**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

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

 

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**FORM 10-Q**

 

**(MARK ONE)**

 

**ý****                                      ****QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**For thequarterly period ended September 30, 2005**

 

**OR**

 

**o****                                      ****TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

 

**CommissionFile 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’stelephone number, including area code: **(612) 376-4400**

 

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Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to the filing requirements for thepast 90 days.  Yes ý     No o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act).  Yes o     No ý

 

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

 

As of November 10,2005, the number of outstanding shares of the Registrant’s Common Stock, parvalue $.01 per share, was 14,631,970 shares.

 

 

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**ESCHELON TELECOM, INC.**

**INDEX TO FORM 10-Q**

 
| **PART I.  FINANCIAL INFORMATION** | 3                                                                                                                            |
|----------------------------------------------|------------------------------------------------------------------------------------------------------------------------------|
|                                         |                                                                                                                         |   |
| Item 1.                                      | Financial Statements:                                                                                                        | 3 |
|                                         |                                                                                                                         |   |
|                                         | Consolidated Balance Sheets –  December 31, 2004 and September 30, 2005 (Unaudited)                           | 3 |
|                                         |                                                                                                                         |   |
|                                         | Unaudited  Consolidated Statements of Operations – Three months and nine months ended  September 30, 2004 and 2005 | 4 |
|                                         |                                                                                                                         |   |
|                                         | Unaudited Consolidated  Statements of Cash Flows – Nine months ended September 30, 2004 and 2005                   | 5 |
|                                         |                                                                                                                         |   |
|                                         | Notes to Consolidated  Financial Statements                                                                                  | 6 |
|                                         |                                                                                                                         |   |
| Item 2.                                      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                  | 21 |
|                                         |                                                                                                                         |   |
| Item 3.                                      | Quantitative  and Qualitative Disclosures About Market Risk                                                                  | 29 |
|                                         |                                                                                                                         |   |
| Item 4.                                      | Controls and  Procedures                                                                                                     | 29 |
|                                         |                                                                                                                         |   |
| **PART II. OTHER  INFORMATION**         | 30                                                                                                                           |
|                                         |                                                                                                                         |   |
| Item 1.                                      | Legal Proceedings                                                                                                            | 30 |
|                                         |                                                                                                                         |   |
| Item 2.                                      | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                 | 30 |
|                                         |                                                                                                                         |   |
| Item 3.                                      | Defaults Upon  Senior Securities                                                                                             | 30 |
|                                         |                                                                                                                         |   |
| Item 4.                                      | Submission  of Matters to a Vote of Security Holders                                                                         | 30 |
|                                         |                                                                                                                         |   |
| Item 5.                                      | Other Information                                                                                                            | 31 |
|                                         |                                                                                                                         |   |
| Item 6.                                      | Exhibits                                                                                                                     | 32 |
|                                         |                                                                                                                         |   |
| Signature                                    | 33                                                                                                                           |

 

2

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**PART I.  FINANCIAL INFORMATION**

 

## **Item1.  Financial Statements**

## ** **

**Eschelon Telecom, Inc.**

**Consolidated Balance Sheets**

**(In Thousands, Except Share and Per Share Amounts)**

 
| ** **                                                                                                                                                                                          | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                                                                                                                                                                          | ** ** | **2004**              | ** ** | **2005**               | ** ** |
| ** **                                                                                                                                                                                          | ** ** | ** **            | ** ** | **(Unaudited)**        | ** ** |
| **Assets**                                                                                                                                                                                          |       |                  |       |                   |       |
| Current assets:                                                                                                                                                                                     |       |                  |       |                   |       |
| Cash and cash  equivalents                                                                                                                                                                          |       | $                     | 26,435     |                   | $          | 14,117 |   |
| Restricted cash                                                                                                                                                                                     |       | 722                   |       | 829                    |       |
| Available-for-sale  securities                                                                                                                                                                      |       | 6,194                 |       | 15,878                 |       |
| Accounts  receivable, net of allowance for doubtful accounts of $817 and $522,  respectively                                                                                                        |       | 18,941                |       | 22,822                 |       |
| Other  receivables                                                                                                                                                                                  |       | 2,976                 |       | 3,484                  |       |
| Inventories                                                                                                                                                                                         |       | 2,873                 |       | 2,979                  |       |
| Prepaid expenses                                                                                                                                                                                    |       | 2,410                 |       | 2,324                  |       |
| Discontinued  assets held for sale                                                                                                                                                                  |       | —                |       | 703                    |       |
| Total current assets                                                                                                                                                                                |       | 60,551                |       | 63,136                 |       |
|                                                                                                                                                                                                |       |                  |       |                   |       |
| Property and equipment, net                                                                                                                                                                         |       | 102,849               |       | 102,763                |       |
|                                                                                                                                                                                                |       |                  |       |                   |       |
| Other assets                                                                                                                                                                                        |       | 1,985                 |       | 1,902                  |       |
| Goodwill                                                                                                                                                                                            |       | 38,776                |       | 38,776                 |       |
| Intangible assets, net                                                                                                                                                                              |       | 32,958                |       | 30,497                 |       |
| Total assets                                                                                                                                                                                        |       | $                     | 237,119    |                   | $          | 237,074 |   |
|                                                                                                                                                                                                |       |                  |       |                   |       |
| **Liabilities and stockholders’ equity (deficit)**                                                                                                                                             |       |                  |       |                   |       |
| Current liabilities:                                                                                                                                                                                |       |                  |       |                   |       |
| Accounts payable                                                                                                                                                                                    |       | $                     | 13,801     |                   | $          | 16,679 |   |
| Accrued  telecommunication costs                                                                                                                                                                    |       | 2,190                 |       | 2,161                  |       |
| Accrued office  rent                                                                                                                                                                                |       | 2,336                 |       | 2,210                  |       |
| Accrued interest  expense                                                                                                                                                                           |       | 4,070                 |       | 400                    |       |
| Accrued expenses                                                                                                                                                                                    |       | 5,998                 |       | 6,326                  |       |
| Deferred revenue                                                                                                                                                                                    |       | 7,300                 |       | 7,826                  |       |
| Accrued  compensation expenses                                                                                                                                                                      |       | 3,588                 |       | 3,295                  |       |
| Capital lease  obligation, current maturities                                                                                                                                                       |       | 1,629                 |       | 662                    |       |
| Discontinued  liabilities held for sale                                                                                                                                                             |       | —                |       | 1,710                  |       |
| Total current liabilities                                                                                                                                                                           |       | 40,912                |       | 41,269                 |       |
|                                                                                                                                                                                                |       |                  |       |                   |       |
| Long-term liabilities:                                                                                                                                                                              |       |                  |       |                   |       |
| Commitments and  contingencies                                                                                                                                                                      |       |                  |       |                   |       |
| Other long-term  liabilities                                                                                                                                                                        |       | 630                   |       | 811                    |       |
| Capital lease  obligation, less current maturities                                                                                                                                                  |       | 2,824                 |       | 4,972                  |       |
| Notes payable                                                                                                                                                                                       |       | 137,778               |       | 91,447                 |       |
| Total liabilities                                                                                                                                                                                   |       | 182,144               |       | 138,499                |       |
|                                                                                                                                                                                                |       |                  |       |                   |       |
| Series A  convertible preferred stock, $0.01 par value per share; 100,000,000 shares  authorized; issued and outstanding shares - 77,526,136 at December 31,  2004                        |       | 48,155                |       | —                 |       |
|                                                                                                                                                                                                |       |                  |       |                   |       |
| Series B  convertible preferred stock, $0.01 par value per share; 25,000,000 shares  authorized; issued and outstanding shares - 20,000,000 at December 31,  2004                         |       | 15,000                |       | —                 |       |
|                                                                                                                                                                                                |       |                  |       |                   |       |
| Stockholders’ equity (deficit):                                                                                                                                                                |       |                  |       |                   |       |
| Common stock,  $0.01 par value per share; 200,000,000 shares authorized; issued and  outstanding shares – 351,134 shares at December 31, 2004; and 14,631,539  at September 30, 2005 |       | 4                     |       | 146                    |       |
| Additional  paid-in capital                                                                                                                                                                         |       | 115,876               |       | 249,502                |       |
| Accumulated  other comprehensive income                                                                                                                                                             |       | 30                    |       | 87                     |       |
| Accumulated  deficit                                                                                                                                                                                |       | (124,056              | )          | (149,920               | )          |
| Deferred  compensation                                                                                                                                                                              |       | (34                   | )          | (1,240                 | )          |
| Total stockholders’ equity (deficit)                                                                                                                                                           |       | (8,180                | )          | 98,575                 |       |
| Total liabilities and stockholders’ equity (deficit)                                                                                                                                           |       | $                     | 237,119    |                   | $          | 237,074 |   |

 

*Seeaccompanying notes.*

 

3

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**Eschelon Telecom, Inc.**

**Unaudited Consolidated Statementsof Operations**

**(In Thousands, Except Share and Per Share Amounts)**

 
| ** **                                          | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                          | ** ** | **2004**                                   | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Revenue:                                            |       |                                       |       |                                      |       |   |   |   |   |
| Network services                                    |       | $                                          | 33,476     |                                      | $          | 51,181 |   | $ | 98,333 |   | $ | 149,944 |   |
| Business telephone  systems                         |       | 7,086                                      |       | 6,731                                     |       | 19,575 |   | 19,422 |   |
| Total revenue                                       |       | 40,562                                     |       | 57,912                                    |       | 117,908 |   | 169,366 |   |
|                                                |       |                                       |       |                                      |       |   |   |   |   |
| Cost of revenue:                                    |       |                                       |       |                                      |       |   |   |   |   |
| Network services                                    |       | 11,736                                     |       | 20,701                                    |       | 35,093 |   | 65,603 |   |
| Business  telephone systems                         |       | 4,305                                      |       | 4,093                                     |       | 11,785 |   | 11,914 |   |
| Total cost of revenue                               |       | 16,041                                     |       | 24,794                                    |       | 46,878 |   | 77,517 |   |
|                                                |       |                                       |       |                                      |       |   |   |   |   |
| Gross profit:                                       |       |                                       |       |                                      |       |   |   |   |   |
| Network services                                    |       | 21,740                                     |       | 30,480                                    |       | 63,240 |   | 84,341 |   |
| Business  telephone systems                         |       | 2,781                                      |       | 2,638                                     |       | 7,790 |   | 7,508 |   |
| Total gross profit                                  |       | 24,521                                     |       | 33,118                                    |       | 71,030 |   | 91,849 |   |
|                                                |       |                                       |       |                                      |       |   |   |   |   |
| Operating expenses:                                 |       |                                       |       |                                      |       |   |   |   |   |
| Sales, general  and administrative                  |       | 18,423                                     |       | 22,378                                    |       | 51,949 |   | 67,823 |   |
| Depreciation and  amortization                      |       | 7,493                                      |       | 9,011                                     |       | 22,705 |   | 26,292 |   |
| Operating income (loss)                             |       | (1,395                                     | )          | 1,729                                     |       | (3,624 | ) | (2,266 | ) |
|                                                |       |                                       |       |                                      |       |   |   |   |   |
| Other income (expense):                             |       |                                       |       |                                      |       |   |   |   |   |
| Interest income                                     |       | 45                                         |       | 269                                       |       | 83 |   | 502 |   |
| Interest expense                                    |       | (2,837                                     | )          | (14,798                                   | )          | (7,911 | ) | (24,612 | ) |
| Gain on  extinguishment of debt                     |       | —                                     |       | —                                    |       | 18,195 |   | — |   |
| Other income  (expense)                             |       | (138                                       | )          | (113                                      | )          | (161 | ) | (59 | ) |
| Income (loss) before taxes                          |       | (4,325                                     | )          | (12,913                                   | )          | 6,582 |   | (26,435 | ) |
| Income taxes                                        |       | (4                                         | )          | —                                    |       | (4 | ) | — |   |
| Net income (loss) before discontinued operation     |       | (4,329                                     | )          | (12,913                                   | )          | 6,578 |   | (26,435 | ) |
| Income from discontinued operation                  |       | —                                     |       | 460                                       |       | — |   | 571 |   |
| Net income (loss)                                   |       | (4,329                                     | )          | (12,453                                   | )          | 6,578 |   | (25,864 | ) |
| Less preferred stock dividends                      |       | (863                                       | )          | —                                    |       | (2,572 | ) | — |   |
| Net income (loss) applicable to common stockholders |       | $                                          | (5,192     | )                                         | $          | (12,453 | ) | $ | 4,006 |   | $ | (25,864 | ) |
|                                                |       |                                       |       |                                      |       |   |   |   |   |
| Net income (loss) per share:                        |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                               |       | $                                          | (17.62     | )                                         | $          | (1.49 | ) | $ | 14.14 |   | $ | (8.53 | ) |
| Diluted                                             |       | $                                          | (17.62     | )                                         | $          | (1.49 | ) | $ | 1.56 |   | $ | (8.53 | ) |
|                                                |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average number of shares outstanding:      |       |                                       |       |                                      |       |   |   |   |   |
| Basic                                               |       | 294,702                                    |       | 8,329,636                                 |       | 283,268 |   | 3,033,623 |   |
| Diluted                                             |       | 294,702                                    |       | 8,329,636                                 |       | 8,132,679 |   | 3,033,623 |   |

 

*See accompanying notes.*

 

4

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**Eschelon Telecom, Inc.**

**Unaudited Consolidated Statementsof Cash Flows**

**(In Thousands)**

 
| ** **                                                                                | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                                  | ** ** | **2005** | ** ** |
| **Operating activities**                                                                  |       |                                      |       |   |   |
| Net income (loss)                                                                         |       | $                                         | 6,578      |   | $ | (25,864 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                                      |       |   |   |
| Depreciation and  amortization expense                                                    |       | 22,705                                    |       | 26,292 |   |
| Other non-cash  items                                                                     |       | 2,212                                     |       | 7,940 |   |
| Gain on  extinguishment of debt                                                           |       | (18,195                                   | )          | — |   |
| Changes in  operating assets and liabilities:                                             |       |                                      |       |   |   |
| Restricted cash                                                                           |       | (651                                      | )          | (107 | ) |
| Accounts  receivable                                                                      |       | 171                                       |       | (4,643 | ) |
| Inventories                                                                               |       | 15                                        |       | (106 | ) |
| Other current  assets and deposits                                                        |       | 47                                        |       | (439 | ) |
| Discontinued  assets held for sale, net of liabilities                                    |       | —                                    |       | 1,223 |   |
| Accounts payable  and accrued expenses                                                    |       | 2,425                                     |       | (619 | ) |
| Deferred revenue                                                                          |       | 762                                       |       | 526 |   |
| Accrued  compensation expense                                                             |       | (949                                      | )          | (293 | ) |
| Net cash provided by operating activities                                                 |       | 15,120                                    |       | 3,910 |   |
|                                                                                      |       |                                      |       |   |   |
| **Investing activities**                                                                  |       |                                      |       |   |   |
| Purchase of net assets held for sale                                                      |       | —                                    |       | (216 | ) |
| Purchases of available-for-sale securities                                                |       | (4,357                                    | )          | (29,744 | ) |
| Proceeds from sale of available-for-sale securities                                       |       | —                                    |       | 20,315 |   |
| Purchases of property and equipment                                                       |       | (10,130                                   | )          | (14,173 | ) |
| Cash paid for customer installation costs                                                 |       | (8,442                                    | )          | (10,103 | ) |
| Proceeds from sales of assets                                                             |       | 25                                        |       | 238 |   |
| Net cash used in investing activities                                                     |       | (22,904                                   | )          | (33,683 | ) |
|                                                                                      |       |                                      |       |   |   |
| **Financing activities**                                                                  |       |                                      |       |   |   |
| Proceeds from issuance of notes payable                                                   |       | 84,813                                    |       | — |   |
| Payments made on bank debt and capital lease  obligations                                 |       | (66,599                                   | )          | (50,780 | ) |
| Proceeds from issuance of stock, net of fees                                              |       | 7                                         |       | 68,583 |   |
| Increase in debt issuance costs                                                           |       | (4,635                                    | )          | (348 | ) |
| Net cash provided by financing activities                                                 |       | 13,586                                    |       | 17,455 |   |
|                                                                                      |       |                                      |       |   |   |
| Net increase (decrease) in cash and cash equivalents                                      |       | 5,802                                     |       | (12,318 | ) |
| Cash and cash equivalents at beginning of period                                          |       | 8,606                                     |       | 26,435 |   |
| Cash and cash equivalents at end of period                                                |       | $                                         | 14,408     |   | $ | 14,117 |   |
| ** **                                                                                | ** ** | ** **                                | ** ** | ** ** | ** ** |
| **Supplemental cash flow information**                                                    |       |                                      |       |   |   |
| Cash paid for interest                                                                    |       | $                                         | 6,394      |   | $ | 18,317 |   |
|                                                                                      |       |                                      |       |   |   |
| **Supplemental noncash activities**                                                       |       |                                      |       |   |   |
| Equipment purchases under capital leases                                                  |       | $                                         | 1,872      |   | $ | 2,785 |   |
| Value of common stock issued to management and  certain members of board of directors     |       | $                                         | 14         |   | $ | 27 |   |

 

*Seeaccompanying notes.*

 

5

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**Eschelon Telecom, Inc.**

**Notes to Consolidated FinancialStatements**

**(In Thousands, Except Share and Per Share Amounts)**

**(Unaudited)**

 

**1.)****          Summaryof Significant Accounting Policies**

 

**Basis ofPresentation**

 

The accompanyingunaudited consolidated financial statements of Eschelon Telecom, Inc. andits subsidiaries (the “Company”) have been prepared in accordance withaccounting principles generally accepted in the United States of America forinterim financial information and the instructions to Form 10-Q and Article 10of Regulation 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 nine month periods ended September 30, 2005 arenot necessarily indicative of the results that may be expected for the yearending December 31, 2005.  Theconsolidated balance sheet at December 31, 2004 has been derived from theaudited consolidated financial statements at that date but does not include allof the information and footnotes required by generally accepted accountingprinciples for complete financial statements. These financial statements should be read in conjunction with theCompany’s audited financial statements and related notes thereto for the yearended December 31, 2004 included in the Eschelon Telecom, Inc. Form 10-Kfiled with the Securities and Exchange Commission on March 31, 2005.

 

**Reclassifications**

 

Certain prior year itemshave been reclassified to conform to current year presentation.

 

## **Available-for-Sale Securities**

## ** **

Short-term investments arecomprised of municipal and United States government debt securities withmaturities of more than three months but less than one year.  In accordance with SFAS No. 115, *Accounting for Certain Investments in Debt and Equity Securities*,and based on the Company’s intentions regarding these instruments, allinvestments in debt securities are classified as available-for-sale andaccounted for at fair value.  Fair valueis determined by quoted market prices, with unrealized gains and lossesreported as a separate component of stockholders’ deficit.  The Company uses the specific identificationof securities sold method to recognize realized gains and losses in earnings.

 

The cost basis, fairvalue and gross unrealized gains of the investment securities available-for-saleas of September 30, 2005 and December 31, 2004, are as follows:

 
| ** **                                                   | ** ** | ** **     | ** ** | ** **     | ** ** | **Gross**      | ** ** | **Gross**      | ** ** |
|--------------------------------------------------------------|------------|----------------|------------|----------------|------------|----------------|------------|----------------|------------|
| ** **                                                   | ** ** | ** **     | ** ** | ** **     | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** |
| ** **                                                   | ** ** | ** **     | ** ** | ** **     | ** ** | **Holding**    | ** ** | **Holding**    | ** ** |
| ** **                                                   | ** ** | **Cost Basis** | ** ** | **Fair Value** | ** ** | **Gains**      | ** ** | **(Losses)**   | ** ** |
|                                                         |       |           |       |           |       |           |       |           |       |
| Available-for-sale securities as of September 30,  2005 |       | $              | 15,791     |           | $          | 15,878         |       | $              | 108        |   | $ | (21 | ) |
|                                                         |       |           |       |           |       |           |       |           |       |
| Available-for-sale securities as of  December 31, 2004  |       | $              | 6,164      |           | $          | 6,194          |       | $              | 30         |   | $ | — |   |

 

Debt securities as of September 30,2005 have maturities of less than twelve months.

 

## **Property and Equipment**

## ** **

Property and equipment,including leasehold improvements, are stated at cost.  All internal costs directly related to theconstruction of the switches and operating and support systems, includingcompensation of certain employees, are capitalized.  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.

 

6

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Property and equipmentconsist of the following:

 
| ** **                                | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                | ** ** | **2004**              | ** ** | **2005**               | ** ** |
|                                      |       |                  |       |                   |       |
| Vehicles                                  |       | $                     | 590        |                   | $          | 1,170 |   |
| Office furniture and equipment            |       | 16,746                |       | 18,469                 |       |
| Computer equipment and software           |       | 34,534                |       | 40,097                 |       |
| Leasehold improvements                    |       | 19,504                |       | 19,819                 |       |
| Switching and data equipment and software |       | 99,736                |       | 107,641                |       |
|                                      |       | 171,110               |       | 187,196                |       |
| Less accumulated depreciation             |       | (68,261               | )          | (84,433                | )          |
|                                      |       | $                     | 102,849    |                   | $          | 102,763 |   |

 

## **Goodwill and Other Intangible Assets**

## ** **

Goodwill represents theexcess of cost over the fair value of net assets acquired.

 

Intangibles consist ofcustomer installation costs, debt issuance costs and non-competeagreements.  The customer installationcosts are being amortized over a period of 48 months, which approximates theaverage life of a customer contract. Debt issuance costs are being amortized over the term of the respectivedebt obligation.  Non-compete agreementcosts represent costs associated with various agreements the Company has enteredinto with existing management of the companies it has acquired and a settlementagreement with a former employee of the Company.  These costs are being amortized over theterms of the agreements.

 

On September 15,2005, the Company redeemed 35% of its outstanding 8 3/8% senior second securednotes due March 15, 2010.  Inconnection with the redemption, the Company wrote off a proportionate amount ofthe associated debt issuance costs resulting in a net decrease to intangibleassets and a corresponding increase to interest expense of $2,597.

 

Intangible assets consistof the following:

 
| ** **                    | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|-------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                    | ** ** | **2004**              | ** ** | **2005**               | ** ** |
|                          |       |                  |       |                   |       |
| Customer installation costs   |       | $                     | 64,087     |                   | $          | 74,204 |   |
| Debt issuance costs           |       | 8,368                 |       | 5,665                  |       |
| Non-compete agreements        |       | 15                    |       | 315                    |       |
|                          |       | 72,470                |       | 80,184                 |       |
| Less accumulated amortization |       | (39,512               | )          | (49,687                | )          |
|                          |       | $                     | 32,958     |                   | $          | 30,497 |   |

 

## **Notes Payable**

## ** **

On September 15,2005, the Company redeemed $50,630 accreted value ($57,750 principal amount) ofthe Company’s 8 3/8% senior second secured notes due March 15, 2010 at aredemption price of 112% of the accreted value. The $6,076 accreted-valuepremium was recorded as interest expense. Proceeds from the Company’s initial public offering of the Company’scommon stock (see Note 4) were used to redeem the notes. 

## ** **

## **Stock-Based Compensation**

## ** **

The Company accounts forits stock-based employee compensation under the recognition and measurementprinciples of Accounting Principles Board (APB) Opinion No. 25, *Accounting for Stock Issued to Employees,*and relatedinterpretations.  Under APB No. 25,when the exercise price of stock options equals the market price of theunderlying stock on the date of grant, no compensation expense is recognized inthe consolidated statement of operations.

 

In preparation for theCompany’s initial public offering of its common stock (see Note 4), the Company’sboard of directors assessed its prior contemporaneous determinations of fairvalue for stock option and stock grants made since May 2004 and madeadjustments to these prior determinations of fair value.  As a

 

7

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result of theseretrospective adjustments to fair value, the Company recognized compensationexpense associated with such stock option and stock grants of $784 in the ninemonths ended September 30, 2005. The Company will record a total of $1,219 of additional compensationexpense through July 2009, at which point all such stock options are fullyvested.

 

The following tableillustrates the effect on net income (loss) per share if the company hadapplied the fair value recognition provision of Statement of FinancialAccounting Standards (SFAS) No. 123, *Accounting for Stock-BasedCompensation,*to stock-based employee compensation:

 

8

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| ** **                                                                                                         | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2004**                                   | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Net income  (loss) applicable to common stockholders, as reported                                                  |       | $                                          | (5,192     | )                                         | $          | (12,453 | ) | $ | 4,006 |   | $ | (25,864 | ) |
| Add: Stock-based  employee compensation expense included in reported net income (loss)                             |       | —                                     |       | 148                                       |       | 20 |   | 796 |   |
| Deduct: Total  stock-based employee compensation expense determined under fair value-based methods  for all awards |       | (2                                         | )          | (123                                      | )          | (49 | ) | (412 | ) |
| Pro forma net  income (loss) applicable to common stockholders                                                     |       | $                                          | (5,194     | )                                         | $          | (12,428 | ) | $ | 3,977 |   | $ | (25,480 | ) |
|                                                                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Net income (loss) per share:                                                                                       |       |                                       |       |                                      |       |   |   |   |   |
| Basic - as  reported                                                                                               |       | $                                          | (17.62     | )                                         | $          | (1.49 | ) | $ | 14.14 |   | $ | (8.53 | ) |
| Basic - pro  forma                                                                                                 |       | $                                          | (17.62     | )                                         | $          | (1.49 | ) | $ | 14.04 |   | $ | (8.40 | ) |
|                                                                                                               |       |                                       |       |                                      |       |   |   |   |   |
| Diluted - as  reported                                                                                             |       | $                                          | (17.62     | )                                         | $          | (1.49 | ) | $ | 1.56 |   | $ | (8.53 | ) |
| Diluted - pro  forma                                                                                               |       | $                                          | (17.62     | )                                         | $          | (1.49 | ) | $ | 1.55 |   | $ | (8.40 | ) |

 

Pro forma informationregarding net income (loss) and net income (loss) per share is required by SFASNo. 123, and has been determined as if the Company had accounted for itsemployee stock options under the fair value method of SFAS No. 123.  The fair value of these options was estimatedat the date of grant using the Black-Scholes option pricing model with the followingassumptions for the three and nine-month periods ended September 30, 2004and 2005:

 
| ** **                      | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|---------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                      | ** ** | **2004**                                   | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Expected dividend yield         |       | —                                     |       | —                                    |       | — |   | — |   |
| Expected stock price volatility |       | 25                                         | %          | 25                                        | %          | 25 | % | 25 | % |
| Risk-free interest rate         |       | 3.47                                       | %          | 3.84%-4.08                                | %          | 3.25%-3.88 | % | 3.71%-4.24 | % |
| Expected life of options        |       | 5 years                                    |       | 5 years                                   |       | 5 years |   | 5 years |   |

 

The Black-Scholes optionvaluation model was developed for use in estimating the fair value of tradedoptions which have no vesting restrictions and are fully transferable.  In addition, option valuation models requirethe input of highly subjective assumptions. Because the Company’s employee stock options have characteristicssignificantly different from those of traded options and because changes in thesubjective input assumptions can materially affect the fair value estimate, inmanagement’s opinion, the existing models do not necessarily provide a reliablesingle measure of the fair value of its employee stock options.

 

## **Net Income (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 the potentially dilutive common shares been issued.  Potentially dilutive shares of common stockinclude stock options, unvested restricted stock grants, Series AConvertible Preferred Stock and Series B Convertible Preferred Stock.  During periods in which a net loss isincurred, diluted earnings per share amounts are the same as basic per shareamounts because the effect of all options, unvested restricted stock grants, Series AConvertible Preferred Stock and Series B Convertible Preferred Stock isanti-dilutive.

 

The following tablepresents a reconciliation of the numerators and denominators of basic anddiluted earnings per common share:

 

9

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| ** **                                                        | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                        | ** ** | **2004**                                   | ** ** | **2005**                                  | ** ** | **2004** | ** ** | **2005** | ** ** |
| Numerator:                                                        | ** ** | ** **                                 | ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income  (loss) applicable to common stockholders, as reported |       | $                                          | (5,192     | )                                         | $          | (12,453 | ) | $ | 4,006 |   | $ | (25,864 | ) |
| Add: Cumulative  preferred stock dividends                        |       | —                                     |       | —                                    |       | 8,698 |   | — |   |
| Deduct:  Unrecognized deferred compensation expense               |       | —                                     |       | —                                    |       | (34 | ) | — |   |
| Numerator for  diluted earnings per share                         |       | $                                          | (5,192     | )                                         | $          | (12,453 | ) | $ | 12,670 |   | $ | (25,864 | ) |
|                                                              |       |                                       |       |                                      |       |   |   |   |   |
| Denominator:                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Weighted average  common shares outstanding                       |       | 294,702                                    |       | 8,329,636                                 |       | 283,268 |   | 3,033,623 |   |
| Effect of  dilutive securities:                                   |       |                                       |       |                                      |       |   |   |   |   |
| Restricted stock  grants                                          |       | —                                     |       | —                                    |       | 29,369 |   | — |   |
| Employee stock  options                                           |       | —                                     |       | —                                    |       | 333,724 |   | — |   |
| Series A  convertible preferred stock                        |       | —                                     |       | —                                    |       | 7,486,318 |   | — |   |
| Denominator for  diluted earnings per share                       |       | 294,702                                    |       | 8,329,636                                 |       | 8,132,679 |   | 3,033,623 |   |
|                                                              |       |                                       |       |                                      |       |   |   |   |   |
| Net income (loss) per share:                                      |       |                                       |       |                                      |       |   |   |   |   |
| Basic - as  reported                                              |       | $                                          | (17.62     | )                                         | $          | (1.49 | ) | $ | 14.14 |   | $ | (8.53 | ) |
| Diluted - as  reported                                            |       | $                                          | (17.62     | )                                         | $          | (1.49 | ) | $ | 1.56 |   | $ | (8.53 | ) |

 

## **New Accounting Pronouncements**

## ** **

In December 2004, asamended on April 14, 2005, the Financial Accounting Standards Board issuedSFAS No. 123R, *Share-Based Payment: anamendment of FASB Statement No. 123 and FASB Statement No. 95*,which requires all share-based payments to employees, including grants ofemployee stock options, to be recognized in the income statement based on theirfair values. Prior to SFAS No. 123R, only certain pro forma disclosures offair value were required. SFAS 123R must be adopted no later than thebeginning of the first fiscal year beginning after June 15, 2005. We willadopt SFAS 123R on January 1, 2006.

 

SFAS 123R permitscompanies to adopt one of two methods: (1) A “modified prospective” methodin which compensation cost is recognized beginning with the effective date (a) basedon the requirements of SFAS 123R for all share-based payments grantedafter the effective date and (b) based on the requirements ofSFAS 123 for all awards granted to employees prior to the effective dateof SFAS 123R that remain unvested on the effective date or (2) A “modifiedretrospective” method that includes the requirements of the modifiedprospective method described above, but also permits entities to restate basedon the amounts previously recognized under FAS 123 for purposes of proforma disclosures either (a) all prior periods presented or (b) priorinterim periods of the year of adoption. We are currently in the process ofevaluating the two option valuation methods and the potential impact on ourfinancial statements.

 

In December 2004,the FASB issued SFAS No. 153, *Exchanges of NonmonetaryAssets*. SFAS No. 153 addresses the measurement of exchange ofnonmonetary assets. SFAS 153 eliminates the exception from fair valuemeasurement for nonmonetary exchanges of similar productive assets inparagraph 21(b) of APB Opinion No. 29, *Accountingfor Nonmonetary Transactions*, and replaces it with an exception forexchanges that do not have commercial substance if the future cash flows of theentity are expected to change significantly as a result of the exchange. SFAS No. 153is effective for nonmonetary asset exchanges occurring in fiscal periodsbeginning after June 15, 2005. We are evaluating the potential impact ofour adoption of SFAS No. 153 on our consolidated financial statements.

 

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

 

*AdvancedTelCom, Inc.*

 

On December 31,2004, the Company acquired all of the outstanding common stock of AdvancedTelCom, Inc. (“ATI”) for $45,495, net of cash acquired.  The results of ATI have been included in theconsolidated financial statements since that date.  As a result of the acquisition, the Companystrengthened its presence in six markets, entered into six adjacent markets,entered one new market and created significant opportunities for cost savingsand increased profitability.

 

10

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TheCompany allocated the purchase price on a preliminary basis using theinformation then available.  Theallocation of the purchase price will be finalized in the fourth quarter of2005.  Upon completion of the finalpurchase price allocation, an additional portion of the excess purchase pricemay be allocated to certain intangibles that are separable from goodwill.  The Company accrued $2,531 in acquisitionrelated expenses, which include severance benefits, relocation costs andcontract termination fees.  At September 30,2005 the balance in the acquisition reserve was as follows:

 
| Balance at  December 31, 2004 |   | $    | 2,531 |   |
|------------------------------------|--------|------|-------|--------|
| Payments                           |   | (995 | )     |
| Balance at September 30, 2005 |   | $    | 1,536 |   |

 

The following unauditedpro forma financial information was prepared in accordance with SFAS No. 141,*Business Combinations*, and assumes theacquisition had occurred at the beginning of the periods presented.  The unaudited pro forma information isprovided for informational purposes only. These pro forma results are based upon the respective historicalfinancial statements of the respective companies, and do not incorporate, nordo they assume, any benefits from cost savings or synergies of operations ofthe combined company.  The pro formaresults of operations do not necessarily reflect the results that would haveoccurred had the acquisition occurred at the beginning of the periods presentedor the results which may occur in the future.

 

The pro forma combined results of continuing operations for the threeand nine months ended September 30, 2004 are as follows:

 
| ** **                          | ** ** | **Three months ended  September 30, 2004** | ** ** | **Nine months ended  September 30, 2004** | ** ** |
|-------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------|------------|
| Revenue                             |       | $                                               | 55,586     |                                           | $          | 162,890 |   |
| Net income                          |       | (2,832                                          | )          | 13,265                                         |       |
| Net income per share – basic   |       | (9.61                                           | )          | 46.83                                          |       |
| Net income per share – diluted |       | (9.61                                           | )          | 2.38                                           |       |
|                                     |            |                                                 |            |                                                |            |  |  |

 

#### *General Electric Business Productivity Solutions*

#### * *

On October 13, 2004the Company entered into an agreement with General Electric Capital Corporationto purchase substantially all of the assets of General Electric BusinessProductivity Solutions (GEBPS) for $100.  The transaction closed on March 31, 2005 and is being accounted foras a discontinued operation. GEBPS constitutes a group of assets that can beclearly distinguished operationally and for financial reporting purposes fromthe rest of the Company.  Management hasdetermined that this group of assets does not fit the Company’s future businessmodel and is committed to sell the net assets. The Company believes that the assets will be sold within the next twelvemonths.  At March 31, 2005 theCompany determined that the plan of sale criteria in SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets*,had been met and classified the assets and liabilities accordingly on thebalance sheet.

 

**3.)****          BenefitContribution Plan**

 

The Company has a definedcontribution salary deferral plan covering substantially all employees under Section 401(k)of the Internal Revenue Code.  TheCompany contributes an amount equal to 45 cents for each dollar contributed byeach employee up to a maximum of 6% of each employee’s compensation.  The Company recognized expense forcontributions to the plan for the three months ended September 30, 2004and 2005 of $199 and $259, respectively, and for the nine months ended September 30,2004 and 2005 of $575 and $728, respectively.

 

11

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**4.)****          CapitalStock**

 

## **Initial Public Offering**

## ** **

OnAugust 9, 2005, the Company consummated an initial public offering of5,357,143 of the Company’s common stock at $14.00 per share.  Net proceeds from the offering, afterdeducting underwriting discounts and commissions, were $69,750.  Proceeds were used to redeem $50,630 accretedvalue ($57,750 principal amount) of the Company’s 8 3/8% senior second securednotes due March 15, 2010; to pay a $6,076 premium due upon redemption ofthe notes; and to pay $1,379 of fees and expenses associated with theoffering.  Approximately $805 will beused for the payment of additional fees and expenses associated with theoffering and approximately $10,860 will be used for general corporate purposes,including the expansion of the Company’s colocation network.

 

**PreferredStock**

 

As a result of theCompany’s initial public offering of common stock on August 9, 2005, allof the Company’s then-outstanding shares of convertible preferred stock andaccumulated dividends were automatically converted to common stock.

 

Prior to the conversion,under the terms of the Company’s Series A Convertible Preferred Stock and Series BConvertible Preferred Stock (collectively, Preferred Stock), the holders wereentitled to receive, when and if declared by the Board of Directors, cumulativedividends on each share of Preferred Stock at the rate of 8% per year whichaccrued daily and, to the extent not paid, accumulated quarterly inarrears.  At December 31, 2004dividends in arrears were $8,777.

 

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

 

## **Stock Options**

## ** **

In November 2002,the Board of Directors approved the Eschelon Telecom, Inc. Stock OptionPlan of 2002 (the “2002 Plan”).  A totalof 1,632,414 shares of the Company’s common stock have been reserved forissuance under the 2002 Plan.  At September 30,2005, the Company had 1,150,507 options outstanding and 192,255 shares ofrestricted common stock issued to certain directors and members of managementunder the 2002 Plan.

 

## **Restricted Common Stock**

## ** **

In February 2003,the Company granted 183,399 shares of restricted common stock to certain of itsdirectors and members of management.  Thefair value per share of this restricted stock was $0.68.  The Company records compensation expense asthe restrictions are removed from the stock and recognizes compensation expenseover the vesting period.  In February 2004,29,958 shares vested resulting in compensation expense of $20.  In February 2005, 17,941 shares vestedresulting in compensation expense of $12. In March 2005, the Company granted 8,856 shares of restrictedcommon stock to a member of its board of directors.  The fair value per share of this restrictedstock was $2.71.  The Company recordedrelated compensation expense of $24.  In July 2005,the Company granted 494 shares of restricted common stock to a former member ofits board of directors as compensation for 494 shares of unvested restrictedcommon stock that was forfeited when membership on the board of directorsended.  The fair value per share of thisrestricted stock was $6.77.  The Companyrecorded related compensation expense of $3.

 

**5.)****          ReverseStock Split**

 

TheCompany completed a 0.0738-for-one reverse stock split affecting alloutstanding shares of common stock on August 2, 2005.  All share and per share data have beenadjusted to reflect the stock split.

 

**6.)****          CondensedConsolidating Financial Information**

 

TheCompany’s 8 3/8% senior second secured notes due 2010 issued by EschelonOperating Company are fully and unconditionally guaranteed jointly andseverally by the Company and all existing subsidiaries and the indenturegoverning the notes requires that any future subsidiaries that are organized inthe United States must also guarantee the notes on the same basis.

 

12

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Thefollowing tables present condensed consolidating balance sheets at December 31,2004 and September 30, 2005 and condensed consolidating statements ofoperations for the three and nine-month periods ended September 30, 2004and 2005.

 

13

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**Unaudited Condensed Consolidating Balance Sheets**

**As of December 31, 2004**

**(In Thousands)**

 
| ** **                                                 | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Assets**                                                 |       |                   |       |          |       |             |       |             |       |             |       |
| Current assets:                                            |       |                   |       |          |       |             |       |             |       |             |       |
| Cash and cash  equivalents                                 |       | $                      | 26,332     |          | $          | —           |       | $                | 103        |             | $          | — |   | $ | 26,435 |   |
| Restricted cash                                            |       | 722                    |       | —        |       | —           |       | —           |       | 722              |       |
| Available-for-sale  securities                             |       | 6,194                  |       | —        |       | —           |       | —           |       | 6,194            |       |
| Accounts  receivable                                       |       | —                 |       | —        |       | 18,941           |       | —           |       | 18,941           |       |
| Other  receivables                                         |       | —                 |       | —        |       | 2,976            |       | —           |       | 2,976            |       |
| Inventories                                                |       | —                 |       | —        |       | 2,873            |       | —           |       | 2,873            |       |
| Prepaid expenses                                           |       | 1,227                  |       | —        |       | 1,183            |       | —           |       | 2,410            |       |
| Total current assets                                       |       | 34,475                 |       | —        |       | 26,076           |       | —           |       | 60,551           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Property and equipment, net                                |       | 82,550                 |       | —        |       | 20,299           |       | —           |       | 102,849          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Investment in affiliates                                   |       | 58,998                 |       | —        |       | —           |       | (58,998          | )          | —           |       |
| Other assets                                               |       | 1,042                  |       | —        |       | 943              |       | —           |       | 1,985            |       |
| Goodwill                                                   |       | —                 |       | —        |       | 38,776           |       | —           |       | 38,776           |       |
| Intangible assets, net                                     |       | 20,438                 |       | —        |       | 12,520           |       | —           |       | 32,958           |       |
| Total assets                                               |       | $                      | 197,503    |          | $          | —           |       | $                | 98,614     |             | $          | (58,998 | ) | $ | 237,119 |   |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Liabilities  and stockholders’ equity (deficit)**   |       |                   |       |          |       |             |       |             |       |             |       |
| Current liabilities:                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Accounts payable                                           |       | $                      | 4,314      |          | $          | —           |       | $                | 9,487      |             | $          | — |   | $ | 13,801 |   |
| Accrued  telecommunication costs                           |       | —                 |       | —        |       | 2,190            |       | —           |       | 2,190            |       |
| Accrued office  rent                                       |       | 1,722                  |       | —        |       | 614              |       | —           |       | 2,336            |       |
| Accrued interest  expense                                  |       | —                 |       | 4,069         |       | 1                |       | —           |       | 4,070            |       |
| Other accrued  expenses                                    |       | 489                    |       | —        |       | 5,509            |       | —           |       | 5,998            |       |
| Deferred revenue                                           |       | —                 |       | —        |       | 7,300            |       | —           |       | 7,300            |       |
| Accrued  compensation expenses                             |       | 2,172                  |       | —        |       | 1,416            |       | —           |       | 3,588            |       |
| Capital lease  obligation, current maturities              |       | 1,526                  |       | —        |       | 103              |       | —           |       | 1,629            |       |
| Total current liabilities                                  |       | 10,223                 |       | 4,069         |       | 26,620           |       | —           |       | 40,912           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Long-term liabilities:                                     |       |                   |       |          |       |             |       |             |       |             |       |
| Other long-term  liabilities                               |       | 76                     |       | —        |       | 554              |       | —           |       | 630              |       |
| Capital lease  obligation, less current maturities         |       | 2,607                  |       | —        |       | 217              |       | —           |       | 2,824            |       |
| Notes payable                                              |       | —                 |       | 137,778       |       | —           |       | —           |       | 137,778          |       |
| Due to (from)  affiliates                                  |       | 235,611                |       | (182,260      | )          | (53,351          | )          | —           |       | —           |       |
| Total liabilities                                          |       | 248,517                |       | (40,413       | )          | (25,960          | )          | —           |       | 182,144          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Convertible preferred stock                                |       | 63,155                 |       | —        |       | —           |       | —           |       | 63,155           |       |
| Stockholders’ equity (deficit)                        |       | (114,169               | )          | 40,413        |       | 124,574          |       | (58,998          | )          | (8,180           | )          |
| Total  liabilities and stockholders’ equity (deficit) |       | $                      | 197,503    |          | $          | —           |       | $                | 98,614     |             | $          | (58,998 | ) | $ | 237,119 |   |

 

14

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**Unaudited Condensed Consolidating Balance Sheets**

**As of September 30, 2005**

**(In Thousands)**

 
| ** **                                                 | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Assets**                                                 |       |                   |       |          |       |             |       |             |       |             |       |
| Current assets:                                            |       |                   |       |          |       |             |       |             |       |             |       |
| Cash and cash  equivalents                                 |       | $                      | 13,834     |          | $          | —           |       | $                | 283        |             | $          | — |   | $ | 14,117 |   |
| Restricted cash                                            |       | 829                    |       | —        |       | —           |       | —           |       | 829              |       |
| Available-for-sale  securities                             |       | 15,878                 |       | —        |       | —           |       | —           |       | 15,878           |       |
| Accounts  receivable                                       |       | —                 |       | —        |       | 22,822           |       | —           |       | 22,822           |       |
| Other  receivables                                         |       | —                 |       | —        |       | 3,484            |       | —           |       | 3,484            |       |
| Inventories                                                |       | —                 |       | —        |       | 2,979            |       | —           |       | 2,979            |       |
| Prepaid expenses                                           |       | 847                    |       | —        |       | 1,477            |       | —           |       | 2,324            |       |
| Discontinued  assets held for sale                         |       | —                 |       | —        |       | 703              |       | —           |       | 703              |       |
| Total current  assets                                      |       | 31,388                 |       | —        |       | 31,748           |       | —           |       | 63,136           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Property and  equipment, net                               |       | 82,629                 |       | —        |       | 20,134           |       | —           |       | 102,763          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Investment in  affiliates                                  |       | 58,998                 |       | —        |       | —           |       | (58,998          | )          | —           |       |
| Other assets                                               |       | 962                    |       | —        |       | 940              |       | —           |       | 1,902            |       |
| Goodwill                                                   |       | —                 |       | —        |       | 38,776           |       | —           |       | 38,776           |       |
| Intangible  assets, net                                    |       | 18,355                 |       | —        |       | 12,142           |       | —           |       | 30,497           |       |
| Total assets                                               |       | $                      | 192,332    |          | $          | —           |       | $                | 103,740    |             | $          | (58,998 | ) | $ | 237,074 |   |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Liabilities  and stockholders’ equity (deficit)**   |       |                   |       |          |       |             |       |             |       |             |       |
| Current  liabilities:                                      |       |                   |       |          |       |             |       |             |       |             |       |
| Accounts payable                                           |       | $                      | 15,003     |          | $          | —           |       | $                | 1,676      |             | $          | — |   | $ | 16,679 |   |
| Accrued  telecommunication costs                           |       | —                 |       | —        |       | 2,161            |       | —           |       | 2,161            |       |
| Accrued office  rent                                       |       | 1,546                  |       | —        |       | 664              |       | —           |       | 2,210            |       |
| Accrued interest  expense                                  |       | —                 |       | 399           |       | 1                |       | —           |       | 400              |       |
| Other accrued  expenses                                    |       | 1,478                  |       | —        |       | 4,848            |       | —           |       | 6,326            |       |
| Deferred revenue                                           |       | —                 |       | —        |       | 7,826            |       | —           |       | 7,826            |       |
| Accrued  compensation expenses                             |       | 2,005                  |       | —        |       | 1,290            |       | —           |       | 3,295            |       |
| Capital lease  obligation, current maturities              |       | 553                    |       | —        |       | 109              |       | —           |       | 662              |       |
| Discontinued  liabilities held for sale                    |       | —                 |       | —        |       | 1,710            |       | —           |       | 1,710            |       |
| Total current  liabilities                                 |       | 20,585                 |       | 399           |       | 20,285           |       | —           |       | 41,269           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Long-term  liabilities:                                    |       |                   |       |          |       |             |       |             |       |             |       |
| Other long-term  liabilities                               |       | 811                    |       | —        |       | —           |       | —           |       | 811              |       |
| Capital lease  obligation, less current maturities         |       | 4,838                  |       | —        |       | 134              |       | —           |       | 4,972            |       |
| Notes payable                                              |       | —                 |       | 91,447        |       | —           |       | —           |       | 91,447           |       |
| Due to (from)  affiliates                                  |       | 199,734                |       | (111,735      | )          | (87,999          | )          | —           |       | —           |       |
| Total  liabilities                                         |       | 225,968                |       | (19,889       | )          | (67,580          | )          | —           |       | 138,499          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Convertible  preferred stock                               |       | —                 |       | —        |       | —           |       | —           |       | —           |       |
| Stockholders’  equity (deficit)                       |       | (33,636                | )          | 19,889        |       | 171,320          |       | (58,998          | )          | 98,575           |       |
| Total  liabilities and stockholders’ equity (deficit) |       | $                      | 192,332    |          | $          | —           |       | $                | 103,740    |             | $          | (58,998 | ) | $ | 237,074 |   |

 

15

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**Unaudited Condensed Consolidating Statement ofOperations**

**For the Three Months Ended September 30, 2004**

**(In Thousands)**

 
| ** **                         | ** ** | **Eschelon  Telecom, Inc.** | ** ** | **Eschelon  Operating  Company** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Consolidated** | ** ** |
|------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|-----------------------------|------------|------------------|------------|
|                               |       |                             |       |                             |       |                        |       |             |       |
| Revenue:                           |       |                             |       |                             |       |                        |       |             |       |
| Network services                   |       | $                                | —     |                             | $          | —                      |       | $                | 33,476     |   | $ | 33,476 |   |
| Business  telephone systems        |       | —                           |       | —                           |       | 7,086                       |       | 7,086            |       |
|                               |       | —                           |       | —                           |       | 40,562                      |       | 40,562           |       |
|                               |       |                             |       |                             |       |                        |       |             |       |
| Cost of revenue:                   |       |                             |       |                             |       |                        |       |             |       |
| Network services                   |       | —                           |       | —                           |       | 11,736                      |       | 11,736           |       |
| Business  telephone systems        |       | —                           |       | —                           |       | 4,305                       |       | 4,305            |       |
|                               |       | —                           |       | —                           |       | 16,041                      |       | 16,041           |       |
|                               |       |                             |       |                             |       |                        |       |             |       |
| Gross profit:                      |       |                             |       |                             |       |                        |       |             |       |
| Network services                   |       | —                           |       | —                           |       | 21,740                      |       | 21,740           |       |
| Business  telephone systems        |       | —                           |       | —                           |       | 2,781                       |       | 2,781            |       |
|                               |       | —                           |       | —                           |       | 24,521                      |       | 24,521           |       |
| Operating expenses:                |       |                             |       |                             |       |                        |       |             |       |
| Sales, general  and administrative |       | 10,376                           |       | —                           |       | 8,047                       |       | 18,423           |       |
| Depreciation and  amortization     |       | 4,891                            |       | —                           |       | 2,602                       |       | 7,493            |       |
| Total operating expenses           |       | 15,267                           |       | —                           |       | 10,649                      |       | 25,916           |       |
|                               |       |                             |       |                             |       |                        |       |             |       |
| Operating income (loss)            |       | (15,267                          | )          | —                           |       | 13,872                      |       | (1,395           | )          |
| Other income (expense)             |       | (376                             | )          | (2,549                           | )          | (5                          | )          | (2,930           | )          |
| Income (loss) before income taxes  |       | (15,643                          | )          | (2,549                           | )          | 13,867                      |       | (4,325           | )          |
| Income taxes                       |       | (4                               | )          | —                           |       | —                      |       | (4               | )          |
| Net income (loss)                  |       | $                                | (15,647    | )                                | $          | (2,549                      | )          | $                | 13,867     |   | $ | (4,329 | ) |

 

16

----

 

**Unaudited Condensed Consolidating Statement ofOperations**

**For the Three Months Ended September 30, 2005**

**(In Thousands)**

 
| ** **                                      | ** ** | **Eschelon  Telecom, Inc.** | ** ** | **Eschelon  Operating  Company** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|-----------------------------|------------|------------------|------------|
|                                            |       |                             |       |                             |       |                        |       |             |       |
| Revenue:                                        |       |                             |       |                             |       |                        |       |             |       |
| Network services                                |       | $                                | —     |                             | $          | —                      |       | $                | 51,181     |   | $ | 51,181 |   |
| Business  telephone systems                     |       | —                           |       | —                           |       | 6,731                       |       | 6,731            |       |
|                                            |       | —                           |       | —                           |       | 57,912                      |       | 57,912           |       |
|                                            |       |                             |       |                             |       |                        |       |             |       |
| Cost of revenue:                                |       |                             |       |                             |       |                        |       |             |       |
| Network services                                |       | —                           |       | —                           |       | 20,701                      |       | 20,701           |       |
| Business telephone  systems                     |       | —                           |       | —                           |       | 4,093                       |       | 4,093            |       |
|                                            |       | —                           |       | —                           |       | 24,794                      |       | 24,794           |       |
|                                            |       |                             |       |                             |       |                        |       |             |       |
| Gross profit:                                   |       |                             |       |                             |       |                        |       |             |       |
| Network services                                |       | —                           |       | —                           |       | 30,480                      |       | 30,480           |       |
| Business  telephone systems                     |       | —                           |       | —                           |       | 2,638                       |       | 2,638            |       |
|                                            |       | —                           |       | —                           |       | 33,118                      |       | 33,118           |       |
| Operating expenses:                             |       |                             |       |                             |       |                        |       |             |       |
| Sales, general  and administrative              |       | 10,643                           |       | —                           |       | 11,735                      |       | 22,378           |       |
| Depreciation and  amortization                  |       | 5,666                            |       | —                           |       | 3,345                       |       | 9,011            |       |
| Total operating expenses                        |       | 16,309                           |       | —                           |       | 15,080                      |       | 31,389           |       |
|                                            |       |                             |       |                             |       |                        |       |             |       |
| Operating income (loss)                         |       | (16,309                          | )          | —                           |       | 18,038                      |       | 1,729            |       |
| Other income (expense)                          |       | (2,978                           | )          | (11,695                          | )          | 31                          |       | (14,642          | )          |
| Income (loss) before income taxes               |       | (19,287                          | )          | (11,695                          | )          | 18,069                      |       | (12,913          | )          |
| Income taxes                                    |       | —                           |       | —                           |       | —                      |       | —           |       |
| Net income (loss) before discontinued operation |       | (19,287                          | )          | (11,695                          | )          | 18,069                      |       | (12,913          | )          |
| Income from discontinued operation, net of tax  |       | —                           |       | —                           |       | 460                         |       | 460              |       |
| Net income (loss)                               |       | $                                | (19,287    | )                                | $          | (11,695                     | )          | $                | 18,529     |   | $ | (12,453 | ) |

 

17

----

 

**Unaudited Condensed Consolidating Statement ofOperations**

**For the Nine Months Ended September 30, 2004**

**(In Thousands)**

 
| ** **                         | ** ** | **Eschelon  Telecom, Inc.** | ** ** | **Eschelon  Operating  Company** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Consolidated** | ** ** |
|------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|-----------------------------|------------|------------------|------------|
|                               |       |                             |       |                             |       |                        |       |             |       |
| Revenue:                           |       |                             |       |                             |       |                        |       |             |       |
| Network services                   |       | $                                | —     |                             | $          | —                      |       | $                | 98,333     |   | $ | 98,333 |   |
| Business  telephone systems        |       | —                           |       | —                           |       | 19,575                      |       | 19,575           |       |
|                               |       | —                           |       | —                           |       | 117,908                     |       | 117,908          |       |
|                               |       |                             |       |                             |       |                        |       |             |       |
| Cost of revenue:                   |       |                             |       |                             |       |                        |       |             |       |
| Network services                   |       | —                           |       | —                           |       | 35,093                      |       | 35,093           |       |
| Business  telephone systems        |       | —                           |       | —                           |       | 11,785                      |       | 11,785           |       |
|                               |       | —                           |       | —                           |       | 46,878                      |       | 46,878           |       |
|                               |       |                             |       |                             |       |                        |       |             |       |
| Gross profit:                      |       |                             |       |                             |       |                        |       |             |       |
| Network services                   |       | —                           |       | —                           |       | 63,240                      |       | 63,240           |       |
| Business  telephone systems        |       | —                           |       | —                           |       | 7,790                       |       | 7,790            |       |
|                               |       | —                           |       | —                           |       | 71,030                      |       | 71,030           |       |
| Operating expenses:                |       |                             |       |                             |       |                        |       |             |       |
| Sales, general  and administrative |       | 28,430                           |       | —                           |       | 23,519                      |       | 51,949           |       |
| Depreciation and  amortization     |       | 14,863                           |       | —                           |       | 7,842                       |       | 22,705           |       |
| Total operating expenses           |       | 43,293                           |       | —                           |       | 31,361                      |       | 74,654           |       |
|                               |       |                             |       |                             |       |                        |       |             |       |
| Operating income (loss)            |       | (43,293                          | )          | —                           |       | 39,669                      |       | (3,624           | )          |
| Other income (expense)             |       | (805                             | )          | 11,027                           |       | (16                         | )          | 10,206           |       |
| Income (loss) before income taxes  |       | (44,098                          | )          | 11,027                           |       | 39,653                      |       | 6,582            |       |
| Income taxes                       |       | (4                               | )          | —                           |       | —                      |       | (4               | )          |
| Net income (loss)                  |       | $                                | (44,102    | )                                | $          | 11,027                      |       | $                | 39,653     |   | $ | 6,578 |   |

 

18

----

 

**Unaudited Condensed Consolidating Statement ofOperations**

**For the Nine Months Ended September 30, 2005**

**(In Thousands)**

 
| ** **                                      | ** ** | **Eschelon  Telecom, Inc.** | ** ** | **Eschelon  Operating  Company** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|-----------------------------|------------|------------------|------------|
|                                            |       |                             |       |                             |       |                        |       |             |       |
| Revenue:                                        |       |                             |       |                             |       |                        |       |             |       |
| Network services                                |       | $                                | —     |                             | $          | —                      |       | $                | 149,944    |   | $ | 149,944 |   |
| Business  telephone systems                     |       | —                           |       | —                           |       | 19,422                      |       | 19,422           |       |
|                                            |       | —                           |       | —                           |       | 169,366                     |       | 169,366          |       |
|                                            |       |                             |       |                             |       |                        |       |             |       |
| Cost of revenue:                                |       |                             |       |                             |       |                        |       |             |       |
| Network services                                |       | —                           |       | —                           |       | 65,603                      |       | 65,603           |       |
| Business  telephone systems                     |       | —                           |       | —                           |       | 11,914                      |       | 11,914           |       |
|                                            |       | —                           |       | —                           |       | 77,517                      |       | 77,517           |       |
|                                            |       |                             |       |                             |       |                        |       |             |       |
| Gross profit:                                   |       |                             |       |                             |       |                        |       |             |       |
| Network services                                |       | —                           |       | —                           |       | 84,341                      |       | 84,341           |       |
| Business  telephone systems                     |       | —                           |       | —                           |       | 7,508                       |       | 7,508            |       |
|                                            |       | —                           |       | —                           |       | 91,849                      |       | 91,849           |       |
| Operating expenses:                             |       |                             |       |                             |       |                        |       |             |       |
| Sales, general  and administrative              |       | 31,768                           |       | —                           |       | 36,055                      |       | 67,823           |       |
| Depreciation and  amortization                  |       | 16,354                           |       | —                           |       | 9,938                       |       | 26,292           |       |
| Total operating expenses                        |       | 48,122                           |       | —                           |       | 45,993                      |       | 94,115           |       |
|                                            |       |                             |       |                             |       |                        |       |             |       |
| Operating income (loss)                         |       | (48,122                          | )          | —                           |       | 45,856                      |       | (2,266           | )          |
| Other income (expense)                          |       | (3,705                           | )          | (20,524                          | )          | 60                          |       | (24,169          | )          |
| Income (loss) before income taxes               |       | (51,827                          | )          | (20,524                          | )          | 45,916                      |       | (26,435          | )          |
| Income taxes                                    |       | —                           |       | —                           |       | —                      |       | —           |       |
| Net income (loss) before discontinued operation |       | (51,827                          | )          | (20,524                          | )          | 45,916                      |       | (26,435          | )          |
| Income from discontinued operation, net of tax  |       | —                           |       | —                           |       | 571                         |       | 571              |       |
| Net income (loss)                               |       | $                                | (51,827    | )                                | $          | (20,524                     | )          | $                | 46,487     |   | $ | (25,864 | ) |

 

19

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**7.)****          SubsequentEvent**

 

On August 9, 2005the Company entered into an agreement with Manhattan TelecommunicationsCorporation to sell Business Productivity Solutions, Inc. (BPS).  BPS is a wholly-owned subsidiary of EschelonOperating Company and is being accounted for as a discontinued operation heldfor sale.  The transaction closed on October 1,2005.

 

20

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

 

## **Forward-Looking and Cautionary Statements**

## ** **

We make “forward-lookingstatements” throughout this document.  Whenever you read a statement that is notsolely a statement of historical 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 negativethereof, and other similar statements), you should understand that ourexpectations may not be correct, although we believe that they arereasonable.  You should also understandthat our plans may change.  We do notguarantee that the events described in this document will happen as describedor that any trends noted in this 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 changing economicor competitive conditions, as well as the negotiation of agreements with thirdparties and other factors discussed herein, which could cause actual results todiffer from present plans or expectations, and such differences could bematerial.  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.

 

**Company Overview**

 

We are a leadingfacilities-based provider of voice and data services and business telephonesystems in 19 markets in the western United States.  As a facilities-based competitivecommunications services provider, we provide services to our customersprimarily through our own network of owned telecommunications switches and relatedequipment and primarily leased telecommunications lines, or transport.  We target the small and medium-sized businesssegment and currently serve over 50,000 customers, primarily within the localservice territory of Qwest.  We believethat we are either the first or second largest competitive communicationsservices provider targeting the small and medium-sized business segment, withan estimated range of 6% to 15% of the market share in each of our markets,based on internally derived market share data as of April 28, 2005.

 

We measure ouroperational performance using a variety of indicators including revenue growth,the percentage of our revenue that comes from customers that we serveon-switch, gross margin percentage, operating expenses as a percentage ofrevenue and access line churn rates. We monitor key operating and customerservice metrics to improve customer service, maintain the quality of ournetwork and reduce costs.

 

ATI generatedapproximately $59.3 million of revenue in 2004. Through this acquisition,we strengthened our presence in six of the markets we already served, enteredinto six adjacent markets, entered into one new market and created significantopportunities for cost savings and increased profitability. By combining our businesses,we have been able to achieve a size and scale that we believe will provide uswith a competitive advantage in our markets and significant opportunities forcost savings and improved cash flow. We are in the process of integrating ATI’soperational, financial and support systems with ours. We expect that ATI willbe substantially integrated by the end of 2005.

 

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 OperatingCompanies (RBOCs), other competitive communications services providers, andlong distance and data service providers. While we compete with wireless providers to a limited extent, we do notbelieve they are a competitive threat in the market, nor are they likely to bein the near future, because of the different service standards that businesscustomers require.

 

21

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**KeyComponents of Results of Operations**

 

***Revenue.***  Network services revenue consists primarilyof local dial tone, switched access lines, long distance, access charges anddata service. Revenue from local telephone service consists of charges forbasic local service, including dedicated T1 access, and custom-calling featuressuch as call waiting and call forwarding. Revenue from long distance serviceconsists of per-minute-of-use charges for a full range of traditional switchedand dedicated long distance, toll-free calling, international, calling card andoperator services. Carrier access revenue consists primarily of usage chargesthat we bill long distance carriers to originate and terminate calls to andfrom our customers. In addition, in some of our markets we currently chargeother local exchange carriers usage charges to originate and terminate localcalls to and from certain customers (otherwise known as reciprocalcompensation).  Revenue from dataservices consists primarily of monthly usage fees for Internet access services.We typically commit our customers to contracts ranging from one to three yearsand provide discounts for longer terms. Network services comprised 88.5% of ourrevenue for the nine months ended September 30, 2005 revenue andrepresents a predominantly recurring revenue stream.

 

Monthly recurring networkservices revenue is recognized in the month the services are used. In the caseof local service revenue, monthly recurring local services charges are billedin advance but accrued for and recognized on a prorated basis based on lengthof service in any given month. Non-recurring revenues from network services arerecognized over the average life of the customers. Long distance and accesscharges are billed in arrears but accrued based on monthly average usage. Wehave a small amount of revenues from reciprocal compensation due to ourbill-and-keep arrangements with Qwest. Under a bill-and-keep arrangement withanother carrier, we have a reciprocal agreement whereby we do not pay the othercarrier to complete our customers’ local calls to their customers and viceversa.  While we currently billapproximately $0.3 million in annual revenue from reciprocal compensation fromQwest and SBC Communications Inc. related to ATI customers, we are evaluatingwhether to seek a bill-and-keep arrangement with Qwest and /or SBC for the ATItraffic. We do not have any wholesale revenue other than access revenue andthis reciprocal compensation.

 

Business telephonesystems revenue consists of revenue from the sale of telephone equipment andthe servicing of telephone equipment systems. Telephone equipment revenue isrecognized upon delivery, completion of the installation and acceptance by thecustomer. Business telephone systems revenue is recognized upon completion ofservice or, in the case of maintenance agreements, is spread equally over thelife of the maintenance contract, which typically ranges from one to two years.

 

***Costof Revenue.***  Ournetwork services cost of revenue consists primarily of the cost of operatingand maintaining our network facilities. The network components for ourfacilities-based business include the cost of:

 

•                  leasing local loops and digital T1 lines thatconnect our customers to our network;

 

•                  leasing high capacity digital lines that connect ourswitching equipment to our colocations;

 

•                  leasing high capacity digital lines thatinterconnect our network with the RBOCs;

 

•                  leasing space in the RBOC central offices forcolocating our equipment;

 

•                  signaling system network connectivity;

 

•                  leasing our ATM long-haul Internet backbone network;and

 

•                  Internet transit and peering, which is the cost ofdelivering Internet traffic from our customers to the public Internet.

 

The costs to lease localloops, digital T1 lines and high capacity digital interoffice facilities fromthe RBOCs vary by carrier and by state and are regulated under federal andstate laws. In virtually all areas, we lease local loops, T1 lines andinteroffice transport facilities from the RBOCs. We lease interoffice transportfacilities from carriers other than the RBOCs where possible in order to lowercosts and improve network redundancy; however, in most cases, the RBOCs are ouronly source for local loops and T1 lines. Prior to January 2005, we purchased, on a wholesale or negotiatedbasis, unbundled network elements platform, or UNE-P, and customized networkelement packages, or UNE-E, from Qwest. We entered into a three-year agreement in 

 

22

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January 2005 withQwest for the provision of their Platform Plus, or QPP, product which replacedUNE-P and UNE-E.  The UNE-P and UNE-Eagreements were terminated with the adoption of the QPP agreement, and allUNE-E and UNE-P lines were moved to QPP on January 1, 2005.

 

Our network services costof revenue also includes the fees we pay for long distance, data and otherservices. We have entered into long-term wholesale purchasing agreements forthese services. Some of these agreements, including our agreement with MCI,also contain significant termination penalties and/or minimum usage volumecommitments. In the event we fail to meet these minimum volume commitments, wemay be obligated to pay underutilization charges. We do not anticipate havingto pay any underutilization charges in the foreseeable future.

 

We carefully review allof our vendor invoices and frequently dispute inaccurate or inappropriatecharges. In cases where we dispute certain charges, we frequently pay onlyundisputed amounts on vendor invoices in order to pay proper amounts owed. Oursingle largest vendor is Qwest, to which we paid $34.4 million for the ninemonths ended September 30, 2005. We use significant estimates to determinethe level of success in dispute resolution and consider past historicalexperience, basis of dispute and current relationship with vendors and aging ofprior disputes in quantifying our estimates.

 

We account for all of ournetwork depreciation in depreciation and amortization expense and do not haveany depreciation expense in cost of revenue.

 

Our most significantbusiness telephone systems costs of revenue are the equipment purchased frommanufacturers and labor for service and equipment installation. To takeadvantage of volume purchase discounts, we purchase equipment primarily fromthree manufacturers pursuant to master purchase agreements we have with thesemanufacturers. For all business telephone systems installations, our policy isto require a 30% deposit before ordering the equipment so our risk of excessinventory or inventory obsolescence is low. Business telephone systems cost ofrevenue also includes salaries and benefits of field technicians as well asvehicle and incidental expenses associated with equipment installation,maintenance and service provisioning.

 

***Sales,General and Administrative.***  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 allowancefor doubtful accounts receivable requires significant estimates. We considertwo primary factors in determining the proper level of the allowance, includinghistorical collections experience and the aging of the accounts receivableportfolio. We perform a rigorous credit review process on each new customerthat involves reviewing the customer’s current service provider bill andpayment history, matching customers with the National Telecommunications DataExchange database for delinquent customers and, in some cases, requestingcredit reviews through Dun and Bradstreet. For each of the nine months ended September30, 2004 and 2005, our bad debt expense as a percentage of revenue was 0.4%.

 

***Depreciationand Amortization.*** Our depreciation and amortization expense currently includesdepreciation for network related voice and data equipment, back office systems,furniture, fixtures, leasehold improvements, office equipment and computers.All internal costs directly related to the expansion of our network andoperating and support systems, including salaries of certain employees, arecapitalized and depreciated over the lives of the switches or systems, as thecase may be. Capitalized customer installation costs are amortized over theapproximate average life of a customer, which is currently 48 months.Detailed annual time studies are used to determine labor capitalization. Thesetime studies are based on employee time sheets for those engaged incapitalizable activities.

 

23

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**Results of Operations**

 

Subsequentto our announcement of operating results on November 2, 2005, we revisedour previously reported results of operations for the three and nine monthsended September 30, 2005.  The changeis the result of writing off a proportionate amount of our debt issuance costsin connection with the redemption of 35% of our outstanding senior secondsecured notes on September 15, 2005. As a result, we recorded $2.6 million of non-cash interest expense whichincreased interest expense to $14.8 million and $24.6 million in the three andnine months ended September 30, 2005, respectively, and our net loss to$12.5 million and $25.9 million for the three and nine months ended September 30,2005, respectively.

 

Selectedconsolidated financial and operating data for the three and nine-month periodsended September 30, 2004 and 2005 is as follows (dollars in thousands,except per unit amounts):

 
| ** **                                               | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                               | ** ** | **2004**                                  | ** ** | **2005**                                 | ** ** | **% Change** | ** ** | **2004** | ** ** | **2005** | ** ** | **% Change** | ** ** |
| ** **                                               | ** ** | **(unaudited)**                           | ** ** | **(unaudited)**                          | ** ** | ** ** | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** ** | ** ** |
| Total revenue                                            |       | $                                         | 40,562     |                                     | $          | 57,912 |   | 42.8 | % | $ | 117,908 |   | $ | 169,366 |   | 43.6 | % |
| Total gross  margin (%)                                  |       | 60.5                                      | %          | 57.2                                     | %          | (5.4 | )% | 60.2 | % | 54.2 | % | (10.0 | )% |
| Capital  expenditures                                    |       | $                                         | 6,616      |                                     | $          | 8,697 |   | 31.5 | % | $ | 20,445 |   | $ | 27,063 |   | 32.4 | % |
| Cash, restricted  cash and available-for-sale securities |       | $                                         | 19,420     |                                     | $          | 30,824 |   | 58.7 | % | $ | 19,420 |   | $ | 30,824 |   | 58.7 | % |
|                                                     |       |                                      |       |                                     |       |   |   |   |   |   |   |   |   |
| Voice lines in  service                                  |       | 167,263                                   |       | 265,132                                  |       | 58.5 | % | 167,263 |   | 265,132 |   | 58.5 | % |
| Data lines in  service                                   |       | 70,165                                    |       | 140,744                                  |       | 100.6 | % | 70,165 |   | 140,744 |   | 100.6 | % |
| Total lines in  service                                  |       | 237,428                                   |       | 405,876                                  |       | 70.9 | % | 237,428 |   | 405,876 |   | 70.9 | % |
| Percent of lines  on switch                              |       | 79.2                                      | %          | 84.6                                     | %          | 6.8 | % | 79.2 | % | 84.6 | % | 6.8 | % |
| Lines sold                                               |       | 23,076                                    |       | 29,043                                   |       | 25.9 | % | 65,312 |   | 82,318 |   | 26.0 | % |
| Average monthly  access line churn                       |       | 1.54                                      | %          | 1.20                                     | %          | (22.6 | )% | 1.54 | % | 1.36 | % | (11.4 | )% |
| Average monthly  network services revenue per line       |       | $                                         | 47.92      |                                     | $          | 42.31 |   | (11.7 | )% | $ | 49.10 |   | $ | 42.37 |   | (13.7 | )% |
|                                                     |       |                                      |       |                                     |       |   |   |   |   |   |   |   |   |
| Total employees                                          |       | 933                                       |       | 1,109                                    |       | 18.8 | % | 933 |   | 1,109 |   | 18.8 | % |
| Quota-carrying  network service salespeople              |       | 165                                       |       | 191                                      |       | 15.8 | % | 165 |   | 191 |   | 15.8 | % |
| Quota-carrying  BTS salespeople                          |       | 37                                        |       | 39                                       |       | 5.4 | % | 37 |   | 39 |   | 5.4 | % |
| Total quota-carrying  salespeople                        |       | 202                                       |       | 230                                      |       | 13.9 | % | 202 |   | 230 |   | 13.9 | % |

 

**ThreeMonths Ended September 30, 2005 Compared to Three Months Ended September 30,2004**

 

***Revenue.*** Revenue for the three months ended September 30, 2004 and 2005 isas follows:

 
| ** **                  | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|-----------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                  | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Revenue (in millions):      |       |            |       |            |       |         |       |
| Voice and data  services    |       | $               | 25.0       |            | $          | 39.0         |       | 55.8 | % |
| Long distance               |       | 5.4             |       | 8.8             |       | 63.9         | %          |
| Access                      |       | 3.1             |       | 3.4             |       | 10.4         | %          |
| Total network  services     |       | 33.5            |       | 51.2            |       | 52.9         | %          |
| Business  telephone systems |       | 7.1             |       | 6.7             |       | (5.0         | )%         |
| Total revenue               |       | $               | 40.6       |            | $          | 57.9         |       | 42.8 | % |

 

Networkservices revenue was $51.2 million for the three months ended September 30,2005, an increase of 52.9% from $33.5 million in the same period of 2004.  The increase in revenue was primarily due tothe inclusion of ATI, which was acquired on December 31, 2004.  Over the past 12 months the number of voicelines in service increased by 58.5% to 265,132 at September 30, 2005 andthe number of data lines in service increased by 100.6% to 140,744 at September 30,2005.  The growth in access lines waspartially offset by declines in pre-subscribed interexchange carrier charge(PICC) revenue, access revenue per minute of use and a decline in data revenueper line.  The decline in PICC revenuewas due to 

 

24

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our dispute with Global Crossing which was resolved in June, 2005.  As a result of that dispute, we elected notto record PICC revenue beginning in November 2004.  The PICC revenue impact was approximately$0.8 million for the three months ended September 30, 2005 as compared tothe three months ended September 30, 2004. Access revenue per minute of use declined as a result of the scheduledFCC reduction of interstate rate levels in June 2004.  Data revenue per line declined due to acombination of customers purchasing more bandwidth at discounted prices andgeneral pricing pressures for data services in our markets.  We expect all of the above trends in linegrowth, PICC revenue, access rates and data revenue per line to continue forthe foreseeable future.  As we continueto grow, our size and average monthly access line churn will begin to limit ouraccess line growth rate on both an absolute and a percentage basis unless weincrease our sales force and extend our network footprint.

 

Businesstelephone systems (BTS) revenue was $6.7 million for the three months ended September 30,2005, a decrease of 5.0% from $7.1 million in the same period of 2004.  The decrease in revenue was primarily due toa decrease in revenue from new systems. We cannot predict future trends in capital spending by small andmedium-sized business customers which drives our BTS revenue.

 

***Cost of Revenue.*** Cost of revenue for the three months ended September 30, 2004 and2005 is as follows:

 
| ** **                     | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|--------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                     | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Cost of revenue (in millions): |       |            |       |            |       |         |       |
| Network services               |       | $               | 11.7       |            | $          | 20.7         |       | 76.4 | % |
| Business  telephone systems    |       | 4.3             |       | 4.1             |       | (4.9         | )%         |
| Total cost of  revenue         |       | $               | 16.0       |            | $          | 24.8         |       | 54.6 | % |

 

Networkservices cost of revenue was $20.7 million for the three months ended September 30,2005, an increase of 76.4% from $11.7 million in the same period of 2004.  The increase was primarily due to theinclusion of ATI.  As a percentage of relatedrevenue, network services cost of revenue for the three months ended September 30,2005 increased to 40.4% from 35.1% for the same period of 2004.

 

BTScost of revenue was $4.1 million for the three months ended September 30,2005, a decrease of 4.9% from $4.3 million in the same period of 2004.  Materials cost decreased due in part to lowernew systems sales in the three months ended September 30, 2005 from thesame period of 2004.  As a percentage ofrelated revenue, BTS cost of revenue for each of the three-month periods ended September 30,2004 and 2005 was 60.8%.  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.

 

***Gross Profit.*** Gross profit for the three months ended September 30, 2004 and 2005is as follows:

 
| ** **                  | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|-----------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                  | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Gross profit (in millions): |       |            |       |            |       |         |       |
| Network services            |       | $               | 21.7       |            | $          | 30.5         |       | 40.2 | % |
| Business  telephone systems |       | 2.8             |       | 2.6             |       | (5.1         | )%         |
| Total gross  profit         |       | $               | 24.5       |            | $          | 33.1         |       | 35.1 | % |

 

Theincrease in gross profit for the three months ended September 30, 2005,from the same period of 2004, is primarily due to the inclusion of ATI.

 

***Sales, General and Administrative Expense.***  Sales, general and administrative expenseswere $22.4 million for the three months ended September 30, 2005, anincrease of 21.5% from $18.4 million in the same period of 2004.  This increase was primarily due to theinclusion of sales, general and administrative expenses of ATI.  As a percentage of revenue, sales, generaland administrative expenses for the three months ended September 30, 2005declined to 38.6% from 45.4% in the same period of 2004 due to the improvedefficiency of our existing operations resulting from our fixed cost structuresupporting a higher level of revenue.  Weexpect this trend to continue as we add more access lines with only modestincreases in our employee base.

 

25

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***Depreciation and Amortization.***  Depreciation and amortization expense was$9.0 million for the three months ended September 30, 2005, an increase of20.2% from $7.5 million in the same period of 2004.  This increase was primarily due to theinclusion of ATI.  As a percentage ofrevenue, depreciation and amortization decreased to 15.6% for the three monthsended September 30, 2005 from 18.5% for the same period of 2004.

 

***Interest.*** Interest expense was $14.8 million for the three months ended September 30,2005, an increase of 421.6% from $2.8 million in the same period of 2004.  On September 15, 2005, we redeemed 35%of our then outstanding 8 3/8% senior second secured notes due 2010 at a redemptionprice of 112% of the accreted value. Interest expense for the three months ended September 30, 2005includes a $6.1 million accreted-value premium and a $1.5 million original-issuediscount catch-up paid upon redemption of the notes and $2.6 million ofnon-cash interest expense for the write-off of a proportionate amount of debtissuance costs.  The remaining increasewas primarily due to higher interest expense as a result of having a higheraverage outstanding debt balance for the three months ended September 30,2005 compared to the three months ended September 30, 2004.

 

***Net Income (Loss).***  Net loss for the three months ended September 30,2005 was $12.5 million compared to a net loss of $4.3 million in the sameperiod of 2004.  This increase in netloss is primarily due to additional interest expense mentioned above.

 

**NineMonths Ended September 30, 2005 versus Nine Months Ended September 30,2004**

 

***Revenue.***  Revenue for the nine months ended September 30,2004 and 2005 is as follows:

 
| ** **                  | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|-----------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                  | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Revenue (in millions):      |       |            |       |            |       |         |       |
| Voice and data  services    |       | $               | 72.6       |            | $          | 114.1        |       | 57.1 | % |
| Long distance               |       | 16.0            |       | 26.0            |       | 62.7         | %          |
| Access                      |       | 9.7             |       | 9.8             |       | 0.8          | %          |
| Total network  services     |       | 98.3            |       | 149.9           |       | 52.5         | %          |
| Business telephone  systems |       | 19.6            |       | 19.4            |       | (0.8         | )%         |
| Total revenue               |       | $               | 117.9      |            | $          | 169.3        |       | 43.6 | % |

 

Networkservices revenue was $149.9 million for the nine months ended September 30,2005, an increase of 52.5% from $98.3 million in the same period of 2004.  The increase in revenue was primarily due tothe inclusion of ATI, which was acquired on December 31, 2004.  Over the past 12 months the number of voicelines in service increased by 58.5% to 265,132 at September 30, 2005 andthe number of data lines in service increased by 100.6% to 140,744 at September 30,2005.  The growth in access lines waspartially offset by declines in pre-subscribed interexchange carrier charge(PICC) revenue, access revenue per minute of use and a decline in data revenueper line.  The decline in PICC revenuewas due to our dispute with Global Crossing which was resolved in June,2005.  As a result of that dispute, weelected not to record PICC revenue beginning in November 2004.  The PICC revenue impact was approximately$2.4 million for the nine months ended September 30, 2005 as compared tothe nine months ended September 30, 2004. Access revenue per minute of use declined as a result of the scheduledFCC reduction of interstate rate levels in June 2004.  Data revenue per line declined due to acombination of customers purchasing more bandwidth at discounted prices andgeneral pricing pressures for data services in our markets.  We expect all of the above trends in linegrowth, PICC revenue, access rates and data revenue per line to continue forthe foreseeable future.  As we continueto grow, our size and average monthly access line churn will begin to limit ouraccess line growth rate on both an absolute and a percentage basis unless weincrease our sales force and extend our network footprint.

 

BTSrevenue was $19.4 million for the nine months ended September 30, 2005, adecrease of 0.8% from $19.6 million in the same period of 2004.  We cannot predict future trends in capitalspending by small and medium-sized business customers.

 

26

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***Cost of Revenue.***  Cost of revenue for the nine months ended September 30,2004 and 2005 is as follows:

 
| ** **                     | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|--------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                     | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Cost of revenue (in millions): |       |            |       |            |       |         |       |
| Network services               |       | $               | 35.1       |            | $          | 65.6         |       | 86.9 | % |
| Business  telephone systems    |       | 11.8            |       | 11.9            |       | 1.1          | %          |
| Total cost of  revenue         |       | $               | 46.9       |            | $          | 77.5         |       | 65.4 | % |

 

Networkservices cost of revenue was $65.6 million for the nine months ended September 30,2005, an increase of 86.9% from $35.1 million in the same period of 2004.  The increase was primarily due to theinclusion of ATI and recording approximately $4.7 million in costs related tothe settlement with Global Crossing in June 2005.  As a percentage of related revenue, networkservices cost of revenue for the nine months ended September 30, 2005 was43.8% compared to 35.7% for the same period of 2004.

 

BTScost of revenue was $11.9 million for the nine months ended September 30,2005, an increase of 1.1% from $11.8 million in the same period of 2004.  As a percentage of related revenue, BTS costof revenue for the nine months ended September 30, 2005 increased to 61.3%from 60.2% for the same period of 2004. We do not expect future improvements in BTS cost of revenue as apercentage of related revenue unless we are able to significantly increase BTS newsystems sales and therefore achieve greater volume discounts or economies ofscale in our workforce.

 

***Gross Profit.***  Gross profit for the nine months ended September 30,2004 and 2005 is as follows:

 
| ** **                  | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|-----------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                  | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Gross profit (in millions): |       |            |       |            |       |         |       |
| Network services            |       | $               | 63.2       |            | $          | 84.3         |       | 33.4 | % |
| Business  telephone systems |       | 7.8             |       | 7.5             |       | (3.6         | )%         |
| Total gross  profit         |       | $               | 71.0       |            | $          | 91.8         |       | 29.3 | % |

 

The increasein gross profit for the nine months ended September 30, 2005, from thesame period of 2004, is primarily due to the inclusion of ATI which waspartially offset by approximately $4.7 million in costs related to thesettlement with Global Crossing in June 2005.

 

***Sales, General and Administrative Expense.***  Sales, general and administrative expenseswere $67.8 million for the nine months ended September 30, 2005, anincrease of 30.6% from $51.9 million in the same period of 2004.  This increase was primarily due to theinclusion of sales, general and administrative expenses of ATI.  As a percentage of revenue, sales, generaland administrative expenses for the nine months ended September 30, 2005declined to 40.0% from 44.1% in the same period of 2004 due to the improvedefficiency of our existing operations resulting from our fixed cost structuresupporting a higher level of revenue.  Weexpect this trend to continue as we add more access lines with only modest increasein our employee base.

 

***Depreciation and Amortization.***  Depreciation and amortization expense was$26.3 million for the nine months ended September 30, 2005, an increase of15.8% from $22.7 million in the same period of 2004.  This increase was primarily due to theinclusion of ATI.  As a percentage ofrevenue, depreciation and amortization decreased to 15.5% for the nine monthsended September 30, 2005 from 19.3% for the same period of 2004.

 

***Interest.*** Interest expense was $24.6 million for the nine months ended September 30,2005, an increase of 211.1% from $7.9 million in the same period of 2004.  On September 15, 2005, we redeemed 35%of our then outstanding 8 3/8% senior second secured notes due 2010 at aredemption price of 112% of the accreted value. Interest expense for the nine months ended September 30, 2005includes a $6.1 million accreted-value premium and a $1.5 million original-issuediscount catch-up paid upon redemption of the notes and $2.6 million ofnon-cash interest expense for the write-off of a proportionate amount of debtissuance costs.  The remaining increasewas primarily due to higher 

 

27

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interest expense as a result of having a higher average outstandingdebt balance for the nine months ended September 30, 2005 compared to thenine months ended September 30, 2004.

 

***Net Income (Loss).***  Net loss for the nine months ended September 30,2005 was $25.9 million compared to net income of $6.6 million in the sameperiod of 2004.  Net income for the ninemonths ended September 30, 2004 included a gain on extinguishment of debtof $18.2 million.  The gain on theextinguishment of debt was the result of paying off our bank facility.  In June 2002, we restructured our bankfacility and because the future cash flows could not be calculated withcertainty, the gain was deferred.  As aresult of the repayment, the excess carrying value of $20.9 million and debtissuance costs of $2.7 million resulted in the $18.2 million gain onextinguishment of debt.  Net income alsodecreased due to recording approximately $4.7 million in costs related to thesettlement with Global Crossing in June 2005 and the additional interestexpense mentioned above.

 

## **Liquidity and Capital Resources**

## ** **

***Principal Sources and Uses of Liquidity.* **Our principal sources of liquidity arecash from operations and our cash and cash equivalents and available-for-salesecurities. Our principal liquidity requirements consist of debt service,capital expenditures and working capital.

 

***Cash Flows Provided by Operating Activities. ***Cash provided byoperating activities was $3.9 million for the nine months ended September 30,2005 compared to cash provided by operating activities of $15.1 million for thesame period of 2004.  The decrease incash provided by operating activities was primarily due to the additionalinterest expense paid upon redemption of 35% our senior second secured notesand due to the increase in cost of revenue related to the settlement withGlobal Crossing in June 2005.

 

***Cash Flows Used in Investing Activities.***  Cash used in investing activities was $33.7million for the nine months ended September 30, 2005 compared to $22.9million for the same period of 2004.  Thecash used in investing activities was for the maintenance and expansion of ournetwork and back office systems and for the investment in available-for-salesecurities with maturity dates of less than twelve months.

 

***Cash Flows Provided by Financing Activities.***  Cash provided by financing activities was$17.5 million for the nine months ended September 30, 2005.  The initial public offering of our commonstock on August 9, 2005 generated approximately $68.4 million afterdeducting underwriting discounts and commissions and fees and expensesassociated with the offering.  A portionof the net proceeds was used to redeemapproximately $50.6 million accreted value ($57.8 million principal amount) ofour 8 3/8% senior second secured notes on September 15, 2005.  We also used cash for payments on capitallease obligations and for debt issuance costs.

 

For thenine months ended September 30, 2004, net cash provided by financingactivities was $13.6 million.  The netproceeds from the issuance of the senior second secured notes in March 2004generated approximately $13.2 million, which is net of a $1.6 millionprepayment penalty.  We also used cashfor payments on capital lease obligations and for debt issuance costs.

 

***Capital Requirements.***  For the nine months ended September 30,2005, we spent $27.1 million on capital expenditures.  We expect to spend approximately $40.0million on capital expenditures in 2005.

 

Basedon our current level of operations and anticipated growth, we believe that ourexisting cash, cash equivalents and short-term investments will be sufficientto fund our operations and we do not currently anticipate the need to raiseadditional financing to fund capital expenditures or operations for at leastthe next 12 months.

 

28

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# **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.  All of our investments havematurities of less than twelve months which reduces our exposure to long-terminterest rate changes.  Interest incomefor the three and nine-month periods ended September 30, 2005 was $0.3million and $0.5 million, respectively, therefore not exposing us to anymeaningful interest income risk had rates dropped.  We had $91.4 million in senior second securednotes outstanding as of September 30, 2005.  These notes are at a fixed interest rate andare therefore not exposed to any interest rate risk.

 

# **Item 4: Controls and Procedures**

# ** **

*Evaluationof disclosure controls and procedures.*  Our management, under the direction and withthe participation of Richard A. Smith, our President and Chief ExecutiveOfficer, and Geoffrey M. Boyd, our Chief Financial Officer, performed anevaluation of the design and operation of our disclosure controls andprocedures (as defined in Rule 13a-15 under the Securities Exchange Act of1934).  Based on that evaluation,Messers. Smith and Boyd concluded that, as of the end of the period covered bythis report, our disclosure controls and procedures were effective in alertingthem timely to material information relating to our company (including ourconsolidated subsidiaries) required to be included in our periodic Exchange Actfilings.

 

*Changesin internal controls over financial reporting.*  During the quarter ended September 30,2005, there have been no changes in our internal controls over financialreporting that materially affected, or are reasonably likely to materiallyaffect, our reported financial results.

 

29

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# **PART II. OTHER INFORMATION**

 

# **Item 1.  LegalProceedings**

 

There are no materialdevelopments since the second quarter Form 10-Q was filed on August 15,2005.

 

We are party from time totime to ordinary course disputes that we do not believe to be material.

 

**Item 2.Unregistered Sales of Equity Securities and Use of Proceeds**

 

We relied upon Rule 701promulgated under the Securities Act to issue the following securities:

 

On July 1, 2005, we issued to an accredited investor, under theEschelon Telecom, Inc. Stock Option Plan of 2002, 494 shares of restrictedcommon stock.

 

On July 1, 2005, we granted to 56 participants, under the EschelonTelecom, Inc. Stock Option Plan of 2002, options to purchase an aggregateof 7,218 shares of common stock, at an exercise price of $6.77 per share.  These options generally vest 20% upon theinitial grant and 20% per year over four years from the date of grant.

 

On August 18,2005, we granted to 662 participants, under the Eschelon Telecom, Inc.Stock Option Plan of 2002, options to purchase an aggregate of 180,652 sharesof common stock, at an exercise price of $12.19 per share.  These options generally vest 20% upon theinitial grant and 20% per year over four years from the date of grant.

 

OnAugust 18, 2005, we granted to a member of the board of directors, under theEschelon Telecom, Inc. Stock Option Plan of 2002, options to purchase anaggregate of 15,000 shares of common stock, at an exercise price of $12.19 pershare. These options vest 33 1/3% upon the initial grant and 33 1/3% per yearover two years from the date of grant.

 

On August 4, 2005,the Securities and Exchange Commission declared effective our RegistrationStatement on Form S-1 (File No. 333-124703).  The offering date was August 9,2005.  The offering has terminated andall of the securities registered have been sold.  The managing underwriters were LehmanBrothers, Jefferies & Company, Inc. and UBS Investment Bank.  Our registration was for 5,357,143 shares ofour common stock, par value $0.01 per share. We sold 5,357,143 shares for $14.00 per share, generating approximately$75.0 million in gross proceeds for us. After deducting underwriting discounts and commissions of $5.3 millionand $2.2 million for estimated fees and expenses associated with the offering,our net proceeds are approximately $67.6 million.  None of the payments for underwritingdiscounts and commissions and other transaction expenses represented direct orindirect payment to any of our directors, officers, persons owning 10% or moreof any class of our equity securities or other affiliates.

 

From the effective dateof the registration statement through September 30, 2005, the followingtable identifies the purposes and approximate amounts of the net proceeds paiddirectly or indirectly to others (dollars in millions):

 
| Redemption of 8 3/8% senior second secured notes due  March 15, 2010 |   | $ | 56.7 |   |
|---------------------------------------------------------------------------|--------|---|------|--------|
| Total use of net  proceeds through September 30, 2005                |   | $ | 56.7 |   |

 

**Item 3.  Defaults Upon Senior Securities**

 

None.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders**

 

On July 1, 2005,pursuant to written consent, the Company’s stockholders approved the followingmatters by the vote indicated below:

 

(i) Reverse stocksplit of the Company’s common stock.

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 7,972,417 |       | 4,269       |       | 331,800     |       |

 

30

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(ii) Adoption of theCompany’s seventh amended and restated certificate of incorporation.

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 7,971,278 |       | 4,416       |       | 332,792     |       |

 

(iii)  Adoption ofthe amended and restated bylaws of the Company.

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 7,972,802 |       | 4,406       |       | 331,278     |       |

 

(iv)  Approval ofthe form of indemnification agreement for the Company’s directors.

 
| **FOR**   | ** ** | **AGAINST** | ** ** | **ABSTAIN** | ** ** |
|-----------|------------|-------------|------------|-------------|------------|
| 7,969,650 |       | 4,406       |       | 334,430     |       |

 

**Item 5. Other Information**

 

None.

 

31

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**Item6.  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. |

 

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**SIGNATURE**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|                          | Eschelon  Telecom, Inc. |
|-------------------------------|------------------------------|
|                          |                         |   |
| Date:  November 14, 2005 | 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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