**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**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 endedSeptember 30, 2006**

 

**OR**

 

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

 

**Commission File Number 000-50706**

 

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**ESCHELON TELECOM, INC.**

(Exact name of registrantas specified in its charter)

** **

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

 

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

 

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

 

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act.

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

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act). Yes o    No x

 

As of October 31, 2006,the number of outstanding shares of the Registrant’s Common Stock, par value$.01 per share, was 17,967,569 shares.

 

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

** **

2

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**PART I. FINANCIAL INFORMATION**

## **Item1.  Financial Statements**

**Eschelon Telecom, Inc.Consolidated Balance Sheets(In Thousands, Except Share and Per Share Amounts)**
| ** **                                                                                                                                                                                  | ** ** | **December 31,**                                                                                    | ** ** | **September 30,**                                                                                   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                                                                                  | ** ** | **        2005        ** | ** ** | **        2006        ** | ** ** |
| ** **                                                                                                                                                                                  | ** ** | ** **                                                                                               | ** ** | **(Unaudited)**                                                                                          | ** ** |
| **Assets**                                                                                                                                                                                  |       |                                                                                                     |       |                                                                                                     |       |
| Current assets:                                                                                                                                                                             |       |                                                                                                     |       |                                                                                                     |       |
| Cash and cash equivalents                                                                                                                                                                   |       | $                                                                                                        | 26,062     |                                                                                                     | $          | 7,760 |   |
| Restricted cash                                                                                                                                                                             |       | 996                                                                                                      |       | 728                                                                                                      |       |
| Available-for-sale securities                                                                                                                                                               |       | 4,760                                                                                                    |       | 68,477                                                                                                   |       |
| Accounts receivable, net of allowance for doubtful accounts  of $492 and $695, respectively                                                                                                 |       | 22,996                                                                                                   |       | 26,239                                                                                                   |       |
| Other receivables                                                                                                                                                                           |       | 3,052                                                                                                    |       | 4,207                                                                                                    |       |
| Inventories                                                                                                                                                                                 |       | 2,927                                                                                                    |       | 3,437                                                                                                    |       |
| Prepaid expenses                                                                                                                                                                            |       | 2,294                                                                                                    |       | 13,914                                                                                                   |       |
| Total current  assets                                                                                                                                                                       |       | 63,087                                                                                                   |       | 124,762                                                                                                  |       |
|                                                                                                                                                                                        |       |                                                                                                     |       |                                                                                                     |       |
| Property and  equipment, net                                                                                                                                                                |       | 126,452                                                                                                  |       | 128,501                                                                                                  |       |
|                                                                                                                                                                                        |       |                                                                                                     |       |                                                                                                     |       |
| Other assets                                                                                                                                                                                |       | 1,506                                                                                                    |       | 1,559                                                                                                    |       |
| Goodwill                                                                                                                                                                                    |       | 7,168                                                                                                    |       | 21,869                                                                                                   |       |
| Intangible  assets, net                                                                                                                                                                     |       | 33,333                                                                                                   |       | 40,554                                                                                                   |       |
| Total assets                                                                                                                                                                                |       | $                                                                                                        | 231,546    |                                                                                                     | $          | 317,245 |   |
|                                                                                                                                                                                        |       |                                                                                                     |       |                                                                                                     |       |
| **Liabilities  and stockholders’ equity**                                                                                                                                              |       |                                                                                                     |       |                                                                                                     |       |
| Current liabilities:                                                                                                                                                                        |       |                                                                                                     |       |                                                                                                     |       |
| Accounts payable                                                                                                                                                                            |       | $                                                                                                        | 16,400     |                                                                                                     | $          | 15,962 |   |
| Accrued telecommunication costs                                                                                                                                                             |       | 4,227                                                                                                    |       | 3,226                                                                                                    |       |
| Accrued office rent                                                                                                                                                                         |       | 2,035                                                                                                    |       | 1,722                                                                                                    |       |
| Accrued interest expense                                                                                                                                                                    |       | 2,646                                                                                                    |       | 579                                                                                                      |       |
| Other accrued expenses                                                                                                                                                                      |       | 5,485                                                                                                    |       | 6,732                                                                                                    |       |
| Deferred revenue                                                                                                                                                                            |       | 7,921                                                                                                    |       | 8,900                                                                                                    |       |
| Accrued compensation expenses                                                                                                                                                               |       | 2,809                                                                                                    |       | 3,953                                                                                                    |       |
| Capital lease obligations, current maturities                                                                                                                                               |       | 2,430                                                                                                    |       | 781                                                                                                      |       |
| Total current  liabilities                                                                                                                                                                  |       | 43,953                                                                                                   |       | 41,855                                                                                                   |       |
|                                                                                                                                                                                        |       |                                                                                                     |       |                                                                                                     |       |
| Long-term  liabilities:                                                                                                                                                                     |       |                                                                                                     |       |                                                                                                     |       |
| Commitments and contingencies                                                                                                                                                               |       |                                                                                                     |       |                                                                                                     |       |
| Other long-term liabilities                                                                                                                                                                 |       | 251                                                                                                      |       | 346                                                                                                      |       |
| Capital lease obligations, less current maturities                                                                                                                                          |       | 2,964                                                                                                    |       | 4,110                                                                                                    |       |
| Notes payable                                                                                                                                                                               |       | 92,125                                                                                                   |       | 140,138                                                                                                  |       |
| Total  liabilities                                                                                                                                                                          |       | 139,293                                                                                                  |       | 186,449                                                                                                  |       |
|                                                                                                                                                                                        |       |                                                                                                     |       |                                                                                                     |       |
| Stockholders’  equity:                                                                                                                                                                 |       |                                                                                                     |       |                                                                                                     |       |
| Preferred stock, $0.01 par value per share;  125,000,000 shares authorized; no shares issued and outstanding                                                                                |       | —                                                                                                   |       | —                                                                                                   |       |
| Common stock, $0.01 par value per share; 200,000,000  shares authorized; issued and outstanding shares – 14,634,279 shares at  December 31, 2005; and 17,946,744 at September 30, 2006 |       | 146                                                                                                      |       | 176                                                                                                      |       |
| Additional paid-in capital                                                                                                                                                                  |       | 248,199                                                                                                  |       | 288,460                                                                                                  |       |
| Accumulated other comprehensive income (loss)                                                                                                                                               |       | 56                                                                                                       |       | (3                                                                                                       | )          |
| Accumulated deficit                                                                                                                                                                         |       | (155,047                                                                                                 | )          | (157,837                                                                                                 | )          |
| Deferred compensation                                                                                                                                                                       |       | (1,101                                                                                                   | )          | —                                                                                                   |       |
| Total  stockholders’ equity                                                                                                                                                            |       | 92,253                                                                                                   |       | 130,796                                                                                                  |       |
| Total liabilities and  stockholders’ equity                                                                                                                                            |       | $                                                                                                        | 231,546    |                                                                                                     | $          | 317,245 |   |

 

*Seeaccompanying notes.*

3

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**Eschelon Telecom, Inc.Unaudited Consolidated Statements of Operations(In Thousands, Except Share and Per Share Amounts)**
| ** **                                                          | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                          | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                          | ** ** | **2005**                         | ** ** | **2006**                        | ** ** | **2005** | ** ** | **2006** | ** ** |
| Revenue:                                                            |       |                             |       |                            |       |   |   |   |   |
| Network services                                                    |       | $                                | 51,181     |                            | $          | 62,373 |   | $ | 149,944 |   | $ | 176,078 |   |
| Business telephone systems                                          |       | 6,731                            |       | 7,433                           |       | 19,422 |   | 21,704 |   |
| Total revenue                                                       |       | 57,912                           |       | 69,806                          |       | 169,366 |   | 197,782 |   |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| Costs and  expenses:                                                |       |                             |       |                            |       |   |   |   |   |
| Network services expense (excluding depreciation and  amortization) |       | 20,701                           |       | 25,735                          |       | 65,603 |   | 71,278 |   |
| Business telephone systems cost of revenue                          |       | 4,093                            |       | 4,619                           |       | 11,914 |   | 13,586 |   |
| Sales, general and administrative                                   |       | 22,378                           |       | 25,849                          |       | 67,823 |   | 74,521 |   |
| Depreciation and amortization                                       |       | 9,011                            |       | 10,839                          |       | 26,292 |   | 30,810 |   |
| Operating income  (loss)                                            |       | 1,729                            |       | 2,764                           |       | (2,266 | ) | 7,587 |   |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| Other income  (expense):                                            |       |                             |       |                            |       |   |   |   |   |
| Interest income                                                     |       | 269                              |       | 1,482                           |       | 502 |   | 2,474 |   |
| Interest expense                                                    |       | (14,798                          | )          | (4,776                          | )          | (24,612 | ) | (12,830 | ) |
| Other income (expense), net                                         |       | (113                             | )          | (78                             | )          | (59 | ) | (21 | ) |
| Loss before  taxes                                                  |       | (12,913                          | )          | (608                            | )          | (26,435 | ) | (2,790 | ) |
| Income taxes                                                        |       | —                           |       | —                          |       | — |   | — |   |
| Net loss before  discontinued operation                             |       | (12,913                          | )          | (608                            | )          | (26,435 | ) | (2,790 | ) |
| Income from  discontinued operation, net of tax                     |       | 460                              |       | —                          |       | 571 |   | — |   |
| Net loss  applicable to common stockholders                         |       | $                                | (12,453    | )                               | $          | (608 | ) | $ | (25,864 | ) | $ | (2,790 | ) |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| Basic and  diluted income (loss) per share:                         |       |                             |       |                            |       |   |   |   |   |
| Continuing operations                                               |       | $                                | (1.55      | )                               | $          | (0.03 | ) | $ | (8.71 | ) | $ | (0.17 | ) |
| Discontinued operations                                             |       | 0.06                             |       | —                          |       | 0.19 |   | — |   |
| Net loss                                                            |       | $                                | (1.49      | )                               | $          | (0.03 | ) | $ | (8.53 | ) | $ | (0.17 | ) |
|                                                                |       |                             |       |                            |       |   |   |   |   |
| Weighted average  number of shares outstanding:                     |       |                             |       |                            |       |   |   |   |   |
| Basic and diluted                                                   |       | 8,329,636                        |       | 17,513,871                      |       | 3,033,623 |   | 16,097,057 |   |

 

*Seeaccompanying notes.*

 

4

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**Eschelon Telecom, Inc.Unaudited Consolidated Statements of Cash Flows(In Thousands)**
| ** **                                                                                | ** ** | **Nine months ended  September 30,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                                | ** ** | **2005**                                            | ** ** | **2006** | ** ** |
| **Operating activities**                                                                  |       |                                                |       |   |   |
| Net loss                                                                                  |       | $                                                   | (25,864    | ) | $ | (2,790 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities:          |       |                                                |       |   |   |
| Depreciation and  amortization expense                                                    |       | 26,292                                              |       | 30,810 |   |
| Other non-cash  items                                                                     |       | 7,940                                               |       | 5,574 |   |
| Changes in  operating assets and liabilities:                                             |       |                                                |       |   |   |
| Restricted cash                                                                           |       | (107                                                | )          | 268 |   |
| Accounts  receivable                                                                      |       | (4,643                                              | )          | (1,742 | ) |
| Inventories                                                                               |       | (106                                                | )          | (510 | ) |
| Prepaid expenses  and other assets                                                        |       | (439                                                | )          | (12,669 | ) |
| Discontinued  assets held for sale, net of liabilities                                    |       | 1,223                                               |       | — |   |
| Accounts payable  and accrued expenses                                                    |       | (619                                                | )          | (5,516 | ) |
| Deferred revenue                                                                          |       | 526                                                 |       | 187 |   |
| Accrued  compensation expense                                                             |       | (293                                                | )          | 1,016 |   |
| Net cash provided by  operating activities                                                |       | 3,910                                               |       | 14,628 |   |
|                                                                                      |       |                                                |       |   |   |
| **Investing activities**                                                                  |       |                                                |       |   |   |
| Purchase of  subsidiaries, net of cash acquired                                           |       | —                                              |       | (19,993 | ) |
| Purchase of assets held  for sale, net of liabilities                                     |       | (216                                                | )          | — |   |
| Purchases of  available-for-sale securities                                               |       | (29,744                                             | )          | (84,468 | ) |
| Proceeds from sales of  available-for-sale securities                                     |       | 20,315                                              |       | 20,800 |   |
| Purchases of property  and equipment                                                      |       | (14,173                                             | )          | (20,456 | ) |
| Cash paid for customer  installation costs                                                |       | (10,103                                             | )          | (11,468 | ) |
| Proceeds from sales of  assets                                                            |       | 238                                                 |       | 112 |   |
| Net cash used in  investing activities                                                    |       | (33,683                                             | )          | (115,473 | ) |
|                                                                                      |       |                                                |       |   |   |
| **Financing activities**                                                                  |       |                                                |       |   |   |
| Proceeds from issuance  of notes payable                                                  |       | —                                              |       | 45,600 |   |
| Payments made on notes  and capital lease obligations                                     |       | (50,780                                             | )          | (1,971 | ) |
| Proceeds from issuance  of stock, net of fees                                             |       | 68,583                                              |       | 40,250 |   |
| Increase in debt  issuance costs                                                          |       | (348                                                | )          | (1,336 | ) |
| Net cash provided by  financing activities                                                |       | 17,455                                              |       | 82,543 |   |
|                                                                                      |       |                                                |       |   |   |
| Net decrease in cash  and cash equivalents                                                |       | (12,318                                             | )          | (18,302 | ) |
| Cash and cash  equivalents at beginning of period                                         |       | 26,435                                              |       | 26,062 |   |
| Cash and cash  equivalents at end of period                                               |       | $                                                   | 14,117     |   | $ | 7,760 |   |
|                                                                                      |       |                                                |       |   |   |
| **Supplemental cash flow  information**                                                   |       |                                                |       |   |   |
| Cash paid for interest                                                                    |       | $                                                   | 18,317     |   | $ | 9,635 |   |
|                                                                                      |       |                                                |       |   |   |
| **Supplemental non-cash  activities**                                                     |       |                                                |       |   |   |
| Equipment purchases  under capital leases                                                 |       | $                                                   | 2,785      |   | $ | 1,480 |   |
| Value of common stock  issued to management and certain members of the board of directors |       | $                                                   | 27         |   | $ | 6,045 |   |

 

*See accompanying notes.*

5

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**Eschelon Telecom, Inc.Notes to Consolidated Financial Statements(In Thousands, Except Share and Per Share Amounts)(Unaudited)**

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

**Basis of Presentation**

The accompanyingunaudited consolidated financial statements of Eschelon Telecom, Inc. and itssubsidiaries (the “Company”) have been prepared in accordance with accountingprinciples generally accepted in the United States of America for interimfinancial information and the instructions to Form 10-Q and Article 10 ofRegulation S-X promulgated by the United States Securities and Exchange Commission(the “SEC”).  Accordingly, they do notinclude all of the information and notes required by accounting principlesgenerally accepted in the United States of America for complete financialstatements.  In the opinion ofmanagement, all adjustments (consisting of normal and recurring adjustments andaccruals) considered necessary for a fair presentation for the periodsindicated have been included.  Operatingresults for the three and nine month periods ended September 30, 2006 are notnecessarily indicative of the results that may be expected for the year endingDecember 31, 2006.  The consolidatedbalance sheet at December 31, 2005 has been derived from the auditedconsolidated financial statements at that date but does not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements.  Thesefinancial statements should be read in conjunction with the Company’s auditedfinancial statements and related notes thereto for the year ended December 31,2005 included in the Eschelon Telecom, Inc. Form 10-K filed with the SEC onMarch 17, 2006.  

## **Principlesof Consolidation**

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

## **Available-for-SaleSecurities**

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

The cost basis,unrealized holding gains, unrealized holding losses and fair value of theinvestment securities available-for-sale as of December 31, 2005 and September30, 2006, are as follows:
| ** **                | ** ** | **December 31, 2005** | ** ** | **September 30, 2006** | ** ** |
|---------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| ** **                | ** ** | ** **                      | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | **Unrealized** | ** ** | ** ** | ** ** |
| ** **                | ** ** | ** **                      | ** ** | **Unrealized**                   | ** ** | ** ** | ** ** | ** ** | ** ** | **Holding** | ** ** | ** ** | ** ** |
| ** **                | ** ** | **Amortized**                   | ** ** | **Holding**                      | ** ** | ** ** | ** ** | **Amortized** | ** ** | **Gains/** | ** ** | ** ** | ** ** |
| ** **                | ** ** | **Cost Basis**             | ** ** | **Gains**                        | ** ** | **Fair Value** | ** ** | **Cost Basis** | ** ** | **(Losses)** | ** ** | **Fair Value** | ** ** |
|                      |       |                            |       |                             |       |   |   |   |   |   |   |   |   |
| U.S. government  agencies |       | $                               | 1,961      |                             | $          | 26 |   | $ | 1,987 |   | $ | 4,003 |   | $ | (6 | ) | $ | 3,997 |   |
| Corporate  obligations    |       | 2,743                           |       | 30                               |       | 2,773 |   | 23,077 |   | 3 |   | 23,080 |   |
| Auction rate  securities  |       | —                          |       | —                           |       | — |   | 41,400 |   | — |   | 41,400 |   |
| Total                     |       | $                               | 4,704      |                             | $          | 56 |   | $ | 4,760 |   | $ | 68,480 |   | $ | (3 | ) | $ | 68,477 |   |

 

As of September 30, 2006,the available-for-sale securities have remaining maturities that range from twodays to 21 months.

6

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## **Propertyand Equipment**

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

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

Property and equipmentconsist of the following:
|                                            | ** ** | **December 31,** | ** ** | **September 30,** | ** ** |
|--------------------------------------------|------------|-----------------------|------------|------------------------|------------|
| ** **                                 | ** ** | **2005**              | ** ** | **2006**               | ** ** |
|                                       |       |                  |       |                   |       |
| Vehicles                                   |       | $                     | 1,375      |                   | $          | 2,136 |   |
| Office furniture  and equipment            |       | 18,229                |       | 20,831                 |       |
| Computer  equipment and software           |       | 41,897                |       | 46,563                 |       |
| Leasehold improvements                     |       | 23,765                |       | 25,686                 |       |
| Switching and  data equipment and software |       | 134,661               |       | 146,959                |       |
|                                       |       | 219,927               |       | 242,175                |       |
| Less accumulated  depreciation             |       | (93,475               | )          | (113,674               | )          |
| Property and equipment,  net               |       | $                     | 126,452    |                   | $          | 128,501 |   |

 

## **Goodwilland Other Intangible Assets**

Goodwill represents theexcess of cost over the fair value of net assets acquired.
| Goodwill at December 31,  2005                               |   | $      | 7,168  |   |
|--------------------------------------------------------------|--------|--------|--------|--------|
| Goodwill related  to the acquisition of Oregon Telecom, Inc. |   | 14,701 |   |
| Impairment  charges                                          |   | — |   |
| Goodwill at September  30, 2006                              |   | $      | 21,869 |   |

 

Intangibles consist ofcustomer installation costs, debt issuance costs, customer relationships,non-compete agreements and developed technology.  The customer installation costs are beingamortized over periods approximating the average life of customers.  Debt issuance costs are being amortized overthe term of the respective debt obligation. Non-compete agreement costs represent costs associated with non-competeagreements with former employees.  Thesecosts are being amortized over the term of the agreements.  Customer relationships and developedtechnology are being amortized over 48 months and 36 months, respectively.

Intangible assets consistof the following:

|                              | ** ** | ** **                      | ** ** | **December 31, 2005**         | ** ** | **September 30, 2006**    | ** ** |
|------------------------------|------------|---------------------------------|------------|-----------------------------------------|------------|-------------------------------------|------------|
| ** **                   | ** ** | **Useful   Life  (years)** | ** ** | **Gross   Carrying   Amount** | ** ** | **Accumulated   Amortization** | ** ** | **Net** | ** ** | **Gross   Carrying   Amount** | ** ** | **Accumulated   Amortization** | ** ** | **Net** | ** ** |
| Customer  installation costs |       | 3-5                             |       | $                                       | 77,650     |                                | $          | 52,034 |   | $ | 25,616 |   | $ | 89,120 |   | $ | 61,124 |   | $ | 27,996 |   |
| Debt issuance costs          |       | 4-6                             |       | 5,666                                   |       | 1,077                               |       | 4,589 |   | 7,001 |   | 1,858 |   | 5,143 |   |
| Customer  relationships      |       | 4                               |       | 3,820                                   |       | 955                                 |       | 2,865 |   | 8,520 |   | 2,259 |   | 6,261 |   |
| Non-compete  agreements      |       | 3-5                             |       | 300                                     |       | 100                                 |       | 200 |   | 1,400 |   | 285 |   | 1,115 |   |
| Developed  technology        |       | 3                               |       | 94                                      |       | 31                                  |       | 63 |   | 94 |   | 55 |   | 39 |   |
| Total                        |       |                            |       | $                                       | 87,530     |                                | $          | 54,197 |   | $ | 33,333 |   | $ | 106,135 |   | $ | 65,581 |   | $ | 40,554 |   |

 

7

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## **Stock-BasedCompensation**

*Stock Option Plan*

A total of 2,632,414shares of the Company’s common stock have been authorized for issuance underthe Eschelon Telecom, Inc. Stock Option Plan of 2002 (the “2002 Plan”).  The 2002 Plan provides for grants ofincentive stock options, non-statutory stock options, stock appreciationrights, restricted or unrestricted stock awards, phantom stock, performanceawards and other stock-based awards to our employees, former employees,officers, directors and consultants.  The2002 Plan is administered by the Compensation Committee of the Board ofDirectors, which has sole discretion and authority, consistent with theprovisions of the 2002 Plan, to determine which eligible participants willreceive awards, when awards will be granted, the terms of awards, and thenumber of shares that will be subject to awards.  The purpose of the 2002 Plan is to enable theCompany to attract, retain and reward the best-available employees, to provideparticipants with incentives to improve stockholder value and to contribute tothe growth and financial success of the Company through their future serviceswith the Company.  All of the Company’semployees, former employees, officers and directors are eligible to participatein the 2002 Plan.  

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

*Stock Options*

EffectiveJanuary 1, 2006, the Company adopted the provisions of SFAS No. 123R (SFAS123R), *Share-Based Payment: an amendment of FASBStatement No. 123 and FASB Statement No. 95,*whichrequires the measurement and recognition of compensation expense for allshare-based payment awards to employees and directors based on estimated fairvalues.  Prior to the adoption of SFAS123R, the Company accounted for its stock-based compensation under therecognition and measurement principles of Accounting Principles Board Opinion No.25 (APB 25), *Accounting for Stock Issued to Employees,*andrelated interpretations.  The Companyrecorded stock-based compensation expense under SFAS 123R for stock optionawards of $200 and $761 for the three and nine months ended September 30, 2006,respectively.  As a result of adoptingSFAS 123R on January 1, 2006, the Company’s net loss for the three and ninemonths ended September 30, 2006 is $61 and $344 greater, respectively, than ifit had continued to account for share-based compensation under APB 25.  As of September 30, 2006, there was $826 ofunrecognized compensation expense related to unvested options granted under theCompany’s share-based payment plans.  Theexpense is expected to be recognized over a weighted-average period of 1.3years.

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

The Company records compensationexpense for employee stock options based on the estimated fair value of theoptions on the date of grant using assumptions required by SFAS 123R.  Due to insufficient history related tooptions, the Company uses the short-cut method accepted by the SEC to determinethe expected life of options.  TheCompany expects to continue using the short-cut method for options grantedthrough December 31, 2007, after which the use of the short-cut method is notpermitted by the SEC.  Volatility isestimated based on an exchange-traded telecommunications fund using data thatcorresponds to the expected term of the options granted.  The risk-free interest rate is based on theFederal Reserve rate for U.S. government securities with a term thatcorresponds to the expected term of the options granted.   The Company uses historical data and otherfactors to estimate the expected forfeiture rate.

8

----

 

The following tablesummarizes the assumptions used to estimate the fair value of options grantedduring the three and nine month periods ended September 30, 2005 and 2006 usingthe Black-Scholes option-pricing model:
| ** **                       | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|----------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                       | ** ** | **2005**                                                 | ** ** | **2006**                                                | ** ** | **2005** | ** ** | **2006** | ** ** |
| Expected  dividend yield         |       | —                                                   |       | —                                                  |       | — |   | — |   |
| Expected stock  price volatility |       | 25                                                       | %          | 26                                                      | %          | 25 | % | 26 | % |
| Risk-free  interest rate         |       | 3.83%-4.0                                                | 8%         | 4.75                                                    | %          | 3.71%-4.2 | 4% | 4.56%-4.9 | 5% |
| Expected life of  options        |       | 5 years                                                  |       | 6 – 6.5 years                                      |       | 5 years |   | 6 – 6.5 years |   |

 

Pro forma informationregarding net loss and net loss per share is required by SFAS 123, and has beendetermined as if the Company had accounted for its employee stock options underthe fair value method of SFAS 123.  Thefollowing table illustrates the effect on net loss per share for the three andnine months ended September 30, 2005, if the Company had applied the fair valuerecognition provision of SFAS 123, *Accounting for Stock-BasedCompensation,*to stock-based employee compensation:
| ** **                                                                                                         | ** ** | **Three months**            | ** ** | **Nine months**             | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                         | ** ** | **ended**                        | ** ** | **ended**                        | ** ** |
| ** **                                                                                                         | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
| Net loss  applicable to common stockholders, as reported                                                           |       | $                                | (12,453    | )                                | $          | (25,864 | ) |
| Add: Stock-based  employee compensation expense included in reported net loss                                      |       | 148                              |       | 796                              |       |
|                                                                                                               |       |                             |       |                             |       |
| Deduct: Total  stock-based employee compensation expense determined under fair value-based  methods for all awards |       | (123                             | )          | (412                             | )          |
| Pro forma net  loss applicable to common stockholders                                                              |       | $                                | (12,428    | )                                | $          | (25,480 | ) |
|                                                                                                               |       |                             |       |                             |       |
| Net loss per  share:                                                                                               |       |                             |       |                             |       |
| Basic and diluted - as reported                                                                                    |       | $                                | (1.49      | )                                | $          | (8.53 | ) |
| Basic and  diluted - pro forma                                                                                     |       | $                                | (1.49      | )                                | $          | (8.40 | ) |

 

The followingtable summarizes the option activity under the 2002 Plan:
| ** **                         | ** ** | **Number of   Options** | ** ** | **Weighted-  Average  Exercise Price** | ** ** | **Weighted-  Average   Remaining   Contractual   Term** | ** ** | **Aggregate   Intrinsic   Value** | ** ** |
|------------------------------------|------------|-----------------------------------|------------|---------------------------------------------|------------|------------------------------------------------------------------------|------------|---------------------------------------------|------------|
|                               |       |                              |       |                                        |       |                                                                   |       |                                        |       |
| Outstanding at  December 31, 2005  |       | 1,167,490                         |       | $                                           | 4.12       |                                                                   |       |                                        |       |   |
| Granted                            |       | 67,873                            |       | 15.19                                       |       |                                                                   |       |                                        |       |
| Canceled                           |       | (28,014                           | )          | 9.34                                        |       |                                                                   |       |                                        |       |
| Exercised                          |       | (372,466                          | )          | 0.79                                        |       |                                                                   |       |                                        |       |
| Outstanding at  September 30, 2006 |       | 834,883                           |       | $                                           | 6.32       |                                                                   | 8.08       |                                        | $          | 8,905 |   |
|                               |       |                              |       |                                        |       |                                                                   |       |                                        |       |
| Exercisable at  September 30, 2006 |       | 431,795                           |       | $                                           | 5.45       |                                                                   | 7.89       |                                        | $          | 4,983 |   |

 

The weighted-averagegrant-date fair value of options granted during the three months endedSeptember 30, 2005 and 2006, was $3.72 and $5.91, respectively.  The weighted-average grant-date fair value ofoptions granted during the nine months ended September 30, 2005 and 2006, was$5.73 and $5.55, respectively.  The totalintrinsic value for options exercised during the three months ended September30, 2005 and 2006, was $162 and $646, respectively. The total intrinsic valuefor options exercised during the nine months ended September 30, 2005 and 2006,was $271 and $5,008, respectively.

Cash received from optionexercises for the three months ended September 30, 2005 and 2006, was $14 and$45, respectively, and for the nine months ended September 30, 2005 and 2006cash received was $58 and $295, respectively.

9

----

 

*Restricted and UnrestrictedCommon Stock*

In 2003, the Companygranted 183,399 shares of restricted common stock to certain of its directorsand members of management.  The Companyrecords compensation expense as the restrictions are removed from thestock.  In 2005, the Company granted9,350 shares of unrestricted common stock to certain directors.  In 2006, the Company granted 390,000 sharesof restricted common stock to certain of its members of management.  Total compensation expense related torestricted and unrestricted common stock for the nine months ended September30, 2005 and 2006, was $39 and $380, respectively.

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

 

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

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

**New Accounting Pronouncements**

In June 2006, theFinancial Accounting Standards Board (FASB) issued FASB Interpretation No. 48(FIN 48), *Accounting for Uncertainty in Income Taxes*.  FIN 48 clarifies the accounting foruncertainty in income taxes recognized in an enterprise’s financial statementsin accordance with SFAS 109, *Accounting forIncome Taxes,* and prescribesa recognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return.  The Company has not yetdetermined the impact, if any, that the adoption of FIN 48 will have on itsconsolidated financial statements.

In September 2006, theFASB issued SFAS No. 157 (SFAS 157), *Fair Value Measurements*.  The standard provides guidance for using fairvalue to measure assets and liabilities. The standard clarifies the principlethat fair value should be based on the assumptions market participants woulduse when pricing the asset or liability and establishes a fair value hierarchythat prioritizes the information used to develop those assumptions. Under thestandard, fair value measurements would be separately disclosed by level withinthe fair value hierarchy.  SFAS 157 iseffective for financial statements issued for fiscal years beginning afterNovember 15, 2007 and interim periods within those fiscal years.  The Company has not yet determined theimpact, if any, that the adoption of SFAS 157 will have on its consolidatedfinancial statements.

In September 2006, theSEC issued Staff Accounting Bulletin No. 108 (SAB 108), *Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements*. SAB 108 provides guidance on how the effects of prior year misstatementsshould be considered in quantifying a current year misstatement.  SAB 108 is effective for financial statementsissued for fiscal years beginning after November 15, 2006.  The Company has not yet determined theimpact, if any, that the adoption of SAB 108 will have on its consolidatedfinancial statements.

10

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

***Oregon Telecom, Inc.***

On April 1, 2006, theCompany completed its acquisition of Oregon Telecom, Inc. (“OTI”), aprivately-held competitive services provider based in Salem, Oregon.    The results of OTI have been included inthe consolidated financial statements since the date of acquisition.  As a result of the acquisition, the Companystrengthened its presence in the Oregon market and created opportunities forcost savings and increased profitability.

The Company acquired allof the outstanding shares of OTI in exchange for cash paid of $19,993 (net ofcash acquired) and assumed the current liabilities of OTI.  The Company acquired $5,800 of intangibleassets, consisting of $4,700 in customer relationships and $1,100 innon-compete agreements.  Goodwill of$14,701 was recorded in this transaction.

The following tablesummarizes the allocation of the purchase price to the fair values of theassets acquired and liabilities assumed at the date of acquisition, inaccordance with the purchase method of accounting:  
| Cash                    |   | $      | 312    |   |
|-------------------------|--------|--------|--------|--------|
| Other current  assets   |   | 2,984  |   |
| Property and  equipment |   | 529    |   |
| Other assets            |   | 57     |   |
| Goodwill                |   | 14,701 |   |
| Intangible  assets      |   | 5,800  |   |
| Current  liabilities    |   | (3,864 | )      |
| Long-term  liabilities  |   | (214   | )      |
| Total purchase price    |   | $      | 20,305 |   |

 

The Company accrued $934in acquisition related expenses, which include severance benefits, relocationcosts and contract termination fees.  AtSeptember 30, 2006, the balance in the acquisition accrual was as follows:
| Balance at April 1, 2006       |   | $   | 934 |   |
|--------------------------------|--------|-----|-----|--------|
| Payments                       |   | (26 | )   |
| Balance at September  30, 2006 |   | $   | 908 |   |

 

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

On March 29, 2006, theCompany completed an offering of $48,000 of 8 3/8% senior second secured notes(“notes”) due 2010 at a discount resulting in a 9.92% yield.  The notes were entered into under a fourthsupplemental indenture to the original indenture dated March 17, 2004, and havethe same terms and conditions of the original indenture.  The Company received net proceeds of approximately$44,264 after deducting fees and expenses associated with the offering.  The Company’s acquisition of Oregon Telecom,Inc. on April 1, 2006, was financed with $20,305 of the proceeds from theoffering.  The remaining proceeds will beused for general corporate purposes and potential future acquisitions.

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

The Company has a definedcontribution salary deferral plan covering substantially all employees underSection 401(k) of the Internal Revenue Code. The Company contributes an amount equal to 45 cents for each dollarcontributed by each employee up to a maximum of 6% of each employee’scompensation.  The Company recognizedexpense for contributions to the plan for the three months ended September 30,2005 and 2006 of $259 and $249, respectively, and for the nine months endedSeptember 30, 2005 and 2006 of $728 and $746, respectively.

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

**PreferredStock**

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

11

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## **CommonStock**

On May 19, 2006, theCompany completed an offering of 2,550,000 shares of the Company’s common stockat $15.70 per share.  After deductingfees and expenses related to the offering, the Company received net proceeds ofapproximately $39,955, which will be used to fund potential futureacquisitions.

**CondensedConsolidating Financial Information**

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

The following tablespresent condensed consolidating balance sheets at December 31, 2005 andSeptember 30, 2006; condensed consolidating statements of operations for thethree and nine month periods ended September 30, 2005 and 2006; and condensedconsolidating statements of cash flows for the nine month periods ended September30, 2005 and 2006.

12

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**Unaudited Condensed Consolidating Balance SheetsAs of December 31, 2005(In Thousands)**
| ** **                                                 | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Assets**                                                 | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                            |       |                   |       |          |       |             |       |             |       |             |       |
| Cash and cash  equivalents                                 |       | $                      | 25,070     |          | $          | —           |       | $                | 992        |             | $          | — |   | $ | 26,062 |   |
| Restricted cash                                            |       | 996                    |       | —        |       | —           |       | —           |       | 996              |       |
| Available-for-sale  securities                             |       | 4,760                  |       | —        |       | —           |       | —           |       | 4,760            |       |
| Accounts  receivable, net                                  |       | —                 |       | —        |       | 22,996           |       | —           |       | 22,996           |       |
| Other  receivables                                         |       | —                 |       | —        |       | 3,052            |       | —           |       | 3,052            |       |
| Inventories                                                |       | —                 |       | —        |       | 2,927            |       | —           |       | 2,927            |       |
| Prepaid expenses                                           |       | 1,149                  |       | —        |       | 1,145            |       | —           |       | 2,294            |       |
| Total current assets                                       |       | 31,975                 |       | —        |       | 31,112           |       | —           |       | 63,087           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Property and equipment,  net                               |       | 82,840                 |       | —        |       | 43,612           |       | —           |       | 126,452          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Investment in affiliates                                   |       | 59,046                 |       | —        |       | —           |       | (59,046          | )          | —           |       |
| Other assets                                               |       | 507                    |       | —        |       | 999              |       | —           |       | 1,506            |       |
| Goodwill                                                   |       | —                 |       | —        |       | 7,168            |       | —           |       | 7,168            |       |
| Intangible assets, net                                     |       | 13,695                 |       | 4,588         |       | 15,050           |       | —           |       | 33,333           |       |
| Total assets                                               |       | $                      | 188,063    |          | $          | 4,588            |       | $                | 97,941     |             | $          | (59,046 | ) | $ | 231,546 |   |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Liabilities and stockholders’  equity (deficit)**   | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current liabilities:                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Accounts payable                                           |       | $                      | 14,602     |          | $          | —           |       | $                | 1,798      |             | $          | — |   | $ | 16,400 |   |
| Accrued  telecommunication costs                           |       | —                 |       | —        |       | 4,227            |       | —           |       | 4,227            |       |
| Accrued office  rent                                       |       | 1,485                  |       | —        |       | 550              |       | —           |       | 2,035            |       |
| Accrued interest  expense                                  |       | —                 |       | 2,645         |       | 1                |       | —           |       | 2,646            |       |
| Other accrued  expenses                                    |       | 944                    |       | —        |       | 4,541            |       | —           |       | 5,485            |       |
| Deferred revenue                                           |       | —                 |       | —        |       | 7,921            |       | —           |       | 7,921            |       |
| Accrued  compensation expenses                             |       | 1,623                  |       | —        |       | 1,186            |       | —           |       | 2,809            |       |
| Capital lease  obligations, current maturities             |       | 2,320                  |       | —        |       | 110              |       | —           |       | 2,430            |       |
| Total current  liabilities                                 |       | 20,974                 |       | 2,645         |       | 20,334           |       | —           |       | 43,953           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Long-term liabilities:                                     |       |                   |       |          |       |             |       |             |       |             |       |
| Other long-term  liabilities                               |       | 251                    |       | —        |       | —           |       | —           |       | 251              |       |
| Capital lease  obligations, less current maturities        |       | 2,857                  |       | —        |       | 107              |       | —           |       | 2,964            |       |
| Notes payable                                              |       | —                 |       | 92,125        |       | —           |       | —           |       | 92,125           |       |
| Due to (from)  affiliates                                  |       | 211,456                |       | (103,502      | )          | (107,954         | )          | —           |       | —           |       |
| Total liabilities                                          |       | 235,538                |       | (8,732        | )          | (87,513          | )          | —           |       | 139,293          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Stockholders’ equity  (deficit)                       |       | (47,475                | )          | 13,320        |       | 185,454          |       | (59,046          | )          | 92,253           |       |
| Total liabilities and  stockholders’ equity (deficit) |       | $                      | 188,063    |          | $          | 4,588            |       | $                | 97,941     |             | $          | (59,046 | ) | $ | 231,546 |   |

 

13

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**Unaudited Condensed Consolidating Balance SheetsAs of September 30, 2006(In Thousands)**
| ** **                                                 | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|------------------|------------|
| ** **                                                 | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** | ** **       | ** ** |
| ** **                                                 | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Assets**                                                 | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                            |       |                   |       |          |       |             |       |             |       |             |       |
| Cash and cash equivalents                                  |       | $                      | 7,008      |          | $          | —           |       | $                | 752        |             | $          | — |   | $ | 7,760 |   |
| Restricted cash                                            |       | 728                    |       | —        |       | —           |       | —           |       | 728              |       |
| Available-for-sale securities                              |       | 68,477                 |       | —        |       | —           |       | —           |       | 68,477           |       |
| Accounts receivable, net                                   |       | —                 |       | —        |       | 26,239           |       | —           |       | 26,239           |       |
| Other receivables                                          |       | 614                    |       | —        |       | 3,593            |       | —           |       | 4,207            |       |
| Inventories                                                |       | —                 |       | —        |       | 3,437            |       | —           |       | 3,437            |       |
| Prepaid expenses                                           |       | 12,342                 |       | —        |       | 1,572            |       | —           |       | 13,914           |       |
| Total current  assets                                      |       | 89,169                 |       | —        |       | 35,593           |       | —           |       | 124,762          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Property and  equipment, net                               |       | 89,299                 |       | —        |       | 39,202           |       | —           |       | 128,501          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Investment in  affiliates                                  |       | 79,351                 |       | —        |       | —           |       | (79,351          | )          | —           |       |
| Other assets                                               |       | 528                    |       | —        |       | 1,031            |       | —           |       | 1,559            |       |
| Goodwill                                                   |       | —                 |       | —        |       | 21,869           |       | —           |       | 21,869           |       |
| Intangible  assets, net                                    |       | 15,612                 |       | 5,143         |       | 19,799           |       | —           |       | 40,554           |       |
| Total assets                                               |       | $                      | 273,959    |          | $          | 5,143            |       | $                | 117,494    |             | $          | (79,351 | ) | $ | 317,245 |   |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| **Liabilities  and stockholders’ equity (deficit)**   | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current  liabilities:                                      |       |                   |       |          |       |             |       |             |       |             |       |
| Accounts payable                                           |       | $                      | 13,602     |          | $          | —           |       | $                | 2,360      |             | $          | — |   | $ | 15,962 |   |
| Accrued telecommunication costs                            |       | —                 |       | —        |       | 3,226            |       | —           |       | 3,226            |       |
| Accrued office rent                                        |       | 1,002                  |       | —        |       | 720              |       | —           |       | 1,722            |       |
| Accrued interest expense                                   |       | —                 |       | 578           |       | 1                |       | —           |       | 579              |       |
| Other accrued expenses                                     |       | 1,456                  |       | —        |       | 5,276            |       | —           |       | 6,732            |       |
| Deferred revenue                                           |       | —                 |       | —        |       | 8,900            |       | —           |       | 8,900            |       |
| Accrued compensation expenses                              |       | 3,008                  |       | —        |       | 945              |       | —           |       | 3,953            |       |
| Capital lease obligations, current maturities              |       | 666                    |       | —        |       | 115              |       | —           |       | 781              |       |
| Total current  liabilities                                 |       | 19,734                 |       | 578           |       | 21,543           |       | —           |       | 41,855           |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Long-term  liabilities:                                    |       |                   |       |          |       |             |       |             |       |             |       |
| Other long-term liabilities                                |       | 132                    |       | —        |       | 214              |       | —           |       | 346              |       |
| Capital lease obligations, less current maturities         |       | 4,090                  |       | —        |       | 20               |       | —           |       | 4,110            |       |
| Notes payable                                              |       | —                 |       | 140,138       |       | —           |       | —           |       | 140,138          |       |
| Due to (from) affiliates                                   |       | 311,178                |       | (136,918      | )          | (174,260         | )          | —           |       | —           |       |
| Total  liabilities                                         |       | 335,134                |       | 3,798         |       | (152,483         | )          | —           |       | 186,449          |       |
|                                                       |       |                   |       |          |       |             |       |             |       |             |       |
| Stockholders’  equity (deficit)                       |       | (61,175                | )          | 1,345         |       | 269,977          |       | (79,351          | )          | 130,796          |       |
| Total  liabilities and stockholders’ equity (deficit) |       | $                      | 273,959    |          | $          | 5,143            |       | $                | 117,494    |             | $          | (79,351 | ) | $ | 317,245 |   |

 

14

----

 

**Unaudited Condensed Consolidating Statement of OperationsFor the Three Months Ended September 30, 2005(In Thousands)**
| ** **                                                          | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                          | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                          | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Revenue:                                                            |       |                   |       |          |       |             |       |             |       |
| Network services                                                    |       | $                      | —     |          | $          | —           |       | $                | 51,181     |   | $ | 51,181 |   |
| Business telephone systems                                          |       | —                 |       | —        |       | 6,731            |       | 6,731            |       |
| Total revenue                                                       |       | —                 |       | —        |       | 57,912           |       | 57,912           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Costs and  expenses:                                                |       |                   |       |          |       |             |       |             |       |
| Network services expense (excluding depreciation and  amortization) |       | —                 |       | —        |       | 20,701           |       | 20,701           |       |
| Business telephone systems cost of revenue                          |       | —                 |       | —        |       | 4,093            |       | 4,093            |       |
| Sales, general and administrative                                   |       | 10,643                 |       | —        |       | 11,735           |       | 22,378           |       |
| Depreciation and amortization                                       |       | 5,666                  |       | —        |       | 3,345            |       | 9,011            |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Operating income  (loss)                                            |       | (16,309                | )          | —        |       | 18,038           |       | 1,729            |       |
| Other income  (expense)                                             |       | (101                   | )          | (14,572       | )          | 31               |       | (14,642          | )          |
| Income (loss)  before income taxes                                  |       | (16,410                | )          | (14,572       | )          | 18,069           |       | (12,913          | )          |
| Income taxes                                                        |       | —                 |       | —        |       | —           |       | —           |       |
| Net income  (loss) before discontinued operation                    |       | (16,410                | )          | (14,572       | )          | 18,069           |       | (12,913          | )          |
| Income from  discontinued operation, net of tax                     |       | —                 |       | —        |       | 460              |       | 460              |       |
| Net income (loss)                                                   |       | $                      | (16,410    | )             | $          | (14,572          | )          | $                | 18,529     |   | $ | (12,453 | ) |

 

15

----

 

**Unaudited Condensed Consolidating Statement ofOperationsFor the Three Months Ended September 30, 2006(In Thousands)**
| ** **                                                          | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                          | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                          | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Revenue:                                                            |       |                   |       |          |       |             |       |             |       |
| Network services                                                    |       | $                      | —     |          | $          | —           |       | $                | 62,373     |   | $ | 62,373 |   |
| Business telephone systems                                          |       | —                 |       | —        |       | 7,433            |       | 7,433            |       |
| Total revenue                                                       |       | —                 |       | —        |       | 69,806           |       | 69,806           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Costs and  expenses:                                                |       |                   |       |          |       |             |       |             |       |
| Network services expense (excluding depreciation and  amortization) |       | —                 |       | —        |       | 25,735           |       | 25,735           |       |
| Business telephone systems cost of revenue                          |       | —                 |       | —        |       | 4,619            |       | 4,619            |       |
| Sales, general and administrative                                   |       | 13,423                 |       | —        |       | 12,426           |       | 25,849           |       |
| Depreciation and amortization                                       |       | 5,864                  |       | —        |       | 4,975            |       | 10,839           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Operating income  (loss)                                            |       | (19,287                | )          | —        |       | 22,051           |       | 2,764            |       |
| Other income  (expense)                                             |       | 1,023                  |       | (4,401        | )          | 6                |       | (3,372           | )          |
| Income (loss)  before income taxes                                  |       | (18,264                | )          | (4,401        | )          | 22,057           |       | (608             | )          |
| Income taxes                                                        |       | —                 |       | —        |       | —           |       | —           |       |
| Net income (loss)                                                   |       | $                      | (18,264    | )             | $          | (4,401           | )          | $                | 22,057     |   | $ | (608 | ) |

 

16

----

 

**Unaudited Condensed Consolidating Statement ofOperationsFor the Nine Months Ended September 30, 2005(In Thousands)**
| ** **                                                          | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                          | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                          | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Revenue:                                                            |       |                   |       |          |       |             |       |             |       |
| Network services                                                    |       | $                      | —     |          | $          | —           |       | $                | 149,944    |   | $ | 149,944 |   |
| Business telephone systems                                          |       | —                 |       | —        |       | 19,422           |       | 19,422           |       |
| Total revenue                                                       |       | —                 |       | —        |       | 169,366          |       | 169,366          |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Costs and  expenses:                                                |       |                   |       |          |       |             |       |             |       |
| Network services expense (excluding depreciation and  amortization) |       | —                 |       | —        |       | 65,603           |       | 65,603           |       |
| Business telephone systems cost of revenue                          |       | —                 |       | —        |       | 11,914           |       | 11,914           |       |
| Sales, general and administrative                                   |       | 31,768                 |       | —        |       | 36,055           |       | 67,823           |       |
| Depreciation and amortization                                       |       | 16,354                 |       | —        |       | 9,938            |       | 26,292           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Operating income  (loss)                                            |       | (48,122                | )          | —        |       | 45,856           |       | (2,266           | )          |
| Other income  (expense)                                             |       | (260                   | )          | (23,969       | )          | 60               |       | (24,169          | )          |
| Income (loss)  before income taxes                                  |       | (48,382                | )          | (23,969       | )          | 45,916           |       | (26,435          | )          |
| Income taxes                                                        |       | —                 |       | —        |       | —           |       | —           |       |
| Net income  (loss) before discontinued operation                    |       | (48,382                | )          | (23,969       | )          | 45,916           |       | (26,435          | )          |
| Income from  discontinued operation, net of tax                     |       | —                 |       | —        |       | 571              |       | 571              |       |
| Net income (loss)                                                   |       | $                      | (48,382    | )             | $          | (23,969          | )          | $                | 46,487     |   | $ | (25,864 | ) |

 

17

----

 

**Unaudited Condensed Consolidating Statement ofOperationsFor the Nine Months Ended September 30, 2006(In Thousands)**
| ** **                                                          | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                          | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                          | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Revenue:                                                            |       |                   |       |          |       |             |       |             |       |
| Network services                                                    |       | $                      | —     |          | $          | —           |       | $                | 176,078    |   | $ | 176,078 |   |
| Business telephone systems                                          |       | —                 |       | —        |       | 21,704           |       | 21,704           |       |
| Total revenue                                                       |       | —                 |       | —        |       | 197,782          |       | 197,782          |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Costs and  expenses:                                                |       |                   |       |          |       |             |       |             |       |
| Network services expense (excluding depreciation and  amortization) |       | —                 |       | —        |       | 71,278           |       | 71,278           |       |
| Business telephone systems cost of revenue                          |       | —                 |       | —        |       | 13,586           |       | 13,586           |       |
| Sales, general and administrative                                   |       | 39,556                 |       | —        |       | 34,965           |       | 74,521           |       |
| Depreciation and amortization                                       |       | 17,090                 |       | —        |       | 13,720           |       | 30,810           |       |
|                                                                |       |                   |       |          |       |             |       |             |       |
| Operating income  (loss)                                            |       | (56,646                | )          | —        |       | 64,233           |       | 7,587            |       |
| Other income  (expense)                                             |       | 1,614                  |       | (11,975       | )          | (16              | )          | (10,377          | )          |
| Income (loss)  before income taxes                                  |       | (55,032                | )          | (11,975       | )          | 64,217           |       | (2,790           | )          |
| Income taxes                                                        |       | —                 |       | —        |       | —           |       | —           |       |
| Net income (loss)                                                   |       | $                      | (55,032    | )             | $          | (11,975          | )          | $                | 64,217     |   | $ | (2,790 | ) |

 

18

----

 

**Unaudited Condensed Consolidating Statement ofCash FlowsFor the Nine Months Ended September 30, 2005(In Thousands)**
| ** **                                                                                           | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                           | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                                                           | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
| **Operating  activities**                                                                            | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Net income  (loss)                                                                                   |       | $                      | (48,382    | )             | $          | (23,969          | )          | $                | 46,487     |   | $ | (25,864 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                   |       |          |       |             |       |             |       |
| Depreciation and amortization                                                                        |       | 16,354                 |       | —        |       | 9,938            |       | 26,292           |       |
| Other non-cash items                                                                                 |       | 883                    |       | 6,295         |       | 762              |       | 7,940            |       |
| Changes in operating assets and liabilities:                                                         |       |                   |       |          |       |             |       |             |       |
| Accounts receivable                                                                                  |       | —                 |       | —        |       | (4,643           | )          | (4,643           | )          |
| Account payable and accrued expenses                                                                 |       | 11,502                 |       | (3,671        | )          | (8,450           | )          | (619             | )          |
| Discontinued assets, net of liabilities                                                              |       | —                 |       | —        |       | 1,223            |       | 1,223            |       |
| Other operating assets and liabilities                                                               |       | 640                    |       | —        |       | (1,059           | )          | (419             | )          |
| Total cash  provided by (used in) operating activities                                               |       | (19,003                | )          | (21,345       | )          | 44,258           |       | 3,910            |       |
|                                                                                                 |       |                   |       |          |       |             |       |             |       |
| **Investing  activities**                                                                            | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Purchase of  assets held for sale, net of liabilities                                                |       | (216                   | )          | —        |       | —           |       | (216             | )          |
| Purchases of  available-for-sale securities                                                          |       | (29,744                | )          | —        |       | —           |       | (29,744          | )          |
| Proceeds from  sales of available-for-sale securities                                                |       | 20,315                 |       | —        |       | —           |       | 20,315           |       |
| Purchases of  property and equipment                                                                 |       | (9,566                 | )          | —        |       | (4,607           | )          | (14,173          | )          |
| Cash paid for  customer installation costs                                                           |       | (5,314                 | )          | —        |       | (4,789           | )          | (10,103          | )          |
| Proceeds from  sale of assets                                                                        |       | 238                    |       | —        |       | —           |       | 238              |       |
| Total cash used  in investing activities                                                             |       | (24,287                | )          | —        |       | (9,396           | )          | (33,683          | )          |
|                                                                                                 |       |                   |       |          |       |             |       |             |       |
| **Financing  activities**                                                                            |       |                   |       |          |       |             |       |             |       |
| Payments made on  notes and capital lease obligations                                                |       | (1,527                 | )          | (49,176       | )          | (77              | )          | (50,780          | )          |
| Proceeds from issuance  of stock, net of fees                                                        |       | 68,583                 |       | —        |       | —           |       | 68,583           |       |
| Increase in debt  issuance costs                                                                     |       | —                 |       | (348          | )          | —           |       | (348             | )          |
| Change in due  to/from affiliates                                                                    |       | (36,264                | )          | 70,869        |       | (34,605          | )          | —           |       |
| Total cash  provided by (used in) financing activities                                               |       | 30,792                 |       | 21,345        |       | (34,682          | )          | 17,455           |       |
|                                                                                                 |       |                   |       |          |       |             |       |             |       |
| Increase  (decrease) in cash and cash equivalents                                                    |       | (12,498                | )          | —        |       | 180              |       | (12,318          | )          |
| Cash and cash  equivalents at beginning of period                                                    |       | 26,332                 |       | —        |       | 103              |       | 26,435           |       |
| Cash and cash  equivalents at end of period                                                          |       | $                      | 13,834     |          | $          | —           |       | $                | 283        |   | $ | 14,117 |   |

 

19

----

 

**Unaudited Condensed Consolidating Statement ofCash FlowsFor the Nine Months Ended September 30, 2006(In Thousands)**
| ** **                                                                                           | ** ** | ** **             | ** ** | **Eschelon**  | ** ** | ** **       | ** ** | ** **       | ** ** |
|------------------------------------------------------------------------------------------------------|------------|------------------------|------------|---------------|------------|------------------|------------|------------------|------------|
| ** **                                                                                           | ** ** | **Eschelon**           | ** ** | **Operating** | ** ** | **Guarantor**    | ** ** | ** **       | ** ** |
| ** **                                                                                           | ** ** | **Telecom, Inc.** | ** ** | **Company**   | ** ** | **Subsidiaries** | ** ** | **Consolidated** | ** ** |
| **Operating  activities**                                                                            | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Net income  (loss)                                                                                   |       | $                      | (55,032    | )             | $          | (11,975          | )          | $                | 64,217     |   | $ | (2,790 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by (used in) operating  activities: |       |                   |       |          |       |             |       |             |       |
| Depreciation and amortization                                                                        |       | 17,200                 |       | —        |       | 13,610           |       | 30,810           |       |
| Other non-cash items                                                                                 |       | 1,097                  |       | 3,194         |       | 1,283            |       | 5,574            |       |
| Changes in operating assets and liabilities:                                                         |       |                   |       |          |       |             |       |             |       |
| Accounts receivable                                                                                  |       | —                 |       | —        |       | (1,742           | )          | (1,742           | )          |
| Account payable and accrued expenses                                                                 |       | (971                   | )          | (2,067        | )          | (2,478           | )          | (5,516           | )          |
| Other operating assets and liabilities                                                               |       | (10,275                | )          | —        |       | (1,433           | )          | (11,708          | )          |
| Total cash  provided by (used in) operating activities                                               |       | $                      | (47,981    | )             | $          | (10,848          | )          | $                | 73,457     |   | $ | 14,628 |   |
|                                                                                                 |       |                   |       |          |       |             |       |             |       |
| **Investing  activities**                                                                            | ** ** | ** **             | ** ** | ** **    | ** ** | ** **       | ** ** | ** **       | ** ** |
| Purchases of  subsidiaries, net of cash acquired                                                     |       | (20,305                | )          | —        |       | 312              |       | (19,993          | )          |
| Purchases of available-for-sale  securities                                                          |       | (84,468                | )          | —        |       | —           |       | (84,468          | )          |
| Proceeds from  sales of available-for-sale securities                                                |       | 20,800                 |       | —        |       | —           |       | 20,800           |       |
| Purchases of  property and equipment                                                                 |       | (17,946                | )          | —        |       | (2,510           | )          | (20,456          | )          |
| Cash paid for  customer installation costs                                                           |       | (6,357                 | )          | —        |       | (5,111           | )          | (11,468          | )          |
| Proceeds from  sale of assets                                                                        |       | 112                    |       | —        |       | —           |       | 112              |       |
| Total cash used  in investing activities                                                             |       | (108,164               | )          | —        |       | (7,309           | )          | (115,473         | )          |
|                                                                                                 |       |                   |       |          |       |             |       |             |       |
| **Financing  activities**                                                                            |       |                   |       |          |       |             |       |             |       |
| Proceeds from  issuance of notes payable                                                             |       | —                 |       | 45,600        |       | —           |       | 45,600           |       |
| Payments made on  notes and capital lease obligations                                                |       | (1,889                 | )          | —        |       | (82              | )          | (1,971           | )          |
| Proceeds from  issuance of stock, net of fees                                                        |       | 40,250                 |       | —        |       | —           |       | 40,250           |       |
| Increase in debt  issuance costs                                                                     |       | —                 |       | (1,336        | )          | —           |       | (1,336           | )          |
| Change in due  to/from affiliates                                                                    |       | 99,722                 |       | (33,416       | )          | (66,306          | )          | —           |       |
| Total cash  provided by (used in) financing activities                                               |       | 138,083                |       | 10,848        |       | (66,388          | )          | 82,543           |       |
|                                                                                                 |       |                   |       |          |       |             |       |             |       |
| Increase  (decrease) in cash and cash equivalents                                                    |       | (18,062                | )          | —        |       | (240             | )          | (18,302          | )          |
| Cash and cash  equivalents at beginning of period                                                    |       | 25,070                 |       | —        |       | 992              |       | 26,062           |       |
| Cash and cash  equivalents at end of period                                                          |       | $                      | 7,008      |          | $          | —           |       | $                | 752        |   | $ | 7,760 |   |

 

20

----

**6.)   SubsequentEvents**

On October 1, 2006, wecompleted our acquisition of OneEighty Communications, Inc. (OneEighty), acompetitive services provider headquartered in Billings, Montana. We paidapproximately $9,900 in cash to acquire OneEighty.

On November 1, 2006, wecompleted our acquisition of Mountain Telecommunications, Inc. (MTI), acompetitive services provider headquartered in Tempe, Arizona. We paidapproximately $40,400 in cash to acquire MTI.

21

----

 

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

## **Forward-Lookingand Cautionary Statements**

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

Forward-lookingstatements, such as those regarding management’s present plans or expectationsfor new product offerings, capital expenditures, cost-saving strategies andgrowth are not guarantees of future performance. They involve risks anduncertainties relative to return expectations and related allocation ofresources, and changing economic or competitive conditions, as well as thenegotiation of agreements with third parties and other factors discussedherein, which could cause actual results to differ from present plans orexpectations, and such differences could be material. Similarly,forward-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 bematerial. All forward-looking statements attributable to us or by any personsacting on our behalf are expressly qualified in their entirety by thesecautionary statements.

As such, actual resultsor circumstances may vary materially from such forward-looking statements orexpectations. Readers are also cautioned not to place undue reliance on theseforward-looking statements which speak only as of the date these statementswere made. Except as required by law, we do not have any obligation to updatethese forward-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 45 markets in the western United States. As a facilities-basedcompetitive communications services provider, we provide services to ourcustomers primarily through our own network of telecommunications switches andrelated equipment and leased telecommunications lines, or transport. We targetthe small and medium-sized business segment and currently serve approximately60,000 customers, primarily within the local service territory of Qwest.

We measure ouroperational performance using a variety of indicators including revenue growth,the percentage of our revenue that comes from customers that we serve on ourswitch, 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. We believe we compete principally by offeringsuperior customer service, accurate billing, a broad set of services andsystems and competitive pricing. We compete with the Regional Bell OperatingCompanies (RBOCs), other competitive communications services providers, andlong distance and data service providers. While wireless providers arecompeting with us, we do not believe they are a significant competitive threatin the markets we serve nor are they likely to be in the near future, becausebusiness customers require different service standards.

**Key Components of Results of Operations**

***Revenue.***  Networkservices revenue consists primarily of local telephone service, long distanceservice, carrier access charges, and data and Internet access services. Revenuefrom local telephone service consists of charges for basic local dial-toneservice, including dedicated T1 access, and custom-calling features suchas call waiting and call forwarding. Revenue from long distance serviceconsists of flat rated and per-minute-of-use charges for a full range oftraditional switched and dedicated long distance, toll-free calling,international calling, calling card and operator services. Carrier accessrevenue consists primarily of usage charges that we bill long distance carriersto originate and terminate calls to and from our customers. In addition, insome of our markets we currently charge other local exchange carriers andwireless carriers usage charges to terminate local and wireless calls to ourcustomers (otherwise known as reciprocal compensation). Revenue from data

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and Internet access services consists primarily of monthly usage feesfor DSL and T1 circuits and Internet access services. We typically commit ourcustomers to contracts ranging from one to three years and provide discountsfor longer terms. Network services revenue comprised 89.0% of our total revenuefor the nine months ended September 30, 2006, and represents a predominantlyrecurring revenue stream.

Monthly recurring network services revenue is recognized in the monththe services are used. In the case of local service revenue, monthly recurringlocal services charges are billed in advance but accrued for and recognized ona prorated basis based on length of service in any given month. Non-recurringrevenues associated with line installations are recognized over the averagelife of the customers. Long distance and carrier access usage charges arebilled in arrears but accrued based on monthly average usage. Prior to 2005, wehad not historically received any revenues from reciprocal compensation due toour bill-and-keep arrangement with Qwest. As a result of the acquisition ofAdvanced TelCom, Inc. (ATI), which was not under a bill-and-keep arrangementwith the RBOCs, and our negotiated reciprocal compensation agreements with afew wireless carriers, we recorded approximately $0.2 million and $0.6 millionof reciprocal compensation revenue for the three and nine month periods endedSeptember 30, 2006, respectively. We do not have any wholesale revenue otherthan carrier access revenue and this reciprocal compensation.

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

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

·                  leasing localloops and digital T1 lines which connect our customers to our network;

·                  leasing highcapacity digital lines that connect our switching equipment to our colocations;

·                  leasing highcapacity digital lines that interconnect our network with the RBOCs;

·                  leasing space,power and terminal connections in the RBOC central offices for colocating ourequipment;

·                  signaling systemnetwork connectivity;

·                  leasing our ATMlong-haul Internet backbone network; and

·                  Internet transitand 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 elementsplatform, or UNE-P, from Qwest and Verizon, and customized network elementpackages, 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 Centrexwere regulated and established by the various state corporation or utilitycommissions. We entered into agreements with Qwest and Verizon for UNE-Preplacement products in 2005. As of September 30, 2006, we had approximately87,000 access lines in service that were formerly categorized as UNE-P accesslines and are now provided under commercial agreements. The Qwest UNE-Eagreement was terminated with the adoption of Qwest’s commercial UNE-Preplacement product, QPP, and all Qwest UNE-E lines were moved to QPP onJanuary 1, 2005. We have incurred higher costs in 2006 to obtain access tocertain elements of telecommunications platforms as a result of the TriennialReview Remand Order (TRRO). We will continue to migrate QPP lines to ourswitches as resources permit to help mitigate the increased costs.

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Our network services expense also includes the fees we pay for longdistance, data and other services. We have entered into wholesale purchasingagreements for these services. Some of the agreements contain significanttermination penalties and/or minimum usage volume commitments. In the event wefail to meet minimum volume commitments, we may be obligated to payunderutilization charges. We do not anticipate having to pay anyunderutilization charges in the foreseeable future.

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

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

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

***Sales, General andAdministrative.***  Sales, general and administrative expensesare comprised primarily of 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 that involvesreviewing the customer’s current service provider bill and payment history,matching customers with the National Telecommunications Data Exchange databasefor delinquent customers and, in some cases, requesting credit reviews throughDun and Bradstreet. For the nine months ended September 30, 2005 and 2006, ourbad debt expense as a percentage of revenue was 0.4% and 0.6%, 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 to determinelabor capitalization. These time studies are based on employee time sheets forthose 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, long distance and Internet access servicesin Oregon to approximately 9,000 business customers that have approximately53,000 access lines. We paid approximately $20.3 million in cash to acquireOTI.

We expect to develop and benefit from synergies as we integrate OTI intoour operations. We estimate we will incur integration expenses of approximately$0.6 million as we integrate OTI’s operations and migrate OTI’s resale lines toour network. We expect to spend approximately $4.7 million for capitalexpenditures for switch hardware and software for the increased on-switch linesand for computer hardware and software necessary to integrate and operate OTI.

On October 1, 2006, wecompleted our acquisition of OneEighty Communications, Inc. (OneEighty), acompetitive services provider headquartered in Billings, Montana. OneEightyprovides local, long distance and Internet access services in Montana toapproximately 1,500 business customers that have approximately 16,000 accesslines. We paid approximately $9.9 million in cash to acquire OneEighty.

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On November 1, 2006, wecompleted our acquisition of Mountain Telecommunications, Inc. (MTI), acompetitive services provider headquartered in Tempe, Arizona. MTI provideslocal, long distance and Internet access services in Arizona to approximately1,100 business customers that have approximately 41,000 access lines. We paidapproximately $40.4 million in cash to acquire MTI.

We expect to develop and benefit from synergies as we integrateOneEighty and MTI into our operations. We estimate we will incur $1.0 - $2.0million integrating MTI and less than $0.3 million integrating OneEighty.

In quarters subsequent to the quarter ended September 30, 2006, weexpect revenue, network services expenses, operating expenses and capitalexpenditures to increase as a result of the acquisition of OneEighty and MTI.

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## **Resultsof Operations**

Selectedconsolidated financial and operating data for the three and nine-month periodsended September 30, 2005 and 2006 is as follows (dollars in thousands, exceptper unit amounts):
|                                                                             | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                                                 | ** ** | **2006**                                                | ** ** | **% Change** | ** ** | **2005** | ** ** | **2006** | ** ** | **% Change** | ** ** |
| ** **                                                                  | ** ** | **(unaudited)**                                          | ** ** | **(unaudited)**                                         | ** ** | ** ** | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** ** | ** ** |
| Total revenue                                                               |       | $                                                        | 57,912     |                                                    | $          | 69,806 |   | 20.5 | % | $ | 169,366 |   | $ | 197,782 |   | 16.8 | % |
| Capital  expenditures                                                       |       | $                                                        | 8,697      |                                                    | $          | 12,781 |   | 46.9 | % | $ | 27,061 |   | $ | 33,404 |   | 23.4 | % |
| Cash, restricted  cash and available-for-sale securities (at end of period) |       | $                                                        | 30,824     |                                                    | $          | 76,965 |   | 149.7 | % | $ | 30,824 |   | $ | 76,965 |   | 149.7 | % |
|                                                                        |       |                                                     |       |                                                    |       |   |   |   |   |   |   |   |   |
| Voice lines in  service (at end of period)                                  |       | 265,132                                                  |       | 322,702                                                 |       | 21.7 | % | 265,132 |   | 322,702 |   | 21.7 | % |
| Data lines in  service (at end of period)                                   |       | 140,744                                                  |       | 191,190                                                 |       | 35.8 | % | 140,744 |   | 191,190 |   | 35.8 | % |
| Total lines in  service (at end of period)                                  |       | 405,876                                                  |       | 513,892                                                 |       | 26.6 | % | 405,876 |   | 513,892 |   | 26.6 | % |
| Percent of lines  on switch (at end of period)                              |       | 84.6                                                     | %          | 83.0                                                    | %          | (1.9 | )% | 84.6 | % | 83.0 | % | (1.9 | )% |
| Lines sold                                                                  |       | 29,043                                                   |       | 39,782                                                  |       | 37.0 | % | 82,318 |   | 106,865 |   | 29.8 | % |
| Average monthly  access line churn (%)                                      |       | 1.20                                                     | %          | 1.10                                                    | %          | (7.8 | )% | 1.36 | % | 1.36 | % | 0.1 | % |
| Average monthly  network services revenue per line                          |       | $                                                        | 42.31      |                                                    | $          | 40.91 |   | (3.3 | )% | $ | 42.37 |   | $ | 41.27 |   | (2.6 | )% |
|                                                                        |       |                                                     |       |                                                    |       |   |   |   |   |   |   |   |   |
| Total employees  (at end of period)                                         |       | 1,109                                                    |       | 1,250                                                   |       | 12.7 | % | 1,109 |   | 1,250 |   | 12.7 | % |
| Quota-carrying  network service salespeople (at end of period)              |       | 191                                                      |       | 268                                                     |       | 40.3 | % | 191 |   | 268 |   | 40.3 | % |
| Quota-carrying  BTS salespeople (at end of period)                          |       | 39                                                       |       | 41                                                      |       | 5.1 | % | 39 |   | 41 |   | 5.1 | % |
| Total quota-carrying  salespeople (at end of period)                        |       | 230                                                      |       | 309                                                     |       | 34.3 | % | 230 |   | 309 |   | 34.3 | % |

 

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

***Revenue.*** Revenue for the three months ended September 30, 2005 and 2006 is asfollows:
|                            | ** ** | **2005**        | ** ** | **2006**        | ** ** | **% Change** | ** ** |
|----------------------------|------------|-----------------|------------|-----------------|------------|-------------------|------------|
| ** **                 | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **        | ** ** |
| Revenue (in  millions):    | ** ** | ** **      |       |            |       |              |       |
| Voice and data services    |       | $               | 39.0       |            | $          | 47.4              |       | 21.5 | % |
| Long distance              |       | 8.8             |       | 10.7            |       | 22.1              | %          |
| Access                     |       | 3.4             |       | 4.3             |       | 25.8              | %          |
| Total network services     |       | 51.2            |       | 62.4            |       | 21.9              | %          |
| Business telephone systems |       | 6.7             |       | 7.4             |       | 10.4              | %          |
| Total revenue              |       | $               | 57.9       |            | $          | 69.8              |       | 20.5 | % |

 

Network servicesrevenue was $62.4 million for the three months ended September 30, 2006, anincrease of 21.9% from $51.2 million in the same period of 2005. The revenuegrowth is primarily due to the inclusion of OTI, which was acquired on April 1,2006, and organic line growth. Over the past 12 months the number of voicelines in service increased by 21.7% to 322,702 at September 30, 2006 and thenumber of data lines in service increased by 35.8% to 191,190 at September 30,2006. The revenue growth associated with access line growth was partiallyoffset by a decline in data revenue per line due to a combination of customerspurchasing more bandwidth at discounted prices and general pricing pressuresfor data services in our markets. We increased our network services sales forcefrom 191 associates at September 30, 2005, to 268 associates at September 30,2006. We expect this increase in sales associates will favorably impact ourlines in service and revenue over the next several quarters.

Business telephonesystems (BTS) revenue was $7.4 million for the three months ended September 30,2006, an increase of 10.4% from $6.7 million in the same period of 2005. The increase in BTS revenue was primarilythe result of increased new system sales and revenue from change orders. We

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cannotpredict the future trends in capital spending by small and medium-sizedbusiness customers, which drives our BTS business.

***NetworkService Expense.*** Network services expense was $25.7 million for the three months endedSeptember 30, 2006, an increase of 24.3% from $20.7 million in the same periodof 2005. The increase is due to the inclusion of OTI and to organic linegrowth. As a percentage of related revenue, network services expense for thethree months ended September 30, 2006, increased to 41.3% from 40.4% for thesame period of 2005 due to the addition of OTI and higher costs associated withTRRO. OTI’s network services expenses are a higher percentage of revenue thanours due to the lack of network facilities. We plan to migrate a portion of OTI’slines to our network over the next 24 months in order to lower costs.

***BTSCost of Revenue.*** BTS cost of revenue was $4.6 million for the three months endedSeptember 30, 2006, an increase of 12.8% from $4.1 million in the same periodof 2005. The increase in BTS cost ofrevenue over the same period as last year is due to the increase in materialsexpense to support the higher level of revenue. As a percentage ofrelated revenue, BTS cost of revenue for the three months ended September 30,2006 increased to 62.1% from 60.8% for the same period of 2005. We do notexpect future improvements in BTS cost of revenue as a percentage of relatedrevenue unless we are able to significantly increase BTS new systems sales andtherefore achieve greater volume discounts or economies of scale in ourworkforce.

***Sales,General and Administrative Expense.***  Sales, general and administrative expenseswere $25.8 million for the three months ended September 30, 2006, an increaseof 15.5% from $22.4 million in the same period of 2005. The increase is due toa number of factors including: 1) the inclusion of OTI, which was acquired onApril 1, 2006, 2) an increase in costs associated with our sales forceexpansion, 3) an increase in operating taxes, 4) costs associated with being apublic company, and 5) an increase in expense related to share-basedcompensation. As a percentage of revenue, sales, general and administrativeexpenses for the three months ended September 30, 2006, declined to 37.0% from38.6% in the same period of 2005 due to the improved efficiency of our existingoperations resulting from our largely fixed cost structure supporting a higherlevel of revenue. Our sales, general and administrative expenses are largelyfixed as they are driven by the 1,250 associates that were employed atSeptember 30, 2006. We expect expenses as a percentage of revenue to continueto decline.

***Depreciationand Amortization.*** Depreciation and amortization expense was $10.8 million for the threemonths ended September 30, 2006, an increase of 20.3% from $9.0 million in thesame period of 2005. This increase was primarily due to the amortizationrelated to the $9.7 million of intangible assets purchased in the ATI and OTIacquisitions and from the depreciation on the $42.2 million of capitalexpenditures over the past 12 months. As a percentage of revenue, depreciationand amortization decreased to 15.5% for the three months ended September 30,2006 from 15.6% for the same period of 2005.

***Interest.***  Interest expense was $4.8 million for thethree months ended September 30, 2006, a decrease of 67.7% from $14.8 millionin the same period of 2005. The decrease was primarily due to 2005 including$10.2 million of interest expense related to the partial redemption of ournotes in September 2005. Partially offsetting this is higher interest as aresult of having a higher average outstanding debt balance for the three monthsended September 30, 2006 compared to the three months ended September 30, 2005.

***NetIncome (Loss).***  Netloss for the three months ended September 30, 2006, was $0.6 million comparedto a net loss of $12.5 million in the same period of 2005. This improvement isprimarily due to the reduction in interest expense mentioned above and to theincrease in revenue.

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**NineMonths Ended September 30, 2006 Compared to Nine Months Ended September 30,2005**

***Revenue.*** Revenue for the nine months ended September 30, 2005 and 2006 is asfollows:
|                             | ** ** | **2005**        | ** ** | **2006**        | ** ** | **% Change** | ** ** |
|-----------------------------|------------|-----------------|------------|-----------------|------------|-------------------|------------|
| ** **                  | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **        | ** ** |
| Revenue (in millions):      | ** ** | ** **      |       |            |       |              |       |
| Voice and data  services    |       | $               | 114.1      |            | $          | 132.8             |       | 16.3 | % |
| Long distance               |       | 26.0            |       | 30.9            |       | 18.9              | %          |
| Access                      |       | 9.8             |       | 12.4            |       | 26.4              | %          |
| Total network  services     |       | 149.9           |       | 176.1           |       | 17.4              | %          |
| Business  telephone systems |       | 19.4            |       | 21.7            |       | 11.7              | %          |
| Total revenue               |       | $               | 169.3      |            | $          | 197.8             |       | 16.8 | % |

 

Network servicesrevenue was $176.1 million for the nine months ended September 30, 2006, anincrease of 17.4% from $149.9 million in the same period of 2005. The revenuegrowth is primarily due to the inclusion of OTI, which was acquired on April 1,2006, and organic line growth. Over the past 12 months the number of voicelines in service increased by 21.7% to 322,702 at September 30, 2006 and thenumber of data lines in service increased by 35.8% to 191,190 at September 30,2006. The revenue growth associated with access lines growth was partiallyoffset by declines in data revenue per line due to a combination of customerspurchasing more bandwidth at discounted prices and general pricing pressuresfor data services in our markets. We increased our network services sales forcefrom 191 associates at September 30, 2005, to 268 associates at September 30,2006. We expect this increase in sales associates will favorably impact ourlines in service and revenue over the next several quarters.

BTS revenue was$21.7 million for the nine months ended September 30, 2006, an increase of11.7% from $19.4 million in the same period of 2005. The increase in BTS revenue was primarily the result of increased newsystem sales and revenue from change orders. We cannot predict the futuretrends in capital spending by small and medium-sized business customers, whichdrives our BTS business.

***NetworkServices Expense.*** Network services expense was $71.3 million for the nine months endedSeptember 30, 2006, an increase of 8.6% from $65.6 million in the same periodof 2005. 2005 includes $4.7 million in costs related to the settlement withGlobal Crossing in June 2005, which is described in our Form 10-K filed withthe SEC on March 17, 2006. 2006 includes network costs associated with OTI,which was acquired April 1, 2006. We continue to experience improvements innetwork services expense relative to the growth in network services revenue dueto several factors, including 1) our continued focus on selling high marginT1-based products, 2) continued higher churn of lower margin analog-basedproducts, 3) favorable negotiation of wholesale long distance costs, and 4)efficiencies associated with the integration of ATI and OTI. These improvementswere partially offset by the inclusion of OTI and higher costs associated withTRRO. OTI’s network services expenses are a higher percentage of revenue thanours due to the lack of network facilities. We plan to migrate a portion of OTI’slines to our network over the next 24 months in order to lower costs. As apercentage of related revenue, network services expense for the nine monthsended September 30, 2006, decreased to 40.5% from 43.8% for the same period of2005.

***BTSCost of Revenue.*** BTS cost of revenue was $13.6 million for the nine months endedSeptember 30, 2006, an increase of 14.0% from $11.9 million in the same periodof 2005. The increase in BTS cost ofrevenue over the same period as last year is due to the increase in materialsexpense to support the higher level of revenue. As a percentage ofrelated revenue, BTS cost of revenue for the nine months ended September 30,2006 increased to 62.6% from 61.3% for the same period of 2005. We do notexpect future improvements in BTS cost of revenue as a percentage of relatedrevenue unless we are able to significantly increase BTS new systems sales andtherefore achieve greater volume discounts or economies of scale in ourworkforce.

***Sales,General and Administrative Expense.***  Sales, general and administrative expenses were$74.5 million for the nine months ended September 30, 2006, an increase of 9.9%from $67.8 million in the same period of 2005. The increase is due to a numberof factors including 1) the inclusion of OTI, which was acquired on April 1,2006, 2) an increase in costs associated with the sales force expansion, 3) anincrease in bad debt expense and operating taxes, 4) costs associated withbeing a public company, and 5) an increase in expense related to share-basedcompensation. As a percentage of revenue, sales, general and

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administrative expensesfor the nine months ended September 30, 2006, declined to 37.7% from 40.0% inthe same period of 2005 due to the improved efficiency of our existingoperations resulting from our largely fixed cost structure supporting a higherlevel of revenue. Our sales, general and administrative expenses are largelyfixed as they are driven by the 1,250 associates that were employed atSeptember 30, 2006. We expect expenses as a percentage of revenue to continueto decline.

***Depreciationand Amortization.*** Depreciation and amortization expense was $30.8 million for the ninemonths ended September 30, 2006, an increase of 17.2% from $26.3 million in thesame period of 2005. This increase was primarily due to the amortization relatedto the $9.7 million of intangible assets purchased in the ATI and OTIacquisitions and from the depreciation on the $42.2 million of capitalexpenditures over the past 12 months. As a percentage of revenue, depreciationand amortization increased to 15.6% for the nine months ended September 30,2006 from 15.5% for the same period of 2005.

***Interest.***  Interest expense was $12.8 million for thenine months ended September 30, 2006, a decrease of 47.9% from $24.6 million inthe same period of 2005. The decrease was primarily due to 2005 including $10.2million of interest expense related to the partial redemption of our notes inSeptember 2005. The decrease was also due to lower interest expense as a resultof having a lower average outstanding debt balance for the nine months endedSeptember 30, 2006 compared to the nine months ended September 30, 2005.

***NetLoss.***  Net loss forthe nine months ended September 30, 2006, was $2.8 million compared to a netloss of $25.9 million in the same period of 2005. This improvement is primarilydue to the increase in revenue, lower interest expense and the improvements incosts and expenses as a percentage of revenue.

## **Liquidityand Capital Resources**

***PrincipalSources and Uses of Liquidity.* **Ourprincipal sources of liquidity are cash from operations and our cash and cashequivalents and available-for-sale securities. We received net proceeds of$44.3 million from the offering of our 8 3/8% senior second secured notes due2010 on March 29, 2006. In May 2006, we completed an offering of 2,550,000shares of our common stock, $0.01 par value, at $15.70 per share. We receivednet proceeds of approximately $40.0 million after deducting associated fees andexpenses. The net proceeds from the offerings provided additional liquidity forfunding the OTI acquisition, the OneEighty acquisition and the MTI acquisition.Our principal liquidity requirements consist of debt service, capitalexpenditures and working capital.

***CashFlows Provided by Operating Activities. ***Cashprovided by operating activities was $14.6 million for the nine months endedSeptember 30, 2006 compared to cash provided by operating activities of $3.9million for the same period of 2005. Theincrease in cash provided by operating activities is primarily due to improvementsin operating income and cash paid for interest. For the nine month periodending September 30, 2006 operating income increased by $9.9 million and cashpaid for interest decreased by $8.7 million as compared to the same period in2005. We expect that our cash provided by operating activities will continue toimprove as we grow revenue.

***CashFlows Used in Investing Activities.***  Cash used in investing activities was $115.5million for the nine months ended September 30, 2006 compared to $33.7 millionfor the same period of 2005. The increase is primarily due to an increase inpurchases of available-for-sale securities and the purchase of OTI. The amountinvested in available-for-sale securities, net of proceeds from sales ofsecurities, was $63.7 million for the nine months ended September 30, 2006,compared to $9.4 million in the same period of 2005. The investment in OTI was$20.0 million, net of cash acquired. Other uses of cash for investingactivities include the maintenance and expansion of our network and back officesystems.

***CashFlows Provided by Financing Activities.*** Cash provided byfinancing activities was $82.5 million for the nine months ended September 30,2006, compared to $17.5 million for the same period of 2005. On March 29, 2006,we completed an offering of $48.0 million in face amount of 8 3/8% seniorsecond secured notes due 2010 at a discount resulting in a 9.92% yield. Aportion of the $44.3 million in net proceeds from the offering was used tofinance the acquisition of Oregon Telecom, Inc. on April 1, 2006. On May 19,2006, we completed an offering of 2,550,000 shares of our common stockresulting in proceeds of $40.0 million after deducting fees and expenses. Wealso used cash for payments on capital lease obligations.

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***CapitalRequirements.***  Forthe nine months ended September 30, 2006, we spent $33.4 million on capitalexpenditures, of which $1.5 million was purchased under capital leases. Weexpect to spend approximately $45.0 - $48.0 million on capital expenditures in2006.

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

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

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

We are exposed to changesin interest rates on our investments in cash equivalents and short-terminvestments. However, interest income for the nine-month period ended June 30,2006 was $2.5 million, therefore not exposing us to any meaningful interestincome risk had rates dropped. We had $140.1 million in senior second securednotes outstanding as of September 30, 2006. These notes are at a fixed interestrate and are therefore not exposed to any interest rate risk.

# **Item 4:  Controls and Procedures**

*Evaluation of Disclosure Controlsand Procedures*

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

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

*Changes in Internal Controls OverFinancial Reporting*

We continue to evaluatethe design and test the effectiveness of our internal controls over financialreporting in accordance with the requirements of Section 404 of theSarbanes-Oxley Act of 2002. As part of that effort, we have enhanced oraugmented certain internal controls as management deemed necessary. However,there have been no changes in our internal controls over financial reportingduring our most recent fiscal quarter that have had an adverse material affect,or are reasonably likely to have an adverse material affect, on our internalcontrols over financial reporting.

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# **PART II. OTHER INFORMATION**

# **Item 1. Legal Proceedings**

There are no materialdevelopments since our quarterly report on Form 10-Q for the period ended June30, 2006 filed on August 11, 2006.

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

# **Item 1A. Risk Factors**

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

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

On March 29, 2006, wecompleted a $48.0 million tack-on offering of our senior second secured notesat a discount resulting in a 9.92% yield. After deducting fees and expensesassociated with the offering, our net proceeds were $44.3 million. Ouracquisition of OTI on April 1, 2006, was financed with $20.3 million of the netproceeds from the offering. Our acquisition of OneEighty on October 1, 2006,was financed with $9.9 million of the net proceeds from the offering. Ouracquisition of MTI on November 1, 2006 was partially financed with theremaining proceeds of $14.1 million.

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. After deducting fees and expenses related tothe offering, we received net proceeds of $40.0 million. Our acquisition of MTIon November 1, 2006 was partially financed with $26.3 million of the proceedsfrom the offering. The remaining proceeds will be used to fund potential futureacquisitions and for general corporate purposes.

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

None.

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

# None.

# **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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*                    Filedherewith.

†                     Furnishedherewith.

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## **SIGNATURE**

Pursuant to the requirementsof the Securities Exchange Act of 1934, the registrant has duly caused thisreport to be signed on its behalf by the undersigned thereunto duly authorized.
|                         | Eschelon Telecom, Inc. |
|-------------------------|------------------------|
|                    |                   |
| Date: November 13, 2006 | By:                    | /S/ Geoffrey M. Boyd |   |
|                    |                   |   |   |
|                    | Name:                  | Geoffrey M. Boyd |   |
|                    | Title:                 | Chief Financial Officer  (Principal Financial and  Accounting Officer and Duly  Authorized Officer) |

 

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