**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

Washington,D.C. 20549-0001

 

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**FORM 10-Q**

 

**(MARK ONE)**

 

| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15**(d)**OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|------------|------------|--------------------------------------------------------------------------------------------------|

 

**For thequarterly period ended September 30, 2004**

 

**OR**

 

| **o** | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15**(d)**OF THE SECURITIES  EXCHANGE ACT OF 1934** |
|-------|------------|---------------------------------------------------------------------------------------------------|

 

**CommissionFile Number 000-50706**

 

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** **

**ESCHELON TELECOM, INC.**

(Exactname of registrant 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 bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to the filing requirements for the past90 days.  Yes ý     No o

 

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

 

Asof November 9, 2004, the number of outstanding shares of the Registrant’sCommon Stock, par value $.01 per share, was 4,734,419 shares and the number ofoutstanding shares of the Registrant’s Preferred Stock, par value $.01 pershare, was 84,306,677 shares, convertible into 101,432,459 shares of CommonStock.

 

** **

 

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**ESCHELONTELECOM, INC.**

**INDEXTO FORM 10-Q**

 

 
| **PART I. FINANCIAL INFORMATION** | 3                                                                                                                       |
|-----------------------------------|-------------------------------------------------------------------------------------------------------------------------|
| Item 1.                           | Financial Statements:                                                                                                   | 3 |
|                              | Consolidated Balance Sheets  — December 31, 2003 and September 30, 2004 (Unaudited)                                | 4 |
|                              | Unaudited  Consolidated Statements of Operations — Three months and nine months ended  September 30, 2003 and 2004 | 4 |
|                              | Unaudited  Consolidated Statements of Cash Flows — Nine months ended September 30, 2003  and 2004                  | 5 |
|                              | Notes to  Consolidated Financial Statements                                                                             | 6 |
| Item  2.                          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                             | 13 |
| Item  3.                          | Quantitative  and Qualitative Disclosures About Market Risk                                                             | 24 |
| Item 4.                           | Controls and Procedures                                                                                                 | 24 |
| **PART II. OTHER INFORMATION**    | 25                                                                                                                      |
| Item 1.                           | Legal Proceedings                                                                                                       | 25 |
| Item 2.                           | Changes in Securities, Use of Proceeds  and Issuer Purchase of Equity Securities                                        | 25 |
| Item 3.                           | Defaults Upon  Securities                                                                                               | 26 |
| Item 4.                           | Submission  of Matters to a Vote of Security Holders                                                                    | 26 |
| Item 5.                           | Other Information                                                                                                       | 26 |
| Item 6.                           | Exhibits and  Reports on Form 8-K                                                                                       | 26 |
|                              | Signature                                                                                                               | 29 |

 

2

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**PARTI.****  FINANCIAL INFORMATION**

 

## **Item 1**. Financial Statements

 

**Eschelon Telecom, Inc.**

**ConsolidatedBalance Sheets**

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

 
| ** **                                                                                                                                                                                      | ** ** | **December 31,  2003** | ** ** | **September 30,  2004** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------------|------------|
|                                                                                                                                                                                            |       |                   |       | **(Unaudited)**         |       |
| **Assets**                                                                                                                                                                                      |       |                   |       |                    |       |
| Current assets:                                                                                                                                                                                 |       |                   |       |                    |       |
| Cash and cash equivalents                                                                                                                                                                       |       | $                      | 8,606      |                    | $          | 14,408 |   |
| Restricted cash                                                                                                                                                                                 |       | —                 |       | 651                     |       |
| Marketable securities                                                                                                                                                                           |       | —                 |       | 4,362                   |       |
| Accounts receivable, net of allowance for doubtful accounts of $739  and $246, respectively                                                                                                     |       | 13,537                 |       | 12,866                  |       |
| Other receivables                                                                                                                                                                               |       | 2,097                  |       | 3,047                   |       |
| Inventories                                                                                                                                                                                     |       | 3,169                  |       | 3,154                   |       |
| Prepaid expenses                                                                                                                                                                                |       | 2,046                  |       | 922                     |       |
| Total current assets                                                                                                                                                                            |       | 29,455                 |       | 39,410                  |       |
|                                                                                                                                                                                            |       |                   |       |                    |       |
| Property and equipment, net                                                                                                                                                                     |       | 86,777                 |       | 85,137                  |       |
|                                                                                                                                                                                            |       |                   |       |                    |       |
| Other assets                                                                                                                                                                                    |       | 1,269                  |       | 1,396                   |       |
| Goodwill                                                                                                                                                                                        |       | 7,168                  |       | 7,168                   |       |
| Intangible assets, net                                                                                                                                                                          |       | 29,052                 |       | 29,727                  |       |
| Total assets                                                                                                                                                                                    |       | $                      | 153,721    |                    | $          | 162,838 |   |
|                                                                                                                                                                                            |       |                   |       |                    |       |
| **Liabilities and stockholders’ deficit**                                                                                                                                                  |       |                   |       |                    |       |
| Current liabilities:                                                                                                                                                                            |       |                   |       |                    |       |
| Accounts payable                                                                                                                                                                                |       | $                      | 4,582      |                    | $          | 4,869 |   |
| Accrued telecommunication costs                                                                                                                                                                 |       | 6,939                  |       | 7,521                   |       |
| Accrued expenses                                                                                                                                                                                |       | 3,240                  |       | 4,796                   |       |
| Deferred revenue                                                                                                                                                                                |       | 3,000                  |       | 3,762                   |       |
| Accrued compensation expenses                                                                                                                                                                   |       | 4,261                  |       | 3,312                   |       |
| Capital lease obligation, current maturities                                                                                                                                                    |       | 1,020                  |       | 311                     |       |
| Total current liabilities                                                                                                                                                                       |       | 23,042                 |       | 24,571                  |       |
|                                                                                                                                                                                            |       |                   |       |                    |       |
| Long-term liabilities:                                                                                                                                                                          |       |                   |       |                    |       |
| Commitments and contingencies (Note 3)                                                                                                                                                          |       |                   |       |                    |       |
| Capital lease obligation                                                                                                                                                                        |       | 576                    |       | 1,979                   |       |
| Notes payable                                                                                                                                                                                   |       | 86,226                 |       | 85,789                  |       |
| Total liabilities                                                                                                                                                                               |       | 109,844                |       | 112,339                 |       |
|                                                                                                                                                                                            |       |                   |       |                    |       |
| Series A convertible preferred stock, $0.01 par value; 100,000,000  shares authorized; 84,306,677 shares outstanding at December 31, 2003 and  September 30, 2004                               |       | 48,948                 |       | 51,520                  |       |
|                                                                                                                                                                                            |       |                   |       |                    |       |
| Stockholders’ deficit:                                                                                                                                                                     |       |                   |       |                    |       |
| Common stock, $0.01 par value; 160,000,000 shares authorized;  4,457,579 shares issued and outstanding at December 31, 2003; and 4,730,919  shares issued and outstanding at September 30, 2004 |       | 45                     |       | 47                      |       |
| Additional paid-in capital                                                                                                                                                                      |       | 120,105                |       | 117,550                 |       |
| Accumulated other comprehensive income                                                                                                                                                          |       | —                 |       | 5                       |       |
| Accumulated deficit                                                                                                                                                                             |       | (125,167               | )          | (118,589                | )          |
| Deferred compensation                                                                                                                                                                           |       | (54                    | )          | (34                     | )          |
| Total stockholders’ deficit                                                                                                                                                                |       | (5,071                 | )          | (1,021                  | )          |
| Total liabilities and stockholders’ deficit                                                                                                                                                |       | $                      | 153,721    |                    | $          | 162,838 |   |
|                                                                                                                                                                                                 |            |                        |            |                         |            |  |  |  |  |  |

 

*See accompanying notes.*

 

 

3

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**Eschelon Telecom, Inc.**

**Unaudited Consolidated Statements of Operations**

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

 
| ** **                                          | ** ** | **Three months ended****September 30,** | ** ** | **Nine months ended****September 30,** | ** ** |
|-----------------------------------------------------|------------|-----------------------------------------|------------|----------------------------------------|------------|
| ** **                                          | ** ** | **2003**                                | ** ** | **2004**                               | ** ** | **2003** | ** ** | **2004** | ** ** |
| Revenue:                                            |       |                                    |       |                                   |       |   |   |   |   |
| Network services                                    |       | $                                       | 29,632     |                                   | $          | 33,476 |   | $ | 84,474 |   | $ | 98,333 |   |
| Business telephone systems                          |       | 6,941                                   |       | 7,086                                  |       | 19,418 |   | 19,575 |   |
| Total revenue                                       |       | 36,573                                  |       | 40,562                                 |       | 103,892 |   | 117,908 |   |
|                                                |       |                                    |       |                                   |       |   |   |   |   |
| Cost of revenue:                                    |       |                                    |       |                                   |       |   |   |   |   |
| Network services                                    |       | 11,791                                  |       | 11,736                                 |       | 33,640 |   | 35,093 |   |
| Business telephone systems                          |       | 4,215                                   |       | 4,305                                  |       | 11,771 |   | 11,785 |   |
| Total cost of revenue                               |       | 16,006                                  |       | 16,041                                 |       | 45,411 |   | 46,878 |   |
|                                                |       |                                    |       |                                   |       |   |   |   |   |
| Gross profit:                                       |       |                                    |       |                                   |       |   |   |   |   |
| Network services                                    |       | 17,841                                  |       | 21,740                                 |       | 50,834 |   | 63,240 |   |
| Business telephone systems                          |       | 2,726                                   |       | 2,781                                  |       | 7,647 |   | 7,790 |   |
| Total gross profit                                  |       | 20,567                                  |       | 24,521                                 |       | 58,481 |   | 71,030 |   |
|                                                |       |                                    |       |                                   |       |   |   |   |   |
| Operating expenses:                                 |       |                                    |       |                                   |       |   |   |   |   |
| Sales, general and administrative                   |       | 17,292                                  |       | 18,423                                 |       | 48,959 |   | 51,949 |   |
| Depreciation and amortization                       |       | 7,057                                   |       | 7,493                                  |       | 22,762 |   | 22,705 |   |
| Operating loss                                      |       | (3,782                                  | )          | (1,395                                 | )          | (13,240 | ) | (3,624 | ) |
|                                                |       |                                    |       |                                   |       |   |   |   |   |
| Other income (expense):                             |       |                                    |       |                                   |       |   |   |   |   |
| Interest income                                     |       | 15                                      |       | 45                                     |       | 162 |   | 83 |   |
| Interest expense                                    |       | (422                                    | )          | (2,837                                 | )          | (1,301 | ) | (7,911 | ) |
| Gain on extinguishment of debt                      |       | —                                  |       | —                                 |       | — |   | 18,195 |   |
| Other expense                                       |       | 502                                     |       | (138                                   | )          | 466 |   | (161 | ) |
| Income (loss) before taxes                          |       | (3,687                                  | )          | (4,325                                 | )          | (13,913 | ) | 6,582 |   |
| Income taxes                                        |       | (28                                     | )          | (4                                     | )          | (28 | ) | (4 | ) |
| Net income (loss)                                   |       | (3,715                                  | )          | (4,329                                 | )          | (13,941 | ) | 6,578 |   |
| Less preferred stock dividends                      |       | (863                                    | )          | (863                                   | )          | (2,562 | ) | (2,572 | ) |
| Net income (loss) applicable to common stockholders |       | $                                       | (4,578     | )                                      | $          | (5,192 | ) | $ | (16,503 | ) | $ | 4,006 |   |
|                                                |       |                                    |       |                                   |       |   |   |   |   |
| Net income (loss) per share:                        |       |                                    |       |                                   |       |   |   |   |   |
| Basic                                               |       | $                                       | (1.43      | )                                      | $          | (1.30 | ) | $ | (5.69 | ) | $ | 1.04 |   |
| Diluted                                             |       | $                                       | (1.43      | )                                      | $          | (1.30 | ) | $ | (5.69 | ) | $ | 0.11 |   |
|                                                |       |                                    |       |                                   |       |   |   |   |   |
| Weighted average number of shares outstanding:      |       |                                    |       |                                   |       |   |   |   |   |
| Basic                                               |       | 3,199,473                               |       | 3,992,931                              |       | 2,902,001 |   | 3,838,007 |   |
| Diluted                                             |       | 3,199,473                               |       | 3,992,931                              |       | 2,902,001 |   | 110,190,030 |   |
|                                                     |            |                                         |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |

* *

* *

*See accompanying notes.*

** **

 

4

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**Eschelon Telecom, Inc.**

**Unaudited Consolidated Statements of Cash Flows**

**(In Thousands)**

 

 
| ** **                                                                                | ** ** | **Nine months ended**** ****September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2003**                                         | ** ** | **2004** | ** ** |
| **Operating activities**                                                                  |       |                                             |       |   |   |
| Net income (loss)                                                                         |       | $                                                | (13,941    | ) | $ | 6,578 |   |
| Adjustments to reconcile net income (loss) to net cash provided by  operating activities: |       |                                             |       |   |   |
| Depreciation and amortization expense                                                     |       | 22,762                                           |       | 22,705 |   |
| Other non-cash items                                                                      |       | 1,050                                            |       | 2,212 |   |
| Gain on extinguishment of debt                                                            |       | —                                           |       | (18,195 | ) |
| Changes in operating assets and liabilities:                                              |       |                                             |       |   |   |
| Increase in restricted cash                                                               |       | —                                           |       | (651 | ) |
| Accounts receivable                                                                       |       | (4,238                                           | )          | 171 |   |
| Inventories                                                                               |       | (685                                             | )          | 15 |   |
| Other current assets and deposits                                                         |       | 1,695                                            |       | 47 |   |
| Accounts payable and accrued expenses                                                     |       | 3,640                                            |       | 2,425 |   |
| Deferred revenue                                                                          |       | 665                                              |       | 762 |   |
| Accrued compensation expense                                                              |       | (742                                             | )          | (949 | ) |
| Net cash provided by operating activities                                                 |       | 10,206                                           |       | 15,120 |   |
|                                                                                      |       |                                             |       |   |   |
| **Investing activities**                                                                  |       |                                             |       |   |   |
| Purchases of marketable securities                                                        |       | —                                           |       | (4,357 | ) |
| Purchases of property and equipment                                                       |       | (10,856                                          | )          | (10,105 | ) |
| Cash paid for customer installation costs                                                 |       | (8,907                                           | )          | (8,442 | ) |
| Net cash used in investing activities                                                     |       | (19,763                                          | )          | (22,904 | ) |
|                                                                                      |       |                                             |       |   |   |
| **Financing activities**                                                                  |       |                                             |       |   |   |
| Proceeds from issuance of notes payable                                                   |       | —                                           |       | 84,813 |   |
| Payments made on bank debt and capital lease obligations                                  |       | (2,081                                           | )          | (66,599 | ) |
| Proceeds from (fees associated with) issuance of stock                                    |       | (58                                              | )          | 7 |   |
| Increase in debt issuance costs                                                           |       | (58                                              | )          | (4,635 | ) |
| Net cash provided by (used in) financing activities                                       |       | (2,197                                           | )          | 13,586 |   |
|                                                                                      |       |                                             |       |   |   |
| Net increase (decrease) in cash and cash equivalents                                      |       | (11,754                                          | )          | 5,802 |   |
| Cash and cash equivalents at beginning of period                                          |       | 19,733                                           |       | 8,606 |   |
| Cash and cash equivalents at end of period                                                |       | $                                                | 7,979      |   | $ | 14,408 |   |
| ** **                                                                                | ** ** | ** **                                       | ** ** | ** ** | ** ** |
| **Supplemental cash flow information**                                                    |       |                                             |       |   |   |
| Cash paid for interest                                                                    |       | $                                                | 327        |   | $ | 6,394 |   |
|                                                                                      |       |                                             |       |   |   |
| **Supplemental noncash activities**                                                       |       |                                             |       |   |   |
| Equipment purchases under capital leases                                                  |       | $                                                | 1,097      |   | $ | 1,872 |   |
| Value of common stock issued to management                                                |       | $                                                | 124        |   | $ | 14 |   |

 

 

*See accompanying notes.*

 

 

 

5

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** **

**Eschelon Telecom, Inc.**

**Notes to Consolidated Financial Statements**

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

**(Unaudited)**

 

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

 

**Basis of Presentation**

 

The accompanyingunaudited consolidated financial statements of Eschelon Telecom, Inc. and itssubsidiaries (the “Company”) have been prepared in accordance with accountingprinciples generally accepted in the United States of America for interimfinancial information and the instructions to Form 10-Q and Article 10 ofRegulation S-X promulgated by the United States Securities and ExchangeCommission (the “SEC”).  Accordingly,they do not include all of the information and notes required by accountingprinciples generally accepted in the United States of America for completefinancial statements.  In the opinion ofmanagement, all adjustments (consisting of normal and recurring adjustments andaccruals) considered necessary for a fair presentation for the periodsindicated have been included.  Operatingresults for the three and nine month periods ended September 30, 2004 are notnecessarily indicative of the results that may be expected for the year endingDecember 31, 2004.  The consolidatedbalance sheet at December 31, 2003 has been derived from the auditedconsolidated financial statements at that date but does not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements.  Thesefinancial statements should be read in conjunction with the Company’s auditedfinancial statements and related notes thereto for the year ended December 31,2003 included in the Eschelon Operating Company Form S-4/A, File No.333-114437-08, filed with the Securities and Exchange Commission on May 6,2004.

 

# **Principles ofConsolidation**

 

The consolidated financial statements includethe accounts of the Company and its wholly owned subsidiaries.  All intercompany balances and transactionshave been eliminated in consolidation.

 

## **Property and Equipment**

 

Property and equipment, including leaseholdimprovements, are stated at cost.  Allinternal costs directly related to the construction of the switches andoperating and support systems, including salaries of certain employees, arecapitalized.  Depreciation is providedusing the straight-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.

 

Property and equipment consist of thefollowing:

 

| ** **                                | ** ** | **December 31,   2003** | ** ** | **September 30,   2004** | ** ** |
|-------------------------------------------|------------|-------------------------|------------|--------------------------|------------|
| Vehicles                                  |       | $                       | 39         |                     | $          | 357 |   |
| Office furniture and equipment            |       | 13,243                  |       | 15,025                   |       |
| Computer equipment and software           |       | 30,264                  |       | 32,443                   |       |
| Leasehold improvements                    |       | 16,931                  |       | 16,992                   |       |
| Switching and data equipment and software |       | 76,751                  |       | 83,428                   |       |
|                                      |       | 137,228                 |       | 148,245                  |       |
| Less accumulated depreciation             |       | (50,451                 | )          | (63,108                  | )          |
|                                      |       | $                       | 86,777     |                     | $          | 85,137 |   |
|                                           |            |                         |            |                          |            |  |  |  |

 

## **Goodwill and Intangibles**

 

Goodwill represents the excess of cost overthe fair value of net assets acquired.

 

 

6

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Intangibles consist of customer installationcosts, debt issuance costs and non-compete agreements.  The customer installation costs are beingamortized over a period of 48 months, which approximates the average life of acustomer contract.  Debt issuance costs arebeing amortized over the term of the respective debt obligation.  Non-compete agreement costs represent costsassociated with various agreements the Company has entered into with existingmanagement of the companies they have acquired. These costs are being amortized over the terms of the agreements.

 

Intangible assets consist of the following:

 

| ** **                    | ** ** | **December 31,  2003** | ** ** | **September 30, 2004** | ** ** |
|-------------------------------|------------|------------------------|------------|------------------------|------------|
| Customer installation costs   |       | $                      | 52,794     |                   | $          | 61,237 |   |
| Debt issuance costs           |       | 5,833                  |       | 4,635                  |       |
| Non-compete agreements        |       | 15                     |       | 15                     |       |
|                          |       | 58,642                 |       | 65,887                 |       |
| Less accumulated amortization |       | (29,590                | )          | (36,160                | )          |
|                          |       | $                      | 29,052     |                   | $          | 29,727 |   |

 

## **Revenue Recognition**

 

Revenues from network services are recognizedin the period in which subscribers use the related services.  Revenues from equipment sales and relatedinstallation charges are recognized upon delivery, completion of theinstallation of the related equipment, and acceptance by the customer, at whichpoint legal title passes to the customer. Revenues for carrier interconnection and access are recognized in theperiod in which the service is provided.

## ** **

## **Use of Estimates**

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the amountsreported in the financial statements and accompanying notes.  Actual results could differ from thoseestimates.

 

## **Stock-Based Compensation**

 

The Company accounts for its stock-basedemployee compensation under the recognition and measurement principles ofAccounting Principles Board (APB) Opinion No. 25, *Accountingfor Stock Issued to Employees,*and related interpretations.  Under APB No. 25, when the exercise price ofstock options equals the market price of the underlying stock on the date ofgrant, no compensation expense is recognized in the consolidated statement ofoperations.

 

The following table illustrates the effect onnet income (loss) per share if the company had applied the fair valuerecognition provision of Statement of Financial Accounting Standards (SFAS) No.123, *Accounting for Stock-Based Compensation,*tostock-based employee compensation:

 

 

7

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| ** **                                                                                                        | ** ** | **Three months ended   September 30,** | ** ** | **Nine months ended   September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2003**                               | ** ** | **2004**                              | ** ** | **2003** | ** ** | **2004** | ** ** |
| Net income (loss) applicable to common stockholders, as reported                                                  |       | $                                      | (4,578     | )                                     | $          | (5,192 | ) | $ | (16,503 | ) | $ | 4,006 |   |
| Add: Stock-based employee compensation expense included in reported  net income (loss)                            |       | —                                 |       | —                                |       | 70 |   | 20 |   |
| Deduct: Total stock-based employee compensation expense determined  under fair value-based methods for all awards |       | (1                                     | )          | (2                                    | )          | (132 | ) | (49 | ) |
| Pro forma net income (loss) applicable to common stockholders                                                     |       | $                                      | (4,579     | )                                     | $          | (5,194 | ) | $ | (16,565 | ) | $ | 3,977 |   |
|                                                                                                              |       |                                   |       |                                  |       |   |   |   |   |
| Net income (loss) per share:                                                                                      |       |                                   |       |                                  |       |   |   |   |   |
| Basic — as reported                                                                                          |       | $                                      | (1.43      | )                                     | $          | (1.30 | ) | $ | (5.69 | ) | $ | 1.04 |   |
| Basic — pro forma                                                                                            |       | $                                      | (1.43      | )                                     | $          | (1.30 | ) | $ | (5.71 | ) | $ | 1.04 |   |
|                                                                                                              |       |                                   |       |                                  |       |   |   |   |   |
| Diluted — as reported                                                                                        |       | $                                      | (1.43      | )                                     | $          | (1.30 | ) | $ | (5.69 | ) | $ | 0.11 |   |
| Diluted — pro forma                                                                                          |       | $                                      | (1.43      | )                                     | $          | (1.30 | ) | $ | (5.71 | ) | $ | 0.11 |   |
|                                                                                                                   |            |                                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |

 

Pro forma information regarding net income(loss) and net income (loss) per share is required by SFAS No. 123, and hasbeen determined as if the Company had accounted for its employee stock optionsunder the fair value method of SFAS No. 123. The fair value of these options was estimated at the date of grant usingthe Black-Scholes option pricing model with the following assumptions for thethree months ended September 30, 2003 and 2004: a risk-free interest rate of 3.25% and 3.47%, respectively; dividend yieldof 0% for each period; volatility factor of the expected market price of theCompany’s common stock of 25% for each period; and a weighted average life ofthe options of five years for each period. The following assumptions were used for the nine months ended September30, 2003 and 2004:  a risk-free interestrate ranging from 3.25% to 3.88%; dividend yield of 0% for each period;volatility factor of the expected market price of the Company’s common stock of25% for each period; and a weighted average life of the options of five yearsfor each period.

 

The Black-Scholes option valuation model wasdeveloped for use in estimating the fair value of traded options which have novesting 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 share is computed based onthe weighted average number of common shares outstanding.  Diluted earnings per share is computed basedon the weighted average number of common shares outstanding adjusted by thenumber of additional shares that would have been outstanding had thepotentially dilutive common shares been issued. Potentially dilutive shares of common stock include stock options,unvested restricted stock grants and Series A 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 andSeries A Convertible Preferred Stock is anti-dilutive.

 

The following table presents a reconciliationof the numerators and denominators of basic and diluted earnings per commonshare:

 

 

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| ** **                                                       | ** ** | **Three months ended   September 30,** | ** ** | **Nine months ended   September 30,** | ** ** |
|------------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|------------|
| ** **                                                       | ** ** | **2003**                               | ** ** | **2004**                              | ** ** | **2003** | ** ** | **2004** | ** ** |
| Numerator:                                                       | ** ** | ** **                             | ** ** | ** **                            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss) applicable to common stockholders, as reported |       | $                                      | (4,578     | )                                     | $          | (5,192 | ) | $ | (16,503 | ) | $ | 4,006 |   |
| Add: Cumulative preferred stock dividends                        |       | —                                 |       | —                                |       | — |   | 8,698 |   |
| Deduct: Unrecognized deferred compensation expense               |       | —                                 |       | —                                |       | — |   | (34 | ) |
| Numerator for diluted earnings per share                         |       | $                                      | (4,578     | )                                     | $          | (5,192 | ) | $ | (16,503 | ) | $ | 12,670 |   |
|                                                             |       |                                   |       |                                  |       |   |   |   |   |
| Denominator:                                                     |       |                                   |       |                                  |       |   |   |   |   |
| Weighted average number of common shares outstanding             |       | 3,199,473                              |       | 3,992,931                             |       | 2,902,001 |   | 3,838,007 |   |
| Effect of dilutive securities:                                   |       |                                   |       |                                  |       |   |   |   |   |
| Restricted stock grants                                          |       | —                                 |       | —                                |       | — |   | 397,918 |   |
| Employee stock options                                           |       | —                                 |       | —                                |       | — |   | 4,521,646 |   |
| Series A convertible preferred stock                             |       | —                                 |       | —                                |       | — |   | 101,432,459 |   |
| Denominator for diluted earnings per share                       |       | 3,199,473                              |       | 3,992,931                             |       | 2,902,001 |   | 110,190,030 |   |
|                                                             |       |                                   |       |                                  |       |   |   |   |   |
| Net income (loss) per share:                                     |       |                                   |       |                                  |       |   |   |   |   |
| Basic — as reported                                         |       | $                                      | (1.43      | )                                     | $          | (1.30 | ) | $ | (5.69 | ) | $ | 1.04 |   |
| Diluted — as reported                                       |       | $                                      | (1.43      | )                                     | $          | (1.30 | ) | $ | (5.69 | ) | $ | 0.11 |   |
|                                                                  |            |                                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

## **New Accounting Pronouncements**

 

In May 2003, the Financial AccountingStandards Board issued SFAS No. 150, *Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity. *SFAS No. 150 requires that certainfinancial instruments, which under previous guidance were accounted for asequity, must now be accounted for as liabilities.  The financial instruments affected includemandatorily redeemable stock, certain financial instruments that require or mayrequire the issuer to buy back some of its shares in exchange for cash or otherassets and certain obligations that can be settled with shares of stock.  SFAS No. 150 is effective for all financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective the beginning of the first interim period after June 15, 2003.  The adoption of SFAS No. 150 did not have amaterial impact on the Company’s financial statements and did not require theCompany to reclassify its Series A Preferred Stock to a liability as the sharesare contingently redeemable.

 

## **Reclassifications**

 

Certain prior year amounts have beenreclassified to conform to current year presentation.

 

**2.)****         ****RestrictedCash**

 

On August 2, 2004,a Nevada state court entered a judgment against the Company for intentionallyinterfering with a former salesperson’s economic relationship with his newemployer in the amount of $376 plus costs. The Company had reason to believe the former employee was violating hisnon-solicitation agreement with the Company. On August 30, 2004, the Company appealed the judgment because, amongother reasons, the jury was not instructed to consider whether the Company wasjustified in informing the new employer of the agreement and the intent toenforce it.  During the appeal process,the Company is required to hold an amount equal to one and one-half times thepending judgment, plus accrued interest, as restricted cash.

 

**3.)****         ****MarketableSecurities**

 

Short-terminvestments are comprised of municipal and United States government debtsecurities.  In accordance with SFAS No.115, *Accounting for Certain Investments in Debtand Equity Securities*, and based on the Company’s intentionsregarding these instruments, all investments in debt securities are classifiedas available-for-sale and accounted for at fair value.

 

The cost basis,fair value and gross unrealized gains of the investment securitiesavailable-for-sale as of September 31, 2004 and December 31, 2003, are asfollows:

 

 

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| ** **                                     | ** ** | **Cost Basis** | ** ** | **Fair Value** | ** ** | **Gross Unrealized Holding   Gains** | ** ** | **Gross Unrealized Holding (Losses)** | ** ** |
|------------------------------------------------|------------|----------------|------------|----------------|------------|--------------------------------------|------------|---------------------------------------|------------|
| Marketable securities as of September 30, 2004 |       | $              | 4,357      |           | $          | 4,362                                |       | $                                     | 5          |   | $ | — |   |
| Marketable securities as of December 31, 2003  |       | $              | —     |           | $          | —                               |       | $                                     | —     |   | $ | — |   |

 

 

Debt securities asof September 30, 2004 have maturities of six months or less.

 

**4.)****         ****NotesPayable**

 

In March 2004, the Company completed anoffering of $100,000 of 8 3/8% senior second secured notes due 2010 at adiscount resulting in a 12% yield. Proceeds from the offering were used to retire bank debt with a principalbalance of $65,421, pay fees related to the offering and provide additionalliquidity to the Company.

 

The carrying value of notes payable iscomprised of the following:

 

| ** **               | ** ** | **December 31,   2003** | ** ** | **September 30,   2004** | ** ** |
|--------------------------|------------|-------------------------|------------|--------------------------|------------|
| Principal balance due    |       | $                       | 64,355     |                     | $          | 100,000 |   |
| Excess carrying value    |       | 21,871                  |       | —                   |       |
| Discount on note payable |       | —                  |       | (14,211                  | )          |
| Carrying value           |       | $                       | 86,226     |                     | $          | 85,789 |   |

 

**5.)****         ****Commitmentsand Contingencies**

 

In April 2003, the Company entered into afive-year agreement with MCI to purchase colocation/LIS transportservices.  The agreement requires thatthe Company maintain monthly minimums as follows:

 

| April 2004-March 2005 |   | $84/month |
|-----------------------|--------|-----------|
| April 2005-March 2006 |   | $88/month |
| April 2006-March 2007 |   | $93/month |
| April 2007-March 2008 |   | $97/month |

 

The Company will pay an underutilizationcharge for any amounts billed under the monthly minimum.

 

In 2000, the Company entered into anamendment of an earlier Master Purchase and Service agreement with NortelNetworks, Inc. (Nortel Networks).  Underthe amendment, the Company committed to purchase and/or license $100,000 ofNortel Networks’ equipment or services. However, the Company is confident that, due to Nortel Networks’discontinuance of certain product lines contemplated in the Amended MasterPurchase and Services agreement, neither party will be held to the conditionsof the contract.

 

In August 2000, the Company entered into aten-year agreement with Global Crossing to purchase a total of $100,000 ofservices.  The agreement does not containmonthly minimums, however a penalty is assessed for early termination uponchange in control.  Upon change incontrol, the remaining early termination penalty is $5,000.

 

**6.)****         ****CapitalStock**

 

Under the terms of theSeries A Convertible Preferred Stock, the holders are entitled to receive, whenand if declared by the Board of Directors, cumulative dividends on each shareof the Series A Convertible Preferred Stock at a rate of 8% per year whichshall accrue daily and, to the extent not paid, shall accumulate quarterly inarrears.  At December 31, 2003 andSeptember 30, 2004, dividends in arrears are $6,127 and $8,698, respectively.

 

 

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The shares of Series AConvertible Preferred Stock, plus all accrued and unpaid dividends at the timeof conversion, are convertible at any time, at the option of the holder, intoshares of the Company’s common stock at the initial conversion price, which isthe original issue price of $0.5079.  Theconversion price is subject to adjustment in the event of certain events, suchas dilutive issuances of additional securities. The Series A Convertible Preferred Stock will automatically convert intocommon stock in the event of an initial public offering raising at least$50,000.  The Series A ConvertiblePreferred Stock may be automatically converted upon the consent of the holdersof at least 60% of the then outstanding shares of Series A ConvertiblePreferred Stock.

 

The shares of Series AConvertible Preferred Stock will be redeemed on the tenth anniversary of theoriginal issuance, if the shares have not previously been redeemed orconverted.  The Company may redeem all ofthe Series A Convertible Preferred Stock upon the effectiveness of an initialpublic offering.  The redemption price ofthe Series A Convertible Preferred stock will be the greater of (i) theoriginal issue price plus all accrued and unpaid dividends or (ii) the fairmarket value of the shares of common stock, as determined by the Board ofDirectors, that would be received upon conversion of (a) the Series A ConvertiblePreferred Stock, and (b) any accrued and unpaid dividends on the Series AConvertible Preferred Stock.  Upon achange of control, the holders of 60% of the then outstanding shares of theSeries A Convertible Preferred Stock may require the Company to redeem all ofor a portion of the Series A Convertible Preferred Stock at a price equal to(1) the liquidation preference (as described below) if the change of controloccurs before the fifth anniversary of the original issue date and (2) theredemption price if the change of control occurs after the fifth anniversary ofthe original issue date.

 

In the event of the Company’sliquidation, the holders of the Series A Convertible Preferred Stock willreceive any distribution of corporate assets before any distributions are madeto a junior class of equity.  The amountto be distributed to the holders of Series A Convertible Preferred Stock willbe the greater of (i) two times the original issue price plus all accrued and unpaiddividends (whether or not yet accumulated) as of the date of distribution, or(ii) the fair market value of the shares of the Company’s common stock, asdetermined by the Board of Directors, that would be received upon (1)conversion of the Series A Convertible Preferred Stock, (2) any accrued andunpaid dividends and, (3) if the liquidation is prior to the fifth anniversaryof the date of issuance of the Series A Convertible Preferred Stock, alladditional dividends that would have been accrued through the fifth anniversarydate.

 

## **Stock Options**

 

In November 2002, the Board of Directorsapproved the Eschelon Telecom, Inc. Stock Option Plan of 2002 (the 2002Plan).  A total of 14,117,647 shares ofthe Company’s common stock have been reserved for issuance under the 2002Plan.  At September 30, 2004, the Companyhad 10,273,030 options outstanding and 2,484,979 shares of restricted commonstock issued to certain directors and members of management under the 2002Plan.

 

## **Restricted Common Stock**

 

In February 2003, the Company granted2,484,979 shares of restricted common stock to certain directors and members ofmanagement.  The fair value per share ofthis restricted stock was $0.05.  TheCompany records compensation expense as the restrictions are removed from thestock.  In February 2003, 1,399,902shares had vested resulting in compensation expense related to restrictedcommon stock of $70.  In February 2004,an additional 405,968 shares had vested resulting in compensation expense of$20.

 

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

 

OnOctober 13, 2004, the Company entered into an agreement with Advanced TelComGroup, Inc. (ATG), a Delaware corporation and a subsidiary of General ElectricCapital Corporation (GECC) providing for the purchase by the Company of 100% ofthe issued and outstanding shares of capital stock of Advanced TelCom, Inc.(ATI), a Delaware corporation and a wholly owned subsidiary of ATG (the ATIAcquisition), for a purchase price of approximately $45,500.  The ATI Acquisition is currently expected toclose on December 31, 2004.  In addition,on October 13, 2004, the Company entered into an agreement with GE BusinessProductivity Solutions, Inc. (GE BPS), a Georgia corporation and a wholly ownedsubsidiary of GECC, providing for the purchase of substantially all of theoperating assets of GE BPS (the GE BPS Acquisition).  Under the agreement, the Company willpurchase the business of GE BPS as a going concern, including substantially allof its operating assets, and the Company will assume certain of its 

 

 

11

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liabilities,for a purchase price of approximately $100. The GE BPS Acquisition is currently expected to close on, or as soon aspossible after, December 31, 2004.

 

 

12

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**Item 2. Management’s****Discussionand Analysis of Financial Condition and Results of Operations**

 

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

 

We make “forward-looking statements”throughout this document.  Whenever youread a statement that is not solely a statement of historical fact (such aswhen we state that we “may,” “will” or “plan to” perform in a certain manner orthat we “intend,” “believe,” “expect,” “anticipate,” “estimate” or “project”that an event will occur, or the negative thereof, and other similarstatements), you should understand that our expectations may not be correct,although we believe that they are reasonable. You should also understand that our plans may change.  We do not guarantee that the transactions andevents described in this document will happen as described or that any positivetrends noted in this document will continue.

 

Forward-looking statements, such as thoseregarding management’s present plans or expectations for new product offerings,capital expenditures, cost-saving strategies and growth are not guarantees offuture performance.  They involve risksand uncertainties relative to return expectations and related allocation ofresources, and changing economic or competitive conditions, as well as thenegotiation of agreements with third parties and other factors discussedherein, which could cause actual results to differ from present plans orexpectations, and such differences could be material.  Similarly, forward-looking statementsregarding management’s present expectations for operating results and cash flowinvolve risks and uncertainties relative to these and other factors, such asthe ability to increase revenues and/or to achieve cost reductions and otherfactors discussed herein, which also would cause actual results to differ frompresent plans.  Such differences could bematerial.  All forward-looking statementsattributable to us or by any persons acting on our behalf are expresslyqualified in their entirety by these cautionary statements.

 

As such, actual results or circumstances may varymaterially from such forward-looking statements or expectations.   Readers are also cautioned not to placeundue reliance on these forward-looking statements which speak only as of thedate these statements were made.  Exceptas required by law, we will not update these forward-looking statements, evenif our situation changes in the future.

 

## **Company Overview**

 

We are a leading facilities-based provider ofintegrated voice and data communications services to small and medium-sizedbusinesses in 12 markets in the western United States.  Our voice and data services, which we referto as network services, include local dial tone, long distance, enhanced voicefeatures and dedicated Internet access services.  We also sell, install and maintain businesstelephone and data systems and equipment, which we call BTS.  We provide these products and servicesindividually or in customized packages to address our customers’ need for anoutsourced voice and data network solution.

 

We have increased our annual revenue everyyear from $41.7 million for the year ended December 31, 1999 to $141.1 millionfor the year ended December 31, 2003, and we have increased our gross profitfrom $14.8 million to $80.3 million over the same period.  As of September 30, 2004, we provided servicethrough 237,428 total access lines, an increase of 15.0% from 206,421 totalaccess lines at December 31, 2003.

 

Our goal is to provide services to ourcustomers on our network, or on-net, which will allow us to continue to expandour operating margins and improve profitability.  We have continued to increase the percentageof on-net customers with a strategically deployed and incentivized salesforce.  Increasing our on-net percentageimproves customer retention, leverages our network, increases profitability andreduces our exposure to regulatory risk. We selectively provide service via the unbundled networkelement-platform, or UNE-P, to reach locations outside of our network footprintof on-net customers and to provide Qwest DSL. For the nine months ended September 30, 2004, 90.8% of our new accesslines installed were on-net and as of September 30, 2004, 79.2% of our totalaccess lines in service were on-net.

 

Customer retention is a key metric that weuse to measure the success of our business. We report monthly access line attrition, or churn, as measured bydividing total access lines disconnected for the month by our total accesslines at the end of the month.  Webelieve our low level of churn reflects our high quality of service and the valueproposition we provide to new and existing customers.  Due to our focus on improved service levels,competitive pricing and customer credit quality, we have reduced our monthlychurn to levels that we believe are industry leading.  For the nine months ended September 30, 2004,our monthly churn averaged 1.54% compared to 1.60% for the year ended December31, 2003.

 

*** ***

 

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***Revenue.***  Networkservices revenue consists primarily of local dial tone, long distance, accesscharges, and data service.  Revenue fromlocal telephone service consists of charges for basic local service, includingdedicated T1 access, and custom-calling features such as call waiting and callforwarding.  Revenue from long distanceservice consists of per-minute-of-use charges for a full range of traditionalswitched and dedicated long distance, toll-free calling, international, callingcard and operator services.  Revenue fromdata services consists primarily of monthly usage fees for dedicated Internetaccess services.

 

Network services revenue is recognized in themonth the services are used.  In the caseof local service revenue, local services charges are billed in advance butaccrued for and recognized on a prorated basis based on length of service inany given month.  Long distance andaccess charges are billed in arrears but accrued based on monthly average usageper line per day.  We do not receive anyrevenues from reciprocal compensation due to our bill-and-keep arrangement withQwest nor do we have any wholesale revenue other than access revenue.  For the nine months ended September 30, 2004,carrier access revenue represented 8.2% of our total revenue.

 

BTS revenue consists of revenue from both thesale of telephone equipment and the servicing of telephone equipmentsystems.  Telephone equipment revenue isrecognized upon delivery and acceptance by the customer.  Service revenue is recognized upon completionof service or, in the case of maintenance agreements, is spread equally overthe life of the maintenance contract.

 

***Cost of revenue.***  Our network services cost consists primarilyof the cost of operating and maintaining our network facilities.  The network components for ourfacilities-based business include the cost of:

 

•   leasing local loops and digital T1 lines which connect our customers to ournetwork;

•   leasing high capacity digital lines thatinterconnect our network with ILECs;

•   leasing high capacity digital lines thatconnect our switching equipment to our colocations;

•   leasing space in ILEC central offices forcolocating our equipment;

•   signaling system network connectivity; and

•   leasing our ATM backbone network.

 

The costs to lease local loops, digital T1lines and high capacity digital interoffice facilities from the ILECs varies bycarrier and by state and are regulated under the Telecommunications Act of1996.  In virtually all areas, we leaselocal loops, T1 lines and interoffice capacity from the ILECs.  We lease interoffice facilities from carriersother than the ILEC where possible in order to lower costs and improve networkredundancy.  However, in most cases, theILEC is the only source for local loops and T1 lines.  We also purchase, on a wholesale ornegotiated basis, UNE-P and customized network element packages, or UNE-E, fromQwest and Centrex services from SBC Communications Inc.  The rates for UNE-P and Centrex are regulatedand established by the various state corporation or utility commissions.  As of September 30, 2004 and December 31,2003, we had 39,590 and 43,107 UNE-P access lines in service,respectively.  As of September 30, 2004and December 31, 2003, we had 7,913 and 8,493 Centrex access lines in service,respectively.  The rates for UNE-E werenegotiated with Qwest under the terms of a five-year contract that expiresDecember 31, 2005.  As of September 30,2004 and December 31, 2003, we had 1,781 and 1,934 UNE-E access lines inservice, respectively.

 

We have entered into wholesale purchasingagreements with long distance and other service providers.  Some of these agreements also containtermination penalties and/or minimum usage volume commitments.  In the event we fail to meet minimum volumecommitments, we may be obligated to pay underutilization charges.  We do not anticipate having to pay anyunderutilization charges in the foreseeable future.

 

We carefully review all of our vendorinvoices and frequently dispute inaccurate or inappropriate charges.  Our single largest vendor is Qwest, to whomwe paid $25.8 million for the year ended December 31, 2003, and $21.4 millionfor the nine months ended September 30, 2004. We frequently short pay vendor invoices in order to pay proper amountsowed.  We use significant estimates todetermine the level of success in dispute resolution and consider pasthistorical experience, basis of dispute, financial status and currentrelationship with vendors and aging of prior disputes in quantifying ourestimates.

 

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

 

 

14

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Our most significant BTS costs are theequipment purchased from manufacturers and labor for service and equipmentinstallation.  To take advantage of volumepurchase discounts, we purchase equipment primarily from threemanufacturers.  For all BTS installationsour policy is to require a 30% deposit before ordering the equipment so ourrisk of excess inventory or inventory obsolescence is low.  BTS cost of revenue also includes salariesand benefits of field technicians as well as vehicle and incidental expensesassociated with equipment installation, maintenance and service provisioning.

 

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

 

Determining our allowance for doubtfulaccounts receivable requires significant estimates.  We consider a number of factors indetermining the proper level of the allowance, including historical collectionsexperience, current economic trends, the aging of the accounts receivableportfolio and changes in the creditworthiness of our customers.  We perform a rigorous credit review processon each new customer that involves reviewing the customer’s current serviceprovider bill and payment history, matching customers with the NationalTelecommunications Data Exchange database for delinquent customers and, in somecases, requesting credit reviews through Dun and Bradstreet.  For the nine months ended September 30, 2003and 2004, our bad debt expense as a percentage of revenue was 0.5% and 0.4%,respectively.

 

***Depreciation and amortization.***  Our depreciation and amortization currentlyincludes depreciation for network related voice and data equipment, back officesystems, furniture, fixtures, leasehold improvements, office equipment andcomputers.  All internal costs directlyrelated to the expansion of our network and operating and support systems,including salaries of certain employees, are capitalized and depreciated overthe lives of the switches or systems, as the case may be.  Capitalized customer installation costs areamortized over the approximate average life of a customer.  Detailed annual time studies are used todetermine labor capitalization.  Thesetime studies are based on employee time sheets for those engaged incapitalizable activities.

 

## **Regulatory Overview**

 

FCC rules implementing the local competitionprovisions of the Telecommunications Act permit CLECs to lease UNEs at ratesdetermined by PUCs employing the FCC’s Total Element Long Run Incremental Cost,or TELRIC, forward-looking, cost-based pricing model.  On September 15, 2003, the FCC opened aproceeding re-examining the TELRIC methodology and wholesale pricing rules forcommunications services made available for resale by ILECs in accordance withthe Telecommunications Act.  Thisproceeding will comprehensively re-examine whether the TELRIC pricing modelproduces unpredictable pricing inconsistent with appropriate economic signals;fails to adequately reflect the real-world attributes of the routing andtopography of an ILEC’s network; and creates disincentives to investment infacilities by understating forward-looking costs in pricing RBOC networkfacilities and overstating efficiency assumptions.  We have joined a coalition of CLECs toparticipate in this proceeding.  Theapplication and effect of a revised TELRIC pricing model on the communicationsindustry generally and on certain of our business activities cannot bedetermined at this time.

 

In its 2003 Triennial Review Order, which wecall the TRO, the FCC substantially modified its rules governing access to UNEsby CLECs.  However, on March 2, 2004, theD.C. Circuit vacated certain portions of the TRO and remanded the TRO to theFCC for further proceedings. Specifically, the Court vacated the FCC’s delegation of decision-makingauthority to state commissions and several of the FCC’s nation-wide impairmentdeterminations.    The Court also foundthat the FCC used a flawed methodology when making certain network elementunbundling determinations and remanded those determinations back to the FCC forfurther analysis and justification.

 

The FCC and the Solicitor General havedeclined to appeal the Court’s order. The National Association of RegulatoryUtility Commissioners and a coalition of CLECs, including Eschelon, separatelyappealed the decision.  The Supreme Courtannounced in October that it will not take the case.

 

In response to the D.C. Court’s order, theFCC released a standstill order on August 20, 2004, requiring ILECs to continueto provide CLECs with access to UNEs until the FCC issues final UNE rules, orfor six months from the effective date of the order, whichever comesfirst.  This order, the “Interim Order”,proposed that in the event the FCC does not promulgate final rules within thesix-month period, CLECs 

 

 

15

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should continue to have access only to theirembedded base of UNEs as of the end of the six-month standstill period.  The FCC proposed that CLECs should pay 15%more for those existing UNEs, or in the case of UNE-P lines one dollar more.  As for new orders placed after the standstillperiod ended, the FCC suggested that CLECs would pay the ILEC’s substantiallyhigher tariffed prices.

 

The FCC’s Interim Order was accompanied by aNotice of Proposed Rulemaking which set out a comment cycle for interestedparties to make filings to assist the FCC in developing final UNE rules.  Comments were due on October 4, 2004 andreplies on October 19, 2004.  The ILECsinterpret the D.C. Court’s decision as requiring the FCC to eliminate unbundledaccess to switching, transport, high capacity loops and dark fiber.  Verizon, Bell South, SBC and Qwest have allfiled comments together with evidence in support of this view.

 

Except for dark fiber, Eschelon uses all ofthe UNEs at issue in the TRO proceeding. Eschelon filed reply comments on its own and participated in filingcomments with a coalition of CLECs as well as with our trade association ALTS -the Association for Local Telecommunications Services.  These filings provide evidence that CLECs arein many instances impaired without access to UNEs.

 

We do not know when the FCC will issue finalUNE rules or what affects those rules will have on Eschelon’s business.  In the event that the FCC does not issuefinal rules before the six-month standstill expires, we do not know whetherCLECs will continue to have access to UNEs or what rates will apply if they do.

 

Several ILECs and their trade associationUSTA — the United States Telephone Association — filed a petition for mandamuswith the D.C. Circuit Court.  Thepetition requested the Court overturn the Interim Order.  The same parties also appealed the InterimOrder to the same Court.  In response tothe mandamus petition, the Court has issued an order holding it in abeyanceuntil January 4, 2005.  This ruling willallow the FCC to follow through on its commitment to issue final UNE rules bythe end of this year.  In summary,although the mandamus petition and the appeal of the Interim Order remainactive proceedings, it now appears that the D.C. Circuit will not act on themuntil at least January 4, 2005.

 

Although the final state of the law withrespect to UNE availability will not be clear for some months, the D.C. CircuitCourt’s March order is now final.  TheILECs have stated that they will follow the “change of law” provisions in ourinterconnection agreements.  In manyagreements, these provisions provide that when a party to the agreementbelieves the governing law has changed its obligations under the agreement, itmay request that the other party enter into negotiations to amend theagreement.  If the parties are unable toagree upon an amendment, the dispute is arbitrated either by a neutralarbitrator or by the relevant state commission. To date, Eschelon has not commenced any negotiations under those of itsagreements that contain this kind of provision.

 

Some agreements that Eschelon has have otherchange of law provisions.  SBC-Nevada hasfiled a complaint against us and other CLECs alleging that we have notconformed our interconnection agreement with SBC-Nevada consistent with therequirements of that agreement.  We havefiled an answer denying SBC’s allegations. Verizon-Washington petitioned the state commission to undertake anarbitration to change its interconnection agreements with many CLECs, includingEschelon.  The Commission dismissed thepetition as to Eschelon and most other CLECs.

 

We do not know whether or when any statecommission might order changes to our interconnection agreements or how suchchanges might affect our business.  Nordo we know whether or when any ILEC may commence change of law negotiationswith us, or the ultimate affects of any such negotiations upon our business.

 

The FCC has encouraged ILECs and CLECs toengage in commercial negotiations to provide access to ILEC facilities that mayno longer be available as UNEs.  Althougha few such agreements have been announced, the great majority of CLECs,including Eschelon, have not succeeded in negotiating new agreements as of thisdate.

 

As a condition of entering the long distancemarkets, the Act requires ILECs to provide CLECs with loops, transport, andunbundled switching.  In the TRO, the FCCdetermined, and the D.C. Circuit Court agreed, that these facilities must bemade available to CLECs at “just and reasonable” rates, in contrast to UNEswhich are available at TELRIC rates.  Wedo not know what “just and reasonable” rates would be nor do we know when suchrates might be established nor the roles of the FCC or state commissions in 

 

 

16

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establishing such rates.  In addition, Bell South has petitioned theFCC requesting that the FCC forebear from requiring RBOCs to provide an elementunder the long distance provisions of the Act if the RBOC is no longer requiredto provide the analogous UNE under the local competition portions of theAct.  The FCC incorporated Bell South’spetition into its Interim Order and Notice of Proposed Rulemaking.  We do not know how the FCC will decide theseissues.

 

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## **Comparison of Financial Results**

 

                **Overview of Results**

 

                Selectedconsolidated financial and operating data for the three and nine month periodsended September 30, 2003 and 2004 is as follows (dollars in thousands, exceptper unit amounts):

 
| ** **                        | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                        | ** ** | **2003**                             | ** ** | **2004**                            | ** ** | **% Change** | ** ** | **2003** | ** ** | **2004** | ** ** | **% Change** | ** ** |
| ** **                        | ** ** | **(unaudited)**                      | ** ** | **(unaudited)**                     | ** ** | ** ** | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** ** | ** ** |
| Total revenue                     |       | $                                    | 36,573     |                                | $          | 40,562 |   | 10.9 | % | $ | 103,892 |   | $ | 117,908 |   | 13.5 | % |
| Total gross  margin (%)           |       | 56.2                                 | %          | 60.5                                | %          | 7.5 | % | 56.3 | % | 60.2 | % | 7.0 | % |
| EBITDA                            |       | $                                    | 3,275      |                                | $          | 6,098 |   | 86.2 | % | $ | 9,592 |   | $ | 19,102 |   | 99.1 | % |
| Capital  expenditures             |       | $                                    | 6,094      |                                | $          | 6,616 |   | 8.6 | % | $ | 20,870 |   | $ | 20,445 |   | (2.0% | ) |
| Cash and  marketable securities   |       | $                                    | 7,979      |                                | $          | 19,421 |   | 143.4 | % | $ | 7,979 |   | $ | 19,421 |   | 143.4 | % |
|                              |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |
| Voice lines in  service           |       | 150,193                              |       | 167,263                             |       | 11.4 | % | 150,193 |   | 167,263 |   | 11.4 | % |
| Data lines in  service            |       | 43,191                               |       | 70,165                              |       | 62.5 | % | 43,191 |   | 70,165 |   | 62.5 | % |
| Total lines in  service           |       | 193,384                              |       | 237,428                             |       | 22.8 | % | 193,384 |   | 237,428 |   | 22.8 | % |
| Lines on-net (%)                  |       | 71.9                                 | %          | 79.2                                | %          | 10.2 | % | 71.9 | % | 79.2 | % | 10.2 | % |
| Lines sold                        |       | 23,341                               |       | 23,076                              |       | (1.1 | )% | 67,207 |   | 65,312 |   | (2.8 | )% |
| Average monthly  churn (%)        |       | 1.51                                 | %          | 1.54                                | %          | 2.0 | % | 1.67 | % | 1.54 | % | (7.8 | )% |
| Average network  revenue per line |       | $                                    | 52.32      |                                | $          | 47.92 |   | (8.4 | )% | $ | 52.90 |   | $ | 49.10 |   | (7.2 | )% |
|                              |       |                                 |       |                                |       |   |   |   |   |   |   |   |   |
| Average total  associates         |       | 908                                  |       | 936                                 |       | 3.0 | % | 902 |   | 913 |   | 1.3 | % |
| Average total  sales associates   |       | 200                                  |       | 202                                 |       | 0.7 | % | 194 |   | 190 |   | (1.8 | )% |
| Average network  sales associates |       | 161                                  |       | 164                                 |       | 2.1 | % | 156 |   | 153 |   | (1.6 | )% |
|                                   |            |                                      |            |                                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Three Months Ended September 30, 2004versus Three Months Ended September 30, 2003**

 

                ***Revenue.***  Revenue for the three months ended September30, 2003 and 2004 is as follows:

 

| ** **                 | ** ** | **2003**        | ** ** | **2004**        | ** ** | **% Change** | ** ** |
|----------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                 | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Revenue (in millions):     |       |            |       |            |       |         |       |
| Voice and data services    |       | $               | 21.6       |            | $          | 25.0         |       | 16.0 | % |
| Long distance              |       | 5.1             |       | 5.4             |       | 5.5          | %          |
| Access                     |       | 3.0             |       | 3.1             |       | 3.8          | %          |
| Total network services     |       | 29.7            |       | 33.5            |       | 13.0         | %          |
| Business telephone systems |       | 6.9             |       | 7.1             |       | 2.1          | %          |
| Total revenue              |       | $               | 36.6       |            | $          | 40.6         |       | 10.9 | % |

 

                Networkservices revenue was $33.5 million for the three months ended September 30,2004, an increase of 13.0% from $29.7 million in the same period of 2003.  The increase in revenue was primarily due toan increase in the average number of voice and data access lines inservice.  Over the past 12 months thenumber of voice lines increased by 11.4% to 167,263 lines at September 30, 2004and the number of data lines increased by 62.5% to 70,165 lines at September30, 2004.  The growth in access lines waspartially offset by declines in long distance and access revenue per minute ofuse and a decline in data revenue per line. Due to continued high levels of competition, long distance revenue perminute of use declined.  Access revenueper minute of use declined in line with the scheduled FCC reduction ofinterstate rate levels.  Data revenue perline declined due to a combination of customers purchasing more bandwidth atdiscounted prices and general pricing pressures for data services in ourmarkets.  We expect all of the abovetrends in line growth, long distance rates, access rates and data revenue perline to continue for the foreseeable future. As we continue to grow, our size and churn will begin to limit ouraccess line growth rate on both an absolute and on a percentage basis unless weincrease our sales force and geographic territory.

 

18

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                BTSrevenue was $7.1 million for the three months ended September 30, 2004, anincrease of 2.1% from $6.9 million in the same period of 2003.  The increase in revenue was primarily due toan increase in revenue from new system sales. This was partially offset by a decline in revenue from changeorders.  We cannot predict future trendsin capital spending by small and medium-sized business customers.

 

                ***Cost of Revenue.***  Cost of revenue for the three months endedSeptember 30, 2003 and 2004 is as follows:

 

| ** **                     | ** ** | **2003**        | ** ** | **2004**        | ** ** | **% Change** | ** ** |
|--------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                     | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Cost of revenue (in millions): |       |            |       |            |       |         |       |
| Network services               |       | $               | 11.8       |            | $          | 11.7         |       | (0.5 | )% |
| Business telephone systems     |       | 4.2             |       | 4.3             |       | 2.1          | %          |
| Total cost of revenue          |       | $               | 16.0       |            | $          | 16.0         |       | 0.2 | % |

 

                Networkservices cost of revenue was $11.7 million for the three months ended September30, 2004, a decrease of 0.5% from $11.8 million in the same period of2003.  As a percentage of relatedrevenue, network services cost of revenue for the three months ended September30, 2004 declined to 35.1% from 39.8% for the same period of 2003.  This improvement was due to the increase inour percentage of access lines on-net to 79.2% as of September 30, 2004 from71.9% as of September 30, 2003.

 

                BTScost of revenue was $4.3 million for the three months ended September 30, 2004,an increase of 2.1% from $4.2 million in the same period of 2003.  This increase was due to an increase inmaterials cost related to the new system sales mentioned previously.  As a percentage of related revenue, BTS costof revenue for the three months ended September 30, 2004 increased to 60.8%from 60.7% for the same period of 2003. We do not expect future improvements in BTS cost of revenue as apercentage of related revenue unless we are able to significantly increase BTSrevenue and therefore achieve greater volume discounts or economies of scale inour workforce.

 

                ***Gross Profit.***  Gross profit for the three months endedSeptember 30, 2003 and 2004 is as follows:

 

| ** **                  | ** ** | **2003**        | ** ** | **2004**        | ** ** | **% Change** | ** ** |
|-----------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                  | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Gross profit (in millions): |       |            |       |            |       |         |       |
| Network services            |       | $               | 17.9       |            | $          | 21.7         |       | 21.8 | % |
| Business telephone systems  |       | 2.7             |       | 2.8             |       | 2.0          | %          |
| Total gross profit          |       | $               | 20.6       |            | $          | 24.5         |       | 19.2 | % |

 

                Theincrease in gross profit for the three months ended September 30, 2004, fromthe same period of 2003, is due to the increase in revenue mentionedpreviously.

 

                ***Sales, General and AdministrativeExpense.***  Sales, generaland administrative expenses were $18.4 million for the three months endedSeptember 30, 2004, an increase of 6.5% from $17.3 million in the same periodof 2003.  The increase is primarily dueto costs associated with the expansion of the agency channel, TRO related costsand legal costs associated with the Qwest litigation in Federal Court.  As a percentage of revenue, sales, generaland administrative expenses for the three months ended September 30, 2004declined to 45.4% from 47.3% in the same period of 2003 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.

 

                ***EBITDA.***  Earnings before interest, taxes, depreciationand amortization (EBITDA) was $6.1 million for the three months ended September30, 2004, an increase of 86.2% from $3.3 million in the same period of2003.  This increase was due to increasedprofit margins and lower sales, general and administrative expenses as apercentage of revenue.

 

EBITDA is a not a measure offinancial performance under generally accepted accounting principles(GAAP).  EBITDA is provided because it isa measure of financial performance commonly used as an indicator of a company’shistorical ability to service debt. EBITDA should not be construed as an alternative to operating income, asan indicator of operating performance nor as an alternative to cash flows 

 

 

19

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provided by operating activities as a measureof liquidity determined in accordance with GAAP.  We may calculate EBITDA differently thanother companies.  The following is aschedule reconciling EBITDA with reported GAAP net income (loss) for the threemonths ended September 30, 2003 and 2004 (dollars in thousands):

 

| ** **                        | ** ** | **2003**        | ** ** | **2004**        | ** ** |
|-----------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                        | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** |
| EBITDA                            |       | $               | 3,275      |            | $          | 6,098 |   |
| Depreciation and amortization     |       | (7,057          | )          | (7,493          | )          |
| Interest expense                  |       | (422            | )          | (2,837          | )          |
| Gain/(loss) on disposal of assets |       | 502             |       | (138            | )          |
| Income taxes                      |       | (28             | )          | (4              | )          |
| Interest income                   |       | 15              |       | 45              |       |
| Net income (loss)                 |       | $               | (3,715     | )               | $          | (4,329 | ) |

 

                ***Depreciation and Amortization.***  Depreciation and amortization expense was$7.5 million for the three months ended September 30, 2004, an increase of 6.2%from $7.1 million in the same period of 2003. As a percentage of revenue, depreciation and amortization decreased to18.5% for the three months ended September 30, 2004 from 19.3% for the sameperiod of 2003.

 

                ***Interest.***  Interest expense was $2.8 million for thethree months ended September 30, 2004, an increase of 572.0% from $0.4 millionin the same period of 2003.  Thisincrease was primarily due to interest expense on our senior second securednotes.

 

**Nine Months Ended September 30, 2004versus Nine Months Ended September 30, 2003**

 

                ***Revenue.***  Revenue for the nine months ended September30, 2003 and 2004 is as follows:

 

| ** **                 | ** ** | **2003**        | ** ** | **2004**        | ** ** | **% Change** | ** ** |
|----------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                 | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Revenue (in millions):     |       |            |       |            |       |         |       |
| Voice and data services    |       | $               | 61.0       |            | $          | 72.6         |       | 18.9 | % |
| Long distance              |       | 14.3            |       | 16.0            |       | 12.2         | %          |
| Access                     |       | 9.2             |       | 9.7             |       | 6.1          | %          |
| Total network services     |       | 84.5            |       | 98.3            |       | 16.4         | %          |
| Business telephone systems |       | 19.4            |       | 19.6            |       | 0.8          | %          |
| Total revenue              |       | $               | 103.9      |            | $          | 117.9        |       | 13.5 | % |

 

                Networkservices revenue was $98.3 million for the nine months ended September 30,2004, an increase of 16.4% from $84.5 million in the same period of 2003.  The increase in revenue was primarily due toan increase in the average number of voice and data access lines inservice.  Over the past 12 months thenumber of voice lines increased by 11.4% to 167,263 lines at September 30,2004, and the number of data lines increased by 62.5% to 70,165 lines atSeptember 30, 2004.  The growth in accesslines was partially offset by declines in long distance and access revenue perminute of use and a decline in data revenue per line.  Due to continued high levels of competition,long distance revenue per minute of use declined.  Access revenue per minute of use declined inline with the scheduled FCC reduction of interstate rate levels.  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, long distance rates, access rates and data revenue per line to continuefor the foreseeable future.  As wecontinue to grow, our size and churn will begin to limit our access line growthrate on both an absolute and on a percentage basis unless we increase our salesforce and geographic territory.

 

                BTSrevenue was $19.6 million for the nine months ended September 30, 2004, anincrease of 0.8% from $19.4 million in the same period of 2003.  We cannot predict future trends in capitalspending by small and medium-sized business customers.

 

20

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                ***Cost of Revenue.***  Cost of revenue for the nine months endedSeptember 30, 2003 and 2004 is as follows:

 

| ** **                     | ** ** | **2003**        | ** ** | **2004**        | ** ** | **% Change** | ** ** |
|--------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                     | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Cost of revenue (in millions): |       |            |       |            |       |         |       |
| Network services               |       | $               | 33.6       |            | $          | 35.1         |       | 4.3 | % |
| Business telephone systems     |       | 11.8            |       | 11.8            |       | 0.1          | %          |
| Total cost of revenue          |       | $               | 45.4       |            | $          | 46.9         |       | 3.2 | % |

 

                Networkservices cost of revenue was $35.1 million for the nine months ended September30, 2004, an increase of 4.3% from $33.6 million in the same period of2003.  This increase is due to our growthin access lines.  As a percentage ofrelated revenue, network services cost of revenue for the nine months endedSeptember 30, 2004 declined to 35.7% from 39.8% for the same period of 2003.  This improvement was due to the increase inour percentage of access lines on-net to 79.2% as of September 30, 2004 from71.9% as of September 30, 2003.

 

                BTScost of revenue was $11.8 million for each of the nine months ended September30, 2003 and 2004.  As a percentage ofrelated revenue, BTS cost of revenue for the nine months ended September 30,2004 decreased to 60.2% from 60.6% for the same period of 2003.  We do not expect future improvements in BTScost of revenue as a percentage of related revenue unless we are able to significantlyincrease BTS revenue and therefore achieve greater volume discounts oreconomies of scale in our workforce.

 

                ***Gross Profit.***  Gross profit for the nine months endedSeptember 30, 2003 and 2004 is as follows:

 

| ** **                  | ** ** | **2003**        | ** ** | **2004**        | ** ** | **% Change** | ** ** |
|-----------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                  | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Gross profit (in millions): |       |            |       |            |       |         |       |
| Network services            |       | $               | 50.9       |            | $          | 63.2         |       | 24.4 | % |
| Business telephone systems  |       | 7.6             |       | 7.8             |       | 1.9          | %          |
| Total gross profit          |       | $               | 58.5       |            | $          | 71.0         |       | 21.5 | % |

 

                Theincrease in gross profit for the nine months ended September 30, 2004, from thesame period of 2003, is due to the increase in revenue mentioned previously.

 

                ***Sales, General and AdministrativeExpense.***  Sales, generaland administrative expenses were $51.9 million for the nine months endedSeptember 30, 2004, an increase of 6.1% from $49.0 million in the same periodof 2003.  The increase is primarily dueto costs associated with the expansion of the agency channel, TRO related costsand legal costs associated with the Qwest litigation in Federal Court.  As a percentage of revenue, sales, general andadministrative expenses for the nine months ended September 30, 2004 declinedto 44.1% from 47.1% in the same period of 2003 due to the improved efficiencyof our existing operations resulting from our fixed cost structure supporting ahigher level of revenue.  We expect thistrend to continue as we add more access lines with only modest increase in ouremployee base.

 

                ***EBITDA.***  Earnings before interest, taxes, depreciationand amortization (EBITDA) was $19.1 million for the nine months ended September30, 2004, an increase of 99.1% from $9.6 million in the same period of2003.  This increase was due to increasedprofit margins and lower sales, general and administrative expenses as apercentage of revenue.

 

The following is a schedulereconciling EBITDA with reported GAAP net income (loss) for the nine monthsended September 30, 2003 and 2004 (dollars in thousands):

 

 

21

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| ** **                        | ** ** | **2003**        | ** ** | **2004**        | ** ** |
|-----------------------------------|------------|-----------------|------------|-----------------|------------|
| ** **                        | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** |
| EBITDA                            |       | $               | 9,592      |            | $          | 19,102 |   |
| Depreciation and amortization     |       | (22,762         | )          | (22,705         | )          |
| Interest expense                  |       | (1,301          | )          | (7,911          | )          |
| Deferred compensation             |       | (70             | )          | (20             | )          |
| Gain (loss) on disposal of assets |       | 466             |       | (162            | )          |
| Income taxes                      |       | (28             | )          | (4              | )          |
| Interest income                   |       | 162             |       | 83              |       |
| Gain on extinguishment of debt    |       | —          |       | 18,195          |       |
| Net income (loss)                 |       | $               | (13,941    | )               | $          | 6,578 |   |

 

                ***Depreciation and Amortization.***  Depreciation and amortization expense was$22.7 million for the nine months ended September 30, 2004, a decrease of 0.3%from $22.8 million in the same period of 2003. This decrease was primarily due to accelerated depreciation in 2003 onthe abandonment of our previous billing system per SFAS No. 144.  As a percentage of revenue, depreciation andamortization decreased to 19.3% for the nine months ended September 30, 2004 from21.9% for the same period of 2003.

 

                ***Interest.***  Interest expense was $7.9 million for thenine months ended September 30, 2004, an increase of 508.0% from $1.3 millionin the same period of 2003.  Thisincrease was primarily due to interest expense on our senior second securednotes.

 

                ***Gain on Extinguishment of Debt.***  Net income for the nine months endedSeptember 30, 2004 included a gain on extinguishment of debt of $18.2million.  The gain on the extinguishmentof 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.

 

## **Liquidity and Capital Resources**

 

**                *Financings.* **In March 2004, we completedan offering of $100 million of 8 3/8% senior second secured notes due 2010 at adiscount resulting in a 12% yield.  Weused the proceeds from our offering to retire bank debt, pay fees related tothe offering and provide additional liquidity to our company.  After repayment of our senior secured bankfacility and fees related to the issuance of the new notes, we receivedincremental cash of approximately $13.2 million.

 

                ***Cash Flows Provided by OperatingActivities. ***Cash providedby operating activities was $15.1 million for the nine months ended September30, 2004 compared to cash provided by operating activities of $10.2 million forthe nine months ended September 30, 2003. Our improvement in cash provided by operating activities was primarilydue to our growth in gross profit accompanied by a smaller increase in ouroperating expenses.  Working capitalimproved primarily through improvement in our accounts receivablecollections.  Average accounts receivabledays sales outstanding improved from 36.1 for the nine months ended September30, 2003 to 30.0 for the nine months ended September 30, 2004.  We do not expect further improvement in ouraccounts receivable days outstanding in the future.

 

                ***Cash Flows Used in InvestingActivities.***  Cash used ininvesting activities was $22.9 million for the nine months ended September 30,2004 compared to $19.8 million for the nine months ended September 30,2003.  The cash used in investingactivities was primarily for the maintenance and expansion of our network andback office systems.  For the nine monthsended September 30, 2004 we also used cash to invest in marketable securitieswith maturity dates of six months or less.

 

                ***Cash Flows Provided by (Used in)Financing Activities.*** Cash provided by financing activities was $13.6 million for the ninemonths ended September 30, 2004.  The netproceeds from the issuance of the senior second secured notes generatedapproximately $13.2 million, which is net of a $1.6 million prepayment penaltymentioned previously.  We also used cashfor payments on capital lease obligations. 

 

 

22

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For the nine months ended September 30, 2003, net cashused in financing activities was $2.2 million, primarily for payments oncapital lease obligations.

 

                Webelieve our existing cash, cash equivalents and short-term investments will besufficient to fund our operations and we do not currently anticipate the needto raise additional financing to fund capital expenditures or operations for atleast the next 12 months.

# ** **

 

23

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# **Item 3. Quantitative** and Qualitative Disclosures AboutMarket Risk

 

We are not exposed to market risks fromchanges in foreign currency exchange rates or commodity prices.  We do not hold any derivative financialinstruments nor do we hold any securities for trading or speculative purposes.

 

We are exposed to changes in interest rateson our investments in cash equivalents and short-term investments.  All of our investments have maturities of sixmonths or less which reduces our exposure to long-term interest ratechanges.  Interest income for the threeand nine-month periods ended September 30, 2004 was $45.0 thousand and $82.5thousand, respectively, therefore not exposing us to any meaningful interestincome risk had rates dropped.  Excludingcapital leases, we had $85.8 million in senior second secured notes outstandingas of September 30, 2004.  These notesare at a fixed interest rate and are therefore not exposed to any interest raterisk.

 

# **Item4:  Controls** andProcedures

 

*Evaluationof disclosure controls and procedures.*  Under the supervision and with theparticipation of our management, including our Chief Executive Officer andChief Financial Officer, we evaluated the effectiveness of the design andoperation of our disclosure controls and procedures (as defined in Rule13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”)).  Based upon that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that, as of the end ofthe period covered by this report, the Company’s disclosure controls andprocedures were effective in timely alerting them to the material informationrelating to the Company (or our consolidated subsidiaries) required to beincluded in the reports we file or submit under the Exchange Act.

 

*Changes ininternal controls over financial reporting.*  During the quarter ended September 30, 2004,there was no change in our internal control over financial reporting (asdefined in Rule 13a-15(f) under the Exchange Act) that has materially affected,or is reasonably likely to materially affect, the Company’s internal controlover financial reporting.

 

 

24

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# **PARTII.** OTHER INFORMATION

 

# **Item1.  Legal**Proceedings

 

On August 2, 2004, a Nevada state courtentered a judgment against Eschelon for intentionally interfering with a formersalesperson’s economic relationship with his new employer in the amount of $376thousand plus costs.  We had reason tobelieve the former employee was violating his non-solicitation agreement withus.  On August 30, 2004 we appealed thejudgment because, among other reasons, the jury was not instructed to considerwhether we were justified in informing the new employer of the agreement andour intent to enforce it.

 

We are a party to several complaint proceedingsagainst Qwest filed with the Arizona, Colorado, Minnesota and Washington publicutility commissions, or PUCs, and two federal court lawsuits involvingQwest.  The Minnesota PUC ordered Qwestto pay us $500 thousand as a refund of overcharges related to enhanced extendedloops and the refund has been received. We have appealed the recent unfavorable decisions by the Minnesota PUCin relation to our complaints regarding Qwest’s withholding of Direct Measuresof Quality, or DMOQ billing credits and our request for a refund from Qwest forovercharges for our colocations.  TheMinnesota PUC and the Arizona Corporation Commission recently granted, and theWashington PUC denied in part and granted in part, our complaints regardingretroactive application of certain favorable UNE rates.  We have appealed the Washington decision onthe basis that its decision was contrary to the evidence.  We have filed a similar complaint in Colorado.  We continue to pursue a lawsuit against Qwestin the United States District Court, Western District of Washington regardingthe financial harm we have suffered as a result of Qwest’s violations of ourinterconnection agreements by failing to provide accurate records relating tointerstate and intrastate long distance calls, failing to develop an unbundlednetwork platform and failing to make DSL available for resale.  The Federal District Court recently deniedQwest’s federal court appeal of the Minnesota PUC’s UNE Cost Order.  Qwest just filed an appeal with the FederalCourt of Appeals.  If Qwest issuccessful, our UNE rates in Minnesota could increase.

 

We are a party to certain regulatoryinvestigations underway in Arizona, Colorado, Oregon and Washington relating tothe alleged failure of Qwest and several CLECs, including us, to submitinterconnection agreements for approval by state regulatory agencies.  The Washington Commission has approved asettlement under which we paid $25 thousand and provided testimony in returnfor dismissal of the case against Eschelon. We cannot predict the outcome of the Arizona, Colorado or Oregoninvestigations or the effect that any corresponding regulatory actions may haveon our business.  A similar investigationby the Minnesota PUC resulted in no direct penalties against us.  The Minnesota Department of Commerce hasfiled a complaint with the Minnesota PUC concerning agreements that CLECs,including us, have with certain interexchange carriers for pricing accessservices.  They have asserted that the agreementsare unlawfully discriminatory and required to be filed.

 

We are in dispute with the Arizona CommissionStaff about the amount of a bond that we need to have on file.  Staff’s position, if adopted by theCommission, could require us to post a bond of up to $5 million, rather thanthe $400 thousand currently on file.

 

We cannot predict the outcome of any of theseproceedings or their effect on our business.

 

**Item 2. Changes****in Securities, Use of Proceedsand Issuer Purchase of Equity Securities**

 

On March 17, 2004, Eschelon Operating Company(a wholly owned subsidiary) issued $100 million principal amount at maturity of8 3/8% Senior Second Secured Notes due in 2010. Jefferies & Company, Inc. and Wachovia Securities were the jointbook-running managers for the transaction. These notes were priced at 84.813% of the principal amount and the grossproceeds were $84.813 million.

 

We offered these notes to qualifiedinstitutional buyers as defined in Rule 144A under the Securities Act, topersons outside the United States under Regulation S of the Securities Act andto a limited number of institutional accredited investors within the meaning ofRule 501 (a) (1), (2), (3) or (7) of the Securities Act.  An exchange offer with the holders of thenotes, whereby the notes were exchanged for a like principal amount ofregistered 8 3/8% Senior Second Secured Notes due 2010, was completed on June18, 2004.

 

 

25

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The proceeds of this transaction were used torepay existing indebtedness of $65.4 million and to pay $6.2 million ofassociated fees and expenses of the offering. The remaining $13.2 million of proceeds is being used for generalcorporate purposes.

 

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

 

On August 12, 2004, we granted to 25participants under the Eschelon Telecom, Inc. Stock Option Plan of 2002 optionsto purchase an aggregate of 112,150 shares of common stock at an exercise priceof $0.10 per share.  These optionsgenerally vest 20% upon the date of the initial grant and 20% per year overfour years from the date of grant.

 

# **Item3.  Defaults** UponSecurities

 

None

 

# **Item4.  Submission** ofMatters to a Vote of Security Holders

 

No matters were submitted to a vote of thesecurity holders during the quarter ended September 30, 2004

 

# **Item5.  Other**Information

 

None

 

# **Item6.  Exhibits** andReports on Form 8-K

 

**a)  Exhibits**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                 | ** ** |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| 3.1*            |       | Fifth Amended and Restated  Certificate of Incorporation of Eschelon Telecom, Inc. filed on June 27,  2002.                                                                                                                                                                                                                                                                                                                                     |       |
| 3.2*            |       | By-Laws of Eschelon  Telecom, Inc.                                                                                                                                                                                                                                                                                                                                                                                                              |       |
| 4.1*            |       | Fourth Amended and  Restated Stockholders Agreement dated June 27, 2002.                                                                                                                                                                                                                                                                                                                                                                        |       |
| 4.2*            |       | Eschelon Telecom, Inc.  2002 Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                                                                                              |       |
| 4.3*            |       | Form of Incentive Stock  Option Grant Agreement Under the Eschelon Telecom, Inc. 2002 Stock Incentive  Plan.                                                                                                                                                                                                                                                                                                                                    |       |
| 4.4*            |       | Form of Nonstatutory Stock  Option Grant Agreement Under the Eschelon Telecom, Inc. 2002 Stock Incentive  Plan.                                                                                                                                                                                                                                                                                                                                 |       |
| 4.5*            |       | Form of Restricted Stock  Grant Agreement Under the Eschelon Telecom, Inc. 2002 Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                                           |       |
| 4.6**           |       | Indenture dated March 17,  2004 by and among Eschelon Operating Company; Eschelon Telecom, Inc.;  Eschelon Telecom of Minnesota, Inc.; Eschelon Telecom of Washington, Inc.;  Eschelon Telecom of Colorado, Inc.; Eschelon Telecom of Nevada, Inc.;  Eschelon Telecom of Utah, Inc.; Eschelon Telecom of Oregon, Inc.; Eschelon  Telecom of Arizona, Inc.; and The Bank of New York Trust Company, N.A.                                         |       |
| 4.7**           |       | Registration Rights  Agreement dated March 17, 2004 by and among Jefferies & Company, Inc.;  Wachovia Capital Markets LLC; Eschelon Operating Company; Eschelon Telecom,  Inc.; Eschelon Telecom of Minnesota, Inc.; Eschelon Telecom of Washington,  Inc.; Eschelon Telecom of Colorado, Inc.; Eschelon Telecom of Nevada, Inc.;  Eschelon Telecom of Utah, Inc.; Eschelon Telecom of Oregon, Inc.; and  Eschelon Telecom of Arizona, Inc. |       |
| 4.8**           |       | Security Agreement dated  March 17, 2004 by and among Eschelon Operating Company; Eschelon Telecom,  Inc.; Eschelon Telecom of Minnesota, Inc.; Eschelon Telecom of Washington,  Inc.; Eschelon Telecom of Colorado, Inc.; Eschelon Telecom of Nevada, Inc.;  Eschelon Telecom of Utah, Inc.; Eschelon Telecom of Oregon, Inc.; Eschelon  Telecom of Arizona, Inc.; and The Bank of New York Trust Company, N.A. (as  Collateral Agent.)        |       |
| 4.9**           |       | Trademark Security  Agreement dated March 17, 2004 by and among Eschelon Operating Company;  Eschelon Telecom, Inc.; and The Bank of New York Trust Company, N.A. (as  Collateral Agent.)                                                                                                                                                                                                                                                       |       |
| 4.10**          |       | Form of Initial 8 3/8  Senior Second Secured Notes due 2010.%                                                                                                                                                                                                                                                                                                                                                                                   |       |
| 4.11**          |       | Form of Guarantee of  Initial 8 3/8 Senior Second Secured Notes due 2010.%                                                                                                                                                                                                                                                                                                                                                                      |       |
| 4.12**          |       | Form of Exchange 8 3/8  Senior Second Secured Notes due 2010.%                                                                                                                                                                                                                                                                                                                                                                                  |       |
| 4.13**          |       | Form of Guarantee of  Exchange 8 3/8 Senior Second Secured Notes due 2010.%                                                                                                                                                                                                                                                                                                                                                                     |       |

 

 

26

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| 10.1*    |   | Change-in-Control  Severance Pay and Employment Agreement dated November 22, 2002 by and between  Eschelon Telecom, Inc. and Richard A. Smith.                              |   |
|----------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| 10.2*    |   | Employment Offer Letter  dated March 7, 2000 from Eschelon Telecom, Inc. to Geoffrey M. Boyd.                                                                               |   |
| 10.2.1*  |   | Severance Pay Letter  Agreement dated November 14, 2002 by and between Eschelon Telecom, Inc. and  Geoffrey M. Boyd.                                                        |   |
| 10.4*    |   | Employment Offer Letter  dated July 19, 1999 from Eschelon Telecom, Inc. to Steven K. Wachter.                                                                              |   |
| 10.5*    |   | Stock Restriction  Agreement dated February 7, 2003 between Eschelon Telecom, Inc. and Marvin C.  Moses.                                                                    |   |
| 10.6*    |   | Stock Restriction  Agreement dated February 7, 2003 between Eschelon Telecom, Inc. and Anthony  J. Cassara.                                                                 |   |
| 10.7*    |   | Stock Restriction  Agreement dated February 7, 2003 between Eschelon Telecom, Inc. and Peter M.  Van Genderen.                                                              |   |
| 10.8*    |   | Carrier Global Services  Agreement dated July 28, 2000 by and between MCI WorldCom Communications,  Inc. and Eschelon Telecom, Inc.                                         |   |
| 10.8.1*  |   | First Amendment dated June  20, 2001 to Carrier Global Services Agreement dated July 28, 2000 by and  between MCI WorldCom Communications, Inc. and Eschelon Telecom, Inc.  |   |
| 10.8.2*  |   | Second Amendment dated  April 8, 2002 to Carrier Global Services Agreement dated July 28, 2000 by and  between MCI WorldCom Communications, Inc. and Eschelon Telecom, Inc. |   |
| 10.8.3*  |   | Third Amendment dated  April 1, 2003 to Carrier Global Services Agreement dated July 28, 2000 by and  between MCI WorldCom Communications, Inc. and Eschelon Telecom, Inc.  |   |
| 10.8.4*  |   | WorldCom Internet  Dedicated Service Agreement and Service Order Form dated June 12, 2003.                                                                                  |   |
| 10.8.5*  |   | WorldCom Internet  Dedicated Service Agreement and Service Order Form dated January 23, 2004.                                                                               |   |
| 10.8.6*  |   | WorldCom Internet  Dedicated T3 Price-Protected Agreement dated July 26, 2001.                                                                                              |   |
| 10.8.7*  |   | WorldCom Wholesale  Dedicated Internet Pricing Sheet                                                                                                                        |   |
| 10.9*    |   | Carrier Service Agreement  dated August 25, 2000 between Global Crossing Bandwidth, Inc. and Eschelon  Telecom, Inc.                                                        |   |
| 10.9.1*  |   | Amendment #1 dated  November 10, 2000 to Carrier Service Agreement dated August 25, 2000 between  Global Crossing Bandwidth, Inc. and Eschelon Telecom, Inc.                |   |
| 10.9.2*  |   | Amendment #2 dated January  2, 2001 to Carrier Service Agreement dated August 25, 2000 between Global  Crossing Bandwidth, Inc. and Eschelon Telecom, Inc.                  |   |
| 10.9.3*  |   | Amendment #3 dated June  25, 2001 to Carrier Service Agreement dated August 25, 2000 between Global  Crossing Bandwidth, Inc. and Eschelon Telecom, Inc.                    |   |
| 10.9.4*  |   | Amendment #4 dated July  17, 2001 to Carrier Service Agreement dated August 25, 2000 between Global  Crossing Bandwidth, Inc. and Eschelon Telecom, Inc.                    |   |
| 10.9.5*  |   | Amendment #5 dated April  25, 2002 to Carrier Service Agreement dated August 25, 2000 between Global  Crossing Bandwidth, Inc. and Eschelon Telecom, Inc.                   |   |
| 10.9.6*  |   | Amendment #6 dated July  12, 2002 to Carrier Service Agreement dated August 25, 2000 between Global  Crossing Bandwidth, Inc. and Eschelon Telecom, Inc.                    |   |
| 10.9.7*  |   | Amendment #7 dated March  26, 2004 to Carrier Service Agreement dated August 25, 2000 between Global  Crossing Bandwidth, Inc. and Eschelon Telecom, Inc.                   |   |
| 10.10*   |   | Advisory Agreement dated  March 15, 2004 among Eschelon Telecom, Inc.; Bain Capital Investors, LLC;  Wind Point Advisor, L.L.C.; and Stolberg, Meehan & Scano, L.L.C.   |   |
| 10.11*   |   | Lease of Office Space by  and between St. Paul Properties, Inc. and Eschelon Telecom, Inc. dated as of  November 18, 2003.                                                  |   |
| 10.12*   |   | Lease Agreement by and  between Timeshare Systems, Inc. and Advanced Telecommunications, Inc. dated  March 3, 1999.                                                         |   |
| 10.13*   |   | Lease For Storage dated  July 30, 1996 by and between T.H.S. Northstar Associates Limited Partnership  and Fishnet.com, Inc.                                                |   |
| 10.13.1* |   | First Amendment dated  March 10, 1998 of Lease for Storage dated July 30, 1996 by and between T.H.S.  Northstar Associates Limited Partnership and Fishnet.com, Inc.        |   |
| 10.13.2* |   | Second Amendment dated  March 27, 1998 of Lease for Storage dated July 30, 1996 by and between T.H.S.  Northstar Associates Limited Partnership and Fishnet.com, Inc.       |   |
| 10.13.3* |   | Third Amendment dated  April 30, 1999 of Lease for Storage dated July 30, 1996 by and between T.H.S.  Northstar Associates Limited Partnership and Fishnet.com, Inc.        |   |
| 10.13.4* |   | Fourth Amendment dated  October 3, 2000 of Lease for Storage dated July 30, 1996 by and between  T.H.S. Northstar Associates Limited Partnership and Fishnet.com, Inc.      |   |

 

 

27

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| 10.13.5* |   | Lease For Storage dated  March 6, 2000 by and between T.H.S. Northstar Associates Limited Partnership  and Fishnet.com, Inc.                                            |   |
|----------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| 10.13.6* |   | Lease For Storage dated  July 11, 1999 by and between T.H.S. Northstar Associates Limited Partnership  and Fishnet.com, Inc.                                            |   |
| 10.14*   |   | Lease Agreement by and  between Duke Realty Limited Partnership and Cady Communications, Inc. dated  May 21, 1999.                                                      |   |
| 10.15*   |   | Lease Agreement between  Seattle Telecom LLC and Advanced Telecommunications, Inc. dated December 20,  1999.                                                            |   |
| 10.16*   |   | Office Lease by and  between Parkside Salt Lake Corporation and Advanced Telecommunications, Inc.  dated December 28, 1999.                                             |   |
| 10.17*   |   | Lease by and between  Denver Place Associates Limited Partnership and Eschelon Telecom of Colorado,  Inc. dated October 24, 2000.                                       |   |
| 10.18*   |   | Office Lease by and  between SOFI-IV SIM Office Investors II, Limited Partnership and Advanced  Telecommunications, Inc. dated December 19, 1999.                       |   |
| 10.18.1* |   | First Amendment dated  March 17, 2003 to Lease by and between SOFI-IV SIM Office Investors II,  Limited Partnership and Eschelon Telecom, Inc. dated December 19, 1999. |   |
| 10.19*   |   | Lease by and between Alco  Investment Company and Advanced Telecommunications, Inc. dated November 19,  1999.                                                           |   |
| 21.1*    |   | Subsidiaries of Eschelon  Telecom, Inc.                                                                                                                                 |   |
| 31.1     |   | Certification by Richard  A. Smith, Chief Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                 |   |
| 31.2     |   | Certification by Geoffrey  M. Boyd, Chief Financial Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                 |   |
| 32.1     |   | Certification by Richard  A. Smith, Chief Executive Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                 |   |
| 32.2     |   | Certification by Geoffrey  M. Boyd, Chief Financial Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                 |   |

----

*                         Incorporated herein by reference toEschelon Telecom, Inc. Registration Statement on Form 10, No. 000-50706.

**                  Incorporated herein byreference to Eschelon Operating Company Registration Statement on Form S-4, No.333-114437.

 

**b)  Reports on Form 8-K**

 

On July 28, 2004, we filed a Form 8-Kcontaining the press release issued on July 26, 2004 announcing the results forthe quarter ended June 30, 2004, and the management script for the investorconference call held on July 26, 2004.

 

 

28

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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 10, 2004 | 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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