**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

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

 

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**FORM 10-Q**

 

**(MARK ONE)**

 
| **ý**                                             | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
|--------------------------------------------------------|-----------------------------------------------------------------------------------------------------|
|                                                   |                                                                                                |
| **For the quarterly  period ended June 30, 2004** |
|                                                   |                                                                                                |
| **OR**                                                 |
|                                                   |                                                                                                |
| **o**                                                  | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |

 

**Commission FileNumber 000-50706**

 

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| **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**

 

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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 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired 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 Rule12b-2 of the Exchange Act.  Yes o   No ý

 

As of August 10, 2004, the number of outstanding shares of theRegistrant’s Common Stock, par value $.01 per share, was 4,665,964 shares andthe number of outstanding shares of the Registrant’s Preferred Stock, par value$.01 per share, was 84,306,677 shares, convertible into 99,732,467 shares ofCommon Stock.

 

 

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**ESCHELON TELECOM, INC.**

**INDEX TO FORM 10-Q**

 
| **PART I.  FINANCIAL INFORMATION** |                                                                                                                   |
|-----------------------------------------|------------------------------------------------------------------------------------------------------------------------|
|                                    |                                                                                                                   |   |
| Item 1.                                 | Financial  Statements:                                                                                                 | 3 |
|                                    |                                                                                                                   |   |
|                                    | Consolidated  Balance Sheets – December 31, 2003 and June 30, 2004 (Unaudited)                          | 3 |
|                                    |                                                                                                                   |   |
|                                    | Unaudited  Consolidated Statements of Operations – Three months and six months ended June 30,  2003 and 2004 | 4 |
|                                    |                                                                                                                   |   |
|                                    | Unaudited  Consolidated Statements of Cash Flows – Six months ended June 30, 2003  and 2004                  | 5 |
|                                    |                                                                                                                   |   |
|                                    | Notes  to Consolidated Financial Statements                                                                            | 6 |
|                                    |                                                                                                                   |   |
| Item 2.                                 | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                            | 12 |
|                                    |                                                                                                                   |   |
| Item 3.                                 | Quantitative  and Qualitative Disclosures About Market Risk                                                            | 21 |
|                                    |                                                                                                                   |   |
| Item 4.                                 | Controls  and Procedures                                                                                               | 21 |
|                                    |                                                                                                                   |   |
| **PART  II.  OTHER INFORMATION**   | 22                                                                                                                     |
|                                    |                                                                                                                   |   |
| Item 1.                                 | Legal  Proceedings                                                                                                     | 22 |
|                                    |                                                                                                                   |   |
| Item 2.                                 | Changes  in Securities, Use of Proceeds and Issuer Purchase of Equity Securities                                       | 22 |
|                                    |                                                                                                                   |   |
| Item 3.                                 | Defaults  Upon Securities                                                                                              | 23 |
|                                    |                                                                                                                   |   |
| Item 4.                                 | Submission  of Matters to a Vote of Security Holders                                                                   | 23 |
|                                    |                                                                                                                   |   |
| Item 5.                                 | Other  Information                                                                                                     | 23 |
|                                    |                                                                                                                   |   |
| Item 6.                                 | Exhibits  and Reports on Form 8-K                                                                                      | 23 |
|                                    |                                                                                                                   |   |
| Signature                               | 26                                                                                                                     |
|                                    |                                                                                                                   |
| Certifications                          |                                                                                                                   |

 

2

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**PART I.  FINANCIAL INFORMATION**

 

## **Item1.**  Financial Statements

 

**Eschelon Telecom, Inc.**

**Consolidated Balance Sheets**

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

 
|                                                                                                                                                                                                  |   | **December 31,  2003** |    | **June 30,  2004** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|-------------------------|--------|
|                                                                                                                                                                                                  |   |                        |    | **(Unaudited)**         |   |
| **Assets**                                                                                                                                                                                            |   |                        |    |                    |   |
| Current assets:                                                                                                                                                                                       |   |                        |    |                    |   |
| Cash and cash equivalents                                                                                                                                                                             |   | $                           | 8,606   |                    | $      | 23,843 |   |
| Accounts receivable, net of allowance for  doubtful accounts of $739 and $445, respectively                                                                                                           |   | 13,537                      |    | 12,106                  |   |
| Other receivables                                                                                                                                                                                     |   | 2,097                       |    | 3,177                   |   |
| Inventories                                                                                                                                                                                           |   | 3,169                       |    | 3,141                   |   |
| Prepaid expenses                                                                                                                                                                                      |   | 2,046                       |    | 2,155                   |   |
| Total current assets                                                                                                                                                                                  |   | 29,455                      |    | 44,422                  |   |
|                                                                                                                                                                                                  |   |                        |    |                    |   |
| Property and equipment, net                                                                                                                                                                           |   | 86,777                      |    | 85,966                  |   |
|                                                                                                                                                                                                  |   |                        |    |                    |   |
| Other assets                                                                                                                                                                                          |   | 1,269                       |    | 1,392                   |   |
| Goodwill                                                                                                                                                                                              |   | 7,168                       |    | 7,168                   |   |
| Intangible assets, net                                                                                                                                                                                |   | 29,052                      |    | 29,678                  |   |
| Total assets                                                                                                                                                                                          |   | $                           | 153,721 |                    | $      | 168,626 |   |
|                                                                                                                                                                                                  |   |                        |    |                    |   |
| **Liabilities and  stockholders’ equity (deficit)**                                                                                                                                              |   |                        |    |                    |   |
| Current liabilities:                                                                                                                                                                                  |   |                        |    |                    |   |
| Accounts payable                                                                                                                                                                                      |   | $                           | 4,582   |                    | $      | 6,140 |   |
| Accrued telecommunication costs                                                                                                                                                                       |   | 6,939                       |    | 6,876                   |   |
| Accrued expenses                                                                                                                                                                                      |   | 3,240                       |    | 6,264                   |   |
| Deferred revenue                                                                                                                                                                                      |   | 3,000                       |    | 3,720                   |   |
| Accrued compensation expenses                                                                                                                                                                         |   | 4,261                       |    | 3,399                   |   |
| Capital lease obligation, current  maturities                                                                                                                                                         |   | 1,020                       |    | 521                     |   |
| Total current liabilities                                                                                                                                                                             |   | 23,042                      |    | 26,920                  |   |
|                                                                                                                                                                                                  |   |                        |    |                    |   |
| Long-term liabilities:                                                                                                                                                                                |   |                        |    |                    |   |
| Commitments and contingencies (Note 3)                                                                                                                                                                |   |                        |    |                    |   |
| Capital lease obligation                                                                                                                                                                              |   | 576                         |    | 1,552                   |   |
| Notes payable                                                                                                                                                                                         |   | 86,226                      |    | 85,332                  |   |
| Total liabilities                                                                                                                                                                                     |   | 109,844                     |    | 113,804                 |   |
|                                                                                                                                                                                                  |   |                        |    |                    |   |
| Series A convertible preferred stock, $0.01  par value; 100,000,000 shares authorized; 84,306,677 shares outstanding at  December 31, 2003 and June 30, 2004                                |   | 48,948                      |    | 50,656                  |   |
|                                                                                                                                                                                                  |   |                        |    |                    |   |
| Stockholders’ equity (deficit):                                                                                                                                                                  |   |                        |    |                    |   |
| Common stock, $0.01 par value; 160,000,000  shares authorized; 4,457,579 shares issued and outstanding at  December 31, 2003, and 4,665,964 shares issued and outstanding at  June 30, 2004 |   | 45                          |    | 47                      |   |
| Additional paid-in capital                                                                                                                                                                            |   | 120,105                     |    | 118,413                 |   |
| Accumulated deficit                                                                                                                                                                                   |   | (125,167                    | )       | (114,260                | )      |
| Deferred compensation                                                                                                                                                                                 |   | (54                         | )       | (34                     | )      |
| Total stockholders’ equity (deficit)                                                                                                                                                             |   | (5,071                      | )       | 4,166                   |   |
| Total liabilities and stockholders’ equity  (deficit)                                                                                                                                            |   | $                           | 153,721 |                    | $      | 168,626 |   |

 

*See accompanying notes.*

 

3

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**Eschelon Telecom, Inc.**

**Unaudited Consolidated Statements ofOperations**

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

 
|                                                 |   | **Three  months ended  June 30,** |   | **Six months  ended  June 30,** |   |
|------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                                                 |   | **2003**                               |   | **2004**                             |   | **2003** |   | **2004** |   |
| Revenue:                                             |   |                                   |   |                                 |   |   |   |   |   |
| Network services                                     |   | $                                      | 28,188 |                                 | $      | 32,745 |   | $ | 54,842 |   | $ | 64,857 |   |
| Business telephone systems                           |   | 7,217                                  |   | 6,406                                |   | 12,477 |   | 12,490 |   |
| Total revenue                                        |   | 35,405                                 |   | 39,151                               |   | 67,319 |   | 77,347 |   |
|                                                 |   |                                   |   |                                 |   |   |   |   |   |
| Cost of revenue:                                     |   |                                   |   |                                 |   |   |   |   |   |
| Network services                                     |   | 11,184                                 |   | 11,592                               |   | 21,849 |   | 23,357 |   |
| Business telephone systems                           |   | 4,189                                  |   | 3,818                                |   | 7,556 |   | 7,480 |   |
| Total cost of revenue                                |   | 15,373                                 |   | 15,410                               |   | 29,405 |   | 30,837 |   |
|                                                 |   |                                   |   |                                 |   |   |   |   |   |
| Gross profit:                                        |   |                                   |   |                                 |   |   |   |   |   |
| Network services                                     |   | 17,004                                 |   | 21,153                               |   | 32,993 |   | 41,500 |   |
| Business telephone systems                           |   | 3,028                                  |   | 2,588                                |   | 4,921 |   | 5,010 |   |
| Total gross profit                                   |   | 20,032                                 |   | 23,741                               |   | 37,914 |   | 46,510 |   |
|                                                 |   |                                   |   |                                 |   |   |   |   |   |
| Operating expenses:                                  |   |                                   |   |                                 |   |   |   |   |   |
| Sales, general and administrative                    |   | 16,148                                 |   | 17,084                               |   | 31,596 |   | 33,506 |   |
| Depreciation and amortization                        |   | 8,056                                  |   | 7,277                                |   | 15,705 |   | 15,212 |   |
| Operating loss                                       |   | (4,172                                 | )      | (620                                 | )      | (9,387 | ) | (2,208 | ) |
|                                                 |   |                                   |   |                                 |   |   |   |   |   |
| Other income (expense):                              |   |                                   |   |                                 |   |   |   |   |   |
| Interest income                                      |   | 55                                     |   | 26                                   |   | 147 |   | 38 |   |
| Interest expense                                     |   | (448                                   | )      | (2,760                               | )      | (879 | ) | (5,074 | ) |
| Gain on extinguishment of debt                       |   | —                                 |   | —                               |   | — |   | 18,195 |   |
| Other expense                                        |   | (36                                    | )      | (23                                  | )      | (106 | ) | (44 | ) |
| Income (loss) before taxes                           |   | (4,601                                 | )      | (3,377                               | )      | (10,225 | ) | 10,907 |   |
| Income taxes                                         |   | —                                 |   | —                               |   | — |   | — |   |
| Net income (loss)                                    |   | (4,601                                 | )      | (3,377                               | )      | (10,225 | ) | 10,907 |   |
| Less preferred stock dividends                       |   | (854                                   | )      | (854                                 | )      | (1,699 | ) | (1,708 | ) |
| Net income (loss) applicable to common  stockholders |   | $                                      | (5,455 | )                                    | $      | (4,231 | ) | $ | (11,924 | ) | $ | 9,199 |   |
|                                                 |   |                                   |   |                                 |   |   |   |   |   |
| Net income (loss) per share:                         |   |                                   |   |                                 |   |   |   |   |   |
| Basic                                                |   | $                                      | (1.76  | )                                    | $      | (1.09 | ) | $ | (4.33 | ) | $ | 2.45 |   |
| Diluted                                              |   | $                                      | (1.76  | )                                    | $      | (1.09 | ) | $ | (4.33 | ) | $ | 0.16 |   |
|                                                 |   |                                   |   |                                 |   |   |   |   |   |
| Weighted average number of shares  outstanding:      |   |                                   |   |                                 |   |   |   |   |   |
| Basic                                                |   | 3,101,923                              |   | 3,889,854                            |   | 2,750,800 |   | 3,759,693 |   |
| Diluted                                              |   | 3,101,923                              |   | 3,889,854                            |   | 2,750,800 |   | 108,475,277 |   |

 

*See accompanying notes.*

 

4

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**Eschelon Telecom, Inc.**

**Unaudited Consolidated Statements of CashFlows**

**(InThousands)**

 
|                                                                                      |   | **Six months  ended  June 30,** |    |
|-------------------------------------------------------------------------------------------|--------|--------------------------------------|---------|
|                                                                                      |   | **2003**                             |    | **2004** |   |
| **Operating  activities**                                                                 |   |                                 |    |   |   |
| Net income (loss)                                                                         |   | $                                    | (10,225 | ) | $ | 10,907 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by operating activities: |   |                                 |    |   |   |
| Depreciation and amortization expense                                                     |   | 15,705                               |    | 15,212 |   |
| Other non-cash items                                                                      |   | 1,067                                |    | 1,409 |   |
| Gain on extinguishment of debt                                                            |   | —                               |    | (18,195 | ) |
| Changes in operating assets and  liabilities:                                             |   |                                 |    |   |   |
| Accounts receivable                                                                       |   | (2,734                               | )       | 987 |   |
| Inventories                                                                               |   | (478                                 | )       | 28 |   |
| Other current assets and deposits                                                         |   | 516                                  |    | (1,312 | ) |
| Accounts payable and accrued expenses                                                     |   | 1,596                                |    | 4,519 |   |
| Deferred revenue                                                                          |   | 511                                  |    | 720 |   |
| Accrued compensation expense                                                              |   | (670                                 | )       | (862 | ) |
| Net cash provided by operating activities                                                 |   | 5,288                                |    | 13,413 |   |
|                                                                                      |   |                                 |    |   |   |
| **Investing  activities**                                                                 |   |                                 |    |   |   |
| Purchases of property and equipment                                                       |   | (8,019                               | )       | (6,979 | ) |
| Cash paid for customer installation costs                                                 |   | (6,037                               | )       | (5,494 | ) |
| Net cash used in investing activities                                                     |   | (14,056                              | )       | (12,473 | ) |
|                                                                                      |   |                                 |    |   |   |
| **Financing  activities**                                                                 |   |                                 |    |   |   |
| Proceeds from issuance of notes payable                                                   |   | —                               |    | 84,813 |   |
| Payments made on bank debt and capital  lease obligations                                 |   | (1,503                               | )       | (66,299 | ) |
| Proceeds from (fees associated with)  issuance of stock                                   |   | (62                                  | )       | 3 |   |
| Increase in debt issuance costs                                                           |   | (58                                  | )       | (4,220 | ) |
| Net cash provided by (used in) financing  activities                                      |   | (1,623                               | )       | 14,297 |   |
|                                                                                      |   |                                 |    |   |   |
| Net increase (decrease) in cash and cash  equivalents                                     |   | (10,391                              | )       | 15,237 |   |
| Cash and cash equivalents at beginning of  period                                         |   | 19,733                               |    | 8,606 |   |
| Cash and cash equivalents at end of period                                                |   | $                                    | 9,342   |   | $ | 23,843 |   |
|                                                                                      |   |                                 |    |   |   |
| **Supplemental cash  flow information**                                                   |   |                                 |    |   |   |
| Cash paid for interest                                                                    |   | $                                    | 232     |   | $ | 4,167 |   |
|                                                                                      |   |                                 |    |   |   |
| **Supplemental  noncash activities**                                                      |   |                                 |    |   |   |
| Equipment purchases under capital leases                                                  |   | $                                    | 710     |   | $ | 1,354 |   |
| Value of common stock issued to management                                                |   | $                                    | 124     |   | $ | 14 |   |

 

*See accompanyingnotes.*

 

5

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**Eschelon Telecom, Inc.**

**Notes to Consolidated Financial Statements**

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

**(Unaudited)**

 

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

 

**Basis of Presentation**

 

The accompanying unaudited consolidated financialstatements of Eschelon Telecom, Inc. and its subsidiaries (the “Company”) havebeen prepared in accordance with accounting principles generally accepted inthe United States of America for interim financial information and theinstructions to Form 10-Q and Article 10 of Regulation S-X promulgated bythe 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, alladjustments (consisting of normal and recurring adjustments and accruals)considered necessary for a fair presentation for the periods indicated havebeen included.  Operating results forthe three and six month periods ended June 30, 2004 are not necessarilyindicative of the results that may be expected for the year endingDecember 31, 2004.  Theconsolidated balance sheet at December 31, 2003 has been derived from theaudited consolidated financial statements at that date but does not include allof the information and footnotes required by generally accepted accountingprinciples for complete financial statements. These financial statements should be read in conjunction with theCompany’s audited financial statements and related notes thereto for the yearended December 31, 2003 included in the Eschelon Operating Company FormS-4/A, File No. 333-114437-08, filed with the Securities and ExchangeCommission on May 6, 2004.

 

# **Principlesof Consolidation**

 

The consolidated financial statements include the accounts of theCompany and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated inconsolidation.

 

## **Property andEquipment**

 

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 salaries of certain employees, are capitalized.  Depreciation is provided using thestraight-line method over the estimated useful lives of the assets.  Leasehold improvements are amortized overthe shorter of the related lease term or the estimated useful life of theasset.

 

Property and equipment consist of the following:

 
|                                      |   | **December 31,  2003** |   | **June 30,  2004** |   |
|-------------------------------------------|--------|-----------------------------|--------|-------------------------|--------|
|                                      |   |                        |   |                    |   |
| Vehicles                                  |   | $                           | 39     |                    | $      | 121 |   |
| Office furniture and equipment            |   | 13,243                      |   | 14,566                  |   |
| Computer equipment and software           |   | 30,264                      |   | 31,965                  |   |
| Leasehold improvements                    |   | 16,931                      |   | 17,287                  |   |
| Switching and data equipment and software |   | 76,751                      |   | 81,338                  |   |
|                                      |   | 137,228                     |   | 145,277                 |   |
| Less accumulated depreciation             |   | (50,451                     | )      | (59,311                 | )      |
|                                      |   | $                           | 86,777 |                    | $      | 85,966 |   |

 

## **Goodwill andIntangibles**

 

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

 

6

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Intangibles consist of debt issuance costs, customer installationcosts, and noncompete agreements.  Debtissuance costs are being amortized over the term of the respective debtobligation.  The customer installationcosts are being amortized over a period of 48 months, which approximates theaverage life of a customer contract. Noncompete agreement costs represent costs associated with variousagreements the Company has entered into with existing management of thecompanies they have acquired.  Thesecosts are being amortized over the terms of the agreements.

 

Intangible assets consist of the following:

 
|                          |   | **December 31,  2003** |   | **June 30,  2004** |   |
|-------------------------------|--------|-----------------------------|--------|-------------------------|--------|
|                          |   |                        |   |                    |   |
| Customer set-up costs         |   | $                           | 52,794 |                    | $      | 58,290 |   |
| Debt issuance costs           |   | 5,833                       |   | 4,220                   |   |
| Non-compete agreements        |   | 15                          |   | 15                      |   |
|                          |   | 58,642                      |   | 65,525                  |   |
| Less accumulated amortization |   | (29,590                     | )      | (32,847                 | )      |
|                          |   | $                           | 29,052 |                    | $      | 29,678 |   |

 

## **RevenueRecognition**

 

Revenues from network services are recognized in the period in whichsubscribers use the related services. Revenues from equipment sales and related installation charges arerecognized upon delivery, completion of the installation of the relatedequipment, and acceptance by the customer, at which point legal title passes tothe customer.  Revenues for carrierinterconnection and access are recognized in the period in which the service isprovided.

 

## **Use of Estimates**

 

The preparation of financial statements in conformity with accountingprinciples generally accepted in the United States requires management to makeestimates and assumptions that affect the amounts reported in the financialstatements and accompanying notes. Actual results could differ from those estimates.

 

## **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 Stock Issued to Employees,*and relatedinterpretations.  Under APB No. 25, whenthe exercise price of stock options equals the market price of the underlyingstock on the date of grant, no compensation expense is recognized in theconsolidated statement of operations.

 

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

 

7

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|                                                                                                              |   | **Three  months ended  June 30,** |   | **Six months  ended  June 30,** |   |
|-------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                                                                                                              |   | **2003**                               |   | **2004**                             |   | **2003** |   | **2004** |   |
| Net income (loss) applicable to common  stockholders, as reported                                                 |   | $                                      | (5,455 | )                                    | $      | (4,231 | ) | $ | (11,924 | ) | $ | 9,199 |   |
| Add: Stock-based employee compensation  expense included in reported net income (loss)                            |   | —                                 |   | —                               |   | 70 |   | 20 |   |
| Deduct: Total stock-based employee  compensation expense determined under fair value-based methods for all awards |   | (4                                     | )      | (16                                  | )      | (131 | ) | (48 | ) |
| Pro forma net income (loss) applicable to  common stockholders                                                    |   | $                                      | (5,459 | )                                    | $      | (4,247 | ) | $ | (11,985 | ) | $ | 9,171 |   |
|                                                                                                              |   |                                   |   |                                 |   |   |   |   |   |
| Net income (loss) per share:                                                                                      |   |                                   |   |                                 |   |   |   |   |   |
| Basic - as reported                                                                                               |   | $                                      | (1.76  | )                                    | $      | (1.09 | ) | $ | (4.33 | ) | $ | 2.45 |   |
| Basic - pro forma                                                                                                 |   | $                                      | (1.76  | )                                    | $      | (1.09 | ) | $ | (4.36 | ) | $ | 2.44 |   |
|                                                                                                              |   |                                   |   |                                 |   |   |   |   |   |
| Diluted - as reported                                                                                             |   | $                                      | (1.76  | )                                    | $      | (1.09 | ) | $ | (4.33 | ) | $ | 0.16 |   |
| Diluted - pro forma                                                                                               |   | $                                      | (1.76  | )                                    | $      | (1.09 | ) | $ | (4.36 | ) | $ | 0.16 |   |

 

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 fair valueof these options was estimated at the date of grant using the Black-Scholesoption pricing model with the following assumptions for the three months endedJune 30, 2003 and 2004:  arisk-free interest rate of 3.25% and 3.88%, respectively; dividend yield of 0%for each period; volatility factor of the expected market price of theCompany’s common stock of 25% for each period; and a weighted average life ofthe options of five years for each period. The following assumptions were used for the six months endedJune 30, 2003 and 2004:  arisk-free interest rate ranging from 3.25% to 3.88%; dividend yield of 0% for eachperiod; volatility factor of the expected market price of the Company’s commonstock of 25% for each period; and a weighted average life of the options offive 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.  Inaddition, 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 input assumptions canmaterially affect the fair value estimate, in management’s opinion, theexisting models do not necessarily provide a reliable single measure of thefair value of its employee stock options.

 

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

 

Basic earnings per share is computed based on the weighted averagenumber of common shares outstanding. Diluted earnings per share is computed based on the weighted averagenumber of common shares outstanding adjusted by the number of additional sharesthat would have been outstanding had the potentially dilutive common sharesbeen issued.  Potentially dilutiveshares of common stock include stock options, unvested restricted stock grantsand Series A Convertible Preferred Stock. During periods in which a net loss is incurred, diluted earnings pershare amounts are the same as basic per share amounts because the effect of alloptions, unvested restricted stock grants and Series A Convertible PreferredStock is anti-dilutive.

 

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

 

8

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|                                                              |   | **Three  months ended  June 30,** |   | **Six months  ended  June 30,** |   |
|-------------------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
|                                                              |   | **2003**                               |   | **2004**                             |   | **2003** |   | **2004** |   |
| Numerator:                                                        |   |                                   |   |                                 |   |   |   |   |   |
| Net income (loss) applicable to common  stockholders, as reported |   | $                                      | (5,455 | )                                    | $      | (4,231 | ) | $ | (11,924 | ) | $ | 9,199 |   |
| Add: Cumulative preferred stock dividends                         |   | —                                 |   | —                               |   | — |   | 7,835 |   |
| Deduct: Unrecognized deferred compensation  expense               |   | —                                 |   | —                               |   | — |   | (34 | ) |
| Numerator for diluted earnings per share                          |   | $                                      | (5,455 | )                                    | $      | (4,231 | ) | $ | (11,924 | ) | $ | 17,000 |   |
|                                                              |   |                                   |   |                                 |   |   |   |   |   |
| Denominator:                                                      |   |                                   |   |                                 |   |   |   |   |   |
| Weighted average number of common shares  outstanding             |   | 3,101,923                              |   | 3,889,854                            |   | 2,750,800 |   | 3,759,693 |   |
| Effect of dilutive securities:                                    |   |                                   |   |                                 |   |   |   |   |   |
| Restricted stock grants                                           |   | —                                 |   | —                               |   | — |   | 426,810 |   |
| Employee stock options                                            |   | —                                 |   | —                               |   | — |   | 4,556,306 |   |
| Series A convertible preferred stock                              |   | —                                 |   | —                               |   | — |   | 99,732,468 |   |
| Denominator for diluted earnings per share                        |   | 3,101,923                              |   | 3,889,854                            |   | 2,750,800 |   | 108,475,277 |   |
|                                                              |   |                                   |   |                                 |   |   |   |   |   |
| Net income (loss) per share:                                      |   |                                   |   |                                 |   |   |   |   |   |
| Basic - as reported                                               |   | $                                      | (1.76  | )                                    | $      | (1.09 | ) | $ | (4.33 | ) | $ | 2.45 |   |
| Diluted - as reported                                             |   | $                                      | (1.76  | )                                    | $      | (1.09 | ) | $ | (4.33 | ) | $ | 0.16 |   |

 

## **New AccountingPronouncements**

 

In May 2003, the Financial Accounting Standards Board issued SFAS No.150, *Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity. *SFAS No. 150requires that certain financial instruments, which under previous guidance wereaccounted for as equity, must now be accounted for as liabilities.  The financial instruments affected includemandatorily redeemable stock, certain financial instruments that require or mayrequire the issuer to buy back some of its shares in exchange for cash or otherassets and certain obligations that can be settled with shares of stock.  SFAS No. 150 is effective for all financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective the beginning of the first interim period after June 15,2003.  The adoption of SFAS No. 150 didnot have a material impact on the Company’s financial statements and did notrequire the Company to reclassify its Series A Preferred Stock to a liabilityas the shares are contingently redeemable.

 

## **Reclassifications**

 

Certain prior year amounts have been reclassified to conform to currentyear presentation.

 

**2.)****          NotesPayable**

 

In March 2004, the Company completed an offering of $100,000 of 83/8% senior second secured notes due 2010 at a discount resulting in a 12%yield.  Proceeds from the offering wereused to retire bank debt with a principal balance of $65,421, pay fees relatedto the offering and provide additional liquidity to the Company.

 

The carrying value of notes payable is comprised of the following:

 
|                     |   | **December 31,  2003** |   | **June 30,  2004** |   |
|--------------------------|--------|-----------------------------|--------|-------------------------|--------|
|                     |   |                        |   |                    |   |
| Principal balance due    |   | $                           | 64,355 |                    | $      | 100,000 |   |
| Excess carrying value    |   | 21,871                      |   | —                  |   |
| Discount on note payable |   | —                      |   | (14,668                 | )      |
| Carrying value           |   | $                           | 86,226 |                    | $      | 85,332 |   |

 

9

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**3.)****          Commitmentsand Contingencies**

 

In April 2003, the Company entered into a five-year agreement withMCI to purchase colocation/LIS transport services.  The agreement requires that the Company maintain monthly minimumsas follows:

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

 

The Company will pay an underutilization charge for any amounts billedunder the monthly minimum.

 

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

 

In August 2000, the Company entered into a ten-year agreement withGlobal Crossing to purchase a total of $100,000 of services.  The agreement does not contain monthlyminimums, however a penalty is assessed for early termination upon change in control.  Upon change in control, the earlytermination penalties are $10,000 through August 2004, and $5,000 fromSeptember 2004 through August 2010.

 

See Regulatory Overview andLegal Proceedings discussion within the Management’s Discussion and Analysisand Legal Proceedings sections presented in this document.

 

**4.)****          CapitalStock**

 

Under the terms of the Series A Convertible Preferred Stock, theholders are entitled to receive, when and if declared by the Board ofDirectors, cumulative dividends on each share of the Series A ConvertiblePreferred Stock at a rate of 8% per year which shall accrue daily and, to theextent not paid, shall accumulate quarterly in arrears.  At December 31, 2003 and June 30,2004, dividends in arrears are $6,127 and $7,835, respectively.

 

The shares of Series A Convertible Preferred Stock, plus all accruedand unpaid dividends at the time of conversion, are convertible at any time, atthe option of the holder, into shares of the Company’s common stock at theinitial conversion price, which is the original issue price of $0.5079.  The conversion price is subject toadjustment in the event of certain events, such as dilutive issuances ofadditional securities.  The Series AConvertible Preferred Stock will automatically convert into common stock in theevent of an initial public offering raising at least the greater of $50,000 orthe amount of principal and interest outstanding under the CreditAgreement.  The Series A ConvertiblePreferred Stock may be automatically converted upon the consent of the holdersof at least 60% of the then outstanding shares of Series A ConvertiblePreferred Stock.

 

The shares of Series A Convertible Preferred Stock will be redeemed onthe tenth anniversary of the original issuance, if the shares have notpreviously been redeemed or converted. The Company may redeem all of the Series A Convertible Preferred Stockupon the effectiveness of an initial public offering.  The redemption price of the Series A Convertible Preferred stockwill be the greater of (i) the original issue price plus all accrued and unpaiddividends or (ii) the fair market value of the shares of common stock, asdetermined by the Board of Directors, that would be received upon conversion of(a) the Series A Convertible Preferred Stock, and (b) any accrued and unpaiddividends on the Series A Convertible Preferred Stock.  Upon a change of control, the holders of 60%of the then outstanding shares of the Series A Convertible Preferred Stock mayrequire the Company to redeem all of or a portion of the Series A ConvertiblePreferred Stock at a price equal to (1) the liquidation preference (asdescribed below) if the change of control occurs before the fifth anniversaryof the original issue date and (2) the redemption price if the change ofcontrol occurs after the fifth anniversary of the original issue date.

 

10

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In the event of the Company’s liquidation, the holders of the Series AConvertible Preferred Stock will receive any distribution of corporate assetsbefore any distributions are made to a junior class of equity.  The amount to be distributed to the holdersof Series A Convertible Preferred Stock will be the greater of (i) two timesthe original issue price plus all accrued and unpaid dividends (whether or notyet accumulated) as of the date of distribution, or (ii) the fair market valueof the shares of the Company’s common stock, as determined by the Board ofDirectors, that would be received upon (1) conversion of the Series AConvertible Preferred Stock, (2) any accrued and unpaid dividends and, (3) ifthe liquidation is prior to the fifth anniversary of the date of issuance ofthe Series A Convertible Preferred Stock, all additional dividends that wouldhave been accrued through the fifth anniversary date.

 

## **Stock Options**

 

In November 2002, the Board of Directors approved the EschelonTelecom, Inc. Stock Option Plan of 2002 (the 2002 Plan).  A total of 14,117,647 shares of theCompany’s common stock have been reserved for issuance under the 2002Plan.  At June 30, 2004, the Companyhad 10,337,796 options outstanding and 2,484,979 shares of restricted commonstock issued to certain directors and members of management under the 2002Plan.

 

## **Restricted CommonStock**

 

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 2003, 1,399,902 shares hadvested resulting in compensation expense related to restricted common stock of$70.  In February 2004, anadditional 405,968 shares had vested resulting in compensation expense of $20.

 

11

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

 

## **Forward-Looking andCautionary 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, orthe negative thereof, and other similar statements), you should understand thatour expectations 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 will happenas described or that any positive trends noted in this document will continue.

 

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 futureperformance.  They involve risks anduncertainties relative to return expectations and related allocation ofresources, and changing economic or competitive conditions, as well as thenegotiation of agreements with third parties and other factors discussedherein, which could cause actual results to differ from present plans orexpectations, and such differences could be material.  Similarly, forward-looking statements regarding management’spresent expectations for operating results and cash flow involve risks anduncertainties relative to these and other factors, such as the ability toincrease revenues and/or to achieve cost reductions and other factors discussedherein, which also would cause actual results to differ from presentplans.  Such differences could bematerial.  All forward-lookingstatements attributable to us or by any persons acting on our behalf areexpressly qualified in their entirety 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,we will not update these forward-looking statements, even if our situationchanges in the future.

 

## **Company Overview**

 

We are a leading facilities-based provider of integrated voice and datacommunications services to small and medium-sized businesses in 12 markets inthe western United States.  Our voiceand data services, which we refer to as network services, include local dialtone, long distance, enhanced voice features and dedicated Internet accessservices.  We also sell, install andmaintain business telephone and data systems and equipment, which we callBTS.  We provide these products andservices individually or in customized packages to address our customers’ needfor an outsourced voice and data network solution.

 

We have increased our annual revenue every year from $41.7 million forthe year ended December 31, 1999 to $141.1 million for the year endedDecember 31, 2003, and we have increased our gross profit from $14.8million to $80.3 million over the same period. As of June 30, 2004, we provided service through 225,949 totalaccess lines, an increase of 9.5% from 206,421 total access lines atDecember 31, 2003.

 

Our goal is to provide services to our customers on our network, oron-net, which will allow us to continue to expand our operating margins andimprove profitability.  We havecontinued to increase the percentage of on-net customers with a strategicallydeployed and incentivized sales force. Increasing our on-net percentage improves customer retention, leveragesour network, increases profitability and reduces our exposure to regulatoryrisk.  We selectively provide servicevia the unbundled network element-platform, or UNE-P, to reach locationsoutside of our network footprint of on-net customers and to provide QwestDSL.  For the six months endedJune 30, 2004, 89.1% of our new access lines installed were on-net and asof June 30, 2004, 77.4% of our total access lines in service were on-net.

 

Customer retention is a key metric that we use to measure the successof our business.  We report monthlyaccess line attrition, or churn, as measured by dividing total access linesdisconnected for the month by our total access lines at the end of themonth.  We believe our low level ofchurn reflects our high quality of service and the value proposition we provideto new and existing customers.  Due toour focus on improved service levels, competitive pricing and customer creditquality, we have reduced our monthly churn to levels that we believe are industryleading.  For the six months ended June 30,2004, our monthly churn averaged 1.53% compared to 1.60% for the year endedDecember 31, 2003.

 

12

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***Revenue.***  Network services revenue consists primarilyof local dial tone, long distance, access charges, and data service.  Revenue from local telephone serviceconsists of charges for basic local service, including dedicated T1 access, andcustom-calling features such as call waiting and call forwarding.  Revenue from long distance service consistsof per-minute-of-use charges for a full range of traditional switched anddedicated long distance, toll-free calling, international, calling card andoperator services.  Revenue from dataservices consists primarily of monthly usage fees for dedicated Internet accessservices.

 

Network services revenue is recognized in the month the services areused.  In the case of local servicerevenue, local services charges are billed in advance but accrued for andrecognized on a prorated basis based on length of service in any givenmonth.  Long distance and access chargesare billed in arrears but accrued based on monthly average usage per line perday.  We do not receive any revenuesfrom reciprocal compensation due to our bill-and-keep arrangement with Qwestnor do we have any wholesale revenue other than access revenue.  For the six month period ended June 30,2004, carrier access revenue represented 8.5% of our total revenue.

 

BTS revenue consists of revenue from both the sale of telephoneequipment and the servicing of telephone equipment systems.  Telephone equipment revenue is recognizedupon delivery and acceptance by the customer. Service revenue is recognized upon completion of service or, in the caseof maintenance agreements, is spread equally over the life of the maintenancecontract.

 

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

 

•      leasing local loops anddigital T1 lines which connect our customers to our network;

 

•      leasing high capacitydigital lines that interconnect our network with ILECs;

 

•      leasing high capacitydigital lines that connect our switching equipment to our colocations;

 

•      leasing space in ILECcentral offices for colocating our equipment;

 

•      signaling system networkconnectivity; and

 

•      leasing our ATM backbonenetwork.

 

The costs to lease local loops, digital T1 lines and high capacitydigital interoffice facilities from the ILECs varies by carrier and by stateand are regulated under the Telecommunications Act of 1996.  In virtually all areas, we lease localloops, T1 lines and interoffice capacity from the ILECs.  We lease interoffice facilities fromcarriers other than the ILEC where possible in order to lower costs and improvenetwork redundancy.  However, in mostcases, the ILEC is the only source for local loops and T1 lines.  We also purchase, on a wholesale ornegotiated basis, UNE-P and customized network element packages, or UNE-E, fromQwest and Centrex services from SBC Communications Inc.  The rates for UNE-P and Centrex areregulated and established by the various state corporation or utilitycommissions.  As of June 30, 2004 andDecember 31, 2003, we had 42,921 and 45,041 UNE-P access lines in service,respectively.  As of June 30, 2004 andDecember 31, 2003, we had 8,095 and 8,493 Centrex access lines in service,respectively.  The rates for UNE-E werenegotiated with Qwest under the terms of a five-year contract that expiresDecember 31, 2005.  As ofJune 30, 2004 and December 31, 2003, we had 1,942 and 1,934 UNE-Eaccess lines in service, respectively.

 

We have entered into wholesale purchasing agreements with long distanceand other service providers.  Some ofthese agreements also contain termination penalties and/or minimum usage volumecommitments.  In the event we fail tomeet minimum volume commitments, we may be obligated to pay underutilizationcharges.  We do not anticipate having topay any underutilization charges in the foreseeable future.

 

We carefully review all of our vendor invoices and frequently disputeinaccurate or inappropriate charges. Our single largest vendor is Qwest, to whom we paid $25.8 million forthe year ended December 31, 2003, and $16.7 million for the six monthsended June 30, 2004.  We frequentlyshort pay vendor invoices in order to pay proper amounts owed.  We use significant estimates to determinethe level of success in dispute resolution and consider past historicalexperience, basis of dispute, financial status and current relationship withvendors and aging of prior disputes in quantifying our estimates.

 

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

 

Our most significant BTS costs are the equipment purchased frommanufacturers and labor for service and equipment installation.  To take advantage of volume purchasediscounts, we purchase equipment primarily

 

13

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from three manufacturers.  ForBTS installations our policy is to require a 30% deposit before ordering theequipment so our risk of excess inventory or inventory obsolescence is low.  BTS cost of revenue also includes salariesand benefits of field technicians as well as vehicle and incidental expensesassociated with equipment installation, maintenance and service provisioning.

 

***Sales, general andadministrative expenses.***  Sales, general and administrative expenses are comprised primarilyof salaries 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 anumber of factors in determining the proper level of the allowance, includinghistorical collections experience, current economic trends, the aging of theaccounts receivable portfolio and changes in the creditworthiness of ourcustomers.  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.  For the six months ended June 30, 2003and 2004, our bad debt expense as a percentage of revenue was 0.5% and 0.6%,respectively.

 

***Depreciation andamortization.*** Our depreciation and amortization currently includes depreciation fornetwork related voice and data equipment, back office systems, furniture,fixtures, leasehold improvements, office equipment and computers.  All internal costs directly related to theexpansion of our network and operating and support systems, including salariesof certain employees, are capitalized and depreciated over the lives of theswitches or systems, as the case may be. Capitalized customer installation costs are amortized over theapproximate average life of a customer. Detailed annual time studies are used to determine laborcapitalization.  These time studies arebased on employee time sheets for those engaged in capitalizable activities.

 

In 2002, we adopted Statement of Financial Accounting Standards (SFAS)No. 142, *Goodwill and Intangible Assets*.  SFAS No. 142 provides that goodwill andintangible assets that have indefinite useful lives not be amortized but ratherbe tested at least annually for impairment.

 

## **Regulatory Overview**

 

FCC rules implementing the local competition provisions of theTelecommunications Act permit CLECs to lease UNEs at rates determined by PUCsemploying the FCC’s Total Element Long Run Incremental Cost, or TELRIC,forward-looking, cost-based pricing model. On September 15, 2003, the FCC opened a proceeding re-examining theTELRIC methodology and wholesale pricing rules for communications services madeavailable for resale by ILECs in accordance with the TelecommunicationsAct.  This proceeding willcomprehensively re-examine whether the TELRIC pricing model producesunpredictable pricing inconsistent with appropriate economic signals; fails toadequately reflect the real-world attributes of the routing and topography ofan ILEC’s network; and creates disincentives to investment in facilities byunderstating forward-looking costs in pricing RBOC network facilities andoverstating efficiency assumptions.  Wehave joined a coalition of CLECs to participate in this proceeding.  The application and effect of a revisedTELRIC pricing model on the communications industry generally and on certain ofour business activities cannot be determined at this time.

 

In August 2003, in its TRO, the FCC substantially modified itsrules governing access to UNEs by CLECs. However, on March 2, 2004, the D.C. Circuit vacated certainportions of the TRO and remanded the TRO to the FCC for furtherproceedings.  Specifically, the Courtvacated the FCC’s delegation of decision-making authority to state commissionsand several of the FCC’s nation-wide impairment determinations.  The Court also found that the FCC used aflawed methodology when making certain network element unbundlingdeterminations and remanded those determinations back to the FCC for furtheranalysis and justification.  The Courttemporarily stayed the effectiveness of its decision until (1) the denial ofany petition for rehearing or (2) May 2, 2004. The Court subsequently extended the effective date until June 15,2004.

 

The FCC and the Solicitor General have declined to appeal the Court’sorder. The National Association of Regulatory Utility Commissioners and acoalition of CLECs, including Eschelon, separately appealed the decision.  We expect to learn whether the Supreme Courtwill take the case before the end of the year.

 

14

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Although the Court’s order is now in effect, we do not know how or whenthe FCC will respond to it.  The FCCcould issue interim rules in a relatively short time period that would remainin effect until permanent rules were issued or the FCC could forego interimrules.  We do not know when the FCCmight issue either interim or permanent rules nor do we know what the ruleswill be or the effect such rules could have upon our business.  However, it has been reported in the tradepress that the FCC will shortly issue a Notice of Proposed Rulemaking that will“preserve rates for unbundled network elements for six months, with rateincreases expected to occur in the months that follow, according to industrysources . . .  It is speculated that anotice of proposed rulemaking to establish permanent rules will be releasedthat calls for grandfathering any lines in service as of the end of thestandstill period at total-element long-run increment cost (TELRIC) rates plusa 15% increase.  It is furtherspeculated that the [Notice] would open the door for ILECs to set the rates fornew network access orders, subject to contractual obligations”(1).

 

The ILECs have stated that they interpret the order as eliminatingunbundled switching, transport, high capacity loops and dark fiber asUNEs.  Except for dark fiber, Eschelonuses all of these UNEs.  Eschelon, alongwith many other CLECs, interprets the effect of the order differently,reasoning that under the 1996 Telecommunications Act as well as under statestatutes, unbundling is still required where CLECs are impaired without accessto UNEs.  Furthermore, whereas the Courtexplicitly vacated the rules requiring the unbundling of mass market switchingand transport, it was silent with respect to high capacity loops.

 

The ILECs have also stated that they will follow the “change of law”provisions in our interconnection agreements. These provisions provide that when a party to the agreement believes thegoverning law has changed its obligations under the agreement, it may requestthat the other party enter into negotiations to amend the agreement.  If the parties are unable to agree upon anamendment, the dispute is arbitrated either by a neutral arbitrator or by therelevant state commission.  Weanticipate that “change of law” negotiations will commence soon.  We do not know when the negotiations mightconclude nor the effect of any amendments arrived at upon our business.

 

The FCC has encouraged ILECs and CLECs to engage in commercial negotiationsto provide access to ILEC facilities that may no longer be available asUNEs.  Although a few such agreementshave been announced, the great majority of CLECs, including Eschelon, have notsucceeded in negotiating new agreements as of this date.  Qwest and MCI recently made public afour-year agreement which provides MCI an alternative to the UNE-P productsthey currently purchase from Qwest today at higher prices.  Qwest has stated that it will make similarterms and conditions available to other CLECs. We are currently evaluating the agreement.  In addition, Eschelon has sent Qwest its own proposal relating toUNE-P, but we have not yet received a response.

 

As a condition of entering the long distance markets, the Act requiresILECs to provide CLECs with loops, transport, and unbundled switching.  In the TRO, the FCC determined, and the D.C.Circuit Court agreed, that these facilities must be made available to CLECs at“just and reasonable” rates, in contrast to UNEs which are available at TELRICrates.  We do not know what “just andreasonable” rates would be nor do we know when such rates might be establishednor the roles of the FCC or state commissions in establishing such rates.  In addition, Bell South has petitioned theFCC requesting that the FCC forebear from requiring RBOCs to provide an elementunder the long distance provisions of the Act if the RBOC is no longer requiredto provide the analogous UNE under the local competition portions of theAct.  We do not know how the FCC willrule on Bell South’s petition.

 

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(1)  *“Interim UNE Rules Expected To Offer Six-Month Freeze, Could Spark BellLegal Fight,” Telecommunications Reports, August 1, 2004.*

 

15

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## **Comparison ofFinancial Results**

 

**Overview of Results**

 

Selected consolidated financial and operating data for the three andsix month periods ended June 30, 2003 and 2004 is as follows (dollars inthousands, except per unit amounts):

 
|                             |   | **Three  months ended June 30,** |   | **Six months  ended June 30,** |   |
|----------------------------------|--------|---------------------------------------|--------|-------------------------------------|--------|
|                             |   | **2003**                              |   | **2004**                            |   | **% Change** |   | **2003** |   | **2004** |   | **% Change** |   |
|                             |   | **(unaudited)**                       |   | **(unaudited)**                     |   |   |   | **(unaudited)** |   | **(unaudited)** |   |   |   |
| Total revenue                    |   | $                                     | 35,405 |                                | $      | 39,151 |   | 10.6 | % | $ | 67,319 |   | $ | 77,347 |   | 14.9 | % |
| Total gross margin (%)           |   | 56.6                                  | %      | 60.6                                | %      | 7.2 | % | 56.3 | % | 60.1 | % | 6.8 | % |
| EBITDA                           |   | $                                     | 3,884  |                                | $      | 6,657 |   | 71.4 | % | $ | 6,318 |   | $ | 13,004 |   | 105.8 | % |
| Capital expenditures             |   | $                                     | 8,054  |                                | $      | 6,789 |   | (15.7 | )% | $ | 14,776 |   | $ | 13,829 |   | (6.4 | )% |
| Cash                             |   | $                                     | 9,342  |                                | $      | 23,843 |   | 155.2 | % | $ | 9,342 |   | $ | 23,843 |   | 155.2 | % |
|                             |   |                                  |   |                                |   |   |   |   |   |   |   |   |   |
| Voice lines in service           |   | 144,396                               |   | 162,622                             |   | 12.6 | % | 144,396 |   | 162,622 |   | 12.6 | % |
| Data lines in service            |   | 36,825                                |   | 63,327                              |   | 72.0 | % | 36,825 |   | 63,327 |   | 72.0 | % |
| Total lines in service           |   | 181,221                               |   | 225,949                             |   | 24.7 | % | 181,221 |   | 225,949 |   | 24.7 | % |
| Lines on-net (%)                 |   | 69.6                                  | %      | 77.4                                | %      | 11.3 | % | 69.6 | % | 77.4 | % | 11.3 | % |
| Lines sold                       |   | 20,889                                |   | 22,773                              |   | 9.0 | % | 43,866 |   | 42,236 |   | (3.7 | )% |
| Average monthly churn (%)        |   | 1.71                                  | %      | 1.52                                | %      | (10.9 | )% | 1.75 | % | 1.53 | % | (12.1 | )% |
| Average network revenue per line |   | $                                     | 52.98  |                                | $      | 49.06 |   | (7.4 | )% | $ | 53.22 |   | $ | 49.73 |   | (6.6 | )% |
|                             |   |                                  |   |                                |   |   |   |   |   |   |   |   |   |
| Average total associates         |   | 890                                   |   | 918                                 |   | 3.1 | % | 898 |   | 902 |   | 0.4 | % |
| Average total sales associates   |   | 189                                   |   | 195                                 |   | 3.2 | % | 190 |   | 184 |   | (3.2 | )% |
| Average network sales associates |   | 152                                   |   | 156                                 |   | 2.9 | % | 153 |   | 148 |   | (3.5 | )% |

 

**ThreeMonths Ended June 30, 2004 versus Three Months Ended June 30, 2003**

 

***Revenue.***  Revenue for the three months endedJune 30, 2003 and 2004 is as follows:

 
|                       |   | **2003**        |   | **2004**        |   | **% Change** |   |
|----------------------------|--------|-----------------|--------|-----------------|--------|--------------|--------|
|                       |   | **(unaudited)** |   | **(unaudited)** |   |         |   |
| Revenue (in millions):     |   |            |   |            |   |         |   |
| Voice and data services    |   | $               | 20.4   |            | $      | 24.1         |   | 18.3 | % |
| Long distance              |   | 4.7             |   | 5.4             |   | 13.8         | %      |
| Access                     |   | 3.1             |   | 3.3             |   | 5.6          | %      |
| Total network services     |   | 28.2            |   | 32.8            |   | 16.2         | %      |
| Business telephone systems |   | 7.2             |   | 6.4             |   | (11.2        | )%     |
| Total revenue              |   | $               | 35.4   |            | $      | 39.2         |   | 10.6 | % |

 

Network services revenue was $32.8 million for the three months endedJune 30, 2004, an increase of 16.2% from $28.2 million in the same periodof 2003.  The increase in revenue wasprimarily due to an increase in the average number of voice and data accesslines in service.  Over the past 12months the number of voice lines increased by 12.6% to 162,622 lines atJune 30, 2004 and the number of data lines increased by 72.0% to 63,327lines at June 30, 2004.  The growthin access lines was partially offset by declines in long distance and accessrevenue per minute of use and a decline in data revenue per line.  Due to continued high levels of competition,long distance revenue per minute of use declined.  Access revenue per minute of use declined in line with thescheduled FCC reduction of interstate rate levels.  Data revenue per line declined due to a combination of customerspurchasing more bandwidth at discounted prices and general pricing pressuresfor data services in our markets.  Weexpect all of the above trends in line growth, long distance rates, accessrates and data revenue per line to continue for the foreseeable future.  As we continue to grow, our size and churnwill begin to limit our access line growth rate on both an absolute and on apercentage basis unless we increase our sales force and geographic territory.

 

16

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BTS revenue was $6.4 million for the three months ended June 30,2004, a decrease of 11.2% from $7.2 million in the same period of 2003.  The decrease in revenue was primarily due toa decrease in revenue from change orders and new system sales.  We cannot predict future trends in capitalspending by small and medium-sized business customers.

 

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

 
|                           |   | **2003**        |   | **2004**        |   | **% Change** |   |
|--------------------------------|--------|-----------------|--------|-----------------|--------|--------------|--------|
|                           |   | **(unaudited)** |   | **(unaudited)** |   |         |   |
| Cost of revenue (in millions): |   |            |   |            |   |         |   |
| Network services               |   | $               | 11.2   |            | $      | 11.6         |   | 3.6 | % |
| Business telephone systems     |   | 4.2             |   | 3.8             |   | (8.9         | )%     |
| Total cost of revenue          |   | $               | 15.4   |            | $      | 15.4         |   | 0.2 | % |

 

Network services cost of revenue was $11.6 million for the three monthsended June 30, 2004, an increase of 3.6% from $11.2 million in the sameperiod of 2003.  This increase is due toour growth in access lines.  As apercentage of related revenue, network services cost of revenue for the threemonths ended June 30, 2004 declined to 35.4% from 39.7% for the sameperiod of 2003.  This improvement wasdue to the increase in our percentage of access lines on-net to 77.4% as ofJune 30, 2004 from 69.6% as of June 30, 2003.

 

BTS cost of revenue was $3.8 million for the three months endedJune 30, 2004, a decrease of 8.9% from $4.2 million in the same period of2003.  This decrease was due to adecrease in materials cost related to the change orders and new system salesmentioned previously.  As a percentageof related revenue, BTS cost of revenue for the three months endedJune 30, 2004 increased to 59.6% from 58.0% for the same period of2003.  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 endedJune 30, 2003 and 2004 is as follows:

 
|                        |   | **2003**        |   | **2004**        |   | **% Change** |   |
|-----------------------------|--------|-----------------|--------|-----------------|--------|--------------|--------|
|                        |   | **(unaudited)** |   | **(unaudited)** |   |         |   |
| Gross profit (in millions): |   |            |   |            |   |         |   |
| Network services            |   | $               | 17.0   |            | $      | 21.2         |   | 24.4 | % |
| Business telephone systems  |   | 3.0             |   | 2.6             |   | (14.5        | )%     |
| Total gross profit          |   | $               | 20.0   |            | $      | 23.8         |   | 18.5 | % |

 

The increase in gross profit for the three months ended June 30,2004, from the same period of 2003, is due to the increase in revenue mentionedpreviously.

 

***Sales, General and Administrative Expense.***  Sales, general and administrative expenseswere $17.1 million for the three months ended June 30, 2004, an increaseof 5.8% from $16.1 million in the same period of 2003.  The increase is primarily due to higheraverage payroll and fringe benefit expenses and an increase in operating taxes.  As a percentage of revenue, sales, generaland administrative expenses for the three months ended June 30, 2004declined to 43.6% from 45.6% in the same period of 2003 due to the improvedefficiency of our existing operations resulting from our fixed cost structuresupporting a higher level of revenue. We expect this trend to continue as we add more access lines with onlymodest increase in our employee base.

 

***EBITDA.***  Earnings before interest, taxes,depreciation and amortization (EBITDA) was $6.7 million for the three monthsended June 30, 2004, an increase of 71.4% from $3.9 million in the sameperiod of 2003.  This increase was dueto increased profit margins and lower sales, general and administrativeexpenses as a percentage of revenue.

 

EBITDA is a not a measure of financial performance under generallyaccepted accounting principles (GAAP). EBITDA is provided because it is a measure of financial performancecommonly used as an indicator of a company’s historical ability to servicedebt.  EBITDA should not be construed asan alternative to operating income, as an indicator of operating performancenor as an alternative to cash flows provided by operating activities as ameasure of liquidity determined in accordance with GAAP.  We may

 

17

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calculate EBITDA differently than other companies.  The following is a schedule reconcilingEBITDA with reported GAAP net income (loss) for the three months endedJune 30, 2003 and 2004 (dollars in thousands):

 
|                          |   | **2003**        |   | **2004**        |   |
|-------------------------------|--------|-----------------|--------|-----------------|--------|
|                          |   | **(unaudited)** |   | **(unaudited)** |   |
| EBITDA                        |   | $               | 3,884  |            | $      | 6,657 |   |
| Depreciation and amortization |   | (8,056          | )      | (7,277          | )      |
| Interest expense              |   | (448            | )      | (2,760          | )      |
| Loss on disposal of assets    |   | (36             | )      | (23             | )      |
| Interest income               |   | 55              |   | 26              |   |
| Net income (loss)             |   | $               | (4,601 | )               | $      | (3,377 | ) |

 

***Depreciation andAmortization.*** Depreciation and amortization expense was $7.3 million for the threemonths ended June 30, 2004, a decrease of 9.7% from $8.1 million in thesame period of 2003.  This decrease wasprimarily due to accelerated depreciation in 2003 on the abandonment of ourprevious billing system per SFAS No. 144. As a percentage of revenue, depreciation and amortization decreased to18.6% for the three months ended June 30, 2004 from 22.8% for the sameperiod of 2003.

 

***Interest.***  Interest expense was $2.8 million for thethree months ended June 30, 2004, an increase of 516.4% from $0.4 millionin the same period of 2003.  Thisincrease was primarily due to interest expense on our senior second securednotes.

 

**SixMonths Ended June 30, 2004 versus Six Months Ended June 30, 2003**

 

***Revenue.*** Revenue for the six months endedJune 30, 2003 and 2004 is as follows:

 
|                       |   | **2003**        |   | **2004**        |   | **% Change** |   |
|----------------------------|--------|-----------------|--------|-----------------|--------|--------------|--------|
|                       |   | **(unaudited)** |   | **(unaudited)** |   |         |   |
| Revenue (in millions):     |   |            |   |            |   |         |   |
| Voice and data services    |   | $               | 39.5   |            | $      | 47.6         |   | 20.6 | % |
| Long distance              |   | 9.2             |   | 10.7            |   | 15.9         | %      |
| Access                     |   | 6.1             |   | 6.6             |   | 7.1          | %      |
| Total network services     |   | 54.8            |   | 64.9            |   | 18.3         | %      |
| Business telephone systems |   | 12.5            |   | 12.5            |   | 0.1          | %      |
| Total revenue              |   | $               | 67.3   |            | $      | 77.4         |   | 14.9 | % |

 

Network services revenue was $64.9 million for the six months endedJune 30, 2004, an increase of 18.3% from $54.8 million in the same periodof 2003.  The increase in revenue wasprimarily due to an increase in the average number of voice and data accesslines in service.  Over the past 12months the number of voice lines increased by 12.6% to 162,622 lines atJune 30, 2004, and the number of data lines increased by 72.0% to 63,327lines at June 30, 2004.  The growthin access lines was partially offset by declines in long distance and accessrevenue per minute of use and a decline in data revenue per line.  Due to continued high levels of competition,long distance revenue per minute of use declined.  Access revenue per minute of use declined in line with thescheduled FCC reduction of interstate rate levels.  Data revenue per line declined due to a combination of customerspurchasing more bandwidth at discounted prices and general pricing pressuresfor data services in our markets.  Weexpect all of the above trends in line growth, long distance rates, access ratesand data revenue per line to continue for the foreseeable future.  As we continue to grow, our size and churnwill begin to limit our access line growth rate on both an absolute and on apercentage basis unless we increase our sales force and geographic territory.

 

BTS revenue was $12.5 million for each of the six months endedJune 30, 2003 and 2004.  We cannotpredict future trends in capital spending by small and medium-sized businesscustomers.

 

18

----

 

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

 
|                           |   | **2003**        |   | **2004**        |   | **% Change** |   |
|--------------------------------|--------|-----------------|--------|-----------------|--------|--------------|--------|
|                           |   | **(unaudited)** |   | **(unaudited)** |   |         |   |
| Cost of revenue (in millions): |   |            |   |            |   |         |   |
| Network services               |   | $               | 21.8   |            | $      | 23.3         |   | 6.9 | % |
| Business telephone systems     |   | 7.6             |   | 7.5             |   | (1.0         | )%     |
| Total cost of revenue          |   | $               | 29.4   |            | $      | 30.8         |   | 4.9 | % |

 

Network services cost of revenue was $23.3 million for the six monthsended June 30, 2004, an increase of 6.9% from $21.8 million in the sameperiod of 2003.  This increase is due toour growth in access lines.  As a percentageof related revenue, network services cost of revenue for the six months endedJune 30, 2004 declined to 36.0% from 39.8% for the same period of2003.  This improvement was due to theincrease in our percentage of access lines on-net to 77.4% as of June 30,2004 from 69.6% as of June 30, 2003.

 

BTS cost of revenue was $7.5 million for the six months endedJune 30, 2004, a decrease of 1.0% from $7.6 million in the same period of2003.  As a percentage of relatedrevenue, BTS cost of revenue for the six months ended June 30, 2004decreased to 59.9% from 60.6% for the same period of 2003.  We do not expect future improvements in BTScost of revenue as a percentage of related revenue unless we are able to significantlyincrease BTS revenue and therefore achieve greater volume discounts oreconomies of scale in our workforce.

 

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

 
|                        |   | **2003**        |   | **2004**        |   | **% Change** |   |
|-----------------------------|--------|-----------------|--------|-----------------|--------|--------------|--------|
|                        |   | **(unaudited)** |   | **(unaudited)** |   |         |   |
| Gross profit (in millions): |   |            |   |            |   |         |   |
| Network services            |   | $               | 33.0   |            | $      | 41.5         |   | 25.8 | % |
| Business telephone systems  |   | 4.9             |   | 5.0             |   | 1.8          | %      |
| Total gross profit          |   | $               | 37.9   |            | $      | 46.5         |   | 22.7 | % |

 

The increase in gross profit for the six months ended June 30,2004, from the same period of 2003, is due to the increase in revenue mentionedpreviously.

 

***Sales, General and Administrative Expense.***  Sales, general and administrative expenseswere $33.5 million for the six months ended June 30, 2004, an increase of6.0% from $31.6 million in the same period of 2003.  The increase is primarily due to higher average payroll, fringebenefit and sales recruiting expenses and an increase in operating taxes.  As a percentage of revenue, sales, generaland administrative expenses for the six months ended June 30, 2004 declinedto 43.3% from 46.9% in the same period of 2003 due to the improved efficiencyof our existing operations resulting from our fixed cost structure supporting ahigher level of revenue.  We expect thistrend to continue as we add more access lines with only modest increase in ouremployee base.

 

***EBITDA.***  Earnings before interest, taxes,depreciation and amortization (EBITDA) was $13.0 million for the six monthsended June 30, 2004, an increase of 105.8% from $6.3 million in the sameperiod of 2003.  This increase was dueto increased profit margins and lower sales, general and administrativeexpenses as a percentage of revenue.

 

The following is a schedule reconciling EBITDA with reported GAAPnet income (loss) for the six months ended June 30, 2003 and 2004 (dollarsin thousands):

 

19

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|                          |   | **2003**        |    | **2004**        |   |
|-------------------------------|--------|-----------------|---------|-----------------|--------|
|                          |   | **(unaudited)** |    | **(unaudited)** |   |
| EBITDA                        |   | $               | 6,318   |            | $      | 13,004 |   |
| Depreciation and amortization |   | (15,705         | )       | (15,212         | )      |
| Interest expense              |   | (879            | )       | (5,074          | )      |
| Deferred compensation         |   | (70             | )       | (20             | )      |
| Loss on disposal of assets    |   | (36             | )       | (24             | )      |
| Interest income               |   | 147             |    | 38              |   |
| Gain on debt restructuring    |   | —          |    | 18,195          |   |
| Net income (loss)             |   | $               | (10,225 | )               | $      | 10,907 |   |

 

***Depreciation andAmortization.*** Depreciation and amortization expense was $15.2 million for the sixmonths ended June 30, 2004, a decrease of 3.1% from $15.7 million in thesame period of 2003.  This decrease wasprimarily due to accelerated depreciation in 2003 on the abandonment of our previousbilling system per SFAS No. 144.  As apercentage of revenue, depreciation and amortization decreased to 19.7% for thesix months ended June 30, 2004 from 23.3% for the same period of 2003.

 

***Interest.***  Interest expense was $5.1 million for thesix months ended June 30, 2004, an increase of 477.2% from $0.9 million inthe same period of 2003.  This increasewas primarily due to interest expense on our senior second secured notes and a$1.6 million prepayment penalty associated with the prepayment of our bankfacility.

 

***Gain onExtinguishment of Debt.***  Net income for the six months ended June 30, 2004 included again on extinguishment of debt of $18.2 million.  The gain on the extinguishment of debt was the result of payingoff our bank facility.  InJune 2002, we restructured our bank facility and because the future cashflows could not be calculated with certainty, the gain was deferred.  As a result of the repayment, the excesscarrying value of $20.9 million and debt issuance costs of $2.7 million resultedin the $18.2 million gain on extinguishment of debt.

 

## **Liquidity and CapitalResources**

 

***Financings.* **In March 2004, we completed anoffering of $100 million of 8 3/8% senior second secured notes due 2010 at adiscount resulting in a 12% yield.  Weused the proceeds from our offering to retire bank debt, pay fees related tothe offering and provide additional liquidity to our company.  After repayment of our senior secured bankfacility and fees related to the issuance of the new notes, we received incrementalcash of approximately $13.6 million.

 

***Cash Flows Providedby Operating Activities. ***Cashprovided by operating activities was $13.4 million for the six months endedJune 30, 2004 compared to cash provided by operating activities of $5.3million for the six months ended June 30, 2003.  Our improvement in cash provided by operating activities wasprimarily due to our growth in gross profit accompanied by a smaller increasein our operating expenses.  Workingcapital improved primarily through improvement in our accounts receivablecollections and an increase in our accounts payable days outstanding.  Average accounts receivable days salesoutstanding improved from 35.0 for the six months ended June 30, 2003 to30.9 for the six months ended June 30, 2004.  Average accounts payable days outstanding increased from 68.0 forthe six months ended June 30, 2003 to 78.3 for the six months endedJune 30, 2004.  We do not expectfurther improvement in our accounts receivable or accounts payable days outstandingin the future.

 

***Cash Flows Used inInvesting Activities.***  Cash used in investing activities was $12.5 million for the sixmonths ended June 30, 2004 compared to $14.1 million for the six monthsended June 30, 2003.  The cash usedin investing activities was primarily for the maintenance and expansion of ournetwork and back office systems.

 

***Cash Flows Provided by (Used in) Financing Activities.***  Cash provided by financing activities was$14.3 million for the six months ended June 30, 2004.  The net proceeds from the issuance of thesenior second secured notes generated approximately $13.6 million, which is netof a $1.6 million prepayment penalty mentioned previously.  For the six months ended June 30, 2003,net cash used in financing activities was $1.6 million, primarily for paymenton capital lease obligations.

 

20

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# **Item 3.**  Quantitative and Qualitative DisclosuresAbout 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 are in cash equivalents with maturities of lessthan three months which reduces our exposure to long-term interest ratechanges.  Interest income for the threeand six month periods ended June 30, 2004 was $26.4 thousand and $37.5thousand, respectively, therefore not exposing us to any meaningful interestincome risk had rates dropped. Excluding capital leases, we had $85.3 million in senior second securednotes outstanding as of June 30, 2004. These notes are at a fixed interest rate and are therefore not exposedto any interest rate risk.

 

# **Item 4**:  Controls and Procedures

 

Based on their evaluation as of the end of the period covered by thisQuarterly Report on Form 10-Q, our principal executive officer and principalfinancial officer with the participation and assistance of our management,concluded that our disclosure controls and procedures, as defined in Rules13a-15(e) promulgated under the Securities Exchange Act of 1934, were effectivein design and operation.  There havebeen no significant changes in our system of internal controls or in otherfactors that could significantly affect internal controls subsequent to thedate of their evaluation.

 

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# **PART II**. OTHER INFORMATION

 

# **Item 1.**  Legal Proceedings

 

On August 2, 2004, a Nevada state court entered a judgment againstEschelon for intentionally interfering with a former salesperson’s economicrelationship with his new employer in the amount of $376 thousand pluscosts.  We had reason to believe theformer employee was violating his non-solicitation agreement with us.  We are considering appealing the judgmentbecause, among other reasons, the jury was not instructed to consider whetherwe were justified in informing the new employer of the agreement and our intentto enforce it.

 

We are a party to several complaint proceedings against Qwest filedwith the Arizona, Colorado, Minnesota and Washington public utilitycommissions, or PUCs, and two federal court lawsuits involving Qwest.  The Minnesota PUC recently ordered Qwest topay us approximately $500 thousand as a refund of overcharges related toenhanced extended loops and Qwest may appeal the order.  We have appealed the recent unfavorabledecisions by the Minnesota PUC in relation to our complaints regarding Qwest’swithholding of Direct Measures of Quality, or DMOQ billing credits and ourrequest for a refund from Qwest for overcharges for our colocations.  The Minnesota PUC and the ArizonaCorporation Commission recently granted, and the Washington PUC denied in partand granted in part, our complaints regarding retroactive application ofcertain favorable UNE rates.  We havefiled a similar complaint in Colorado. We continue to pursue a lawsuit against Qwest in the United StatesDistrict Court, Western District of Washington regarding the financial harm wehave suffered as a result of Qwest’s violations of our interconnectionagreements by failing to provide accurate records relating to interstate andintrastate long distance calls, failing to develop an unbundled networkplatform and failing to make DSL available for resale.  We also are opposing Qwest’s federal courtappeal of the Minnesota PUC’s UNE Cost Order. If Qwest is successful, our UNE rates in Minnesota could increase.

 

We are a party to certain regulatory investigations underway inArizona, Colorado and Washington relating to the alleged failure of Qwest andseveral CLECs, including us, to submit interconnection agreements for approvalby state regulatory agencies.  We cannotpredict the outcome of the Arizona, Colorado or Washington investigations orthe effect that any corresponding regulatory actions may have on ourbusiness.  A similar investigation bythe Minnesota PUC resulted in no direct penalties against us.  The Minnesota Department of Commerce hasfiled a complaint with the Minnesota PUC concerning agreements that CLECs,including us, have with certain interexchange carriers for pricing accessservices.  They have asserted that theagreements are unlawfully discriminatory and required to be filed.

 

We cannot predict the outcome of any of these proceedings or theireffect on our business.

 

**Item2.****Changes in Securities, Use of Proceeds and IssuerPurchase of Equity Securities**

 

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

 

We offered these notes to qualified institutional buyers as defined inRule 144A under the Securities Act, to persons outside the United States underRegulation S of the Securities Act and to a limited number of institutionalaccredited investors within the meaning of Rule 501 (a) (1), (2), (3) or (7) ofthe Securities Act.  An exchange offerwith the holders of the notes, whereby the notes were exchanged for a likeprincipal amount of registered 8 3/8% Senior Second Secured Notes due 2010, wascompleted on June 18, 2004.

 

The proceeds of this transaction were used to repay existingindebtedness of $65.4 million and to pay $5.8 million of associated fees andexpenses of the offering.  The remaining$13.6 million of proceeds is being used for general corporate purposes.

 

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

 

On March 15, 2004, we granted to 186 participants under theEschelon Telecom, Inc. Stock Option Plan of 2002 options to purchase anaggregate of 277,617 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.

 

On May 20, 2004, we granted to 417 participants under the EschelonTelecom, Inc. Stock Option Plan of 2002 options to purchase an aggregate of986,817 shares of common stock at an exercise price of $0.10 per share.  These options generally vest 20% upon thedate of the initial grant and 20% per year over four years from the date ofgrant.

 

22

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On May 20, 2004, we issued to two independent members of our Board ofDirectors 140,365 shares of common stock at a price of $0.10 per share ascompensation for Board duties.

 

# **Item 3.**  Defaults Upon 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 June 30, 2004

 

# **Item 5.**  Other Information

 

None

 

# **Item 6.**  Exhibits and Reports on Form 8-K

 

**a) Exhibits**

 
| **Exhibit No.** |   | **Description**                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|-----------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1*            |   | Fifth Amended and Restated Certificate of Incorporation of Eschelon  Telecom, Inc. filed on June 27, 2002.                                                                                                                                                                                                                                                                                                                                     |
| 3.2*            |   | By-Laws of Eschelon Telecom, Inc.                                                                                                                                                                                                                                                                                                                                                                                                                   |
| 4.1*            |   | Fourth Amended and Restated Stockholders Agreement dated  June 27, 2002.                                                                                                                                                                                                                                                                                                                                                                       |
| 4.2*            |   | Eschelon Telecom, Inc. 2002 Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                                                                                                   |
| 4.3*            |   | Form of Incentive Stock Option Grant Agreement Under the Eschelon  Telecom, Inc. 2002 Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                                         |
| 4.4*            |   | Form of Nonstatutory Stock Option Grant Agreement Under the Eschelon  Telecom, Inc. 2002 Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                                      |
| 4.5*            |   | Form of Restricted Stock Grant Agreement Under the Eschelon Telecom,  Inc. 2002 Stock Incentive Plan.                                                                                                                                                                                                                                                                                                                                               |
| 4.6**           |   | Indenture dated March 17, 2004 by and among Eschelon Operating  Company; Eschelon Telecom, Inc.; Eschelon Telecom of Minnesota, Inc.;  Eschelon Telecom of Washington, Inc.; Eschelon Telecom of Colorado, Inc.;  Eschelon Telecom of Nevada, Inc.; Eschelon Telecom of Utah, Inc.; Eschelon  Telecom of Oregon, Inc.; Eschelon Telecom of Arizona, Inc.; and The Bank of  New York Trust Company, N.A.                                        |
| 4.7**           |   | Registration Rights Agreement dated March 17, 2004 by and among  Jefferies & Company, Inc.; Wachovia Capital Markets LLC; Eschelon  Operating Company; Eschelon Telecom, Inc.; Eschelon Telecom of Minnesota,  Inc.; Eschelon Telecom of Washington, Inc.; Eschelon Telecom of Colorado,  Inc.; Eschelon Telecom of Nevada, Inc.; Eschelon Telecom of Utah, Inc.;  Eschelon Telecom of Oregon, Inc.; and Eschelon Telecom of Arizona, Inc. |
| 4.8**           |   | Security Agreement dated March 17, 2004 by and among Eschelon  Operating Company; Eschelon Telecom, Inc.; Eschelon Telecom of Minnesota,  Inc.; Eschelon Telecom of Washington, Inc.; Eschelon Telecom of Colorado,  Inc.; Eschelon Telecom of Nevada, Inc.; Eschelon Telecom of Utah, Inc.;  Eschelon Telecom of Oregon, Inc.; Eschelon Telecom of Arizona, Inc.; and The  Bank of New York Trust Company, N.A. (as Collateral Agent).        |
| 4.9**           |   | Trademark Security Agreement dated March 17, 2004 by and among  Eschelon Operating Company; Eschelon Telecom, Inc.; and The Bank of New York  Trust Company, N.A. (as Collateral Agent).                                                                                                                                                                                                                                                       |
| 4.10**          |   | Form of Initial 8 3/8% Senior Second Secured Notes due 2010.                                                                                                                                                                                                                                                                                                                                                                                        |
| 4.11**          |   | Form of Guarantee of Initial 8 3/8% Senior Second Secured Notes due  2010.                                                                                                                                                                                                                                                                                                                                                                          |
| 4.12**          |   | Form of Exchange 8 3/8% Senior Second Secured Notes due 2010.                                                                                                                                                                                                                                                                                                                                                                                       |
| 4.13**          |   | Form of Guarantee of Exchange 8 3/8% Senior Second Secured Notes due  2010.                                                                                                                                                                                                                                                                                                                                                                         |
| 10.1*           |   | Change-in-Control Severance Pay and Employment Agreement dated  November 22, 2002 by and between Eschelon Telecom, Inc. and Richard A.  Smith.                                                                                                                                                                                                                                                                                                 |
| 10.2*           |   | Employment Offer Letter dated March 7, 2000 from Eschelon  Telecom, Inc. to Geoffrey M. Boyd.                                                                                                                                                                                                                                                                                                                                                  |
| 10.2.1*         |   | Severance Pay Letter Agreement dated November 14, 2002 by and  between Eschelon Telecom, Inc. and Geoffrey M. Boyd.                                                                                                                                                                                                                                                                                                                            |
| 10.4*           |   | Employment Offer Letter dated July 19, 1999 from Eschelon  Telecom, Inc. to Steven K. Wachter.                                                                                                                                                                                                                                                                                                                                                 |

 

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| 10.5*    |   | Stock Restriction Agreement dated February 7, 2003 between  Eschelon Telecom, Inc. and Marvin C. Moses.                                                                          |
|----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.6*    |   | Stock Restriction Agreement dated February 7, 2003 between  Eschelon Telecom, Inc. and Anthony J. Cassara.                                                                       |
| 10.7*    |   | Stock Restriction Agreement dated February 7, 2003 between  Eschelon Telecom, Inc. and Peter M. Van Genderen.                                                                    |
| 10.8*    |   | Carrier Global Services Agreement dated July 28, 2000 by and  between MCI WorldCom Communications, Inc. and Eschelon Telecom, Inc.                                               |
| 10.8.1*  |   | First Amendment dated June 20, 2001 to Carrier Global Services  Agreement dated July 28, 2000 by and between MCI WorldCom  Communications, Inc. and Eschelon Telecom, Inc.  |
| 10.8.2*  |   | Second Amendment dated April 8, 2002 to Carrier Global Services  Agreement dated July 28, 2000 by and between MCI WorldCom Communications,  Inc. and Eschelon Telecom, Inc. |
| 10.8.3*  |   | Third Amendment dated April 1, 2003 to Carrier Global Services  Agreement dated July 28, 2000 by and between MCI WorldCom  Communications, Inc. and Eschelon Telecom, Inc.  |
| 10.8.4*  |   | WorldCom Internet Dedicated Service Agreement and Service Order Form  dated June 12, 2003.                                                                                       |
| 10.8.5*  |   | WorldCom Internet Dedicated Service Agreement and Service Order Form  dated January 23, 2004.                                                                                    |
| 10.8.6*  |   | WorldCom Internet Dedicated T3 Price-Protected Agreement dated  July 26, 2001.                                                                                                   |
| 10.8.7*  |   | WorldCom Wholesale Dedicated Internet Pricing Sheet                                                                                                                                   |
| 10.9*    |   | Carrier Service Agreement dated August 25, 2000 between Global  Crossing Bandwidth, Inc. and Eschelon Telecom, Inc.                                                              |
| 10.9.1*  |   | Amendment #1 dated November 10, 2000 to Carrier Service Agreement  dated August 25, 2000 between Global Crossing Bandwidth, Inc. and  Eschelon Telecom, Inc.                |
| 10.9.2*  |   | Amendment #2 dated January 2, 2001 to Carrier Service Agreement  dated August 25, 2000 between Global Crossing Bandwidth, Inc. and  Eschelon Telecom, Inc.                  |
| 10.9.3*  |   | Amendment #3 dated June 25, 2001 to Carrier Service Agreement  dated August 25, 2000 between Global Crossing Bandwidth, Inc. and  Eschelon Telecom, Inc.                    |
| 10.9.4*  |   | Amendment #4 dated July 17, 2001 to Carrier Service Agreement  dated August 25, 2000 between Global Crossing Bandwidth, Inc. and  Eschelon Telecom, Inc.                    |
| 10.9.5*  |   | Amendment #5 dated April 25, 2002 to Carrier Service Agreement  dated August 25, 2000 between Global Crossing Bandwidth, Inc. and  Eschelon Telecom, Inc.                   |
| 10.9.6*  |   | Amendment #6 dated July 12, 2002 to Carrier Service Agreement  dated August 25, 2000 between Global Crossing Bandwidth, Inc. and  Eschelon Telecom, Inc.                    |
| 10.9.7*  |   | Amendment #7 dated March 26, 2004 to Carrier Service Agreement  dated August 25, 2000 between Global Crossing Bandwidth, Inc. and  Eschelon Telecom, Inc.                   |
| 10.10*   |   | Advisory Agreement dated March 15, 2004 among Eschelon Telecom,  Inc.; Bain Capital Investors, LLC; Wind Point Advisor, L.L.C.; and Stolberg,  Meehan & Scano, L.L.C.        |
| 10.11*   |   | Lease of Office Space by and between St. Paul Properties, Inc. and  Eschelon Telecom, Inc. dated as of November 18, 2003.                                                        |
| 10.12*   |   | Lease Agreement by and between Timeshare Systems, Inc. and Advanced  Telecommunications, Inc. dated March 3, 1999.                                                               |
| 10.13*   |   | Lease For Storage dated July 30, 1996 by and between T.H.S.  Northstar Associates Limited Partnership and Fishnet.com, Inc.                                                      |
| 10.13.1* |   | First Amendment dated March 10, 1998 of Lease for Storage dated  July 30, 1996 by and between T.H.S. Northstar Associates Limited  Partnership and Fishnet.com, Inc.        |
| 10.13.2* |   | Second Amendment dated March 27, 1998 of Lease for Storage dated  July 30, 1996 by and between T.H.S. Northstar Associates Limited  Partnership and Fishnet.com, Inc.       |
| 10.13.3* |   | Third Amendment dated April 30, 1999 of Lease for Storage dated  July 30, 1996 by and between T.H.S. Northstar Associates Limited  Partnership and Fishnet.com, Inc.        |
| 10.13.4* |   | Fourth Amendment dated October 3, 2000 of Lease for Storage  dated July 30, 1996 by and between T.H.S. Northstar Associates Limited  Partnership and Fishnet.com, Inc.      |
| 10.13.5* |   | Lease For Storage dated March 6, 2000 by and between T.H.S.  Northstar Associates Limited Partnership and Fishnet.com, Inc.                                                      |
| 10.13.6* |   | Lease For Storage dated July 11, 1999 by and between T.H.S.  Northstar Associates Limited Partnership and Fishnet.com, Inc.                                                      |

 

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

 

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

 

**                                                                                  Incorporatedherein by reference to Eschelon Operating Company Registration Statement on FormS-4, No. 333-114437.

 

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

 

On June 10, 2004, Eschelon Operating Company (a wholly ownedsubsidiary) filed a Form 8-K containing the press release issued on June 10,2004 announcing the extension of our exchange offer.

 

25

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**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:  August 11, 2004 | By:                    | /S/ Geoffrey M. Boyd |   |
|                             |                   |   |
|                             | Name:                  | Geoffrey M. Boyd |
|                             | Title:                 | Chief Financial Officer |
|                             |                   | (Principal  Financial and  Accounting Officer and Duly  Authorized Officer) |

 

26

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