**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

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

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**FORM 10-Q**

| **(MARK ONE)** |
|----------------|
| ** **     |
| **x**          |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **     |   | ** ** |
| ** **     |   | **For the  quarterly period ended March 31, 2007** |
| ** **     |   | ** ** |
| ** **     |   | **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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**ESCHELON TELECOM, INC.**

(Exact name ofregistrant as specified in its charter)

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

 

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

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Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to the filing requirements for the past90 days. Yes x    Noo

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                                            Acceleratedfiler x                                            Non-acceleratedfiler o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). Yes o    Nox

As of April 30, 2007, thenumber of outstanding shares of the Registrant’s Common Stock, par value $.01per share, was 18,074,957 shares.

 

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**ESCHELONTELECOM, INC.**

**INDEX TO FORM 10-Q**
| **PART I. FINANCIAL  INFORMATION** |
|------------------------------------|
|                               |
| Item 1.                            | Financial  Statements: |
|                               |   |
|                               | Consolidated  Balance Sheets – March 31, 2007 (Unaudited) and December 31, 2006 |
|                               |   |
|                               | Unaudited  Consolidated Statements of Operations – Three months ended March 31, 2007 and  2006 |
|                               |   |
|                               | Unaudited  Consolidated Statements of Cash Flows – Three months ended March 31, 2007 and  2006 |
|                               |   |
|                               | Notes to  Consolidated Financial Statements |
|                               |   |
| Item 2.                            | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|                               |   |
| Item 3.                            | Quantitative  and Qualitative Disclosures About Market Risk |
|                               |   |
| Item 4.                            | Controls and  Procedures |
|                               |   |
|                               |   |
| **PART II. OTHER  INFORMATION**    |
| ** **                         |
| Item 1.                            | Legal Proceedings |
|                               |   |
| Item  1A.                          | Risk  Factors |
|                               |   |
| Item 2.                            | Unregistered  Sales of Equity Securities and Use of Proceeds |
|                               |   |
| Item 3.                            | Defaults Upon  Senior Securities |
|                               |   |
| Item 4.                            | Submission of  Matters to a Vote of Security Holders |
|                               |   |
| Item 5.                            | Other Information |
|                               |   |
| Item  6.                           | Exhibits |
|                               |   |
| Signature                          |   |

 

2

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**PART I. FINANCIAL INFORMATION**

## **Item1.  Financial Statements**

**Eschelon Telecom, Inc.**

**ConsolidatedBalance Sheets**

**(InThousands, Except Share and Per Share Amounts)**
| ** **                                                                                                                                                           | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                           | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| ** **                                                                                                                                                           | ** ** | **(Unaudited)**    | ** ** | ** **            | ** ** |
| **Assets**                                                                                                                                                           |       |               |       |                  |       |
| Current assets:                                                                                                                                                      |       |               |       |                  |       |
| Cash and cash  equivalents                                                                                                                                           |       | $                  | 21,155     |                  | $          | 21,146 |   |
| Restricted cash                                                                                                                                                      |       | 650                |       | 1,224                 |       |
| Available-for-sale  securities                                                                                                                                       |       | 4,698              |       | 17,097                |       |
| Accounts  receivable, net of allowance for doubtful accounts of $932 and $903,  respectively                                                                         |       | 27,232             |       | 27,592                |       |
| Other  receivables                                                                                                                                                   |       | 4,737              |       | 4,025                 |       |
| Inventories                                                                                                                                                          |       | 3,322              |       | 3,552                 |       |
| Prepaid expenses                                                                                                                                                     |       | 6,955              |       | 2,314                 |       |
| Total current assets                                                                                                                                                 |       | 68,749             |       | 76,950                |       |
|                                                                                                                                                                 |       |               |       |                  |       |
| Property and equipment,  net                                                                                                                                         |       | 149,385            |       | 145,785               |       |
|                                                                                                                                                                 |       |               |       |                  |       |
| Other assets                                                                                                                                                         |       | 1,528              |       | 2,185                 |       |
| Goodwill                                                                                                                                                             |       | 59,670             |       | 59,670                |       |
| Intangible assets, net                                                                                                                                               |       | 47,870             |       | 45,931                |       |
| Total assets                                                                                                                                                         |       | $                  | 327,202    |                  | $          | 330,521 |   |
|                                                                                                                                                                 |       |               |       |                  |       |
| **Liabilities and stockholders’  equity**                                                                                                                       |       |               |       |                  |       |
| Current liabilities:                                                                                                                                                 |       |               |       |                  |       |
| Accounts payable                                                                                                                                                     |       | $                  | 16,564     |                  | $          | 17,641 |   |
| Accrued  telecommunication costs                                                                                                                                     |       | 3,870              |       | 5,730                 |       |
| Accrued office  rent                                                                                                                                                 |       | 2,471              |       | 2,521                 |       |
| Accrued interest  expense                                                                                                                                            |       | 601                |       | 3,829                 |       |
| Other accrued  expenses                                                                                                                                              |       | 7,660              |       | 7,433                 |       |
| Deferred revenue                                                                                                                                                     |       | 10,337             |       | 10,109                |       |
| Accrued  compensation expenses                                                                                                                                       |       | 5,700              |       | 4,174                 |       |
| Capital lease  obligations, current maturities                                                                                                                       |       | 2,334              |       | 3,131                 |       |
| Total current  liabilities                                                                                                                                           |       | 49,537             |       | 54,568                |       |
|                                                                                                                                                                 |       |               |       |                  |       |
| Long-term liabilities:                                                                                                                                               |       |               |       |                  |       |
| Commitments and  contingencies                                                                                                                                       |       |               |       |                  |       |
| Other long-term  liabilities                                                                                                                                         |       | 1,256              |       | 1,262                 |       |
| Capital lease  obligations, less current maturities                                                                                                                  |       | 2,215              |       | 2,201                 |       |
| Notes payable                                                                                                                                                        |       | 141,951            |       | 141,040               |       |
| Total liabilities                                                                                                                                                    |       | 194,959            |       | 199,071               |       |
|                                                                                                                                                                 |       |               |       |                  |       |
| Stockholders’ equity:                                                                                                                                           |       |               |       |                  |       |
| Common stock,  $0.01 par value per share; 200,000,000 shares authorized; issued and  outstanding shares – 18,073,545 shares and 17,997,869 shares, respectively |       | 177                |       | 176                   |       |
| Additional  paid-in capital                                                                                                                                          |       | 289,871            |       | 289,101               |       |
| Accumulated  other comprehensive income (loss)                                                                                                                       |       | —             |       | —                |       |
| Accumulated  deficit                                                                                                                                                 |       | (157,805           | )          | (157,827              | )          |
| Total stockholders’  equity                                                                                                                                     |       | 132,243            |       | 131,450               |       |
| Total liabilities and  stockholders’ equity                                                                                                                     |       | $                  | 327,202    |                  | $          | 330,521 |   |

 

*Seeaccompanying notes.*

3

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**Eschelon Telecom, Inc.**

**UnauditedConsolidated Statements of Operations**

**(InThousands, Except Share and Per Share Amounts)**
| ** **                                                          | ** ** | **Three months ended** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                          | ** ** | **March 31,**               | ** ** |
| ** **                                                          | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| Revenue:                                                            |       |                             |       |   |   |
| Network services                                                    |       | $                                | 72,754     |   | $ | 52,785 |   |
| Business telephone systems                                          |       | 7,553                            |       | 6,941 |   |
| Total revenue                                                       |       | 80,307                           |       | 59,726 |   |
|                                                                |       |                             |       |   |   |
| Costs and  expenses:                                                |       |                             |       |   |   |
| Network services expense (excluding depreciation and  amortization) |       | 28,541                           |       | 20,763 |   |
| Business telephone systems cost of revenue                          |       | 4,624                            |       | 4,553 |   |
| Sales, general and administrative                                   |       | 29,899                           |       | 22,699 |   |
| Depreciation and amortization                                       |       | 11,836                           |       | 10,176 |   |
| Operating income                                                    |       | 5,407                            |       | 1,535 |   |
|                                                                |       |                             |       |   |   |
| Other income  (expense):                                            |       |                             |       |   |   |
| Interest income                                                     |       | 391                              |       | 233 |   |
| Interest expense                                                    |       | (4,773                           | )          | (3,400 | ) |
| Other income (expense), net                                         |       | (1,003                           | )          | 49 |   |
| Income (loss)  before taxes                                         |       | 22                               |       | (1,583 | ) |
| Income taxes                                                        |       | —                           |       | — |   |
| Net income  (loss)                                                  |       | $                                | 22         |   | $ | (1,583 | ) |
|                                                                |       |                             |       |   |   |
| Net income  (loss) per share:                                       |       |                             |       |   |   |
| Basic and diluted                                                   |       | $                                | 0.00       |   | $ | (0.11 | ) |
|                                                                |       |                             |       |   |   |
| Weighted average  number of shares outstanding:                     |       |                             |       |   |   |
| Basic                                                               |       | 17,648,167                       |       | 14,680,783 |   |
| Diluted                                                             |       | 18,320,919                       |       | 14,680,783 |   |

 

*See accompanying notes.*

4

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**Eschelon Telecom, Inc.**

**UnauditedConsolidated Statements of Cash Flows**

**(InThousands)**
| ** **                                                                                | ** ** | **Three months ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                | ** ** | **March 31,**               | ** ** |
| ** **                                                                                | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| **Operating  activities**                                                                 | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                        |       | $                                | 22         |   | $ | (1,583 | ) |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                             |       |   |   |
| Depreciation and amortization expense                                                     |       | 11,836                           |       | 10,176 |   |
| Provision for bad debt expense                                                            |       | 265                              |       | 275 |   |
| Non-cash interest expense, net of non-cash interest  income                               |       | 1,220                            |       | 916 |   |
| Non-cash share-based compensation expense                                                 |       | 550                              |       | 346 |   |
| Other non-cash items                                                                      |       | (5                               | )          | (49 | ) |
| Changes in operating assets and liabilities:                                              |       |                             |       |   |   |
| Accounts receivable                                                                       |       | 95                               |       | 961 |   |
| Inventories                                                                               |       | 230                              |       | (331 | ) |
| Prepaid expenses and other assets                                                         |       | (4,696                           | )          | (1,416 | ) |
| Accounts payable and accrued expenses                                                     |       | (5,987                           | )          | (1,775 | ) |
| Deferred revenue                                                                          |       | 228                              |       | 11 |   |
| Accrued compensation expense                                                              |       | 1,526                            |       | 737 |   |
| Net cash  provided by operating activities                                                |       | 5,284                            |       | 8,268 |   |
|                                                                                      |       |                             |       |   |   |
| **Investing  activities**                                                                 | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Purchases of  available-for-sale securities                                               |       | (3,750                           | )          | — |   |
| Proceeds from  sales of available-for-sale securities                                     |       | 16,150                           |       | 4,000 |   |
| Purchases of  property and equipment                                                      |       | (11,152                          | )          | (5,360 | ) |
| Cash paid for  customer installation costs                                                |       | (6,521                           | )          | (3,640 | ) |
| Decrease in  restricted cash                                                              |       | 574                              |       | 103 |   |
| Proceeds from  sales of assets                                                            |       | 9                                |       | 28 |   |
| Net cash used in  investing activities                                                    |       | (4,690                           | )          | (4,869 | ) |
|                                                                                      |       |                             |       |   |   |
| **Financing  activities**                                                                 | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Proceeds from  issuance of notes payable                                                  |       | —                           |       | 45,600 |   |
| Payments made on  notes and capital lease obligations                                     |       | (806                             | )          | (638 | ) |
| Proceeds from  issuance of stock, net of fees                                             |       | 221                              |       | 153 |   |
| Increase in debt  issuance costs                                                          |       | —                           |       | (996 | ) |
| Net cash (used  in) provided by financing activities                                      |       | (585                             | )          | 44,119 |   |
|                                                                                      |       |                             |       |   |   |
| Net increase in  cash and cash equivalents                                                |       | 9                                |       | 47,518 |   |
| Cash and cash  equivalents at beginning of period                                         |       | 21,146                           |       | 26,062 |   |
| Cash and cash  equivalents at end of period                                               |       | $                                | 21,155     |   | $ | 73,580 |   |
|                                                                                      |       |                             |       |   |   |
| **Supplemental  cash flow information**                                                   | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Cash paid for  interest                                                                   |       | $                                | 3,552      |   | $ | 2,485 |   |
|                                                                                      |       |                             |       |   |   |
| **Supplemental  non-cash activities**                                                     | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Equipment purchases  under capital leases                                                 |       | $                                | 34         |   | $ | 21 |   |

 

*Seeaccompanying notes.*

 

5

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**Eschelon Telecom, Inc.**

**Notes toConsolidated Financial Statements**

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

**(Unaudited)**

**Note 1:   Basis of Presentation**

The accompanyingunaudited consolidated financial statements of Eschelon Telecom, Inc. and itssubsidiaries (the “Company”) have been prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”) forinterim financial information and the instructions to Form 10-Q and Article 10of Regulation S-X promulgated by the United States Securities and ExchangeCommission (the “SEC”).  Accordingly,they do not include all of the information and notes required by GAAP forcomplete financial statements.  In theopinion of management, normal and recurring adjustments and accruals considerednecessary for a fair presentation for the periods indicated have beenincluded.  Operating results for thequarter ended March 31, 2007 are not necessarily indicative of the results thatmay be expected for the year ending December 31, 2007.

These financialstatements should be read in conjunction with the Company’s audited financialstatements and related notes thereto for the year ended December 31, 2006included in the Eschelon Telecom, Inc. Form 10-K filed with the SEC on March12, 2007.

## *Principles of Consolidation:*   The consolidated financial statementsinclude the accounts of the Company and its wholly owned subsidiaries.  All intercompany balances and transactionshave been eliminated in consolidation.

## *Reclassifications:*   Certain prior year items have beenreclassified to conform to current year presentation.

*Presentation of Taxes in theStatement of Operations:* The Company presents taxes and surcharges on a gross basis in theconsolidated statement of operations. Taxes collected from customers are reflected in revenues and taxessubmitted to governmental agencies are reflected in costs and expenses.  In accordance with EITF 06-3, *How Taxes Collected from Customers and Remitted to GovernmentalAuthorities Should Be Presented in the Income Statement*, thefollowing table summarizes the taxes reported in the consolidated statements ofoperations:
| ** **                                    | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                    | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
| Taxes reflected in  network services revenues |       | $                                                    | 2,303      |   | $ | 1,613 |   |
| Taxes reflected in network services expenses  |       | $                                                    | 2,181      |   | $ | 1,522 |   |

 

## **Note2:   Recent Developments**

On March 20, 2007, theCompany announced that it signed a definitive agreement to be acquired byPortland, Oregon-based Integra Telecom, Inc., a privately-held integratedcommunications provider offering retail services to customers in Oregon,Washington, Utah, Idaho, California, Arizona, Minnesota, and North Dakota.  Under the terms of the agreement, which wasapproved by the boards of directors of both companies, Integra Telecom willacquire Eschelon for $30.00 a share in cash, which equates to a total equityvalue of approximately $566,000 on a fully diluted basis. The acquisition willbe financed through a fully committed senior credit facility arranged byDeutsche Bank Securities. The transaction is subject to the approval of amajority of the Company’s shareholders and the satisfaction of customaryclosing conditions and regulatory approvals and is anticipated to close duringthe third quarter of 2007.

On April 27, 2007, theCompany filed with the SEC and mailed to its stockholders a Definitive ProxyStatement in connection with the transaction. The Definitive Proxy Statementcontains important information about the Company, Integra, the Merger andrelated matters. Investors and security holders are urged to read theDefinitive Proxy Statement carefully.

6

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## **Note3:   Investments**

Available-for-salesecurities consist of the following:
| ** **               | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|--------------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | ** **                   | ** ** | **Unrealized**                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** |
| ** **               | ** ** | ** **                   | ** ** | **Holding**                     | ** ** | ** ** | ** ** | ** ** | ** ** | **Holding** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Amortized**                | ** ** | **Gains/**                      | ** ** | ** ** | ** ** | **Amortized** | ** ** | **Gains/** | ** ** | ** ** | ** ** |
| ** **               | ** ** | **Cost Basis**          | ** ** | **(Losses)**                    | ** ** | **Fair Value** | ** ** | **Cost Basis** | ** ** | **(Losses)** | ** ** | **Fair Value** | ** ** |
|                     |       |                         |       |                            |       |   |   |   |   |   |   |   |   |
| Corporate  obligations   |       | $                            | 1,498      |                            | $          | — |   | $ | 1,498 |   | $ | 1,497 |   | $ | — |   | $ | 1,497 |   |
| Auction rate  securities |       | 3,200                        |       | —                          |       | 3,200 |   | 15,600 |   | — |   | 15,600 |   |
| Total                    |       | $                            | 4,698      |                            | $          | — |   | $ | 4,698 |   | $ | 17,097 |   | $ | — |   | $ | 17,097 |   |

 

## **Note4:   Property and Equipment**

Property and equipmentconsist of the following:
|                                            | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                 | ** ** | **2007**           | ** ** | **2006**              | ** ** |
|                                       |       |               |       |                  |       |
| Vehicles                                   |       | $                  | 2,335      |                  | $          | 2,312 |   |
| Office furniture  and equipment            |       | 27,586             |       | 26,559                |       |
| Computer  equipment and software           |       | 50,964             |       | 49,620                |       |
| Leasehold  improvements                    |       | 27,986             |       | 27,272                |       |
| Switching and  data equipment and software |       | 180,955            |       | 172,899               |       |
|                                       |       | 289,826            |       | 278,662               |       |
| Less accumulated  depreciation             |       | (140,441           | )          | (132,877              | )          |
| Property and equipment,  net               |       | $                  | 149,385    |                  | $          | 145,785 |   |

 

## **Note5:   Goodwill and Other Intangible Assets**

Goodwill represents theexcess of cost over the fair value of net assets acquired.  In 2006, the Company recorded $52,502 ofgoodwill in connection with the acquisitions of Oregon Telecom, Inc. (OTI),OneEighty Communications, Inc. (OneEighty) and Mountain Telecommunications,Inc. (MTI).  The goodwill related to theOneEighty and MTI acquisitions is not deductible for tax purposes.

In connection with theOTI and MTI acquisitions, the Company recorded intangible assets of $5,800 and$2,122, respectively.  The OTI intangibleassets consists of customer relationships and non-compete agreements and theMTI intangible assets consists of several right to use agreements.

In August 2006, theCompany entered into an agreement to purchase a selected customer base from TelWest Communications, LLC (Tel West) in exchange for $500 per access line, notto exceed $5,300.  As of March 31, 2007,the Company paid Tel West $5,300 and recorded $5,415, including transactionfees, in customer installation costs.

Intangible assets consistof the following:
| ** **                   | ** ** | ** **                      | ** ** | **March 31, 2007**            | ** ** | **December 31, 2006**     | ** ** |
|------------------------------|------------|---------------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|
| ** **                   | ** ** | **Useful   Life  (years)** | ** ** | **Gross   Carrying   Amount** | ** ** | **Accumulated   Amortization** | ** ** | **Net** | ** ** | **Gross   Carrying   Amount** | ** ** | **Accumulated   Amortization** | ** ** | **Net** | ** ** |
| Customer  installation costs |       | 3-5                             |       | $                                       | 103,087    |                                | $          | 67,973 |   | $ | 35,114 |   | $ | 96,565 |   | $ | 64,364 |   | $ | 32,201 |   |
| Debt issuance  costs         |       | 4-6                             |       | 7,001                                   |       | 2,469                               |       | 4,532 |   | 7,001 |   | 2,159 |   | 4,842 |   |
| Customer relationships       |       | 4                               |       | 8,520                                   |       | 3,325                               |       | 5,195 |   | 8,520 |   | 2,792 |   | 5,728 |   |
| Right to use  agreements     |       | 10-20                           |       | 2,122                                   |       | 72                                  |       | 2,050 |   | 2,122 |   | 29 |   | 2,093 |   |
| Non-compete  agreements      |       | 3-5                             |       | 1,400                                   |       | 445                                 |       | 955 |   | 1,400 |   | 365 |   | 1,035 |   |
| Developed  technology        |       | 3                               |       | 94                                      |       | 70                                  |       | 24 |   | 94 |   | 62 |   | 32 |   |
| Total                        |       |                            |       | $                                       | 122,224    |                                | $          | 74,354 |   | $ | 47,870 |   | $ | 115,702 |   | $ | 69,771 |   | $ | 45,931 |   |

 

7

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**Note 6:   Acquisitions**

*Mountain Telecommunications, Inc(MTI):*   OnNovember 1, 2006, the Company completed the acquisition of MTI, a competitiveservices provider based in Tempe, Arizona. MTI provides services in Phoenix, Tucson and markets throughout thestate of Arizona expanding the Company’s market presence in Arizona.  The Company expects to benefit from operatingsynergies by consolidating MTI’s operation into its existing business.  The results of MTI subsequent to November 1,2006 are included in the results of operations. In the MTI transaction, the Company acquired all of the outstandingshares of MTI in exchange for $37,256 (net of cash acquired) and certainassumed liabilities.

*OneEighty Communications, Inc (OneEighty):*   On October 1, 2006, the Company completedthe acquisition of OneEighty, a competitive services provider based in Billings,Montana.  The acquisition of OneEightyexpanded the Company’s market presence into Montana.  The Company expects to benefit through marketgrowth, leveraging its size, existing investments in infrastructure and fromoperating synergies.  The results ofOneEighty subsequent to October 1, 2006 are included in the results ofoperations.  In the OneEightytransaction, the Company acquired all of the outstanding shares of OneEighty inexchange for $9,959 (net of cash acquired) and certain assumed liabilities.

*Oregon Telecom, Inc (OTI):*   On April 1, 2006, the Company completed theacquisition of OTI, a privately-held competitive services provider based inSalem, Oregon.  The acquisition of OTIexpanded the Company’s market presence in the Pacific Northwest.  The Company expects to benefit from operatingsynergies from consolidating OTI’s operation into its existing business.  The results of OTI subsequent to April 1,2006 are included in the results of operations. In the OTI transaction, the Company acquired all of the outstanding sharesof OTI in exchange for $19,993 (net of cash acquired) and certain assumedliabilities.

The following tablesummarizes the allocation of the purchase price to the fair value of the assetsacquired and liabilities assumed at the date of each acquisition describedabove, including any adjustments to the purchase price allocation through March31, 2007:
|                            | ** ** | **MTI**                    | ** ** | **OneEighty**                   | ** ** | **OTI**                       | ** ** |
|----------------------------|------------|----------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                 | ** ** | **November 1,  2006** | ** ** | **October 1,   2006** | ** ** | **April 1,   2006** | ** ** |
| Current assets             |       | $                          | 2,728      |                            | $          | 761                           |       | $ | 3,297 |   |
| Property and  equipment    |       | 6,947                      |       | 4,152                           |       | 529                           |       |
| Other assets               |       | 21                         |       | 348                             |       | 57                            |       |
| Goodwill                   |       | 32,224                     |       | 5,643                           |       | 14,635                        |       |
| Intangible  assets         |       | 2,122                      |       | —                          |       | 5,800                         |       |
| Total assets  acquired     |       | 44,042                     |       | 10,904                          |       | 24,318                        |       |
| Current  liabilities       |       | 4,709                      |       | 739                             |       | 4,013                         |       |
| Long-term  liabilities     |       | 2,019                      |       | —                          |       | —                        |       |
| Total  liabilities assumed |       | 6,728                      |       | 739                             |       | 4,013                         |       |
| Net assets  acquired       |       | 37,314                     |       | 10,165                          |       | 20,305                        |       |
| Less cash  acquired        |       | 58                         |       | 206                             |       | 312                           |       |
| Net cash paid              |       | $                          | 37,256     |                            | $          | 9,959                         |       | $ | 19,993 |   |

 

The OneEighty and MTIpurchase prices have been allocated on a preliminary basis as of March 31,2007.  The Company is in the process offinalizing the fair value of the fixed assets and separately identifiableintangible assets acquired.

In accordance with EITF95-3, *Recognition of Liabilities in Connection with aPurchase Business Combination*, the Company recorded acquisitionliabilities consisting of severance benefits, relocation and contracttermination penalties.   The followingtable summarizes the acquisition liabilities recorded:
| ** **         | ** ** | **March 31, 2007** | ** ** | **December 31, 2006** | ** ** |
|--------------------|------------|------------------------------|------------|---------------------------------|------------|
| ** **         | ** ** | **MTI**                      | ** ** | **OneEighty**                   | ** ** | **OTI** | ** ** | **MTI** | ** ** | **OneEighty** | ** ** | **OTI** | ** ** |
| Beginning  Balance |       | $                            | 340        |                            | $          | 21 |   | $ | 794 |   | $ | 340 |   | $ | 21 |   | $ | 867 |   |
| Payments           |       | 33                           |       | —                          |       | 51 |   | — |   | — |   | 73 |   |
| Ending Balance     |       | $                            | 307        |                            | $          | 21 |   | $ | 743 |   | $ | 340 |   | $ | 21 |   | $ | 794 |   |

 

8

----

**Note 7:   Share-based Compensation**

Share-based compensationrecognized under Statement of Financial Accounting Standards No. 123(R), *Share-Based Payment: an amendment to FASB Statement No. 123 and FASBStatement No. 95*, for the three months ended March 31, 2007 and 2006was $550 and $346, respectively.

**Note8:   Benefit Contribution Plan**

The Company has a definedcontribution salary deferral plan covering substantially all employees underSection 401(k) of the Internal Revenue Code. The Company contributes an amount equal to 45 cents for each dollarcontributed by each employee up to a maximum of 6% of each employee’scompensation.  The Company recognizedexpense for contributions to the plan for the three months ended March 31, 2007and 2006 of $282 and $230, respectively.

**Note9:   Preferred Stock**

The Company has125,000,000 of undesignated preferred shares authorized and no shares ofpreferred stock outstanding.

## **Note10:   Net Income (Loss) Per Share**

The following tablepresents a reconciliation of the numerators and denominators of basic anddiluted net income (loss) per share:
| ** **                                                 | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                 | ** ** | **2007**                                             | ** ** | **2006** | ** ** |
| **Numerator:**                                             |       |                                                 |       |   |   |
| Net income  (loss)                                         |       | $                                                    | 22         |   | $ | (1,583 | ) |
|                                                       |       |                                                 |       |   |   |
| **Denominator:**                                           |       |                                                 |       |   |   |
| Weighted average  common shares outstanding – basic   |       | 17,648,167                                           |       | 14,680,783 |   |
| Employee stock  options                                    |       | 498,667                                              |       | — |   |
| Restricted stock  awards                                   |       | 174,085                                              |       | — |   |
| Weighted average  common shares outstanding – diluted |       | 18,320,919                                           |       | 14,680,783 |   |
|                                                       |       |                                                 |       |   |   |
| Basic and diluted  income (loss) per share                 |       | $                                                    | 0.00       |   | $ | (0.11 | ) |

 

For the three monthsended March 31, 2007, the Company excluded from dilutive securities employeestock options to acquire 36,556 shares because the exercise prices of theseoptions were greater than the average market price for the period of our commonshares.

For the three monthsended March 31, 2006, the Company did not have any potentially dilutive sharesbecause a loss was reported.

**Note11:  Income Taxes**

Under the liabilitymethod of accounting for income taxes, a deferred tax asset represents futuretax benefits to be received when certain expenses and losses previouslyrecognized in the financial statements become deductible under applicable incometax laws. The realization of a deferred tax asset is dependent on futuretaxable income against which these deductions can be applied.  Statement of Financial Accounting StandardsNo. 109, *Accounting for Income Taxes*,requires that a valuation allowance be established when it is more likely thannot that all or a portion of the deferred tax assets will not be realized.  The Company has a history of losses and hasconcluded that a full valuation allowance should be recorded against the netdeferred tax assets.  As of March 31,2007, the Company’s net deferred taxes were $56,349, consisting mainly of netoperating losses.  The net operatinglosses begin to expire in 2019.  Shouldthe Company incur an ownership change in the future, Section 382 of the UnitedStates Internal Revenue Code may limit the amount of net operating lossesavailable to offset future taxable income.

The company adopted FASBInterpretation No. 48, *Accounting for Uncertaintyin Income Taxes — an Interpretation of FASB Statement No. 109* (FIN48) on January 1, 2007.  FIN 48 clarifiesthe accounting 

9

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and reporting for taxuncertainties. It requires application of a “more likely than not” threshold tothe recognition and derecognition of tax positions.  Subsequent to the adoption of FIN 48,management concluded that the Company’s tax positions are either highly certainor immaterial in nature, therefore it has not recorded any reserve for incometax contingencies as of March 31, 2007.

**Note12:   Subsequent Event**

On May 1, 2007, the Companycompleted its acquisition of United Communications, Inc. (d.b.a. UNICOM), aprivately-held competitive services provider headquartered in Bend,Oregon.  The Company acquired all of the outstandingshares of UNICOM in exchange for approximately $13,900 in cash.  UNICOM has approximately $19,000 inannual revenue and sells local, long distance, Internet access services andbusiness telephone systems throughout Oregon and parts of Washington.  UNICOM has approximately 28,000 equivalentaccess lines.  The Company expects tocreate significant synergies by integrating UNICOM with its existingoperations.

**Note13:   Condensed Consolidating FinancialInformation**

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 March 31, 2007 and December31, 2006; condensed consolidating statements of operations for the three monthperiods ended March 31, 2007 and 2006; and condensed consolidating statementsof cash flows for the three month periods ended March 31, 2007 and 2006.

10

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**Unaudited Condensed ConsolidatingBalance Sheets**

**As of March 31, 2007**

**(InThousands)**
| ** **                                                 | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Assets**                                                 | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                            |       |                   |       |          |       |             |       |             |       |             |       |
| Cash and cash equivalents                                  |       | $                      | 20,233     |          | $          | —           |       | $                | 922        |             | $          | — |   | $ | 21,155 |   |
| Restricted cash                                            |       | 650                    |       | —        |       | —           |       | —           |       | 650              |       |
| Available-for-sale securities                              |       | 4,698                  |       | —        |       | —           |       | —           |       | 4,698            |       |
| Accounts receivable, net                                   |       | —                 |       | —        |       | 27,232           |       | —           |       | 27,232           |       |
| Other receivables                                          |       | 211                    |       | —        |       | 4,526            |       | —           |       | 4,737            |       |
| Inventories                                                |       | —                 |       | —        |       | 3,322            |       | —           |       | 3,322            |       |
| Prepaid expenses                                           |       | 5,081                  |       | —        |       | 1,874            |       | —           |       | 6,955            |       |
| Total current  assets                                      |       | 30,873                 |       | —        |       | 37,876           |       | —           |       | 68,749           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Property and  equipment, net                               |       | 102,663                |       | —        |       | 46,722           |       | —           |       | 149,385          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Investment in  affiliates                                  |       | 126,830                |       | —        |       | —           |       | (126,830         | )          | —           |       |
| Other assets                                               |       | 317                    |       | —        |       | 1,211            |       | —           |       | 1,528            |       |
| Goodwill                                                   |       | —                 |       | —        |       | 59,670           |       | —           |       | 59,670           |       |
| Intangible  assets, net                                    |       | 16,575                 |       | 4,532         |       | 26,763           |       | —           |       | 47,870           |       |
| Total assets                                               |       | $                      | 277,258    |          | $          | 4,532            |       | $                | 172,242    |             | $          | (126,830 | ) | $ | 327,202 |   |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Liabilities  and stockholders’ equity (deficit)**   | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current  liabilities:                                      |       |                   |       |          |       |             |       |             |       |             |       |
| Accounts payable                                           |       | $                      | 14,302     |          | $          | —           |       | $                | 2,262      |             | $          | — |   | $ | 16,564 |   |
| Accrued telecommunication costs                            |       | —                 |       | —        |       | 3,870            |       | —           |       | 3,870            |       |
| Accrued office rent                                        |       | 1,699                  |       | —        |       | 772              |       | —           |       | 2,471            |       |
| Accrued interest expense                                   |       | —                 |       | 578           |       | 23               |       | —           |       | 601              |       |
| Other accrued expenses                                     |       | 1,017                  |       | —        |       | 6,643            |       | —           |       | 7,660            |       |
| Deferred revenue                                           |       | —                 |       | —        |       | 10,337           |       | —           |       | 10,337           |       |
| Accrued compensation expenses                              |       | 4,661                  |       | —        |       | 1,039            |       | —           |       | 5,700            |       |
| Capital lease obligations, current maturities              |       | 1,965                  |       | —        |       | 369              |       | —           |       | 2,334            |       |
| Total current  liabilities                                 |       | 23,644                 |       | 578           |       | 25,315           |       | —           |       | 49,537           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Long-term  liabilities:                                    |       |                   |       |          |       |             |       |             |       |             |       |
| Other long-term liabilities                                |       | 19                     |       | —        |       | 1,237            |       | —           |       | 1,256            |       |
| Capital lease obligations, less current maturities         |       | 1,510                  |       | —        |       | 705              |       | —           |       | 2,215            |       |
| Notes payable                                              |       | —                 |       | 141,951       |       | —           |       | —           |       | 141,951          |       |
| Due to (from) affiliates                                   |       | 355,850                |       | (129,778      | )          | (226,072         | )          | —           |       | —           |       |
| Total  liabilities                                         |       | 381,023                |       | 12,751        |       | (198,815         | )          | —           |       | 194,959          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Stockholders’  equity (deficit)                       |       | (103,765               | )          | (8,219        | )          | 371,057          |       | (126,830         | )          | 132,243          |       |
| Total liabilities and  stockholders’ equity (deficit) |       | $                      | 277,258    |          | $          | 4,532            |       | $                | 172,242    |             | $          | (126,830 | ) | $ | 327,202 |   |

 

11

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**Unaudited Condensed ConsolidatingBalance Sheets**

**As of December 31, 2006**

**(InThousands)**
| ** **                                                 | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Assets**                                                 | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                            |       |                   |       |          |       |             |       |             |       |             |       |
| Cash and cash equivalents                                  |       | $                      | 18,868     |          | $          | —           |       | $                | 2,278      |             | $          | — |   | $ | 21,146 |   |
| Restricted cash                                            |       | 1,224                  |       | —        |       | —           |       | —           |       | 1,224            |       |
| Available-for-sale securities                              |       | 17,097                 |       | —        |       | —           |       | —           |       | 17,097           |       |
| Accounts receivable, net                                   |       | —                 |       | —        |       | 27,592           |       | —           |       | 27,592           |       |
| Other receivables                                          |       | 304                    |       | —        |       | 3,721            |       | —           |       | 4,025            |       |
| Inventories                                                |       | —                 |       | —        |       | 3,552            |       | —           |       | 3,552            |       |
| Prepaid expenses                                           |       | 893                    |       | —        |       | 1,421            |       | —           |       | 2,314            |       |
| Total current  assets                                      |       | 38,386                 |       | —        |       | 38,564           |       | —           |       | 76,950           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Property and  equipment, net                               |       | 97,535                 |       | —        |       | 48,250           |       | —           |       | 145,785          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Investment in  affiliates                                  |       | 126,830                |       | —        |       | —           |       | (126,830         | )          | —           |       |
| Other assets                                               |       | 513                    |       | —        |       | 1,672            |       | —           |       | 2,185            |       |
| Goodwill                                                   |       | —                 |       | —        |       | 59,670           |       | —           |       | 59,670           |       |
| Intangible  assets, net                                    |       | 16,011                 |       | 4,842         |       | 25,078           |       | —           |       | 45,931           |       |
| Total assets                                               |       | $                      | 279,275    |          | $          | 4,842            |       | $                | 173,234    |             | $          | (126,830 | ) | $ | 330,521 |   |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Liabilities  and stockholders’ equity (deficit)**   | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current  liabilities:                                      |       |                   |       |          |       |             |       |             |       |             |       |
| Accounts payable                                           |       | $                      | 14,070     |          | $          | —           |       | $                | 3,571      |             | $          | — |   | $ | 17,641 |   |
| Accrued telecommunication costs                            |       | —                 |       | —        |       | 5,730            |       | —           |       | 5,730            |       |
| Accrued office rent                                        |       | 1,768                  |       | —        |       | 753              |       | —           |       | 2,521            |       |
| Accrued interest expense                                   |       | —                 |       | 3,828         |       | 1                |       | —           |       | 3,829            |       |
| Other accrued expenses                                     |       | 911                    |       | —        |       | 6,522            |       | —           |       | 7,433            |       |
| Deferred revenue                                           |       | —                 |       | —        |       | 10,109           |       | —           |       | 10,109           |       |
| Accrued compensation expenses                              |       | 2,597                  |       | —        |       | 1,577            |       | —           |       | 4,174            |       |
| Capital lease obligations, current maturities              |       | 2,616                  |       | —        |       | 515              |       | —           |       | 3,131            |       |
| Total current  liabilities                                 |       | 21,962                 |       | 3,828         |       | 28,778           |       | —           |       | 54,568           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Long-term  liabilities:                                    |       |                   |       |          |       |             |       |             |       |             |       |
| Other long-term liabilities                                |       | 25                     |       | —        |       | 1,237            |       | —           |       | 1,262            |       |
| Capital lease obligations, less current maturities         |       | 1,490                  |       | —        |       | 711              |       | —           |       | 2,201            |       |
| Notes payable                                              |       | —                 |       | 141,040       |       | —           |       | —           |       | 141,040          |       |
| Due to (from) affiliates                                   |       | 336,758                |       | (136,599      | )          | (200,159         | )          | —           |       | —           |       |
| Total  liabilities                                         |       | 360,235                |       | 8,269         |       | (169,433         | )          | —           |       | 199,071          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Stockholders’  equity (deficit)                       |       | (80,960                | )          | (3,427        | )          | 342,667          |       | (126,830         | )          | 131,450          |       |
| Total  liabilities and stockholders’ equity (deficit) |       | $                      | 279,275    |          | $          | 4,842            |       | $                | 173,234    |             | $          | (126,830 | ) | $ | 330,521 |   |

 

12

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**Unaudited Condensed ConsolidatingStatement of Operations**

**For the Three Months Ended March31, 2007**

**(InThousands)**
| ** **                                                          | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                          | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                          | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Revenue:                                                            |       |                   |       |          |       |             |       |             |       |
| Network services                                                    |       | $                      | —     |          | $          | —           |       | $                | 72,754     |   | $ | 72,754 |   |
| Business telephone systems                                          |       | —                 |       | —        |       | 7,553            |       | 7,553            |       |
| Total revenue                                                       |       | —                 |       | —        |       | 80,307           |       | 80,307           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Costs and  expenses:                                                |       |                   |       |          |       |             |       |             |       |
| Network services expense (excluding depreciation and  amortization) |       | —                 |       | —        |       | 28,541           |       | 28,541           |       |
| Business telephone systems cost of revenue                          |       | —                 |       | —        |       | 4,624            |       | 4,624            |       |
| Sales, general and administrative                                   |       | 16,238                 |       | —        |       | 13,661           |       | 29,899           |       |
| Depreciation and amortization                                       |       | 6,751                  |       | —        |       | 5,085            |       | 11,836           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Operating income  (loss)                                            |       | (22,989                | )          | —        |       | 28,396           |       | 5,407            |       |
| Other income  (expense)                                             |       | (587                   | )          | (4,792        | )          | (6               | )          | (5,385           | )          |
| Income (loss)  before income taxes                                  |       | (23,576                | )          | (4,792        | )          | 28,390           |       | 22               |       |
| Income taxes                                                        |       | —                 |       | —        |       | —           |       | —           |       |
| Net income (loss)                                                   |       | $                      | (23,576    | )             | $          | (4,792           | )          | $                | 28,390     |   | $ | 22 |   |

 

13

----

**Unaudited Condensed ConsolidatingStatement of Operations**

**For the Three Months Ended March31, 2006**

**(InThousands)**
| ** **                                                          | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                          | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                          | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Revenue:                                                            |       |                   |       |          |       |             |       |             |       |
| Network services                                                    |       | $                      | —     |          | $          | —           |       | $                | 52,785     |   | $ | 52,785 |   |
| Business telephone systems                                          |       | —                 |       | —        |       | 6,941            |       | 6,941            |       |
| Total revenue                                                       |       | —                 |       | —        |       | 59,726           |       | 59,726           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Costs and  expenses:                                                |       |                   |       |          |       |             |       |             |       |
| Network services expense (excluding depreciation and  amortization) |       | —                 |       | —        |       | 20,763           |       | 20,763           |       |
| Business telephone systems cost of revenue                          |       | —                 |       | —        |       | 4,553            |       | 4,553            |       |
| Sales, general and administrative                                   |       | 12,722                 |       | —        |       | 9,977            |       | 22,699           |       |
| Depreciation and amortization                                       |       | 5,609                  |       | —        |       | 4,567            |       | 10,176           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Operating income  (loss)                                            |       | (18,331                | )          | —        |       | 19,866           |       | 1,535            |       |
| Other income  (expense)                                             |       | 99                     |       | (3,194        | )          | (23              | )          | (3,118           | )          |
| Income (loss)  before income taxes                                  |       | (18,232                | )          | (3,194        | )          | 19,843           |       | (1,583           | )          |
| Income taxes                                                        |       | —                 |       | —        |       | —           |       | —           |       |
| Net income  (loss)                                                  |       | $                      | (18,232    | )             | $          | (3,194           | )          | $                | 19,843     |   | $ | (1,583 | ) |

 

14

----

** Unaudited Condensed Consolidating Statement ofCash Flows**

**For the Three Months Ended March31, 2007**

**(InThousands)**
| ** **                                              | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                              | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                              | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
| **Operating  activities**                               | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Net income  (loss)                                      |       | $                      | (23,576    | )             | $          | (4,792           | )          | $                | 28,390     |   | $ | 22 |   |
| Adjustments to  reconcile net income (loss) to net cash |       |                   |       |          |       |             |       |             |       |
|  provided by  (used in) operating activities:      |       |                   |       |          |       |             |       |             |       |
|  Depreciation  and amortization                    |       | 6,751                  |       | —        |       | 5,085            |       | 11,836           |       |
|  Non-cash  interest expense (interest income)      |       | (1                     | )          | 1,221         |       | —           |       | 1,220            |       |
|  Non-cash  share-based compensation expense        |       | 550                    |       |          |       | —           |       | 550              |       |
|  Other  non-cash items                             |       | (5                     | )          | —        |       | 265              |       | 260              |       |
|  Changes in  operating assets and liabilities:     |       |                   |       |          |       |             |       |             |       |
| Accounts receivable                                     |       | —                 |       | —        |       | 95               |       | 95               |       |
| Account payable and accrued expenses                    |       | 270                    |       | (3,250        | )          | (3,007           | )          | (5,987           | )          |
| Other operating assets and liabilities                  |       | (1,835                 | )          | —        |       | (877             | )          | (2,712           | )          |
| Total cash  provided by (used in) operating activities  |       | (17,846                | )          | (6,821        | )          | 29,951           |       | 5,284            |       |
|                                                    |       |                   |       |          |       |             |       |             |       |
| **Investing  activities**                               | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Purchases of  available-for-sale securities             |       | (3,750                 | )          | —        |       | —           |       | (3,750           | )          |
| Proceeds from  sales of available-for-sale securities   |       | 16,150                 |       | —        |       | —           |       | 16,150           |       |
| Purchases of  property and equipment                    |       | (10,017                | )          | —        |       | (1,135           | )          | (11,152          | )          |
| Cash paid for  customer installation costs              |       | (2,414                 | )          | —        |       | (4,107           | )          | (6,521           | )          |
| Decrease in  restricted cash                            |       | 574                    |       | —        |       | —           |       | 574              |       |
| Proceeds from  sale of assets                           |       | 9                      |       | —        |       | —           |       | 9                |       |
| Total cash  provided by (used in) investing activities  |       | 552                    |       | —        |       | (5,242           | )          | (4,690           | )          |
|                                                    |       |                   |       |          |       |             |       |             |       |
| **Financing  activities**                               |       |                   |       |          |       |             |       |             |       |
| Payments made on  notes and capital lease obligations   |       | (654                   | )          | —        |       | (152             | )          | (806             | )          |
| Proceeds from  issuance of stock, net of fees           |       | 221                    |       | —        |       | —           |       | 221              |       |
| Increase in debt  issuance costs                        |       | —                 |       | —        |       | —           |       | —           |       |
| Change in due  to/from affiliates                       |       | 19,092                 |       | 6,821         |       | (25,913          | )          | —           |       |
| Total cash  provided by (used in) financing activities  |       | 18,659                 |       | 6,821         |       | (26,065          | )          | (585             | )          |
|                                                    |       |                   |       |          |       |             |       |             |       |
| Increase  (decrease) in cash and cash equivalents       |       | 1,365                  |       | —        |       | (1,356           | )          | 9                |       |
| Cash and cash  equivalents at beginning of period       |       | 18,868                 |       | —        |       | 2,278            |       | 21,146           |       |
| Cash and cash  equivalents at end of period             |       | $                      | 20,233     |          | $          | —           |       | $                | 922        |   | $ | 21,155 |   |

 

15

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**Unaudited Condensed ConsolidatingStatement of Cash Flows**

**For the Three Months Ended March31, 2006**

**(InThousands)**
| ** **                                                                                           | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                           | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                                                           | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
| **Operating  activities**                                                                            | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Net income  (loss)                                                                                   |       | $                      | (18,232    | )             | $          | (3,194           | )          | $                | 19,843     |   | $ | (1,583 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                   |       |          |       |             |       |             |       |
|  Depreciation  and amortization                                                                 |       | 5,609                  |       | —        |       | 4,567            |       | 10,176           |       |
|  Non-cash  interest expense                                                                     |       | 1                      |       | 915           |       | —           |       | 916              |       |
|  Non-cash  share-based compensation expense                                                     |       | 346                    |       | —        |       | —           |       | 346              |       |
|  Other  non-cash items                                                                          |       | (84                    | )          | —        |       | 310              |       | 226              |       |
|  Changes in  operating assets and liabilities:                                                  |       |                   |       |          |       |             |       |             |       |
| Accounts receivable                                                                                  |       | —                 |       | —        |       | 961              |       | 961              |       |
| Account payable and accrued expenses                                                                 |       | (1,263                 | )          | (2,067        | )          | 1,555            |       | (1,775           | )          |
| Other operating assets and liabilities                                                               |       | 515                    |       | —        |       | (1,514           | )          | (999             | )          |
| Total cash  provided by (used in) operating activities                                               |       | (13,108                | )          | (4,346        | )          | 25,722           |       | 8,268            |       |
|                                                                                                 |       |                   |       |          |       |             |       |             |       |
| **Investing  activities**                                                                            | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Proceeds from  sales of available-for-sale securities                                                |       | 4,000                  |       | —        |       | —           |       | 4,000            |       |
| Purchases of  property and equipment                                                                 |       | (4,877                 | )          | —        |       | (483             | )          | (5,360           | )          |
| Cash paid for  customer installation costs                                                           |       | (2,092                 | )          | —        |       | (1,548           | )          | (3,640           | )          |
| Decrease in  restricted cash                                                                         |       | 103                    |       | —        |       | —           |       | 103              |       |
| Proceeds from  sale of assets                                                                        |       | 28                     |       | —        |       | —           |       | 28               |       |
| Total cash used  in investing activities                                                             |       | (2,838                 | )          | —        |       | (2,031           | )          | (4,869           | )          |
|                                                                                                 |       |                   |       |          |       |             |       |             |       |
| **Financing  activities**                                                                            |       |                   |       |          |       |             |       |             |       |
| Proceeds from  issuance of notes payable                                                             |       | —                 |       | 45,600        |       | —           |       | 45,600           |       |
| Payments made on  notes and capital lease obligations                                                |       | (610                   | )          | —        |       | (28              | )          | (638             | )          |
| Proceeds from  issuance of stock, net of fees                                                        |       | 153                    |       | —        |       | —           |       | 153              |       |
| Increase in debt  issuance costs                                                                     |       | —                 |       | (996          | )          | —           |       | (996             | )          |
| Change in due  to/from affiliates                                                                    |       | 64,998                 |       | (40,258       | )          | (24,740          | )          | —           |       |
| Total cash  provided by (used in) financing activities                                               |       | 64,541                 |       | 4,346         |       | (24,768          | )          | 44,119           |       |
|                                                                                                 |       |                   |       |          |       |             |       |             |       |
| Increase  (decrease) in cash and cash equivalents                                                    |       | 48,595                 |       | —        |       | (1,077           | )          | 47,518           |       |
| Cash and cash  equivalents at beginning of period                                                    |       | 25,070                 |       | —        |       | 992              |       | 26,062           |       |
| Cash and cash  equivalents at end of period                                                          |       | $                      | 73,665     |          | $          | —           |       | $                | (85        | ) | $ | 73,580 |   |

 

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

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

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

Forward-lookingstatements, such as those regarding management’s present plans or expectationsfor new product offerings, capital expenditures, cost-saving strategies andgrowth are not guarantees of future performance.  They involve risks and uncertainties relativeto return expectations and related allocation of resources, and changingeconomic or competitive conditions, as well as the negotiation of agreementswith third parties and other factors discussed herein, which could cause actualresults to differ from present plans or expectations, and such differencescould be material.  Similarly,forward-looking statements regarding management’s present expectations foroperating results and cash flow involve risks and uncertainties relative tothese and other factors, such as the ability to increase revenues and/or toachieve cost reductions and other factors discussed herein, which also wouldcause actual results to differ from present plans.  Such differences could be material.  All forward-looking statements attributableto us or by any persons acting on our behalf are expressly qualified in theirentirety by these cautionary statements.

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

## **CompanyOverview**

We are a leadingfacilities-based provider of voice and data services and business telephonesystems in 46 markets in the western United States.  As a facilities-based competitivecommunications services provider, we provide services to our customersprimarily through our own network of telecommunications switches and relatedequipment and leased telecommunications lines, or transport.  We target the small and medium-sized businesssegment and currently serve more than 60,000 customers, primarily within thelocal service territory of Qwest.

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

The telecommunicationsindustry is highly competitive.  Webelieve we compete principally by offering superior customer service, accuratebilling, a broad set of services and systems and competitive pricing.  We compete with the Regional Bell OperatingCompanies (RBOCs), other competitive communications services providers, andlong distance and data service providers. While wireless and cable providers are competing with us, we do notbelieve they are a significant competitive threat in the markets we serve norare they likely to be in the near future, because business customers generallyrequire different service standards.

**Key Components of Results of Operations**

***Network Service Revenue.***  Ournetwork services revenue consists primarily of local telephone service, longdistance service, carrier access charges, and data and Internet accessservices. Revenue from local telephone service consists of charges for basiclocal dial-tone service, including dedicated T1 access, and custom-callingfeatures such as call waiting and call forwarding. Revenue from long distanceservice consists of flat rated and per-minute-of-use charges for a full rangeof traditional switched and dedicated long distance, toll-free calling, internationalcalling, calling card and operator services. Carrier access revenue consistsprimarily of usage charges that we bill long distance carriers to originate andterminate calls to and from our customers. In addition, in some of our marketswe currently charge other local exchange carriers and wireless carriers usage 

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charges to terminate local calls to our customers (otherwise known asreciprocal compensation).   For the threemonths ended March 31, 2007 and 2006, we recorded reciprocal compensation revenueof $0.3 million and $0.2 million, respectively. Excluding carrier access and reciprocal compensation, less than onepercent of our revenue is wholesale revenue. Revenue from data and Internet access services consists primarily ofmonthly usage fees for DSL and T1 circuits and Internet access services. Wetypically commit our customers to contracts ranging from one to three years andprovide discounts for longer terms. Network services revenue comprised 90.6% ofour total revenue for the three months ended March 31, 2007, and represents apredominantly recurring revenue stream.

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

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

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

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

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

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

·                  signalingsystem network connectivity;

·                  leasingour ATM long-haul Internet backbone network; and

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

The costs to lease local loops, digital T1 lines and high capacitydigital interoffice transport facilities from the RBOCs vary by carrier and bystate and in many cases are regulated under federal and state laws. Invirtually all areas, we lease local loops, T1 lines and interoffice transportcapacity from the RBOCs. We lease interoffice facilities from carriers otherthan the RBOCs where possible in order to lower costs and improve networkredundancy; however, in most cases, the RBOCs are our only source for end-userlocal loops and T1 lines.  Historically,we purchased unbundled network elements platform, or UNE-P, from Qwest andVerizon, and customized network element packages, or UNE-E, from Qwest.  We also purchase, on a resale basis, Centrexservices, which are services for the portion of the public telephone switchthat is dedicated to a customer, from AT&T. The rates for UNE-P and Centrex were regulated and established by thevarious state corporation or utility commissions.  We entered into agreements with Qwest andVerizon for UNE-P replacement products in 2005. As of  March 31, 2007, we hadapproximately 88,000 access lines in service that are now provided undercommercial agreements.  The Qwest UNE-Eagreement was terminated with the adoption of Qwest’s commercial UNE-Preplacement product, QPP, and all Qwest UNE-E lines were moved to QPP onJanuary 1, 2005.

Our network services expense also includes the fees we pay for longdistance, data and other services. We have entered into wholesale purchasingagreements for these services.  Some ofthe agreements contain significant termination penalties and/or minimum usagevolume commitments. In the event we fail to meet minimum volume commitments, wemay be obligated to pay underutilization charges. We do not anticipate havingto pay any underutilization charges in the foreseeable future.

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

***Business Telephone SystemsCost of Revenue.***  Our most significant business telephonesystems costs of revenue are the equipment purchased from manufacturers andlabor for service installation. To take advantage 

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of volume purchase discounts, wepurchase equipment primarily from three manufacturers pursuant to masterpurchase agreements we have with these manufacturers. For all business telephonesystems installations, our policy is to require a 30% deposit before orderingthe equipment so our risk of excess inventory or inventory obsolescence is low.Business telephone systems cost of revenue also includes salaries and benefitsof field technicians as well as vehicle and incidental expenses associated withequipment installation, maintenance and service provisioning.

***Sales, General andAdministrative.***  Sales, general and administrative expensesare comprised primarily of employee compensation and benefits, salescommissions, occupancy costs, bad debt, operating taxes, billing andprofessional services.

Determining our allowance fordoubtful accounts receivable requires significant estimates. We consider twoprimary factors in determining the proper level of the allowance, includinghistorical collections experience and the aging of the accounts receivableportfolio. We perform a credit review process on each new customer thatinvolves reviewing the customer’s current service provider bill and paymenthistory, matching customers with the National Telecommunications Data Exchangedatabase for delinquent customers and, in some cases, requesting credit reviewsthrough Dun and Bradstreet. For the three months ended March 31, 2007 and 2006,our bad debt expense as a percentage of revenue was 0.3% and 0.5%,respectively.

***Depreciation andAmortization.***  Our depreciation and amortization expenseincludes depreciation for network related voice and data equipment, back officesystems, furniture, fixtures, leasehold improvements, office equipment andcomputers. All internal costs directly related to the expansion of our networkand operating and support systems, including salaries of certain employees, arecapitalized and depreciated over the lives of the switches or systems, as thecase may be. Capitalized customer installation costs are amortized over periodsapproximating the average life of customers. Detailed time studies are used todetermine labor capitalization rates. These time studies are based on employeetime sheets for those engaged in capitalizable activities.

**Acquisitions**

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

On October 1, 2006, wecompleted our acquisition of OneEighty Communications, Inc. (OneEighty), acompetitive services provider headquartered in Billings, Montana.  OneEighty provides local, long distance andInternet access services in Montana to approximately 1,400 business customersthat have approximately 16,000 access lines. We paid approximately $10.2 million in cash to acquire OneEighty.  The results of OneEighty subsequent toOctober 1, 2006 are included in the results of operations.

On November 1, 2006, wecompleted our acquisition of Mountain Telecommunications, Inc. (MTI), acompetitive services provider headquartered in Tempe, Arizona.  MTI provides local, long distance andInternet access services in Arizona to approximately 1,400 business customersthat have approximately 45,000 access lines. We paid approximately $37.3 million in cash to acquire MTI.  The results of MTI subsequent to November 1,2006 are included in the results of operations.

We expect to develop and benefit from synergies as we integrateOneEighty and MTI into our operations. We estimate we will incur $1.0 - $2.0 million integrating MTI andapproximately $0.4 million integrating OneEighty.

On May 1, 2007, wecompleted our acquisition of United Communications, Inc. (d.b.a. UNICOM), aprivately-held competitive services provider headquartered in Bend,Oregon.  We acquired all of the outstanding shares ofUNICOM in exchange for approximately $13.9 million in cash.  UNICOM has approximately $19.0 millionin annual revenue and sells local, long distance, Internet access services andbusiness telephone systems throughout Oregon and parts of Washington.  UNICOM has approximately 28,000 equivalent accesslines.  We expect to create significantsynergies by integrating UNICOM with our existing operations.  We expect revenue, operating income and netincome to be positively impacted in future quarters with the acquisition ofUNICOM.

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## **RecentDevelopments**

On March 20, 2007, weannounced that we signed a definitive agreement to be acquired by Portland,Oregon-based Integra Telecom, Inc., a privately-held integrated communicationsprovider offering retail services to businesses in Oregon, Washington, Utah,Idaho, California, Arizona, Minnesota, and North Dakota.  Under the terms of the agreement, which wasapproved by the boards of directors of both companies, Integra Telecom willacquire us for $30.00 a share in cash, which equates to a total equity value ofapproximately $566 million on a fully diluted basis. The acquisition will befinanced through a fully committed senior credit facility arranged by DeutscheBank Securities. The transaction is subject to the approval of a majority ofour shareholders and the satisfaction of customary closing conditions andregulatory approvals and is anticipated to close during the third quarter of2007.

On April 27, 2007, wefiled with the SEC and mailed to our stockholders a Definitive Proxy Statementin connection with the transaction. The Definitive Proxy Statement containsimportant information about us, Integra, the Merger and related matters.Investors and security holders are urged to read the Definitive Proxy Statementcarefully.

## **Resultsof Operations**

Selectedconsolidated financial and operating data for the three months ended March 31,2007 and 2006 is as follows (dollars in thousands, except per unit amounts):
| ** **                                               | ** ** | **Three months ended March 31,** | ** ** |
|----------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                               | ** ** | **2007**                                             | ** ** | **2006** | ** ** | **% Change** | ** ** |
| ** **                                               | ** ** | **(unaudited)**                                      | ** ** | **(unaudited)** | ** ** | ** ** | ** ** |
| Total revenue                                            |       | $                                                    | 80,307     |   | $ | 59,726 |   | 34.5 | % |
| Capital expenditures                                     |       | $                                                    | 17,707     |   | $ | 9,021 |   | 96.3 | % |
| Cash, restricted  cash and available-for-sale securities |       | $                                                    | 26,503     |   | $ | 75,268 |   | (64.8 | )% |
|                                                     |       |                                                 |       |   |   |   |   |
| Voice lines in  service                                  |       | 370,525                                              |       | 273,449 |   | 35.5 | % |
| Data lines in  service                                   |       | 256,972                                              |       | 154,072 |   | 66.8 | % |
| Total lines in  service                                  |       | 627,497                                              |       | 427,521 |   | 46.8 | % |
| Percent of lines  on switch                              |       | 86.0                                                 | %          | 87.1 | % | (1.3 | )% |
| Lines sold                                               |       | 45,582                                               |       | 30,740 |   | 48.3 | % |
| Average monthly  access line churn (%)                   |       | 1.27                                                 | %          | 1.56 | % | (18.6 | )% |
| Average monthly  network services revenue per line       |       | $                                                    | 39.24      |   | $ | 41.61 |   | (5.7 | )% |
|                                                     |       |                                                 |       |   |   |   |   |
| Total employees                                          |       | 1,393                                                |       | 1,100 |   | 26.6 | % |
| Quota-carrying  network service salespeople              |       | 277                                                  |       | 205 |   | 35.1 | % |
| Quota-carrying  BTS salespeople                          |       | 49                                                   |       | 45 |   | 8.9 | % |
| Total quota-carrying  salespeople                        |       | 326                                                  |       | 250 |   | 30.4 | % |

 

**Three Months Ended March 31, 2007 Compared to ThreeMonths Ended March 31, 2006**

***Revenue.***  Revenue for the three months ended March 31,2007 and 2006 is as follows:
|                            | ** ** | **2007**        | ** ** | **2006**        | ** ** | **% Change** | ** ** |
|----------------------------|------------|-----------------|------------|-----------------|------------|-------------------|------------|
| ** **                 | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **        | ** ** |
| Revenue (in  millions):    | ** ** | ** **      |       |            |       |              |       |
| Voice and data services    |       | $               | 56.5       |            | $          | 39.7              |       | 42.4 | % |
| Long distance              |       | 11.4            |       | 9.4             |       | 21.5              | %          |
| Access                     |       | 4.8             |       | 3.7             |       | 30.6              | %          |
| Total network services     |       | 72.7            |       | 52.8            |       | 37.8              | %          |
| Business telephone systems |       | 7.6             |       | 6.9             |       | 8.8               | %          |
| Total revenue              |       | $               | 80.3       |            | $          | 59.7              |       | 34.5 | % |

 

Network servicesrevenue was $72.7 million for the three months ended March 31, 2007, anincrease of 37.8% from $52.8 million in the same period of 2006.  The revenue growth is primarily due to 

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the inclusion of ouracquisitions in 2006 and organic line growth. Over the past 12 months the number of lines in service increased by46.8% to 627,497 at March 31, 2007, approximately 114,000 lines in service ofour overall growth of 199,976 lines in service is attributed to our 2006acquisitions.  Our revenue growth waspartially offset by a decline in data revenue per line due to a combination ofcustomers purchasing more bandwidth at discounted prices and general pricingpressures for data services in our markets. We increased our network services sales force from 205 associates atMarch 31, 2006, to 277 associates at March 31, 2007.  We expect this increase in sales associateswill favorably impact our lines in service and revenue over the next severalquarters.

Business telephonesystems (BTS) revenue was $7.6 million for the three months ended March 31,2007, an increase of 8.8% from $6.9 million in the same period of 2006.  Theincrease in BTS revenue was primarily the result of increased new system salesand revenue from change orders.  We cannot predict the future trends incapital spending by small and medium-sized business customers, which drives ourBTS business.

***NetworkService Expense.*** Network services expense was $28.5 million for the three months endedMarch 31, 2007, an increase of 37.5% from $20.8 million in the same period of2006.  The increase is due primarily tothe inclusion of our 2006 acquisitions, organic line growth and to a lesserextent TRRO cost increases.  As apercentage of related revenue, network services expense for the three monthsended March 31, 2007, was 39.2% compared to 39.3% for the same period of2006.  We expect our network serviceexpense as a percentage of related revenue to decrease in the future as wecontinue to sell more T1 lines and install more lines on our switches.

***BTSCost of Revenue.*** BTS cost of revenue was $4.6 million for the three months ended March31, 2007, an increase of 1.6% from $4.5 million in the same period of2006.  As a percentage of relatedrevenue, BTS cost of revenue for the three months ended March 31, 2007decreased to 61.2% from 65.6% for the same period of 2006.  BTS cost of revenue was favorably impacted bythe increase in change order revenue in first quarter of 2007. We do not expectthis trend in BTS cost of revenue as a percentage of related revenue tocontinue.

***Sales,General and Administrative Expense.***  Sales, general and administrative expenseswere $29.9 million for the three months ended March 31, 2007, an increase of31.7% from $22.7 million in the same period of 2006.  The increase is due to a number of factorsincluding:  1) the inclusion of our 2006acquisitions, 2) an increase in expenses associated with our sales forceexpansion, 3) an increase in employee compensation and benefits expense, and 4)expenses incurred associated with being a public company.  As a percentage of revenue, sales, generaland administrative expenses for the three months ended March 31, 2007, declinedto 37.2% from 38.0% in the same period of 2006 due to the improved efficiencyof our existing operations resulting from our largely fixed cost structuresupporting a higher level of revenue. Our sales, general and administrative expenses are largely fixed as theyare driven by the 1,393 associates that were employed at March 31, 2007.  We expect expenses as a percentage of revenueto continue to decline.

***Depreciationand Amortization.*** Depreciation and amortization expense was $11.8 million for the threemonths ended March 31, 2007, an increase of 16.3% from $10.2 million in thesame period of 2006.  This increase wasprimarily due to the inclusion of our 2006 acquisitions and from thedepreciation and amortization associated with our capital expenditures over thepast 12 months.  As a percentage ofrevenue, depreciation and amortization decreased to 14.7% for the three monthsended March 31, 2007 from 17.0% for the same period of 2006.

***Interest.***  Interest expense was $4.8 million for thethree months ended March 31, 2007, an increase of 40.4% from $3.4 million inthe same period of 2006.  The increasewas primarily due to our March 29, 2006 offering of $48.0 million in faceamount of 8 3/8% senior second secured notes due 2010 at a discount resultingin a 9.92% yield.

***Otherexpense.***** Other expense for the three months ended March31, 2007, was $1.0 million compared to none in the same period of 2006.  The increase is related to expenses incurredin association with the definitive agreement to be acquired by Integra Telecom,Inc.

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**Liquidity and Capital Resources**

***PrincipalSources and Uses of Liquidity.* **Ourprincipal sources of liquidity are cash from operations and our cash and cashequivalents and available-for-sale securities. Our  principal liquidityrequirements consist of debt service, capital expenditures and working capital.  We are in the process of obtaining a bankline of credit to supplement our liquidity needs.

***CashFlows Provided by Operating Activities. ***Cashprovided by operating activities was $5.3 million for the three months endedMarch 31, 2007 compared to cash provided by operating activities of $8.3million for the same period of 2006.  The decrease in cash provided by operatingactivities is primarily due to the following factors:  1) paid $1.1 million more in interestcompared to the same period of 2006, 2) paid $1.0 million in the first quarterof 2007 related to the Integra Telecom, Inc. transaction, 3) the change in netoperating assets increased by $6.8 million, due to acquisitions, and 4) thepreceding three items are partially offset by a $3.9 million increase inoperating income compared to the same period of 2006.

***CashFlows Used in Investing Activities.***  Cash used in investing activities was $4.7million for the three months ended March 31, 2007 compared to $4.9 million forthe same period of 2006.  The decrease isprimarily due to selling available-for-sale securities partially offset by anincreased level of capital expenditures. The amount from sales of our investments, net of proceeds, was $12.4million for the three months ended March 31, 2007, compared to $4.0 million inthe same period of 2006.  Capitalexpenditures increased by $8.7 million compared to the same period of2006.  The increase is primarily due tocash paid to add capacity and convert a selected customer base from Tel WestCommunications, LLC; greater capacity requirements to support record line salesand associated installations; and the purchase of equipment related to our VOIProllout and new market expansion.

***CashFlows Used in/Provided by Financing Activities.***  Cash used in financing activities was $0.6million for the three months ended March 31, 2007, compared to $44.1 million ofcash provided for the same period of 2006. On March 29, 2006, we completed an offering of $48.0 million in faceamount of 8 3/8% senior second secured notes due 2010 at a discount resultingin a 9.92% yield.  The net proceeds of $44.3million from the offering were used to finance the acquisition of OregonTelecom, Inc. on April 1, 2006; OneEighty on October 1, 2006; and MTI onNovember 1, 2006.

***CapitalRequirements.***  Forthe three months ended March 31, 2007, we spent $17.7 million on capitalexpenditures, of which $0.03 million was purchased under capital leases.  We expect to spend approximately $54.0 -$58.0 million on capital expenditures in 2007.

Based on our current level of operations and anticipated growth, webelieve that our existing cash, cash equivalents and short-term investmentswill be sufficient to fund our operations. We are in the process of obtaining a bank line credit for back-upliquidity purposes.

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

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

We are exposed to changesin interest rates on our investments in cash equivalents and available-for-salesecurities.  However, interest income forthe three month period ended March 31, 2007 was $0.4 million, therefore notexposing us to any meaningful interest income risk had rates dropped.  We had $142.0 million in senior secondsecured notes outstanding as of March 31, 2007. These notes are at a fixed interest rate and are therefore not exposedto any interest rate risk.

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# **Item 4: Controls and Procedures**

*Evaluation of Disclosure Controls and Procedures*

We have establisheddisclosure controls and procedures to ensure that information required to bedisclosed in our reports under the Securities Exchange Act of 1934, as amended,is recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms, andthat such information is accumulated and communicated to our Board of Directors and senior management,including our principal executiveofficer and principal financial officer, as appropriate, to allow timelydecisions regarding required disclosure. In designing and evaluating thedisclosure controls and procedures, management recognized that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement necessarily was required to apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures.

Based on their evaluation, the principal executive officer andprincipal financial officer of the Company have concluded that the design andoperation of our disclosure controls and procedures were effective to ensureinformation required to be disclosed in this Form 10-Q was processed, recorded,summarized and reported within the time periods specified in the rules andinstructions for the Form 10-Q.

*Changes in Internal Controls Over FinancialReporting*

During the first quarter of fiscal 2007, there was nochange in our internal control over financial reporting (as defined in Rule 13a-15(f)under the Exchange Act) that materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

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

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# **PART II. OTHER INFORMATION**

# **Item 1. Legal Proceedings**

On March 20, 2007, weannounced that we signed a definitive agreement to be acquired by Portland,Oregon-based Integra Telecom, Inc.  Underthe terms of the agreement, which was approved by the boards of directors ofboth companies, Integra Telecom will acquire us for $30.00 a share in cash,which equates to a total equity value of approximately $566 million on a fullydiluted basis.

A stockholder complainthas been filed as a purported class action on behalf of all public stockholdersagainst us and each of our directors in the District Court of the FourthJudicial District in and for Hennepin County, Minnesota.  The complaint alleges, among other things,that our directors breached their fiduciary duties in connection with theproposed transaction mentioned above by failing to maximize stockholder valueand by approving a transaction that purportedly benefits certain members ofmanagement at the expense of our public stockholders.  Among other things, the complaint seeks toenjoin us from proceeding with or consummating the merger.  Based on the facts known to date, we believethat the claim asserted is without merit and intend to defend this suit vigorously.  The absence of an injunction arising fromthis matter prohibiting the consummation of the merger is a condition to theclosing of the merger.

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

# **Item 1A. Risk Factors**

On April 27, 2007, Qwestfiled four separate petitions requesting that the FCC forbear from applyingcertain regulatory obligations on Qwest in the metropolitan service areas ofDenver, Minneapolis, Phoenix and Seattle. Qwest seeks regulatory relief in these areas similar to the relief theFCC granted it in December 2005 in the Omaha metropolitan service area.  Qwest seeks relief from its obligation toprovide unbundled loops and dedicated transport as well as from dominantcarrier regulation due to the significant inroads into its market share thatcompetitive service providers have made. The FCC has not yet set dates for public comment on Qwest’s petitionsand the outcome of these petitions cannot be predicted at this time.  However, if Qwest’s petitions are granted,our ability to purchase wholesale network services from Qwest at prices thatwould allow us to achieve our target profit margin in those markets could beadversely affected.

On March 9, 2007, the FCCpartially granted Qwest’s petition for forbearance or interim waivers of somedominant carrier regulations applicable to the long distance services of formerBell Operating Companies (“BOCs”).  TheFCC thereby removed some of the competitive safeguards previously applicable toQwest’s long distance wholesale and retail services provided, including Qwest’soperations in states in which we operate. Since the Qwest order is very recent, we cannot predict the effect itwill have on us.  Elimination of BOCregulatory constraints could make it more difficult for us to compete withQwest in offering long distance services.

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

On May 19, 2006, wecompleted an offering of 2,550,000 shares of our common stock, $0.01 par valueper share, at $15.70 per share.  Afterdeducting fees and expenses related to the offering, we received net proceedsof $40.0 million.  Our acquisition of MTIon November 1, 2006 was partially financed with $26.3 million of the proceedsfrom the offering.  The remainingproceeds of $13.7 million were used to fund capital expenditures associatedwith our VOIP rollout and new market expansion and to fund the acquisition of aselected customer base from Tel West Communications, LLC.

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

None.

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

# None.

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# **Item 5. Other Information**

None.

# **Item 6. Exhibits**

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

 

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*  Filed herewith.

†  Furnished herewith.

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## **SIGNATURE**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.
|                    |                   |                        |   |   |
|-------------------------|------------------------|-----------------------------|--------|--------|
|                         | Eschelon Telecom, Inc. |
|                    |                   |
| Date:  May 9, 2007 | 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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