**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**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 the  quarterly period ended March 31, 2006** |
|                                                    |   |   |
| **OR**                                                  |
|                                                    |   |   |
| **o**                                                   | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                    |   |   |
| **Commission  File Number 000-50706**                   |

 

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**ESCHELONTELECOM, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

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

 

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

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act.

 

| Large accelerated filer o |   | Accelerated filer o |   | Non-accelerated filer ý |
|---------------------------|--------|---------------------|--------|------------------------------|

 

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

 

As of April 30,2006, the number of outstanding shares of the Registrant’s Common Stock, parvalue $.01 per share, was 14,864,283 shares.

 

 

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**ESCHELON TELECOM, INC.**

**INDEX TO FORM 10-Q**

 
| **PART I.  FINANCIAL INFORMATION** | **3**  |
|-----------------------------------------|--------|
|                                    |   |   |   |
| Item 1.                                 |   | Financial Statements: | 3 |
|                                    |   |   |   |
|                                    |   | Consolidated Balance Sheets –  December 31, 2005 and March 31, 2006 (Unaudited) | 3 |
|                                    |   |   |   |
|                                    |   | Unaudited Consolidated  Statements of Operations – Three months ended March 31, 2005 and 2006 | 4 |
|                                    |   |   |   |
|                                    |   | Unaudited Consolidated  Statements of Cash Flows – Three months ended March 31, 2005 and 2006 | 5 |
|                                    |   |   |   |
|                                    |   | Notes to Consolidated  Financial Statements | 6 |
|                                    |   |   |   |
| Item 2.                                 |   | Management’s Discussion and  Analysis of Financial Condition and Results of Operations | 17 |
|                                    |   |   |   |
| Item 3.                                 |   | Quantitative and Qualitative  Disclosures About Market Risk | 23 |
|                                    |   |   |   |
| Item 4.                                 |   | Controls and Procedures | 23 |
|                                    |   |   |   |
| **PART II.  OTHER INFORMATION**    | **24** |
|                                    |   |   |   |
| Item 1.                                 |   | Legal Proceedings | 24 |
|                                    |   |   |   |
| Item 1A.                                |   | Risk Factors | 24 |
|                                    |   |   |   |
| Item 2.                                 |   | Unregistered Sales of Equity  Securities and Use of Proceeds | 24 |
|                                    |   |   |   |
| Item 3.                                 |   | Defaults Upon Senior  Securities | 24 |
|                                    |   |   |   |
| Item 4.                                 |   | Submission of Matters to a  Vote of Security Holders | 24 |
|                                    |   |   |   |
| Item 5.                                 |   | Other Information | 24 |
|                                    |   |   |   |
| Item 6.                                 |   | Exhibits | 25 |
|                                    |   |   |   |
| Signature                               |   |   | 26 |

 

2

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**PART I. FINANCIAL INFORMATION**

 

## **Item 1. Financial Statements**

## ** **

**Eschelon Telecom, Inc.**

**Consolidated Balance Sheets**

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

 
| ** **                                                                                                                                                                                        | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                                        | ** ** | **2005**              | ** ** | **2006**           | ** ** |
| ** **                                                                                                                                                                                        | ** ** | ** **            | ** ** | **(Unaudited)**    | ** ** |
| **Assets**                                                                                                                                                                                        |       |                  |       |               |       |
| Current assets:                                                                                                                                                                                   |       |                  |       |               |       |
| Cash and cash equivalents                                                                                                                                                                         |       | $                     | 26,062     |               | $          | 73,580 |   |
| Restricted cash                                                                                                                                                                                   |       | 996                   |       | 893                |       |
| Available-for-sale securities                                                                                                                                                                     |       | 4,760                 |       | 795                |       |
| Accounts receivable, net of allowance for doubtful  accounts of $492 and $649, respectively                                                                                                       |       | 22,996                |       | 21,760             |       |
| Other receivables                                                                                                                                                                                 |       | 3,052                 |       | 3,308              |       |
| Inventories                                                                                                                                                                                       |       | 2,927                 |       | 3,258              |       |
| Prepaid expenses                                                                                                                                                                                  |       | 2,294                 |       | 3,394              |       |
| Total current assets                                                                                                                                                                              |       | 63,087                |       | 106,988            |       |
|                                                                                                                                                                                              |       |                  |       |               |       |
| Property and equipment, net                                                                                                                                                                       |       | 126,452               |       | 124,811            |       |
|                                                                                                                                                                                              |       |                  |       |               |       |
| Other assets                                                                                                                                                                                      |       | 1,506                 |       | 1,466              |       |
| Goodwill                                                                                                                                                                                          |       | 7,168                 |       | 7,168              |       |
| Intangible assets, net                                                                                                                                                                            |       | 33,333                |       | 34,546             |       |
| Total assets                                                                                                                                                                                      |       | $                     | 231,546    |               | $          | 274,979 |   |
|                                                                                                                                                                                              |       |                  |       |               |       |
| **Liabilities and stockholders’ equity**                                                                                                                                                     |       |                  |       |               |       |
| Current liabilities:                                                                                                                                                                              |       |                  |       |               |       |
| Accounts payable                                                                                                                                                                                  |       | $                     | 16,400     |               | $          | 15,418 |   |
| Accrued telecommunication costs                                                                                                                                                                   |       | 4,227                 |       | 5,008              |       |
| Accrued office rent                                                                                                                                                                               |       | 2,035                 |       | 1,864              |       |
| Accrued interest expense                                                                                                                                                                          |       | 2,646                 |       | 579                |       |
| Other accrued expenses                                                                                                                                                                            |       | 5,485                 |       | 6,149              |       |
| Deferred revenue                                                                                                                                                                                  |       | 7,921                 |       | 7,932              |       |
| Accrued compensation expenses                                                                                                                                                                     |       | 2,809                 |       | 3,546              |       |
| Capital lease obligations, current maturities                                                                                                                                                     |       | 2,430                 |       | 1,833              |       |
| Total current liabilities                                                                                                                                                                         |       | 43,953                |       | 42,329             |       |
|                                                                                                                                                                                              |       |                  |       |               |       |
| Long-term liabilities:                                                                                                                                                                            |       |                  |       |               |       |
| Commitments and contingencies                                                                                                                                                                     |       |                  |       |               |       |
| Other long-term liabilities                                                                                                                                                                       |       | 251                   |       | 144                |       |
| Capital lease obligations, less current maturities                                                                                                                                                |       | 2,964                 |       | 2,946              |       |
| Notes payable                                                                                                                                                                                     |       | 92,125                |       | 138,433            |       |
| Total liabilities                                                                                                                                                                                 |       | 139,293               |       | 183,852            |       |
|                                                                                                                                                                                              |       |                  |       |               |       |
| Stockholders’ equity:                                                                                                                                                                        |       |                  |       |               |       |
| Preferred stock, $0.01 par value per share;  125,000,000 shares authorized; no shares issued and outstanding                                                                                      |       | —                |       | —             |       |
| Common stock, $0.01 par value per share; 200,000,000  shares authorized; issued and outstanding shares – 14,634,279 shares at December 31,  2005; and 14,848,007 at March 31, 2006 |       | 146                   |       | 148                |       |
| Additional paid-in capital                                                                                                                                                                        |       | 248,199               |       | 247,596            |       |
| Accumulated other comprehensive income                                                                                                                                                            |       | 56                    |       | 13                 |       |
| Accumulated deficit                                                                                                                                                                               |       | (155,047              | )          | (156,630           | )          |
| Deferred compensation                                                                                                                                                                             |       | (1,101                | )          | —             |       |
| Total stockholders’ equity                                                                                                                                                                   |       | 92,253                |       | 91,127             |       |
| Total liabilities and stockholders’ equity                                                                                                                                                   |       | $                     | 231,546    |               | $          | 274,979 |   |

 

*See accompanying notes.*

 

3

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**Eschelon Telecom, Inc.**

**Unaudited Consolidated Statements of Operations**

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

 
| ** **                                                     | ** ** | **Three months ended** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                     | ** ** | **March 31,**               | ** ** |
| ** **                                                     | ** ** | **2005**                         | ** ** | **2006** | ** ** |
| Revenue:                                                       |       |                             |       |   |   |
| Network services                                               |       | $                                | 48,668     |   | $ | 52,785 |   |
| Business telephone systems                                     |       | 5,865                            |       | 6,941 |   |
| Total revenue                                                  |       | 54,533                           |       | 59,726 |   |
|                                                           |       |                             |       |   |   |
| Cost of revenue:                                               |       |                             |       |   |   |
| Network services (exclusive of depreciation and  amortization) |       | 20,001                           |       | 20,763 |   |
| Business telephone systems                                     |       | 3,630                            |       | 4,553 |   |
| Total cost of revenue                                          |       | 23,631                           |       | 25,316 |   |
|                                                           |       |                             |       |   |   |
| Gross profit:                                                  |       |                             |       |   |   |
| Network services                                               |       | 28,667                           |       | 32,022 |   |
| Business telephone systems                                     |       | 2,235                            |       | 2,388 |   |
| Total gross profit                                             |       | 30,902                           |       | 34,410 |   |
|                                                           |       |                             |       |   |   |
| Operating expenses:                                            |       |                             |       |   |   |
| Sales, general and administrative                              |       | 22,365                           |       | 22,699 |   |
| Depreciation and amortization                                  |       | 8,574                            |       | 10,176 |   |
| Operating income (loss)                                        |       | (37                              | )          | 1,535 |   |
|                                                           |       |                             |       |   |   |
| Other income (expense):                                        |       |                             |       |   |   |
| Interest income                                                |       | 131                              |       | 233 |   |
| Interest expense                                               |       | (4,862                           | )          | (3,400 | ) |
| Other income                                                   |       | —                           |       | 49 |   |
| Loss before income taxes                                       |       | (4,768                           | )          | (1,583 | ) |
| Income taxes                                                   |       | —                           |       | — |   |
| Net loss                                                       |       | (4,768                           | )          | (1,583 | ) |
| Less preferred stock dividends                                 |       | (1,079                           | )          | — |   |
| Net loss applicable to common stockholders                     |       | $                                | (5,847     | ) | $ | (1,583 | ) |
|                                                           |       |                             |       |   |   |
| Net loss per share:                                            |       |                             |       |   |   |
| Basic and diluted                                              |       | $                                | (18.70     | ) | $ | (0.11 | ) |
|                                                           |       |                             |       |   |   |
| Weighted average number of shares outstanding:                 |       |                             |       |   |   |
| Basic and diluted                                              |       | 313,400                          |       | 14,680,783 |   |

 

*See accompanying notes.*

 

4

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**Eschelon Telecom, Inc.**

**Unaudited Consolidated Statements of Cash Flows**

**(In Thousands)**

 
| ** **                                                                            | ** ** | **Three months ended** | ** ** |
|---------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                            | ** ** | **March 31,**               | ** ** |
| ** **                                                                            | ** ** | **2005**                         | ** ** | **2006** | ** ** |
| **Operating activities**                                                              |       |                             |       |   |   |
| Net loss                                                                              |       | $                                | (4,768     | ) | $ | (1,583 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities:      |       |                             |       |   |   |
| Depreciation and amortization expense                                                 |       | 8,574                            |       | 10,176 |   |
| Other non-cash items                                                                  |       | 1,342                            |       | 1,488 |   |
| Changes in operating assets and liabilities:                                          |       |                             |       |   |   |
| Restricted cash                                                                       |       | 71                               |       | 103 |   |
| Accounts receivable                                                                   |       | (302                             | )          | 961 |   |
| Inventories                                                                           |       | (379                             | )          | (331 | ) |
| Prepaid expenses and other assets                                                     |       | 450                              |       | (1,416 | ) |
| Accounts payable and accrued expenses                                                 |       | (3,454                           | )          | (1,775 | ) |
| Deferred revenue                                                                      |       | 23                               |       | 11 |   |
| Accrued compensation expense                                                          |       | 793                              |       | 737 |   |
| Net cash provided by operating activities                                             |       | 2,350                            |       | 8,371 |   |
|                                                                                  |       |                             |       |   |   |
| **Investing activities**                                                              |       |                             |       |   |   |
| Purchase of assets held for sale, net of liabilities                                  |       | (216                             | )          | — |   |
| Purchases of available-for-sale securities                                            |       | (14,134                          | )          | — |   |
| Proceeds from sales of available-for-sale securities                                  |       | 7,646                            |       | 4,000 |   |
| Purchases of property and equipment                                                   |       | (4,972                           | )          | (5,360 | ) |
| Cash paid for customer installation costs                                             |       | (3,343                           | )          | (3,640 | ) |
| Proceeds from sales of assets                                                         |       | 5                                |       | 28 |   |
| Net cash used in investing activities                                                 |       | (15,013                          | )          | (4,972 | ) |
|                                                                                  |       |                             |       |   |   |
| **Financing activities**                                                              |       |                             |       |   |   |
| Proceeds from issuance of notes payable                                               |       | —                           |       | 45,600 |   |
| Payments made on notes and capital lease obligations                                  |       | (453                             | )          | (638 | ) |
| Proceeds from issuance of stock, net of fees                                          |       | 1                                |       | 153 |   |
| Increase in debt issuance costs                                                       |       | (240                             | )          | (996 | ) |
| Net cash provided by (used in) financing activities                                   |       | (692                             | )          | 44,119 |   |
|                                                                                  |       |                             |       |   |   |
| Net increase (decrease) in cash and cash equivalents                                  |       | (13,355                          | )          | 47,518 |   |
| Cash and cash equivalents at beginning of period                                      |       | 26,435                           |       | 26,062 |   |
| Cash and cash equivalents at end of period                                            |       | $                                | 13,080     |   | $ | 73,580 |   |
| ** **                                                                            | ** ** | ** **                       | ** ** | ** ** | ** ** |
| **Supplemental cash flow information**                                                |       |                             |       |   |   |
| Cash paid for interest                                                                |       | $                                | 3,643      |   | $ | 2,485 |   |
|                                                                                  |       |                             |       |   |   |
| **Supplemental noncash activities**                                                   |       |                             |       |   |   |
| Equipment purchases under capital leases                                              |       | $                                | 584        |   | $ | 21 |   |
| Value of common stock issued to management and  certain members of board of directors |       | $                                | 24         |   | $ | — |   |
|                                                                                       |            |                                  |            |  |  |  |  |  |  |

 

*See accompanying notes.*

 

5

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**Eschelon Telecom, Inc.**

**Notes to Consolidated Financial Statements**

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

**(Unaudited)**

 

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

 

**Basis ofPresentation**

 

The accompanyingunaudited consolidated financial statements of Eschelon Telecom, Inc. andits subsidiaries (the “Company”) have been prepared in accordance withaccounting principles generally accepted in the United States of America forinterim financial information and the instructions to Form 10-Q and Article 10of Regulation S-X promulgated by the United States Securities and ExchangeCommission (the “SEC”). Accordingly, they do not include all of the informationand notes required by accounting principles generally accepted in the UnitedStates of America for complete financial 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. Operating results for the three month periodended March 31, 2006 are not necessarily indicative of the results that may beexpected for the year ending December 31, 2006. The consolidated balancesheet at December 31, 2005 has been derived from the audited consolidatedfinancial statements at that date but does not include all of the informationand footnotes required by generally accepted accounting principles for completefinancial statements. These financial statements should be read in conjunctionwith the Company’s audited financial statements and related notes thereto forthe year ended December 31, 2005 included in the Eschelon Telecom, Inc.Form 10-K filed with the SEC on March 17, 2006.

 

## **Principles of Consolidation**

## ** **

The consolidatedfinancial statements include the accounts of the Company and its wholly ownedsubsidiaries. All intercompany balances and transactions have been eliminatedin consolidation.

 

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

## ** **

Short-term investmentsare comprised of municipal and United States government debt securities withmaturities of more than three months but less than one year. In accordance withStatement of Financial Accounting Standards (SFAS) No. 115, *Accounting for Certain Investments in Debt and Equity Securities*,and based on the Company’s intentions regarding these instruments, allinvestments in debt securities are classified as available-for-sale andaccounted for at fair value. Fair value is determined by quoted market prices,with unrealized gains and losses reported as a separate component ofstockholders’ equity. The Company uses the specific identification ofsecurities sold method to recognize realized gains and losses in earnings.

 

The cost basis,unrealized holding gains and fair value of the investment securitiesavailable-for-sale as of March 31, 2006 and December 31, 2005, are asfollows:

 
| ** **                                                  | ** ** | ** **          | ** ** | **Unrealized** | ** ** | ** **          | ** ** |
|-------------------------------------------------------------|------------|---------------------|------------|----------------|------------|---------------------|------------|
| ** **                                                  | ** ** | ** **          | ** ** | **Holding**    | ** ** | ** **          | ** ** |
| ** **                                                  | ** ** | **Cost Basis** | ** ** | **Gains**      | ** ** | **Fair Value** | ** ** |
|                                                        |       |                |       |           |       |                |       |
| Available-for-sale securities as of March 31,  2006    |       | $                   | 782        |           | $          | 13                  |       | $ | 795 |   |
|                                                        |       |                |       |           |       |                |       |
| Available-for-sale securities as of December 31,  2005 |       | $                   | 4,704      |           | $          | 56                  |       | $ | 4,760 |   |

 

Debt securities as of March 31,2006, have maturities of less than six months.

 

## **Property and Equipment**

## ** **

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

 

6

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

 

Property and equipmentconsist of the following:

 
| ** **                                | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                | ** ** | **2005**              | ** ** | **2006**           | ** ** |
|                                      |       |                  |       |               |       |
| Vehicles                                  |       | $                     | 1,375      |               | $          | 1,406 |   |
| Office furniture and equipment            |       | 18,229                |       | 18,758             |       |
| Computer equipment and software           |       | 41,897                |       | 42,885             |       |
| Leasehold improvements                    |       | 23,765                |       | 24,511             |       |
| Switching and data equipment and software |       | 134,661               |       | 137,604            |       |
|                                      |       | 219,927               |       | 225,164            |       |
| Less accumulated depreciation             |       | (93,475               | )          | (100,353           | )          |
| Property and equipment, net               |       | $                     | 126,452    |               | $          | 124,811 |   |

 

## **Goodwill and Other Intangible Assets**

## ** **

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

 

Intangibles consist ofcustomer installation costs, debt issuance costs, customer relationships, non-competeagreements and developed technology. The customer installation costs are beingamortized over a period of 48 months, which approximates the average life of acustomer contract. Debt issuance costs are being amortized over the term of therespective debt obligation. Non-compete agreement costs represent costsassociated with a non-compete agreement with a former employee. These costs arebeing amortized over the term of the agreement. Customer relationships anddeveloped technology are being amortized over four and three years,respectively.

 

Intangible assets consistof the following:

 
| ** **                    | ** ** | **December 31,** | ** ** | **March 31,** | ** ** |
|-------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                    | ** ** | **2005**              | ** ** | **2006**           | ** ** |
|                          |       |                  |       |               |       |
| Customer installation costs   |       | $                     | 77,650     |               | $          | 81,370 |   |
| Debt issuance costs           |       | 5,666                 |       | 6,662              |       |
| Customer relationships        |       | 3,820                 |       | 3,820              |       |
| Non-compete agreements        |       | 300                   |       | 300                |       |
| Developed technology          |       | 94                    |       | 94                 |       |
|                          |       | 87,530                |       | 92,246             |       |
| Less accumulated amortization |       | (54,197               | )          | (57,700            | )          |
| Intangible assets, net        |       | $                     | 33,333     |               | $          | 34,546 |   |

 

7

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## **Stock-Based Compensation**

## ** **

*StockOption Plan*

 

A total of 1,632,414shares of the Company’s common stock have been authorized for issuance underthe Eschelon Telecom, Inc. Stock Option Plan of 2002 (the “2002 Plan”). The2002 Plan provides for grants of incentive stock options, non-statutory stockoptions, stock appreciation rights, restricted or unrestricted stock awards,phantom stock, performance awards and other stock-based awards to ouremployees, former employees, officers, directors and consultants. The 2002 Planis administered by the Compensation Committee of the Board of Directors, whichhas sole discretion and authority, consistent with the provisions of the 2002Plan, to determine which eligible participants will receive awards, when awardswill be granted, the terms of awards, and the number of shares that will besubject to awards. The purpose of the 2002 Plan is to enable the Company toattract, retain and reward the best-available persons, to provide participantswith incentives to improve stockholder value and to contribute to the growthand financial success of the Company through their future services of theCompany. All of the Company’s employees, former employees, officers anddirectors are eligible to participate in the 2002 Plan.

 

The exercise price ofincentive stock options may not be less than the fair market value of thestock on the date of grant and the options are exercisable for a period not toexceed ten years from date of grant. Options and restricted stock awards aretypically subject to one of the following vesting schedules:  (1) 20% upon the initial grant and 20% peryear over four years from the date of grant, (2) 20% per year over five yearsfrom the date of grant, or (3) 33 1/3% upon the initial grant and 33 1/3%per year over two years from the date of grant. Awards granted may besubject to other vesting terms as determined by the Compensation Committee.

 

*StockOptions*

 

Effective January 1,2006, the Company adopted the provisions of SFAS No. 123R (SFAS 123R), *Share-Based Payment: an amendment of FASB Statement No. 123 andFASB Statement No. 95,*which requires the measurement andrecognition of compensation expense for all share-based payment awards toemployees and directors based on estimated fair values. Prior to the adoptionof SFAS 123R, the Company accounted for its stock-based compensation under therecognition and measurement principles of Accounting Principles Board Opinion No. 25(APB 25), *Accounting for Stock Issued to Employees,*andrelated interpretations. The Company recorded $336 of stock-based compensationexpense under SFAS 123R for the three months ended March 31, 2006 forstock option awards. Under APB 25, $139 of stock-based compensation expensewould have been recorded for the same period. For the three months ended March 31,2006, $10 was recorded for vested restricted awards. At March 31, 2006,there is $1,064 of total unrecognized compensation expense related to unvestedshares granted under the Company’s share-based payment plans, of which $1,053relates to service-based option awards and $11 relates to restricted stockawards. The expense is expected to be recognized over a weighted-average periodof 1.1 years.

 

The Company adopted SFAS123R using the modified prospective transition method and the straight-lineattribution method for recognizing compensation expense. Under the modifiedprospective transition method, compensation expense recognized during the threemonths ended March 31, 2006, included: (a) the quarterly prorated portion of compensation expense for allshare-based awards granted prior to January 1, 2006, but not yet vested,based on the grant date fair value estimated in accordance with the originalprovisions of SFAS 123, and (b) the quarterly prorated portion of compensationexpense for all share-based awards granted subsequent to adoption of SFAS 123R,based on the grant date fair value estimated in accordance with the provisionsof SFAS 123R. In accordance with the modified prospective transition method,the Company’s consolidated financial statements for periods prior to the adoptionof SFAS 123R have not been restated to reflect the impact of the provisions ofSFAS 123R.

 

The Company recordscompensation expense for employee stock options based on the estimated fairvalue of the options on the date of grant using assumptions required by SFAS123R. Due to insufficient history related to options, the Company uses theshort-cut method accepted by the SEC to determine the expected life of options.The Company expects to continue using the short-cut method for options grantedthrough December 31, 2007, after which the use of the short-cut method is notpermitted by the SEC. Volatility is estimated based on an exchange-tradedtelecommunications fund using data which corresponds to the expected term ofthe options granted. The risk-free interest rate is based on the FederalReserve rate for U.S. government securities with a term that corresponds to theexpected term of the options granted. The Company uses historical data andother factors to estimate the expected forfeiture rate.

 

8

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The following tablesummarizes the assumptions used to estimate the fair value of options grantedduring the three month periods ended March 31, 2005 and 2006 using theBlack-Scholes option-pricing model:

 
| ** **                      | ** ** | **Three months ended  March 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------------|------------|
| ** **                      | ** ** | **2005**                                         | ** ** | **2006** | ** ** |
| Expected dividend yield         |       | —                                           |       | — |   |
| Expected stock price volatility |       | 25                                               | %          | 26 | % |
| Risk-free interest rate         |       | 3.71                                             | %          | 4.56 | % |
| Expected life of options        |       | 5 years                                          |       | 6 – 6.5 years |   |

 

Pro forma informationregarding net loss and net loss per share is required by SFAS 123, and has beendetermined as if the Company had accounted for its employee stock options underthe fair value method of SFAS 123. The following table illustrates the effecton net loss per share for the three months ended March 31, 2005, if the Companyhad applied the fair value recognition provision of SFAS 123, *Accounting for Stock-Based Compensation,*to stock-basedemployee compensation:

 
| ** **                                                                                                        | ** ** | **Three months**        | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                        | ** ** | **Ended**                    | ** ** |
| ** **                                                                                                        | ** ** | **March 31, 2005** | ** ** |
| Net loss applicable to common stockholders, as  reported                                                          |       | $                            | (5,847     | ) |
| Add: Stock-based employee compensation expense  included in reported net loss                                     |       | 12                           |       |
| Deduct: Total stock-based employee compensation  expense determined under fair value-based methods for all awards |       | (17                          | )          |
| Pro forma net loss applicable to common stockholders                                                              |       | $                            | (5,852     | ) |
|                                                                                                              |       |                         |       |
| Net loss per share:                                                                                               |       |                         |       |
| Basic and diluted - as reported                                                                                   |       | $                            | (18.70     | ) |
| Basic and diluted - pro forma                                                                                     |       | $                            | (18.70     | ) |

 

The following tablesummarizes the option activity under the 2002 Plan:

 
| ** **                                                        | ** ** | **Number of  Options** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Weighted-  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic Value** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------|------------|
|                                                              |       |                        |       |                                        |       |                                                 |       |                                |       |
| Outstanding at December 31, 2005                             |       | 1,167,490                   |       | $                                           | 4.12       |                                                 |       |                                |       |   |
| Granted                                                           |       | 13,638                      |       | 12.00                                       |       |                                                 |       |                                |       |
| Canceled                                                          |       | (11,537                     | )          | 7.07                                        |       |                                                 |       |                                |       |
| Exercised                                                         |       | (218,214                    | )          | 0.72                                        |       |                                                 |       |                                |       |
| Outstanding at March 31, 2006                                |       | 951,377                     |       | $                                           | 4.97       |                                                 | 8.22       |                                | $          | 10,227 |   |
|                                                              |       |                        |       |                                        |       |                                                 |       |                                |       |
| Vested and expected to vest in the future at March 31,  2006 |       | 948,735                     |       | $                                           | 4.97       |                                                 | 8.22       |                                | $          | 10,204 |   |
| Exercisable at March 31, 2006                                |       | 417,740                     |       | $                                           | 3.09       |                                                 | 7.63       |                                | $          | 5,274 |   |

## ** **

The weighted-averagegrant-date fair value of options granted during the three months ended March 31,2006 and 2005, was $4.35 and $2.27, respectively. The total intrinsic value foroptions exercised during the three months ended March 31, 2006 and 2005,was $2,708 and $1, respectively.

 

Cash received from optionexercises for the three months ended March 31, 2006 and 2005, was $153 and$1, respectively.

 

9

----

 

*Restrictedand Unrestricted Common Stock*

 

In 2003, the Companygranted 183,399 shares of restricted common stock to certain of its directorsand members of management. The Company records compensation expense as therestrictions are removed from the stock. In 2005, the Company granted 9,350shares of unrestricted common stock to certain directors. Total compensationexpense related to restricted and unrestricted common stock for the threemonths ended March 31, 2006 and 2005, is $10 and $36, respectively.

 

The following tablesummarizes the activity of the Company’s unvested restricted common shares forthe three months ended March 31, 2006:

 
| ** **                         | ** ** | **Number of  Shares** | ** ** | **Weighted  Average Grant-  Date Fair Value** | ** ** |
|------------------------------------|------------|----------------------------|------------|--------------------------------------------------------------|------------|
|                               |       |                       |       |                                                         |       |
| Unvested at December 31, 2005 |       | 31,686                     |       | $                                                            | 0.68       |   |
| Granted                            |       | —                     |       | —                                                       |       |
| Vested                             |       | (15,842                    | )          | 0.68                                                         |       |
| Forfeited                          |       | —                     |       | —                                                       |       |
| Unvested at March 31, 2006    |       | 15,844                     |       | $                                                            | 0.68       |   |

## ** **

## **Net Income (Loss) Per Share**

## ** **

Basic earnings per shareis computed based on the weighted average number of common shares outstanding. Dilutedearnings per share is computed based on the weighted average number of commonshares outstanding adjusted by the number of additional shares that would havebeen outstanding had potentially dilutive common shares been issued. Potentiallydilutive shares of common stock include unexercised stock options and unvestedrestricted stock grants. The Company does not have any potentially dilutiveshares because net losses were reported in all periods presented.

 

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

 

***AdvancedTelCom, Inc.***

 

In connection with theacquisition of Advanced TelCom, Inc. on December 31, 2004, theCompany accrued $2,531 in acquisition related expenses, which includedseverance benefits, relocation costs and contract termination fees. During thefourth quarter of 2005 the Company finalized its liabilities incurred in connectionwith the acquisition and recorded an adjustment to decrease the recordedliabilities by $403, which was recorded as a reduction to goodwill. As of March 31,2006, $93 of the acquisition related expenses have yet to be paid.

 

**3.)****          NotesPayable**

 

On March 29, 2006,the Company completed an offering of $48,000 of 8 3/8% senior second securednotes (“notes”) due 2010 at a discount resulting in a 9.92% yield. The noteswere entered into under a fourth supplemental indenture to the originalindenture dated March 17, 2004, and have the same terms and conditions ofthe original indenture. The Company received net proceeds of approximately$44,604 after deducting fees and expenses associated with the offering. TheCompany’s acquisition of Oregon Telecom, Inc. on April 1, 2006, wasfinanced with approximately $20,000 of the proceeds from the offering. Theremaining proceeds will be used for general corporate purposes and potentialfuture acquisitions.

 

**4.)****          BenefitContribution Plan**

 

The Company has a definedcontribution salary deferral plan covering substantially all employees under Section 401(k)of the Internal Revenue Code. The Company contributes an amount equal to 45cents for each dollar contributed by each employee up to a maximum of 6% ofeach employee’s compensation. The Company recognized expense for contributionsto the plan for the three months ended March 31, 2005 and 2006 of $227 and$230, respectively.

 

10

----

 

**5.)****          CapitalStock**

 

**PreferredStock**

 

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

 

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

 

Prior to the conversion,under the terms of the Company’s Series A Convertible Preferred Stock and Series BConvertible Preferred Stock (collectively, “Preferred Stock”), the holders wereentitled to receive, when and if declared by the Board of Directors, cumulativedividends on each share of Preferred Stock at the rate of 8% per year whichaccrued daily and, to the extent not paid, accumulated quarterly in arrears. AtMarch 31, 2005, dividends in arrears were $9,856.

 

**6.)****          ReverseStock Split**

 

The Company completed a0.0738-for-one reverse stock split affecting all outstanding shares of commonstock on August 2, 2005. All share and per share data have been adjustedto reflect the stock split.

 

**7.)****          CondensedConsolidating Financial Information**

 

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

 

The following tablespresent condensed consolidating balance sheets at December 31, 2005 and March 31,2006 and condensed consolidating statements of operations for the three-monthperiods ended March 31, 2005 and 2006.

 

11

----

 

**Unaudited Condensed Consolidating Balance Sheets**

**As of December 31, 2005**

**(In Thousands)**

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

 

12

----

 

**Unaudited Condensed Consolidating Balance Sheets**

**As of March 31, 2006**

**(In Thousands)**

 
| ** **                                                | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                      |       |                   |       |          |       |             |       |             |       |             |       |
| **Assets**                                                |       |                   |       |          |       |             |       |             |       |             |       |
| Current assets:                                           |       |                   |       |          |       |             |       |             |       |             |       |
| Cash and cash equivalents                                 |       | $                      | 73,665     |          | $          | —           |       | $                | (85        | )                | $          | — |   | $ | 73,580 |   |
| Restricted cash                                           |       | 893                    |       | —        |       | —           |       | —           |       | 893              |       |
| Available-for-sale securities                             |       | 795                    |       | —        |       | —           |       | —           |       | 795              |       |
| Accounts receivable                                       |       | —                 |       | —        |       | 21,760           |       | —           |       | 21,760           |       |
| Other receivables                                         |       | —                 |       | —        |       | 3,308            |       | —           |       | 3,308            |       |
| Inventories                                               |       | —                 |       | —        |       | 3,258            |       | —           |       | 3,258            |       |
| Prepaid expenses                                          |       | 1,708                  |       | —        |       | 1,686            |       | —           |       | 3,394            |       |
| Total current assets                                      |       | 77,061                 |       | —        |       | 29,927           |       | —           |       | 106,988          |       |
|                                                      |       |                   |       |          |       |             |       |             |       |             |       |
| Property and equipment, net                               |       | 83,397                 |       | —        |       | 41,414           |       | —           |       | 124,811          |       |
|                                                      |       |                   |       |          |       |             |       |             |       |             |       |
| Investment in affiliates                                  |       | 59,046                 |       | —        |       | —           |       | (59,046          | )          | —           |       |
| Other assets                                              |       | 509                    |       | —        |       | 957              |       | —           |       | 1,466            |       |
| Goodwill                                                  |       | —                 |       | —        |       | 7,168            |       | —           |       | 7,168            |       |
| Intangible assets, net                                    |       | 14,492                 |       | 5,378         |       | 14,676           |       | —           |       | 34,546           |       |
| Total assets                                              |       | $                      | 234,505    |          | $          | 5,378            |       | $                | 94,142     |             | $          | (59,046 | ) | $ | 274,979 |   |
|                                                      |       |                   |       |          |       |             |       |             |       |             |       |
| **Liabilities and stockholders’ equity (deficit)**   |       |                   |       |          |       |             |       |             |       |             |       |
| Current liabilities:                                      |       |                   |       |          |       |             |       |             |       |             |       |
| Accounts payable                                          |       | $                      | 13,489     |          | $          | —           |       | $                | 1,929      |             | $          | — |   | $ | 15,418 |   |
| Accrued telecommunication costs                           |       | —                 |       | —        |       | 5,008            |       | —           |       | 5,008            |       |
| Accrued office rent                                       |       | 1,076                  |       | —        |       | 788              |       | —           |       | 1,864            |       |
| Accrued interest expense                                  |       | —                 |       | 578           |       | 1                |       | —           |       | 579              |       |
| Other accrued expenses                                    |       | 1,203                  |       | —        |       | 4,946            |       | —           |       | 6,149            |       |
| Deferred revenue                                          |       | —                 |       | —        |       | 7,932            |       | —           |       | 7,932            |       |
| Accrued compensation expenses                             |       | 2,799                  |       | —        |       | 747              |       | —           |       | 3,546            |       |
| Capital lease obligations, current maturities             |       | 1,721                  |       | —        |       | 112              |       | —           |       | 1,833            |       |
| Total current liabilities                                 |       | 20,288                 |       | 578           |       | 21,463           |       | —           |       | 42,329           |       |
|                                                      |       |                   |       |          |       |             |       |             |       |             |       |
| Long-term liabilities:                                    |       |                   |       |          |       |             |       |             |       |             |       |
| Other long-term liabilities                               |       | 144                    |       | —        |       | —           |       | —           |       | 144              |       |
| Capital lease obligations, less current maturities        |       | 2,868                  |       | —        |       | 78               |       | —           |       | 2,946            |       |
| Notes payable                                             |       | —                 |       | 138,433       |       | —           |       | —           |       | 138,433          |       |
| Due to (from) affiliates                                  |       | 218,343                |       | (146,211      | )          | (132,366         | )          | —           |       | —           |       |
| Total liabilities                                         |       | 311,643                |       | (7,200        | )          | (110,825         | )          | —           |       | 183,852          |       |
|                                                      |       |                   |       |          |       |             |       |             |       |             |       |
| Convertible preferred stock                               |       | —                 |       | —        |       | —           |       | —           |       | —           |       |
| Stockholders’ equity (deficit)                       |       | (71,760                | )          | 12,578        |       | 204,967          |       | (59,046          | )          | 91,127           |       |
| Total liabilities and stockholders’ equity (deficit) |       | $                      | 239,883    |          | $          | 5,378            |       | $                | 94,142     |             | $          | (59,046 | ) | $ | 274,979 |   |

 

13

----

 

**Unaudited Condensed Consolidating Statement ofOperations**

**For the Three Months Ended March 31, 2005**

**(In Thousands)**

 
| ** **                        | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                        | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                        | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                              |       |                   |       |          |       |             |       |             |       |
| Revenue:                          |       |                   |       |          |       |             |       |             |       |
| Network services                  |       | $                      | —     |          | $          | —           |       | $                | 48,668     |   | $ | 48,668 |   |
| Business telephone systems        |       | —                 |       | —        |       | 5,865            |       | 5,865            |       |
|                              |       | —                 |       | —        |       | 54,533           |       | 54,533           |       |
|                              |       |                   |       |          |       |             |       |             |       |
| Cost of revenue:                  |       |                   |       |          |       |             |       |             |       |
| Network services                  |       | —                 |       | —        |       | 20,001           |       | 20,001           |       |
| Business telephone systems        |       | —                 |       | —        |       | 3,630            |       | 3,630            |       |
|                              |       | —                 |       | —        |       | 23,631           |       | 23,631           |       |
|                              |       |                   |       |          |       |             |       |             |       |
| Gross profit:                     |       |                   |       |          |       |             |       |             |       |
| Network services                  |       | —                 |       | —        |       | 28,667           |       | 28,667           |       |
| Business telephone systems        |       | —                 |       | —        |       | 2,235            |       | 2,235            |       |
|                              |       | —                 |       | —        |       | 30,902           |       | 30,902           |       |
| Operating expenses:               |       |                   |       |          |       |             |       |             |       |
| Sales, general and administrative |       | 10,473                 |       | —        |       | 11,892           |       | 22,365           |       |
| Depreciation and amortization     |       | 5,272                  |       | —        |       | 3,302            |       | 8,574            |       |
| Total operating expenses          |       | 15,745                 |       | —        |       | 15,194           |       | 30,939           |       |
|                              |       |                   |       |          |       |             |       |             |       |
| Operating income (loss)           |       | (15,745                | )          | —        |       | 15,708           |       | (37              | )          |
| Other income (expense)            |       | (67                    | )          | (4,674        | )          | 10               |       | (4,731           | )          |
| Income (loss) before income taxes |       | (15,812                | )          | (4,674        | )          | 15,718           |       | (4,768           | )          |
| Income taxes                      |       | —                 |       | —        |       | —           |       | —           |       |
| Net income (loss)                 |       | $                      | (15,812    | )             | $          | (4,674           | )          | $                | 15,718     |   | $ | (4,768 | ) |

 

14

----

 

**Unaudited Condensed Consolidating Statement ofOperations**

**For the Three Months Ended March 31, 2006**

**(In Thousands)**

 
| ** **                        | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                        | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                        | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                              |       |                   |       |          |       |             |       |             |       |
| Revenue:                          |       |                   |       |          |       |             |       |             |       |
| Network services                  |       | $                      | —     |          | $          | —           |       | $                | 52,785     |   | $ | 52,785 |   |
| Business telephone systems        |       | —                 |       | —        |       | 6,941            |       | 6,941            |       |
|                              |       | —                 |       | —        |       | 59,726           |       | 59,726           |       |
|                              |       |                   |       |          |       |             |       |             |       |
| Cost of revenue:                  |       |                   |       |          |       |             |       |             |       |
| Network services                  |       | —                 |       | —        |       | 20,763           |       | 20,763           |       |
| Business telephone systems        |       | —                 |       | —        |       | 4,553            |       | 4,553            |       |
|                              |       | —                 |       | —        |       | 25,316           |       | 25,316           |       |
|                              |       |                   |       |          |       |             |       |             |       |
| Gross profit:                     |       |                   |       |          |       |             |       |             |       |
| Network services                  |       | —                 |       | —        |       | 32,022           |       | 32,022           |       |
| Business telephone systems        |       | —                 |       | —        |       | 2,388            |       | 2,388            |       |
|                              |       | —                 |       | —        |       | 34,410           |       | 34,410           |       |
| Operating expenses:               |       |                   |       |          |       |             |       |             |       |
| Sales, general and administrative |       | 12,722                 |       | —        |       | 9,977            |       | 22,699           |       |
| Depreciation and amortization     |       | 5,609                  |       | —        |       | 4,567            |       | 10,176           |       |
| Total operating expenses          |       | 18,331                 |       | —        |       | 14,544           |       | 32,875           |       |
|                              |       |                   |       |          |       |             |       |             |       |
| Operating income (loss)           |       | (18,331                | )          | —        |       | 19,866           |       | 1,535            |       |
| Other income (expense)            |       | 244                    |       | (3,339        | )          | (23              | )          | (3,118           | )          |
| Income (loss) before income taxes |       | (18,087                | )          | (3,339        | )          | 19,843           |       | (1,583           | )          |
| Income taxes                      |       | —                 |       | —        |       | —           |       | —           |       |
| Net income (loss)                 |       | $                      | (18,087    | )             | $          | (3,339           | )          | $                | 19,843     |   | $ | (1,583 | ) |

 

15

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**8.)****          SubsequentEvent**

 

On April 1, 2006, the Company completed itsacquisition of Oregon Telecom, Inc., a privately-held competitive servicesprovider based in Salem, Oregon. The Company paid approximately $20,000 in cashto acquire Oregon Telecom, Inc.

 

16

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

 

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

## ** **

We make “forward-lookingstatements” throughout this document. Whenever you read a statement that is notsolely a statement of historical fact (such as when we state that we “may,” “will”or “plan to” perform in a certain manner or that we “intend,” “believe,” “expect,”“anticipate,” “estimate” or “project” that an event will occur, or the negativethereof, and other similar statements), you should understand that ourexpectations may not be correct, although we believe that they arereasonable. You should also understand that our plans may change. We donot guarantee that the events described in this document will happen asdescribed or that any trends noted in this document will continue.

 

Forward-lookingstatements, such as those regarding management’s present plans or expectationsfor new product offerings, capital expenditures, cost-saving strategies andgrowth are not guarantees of future performance. They involve risks anduncertainties 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-lookingstatements regarding management’s present expectations for operating resultsand cash flow involve risks and uncertainties relative to these and otherfactors, such as the ability to increase revenues and/or to achieve costreductions and other factors discussed herein, which also would cause actualresults to differ from present plans. Such differences could be material. Allforward-looking statements attributable to us or by any persons acting on ourbehalf are expressly qualified in their entirety by these cautionarystatements.

 

As such, actual resultsor circumstances may vary materially from such forward-looking statementsor expectations. Readers are also cautioned not to place undue reliance onthese forward-looking statements which speak only as of the date thesestatements were made. Except as required by law, we do not have any obligationto update these forward-looking statements, even if our situation changes inthe future.

 

## **Company Overview**

## ** **

We are a leadingfacilities-based provider of voice and data services and business telephonesystems in 19 markets in the western United States. As a facilities-basedcompetitive communications services provider, we provide services to ourcustomers primarily through our own network of telecommunications switches andrelated equipment and primarily leased telecommunications lines, or transport. Wetarget the small and medium-sized business segment and currently serve over50,000 customers, primarily within the local service territory of Qwest.

 

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

 

The telecommunicationsindustry is highly competitive. We believe we compete principally by offeringsuperior customer service, accurate billing, a broad set of services andsystems and competitive pricing. We compete with the Regional Bell OperatingCompanies (RBOCs), other competitive communications services providers, andlong distance and data service providers. While wireless providers arecompeting with us, we do not believe they are a competitive threat in themarket nor are they likely to be in the near future, because of the differentservice standards that business customers require.

 

**KeyComponents of Results of Operations**

 

***Revenue.***Network services revenue consists primarily of local dialtone, switched access lines, long distance, access charges and data service.Revenue from local telephone service consists of charges for basic localservice, including dedicated T1 access, and custom-calling features such ascall waiting and call forwarding. Revenue from long distance service consistsof per-minute-of-use charges for a full range of traditional switched anddedicated long distance, toll-free calling, international, calling card andoperator services. Carrier access revenue consists primarily of usage chargesthat we bill long distance carriers to originate and terminate calls to andfrom our customers. In addition, in some of our markets we currently chargeother local exchange carriers and wireless carriers usage charges to originateand terminate local and wireless calls to and

 

17

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from certain customers(otherwise known as reciprocal compensation). Revenue from data servicesconsists primarily of monthly usage fees for Internet access services. Wetypically commit our customers to contracts ranging from one to three years andprovide discounts for longer terms. Network services revenue comprised 88.4% ofour total revenue for the three months ended March 31, 2006, andrepresents a predominantly recurring revenue stream.

 

Monthly recurring networkservices revenue is recognized in the month the services are used. In the caseof local service revenue, monthly recurring local services charges are billedin advance but accrued for and recognized on a prorated basis based on lengthof service in any given month. Non-recurring revenues associated with lineinstallations are recognized over the average life of the customers. Longdistance and access charges are billed in arrears but accrued based on monthlyaverage usage. Prior to 2005, we had not historically received any revenuesfrom reciprocal compensation due to our bill-and-keep arrangement with Qwest. Asa result of the acquisition of Advanced TelCom, Inc., which was not undera bill-and-keep arrangement with the RBOCs, and our recently negotiatedreciprocal compensation agreements with a few wireless carriers, we recordedapproximately $0.2 million and $0.3 million of reciprocal compensation revenuefor the three month periods ended March 31, 2006 and 2005, respectively. Wedo not have any wholesale revenue other than access revenue and this reciprocalcompensation.

 

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

 

***Costof Revenue.***Our network services cost of revenue consistsprimarily of the cost of operating our network facilities. The networkcomponents for our facilities-based business include the cost of:

 

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

 

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

 

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

 

•                  leasing space, power and terminal connections in theRBOC central offices for colocating our equipment;

 

•                  signaling system network connectivity;

 

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

 

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

 

The costs to lease localloops, digital T1 lines and high capacity digital interoffice transportfacilities from the RBOCs varies by carrier and by state and are regulatedunder federal and state laws. In virtually all areas, we lease local loops, T1lines and interoffice transport capacity from the RBOCs. We lease interofficefacilities from carriers other than the RBOCs where possible in order to lowercosts and improve network redundancy; however, in most cases, the RBOCs are ouronly source for local loops and T1 lines. Historically, we purchased, on awholesale or negotiated basis, unbundled network elements platform, or UNE-P,from Qwest, AT&T and Verizon, and customized network element packages, orUNE-E, from Qwest. We also purchase, on a wholesale or negotiated basis, Centrexservices, which are services for the portion of the public telephone switchthat is dedicated to a customer, from AT&T. The rates for UNE-P and Centrexwere regulated and established by the various state corporation or utilitycommissions. We entered into agreements with Qwest and Verizon for UNE-Preplacement products in 2005. As of March 31, 2006, we had approximately 53,600access lines in service that were formerly categorized as UNE-P access linesand are now provided under commercial agreements. The Qwest UNE-E agreement wasterminated with the adoption of Qwest’s commercial UNE-P replacement product,QPP, and all Qwest UNE-E lines were moved to QPP on January 1, 2005. Webelieve we will incur higher costs in 2006 to obtain access to certain elementsof telecommunications platforms as a result of the Triennial Review RemandOrder. We will continue to migrate QPP lines to our switches as resourcespermit to help mitigate the increased costs.

 

18

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Our network services costof revenue also includes the fees we pay for long distance, data and otherservices. We have entered into long-term wholesale purchasing agreements forthese services. Some of the agreements contain significant terminationpenalties and/or minimum usage volume commitments. In the event we fail to meetminimum volume commitments, we may be obligated to pay underutilizationcharges. We do not anticipate having to pay any underutilization charges in theforeseeable future.

 

We carefully review allof our vendor invoices and frequently dispute inaccurate or inappropriatecharges. In cases where we dispute certain charges, we frequently pay onlyundisputed amounts on vendor invoices in order to pay proper amounts owed. Oursingle largest vendor is Qwest. We use estimates to determine the level ofsuccess in dispute resolution and consider past historical experience, basis ofdispute, financial status and current relationship with vendors and aging ofprior disputes in quantifying our estimates.

 

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

 

Our most significantbusiness telephone systems costs of revenue are the equipment purchased frommanufacturers and labor for service installation. To take advantage of volumepurchase discounts, we purchase equipment primarily from three manufacturerspursuant to master purchase agreements we have with these manufacturers. Forall business telephone systems installations, our policy is to require a 30%deposit before ordering the equipment so our risk of excess inventory orinventory obsolescence is low. Business telephone systems cost of revenue alsoincludes salaries and benefits of field technicians as well as vehicle andincidental expenses associated with equipment installation, maintenance andservice provisioning.

 

***Sales,General and Administrative.***Sales, general andadministrative expenses are comprised primarily of salaries and benefits,bonuses, commissions, occupancy costs, sales and marketing expenses, bad debt,billing and professional services.

 

Determining our allowancefor doubtful accounts receivable requires significant estimates. We considertwo primary factors in determining the proper level of the allowance, includinghistorical collections experience and the aging of the accounts receivableportfolio. We perform a credit review process on each new customer thatinvolves reviewing the customer’s current service provider bill and payment history,matching customers with the National Telecommunications Data Exchange databasefor delinquent customers and, in some cases, requesting credit reviews throughDun and Bradstreet. For each of the three months ended March 31, 2005 and2006, our bad debt expense as a percentage of revenue was 0.2% and 0.5%respectively.

 

***Depreciationand Amortization.***Our depreciation and amortizationexpense currently includes depreciation for network related voice and dataequipment, back office systems, furniture, fixtures, leasehold improvements,office equipment and computers. All internal costs directly related to theexpansion of our network and operating and support systems, including salariesof certain employees, are capitalized and depreciated over the lives of theswitches or systems, as the case may be. Capitalized customer installationcosts are amortized over the approximate average life of a customer, which iscurrently 48 months. Detailed time studies are used to determine laborcapitalization. These time studies are based on employee time sheets for thoseengaged in capitalizable activities.

 

**Acquisitions**

 

On April 1, 2006, wecompleted our acquisition of Oregon Telecom, Inc. (OTI), a privately-heldcompetitive services provider based in Salem, Oregon. OTI is a reseller of local,long distance and Internet access services in Oregon to approximately 9,000 businesscustomers that have approximately 53,000 access lines. We paid approximately$20 million in cash to acquire OTI.

 

We expect to develop andbenefit from synergies as we integrate OTI into our operations. We estimate wewill incur integration expenses of approximately $0.6 million as we integrate OTI’soperations and migrate OTI’s resale lines to on-net lines. We expect to spendapproximately $4.7 million for capital expenditures for switch hardware andsoftware for the increased on-net lines and for computer hardware and softwarenecessary to integrate and operate OTI.

 

In quarters subsequent tothe quarter ended March 31, 2006, we expect revenue, cost of sales,operating expenses and capital expenditures to increase as a result of theacquisition of OTI.

 

19

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## **Results of Operations**

## ** **

Selectedconsolidated financial and operating data for the three-month periods ended March 31,2005 and 2006 is as follows (dollars in thousands, except per unit amounts):

 
| ** **                                               | ** ** | **Three months ended March 31,** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                             | ** ** | **2006** | ** ** | **% Change** | ** ** |
|                                                     |       | **(unaudited)**                                      |       | **(unaudited)** |   |   |   |
| Total revenue                                            |       | $                                                    | 54,533     |   | $ | 59,726 |   | 9.5 | % |
| Total gross margin (%)                                   |       | 56.7                                                 | %          | 57.6 | % | 1.7 | % |
| Capital expenditures                                     |       | $                                                    | 8,898      |   | $ | 9,021 |   | 1.4 | % |
| Cash, restricted cash and available-for-sale  securities |       | $                                                    | 26,484     |   | $ | 75,268 |   | 184.2 | % |
|                                                     |       |                                                 |       |   |   |   |   |
| Voice lines in service                                   |       | 259,594                                              |       | 273,449 |   | 5.3 | % |
| Data lines in service                                    |       | 127,183                                              |       | 154,072 |   | 21.1 | % |
| Total lines in service                                   |       | 386,777                                              |       | 427,521 |   | 10.5 | % |
| Percent of lines on switch                               |       | 82.6                                                 | %          | 87.1 | % | 5.4 | % |
| Lines sold                                               |       | 26,495                                               |       | 30,740 |   | 16.0 | % |
| Average monthly access line churn (%)                    |       | 1.51                                                 | %          | 1.56 | % | 2.9 | % |
| Average monthly network services revenue per line        |       | $                                                    | 42.30      |   | $ | 41.61 |   | (1.6 | )% |
|                                                     |       |                                                 |       |   |   |   |   |
| Total employees                                          |       | 1,130                                                |       | 1,100 |   | (2.7 | )% |
| Quota-carrying network service salespeople               |       | 191                                                  |       | 205 |   | 7.3 | % |
| Quota-carrying BTS salespeople                           |       | 39                                                   |       | 45 |   | 15.4 | % |
| Total quota-carrying salespeople                         |       | 230                                                  |       | 250 |   | 8.7 | % |

 

**ThreeMonths Ended March 31, 2006 Compared to Three Months Ended March 31,2005**

 

***Revenue.***Revenue for the three months ended March 31,2005 and 2006 is as follows:

 
| ** **                 | ** ** | **2005**        | ** ** | **2006**        | ** ** | **% Change** | ** ** |
|----------------------------|------------|-----------------|------------|-----------------|------------|-------------------|------------|
| ** **                 | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **        | ** ** |
| Revenue (in millions):     |       |            |       |            |       |              |       |
| Voice and data services    |       | $               | 37.1       |            | $          | 39.7              |       | 6.9 | % |
| Long distance              |       | 8.6             |       | 9.4             |       | 9.8               | %          |
| Access                     |       | 3.0             |       | 3.7             |       | 23.3              | %          |
| Total network services     |       | 48.7            |       | 52.8            |       | 8.5               | %          |
| Business telephone systems |       | 5.8             |       | 6.9             |       | 18.3              | %          |
| Total revenue              |       | $               | 54.5       |            | $          | 59.7              |       | 9.5 | % |

 

Networkservices revenue was $52.8 million for the three months ended March 31,2006, an increase of 8.5% from $48.7 million in the same period of 2005. Therevenue growth is primarily due to higher access lines in service. Over thepast 12 months the number of voice lines in service increased by 5.3% to273,449 at March 31, 2006 and the number of data lines in serviceincreased by 21.1% to 154,072 at March 31, 2006. The revenue growthassociated with access lines growth was partially offset by declines in data revenueper line due to a combination of customers purchasing more bandwidth atdiscounted prices and general pricing pressures for data services in ourmarkets. We expect the trends in access line growth and data revenue per linereductions to continue for the foreseeable future. As we continue to grow, oursize and average monthly access line churn will begin to limit our access linegrowth rate on both an absolute and a percentage basis unless we increase oursales force and extend our network footprint. We increased our sales force from230 associates at March 31, 2005, to 250 associates at March 31, 2006.We plan to add another 40-50 sales associates over the next 12-24 months.

 

Businesstelephone systems (BTS) revenue was $6.9 million for the three months ended March 31,2006, an increase of 18.3% from $5.8 million in the same period of 2005. Theincrease in revenue was primarily due to an increase in revenue from newsystems sales. We cannot predict future trends in capital spending by small andmedium-sized business customers which drives our BTS revenue.

 

20

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***Cost of Revenue.***Cost of revenue for the threemonths ended March 31, 2005 and 2006 is as follows:

 

 
| ** **                     | ** ** | **2005**        | ** ** | **2006**        | ** ** | **% Change** | ** ** |
|--------------------------------|------------|-----------------|------------|-----------------|------------|-------------------|------------|
| ** **                     | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **        | ** ** |
| Cost of revenue (in millions): |       |            |       |            |       |              |       |
| Network services               |       | $               | 20.0       |            | $          | 20.8              |       | 3.8 | % |
| Business telephone systems     |       | 3.6             |       | 4.5             |       | 25.4              | %          |
| Total cost of revenue          |       | $               | 23.6       |            | $          | 25.3              |       | 7.1 | % |

 

Networkservices cost of revenue was $20.8 million for the three months ended March 31,2006, an increase of 3.8% from $20.0 million in the same period of 2005. Theincrease is attributable to higher number of access lines in service andadditional costs incurred as a result of our QPP agreement with Qwest. As apercentage of related revenue, network services cost of revenue for the threemonths ended March 31, 2006, decreased to 39.3% from 41.1% for the sameperiod of 2005.

 

BTScost of revenue was $4.5 million for the three months ended March 31,2006, an increase of 25.4% from $3.6 million in the same period of 2005. Materialand labor costs increased due in part to higher new systems sales in thethree months ended March 31, 2006 from the same period of 2005. As apercentage of related revenue, BTS cost of revenue for the three months ended March 31,2006 increased to 65.6% from 61.9% for the same period of 2005. We do notexpect future improvements in BTS cost of revenue as a percentage of relatedrevenue unless we are able to significantly increase BTS new systems sales andtherefore achieve greater volume discounts or economies of scale in ourworkforce.

 

***Gross Profit.***Gross profit for the three monthsended March 31, 2005 and 2006 is as follows:

 
| ** **                  | ** ** | **2005**        | ** ** | **2006**        | ** ** | **% Change** | ** ** |
|-----------------------------|------------|-----------------|------------|-----------------|------------|-------------------|------------|
| ** **                  | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **        | ** ** |
| Gross profit (in millions): |       |            |       |            |       |              |       |
| Network services            |       | $               | 28.7       |            | $          | 32.0              |       | 11.7 | % |
| Business telephone systems  |       | 2.2             |       | 2.4             |       | 6.9               | %          |
| Total gross profit          |       | $               | 30.9       |            | $          | 34.4              |       | 11.4 | % |

 

Theincrease in gross profit for the three months ended March 31, 2006, fromthe same period of 2005, is primarily due to higher access lines in service andhigher BTS new system sales, which was partially offset by higher QPP costs. Weanticipate that our BTS gross margin percentage will increase by fivepercentage points in the second quarter with that trend continuing through theremainder of 2006. This is a result of analyzing our internal allocation oflabor costs supporting our BTS and network services products. Over theremainder of 2006 a lower amount of labor costs will be allocated to BTS costof revenue and more labor costs will be allocated to sales, general andadministrative expenses. While this will increase BTS gross margin, it will nothave an impact on net income.

 

***Sales, General and Administrative Expense.***Sales,general and administrative expenses were $22.7 million for the three monthsended March 31, 2006, an increase of 1.5% from $22.3 million in the sameperiod of 2005. As a percentage of revenue, sales, general and administrativeexpenses for the three months ended March 31, 2006, declined to 38.0% from41.0% in the same period of 2005 due to the improved efficiency of our existingoperations resulting from our fixed cost structure supporting a higher level ofrevenue. Sales, general and administrative expenses will increase due to theacquisition of Oregon Telecom, Inc. on April 1, 2006, however, weexpect expenses as a percentage of revenue to continue to decline.

 

***Depreciation and Amortization.***Depreciation andamortization expense was $10.2 million for the three months ended March 31,2006, an increase of 18.7% from $8.6 million in the same period of 2005. Thisincrease was primarily due to the resulting additional depreciation expensefrom the true-up of fair market value of ATI assets at the end of 2005. As apercentage of revenue, depreciation and amortization increased to 17.0% for thethree months ended March 31, 2006 from 15.7% for the same period of 2005.

 

***Interest.***Interest expense was $3.4 million forthe three months ended March 31, 2006, a decrease of 30.1% from $4.9million in the same period of 2005. The decrease was primarily due to lowerinterest expense as a result of having a lower average outstanding debt balancefor the three months ended March 31, 2006

 

21

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compared to the threemonths ended March 31, 2005. Our interest expense will increase nextquarter due to our debt offering that we completed on March 29, 2006.

 

***Net Income (Loss).***Net loss for the three monthsended March 31, 2006, was $1.6 million compared to a net loss of $4.8million in the same period of 2005. This improvement is primarily due to theimprovement in gross profit mentioned above.

 

## **Liquidity and Capital Resources**

## ** **

***Principal Sources and Uses of Liquidity.***Ourprincipal sources of liquidity are cash from operations and our cash and cashequivalents and available-for-sale securities. The net proceeds of $44.6million from the offering of our 8 3/8% senior second secured notes due 2010 onMarch 29, 2006 provided additional liquidity for funding the OregonTelecom, Inc. acquisition and any future acquisitions and for generalcorporate purposes. Our principal liquidity requirements consist of debtservice, capital expenditures and working capital.

 

***Cash Flows Provided by Operating Activities.***Cashprovided by operating activities was $8.4 million for the three months ended March 31,2006 compared to cash provided by operating activities of $2.4 million for thesame period of 2005. The increase in cash provided by operating activities wasprimarily due to the lower interest expense as a result of having a loweraverage outstanding debt balance and due to the improvement in gross profit.

 

***Cash Flows Used in Investing Activities.***Cashused in investing activities was $5.0 million for the three months ended March 31,2006 compared to $15.0 million for the same period of 2005. The decrease isprimarily due to 2005 including $14.1 million for purchases ofavailable-for-sale securities. During the three months ended March 31,2006, we did not purchase any available-for-sale securities. Proceeds fromsales of available-for-sale securities were $4.0 million for the three monthsended March 31, 2006, compared to $7.6 million in the same period of 2005.Other uses of cash for investing activities include the maintenance andexpansion of our network and back office systems.

 

***Cash Flows Provided by (Used in) Financing Activities.***Cashprovided by financing activities was $44.1 million for the three months ended March 31,2006, compared to a use of cash of $0.7 million for the same period of 2005. OnMarch 29, 2006, we completed an offering of $48.0 million in face amount of8 3/8% senior second secured notes due 2010 at a discount resulting in a 9.92%yield. A portion of the $45.6 million gross proceeds from the offering was usedto finance the acquisition of Oregon Telecom, Inc. on April 1, 2006. Wealso used cash for payments on capital lease obligations and for debt issuancecosts.

 

***Capital Requirements.***For the three months ended March 31,2006, we spent $9.0 million on capital expenditures. We expect to spendapproximately $48.0 - $51.0 million on capital expenditures in 2006, including$3.6 million to operate and integrate Oregon Telecom, Inc. and $3.0million for additional switch hardware, labor and installation charges needed toexpand the scope of and accelerate our sales effort.

 

Basedon our current level of operations and anticipated growth, we believe that ourexisting cash, cash equivalents and short-term investments will be sufficientto fund our operations and we do not currently anticipate the need to raiseadditional financing to fund capital expenditures or operations for at leastthe next 12 months. However, any future acquisitions or other significantunplanned costs or cash requirements may require that we raise additionalfunds through the issuance of debt or equity.

 

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# **Item 3. Quantitative andQualitative Disclosures About Market Risk**

# ** **

We are not exposed tomarket risks from changes in foreign currency exchange rates or commodityprices. We do not hold any derivative financial instruments nor do we hold anysecurities for trading or speculative purposes.

 

We are exposed to changesin interest rates on our investments in cash equivalents and short-terminvestments. All of our investments have maturities of less than twelve monthswhich reduces our exposure to long-term interest rate changes. Interest incomefor the three-month period ended March 31, 2006 was $0.2 million,therefore not exposing us to any meaningful interest income risk had ratesdropped. We had $138.4 million in senior second secured notes outstanding as ofMarch 31, 2006. These notes are at a fixed interest rate and are thereforenot exposed to any interest rate risk.

 

# **Item 4:  Controls and Procedures**

# ** **

*Evaluationof Disclosure Controls and Procedures*

 

Wemaintain disclosure controls and procedures that are designed to ensure thatinformation required to be disclosed in our reports under the SecuritiesExchange Act of 1934, as amended, is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms,and that such information is accumulated and communicated to our management,including our principal executive officer and principal financial officer, asappropriate, to allow timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, managementrecognized that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management necessarily was required to apply itsjudgment in evaluating the cost-benefit relationship of possible controls andprocedures.

 

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

 

*Changesin Internal Controls Over Financial Reporting*

 

There has been no changein our internal controls over financial reporting during our most recent fiscalquarter that has materially affected, or is reasonably likely to materiallyaffect, our internal controls over financial reporting.

 

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# **PART II. OTHER INFORMATION**

# ** **

# **Item 1. Legal Proceedings**

# ** **

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

 

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

 

# **Item 1A. Risk Factors**

# ** **

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

 

**Item 2. UnregisteredSales of Equity Securities and Use of Proceeds**

 

On August 4, 2005,the Securities and Exchange Commission declared effective our RegistrationStatement on Form S-1 (File No. 333-124703). The public offering datewas August 9, 2005. The managing underwriters were Lehman Brothers,Jefferies & Company, Inc. and UBS Investment Bank. Ourregistration statement was for 5,357,143 shares of our common stock, par value$0.01 per share. We sold 5,357,143 shares for $14.00 per share, generatingapproximately $75.0 million in gross proceeds for us. After deductingunderwriting discounts and commissions of $5.3 million and $2.2 million forestimated fees and expenses associated with the offering, our net proceeds wereapproximately $67.6 million.

 

From the effective dateof the registration statement through March 31, 2006, the following tableidentifies the purposes and approximate amounts of the net proceeds paiddirectly or indirectly to others (dollars in millions):

 
| Redemption of 8 3/8% senior second secured notes due  March 15, 2010 |   | $    | 56.7   |   |
|---------------------------------------------------------------------------|--------|------|--------|--------|
| General corporate purposes                                                |   | 10.9 |   |
| Total use of net proceeds through March 31,  2006                    |   | $    | 67.6   |   |

 

On March 29, 2006,we completed a $48.0 million tack-on offering of our senior second securednotes at a discount resulting in a 9.92% yield. After deducting fees andexpenses associated with the offering, our net proceeds were approximately$44.6 million. Our acquisition of Oregon Telecom, Inc. on April 1,2006, was financed with approximately $20.0 million of the net proceeds fromthe offering. The remaining net proceeds of approximately $24.6 million will beused for general corporate purposes and potential future acquisitions.

 

# **Item 3. Defaults UponSenior Securities**

# ** **

None.

 

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

# ** **

No matters were submittedto a vote of the security holders during the quarter ended March 31, 2006.

 

# **Item 5. Other Information**

# ** **

None.

 

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# **Item 6. Exhibits**

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

 

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*  Filed herewith.

†  Furnished herewith.

 

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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: May 12,  2006 | By:                         | /S/ Geoffrey M.  Boyd |   |
|                     |                        |   |
|                     | Name:                       | Geoffrey M. Boyd |
|                     | Title:                      | Chief Financial  Officer |
|                     |                        | (Principal  Financial and  Accounting Officer and Duly  Authorized Officer) |

 

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