Income (loss)  before income taxes                                  |       | (31,972                | )          | (9,397        | )          | 27,847           |       | (13,522          | )          |
| Income taxes                                                        |       | —                 |       | —        |       | —           |       | —           |       |
| Net income  (loss) before discontinued operation                    |       | (31,972                | )          | (9,397        | )          | 27,847           |       | (13,522          | )          |
| Income from  discontinued operation, net of tax                     |       | —                 |       | —        |       | 111              |       | 111              |       |
| Net income (loss)                                                   |       | $                      | (31,972    | )             | $          | (9,397           | )          | $                | 27,958     |   | $ | (13,411 | ) |

 

16

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**Unaudited Condensed ConsolidatingStatement of Operations**

**For the Six Months Ended June 30,2006**

**(InThousands)**
| ** **                                                          | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                          | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                          | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Revenue:                                                            |       |                   |       |          |       |             |       |             |       |
| Network services                                                    |       | $                      | —     |          | $          | —           |       | $                | 113,705    |   | $ | 113,705 |   |
| Business  telephone systems                                         |       | —                 |       | —        |       | 14,271           |       | 14,271           |       |
| Total revenue                                                       |       | —                 |       | —        |       | 127,976          |       | 127,976          |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Costs and expenses:                                                 |       |                   |       |          |       |             |       |             |       |
| Network services  expense (excluding depreciation and amortization) |       | —                 |       | —        |       | 45,543           |       | 45,543           |       |
| Business  telephone systems cost of revenue                         |       | —                 |       | —        |       | 8,967            |       | 8,967            |       |
| Sales, general  and administrative                                  |       | 26,133                 |       | —        |       | 22,539           |       | 48,672           |       |
| Depreciation and  amortization                                      |       | 11,226                 |       | —        |       | 8,745            |       | 19,971           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Operating income (loss)                                             |       | (37,359                | )          | —        |       | 42,182           |       | 4,823            |       |
| Other income (expense)                                              |       | 736                    |       | (7,719        | )          | (22              | )          | (7,005           | )          |
| Income (loss) before  income taxes                                  |       | (36,623                | )          | (7,719        | )          | 42,160           |       | (2,182           | )          |
| Income taxes                                                        |       | —                 |       | —        |       | —           |       | —           |       |
| Net income (loss)                                                   |       | $                      | (36,623    | )             | $          | (7,719           | )          | $                | 42,160     |   | $ | (2,182 | ) |

 

17

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**UnauditedCondensed Consolidating Statement of Cash Flows****For the Six Months Ended June 30, 2005****(In Thousands)**
| ** **                                             | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                             | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                             | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                                   |       |                   |       |          |       |             |       |             |       |
| Total cash provided by  (used in) operating activities |       | $                      | (19,636    | )             | $          | (6,338           | )          | $                | 31,615     |   | $ | 5,641 |   |
|                                                   |       |                   |       |          |       |             |       |             |       |
| **Investing activities**                               | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Purchase of assets held  for sale, net of liabilities  |       | —                 |       | —        |       | (216             | )          | (216             | )          |
| Purchases of available-for-sale  securities            |       | (18,637                | )          | —        |       | —           |       | (18,637          | )          |
| Proceeds from sales of  available-for-sale securities  |       | 13,218                 |       | —        |       | —           |       | 13,218           |       |
| Purchases of property  and equipment                   |       | (5,677                 | )          | —        |       | (3,576           | )          | (9,253           | )          |
| Cash paid for customer  installation costs             |       | (3,082                 | )          | —        |       | (3,558           | )          | (6,640           | )          |
| Proceeds from sale of  assets                          |       | 6                      |       | —        |       | —           |       | 6                |       |
| Total cash used in  investing activities               |       | (14,172                | )          | —        |       | (7,350           | )          | (21,522          | )          |
|                                                   |       |                   |       |          |       |             |       |             |       |
| **Financing activities**                               |       |                   |       |          |       |             |       |             |       |
| Payments made on notes  and capital lease obligations  |       | (978                   | )          | —        |       | (50              | )          | (1,028           | )          |
| Proceeds from issuance  of stock, net of fees          |       | 200                    |       | —        |       | —           |       | 200              |       |
| Increase in debt  issuance costs                       |       | —                 |       | (347          | )          | —           |       | (347             | )          |
| Change in due to/from  affiliates                      |       | 15,345                 |       | 6,685         |       | (22,030          | )          | —           |       |
| Total cash provided by  (used in) financing activities |       | 14,567                 |       | 6,338         |       | (22,080          | )          | (1,175           | )          |
|                                                   |       |                   |       |          |       |             |       |             |       |
| Increase (decrease) in  cash and cash equivalents      |       | (19,241                | )          | —        |       | 2,185            |       | (17,056          | )          |
| Cash and cash  equivalents at beginning of period      |       | 26,332                 |       | —        |       | 103              |       | 26,435           |       |
| Cash and cash equivalents at end of period             |       | $                      | 7,091      |          | $          | —           |       | $                | 2,288      |   | $ | 9,379 |   |

 

18

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**UnauditedCondensed Consolidating Statement of Cash Flows****For the Six Months Ended June 30, 2006****(In Thousands)**
| ** **                                             | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                             | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                             | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                                   |       |                   |       |          |       |             |       |             |       |
| Total cash  provided by (used in) operating activities |       | $                      | (27,492    | )             | $          | (5,047           | )          | $                | 49,159     |   | $ | 16,620 |   |
|                                                   |       |                   |       |          |       |             |       |             |       |
| **Investing  activities**                              | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Purchases of  subsidiaries, net of cash acquired       |       | —                 |       | —        |       | (19,956          | )          | (19,956          | )          |
| Purchases of  available-for-sale securities            |       | (68,268                | )          | —        |       | —           |       | (68,268          | )          |
| Proceeds from  sales of available-for-sale securities  |       | 8,800                  |       | —        |       | —           |       | 8,800            |       |
| Purchases of  property and equipment                   |       | (10,444                | )          | —        |       | (1,579           | )          | (12,023          | )          |
| Cash paid for  customer installation costs             |       | (4,224                 | )          | —        |       | (3,355           | )          | (7,579           | )          |
| Proceeds from  sale of assets                          |       | 72                     |       | —        |       | —           |       | 72               |       |
| Total cash used  in investing activities               |       | (74,064                | )          | —        |       | (24,890          | )          | (98,954          | )          |
|                                                   |       |                   |       |          |       |             |       |             |       |
| **Financing  activities**                              |       |                   |       |          |       |             |       |             |       |
| Proceeds from  issuance of notes payable               |       | —                 |       | 45,600        |       | —           |       | 45,600           |       |
| Payments made on  notes and capital lease obligations  |       | (1,223                 | )          | —        |       | (55              | )          | (1,278           | )          |
| Proceeds from  issuance of stock, net of fees          |       | 40,267                 |       | —        |       | —           |       | 40,267           |       |
| Increase in debt  issuance costs                       |       | —                 |       | (1,311        | )          | —           |       | (1,311           | )          |
| Change in due  to/from affiliates                      |       | 63,677                 |       | (39,242       | )          | (24,435          | )          | —           |       |
| Total cash  provided by (used in) financing activities |       | 102,721                |       | 5,047         |       | (24,490          | )          | 83,278           |       |
|                                                   |       |                   |       |          |       |             |       |             |       |
| Increase  (decrease) in cash and cash equivalents      |       | 1,165                  |       | —        |       | (221             | )          | 944              |       |
| Cash and cash  equivalents at beginning of period      |       | 25,070                 |       | —        |       | 992              |       | 26,062           |       |
| Cash and cash  equivalents at end of period            |       | $                      | 26,235     |          | $          | —           |       | $                | 771        |   | $ | 27,006 |   |

 

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**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

## **Forward-Lookingand Cautionary Statements**

We make “forward-lookingstatements” throughout this document. Whenever you read a statement that is not solely a statement ofhistorical fact (such as when we state that we “may,” “will” or “plan to”perform in a certain manner or that we “intend,” “believe,” “expect,” “anticipate,”“estimate” or “project” that an event will occur, or the negative thereof, andother similar statements), you should understand that our expectations may notbe correct, although we believe that they are reasonable.  You should also understand that our plans maychange.  We do not guarantee that the eventsdescribed in this document will happen as described or that any trends noted inthis document will continue.

Forward-lookingstatements, such as those regarding management’s present plans or expectationsfor new product offerings, capital expenditures, cost-saving strategies andgrowth are not guarantees of future performance.  They involve risks and uncertainties relativeto return expectations and related allocation of resources, and changingeconomic or competitive conditions, as well as the negotiation of agreementswith third parties and other factors discussed herein, which could cause actualresults to differ from present plans or expectations, and such differencescould be material.  Similarly, forward-lookingstatements regarding management’s present expectations for operating resultsand cash flow involve risks and uncertainties relative to these and otherfactors, such as the ability to increase revenues and/or to achieve costreductions and other factors discussed herein, which also would cause actualresults to differ from present plans. Such differences could be material. All forward-looking statements attributable to us or by any personsacting on our behalf are expressly qualified in their entirety by thesecautionary statements.

As such, actual resultsor circumstances may vary materially from such forward-looking statements orexpectations.  Readers are also cautionednot to place undue reliance on these forward-looking statements which speakonly as of the date these statements were made. Except as required by law, we do not have any obligation to update theseforward-looking statements, even if our situation changes in the future.

## **CompanyOverview**

We are a leadingfacilities-based provider of voice and data services and business telephonesystems in 23 markets in the western United States.  As a facilities-based competitivecommunications services provider, we provide services to our customersprimarily through our own network of telecommunications switches and relatedequipment and leased telecommunications lines, or transport.  We target the small and medium-sized businesssegment and currently serve approximately 60,000 customers, primarily withinthe local service territory of Qwest.

We measure ouroperational performance using a variety of indicators including revenue growth,the percentage of our revenue that comes from customers that we serve on-net,costs and expenses as a percentage of revenue and access line churn rates. Wemonitor key operating and customer service metrics to improve customer service,maintain the quality of our network and reduce costs.

The telecommunicationsindustry is highly competitive.  Webelieve we compete principally by offering superior customer service, accuratebilling, a broad set of services and systems and competitive pricing.  We compete with the Regional Bell Operating Companies(RBOCs), other competitive communications services providers, and long distanceand data service providers.  Whilewireless providers are competing with us, we do not believe they are acompetitive threat in the markets we serve nor are they likely to be in thenear future, because of the different service standards that business customersrequire.

**Key Components of Results of Operations**

***Revenue.***  Networkservices revenue consists primarily of local telephone service, long distanceservice, carrier access charges and data and Internet access services. Revenuefrom local telephone service consists of charges for basic local dial-toneservice, including dedicated T1 access, and custom-calling features such ascall waiting and call forwarding. Revenue from long distance service consistsof flat rated and per-minute-of-use charges for a full range of traditionalswitched and dedicated long distance, toll-free calling, international calling,calling card and operator services. Carrier access revenue consists primarilyof usage charges that we bill long distance carriers to originate and terminatecalls to and from our customers. In addition, in some of our markets wecurrently charge other local exchange carriers and wireless carriers usagecharges to terminate local and wireless calls to our customers (otherwise knownas reciprocal compensation).  Revenuefrom data

20

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and Internet access services consists primarily of monthly usage feesfor DSL and T1 circuits and Internet access services. We typically commit ourcustomers to contracts ranging from one to three years and provide discountsfor longer terms. Network services revenue comprised 88.8% of our total revenuefor the six months ended June 30, 2006, and represents a predominantlyrecurring revenue stream.

Monthly recurring network services revenue is recognized in the monththe services are used. In the case of local service revenue, monthly recurringlocal services charges are billed in advance but accrued for and recognized ona prorated basis based on length of service in any given month. Non-recurringrevenues associated with line installations are recognized over the averagelife of the customers. Long distance and carrier access usage charges arebilled in arrears but accrued based on monthly average usage. Prior to 2005, wehad not historically received any revenues from reciprocal compensation due toour bill-and-keep arrangement with Qwest. As a result of the acquisition of Advanced TelCom, Inc., which was notunder a bill-and-keep arrangement with the RBOCs, and our recently negotiatedreciprocal compensation agreements with a few wireless carriers, we recordedapproximately $0.2 million and $0.4 million of reciprocal compensation revenuefor the three and six-month periods ended June 30, 2006, respectively.  We do not have any wholesale revenue otherthan carrier access revenue and this reciprocal compensation.

Business telephone systems revenue consists of revenue from the sale oftelephone equipment and the servicing of telephone equipment systems. Telephoneequipment revenue is recognized upon delivery, completion of the installationand acceptance by the customer. Business telephone service revenue isrecognized upon completion of service or, in the case of maintenanceagreements, is spread equally over the life of the maintenance contract, whichtypically ranges from one to two years.

***Network Services Expense.***  Ournetwork services expense consists primarily of the cost of operating ournetwork facilities. The network components for our facilities-based businessinclude the cost of:

·                     leasinglocal loops and digital T1 lines which connect our customers to our network;

·                     leasinghigh capacity digital lines that connect our switching equipment to ourcolocations;

·                     leasinghigh capacity digital lines that interconnect our network with the RBOCs;

·                     leasingspace, power and terminal connections in the RBOC central offices forcolocating our equipment;

·                     signalingsystem network connectivity;

·                     leasingour ATM long-haul Internet backbone network; and

·                     Internettransit and peering, which is the cost of delivering Internet traffic from ourcustomers to the public Internet.

The costs to lease local loops, digital T1 lines and high capacitydigital interoffice transport facilities from the RBOCs vary by carrier and bystate and in many cases are regulated under federal and state laws. Invirtually all areas, we lease local loops, T1 lines and interoffice transportcapacity from the RBOCs. We lease interoffice facilities from carriers otherthan the RBOCs where possible in order to lower costs and improve networkredundancy; however, in most cases, the RBOCs are our only source for end-userlocal loops and T1 lines.  Historically,we purchased unbundled network elements platform, or UNE-P, from Qwest and Verizon,and customized network element packages, or UNE-E, from Qwest.  We also purchase, on a resale basis, Centrexservices, which are services for the portion of the public telephone switchthat is dedicated to a customer, from AT&T. The rates for UNE-P and Centrex were regulated and established by thevarious state corporation or utility commissions.  We entered into agreements with Qwest andVerizon for UNE-P replacement products in 2005. As of June 30, 2006, we had approximately 88,000 access lines in servicethat were formerly categorized as UNE-P access lines and are now provided undercommercial agreements.  The Qwest UNE-Eagreement was terminated with the adoption of Qwest’s commercial UNE-Preplacement product, QPP, and all Qwest UNE-E lines were moved to QPP onJanuary 1, 2005.  We believe we willincur higher costs in 2006 to obtain access to certain elements oftelecommunications platforms as a result of the Triennial Review Remand Order.  We will continue to migrate QPP lines to ourswitches as resources permit to help mitigate the increased costs.

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Our network services expense also includes the fees we pay for longdistance, data and other services. We have entered into long-term wholesalepurchasing agreements for these services. Some of the agreements containsignificant termination penalties and/or minimum usage volume commitments. Inthe event we fail to meet minimum volume commitments, we may be obligated topay underutilization charges. We do not anticipate having to pay any underutilizationcharges in the foreseeable future.

We carefully review all of our vendor invoices and frequently disputeinaccurate or inappropriate charges. In cases where we dispute certain charges,we frequently pay only undisputed amounts on vendor invoices in order to payproper amounts owed.  Our single largestvendor is Qwest.  We use estimates todetermine the level of success in dispute resolution and consider pasthistorical experience, basis of dispute, financial status and currentrelationship with vendors and aging of prior disputes in quantifying ourestimates.

We account for all of our networkdepreciation in depreciation and amortization expense and do not have anydepreciation expense in network services expense.

***Business Telephone SystemsCost of Revenue.***  Our most significant business telephonesystems costs of revenue are the equipment purchased from manufacturers andlabor for service installation. To take advantage of volume purchase discounts,we purchase equipment primarily from three manufacturers pursuant to masterpurchase agreements we have with these manufacturers. For all businesstelephone systems installations, our policy is to require a 30% deposit beforeordering the equipment so our risk of excess inventory or inventoryobsolescence is low. Business telephone systems cost of revenue also includessalaries and benefits of field technicians as well as vehicle and incidentalexpenses associated with equipment installation, maintenance and serviceprovisioning.

***Sales, General andAdministrative.***  Sales, general and administrative expensesare comprised primarily of salaries and benefits, bonuses, commissions,occupancy costs, sales and marketing expenses, bad debt, billing andprofessional services.

Determining our allowance fordoubtful accounts receivable requires significant estimates. We consider twoprimary factors in determining the proper level of the allowance, includinghistorical collections experience and the aging of the accounts receivableportfolio. We perform a credit review process on each new customer thatinvolves reviewing the customer’s current service provider bill and paymenthistory, matching customers with the National Telecommunications Data Exchangedatabase for delinquent customers and, in some cases, requesting credit reviewsthrough Dun and Bradstreet. For each of the six months ended June 30, 2005 and2006, our bad debt expense as a percentage of revenue was 0.3% and 0.6%respectively.

***Depreciation andAmortization.***  Our depreciation and amortization expensecurrently includes depreciation for network related voice and data equipment,back office systems, furniture, fixtures, leasehold improvements, officeequipment and computers. All internal costs directly related to the expansionof our network and operating and support systems, including salaries of certainemployees, are capitalized and depreciated over the lives of the switches orsystems, as the case may be. Capitalized customer installation costs areamortized over the approximate average life of a customer, which is currently48 months. Detailed time studies are used to determine laborcapitalization. These time studies are based on employee time sheets for thoseengaged in capitalizable activities.

**Acquisitions**

On April 1, 2006, we completed our acquisition of Oregon Telecom, Inc.(OTI), a privately-held competitive services provider based in Salem,Oregon.  OTI is a reseller of local, longdistance and Internet access services in Oregon to approximately 9,000 businesscustomers that have approximately 53,000 access lines.  We paid approximately $20.3 million in cashto acquire OTI.

We expect to develop and benefit from synergies as we integrate OTI intoour operations.  We estimate we willincur integration expenses of approximately $0.6 million as we integrate OTI’soperations and migrate OTI’s resale lines to our network.  We expect to spend approximately $4.7 millionfor capital expenditures for switch hardware and software for the increased on-switchlines and for computer hardware and software necessary to integrate and operateOTI.

In quarters subsequent to the quarter ended March 31, 2006, we expectrevenue, cost of sales, operating expenses and capital expenditures to increaseas a result of the acquisition of OTI.

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**Recent Developments**

On June 29, 2006, weannounced that that we signed a definitive agreement to acquire MountainTelecommunications, Inc. (MTI), a competitive services provider based in Tempe,Arizona.  We will pay approximately $40.0million in cash to acquire MTI.

On August 9, 2006, we announcedthat we signed a definitive agreement to acquire OneEighty Communications, Inc.(OneEighty), a competitive services provider based in Billings, Montana.  We will pay approximately $9.5 million incash to acquire OneEighty.

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**Resultsof Operations**

Selectedconsolidated financial and operating data for the three and six-month periodsended June 30, 2005 and 2006 is as follows (dollars in thousands, except perunit amounts):
| ** **                                                                  | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                                            | ** ** | **2006**                                          | ** ** | **% Change** | ** ** | **2005** | ** ** | **2006** | ** ** | **% Change** | ** ** |
| ** **                                                                  | ** ** | **(unaudited)**                                     | ** ** | **(unaudited)**                                   | ** ** | ** ** | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** ** | ** ** |
| Total revenue                                                               |       | $                                                   | 56,921     |                                              | $          | 68,250 |   | 19.9 | % | $ | 111,454 |   | $ | 127,976 |   | 14.8 | % |
| Capital  expenditures                                                       |       | $                                                   | 9,468      |                                              | $          | 11,603 |   | 22.6 | % | $ | 18,366 |   | $ | 20,623 |   | 12.3 | % |
| Cash, restricted  cash and available-for-sale securities (at end of period) |       | $                                                   | 22,026     |                                              | $          | 91,876 |   | 317.1 | % | $ | 22,026 |   | $ | 91,876 |   | 317.1 | % |
|                                                                        |       |                                                |       |                                              |       |   |   |   |   |   |   |   |   |
| Voice lines in  service (at end of period)                                  |       | 262,815                                             |       | 318,138                                           |       | 21.1 | % | 262,815 |   | 318,138 |   | 21.1 | % |
| Data lines in  service (at end of period)                                   |       | 134,821                                             |       | 177,913                                           |       | 32.0 | % | 134,821 |   | 177,913 |   | 32.0 | % |
| Total lines in  service (at end of period)                                  |       | 397,636                                             |       | 496,051                                           |       | 24.8 | % | 397,636 |   | 496,051 |   | 24.8 | % |
| Percent of lines  on switch (at end of period)                              |       | 84.0                                                | %          | 82.2                                              | %          | (2.2 | )% | 84.0 | % | 82.2 | % | (2.2 | )% |
| Lines sold                                                                  |       | 26,780                                              |       | 36,343                                            |       | 35.7 | % | 53,275 |   | 67,083 |   | 25.9 | % |
| Average monthly  access line churn (%)                                      |       | 1.38                                                | %          | 1.43                                              | %          | 3.9 | % | 1.45 | % | 1.49 | % | 3.4 | % |
| Average monthly  network services revenue per line                          |       | $                                                   | 42.48      |                                              | $          | 41.36 |   | (2.6 | )% | $ | 42.39 |   | $ | 41.48 |   | (2.2 | )% |
|                                                                        |       |                                                |       |                                              |       |   |   |   |   |   |   |   |   |
| Total employees  (at end of period)                                         |       | 1,134                                               |       | 1,269                                             |       | 11.9 | % | 1,134 |   | 1,269 |   | 11.9 | % |
| Quota-carrying  network service salespeople (at end of period)              |       | 208                                                 |       | 273                                               |       | 31.3 | % | 208 |   | 273 |   | 31.3 | % |
| Quota-carrying  BTS salespeople (at end of period)                          |       | 39                                                  |       | 48                                                |       | 23.1 | % | 39 |   | 48 |   | 23.1 | % |
| Total quota-carrying  salespeople (at end of period)                        |       | 247                                                 |       | 321                                               |       | 30.0 | % | 247 |   | 321 |   | 30.0 | % |

 

**Three Months Ended June 30, 2006Compared to Three Months Ended June 30, 2005**

***Revenue.***  Revenue for the three months ended June 30,2005 and 2006 is as follows:
|                            | ** ** | **2005**        | ** ** | **2006**        | ** ** | **% Change** | ** ** |
|----------------------------|------------|-----------------|------------|-----------------|------------|-------------------|------------|
| ** **                 | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **        | ** ** |
| Revenue (in  millions):    |       |            |       |            |       |              |       |
| Voice and data services    |       | $               | 38.0       |            | $          | 45.7              |       | 20.2 | % |
| Long distance              |       | 8.7             |       | 10.8            |       | 24.7              | %          |
| Access                     |       | 3.4             |       | 4.4             |       | 29.8              | %          |
| Total network services     |       | 50.1            |       | 60.9            |       | 21.6              | %          |
| Business telephone systems |       | 6.8             |       | 7.3             |       | 7.4               | %          |
| Total revenue              |       | $               | 56.9       |            | $          | 68.2              |       | 19.9 | % |

 

Network servicesrevenue was $60.9 million for the three months ended June 30, 2006, an increaseof 21.6% from $50.1 million in the same period of 2005.  The revenue growth is primarily due to theinclusion of OTI, which was acquired on April 1, 2006, and organic linegrowth.  Over the past 12 months thenumber of voice lines in service increased by 21.1% to 318,138 at June 30, 2006and the number of data lines in service increased by 32.0% to 177,913 at June30, 2006.  The revenue growth associatedwith access lines growth was partially offset by declines in data revenue perline due to a combination of customers purchasing more bandwidth at discountedprices and general pricing pressures for data services in our markets.  We increased our network services sales forcefrom 208 associates at June 30, 2005, to 273 associates at June 30, 2006.  We expect this increase in sales associateswill favorably impact our lines in service and revenue over the next severalquarters.

Business telephonesystems (BTS) revenue was $7.3 million for the three months ended June 30,2006, an increase of 7.4% from $6.8 million in the same period of 2005.  Theincrease in BTS revenue was primarily a result of increasing our BTS salesforce from 39 associates at

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June30, 2005 to 48 associates at June 30, 2006.  We anticipate this increasein the sale force will favorably impact our revenue in the future. However wecan not predict the future trends in capital spending by small and medium-sizedbusiness customers, which drives our BTS business.

***NetworkService Expense.*** Network services expense was $24.8 million for the three months endedJune 30, 2006, a decrease of 0.5% from $24.9 million in the same period of2005.  The decrease is due in part torecording approximately $4.7 million in costs related to the settlement withGlobal Crossing in June 2005, which is described in our Form 10-K filed withthe SEC on March 17, 2006.  Partiallyoffsetting this is approximately $4.0 million in costs related to the inclusionof OTI in the three months ended June 30, 2006. In addition, we continue to experience improvements in network servicesexpense relative to the growth in network services revenue due to several factors,including 1) our continued focus on selling high margin T1-based products, 2)continued higher churn of lower margin analog-based products, 3) favorablenegotiation of wholesale long distance costs, and 4) efficiencies associatedwith the integration of ATI.  As apercentage of related revenue, network services expense for the three monthsended June 30, 2006, decreased to 40.7% from 49.7% for the same period of 2005.

***BTSCost of Revenue.*** BTS cost of revenue was $4.4 million for the three months ended June 30,2006, an increase of 5.3% from $4.2 million in the same period of 2005.  Theincrease in BTS cost of revenue over the same period as last year is due to theincrease in materials expense to support the higher level of revenue.  As a percentage of related revenue, BTS costof revenue for the three months ended June 30, 2006 decreased to 60.2% from61.4% for the same period of 2005.  We donot expect future improvements in BTS cost of revenue as a percentage ofrelated revenue unless we are able to significantly increase BTS new systemssales and therefore achieve greater volume discounts or economies of scale inour workforce.

***Sales,General and Administrative Expense.***  Sales, general and administrative expenseswere $26.0 million for the three months ended June 30, 2006, an increase of12.5% from $23.1 million in the same period of 2005.  The increase is due to a number of factorsincluding 1) the inclusion of OTI, which was acquired on April 1, 2006, 2) anincrease in costs associated with the sales force expansion, 3) an increase inbad debt expense and operating taxes, and 4) costs associated with being apublic company.  As a percentage ofrevenue, sales, general and administrative expenses for the three months endedJune 30, 2006, declined to 38.1% from 40.5% in the same period of 2005 due tothe improved efficiency of our existing operations resulting from our largelyfixed cost structure supporting a higher level of revenue.  We expect expenses as a percentage of revenueto continue to decline.

***Depreciationand Amortization.*** Depreciation and amortization expense was $9.8 million for the threemonths ended June 30, 2006, an increase of 12.5% from $8.7 million in the sameperiod of 2005.  This increase wasprimarily due to the resulting additional depreciation expense from the true-upof fair market value of ATI assets at the end of 2005.  As a percentage of revenue, depreciation andamortization decreased to 14.4% for the three months ended June 30, 2006 from15.3% for the same period of 2005.

***Interest.***  Interest expense was $4.7 million for thethree months ended June 30, 2006, a decrease of 6.0% from $5.0 million in thesame period of 2005.  The decrease wasprimarily due to lower interest expense as a result of having a lower averageoutstanding debt balance for the three months ended June 30, 2006 compared tothe three months ended June 30, 2005.

***NetIncome (Loss).***  Netloss for the three months ended June 30, 2006, was $0.6 million compared to anet loss of $8.6 million in the same period of 2005.  This improvement is primarily due to theimprovement in operating income.

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**Six Months Ended June 30, 2006 Compared to SixMonths Ended June 30, 2005**

** **

***Revenue.***  Revenue for the six months ended June 30,2005 and 2006 is as follows:
|                            | ** ** | **2005**        | ** ** | **2006**        | ** ** | **% Change** | ** ** |
|----------------------------|------------|-----------------|------------|-----------------|------------|-------------------|------------|
| ** **                 | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **        | ** ** |
| Revenue (in  millions):    |       |            |       |            |       |              |       |
| Voice and data services    |       | $               | 75.2       |            | $          | 85.4              |       | 13.6 | % |
| Long distance              |       | 17.1            |       | 20.2            |       | 17.3              | %          |
| Access                     |       | 6.4             |       | 8.1             |       | 26.7              | %          |
| Total network services     |       | 98.7            |       | 113.7           |       | 15.1              | %          |
| Business telephone systems |       | 12.7            |       | 14.3            |       | 12.4              | %          |
| Total revenue              |       | $               | 111.4      |            | $          | 128.0             |       | 14.8 | % |

 

Network servicesrevenue was $113.7 million for the six months ended June 30, 2006, an increaseof 15.1% from $98.7 million in the same period of 2005.  The revenue growth is primarily due to theinclusion of OTI, which was acquired on April 1, 2006, and organic linegrowth.  Over the past 12 months thenumber of voice lines in service increased by 21.1% to 318,138 at June 30, 2006and the number of data lines in service increased by 32.0% to 177,913 at June30, 2006.  The revenue growth associatedwith access lines growth was partially offset by declines in data revenue perline due to a combination of customers purchasing more bandwidth at discountedprices and general pricing pressures for data services in our markets.  We increased our network services sales forcefrom 208 associates at June 30, 2005, to 273 associates at June 30, 2006.  We expect this increase in sales associateswill favorably impact our lines in service and revenue over the next severalquarters.

BTS revenue was$14.3 million for the six months ended June 30, 2006, an increase of 12.4% from$12.7 million in the same period of 2005. The increase in BTS revenue wasprimarily a result of increasing our BTS sales force from 39 associates at June30, 2005 to 48 associates at June 30, 2006.  We anticipate this increasein the sale force will favorably impact our revenue in the future. However wecan not predict the future trends in capital spending by small and medium-sizedbusiness customers, which drives our BTS business.

***NetworkServices Expense.*** Network services expense was $45.5 million for the six months ended June30, 2006, an increase of 1.4% from $44.9 million in the same period of2005.  2005 includes $4.7 million incosts related to the settlement with Global Crossing in June 2005, which isdescribed in our Form 10-K filed with the SEC on March 17, 2006.  2006 includes $4.0 million in costsassociated with OTI, which was acquired April 1, 2006.  In addition, we continue to experienceimprovements in network services expense relative to the growth in networkservices revenue due to several factors, including 1) our continued focus onselling high margin T1-based products, 2) continued higher churn of lowermargin analog-based products, 3) favorable negotiation of wholesale longdistance costs, and 4) efficiencies associated with the integration ofATI.  As a percentage of related revenue,network services expense for the six months ended June 30, 2006, decreased to40.1% from 45.5% for the same period of 2005.

***BTSCost of Revenue.*** BTS cost of revenue was $9.0 million for the six months ended June 30,2006, an increase of 14.7% from $7.8 million in the same period of 2005.  Theincrease in BTS cost of revenue over the same period as last year is due to theincrease in materials expense to support the higher level of revenue.  As a percentage of related revenue, BTS costof revenue for the six months ended June 30, 2006 increased to 62.8% from 61.6%for the same period of 2005.  We do notexpect future improvements in BTS cost of revenue as a percentage of relatedrevenue unless we are able to significantly increase BTS new systems sales andtherefore achieve greater volume discounts or economies of scale in ourworkforce.

***Sales,General and Administrative Expense.***  Sales, general and administrative expenseswere $48.7 million for the six months ended June 30, 2006, an increase of 7.1%from $45.4 million in the same period of 2005. The increase is due to a number of factors including 1) the inclusion ofOTI, which was acquired on April 1, 2006, 2) an increase in costs associatedwith the sales force expansion, 3) an increase in bad debt expense andoperating taxes, and 4) costs associated with being a public company.  As a percentage of revenue, sales, generaland administrative expenses for the six months ended June 30, 2006, declined to38.0% from 40.8% in the same period of 2005 due to the improved efficiency ofour existing

26

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operations resulting fromour largely fixed cost structure supporting a higher level of revenue.  We expect expenses as a percentage of revenueto continue to decline.

***Depreciationand Amortization.*** Depreciation and amortization expense was $20.0 million for the sixmonths ended June 30, 2006, an increase of 15.6% from $17.3 million in the sameperiod of 2005.  This increase wasprimarily due to the resulting additional depreciation expense from the true-upof fair market value of ATI assets at the end of 2005.  As a percentage of revenue, depreciation andamortization increased to 15.6% for the six months ended June 30, 2006 from15.5% for the same period of 2005.

***Interest.***  Interest expense was $8.1 million for the sixmonths ended June 30, 2006, a decrease of 17.9% from $9.8 million in the sameperiod of 2005.  The decrease wasprimarily due to lower interest expense as a result of having a lower averageoutstanding debt balance for the six months ended June 30, 2006 compared to thesix months ended June 30, 2005.

***NetLoss.***  Net loss forthe six months ended June 30, 2006, was $2.2 million compared to a net loss of$13.4 million in the same period of 2005. This improvement is primarily due to the improvement in revenuementioned above.

## **Liquidityand Capital Resources**

***PrincipalSources and Uses of Liquidity.* **Ourprincipal sources of liquidity are cash from operations and our cash and cashequivalents and available-for-sale securities. The net proceeds of $44.3 million from the offering of our 8 3/8% seniorsecond secured notes due 2010 on March 29, 2006 provided additional liquidityfor funding the Oregon Telecom, Inc. acquisition and any future acquisitionsand for general corporate purposes.  InMay 2006, we completed an offering of 2,550,000 shares of our common stock,$0.01 par value, at $15.70 per share.  Wereceived net proceeds of approximately $40.0 million after deducting associatedfees and expenses.  The net proceeds willbe used to fund potential future acquisitions. Our principal liquidity requirements consist of debt service, capitalexpenditures and working capital.

***CashFlows Provided by Operating Activities. ***Cashprovided by operating activities was $16.6 million for the six months endedJune 30, 2006 compared to cash provided by operating activities of $5.6 millionfor the same period of 2005.  The increase in cash provided by operatingactivities is primarily due to improvements in operating income and cash paidfor interest.  For the six month period ending June 30, 2006 operatingincome increased by $8.8 million and cash paid for interest decreased by $1.3million as compared to the same period in 2005.  We expect that our cashprovided by operating activities will continue to improve, however, not at thesame rate as the three month period ending June 30, 2006.  Please refer tothe network services expense section for further explanation.

***CashFlows Used in Investing Activities.***  Cash used in investing activities was $99.0million for the six months ended June 30, 2006 compared to $21.5 million forthe same period of 2005.  The increase isprimarily due to an increase in purchases of available-for-sale securities andthe purchase of OTI.  The amount investedin available-for-sale securities, net of proceeds from sales of securities, was$59.5 million for the six months ended June 30, 2006, compared to $5.4 millionin the same period of 2005.  Theinvestment in OTI was $20.3 million, net of cash acquired.  Other uses of cash for investing activitiesinclude the maintenance and expansion of our network and back office systems.

***CashFlows Provided by (Used in) Financing Activities.***  Cash provided by financing activities was$83.3 million for the six months ended June 30, 2006, compared to a use of cashof $1.2 million for the same period of 2005. On March 29, 2006, we completed an offering of $48.0 million in faceamount of 8 3/8% senior second secured notes due 2010 at a discount resultingin a 9.92% yield.  A portion of the $44.3million in net proceeds from the offering was used to finance the acquisitionof Oregon Telecom, Inc. on April 1, 2006. On May 19, 2006, we completed an offering of 2,550,000 shares of ourcommon stock resulting in proceeds of $40.0 million after deducting fees andexpenses.  We also used cash for paymentson capital lease obligations and for debt issuance costs.

***CapitalRequirements.***  Forthe six months ended June 30, 2006, we spent $20.6 million on capitalexpenditures.  We expect to spendapproximately $48.0 - $51.0 million on capital expenditures in 2006, including$3.6 million to operate and integrate Oregon Telecom, Inc. and $3.0 million foradditional switch hardware, labor and installation charges needed to expand thescope of and accelerate our sales effort.

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Based on our current level of operations and anticipated growth, webelieve that our existing cash, cash equivalents and short-term investmentswill be sufficient to fund our operations and we do not currently anticipatethe need to raise additional financing to fund capital expenditures oroperations for at least the next 12 months.  However, any future acquisitions or anysignificant unplanned costs or cash requirements may require that we raiseadditional funds through the issuance of debt or equity.

# **Item 3. Quantitative and Qualitative Disclosures About Market Risk**

We are not exposed tomarket risks from changes in foreign currency exchange rates or commodityprices.  We do not hold any derivativefinancial instruments nor do we hold any securities for trading or speculativepurposes.

We are exposed to changesin interest rates on our investments in cash equivalents and short-terminvestments.  However, interest incomefor the six-month period ended June 30, 2006 was $1.0 million, therefore notexposing us to any meaningful interest income risk had rates dropped.  We had $139.3 million in senior secondsecured notes outstanding as of June 30, 2006. These notes are at a fixed interest rate and are therefore not exposedto any interest rate risk.

# **Item 4: Controls and Procedures**

*Evaluation of Disclosure Controlsand Procedures*

Wemaintain disclosure controls and procedures that are designed to ensure thatinformation required to be disclosed in our reports under the SecuritiesExchange Act of 1934, as amended, is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms, andthat such information is accumulated and communicated to our management,including our principal executive officer and principal financial officer, asappropriate, to allow timely decisions regarding required disclosure.  In designing and evaluating the disclosurecontrols and procedures, management recognized that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures.

Asrequired by SEC Rule 13a-15(b), an evaluation was performed under thesupervision and with the participation of our management, including ourprincipal executive officer and our principal financial officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934) as of the end of the period covered by this report.  Based upon that evaluation, our management,including our principal executive officer and our principal financial officer,concluded that the design and operation of these disclosure controls andprocedures were effective at the reasonable assurance level.

*Changes in Internal Controls OverFinancial Reporting*

We continue to evaluatethe design and test the effectiveness of our internal controls over financialreporting in accordance with the requirements of Section 404 of the Sarbanes-OxleyAct of 2002.  As part of that effort, wehave enhanced or augmented certain internal controls as management deemednecessary.  However, there have been nochanges in our internal controls over financial reporting during our mostrecent fiscal quarter that have had an adverse material affect, or arereasonably likely to have an adverse material affect, on our internal controlsover financial reporting.

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**PART II.OTHER INFORMATION**

# **Item 1. Legal Proceedings**

Qwest has filed acomplaint against Advanced TelCom, Inc., an Eschelon subsidiary, and a numberof other competitive local exchange carriers with the Washington Utilities andTransportation Commission.  The complaintalleges that the defendants are illegally evading Qwest’s access charges, butdoes not specify the amount of damages sought. We have filed an answer denying Qwest’s allegations and we willvigorously defend ourselves.  We do notbelieve we commit the practices Qwest alleges but we cannot predict the outcomeof the case.

Weare party from time to time to ordinary course disputes that we do not believeto be material.

# **Item 1A. Risk Factors**

There are no materialdevelopments since our annual report on Form 10-K was filed on March 17, 2006.

**Item2.  Unregistered Sales of EquitySecurities and Use of Proceeds**

On March 29, 2006, wecompleted a $48.0 million tack-on offering of our senior second secured notesat a discount resulting in a 9.92% yield. After deducting fees and expenses associated with the offering, our netproceeds were approximately $44.3 million. Our acquisition of Oregon Telecom, Inc. on April 1, 2006, was financedwith approximately $20.3 million of the net proceeds from the offering.  The remaining net proceeds of approximately$24.0 million will be used for general corporate purposes and potential futureacquisitions.

On May 19, 2006, wecompleted an offering of 2,550,000 shares of our common stock, $0.01 par valueper share, at $15.70 per share.  Afterdeducting fees and expenses related to the offering, we received net proceedsof approximately $40.0 million, which will be used to fund potential futureacquisitions.

# **Item 3. Defaults Upon Senior Securities**

None.

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

At the Annual Meeting ofStockholders of Eschelon Telecom, Inc. on May 18, 2006, the Company’sstockholders approved the following matters by the vote indicated below:

(i) Election ofDirectors.
|                       | ** ** | **FOR**    | ** ** | **WITHHOLD** |
|-----------------------|------------|------------|------------|--------------|
| Richard A. Smith      |       | 14,338,465 |       | 3,502        |
| Clifford D.  Williams |       | 14,338,465 |       | 3,502        |
| Louis L. Massaro      |       | 14,338,465 |       | 3,502        |
| Marvin C. Moses       |       | 14,338,465 |       | 3,502        |
| Mark E. Nunnelly      |       | 14,313,265 |       | 28,702       |
| Ian K. Loring         |       | 14,338,465 |       | 3,502        |
| James P.  TenBroek    |       | 14,313,265 |       | 28,702       |

 

(ii) Ratification ofErnst & Young LLP as Independent Registered Public Accounting Firm for2006.
| FOR        | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** | **BROKER NON-VOTE** |
|------------|------------|-------------|------------|-------------|------------|---------------------|
| 14,340,347 |       | 100         |       | 1,520       |       | 0                   |

 

(iii) Approval ofAmendment to the 2002 Stock Incentive Plan.
| FOR        | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** | **BROKER NON-VOTE** |
|------------|------------|-------------|------------|-------------|------------|---------------------|
| 10,786,179 |       | 87,501      |       | 76,720      |       | 3,391,567           |

 

**Item 5.  Other Information**

 

None.

**Item 6.  Exhibits**

 
| Exhibit  Number | ** ** | **Description**                                                                                      |
|-----------------|------------|------------------------------------------------------------------------------------------------------|
| 31.1*           |       | Certification by Chief Executive Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002. |
| 31.2*           |       | Certification by Chief Financial Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002. |
| 32.1†      |       | Certification by Chief Executive Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2†      |       | Certification by Chief Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |

 

----

*  Filed herewith.

†  Furnished herewith.

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## **SIGNATURE**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                       |   | Eschelon Telecom, Inc. |                                                                       |
|-----------------------|--------|------------------------|----------------------------------------------------------------------------|
|                  |   |                   |
| Date: August 11, 2006 |   | By:                    | /S/ Geoffrey M. Boyd                                                       |   |
|                  |   |                   |                                                                       |
|                  |   | Name:                  | Geoffrey M. Boyd                                                           |   |
|                  |   | Title:                 | Chief Financial Officer                                                    |   |
|                  |   |                   | (Principal Financial and  Accounting Officer and Duly  Authorized Officer) |   |
|                       |        |                        |                                                                            |  |  |

 

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