**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

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

 

----

 

**FORM 10-Q**

 

**(MARK ONE)**

 
| **ý**                                             | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|--------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
|                                                   |       |                                                                                                    |
| **For the quarterly period ended March 31, 2005** |
|                                                   |       |                                                                                                    |
| **OR**                                                 |
|                                                   |       |                                                                                                    |
| **o**                                                  | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**Commission File Number 000-50706**

 

----

** **

**ESCHELON TELECOM, INC.**

(Exact name of registrant as specified in its charter)

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

 

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

 

----

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to the filingrequirements for the past 90 days.  Yes ý  No  o

 

Indicate bycheck mark whether the registrant is an accelerated filer as defined in Rule 12b-2of the Exchange Act.  Yes  o No  ý

 

As of May 11,2005, the number of outstanding shares of the Registrant’s Common Stock, parvalue $.01 per share, was 5,568,587 shares; the number of outstanding shares ofthe Registrant’s Series A Convertible Preferred Stock, par value $.01 pershare, was 77,526,136 shares, convertible into 97,032,770 shares of CommonStock; and the number of outstanding shares of the Registrant’s Series BConvertible Preferred Stock, par value $.01 per share, was 20,205,736 shares,convertible into 20,790,577 shares of Common Stock.

 

 

----

 

**ESCHELON TELECOM, INC.**

**INDEX TO FORM 10-Q**

 
| **PART I.  FINANCIAL INFORMATION** | 3                                                                                                        |
|-----------------------------------------|----------------------------------------------------------------------------------------------------------|
|                                    |                                                                                                     |   |
| Item 1.                                 | Financial Statements:                                                                                    | 3 |
|                                    |                                                                                                     |   |
|                                    | Consolidated Balance Sheets  – December 31, 2004 and March 31, 2005 (Unaudited)           | 3 |
|                                    |                                                                                                     |   |
|                                    | Unaudited  Consolidated Statements of Operations – Three months ended March 31,  2004 and 2005 | 4 |
|                                    |                                                                                                     |   |
|                                    | Unaudited  Consolidated Statements of Cash Flows – Three months ended March 31,  2004 and 2005 | 5 |
|                                    |                                                                                                     |   |
|                                    | Notes to  Consolidated Financial Statements                                                              | 6 |
|                                    |                                                                                                     |   |
| Item  2.                                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations              | 12 |
|                                    |                                                                                                     |   |
| Item  3.                                | Quantitative  and Qualitative Disclosures About Market Risk                                              | 19 |
|                                    |                                                                                                     |   |
| Item  4.                                | Controls  and Procedures                                                                                 | 19 |
|                                    |                                                                                                     |   |
| **PART II. OTHER  INFORMATION**    | 20                                                                                                       |
|                                    |                                                                                                     |   |
| Item 1.                                 | Legal Proceedings                                                                                        | 20 |
|                                    |                                                                                                     |   |
| Item 2.                                 | Unregistered Sales of Equity Securities and Use  of Proceeds                                             | 20 |
|                                    |                                                                                                     |   |
| Item 3.                                 | Defaults Upon Senior Securities                                                                          | 21 |
|                                    |                                                                                                     |   |
| Item 4.                                 | Submission of Matters to a Vote of Security  Holders                                                     | 21 |
|                                    |                                                                                                     |   |
| Item 5.                                 | Other Information                                                                                        | 21 |
|                                    |                                                                                                     |   |
| Item 6.                                 | Exhibits                                                                                                 | 21 |
|                                    |                                                                                                     |   |
| Signature                               | 22                                                                                                       |

 

2

----

 

**PART I.  FINANCIAL INFORMATION**

 

## **Item 1.  Financial Statements**

## ** **

**Eschelon Telecom, Inc.**

**Consolidated Balance Sheets**

**(InThousands, Except Share and Per Share Amounts)**

 
| ** **                                                                                                                                                                                                  | ** ** | **December 31,  2004** | ** ** | **March 31,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                                                                                  | ** ** | ** **                  | ** ** | **(Unaudited)**          | ** ** |
| **Assets**                                                                                                                                                                                                  |       |                        |       |                     |       |
| Current assets:                                                                                                                                                                                             |       |                        |       |                     |       |
| Cash and cash equivalents                                                                                                                                                                                   |       | $                           | 26,435     |                     | $          | 13,080 |   |
| Restricted cash                                                                                                                                                                                             |       | 722                         |       | 651                      |       |
| Available-for-sale securities                                                                                                                                                                               |       | 6,194                       |       | 12,753                   |       |
| Accounts receivable, net of allowance for  doubtful accounts of $817 and $715, respectively                                                                                                                 |       | 18,941                      |       | 19,156                   |       |
| Other receivables                                                                                                                                                                                           |       | 2,976                       |       | 2,891                    |       |
| Inventories                                                                                                                                                                                                 |       | 2,873                       |       | 3,252                    |       |
| Prepaid expenses                                                                                                                                                                                            |       | 2,410                       |       | 1,948                    |       |
| Discontinued assets held for sale                                                                                                                                                                           |       | —                      |       | 1,023                    |       |
| Total current assets                                                                                                                                                                                        |       | 60,551                      |       | 54,754                   |       |
|                                                                                                                                                                                                        |       |                        |       |                     |       |
| Property and equipment, net                                                                                                                                                                                 |       | 102,849                     |       | 102,960                  |       |
|                                                                                                                                                                                                        |       |                        |       |                     |       |
| Other assets                                                                                                                                                                                                |       | 1,985                       |       | 1,982                    |       |
| Goodwill                                                                                                                                                                                                    |       | 38,776                      |       | 38,776                   |       |
| Intangible assets, net                                                                                                                                                                                      |       | 32,958                      |       | 33,374                   |       |
| Total assets                                                                                                                                                                                                |       | $                           | 237,119    |                     | $          | 231,846 |   |
|                                                                                                                                                                                                        |       |                        |       |                     |       |
| **Liabilities and stockholders’ deficit**                                                                                                                                                              |       |                        |       |                     |       |
| Current liabilities:                                                                                                                                                                                        |       |                        |       |                     |       |
| Accounts payable                                                                                                                                                                                            |       | $                           | 8,375      |                     | $          | 8,536 |   |
| Accrued telecommunication costs                                                                                                                                                                             |       | 7,616                       |       | 8,403                    |       |
| Accrued office rent                                                                                                                                                                                         |       | 2,336                       |       | 2,282                    |       |
| Accrued interest expense                                                                                                                                                                                    |       | 4,070                       |       | 615                      |       |
| Accrued expenses                                                                                                                                                                                            |       | 5,998                       |       | 5,156                    |       |
| Deferred revenue                                                                                                                                                                                            |       | 7,300                       |       | 7,323                    |       |
| Accrued compensation expenses                                                                                                                                                                               |       | 3,588                       |       | 4,381                    |       |
| Capital lease obligation, current  maturities                                                                                                                                                               |       | 1,629                       |       | 1,369                    |       |
| Discontinued liabilities held for sale                                                                                                                                                                      |       | —                      |       | 807                      |       |
| Total current liabilities                                                                                                                                                                                   |       | 40,912                      |       | 38,872                   |       |
|                                                                                                                                                                                                        |       |                        |       |                     |       |
| Long-term liabilities:                                                                                                                                                                                      |       |                        |       |                     |       |
| Commitments and contingencies (See Note 5)                                                                                                                                                                  |       |                        |       |                     |       |
| Other long-term liabilities                                                                                                                                                                                 |       | 630                         |       | 772                      |       |
| Capital lease obligation, less current  maturities                                                                                                                                                          |       | 2,824                       |       | 3,215                    |       |
| Notes payable                                                                                                                                                                                               |       | 137,778                     |       | 138,718                  |       |
| Total liabilities                                                                                                                                                                                           |       | 182,144                     |       | 181,577                  |       |
|                                                                                                                                                                                                        |       |                        |       |                     |       |
| Series A convertible preferred stock,  $0.01 par value per share; 100,000,000 shares authorized; issued and  outstanding shares - 77,526,136 shares at December 31, 2004 and  March 31, 2005 |       | 48,155                      |       | 48,931                   |       |
|                                                                                                                                                                                                        |       |                        |       |                     |       |
| Series B convertible preferred stock,  $0.01 par value per share; 25,000,000 shares authorized; 20,000,000 shares  issued and outstanding at December 31, 2004 and March 31, 2005            |       | 15,000                      |       | 15,303                   |       |
|                                                                                                                                                                                                        |       |                        |       |                     |       |
| Stockholders’ deficit:                                                                                                                                                                                 |       |                        |       |                     |       |
| Common stock, $0.01 par value per share;  200,000,000 shares authorized; issued and outstanding shares - 4,758,518  shares at December 31, 2004; and 4,894,208 at March 31, 2005                  |       | 48                          |       | 49                       |       |
| Additional paid-in capital                                                                                                                                                                                  |       | 115,832                     |       | 114,777                  |       |
| Accumulated other comprehensive income                                                                                                                                                                      |       | 30                          |       | 55                       |       |
| Accumulated deficit                                                                                                                                                                                         |       | (124,056                    | )          | (128,824                 | )          |
| Deferred compensation                                                                                                                                                                                       |       | (34                         | )          | (22                      | )          |
| Total stockholders’ deficit                                                                                                                                                                            |       | (8,180                      | )          | (13,965                  | )          |
| Total liabilities and stockholders’ deficit                                                                                                                                                            |       | $                           | 237,119    |                     | $          | 231,846 |   |

 

*See accompanying notes.*

 

3

----

 

**Eschelon Telecom, Inc.**

**Unaudited Consolidated Statements ofOperations**

**(InThousands, Except Share and Per Share Amounts)**

 
| ** **                                           | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                           | ** ** | **2004**                               | ** ** | **2005** | ** ** |
| Revenue:                                             |       |                                   |       |   |   |
| Network services                                     |       | $                                      | 32,113     |   | $ | 48,668 |   |
| BTS                                                  |       | 6,083                                  |       | 5,865 |   |
| Total revenue                                        |       | 38,196                                 |       | 54,533 |   |
|                                                 |       |                                   |       |   |   |
| Cost of revenue:                                     |       |                                   |       |   |   |
| Network services                                     |       | 11,766                                 |       | 20,001 |   |
| BTS                                                  |       | 3,662                                  |       | 3,630 |   |
| Total cost of revenue                                |       | 15,428                                 |       | 23,631 |   |
|                                                 |       |                                   |       |   |   |
| Gross profit:                                        |       |                                   |       |   |   |
| Network services                                     |       | 20,347                                 |       | 28,667 |   |
| BTS                                                  |       | 2,421                                  |       | 2,235 |   |
| Total gross profit                                   |       | 22,768                                 |       | 30,902 |   |
|                                                 |       |                                   |       |   |   |
| Operating expenses:                                  |       |                                   |       |   |   |
| Sales, general and administrative                    |       | 16,442                                 |       | 22,365 |   |
| Depreciation and amortization                        |       | 7,934                                  |       | 8,574 |   |
| Operating loss                                       |       | (1,608                                 | )          | (37 | ) |
|                                                 |       |                                   |       |   |   |
| Other income (expense):                              |       |                                   |       |   |   |
| Interest income                                      |       | 11                                     |       | 131 |   |
| Interest expense                                     |       | (2,314                                 | )          | (4,862 | ) |
| Gain on extinguishment of debt                       |       | 18,195                                 |       | — |   |
| Other expense                                        |       | (1                                     | )          | — |   |
| Income (loss) before taxes                           |       | 14,283                                 |       | (4,768 | ) |
| Income taxes                                         |       | —                                 |       | — |   |
| Net income (loss)                                    |       | 14,283                                 |       | (4,768 | ) |
| Less preferred stock dividends                       |       | (854                                   | )          | (1,079 | ) |
| Net income (loss) applicable to common  stockholders |       | $                                      | 13,429     |   | $ | (5,847 | ) |
|                                                 |       |                                   |       |   |   |
| Net income (loss) per share:                         |       |                                   |       |   |   |
| Basic                                                |       | $                                      | 3.70       |   | $ | (1.38 | ) |
| Diluted                                              |       | $                                      | 0.19       |   | $ | (1.38 | ) |
|                                                 |       |                                   |       |   |   |
| Weighted average number of shares  outstanding:      |       |                                   |       |   |   |
| Basic                                                |       | 3,629,541                              |       | 4,246,275 |   |
| Diluted                                              |       | 106,786,128                            |       | 4,246,275 |   |

 

*See accompanying notes.*

 

4

----

 

**Eschelon Telecom, Inc.**

**Unaudited Consolidated Statements of CashFlows**

**(InThousands)**

 
| ** **                                                                                | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                | ** ** | **2004**                               | ** ** | **2005** | ** ** |
| **Operating activities**                                                                  |       |                                   |       |   |   |
| Net income (loss)                                                                         |       | $                                      | 14,283     |   | $ | (4,768 | ) |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities: |       |                                   |       |   |   |
| Depreciation and amortization expense                                                     |       | 7,934                                  |       | 8,574 |   |
| Other non-cash items                                                                      |       | 654                                    |       | 1,342 |   |
| Gain on extinguishment of debt                                                            |       | (18,195                                | )          | — |   |
| Changes in operating assets and  liabilities:                                             |       |                                   |       |   |   |
| Restricted cash                                                                           |       | —                                 |       | 71 |   |
| Accounts receivable                                                                       |       | (164                                   | )          | (302 | ) |
| Inventories                                                                               |       | (5                                     | )          | (379 | ) |
| Other current assets and deposits                                                         |       | 572                                    |       | 450 |   |
| Accounts payable and accrued expenses                                                     |       | 2,210                                  |       | (3,454 | ) |
| Deferred revenue                                                                          |       | 76                                     |       | 23 |   |
| Accrued compensation expense                                                              |       | (326                                   | )          | 793 |   |
| Net cash provided by operating activities                                                 |       | 7,039                                  |       | 2,350 |   |
|                                                                                      |       |                                   |       |   |   |
| **Investing activities**                                                                  |       |                                   |       |   |   |
| Purchases of available-for-sale securities                                                |       | —                                 |       | (14,134 | ) |
| Purchases of property and equipment                                                       |       | (3,916                                 | )          | (4,972 | ) |
| Cash paid for customer installation costs                                                 |       | (2,780                                 | )          | (3,343 | ) |
| Proceeds from sale of available-for-sale  securities                                      |       | —                                 |       | 7,646 |   |
| Purchase of net assets held for sale                                                      |       | —                                 |       | (216 | ) |
| Proceeds from sales of assets                                                             |       | 2                                      |       | 5 |   |
| Net cash used in investing activities                                                     |       | (6,694                                 | )          | (15,013 | ) |
|                                                                                      |       |                                   |       |   |   |
| **Financing activities**                                                                  |       |                                   |       |   |   |
| Proceeds from issuance of notes payable                                                   |       | 84,813                                 |       | — |   |
| Payments made on bank debt and capital  lease obligations                                 |       | (65,950                                | )          | (453 | ) |
| Proceeds from (fees associated with)  issuance of stock                                   |       | 2                                      |       | 1 |   |
| Increase in debt issuance costs                                                           |       | (4,220                                 | )          | (240 | ) |
| Net cash provided by (used in) financing  activities                                      |       | 14,645                                 |       | (692 | ) |
|                                                                                      |       |                                   |       |   |   |
| Net increase (decrease) in cash and cash  equivalents                                     |       | 14,990                                 |       | (13,355 | ) |
| Cash and cash equivalents at beginning of  period                                         |       | 8,606                                  |       | 26,435 |   |
| Cash and cash equivalents at end of period                                                |       | $                                      | 23,596     |   | $ | 13,080 |   |
| ** **                                                                                | ** ** | ** **                             | ** ** | ** ** | ** ** |
| **Supplemental cash flow information**                                                    |       |                                   |       |   |   |
| Cash paid for interest                                                                    |       | $                                      | 1,980      |   | $ | 3,643 |   |
|                                                                                      |       |                                   |       |   |   |
| **Supplemental noncash activities**                                                       |       |                                   |       |   |   |
| Equipment purchases under capital leases                                                  |       | $                                      | 345        |   | $ | 584 |   |
| Value of common stock issued to management  and certain members of board of directors     |       | $                                      | —     |   | $ | 24 |   |

 

*See accompanying notes.*

 

5

----

 

**Eschelon Telecom, Inc.**

**Notes to Consolidated Financial Statements**

**(InThousands, Except Share and Per Share Amounts)**

**(Unaudited)**

 

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

 

**Basis ofPresentation**

 

The accompanying unaudited consolidatedfinancial statements of Eschelon Telecom, Inc. and its subsidiaries (the “Company”)have been prepared in accordance with accounting principles generally acceptedin the United States of America for interim financial information and theinstructions to Form 10-Q and Article 10 of Regulation S-Xpromulgated by the United States Securities and Exchange Commission (the “SEC”).  Accordingly, they do not include all of theinformation and notes required by accounting principles generally accepted inthe United States of America for complete financial statements.  In the opinion of management, all adjustments(consisting of normal and recurring adjustments and accruals) considerednecessary for a fair presentation for the periods indicated have beenincluded.  Operating results for thethree-month period ended March 31, 2005 are not necessarily indicative ofthe results that may be expected for the year ending December 31,2005.  The consolidated balance sheet at December 31,2004 has been derived from the audited consolidated financial statements atthat date but does not include all of the information and footnotes required bygenerally accepted accounting principles for complete financialstatements.  These financial statementsshould be read in conjunction with the Company’s audited financial statementsand related notes thereto for the year ended December 31, 2004 included inthe Eschelon Telecom, Inc. Form 10-K filed with the Securities andExchange Commission on March 31, 2005.

 

## **Available-for-SaleSecurities**

## ** **

Short-term investments are comprised ofmunicipal and United States government debt securities with maturities of morethan three months but less than one year. In accordance with SFAS No. 115, *Accountingfor Certain Investments in Debt and Equity Securities*, and based onthe Company’s intentions regarding these instruments, all investments in debtsecurities are classified as available-for-sale and accounted for at fairvalue.  Fair value is determined byquoted market prices, with unrealized gains and losses reported as a separatecomponent of stockholders’ deficit.  TheCompany uses the specific identification of securities sold method to recognizerealized gains and losses in earnings.

 

6

----

 

The cost basis, fair value and grossunrealized gains of the investment securities available-for-sale as of March 31,2005 and December 31, 2004, are as follows:

 
| ** **                                                  | ** ** | **Cost Basis** | ** ** | **Fair Value** | ** ** | **Gross  Unrealized  Holding  Gains** | ** ** | **Gross  Unrealized  Holding  (Losses)** | ** ** |
|-------------------------------------------------------------|------------|----------------|------------|----------------|------------|---------------------------------------|------------|------------------------------------------|------------|
|                                                        |       |           |       |           |       |                                  |       |                                     |       |
| Available-for-sale securities as of  March 31, 2005    |       | $              | 12,698     |           | $          | 12,753                                |       | $                                        | 63         |   | $ | (8 | ) |
|                                                        |       |           |       |           |       |                                  |       |                                     |       |
| Available-for-sale securities as of  December 31, 2004 |       | $              | 6,164      |           | $          | 6,194                                 |       | $                                        | 30         |   | $ | — |   |

 

Debt securities as of March 31, 2005have maturities of six months or less.

 

## **Propertyand Equipment**

## ** **

Property and equipment, including leasehold improvements, are stated atcost.  All internal costs directlyrelated to the construction of the switches and operating and support systems,including compensation of certain employees, are capitalized.  Depreciation is provided using thestraight-line method over the estimated useful lives of the assets.  Leasehold improvements are amortized over theshorter of the related lease term or the estimated useful life of the asset.

 

Property and equipment consist of the following:

 
| ** **                                | ** ** | **December 31,  2004** | ** ** | **March 31,  2005** | ** ** |
|-------------------------------------------|------------|-----------------------------|------------|--------------------------|------------|
|                                      |       |                        |       |                     |       |
| Vehicles                                  |       | $                           | 590        |                     | $          | 810 |   |
| Office furniture and equipment            |       | 16,746                      |       | 17,394                   |       |
| Computer equipment and software           |       | 34,534                      |       | 36,157                   |       |
| Leasehold improvements                    |       | 19,504                      |       | 19,633                   |       |
| Switching and data equipment and software |       | 99,736                      |       | 102,566                  |       |
|                                      |       | 171,110                     |       | 176,560                  |       |
| Less accumulated depreciation             |       | (68,261                     | )          | (73,600                  | )          |
|                                      |       | $                           | 102,849    |                     | $          | 102,960 |   |

 

## **Goodwilland Other Intangible Assets**

## ** **

Goodwill represents the excess of cost over the fair value of netassets acquired.

 

Intangibles consist of customer installation costs, debt issuance costsand non-compete agreements.  The customerinstallation costs are being amortized over a period of 48 months, whichapproximates the average life of a customer contract.  Debt issuance costs are being amortized overthe term of the respective debt obligation. Non-compete agreement costs represent costs associated with variousagreements the Company has entered into with existing management of thecompanies it has acquired and a settlement agreement with a former employee ofthe Company.  These costs are being amortizedover the terms of the agreements.

 

Intangible assets consist of the following:

 
| ** **                    | ** ** | **December 31,  2004** | ** ** | **March 31,  2005** | ** ** |
|-------------------------------|------------|-----------------------------|------------|--------------------------|------------|
|                          |       |                        |       |                     |       |
| Customer installation costs   |       | $                           | 64,087     |                     | $          | 67,429 |   |
| Debt issuance costs           |       | 8,368                       |       | 8,608                    |       |
| Non-compete agreements        |       | 15                          |       | 315                      |       |
|                          |       | 72,470                      |       | 76,352                   |       |
| Less accumulated amortization |       | (39,512                     | )          | (42,978                  | )          |
|                          |       | $                           | 32,958     |                     | $          | 33,374 |   |

 

7

----

 

## **Stock-BasedCompensation**

## ** **

The Company accounts for its stock-based employee compensation underthe recognition and measurement principles of Accounting Principles Board (APB)Opinion No. 25, *Accounting for StockIssued to Employees,*and related interpretations.  Under APB No. 25, when the exerciseprice of stock options equals the market price of the underlying stock on thedate of grant, no compensation expense is recognized in the consolidatedstatement of operations.

 

The following table illustrates the effect on net income (loss) pershare if the company had applied the fair value recognition provision of Statementof Financial Accounting Standards (SFAS) No. 123, *Accountingfor Stock-Based Compensation,*to stock-based employee compensation:

 
| ** **                                                                                                        | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2004**                               | ** ** | **2005** | ** ** |
| Net income (loss) applicable to common stockholders,  as reported                                                 |       | $                                      | 13,429     |   | $ | (5,847 | ) |
| Add: Stock-based employee compensation expense  included in reported net income (loss)                            |       | 20                                     |       | 12 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value-based methods for all awards |       | (32                                    | )          | (17 | ) |
| Pro forma net income (loss) applicable to common  stockholders                                                    |       | $                                      | 13,417     |   | $ | (5,852 | ) |
|                                                                                                              |       |                                   |       |   |   |
| Net income (loss) per share:                                                                                      |       |                                   |       |   |   |
| Basic - as reported                                                                                               |       | $                                      | 3.70       |   | $ | (1.38 | ) |
| Basic - pro forma                                                                                                 |       | $                                      | 3.70       |   | $ | (1.38 | ) |
|                                                                                                              |       |                                   |       |   |   |
| Diluted - as reported                                                                                             |       | $                                      | 0.19       |   | $ | (1.38 | ) |
| Diluted - pro forma                                                                                               |       | $                                      | 0.19       |   | $ | (1.38 | ) |

 

Pro forma information regarding net income (loss) and net income (loss)per share is required by SFAS No. 123, and has been determined as if theCompany had accounted for its employee stock options under the fair valuemethod of SFAS No. 123.  The fairvalue of these options was estimated at the date of grant using theBlack-Scholes option pricing model with the following assumptions for the threemonths ended March 31, 2004 and 2005: a risk-free interest rate of 3.25% and 3.71%, respectively; dividendyield of 0% for each period; volatility factor of the expected market price ofthe Company’s common stock of 25% for each period; and a weighted average lifeof the options of five years for each period.

 

The Black-Scholes option valuation model was developed for use inestimating the fair value of traded options which have no vesting restrictionsand are fully transferable.  In addition,option valuation models require the input of highly subjectiveassumptions.  Because the Company’semployee stock options have characteristics significantly different from thoseof traded options and because changes in the subjective

 

8

----

 

input assumptions can materially affect the fair value estimate, inmanagement’s opinion, the existing models do not necessarily provide a reliablesingle measure of the fair value of its employee stock options.

 

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

## ** **

Basic earnings per share is computed based on the weighted average numberof common shares outstanding.  Dilutedearnings per share is computed based on the weighted average number of commonshares outstanding adjusted by the number of additional shares that would havebeen outstanding had the potentially dilutive common shares been issued.  Potentially dilutive shares of common stockinclude stock options, unvested restricted stock grants, Series AConvertible Preferred Stock and Series B Convertible Preferred Stock.  During periods in which a net loss isincurred, diluted earnings per share amounts are the same as basic per shareamounts because the effect of all options, unvested restricted stock grants, Series AConvertible Preferred Stock and Series B Convertible Preferred Stock isanti-dilutive.

 

The following table presents a reconciliation of the numerators anddenominators of basic and diluted earnings per common share:

 
| ** **                                                        | ** ** | **Three months ended  March 31,** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                        | ** ** | **2004**                               | ** ** | **2005** | ** ** |
| Numerator:                                                        | ** ** | ** **                             | ** ** | ** ** | ** ** |
| Net income (loss) applicable to common stockholders,  as reported |       | $                                      | 13,429     |   | $ | (5,847 | ) |
| Add: Cumulative preferred stock dividends                         |       | 6,981                                  |       | — |   |
| Deduct: Unrecognized deferred compensation  expense               |       | (34                                    | )          | — |   |
| Numerator for diluted earnings per share                          |       | $                                      | 20,376     |   | $ | (5,847 | ) |
|                                                              |       |                                   |       |   |   |
| Denominator:                                                      |       |                                   |       |   |   |
| Weighted average number of common shares  outstanding             |       | 3,629,541                              |       | 4,246,275 |   |
| Effect of dilutive securities:                                    |       |                                   |       |   |   |
| Restricted stock grants                                           |       | 512,859                                |       | — |   |
| Employee stock options                                            |       | 4,592,774                              |       | — |   |
| Series A convertible preferred stock                         |       | 98,050,954                             |       | — |   |
| Denominator for diluted earnings per share                        |       | 106,786,128                            |       | 4,246,275 |   |
|                                                              |       |                                   |       |   |   |
| Net income (loss) per share:                                      |       |                                   |       |   |   |
| Basic - as reported                                               |       | $                                      | 3.70       |   | $ | (1.38 | ) |
| Diluted - as reported                                             |       | $                                      | 0.19       |   | $ | (1.38 | ) |

 

## **NewAccounting Pronouncements**

## ** **

In December 2004, as amended on April 14, 2005, the FinancialAccounting Standards Board issued SFAS No. 123R, *Share-Based Payment: an amendment of FASB Statement No. 123and FASB Statement No. 95*, which requires all share-basedpayments to employees, including grants of employee stock options, to berecognized in the income statement based on their fair values. Prior to SFAS No. 123R,only certain pro forma disclosures of fair value were required. SFAS 123Rmust be adopted no later than the beginning of the first fiscal year beginningafter June 15, 2005. We will adopt SFAS 123R on January 1, 2006.

 

SFAS 123R permits companies to adopt one of two methods: (1) A“modified prospective” method in which compensation cost is recognizedbeginning with the effective date (a) based on the requirements ofSFAS 123R for all share-based payments granted after the effective dateand (b) based on the requirements of SFAS 123 for all awards grantedto employees prior to the effective date of SFAS 123R that remain unvestedon the effective date or (2) A “modified retrospective” method thatincludes the requirements of the modified prospective method described above,but also permits entities to restate based on the amounts previously recognizedunder FAS 123 for purposes of pro forma disclosures either (a) allprior periods presented or (b) prior interim periods of the year ofadoption. We are currently in the process of evaluating the two optionvaluation methods and the potential impact on our financial statements.

 

In December 2004, the FASB issued SFAS No. 153, *Exchanges of Nonmonetary Assets*. SFAS No. 153addresses the measurement of exchange of nonmonetary assets. SFAS 153eliminates the exception from

 

9

----

 

fair value measurement for nonmonetary exchanges of similar productiveassets in paragraph 21(b) of APB Opinion No. 29, *Accounting for Nonmonetary Transactions*,and replaces it with an exception for exchanges that do not have commercialsubstance if the future cash flows of the entity are expected to changesignificantly as a result of the exchange. SFAS No. 153 is effective fornonmonetary asset exchanges occurring in fiscal periods beginning after June 15,2005. We are evaluating the potential impact of our adoption of SFAS No. 153on our consolidated financial statements.

 

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

 

*Advanced TelCom, Inc.*

 

OnDecember 31, 2004, the Company acquired all of the outstanding commonstock of Advanced TelCom, Inc. (“ATI”) for $45,495, net of cashacquired.  The results of ATI have beenincluded in the consolidated financial statements since that date.  As a result of the acquisition, the Companystrengthened its presence in five markets, entered into six adjacent markets,entered one new market and created significant opportunities for cost savingsand increased profitability.

 

TheCompany allocated the purchase price on a preliminary basis using theinformation then available.  Theallocation of the purchase price will be finalized in 2005.  Upon completion of the final purchase priceallocation, an additional portion of the excess purchase price may be allocatedto certain intangibles that are separable from goodwill.  The Company accrued $2,531 in acquisitionrelated expenses, which include severance benefits, relocation costs and contracttermination fees.  At March 31, 2005the balance in the acquisition reserve was as follows:

 
| Balance at December 31, 2004 |   | $    | 2,531 |   |
|-----------------------------------|--------|------|-------|--------|
| Payments                          |   | (103 | )     |
| Balance at March 31, 2005    |   | $    | 2,428 |   |

 

The following unauditedpro forma financial information was prepared in accordance with SFAS No. 141, *Business Combinations*, and assumes the acquisition hadoccurred at the beginning of the periods presented.  The unaudited pro forma information isprovided for informational purposes only. These pro forma results are based upon the respective historical financialstatements of the respective companies, and do not incorporate, nor do theyassume, any benefits from cost savings or synergies of operations of thecombined company.  The pro forma resultsof operations do not necessarily reflect the results that would have occurredhad the acquisition occurred at the beginning of the periods presented or theresults which may occur in the future.

 

The pro forma combinedresults of continuing operations for the three months ended March 31, 2004 areas follows:

 
| Revenue                             |   | $      | 53,576 |   |
|-------------------------------------|--------|--------|--------|--------|
| Net income                          |   | 17,938 |   |
| Net income per share – basic   |   | 4.71   |   |
| Net income per share – diluted |   | 0.23   |   |

#### * *

#### *GeneralElectric Business Productivity Solutions*

#### * *

On October 13, 2004 the Company entered into an agreement withGeneral Electric Capital Corporation to purchase substantially all of theassets of General Electric Business Productivity Solutions (GEBPS) for$100.   The transaction closed on March 31,2005 and will be accounted for as a discontinued operation. GEBPS constitutes agroup of assets that can be clearly distinguished operationally and forfinancial reporting purposes from the rest of the Company.  Management has determined that the group ofassets does not fit the Company’s future business model and is committed tosell the net assets with a carrying value of $216, which approximates the fairvalue less cost to sell the group of assets. The Company believes that the assets will be sold within the next twelvemonths.  At March 31, 2005 theCompany determined that the plan of sale criteria in SFAS No. 144, *Accounting for the Impairment or Disposal ofLong-Lived Assets*, had been met and classified the assets andliabilities accordingly on the balance sheet.

 

The fair value less cost to sell the GEBPS assets is presented in thebalance sheet as follows:

 
| Discontinued operation assets held for sale       |   | $    | 1,023 |   |
|---------------------------------------------------|--------|------|-------|--------|
| Discontinued operation liabilities held for  sale |   | (807 | )     |
| Fair value less cost to sell                      |   | $    | 216   |   |

 

10

----

 

**3.)****          Benefit Contribution Plan**

 

The Company has a defined contribution salary deferral plan coveringsubstantially all employees under Section 401(k) of the Internal RevenueCode.  The Company contributes an amountequal to 45 cents for each dollar contributed by each employee up to a maximumof 6% of each employee’s compensation. The Company recognized expense for contributions to the plan for thethree months ended March 31, 2004 and 2005 of $186 and $227, respectively.

 

**4.)****          Capital Stock**

 

**Preferred Stock**

 

Under the terms of the Series A Convertible Preferred Stock and Series BConvertible Preferred Stock (collectively, Preferred Stock), the holders areentitled to receive, when and if declared by the Board of Directors, cumulativedividends on each share of Preferred Stock at the rate of 8% per year whichshall accrue daily and, to the extent not paid, shall accumulate quarterly inarrears.  At December 31, 2004 and March 31,2005, dividends in arrears are $8,777 and $9,856, respectively.

 

## **StockOptions**

## ** **

In November 2002, the Board of Directors approved the EschelonTelecom, Inc. Stock Option Plan of 2002 (the 2002 Plan).  A total of 16,117,647 shares of the Company’scommon stock have been reserved for issuance under the 2002 Plan.  At March 31, 2005, the Company had10,187,904 options outstanding and 2,604,979 shares of restricted common stockissued to certain directors and members of management under the 2002 Plan.

 

## **RestrictedCommon Stock**

## ** **

In February 2003, the Company granted 2,484,979 shares ofrestricted common stock to certain directors and members of management.  The fair value per share of this restrictedstock was $0.05.  The Company recordscompensation expense as the restrictions are removed from the stock.  In February 2004, 405,968 shares vestedresulting in compensation expense of $20. In February 2005, 243,168 shares vested resulting in compensationexpense of $12.  In March 2005, theCompany granted 120,000 shares of restricted common stock to a member of theboard of directors.  The fair value pershare of this restricted stock was $0.20. The Company recorded related compensation expense of $24.

 

**5.)****         ****Commitments and Contingencies**

 

In March 2005, we settled several lawsuits against Qwest onmutually acceptable terms.  As a resultof the settlement agreement, our suit against Qwest in the United StatesDistrict Court, Western District of Washington regarding access, thedevelopment of an unbundled network element platform, and failing to make DSLavailable for resale was dismissed and we agreed to withdraw our appeal in theUnited States District Court, District of Minnesota of the unfavorable decisionof the Minnesota PUC denying us service quality credits.

 

11

----

 

**Item2.  Managemen****t’s Discussion and Analysis of Financial Condition andResults of Operations**

 

## **Forward-Lookingand Cautionary Statements**

## ** **

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

 

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

 

As such, actual results or circumstances may vary materially from suchforward-looking statements or expectations. 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, wewill not update these forward-looking statements, even if our situation changesin the future.

 

## **CompanyOverview**

## ** **

We are a leading facilities-based provider of voice and data servicesand business telephone systems in 19 markets in the western United States.  We target the small and medium-sized businesssegment and serve over 50,000 customers, primarily within the local serviceterritory of Qwest.  We believe that weare either the first or second largest competitive communications servicesprovider targeting the small and medium-sized business segment in each of ourmarkets, based on internally derived market share data.

 

Early in our development, we expanded into new markets generallythrough acquisitions of companies that we augmented with our network servicescapabilities. We were founded in 1996 and shortly thereafter we merged withCady Communications, a business telephone systems (“BTS”) company based inMinnesota, and began offering local and long distance voice services. In 1997and 1998, we acquired three additional BTS companies and launched voiceservices in five additional markets, including Denver, Phoenix, Portland, SaltLake City and Seattle. In December 1999, we activated our first switch. InJanuary 2000, we acquired an Internet service provider and began providingadvanced data services. In March 2000 we began providing voice and dataservices over our network, which began our transition to a facilities-basedcompetitive communications services provider. In January 2001, we acquireda BTS company in Salt Lake City. On December 31, 2004, we consummated oureighth acquisition, Advanced TelCom, Inc. (ATI), whereby we enhanced ourpresence in Washington, Oregon and Nevada and entered California.

 

We measure our operational performance using a variety of indicatorsincluding revenue growth, the percentage of our revenue that comes fromcustomers that we serve on-switch, gross margin percentage, operating expensesas a percentage of revenue and access line churn rates. We monitor keyoperating and customer service metrics to improve customer service, maintainthe quality of our network and reduce costs.

 

ATI generated approximately $59.3 million of revenue in 2004.Through this acquisition, we strengthened our presence in five of the marketswe already served, entered into six adjacent markets, entered into one newmarket and created significant opportunities for cost savings and increasedprofitability. By combining our businesses, we have been able to achieve a sizeand scale that we believe will provide us with a competitive advantage in ourmarkets and significant opportunities for cost savings and improved cash

 

12

----

 

flow. We are in the process of integrating ATI’s operational, financialand support systems with ours. We expect that ATI will be substantiallyintegrated by the end of 2005.

 

**Key Components of Results of Operations**

 

***Revenue.***  Network services revenue consists primarilyof local dial tone, switched access lines, long distance, access charges anddata service. Revenue from local telephone service consists of charges forbasic local service, including dedicated T1 access, and custom-calling featuressuch as call waiting and call forwarding. Revenue from long distance serviceconsists of per-minute-of-use charges for a full range of traditional switchedand dedicated long distance, toll-free calling, international, calling card andoperator services. Carrier access revenue consists primarily of usage chargesthat we bill long distance carriers to originate and terminate calls to andfrom our customers. In addition, ATI currently charges other local exchangecarriers usage charges to originate and terminate local calls to and from itscustomers (otherwise known as reciprocal compensation). Revenue from dataservices consists primarily of monthly usage fees for dedicated Internet accessservices. We typically commit our customers to contracts ranging from one tofive years and provide discounts for longer terms. Network services comprised89.2% of our revenue for the three months ended March 31, 2005 revenue andrepresents a predominantly recurring 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 from network services are recognized over the average life of thecustomers. Long distance and access charges are billed in arrears but accruedbased on monthly average usage. We have not historically received any revenuesfrom reciprocal compensation due to our bill-and-keep arrangement with Qwest.While ATI currently receives approximately $0.3 million in annual revenuefrom reciprocal compensation from Qwest and SBC Communications Inc., we areevaluating whether to seek a bill-and-keep arrangement with Qwest and /or SBCfor ATI. We do not have any wholesale revenue other than access revenue and ATIreciprocal compensation.

 

BTS service revenue consists of revenue from the sale of telephoneequipment and the servicing of telephone equipment systems. Telephone equipmentrevenue is recognized upon delivery, completion of the installation andacceptance by the customer. BTS service revenue is recognized upon completionof service or, in the case of maintenance agreements, is spread equally overthe life of the maintenance contract, which typically ranges from monthly tofive years.

 

***Cost of Revenue.***  Our network services cost of revenue consistsprimarily of the cost of operating and maintaining our network facilities. Thenetwork components for our facilities-based business include the cost of

 

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

 

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

 

•                  leasing high capacity digital lines thatinterconnect our network with the Rebional Bell Operating Companies, or RBOCs;

 

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

 

•                  signaling system network connectivity;

 

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

 

•                  Internet transit and peering.

 

The costs to lease local loops, digital T1 lines and high capacitydigital interoffice facilities from the RBOCs varies by carrier and by stateand are regulated under federal and state laws. In virtually all areas, welease local loops, T1 lines and interoffice capacity from RBOCs. We leaseinteroffice facilities from carriers other than the RBOCs where possible inorder to lower costs and improve network redundancy; however, in most cases,the RBOCs are our only source for local loops and T1 lines.  Prior to January 2005, we purchased, ona wholesale or negotiated basis, unbundled network elements platform, or UNE-P,and customized network element packages, or UNE-E, from Qwest.  We entered into a three year agreement in January 2005with Qwest for the provision of their Platform Plus, or QPP, product whichreplaced UNE-P and UNE-E.  The

 

13

----

 

UNE-P and UNE-E agreements were terminated with the adoption of the QPPagreement, and all UNE-E and UNE-P lines were moved to QPP on January 1,2005.

 

Our cost of revenue also includes the fees we pay for long distance,data and other services. We have entered into long-term wholesale purchasingagreements for these services. Some of these agreements, including ouragreements with Global Crossing and MCI, also contain significant termination penaltiesand/or minimum usage volume commitments. In the event we fail to meet theseminimum volume commitments, we may be obligated to pay underutilizationcharges. We do not anticipate having to pay any underutilization charges in theforeseeable future.

 

We carefully review all of our vendor invoices and frequently disputeinaccurate or inappropriate charges. In cases where we dispute certain changes,we frequently pay only undisputed amounts on vendor invoices in order to payproper amounts owed. Our single largest vendor is Qwest, to which we paid$11.6 million for the three months ended March 31, 2005. We usesignificant estimates to determine the level of success in dispute resolutionand consider past historical experience, basis of dispute, financial status andcurrent relationship with vendors and aging of prior disputes in quantifyingour estimates.

 

We account for all of our network depreciation in depreciation andamortization expense and do not have any depreciation expense in cost ofrevenue.

 

Our most significant BTS costs of revenue are the equipment purchasedfrom manufacturers and labor for service and equipment installation. To takeadvantage of volume purchase discounts, we purchase equipment primarily fromthree manufacturers pursuant to master purchase agreements we have with thesemanufacturers. For all BTS installations, our policy is to require a 30%deposit before ordering the equipment so our risk of excess inventory orinventory obsolescence is low. BTS cost of revenue also includes salaries andbenefits of field technicians as well as vehicle and incidental expensesassociated with equipment installation, maintenance and service provisioning.

 

***Sales, General andAdministrative.*** Sales, general and administrative expenses are comprised primarily ofsalaries and benefits, bonuses, commissions, occupancy costs, sales andmarketing expenses, bad debt, billing and professional services.

 

Determining our allowance for doubtful accounts receivable requiressignificant estimates. We consider two primary factors in determining theproper level of the allowance, including historical collections experience andthe aging of the accounts receivable portfolio. We perform a rigorous creditreview process on each new customer that involves reviewing the customer’scurrent service provider bill and payment history, matching customers with theNational Telecommunications Data Exchange database for delinquent customersand, in some cases, requesting credit reviews through Dun and Bradstreet. Forthe three months ended March 31, 2004 and 2005, our bad debt expense as apercentage of revenue was 0.8% and 0.2%, respectively.

 

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

 

14

----

 

## **Comparisonof Financial Results**

## ** **

**Overview of Results**

 

Selected consolidated financial and operating data for the three-monthperiod ended March 31, 2004 and 2005 is as follows (dollars in thousands,except per unit amounts):

 
| ** **                                         | ** ** | **Three months ended March 31,** | ** ** |
|----------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                         | ** ** | **2004**                              | ** ** | **2005** | ** ** | **% Change** | ** ** |
| ** **                                         | ** ** | **(unaudited)**                       | ** ** | **(unaudited)** | ** ** | ** ** | ** ** |
| Total revenue                                      |       | $                                     | 38,196     |   | $ | 54,533 |   | 42.8 | % |
| Total gross margin (%)                             |       | 59.6                                  | %          | 56.7 | % | (4.9 | )% |
| Capital expenditures                               |       | $                                     | 7,041      |   | $ | 8,898 |   | 26.4 | % |
| Cash and available-for-sale securities             |       | $                                     | 23,596     |   | $ | 25,833 |   | 9.5 | % |
|                                               |       |                                  |       |   |   |   |   |
| Voice lines in service                             |       | 159,354                               |       | 259,594 |   | 62.9 | % |
| Data lines in service                              |       | 56,180                                |       | 127,183 |   | 126.4 | % |
| Total lines in service                             |       | 215,534                               |       | 386,777 |   | 79.5 | % |
| Percent of lines on switch                         |       | 75.6                                  | %          | 82.6 | % | 9.2 | % |
| Lines sold                                         |       | 19,463                                |       | 26,495 |   | 36.1 | % |
| Average monthly access line churn (%)              |       | 1.55                                  | %          | 1.51 | % | (2.1 | )% |
| Average monthly network services revenue  per line |       | $                                     | 50.42      |   | $ | 42.30 |   | (16.1 | )% |
|                                               |       |                                  |       |   |   |   |   |
| Total full-time equivalent employees               |       | 895                                   |       | 1,117 |   | 24.8 | % |
| Quota-carrying network service salespeople         |       | 145                                   |       | 191 |   | 31.7 | % |
| Quota-carrying BTS salespeople                     |       | 33                                    |       | 39 |   | 18.2 | % |
| Total quota-carrying salespeople                   |       | 178                                   |       | 230 |   | 29.2 | % |

 

**ThreeMonths Ended March 31, 2005 compared to Three Months Ended March 31,2004**

 

***Revenue.***  Revenue for the three months ended March 31,2004 and 2005 is as follows:

 
| ** **                 | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|----------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                 | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Revenue (in millions):     |       |            |       |            |       |         |       |
| Voice and data services    |       | $               | 23.5       |            | $          | 37.1         |       | 57.5 | % |
| Long distance              |       | 5.3             |       | 8.6             |       | 62.6         | %          |
| Access                     |       | 3.3             |       | 3.0             |       | (8.7         | )%         |
| Total network services     |       | 32.1            |       | 48.7            |       | 51.6         | %          |
| Business telephone systems |       | 6.1             |       | 5.8             |       | (3.6         | )%         |
| Total revenue              |       | $               | 38.2       |            | $          | 54.5         |       | 42.8 | % |

 

Network services revenue was $48.7 million for the three months ended March 31,2005, an increase of 51.6% from $32.1 million in the same period of 2004.  The increase in revenue was primarily due tothe inclusion of ATI, which was acquired on December 31, 2004.  Over the past 12 months the number of voicelines in service increased by 62.9% to 259,594 at March 31, 2005 and thenumber of data lines in service increased by 126.4% to 127,183 at March 31,2005.  The growth in access lines waspartially offset by declines in pre-subscribed interexchange carrier charge(PICC) revenue, access revenue per minute of use and a decline in data revenueper line.  The decline in PICC revenuewas due to our pending dispute with Global Crossing.  As a result of that dispute, we elected notto record PICC revenue beginning in November 2004.  The PICC revenue impact was approximately$0.8 million for the three months ended March 31, 2005 as compared to thethree months ended March 31, 2004. Access revenue per minute of use declined as a result of the scheduledFCC reduction of interstate rate levels in June 2004.  Data revenue per line declined due to acombination of customers purchasing more bandwidth at discounted prices andgeneral pricing pressures for data services in our markets.  We expect all of the above trends in linegrowth, PICC revenue, access rates and data revenue per line to continue forthe foreseeable future.  As we continueto grow, our size and average monthly access line churn will begin to limit our

 

15

----

 

access line growth rate on bothan absolute and a percentage basis unless we increase our sales force andextend our network footprint.

 

BTS revenue was $5.8 million for the three months ended March 31,2005, a decrease of 3.6% from $6.1 million in the same period of 2004.  The decrease in revenue was primarily due toa decrease in revenue from change orders. This was partially offset by an increase in revenue from newsystems.  We cannot predict future trendsin capital spending by small and medium-sized business customers which drivesour BTS revenue.

 

***Cost of Revenue.***  Cost of revenue for the three months ended March 31,2004 and 2005 is as follows:

 
| ** **                     | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|--------------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                     | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Cost of revenue (in millions): |       |            |       |            |       |         |       |
| Network services               |       | $               | 11.7       |            | $          | 20.0         |       | 70.0 | % |
| Business telephone systems     |       | 3.7             |       | 3.6             |       | (0.9         | )%         |
| Total cost of revenue          |       | $               | 15.4       |            | $          | 23.6         |       | 53.2 | % |

 

Network services cost of revenue was $20.0 million for the three monthsended March 31, 2005, an increase of 70.0% from $11.7 million in the sameperiod of 2004.  The increase wasprimarily due to the inclusion of ATI.  Inaddition, we experienced an increase of approximately $0.6 million in the threemonths ended March 31, 2005 related to the impact of QPP.  We anticipate this expense increase willcontinue in the future.  As a percentageof related revenue, network services cost of revenue for the three months endedMarch 31, 2005 increased to 41.1% from 36.6% for the same period of 2004.

 

BTS cost of revenue was $3.6 million for the three months ended March 31,2005, a decrease of 0.9% from $3.7 million in the same period of 2004.  Both materials cost and labor cost stayedrelatively flat in the three months ended March 31, 2005 from the sameperiod of 2004.  As a percentage ofrelated revenue, BTS cost of revenue for the three months ended March 31,2005 increased to 61.9% from 60.2% for the same period of 2004.  This was primarily due to the decline inrevenue mentioned previously without a corresponding decline in laborcosts.  We do not expect futureimprovements in BTS cost of revenue as a percentage of related revenue unlesswe are able to significantly increase BTS revenue and therefore achieve greatervolume discounts or economies of scale in our workforce.

 

***Gross Profit.***  Gross profit for the three months ended March 31,2004 and 2005 is as follows:

 
| ** **                  | ** ** | **2004**        | ** ** | **2005**        | ** ** | **% Change** | ** ** |
|-----------------------------|------------|-----------------|------------|-----------------|------------|--------------|------------|
| ** **                  | ** ** | **(unaudited)** | ** ** | **(unaudited)** | ** ** | ** **   | ** ** |
| Gross profit (in millions): |       |            |       |            |       |         |       |
| Network services            |       | $               | 20.4       |            | $          | 28.7         |       | 40.9 | % |
| Business telephone systems  |       | 2.4             |       | 2.2             |       | (7.7         | )%         |
| Total gross profit          |       | $               | 22.8       |            | $          | 30.9         |       | 35.7 | % |

 

The increase in gross profit for the three months ended March 31,2005, from the same period of 2004, was primarily due to the inclusion of ATI.

 

***Sales, General and Administrative Expense.***  Sales, general and administrative expenseswere $22.3 million for the three months ended March 31, 2005, an increaseof 36.0% from $16.4 million in the same period of 2004.  This increase was primarily due to theinclusion of sales, general and administrative expenses of ATI.  As a percentage of revenue, sales, generaland administrative expenses for the three months ended March 31, 2005declined to 41.0% from 43.0% in the same period of 2004 due to the improvedefficiency of our existing operations resulting from our fixed cost structuresupporting a higher level of revenue.  Weexpect this trend to continue as we add more access lines with only modestincreases in our employee base.  Weexpect legal expenses included in sales, general and administrative expenses todecrease in the second quarter of 2005 as a result of the settlement of ourlawsuit against Qwest in March 2005.

 

16

----

 

***Depreciation andAmortization.*** Depreciation and amortization expense was $8.6 million for the threemonths ended March 31, 2005, an increase of 8.1% from $7.9 million in thesame period of 2004.  This increase wasprimarily due to the inclusion of ATI. As a percentage of revenue, depreciation and amortization decreased to15.7% for the three months ended March 31, 2005 from 20.8% for the sameperiod of 2004.

 

***Interest.***  Interest expense was $4.9 million for the threemonths ended March 31, 2005, an increase of 110.1% from $2.3 million inthe same period of 2004.  This increasewas primarily due to interest expense on our 8 3/8% senior second secured notesdue 2010 issued in March and November of 2004.

 

***Net Income (Loss). ***Net loss for thethree months ended March 31, 2005 was $4.8 million compared to net income of$14.3 million in the same period of 2004. The net income in 2004 was primarily due to an $18.2 million gain onextinguishment of debt.

 

## **Liquidityand Capital Resources**

## ** **

***Principal Sourcesand Uses of Liquidity.* **Our principal sources of liquidity are cash from operations and ourcash and cash equivalents and available-for-sale securities. Our principalliquidity requirements consist of debt service, capital expenditures andworking capital.

 

***Cash Flows Providedby Operating Activities. ***Cashprovided by operating activities was $2.4 million for the three months ended March 31,2005 compared to cash provided by operating activities of $7.0 million for thesame period of 2004.  The decrease incash provided by operating activities was primarily due to the semi-annualinterest payment in March 2005 on our senior second secured notes.

 

***Cash Flows Used inInvesting Activities.***  Cash used in investing activities was $15.0million for the three months ended March 31, 2005 compared to $6.7 millionfor the same period of 2004.  The cashused in investing activities was for the maintenance and expansion of ournetwork and back office systems and for the investment in available-for-salesecurities with maturity dates of six months or less.

 

***Cash Flows Provided by (Used in) Financing Activities.***  Cash used in financing activities was $0.7million for the three months ended March 31, 2005.  The cash used in financing activities wasprimarily for payments on capital lease obligation and for debt issuancecosts.  For the three months ended March 31,2004, net cash provided by financing activities was $14.6 million.  The net proceeds from the issuance of thesenior second secured notes in March 2004 generated approximately $13.2million, which is net of a $1.6 million prepayment penalty.  We also used cash for payments on capitallease obligations.

 

17

----

 

***Capital Requirements.***  For the three months ended March 31,2005, we spent $8.3 million on capital expenditures.  We expect to spend approximately $44.6million on capital expenditures in 2005, approximately $4.1 million of whichwill be to integrate ATI into our operations.

 

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

 

18

----

 

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

# ** **

We are not exposed to market risks from changes in foreign currencyexchange rates or commodity prices.  Wedo not hold any derivative financial instruments nor do we hold any securitiesfor trading or speculative purposes.

 

We are exposed to changes in interest rates on our investments in cashequivalents and short-term investments. All of our investments have maturities of six months or less whichreduces our exposure to long-term interest rate changes.  Interest income for the three-month periodended March 31, 2005 was $0.1 million, therefore not exposing us to anymeaningful interest income risk had rates dropped.  We had $138.7 million in senior secondsecured notes outstanding as of March 31, 2005.  These notes are at a fixed interest rate andare therefore not exposed to any interest rate risk.

 

# **Item 4:  Controls and**Procedures

# ** **

*Evaluation of disclosure controls andprocedures.*  Ourmanagement, under the direction and with the participation of Richard A. Smith,our President and Chief Executive Officer, and Geoffrey M. Boyd, our ChiefFinancial Officer, performed an evaluation of the design and operation of ourdisclosure controls and procedures (as defined in Rule 13a-15 under theSecurities Exchange Act of 1934).  Basedon that evaluation, Messers. Smith and Boyd concluded that, as of the end ofthe period covered by this report, our disclosure controls and procedures areeffective.

 

*Changes in internal controls over financialreporting.* During the quarter ended March 31, 2005, there have been nosignificant changes in our internal controls over financial reporting thatmaterially affected, or are reasonably likely to materially affect, ourreported financial results.

 

19

----

 

# **PART II.OTHER INFORMATION**

# ** **

# **Item 1.  Legal**Proceedings

# ** **

In August 2000, we entered into an agreement with Global CrossingBandwidth, Inc. to be our exclusive global carrier for all of our dataservice needs and 95% of our voice service needs for a ten-year period. Theagreement calls for us to pay for at least $100 million of services overthe initial term of the agreement. Global Crossing filed a suit against us in February 2005in the federal district court for the Western District of New York. The suitalleges that we owe approximately $8.4 million in unpaid pre-subscribedinter-exchange carrier charges, or PICC, and further seeks a declaratory rulingthat Global Crossing may terminate the agreement. We believe that we havestrong defenses to Global Crossing’s claim for PICC charges and we intend tovigorously defend against the suit. We are unable to predict the outcome ofthis litigation or Global Crossing’s actions during the litigation process.

 

In March 2005, we settled several lawsuits against Qwest onmutually acceptable terms.  As a resultof the settlement agreement, our suit against Qwest in the United StatesDistrict Court, Western District of Washington regarding access, thedevelopment of an unbundled network element platform, and failing to make DSLavailable for resale was dismissed and we agreed withdraw our appeal in theUnited States District Court, District of Minnesota of the unfavorable decisionof the Minnesota PUC denying us service quality credits.

 

Investigations are ongoing in Arizona, Oregon and Colorado relating tothe alleged failure of Qwest and several competitive communications servicesproviders, including us, to submit interconnection agreements for approval bystate regulatory agencies. Each PUC has the authority to assess fines of up toseveral thousand dollars for each agreement for each day the agreement was notfiled. Consequently we could potentially face fines in each state. Further,each PUC has the authority to revoke our authority to provide service, althoughno one has suggested doing so with respect to Qwest or any competitivecommunications services provider involved in the proceedings. A similarinvestigation by the Minnesota PUC resulted in no direct penalties against uswhile the Washington Commission approved a settlement under which we paid$25,000 and provided testimony in return for dismissal of the case against us.We have reached a settlement with the Arizona Corporation Commission staff thatrequires us to pay a penalty of $80,000, half of which would be due on approvalof the settlement by the Arizona Corporation Commission and half of which wouldbe payable the following year. The Oregon PUC has initiated proceedings againstQwest, but not against any competitive communications services provider. AnAdministrative Law Judge in Colorado recommended that the Colorado Commissionnot pursue a case against the competitive communications services providers onthe basis that the competitive communications services providers did not havean obligation to file the agreements. The PUC has not initiated a complaintproceeding against any party. Qwest and the Colorado Consumer Council haveproposed a settlement which the PUC did not accept. The PUC has ordered thatfurther hearings be held to determine if a “global comprehensive agreement canbe reached.” We cannot predict how these matters will ultimately be resolved.

 

The Minnesota Department of Commerce has filed a complaint with theMinnesota PUC concerning agreements that competitive communications servicesproviders, including us, have with certain interexchange carriers for pricingaccess services. They have asserted that the agreements are unlawfullydiscriminatory and required to be filed. Potentially, the PUC could assess afine of up to several thousand dollars for each agreement for each day it wasnot filed and could revoke our authority to provide service in Minnesota. Wehave entered into a settlement with the Minnesota Department of Commerce which,if approved by the PUC, would require us to pay a penalty of $15,000 and reviseour intrastate access tariff. We cannot predict the outcome of this proceedingor its effect on our business.

 

We have disputed the amount of a bond that we are required to post withthe Arizona Corporation Commission. The Arizona Corporation Commission recentlyruled to reduce our bond to $235,000 rather than the $400,000 bond currentlyposted. However, future proceedings could result in a substantial increase inthe bond, depending on Arizona Corporation Commission decisions on its policiesconcerning bond requirements.

 

We cannot predict the outcome of any of these proceedings or theireffect on our business. We are party from time to time to other ordinary coursedisputes that we do not believe to be material.

 

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

 

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

 

20

----

 

On January 3, 2005, we granted to 240 participants under theEschelon Telecom, Inc. Stock Option Plan of 2002 options to purchase anaggregate of 147,100 shares of common stock at an exercise price of $0.10 pershare.  These options generally vest 20%upon the date of the initial grant and 20% per year over four years from thedate of grant.

 

In March 2005, we issued 120,000 shares of our restricted commonstock valued at $0.20 per share to a director as compensation for services onour board of directors for 2005.

 

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

# ** **

None.

 

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

# ** **

No matters were submitted to a vote of the security holders during thequarter ended March 31, 2005.

 

# **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. |

 

21

----

 

## **SIGNATURE**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
|                    | Eschelon Telecom, Inc. |
|-------------------------|-----------------------------|
|                    |                        |   |
| Date: May 16, 2005 | By:                         | /S/ Geoffrey M. Boyd |   |
|                    |                        |   |
|                    | Name:                       | Geoffrey M. Boyd |
|                    | Title:                      | Chief Financial Officer |
|                    |                        | (Principal  Financial and  Accounting Officer and Duly  Authorized Officer) |

 

22

----