##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
  Washington, D.C. 20549
 
 FORM 10-Q þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2005 OR o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR
15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 Commission File No. 0-30900   XO Communications, Inc. (Exact name of registrant as specified in its charter)
 Delaware
(State or other jurisdiction of
incorporation or organization)
    
    54-1983517
(I.R.S. employer
identification no.)
 11111 Sunset Hills Road
Reston, Virginia 20190
(Address of principal executive offices, including zip code)
(703) 547-2000
(Registrants telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months
(or for such shorter period that the Registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days. YES þ NO o Indicate by check mark whether the Registrant is an accelerated filer (as defined by Rule
12b-2 of the Exchange Act.). YES þ NO o APPLICABLE ONLY TO ISSUERS INVOLVED IN BANKRUPTCY PROCEEDINGS DURING THE
PRECEEDING FIVE YEARS: Indicate by check mark whether the registrant has filed all documents and reports required to
be filed by Section 12, 13, or 15(d) of the Securities Exchange Act of 1934 subsequent to the
distribution of securities under a plan confirmed by a court. YES þ NO o As
of May 5, 2005, the number of shares of common stock of XO Communications, Inc. issued and
outstanding was 181,933,035.




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XO Communications, Inc. and Subsidiaries
Index to Form 10-Q PagePart I. Financial InformationItem 1. XO Communications, Inc. and Subsidiaries Condensed Consolidated Financial StatementsCondensed Consolidated Balance Sheets as of March 31, 2005 and December 31, 2004
    
    
    1Condensed Consolidated Statements of Operations for the Three Months Ended March 31,
2005 and March 31, 2004
    
    
    2Condensed Consolidated Statements of Cash Flows for the Three Months Ended March 31,
2005 and March 31, 2004
    
    
    3Notes to Condensed Consolidated Financial Statements
    
    
    4Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    11Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    22Item 4. Controls and Procedures
    
    
    23Part II. Other InformationItem 1. Legal Proceedings
    
    
    24Item 2. Changes in Securities and Use of Proceeds
    
    
    24Item 3. Defaults Upon Securities
    
    
    24Item 4. Submission of Matters to a Vote of Security Holders
    
    
    24Item 5. Other Information
    
    
    24Item 6. Exhibits and Reports on Form 8-K
    
    
    24Signatures
    
    
    25




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##### 



PART I. FINANCIAL INFORMATION Item 1. Financial Statements XO Communications, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(Amounts in thousands, except for share and per share data) March 31,
    
    
    December 31,2005
    
    
    2004(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    256,617
    
    
    $
    233,989Marketable
securities and other investments
    
    
    10,675
    
    
    
    17,300Accounts receivable, net of allowance for doubtful accounts of $38,776 at
March 31, 2005 and $38,981 at December 31, 2004, respectively
    
    
    133,980
    
    
    
    150,101Other current assets
    
    
    30,688
    
    
    
    50,864Total current assets
    
    
    431,960
    
    
    
    452,254Property and equipment, net
    
    
    791,892
    
    
    
    820,536Broadband wireless licenses and other intangibles, net
    
    
    127,773
    
    
    
    139,866Other assets, net
    
    
    46,375
    
    
    
    46,729Total assets
    
    $
    1,398,000
    
    
    $
    1,459,385LIABILITIES, CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    77,885
    
    
    $
    88,010Other current liabilities
    
    
    229,625
    
    
    
    241,532Total current liabilities
    
    
    307,510
    
    
    
    329,542Long-term debt and accrued interest payable
    
    
    374,195
    
    
    
    366,247Other long-term liabilities
    
    
    71,272
    
    
    
    73,691Total liabilities
    
    
    752,977
    
    
    
    769,480Class A convertible preferred stock
    
    
    207,451
    
    
    
    204,353Commitments and contingenciesStockholders equity:Preferred stock: par value $0.01 per share, 200,000,000 shares
authorized: 4,000,000 shares of Class A convertible preferred stock
issued and outstanding on March 31, 2005 and December 31, 2004
    
    
    
    
    
    
    Warrants and common stock, par value $0.01 per share, 1,000,000,000
shares authorized: 181,933,035 shares issued and outstanding on March 31,
2005 and December 31, 2004
    
    
    986,415
    
    
    
    989,511Deferred compensation
    
    
    (508
    )
    
    
    (574
    )Accumulated other comprehensive income
    
    
    2,620
    
    
    
    4,712Accumulated deficit
    
    
    (550,955
    )
    
    
    (508,097
    )Total stockholders equity
    
    
    437,572
    
    
    
    485,552Total liabilities, convertible preferred stock and stockholders equity
    
    $
    1,398,000
    
    
    $
    1,459,385
 See accompanying notes to the unaudited condensed consolidated financial statements. 1




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XO Communications, Inc. and Subsidiaries
Condensed Consolidated Statements of Operations
(Amounts in thousands, except for share and per share data)
(Unaudited) Three months
    
    
    Three monthsended
    
    
    endedMarch 31,
    
    
    March 31,2005
    
    
    2004Revenue
    
    $
    361,504
    
    
    $
    260,945Costs and expenses:Cost of service (exclusive of depreciation and amortization)
    
    
    147,922
    
    
    
    109,961Selling, operating, and general
    
    
    191,694
    
    
    
    168,553Depreciation and amortization
    
    
    58,365
    
    
    
    25,697Total costs and expenses
    
    
    397,981
    
    
    
    304,211Loss from operations
    
    
    (36,477
    )
    
    
    (43,266
    )Interest income
    
    
    1,893
    
    
    
    1,705Investment
loss, net
    
    
    (271
    )
    
    
    (329
    )Interest expense, net
    
    
    (8,004
    )
    
    
    (6,604
    )Net loss
    
    $
    (42,859
    )
    
    $
    (48,494
    )Preferred stock accretion
    
    
    (3,097
    )
    
    
    Net loss applicable to common shares
    
    $
    (45,956
    )
    
    
    (48,494
    )Net loss per common share, basic and diluted
    
    $
    (0.25
    )
    
    $
    (0.37
    )Weighted average shares, basic and diluted
    
    
    181,933,035
    
    
    
    129,406,599
 See accompanying notes to the unaudited condensed consolidated financial statements. 2




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XO Communications, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(Amounts in thousands)
(Unaudited) Three months
    
    
    Three monthsEnded
    
    
    EndedMarch 31,
    
    
    March 31,2005
    
    
    2004OPERATING ACTIVITIES:Net loss
    
    $
    (42,859
    )
    
    $
    (48,494
    )Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:Depreciation and amortization
    
    
    58,365
    
    
    
    25,697Accrual of interest
    
    
    7,948
    
    
    
    6,704Stock-based compensation
    
    
    66
    
    
    
    129Realized loss on investments
    
    
    3,191
    
    
    
    328Changes in assets and liabilities:Accounts receivable
    
    
    16,121
    
    
    
    (3,076
    )Other assets
    
    
    (4,900
    )
    
    
    (8,340
    )Accounts payable
    
    
    (6,180
    )
    
    
    3,253Accrued liabilities
    
    
    (13,470
    )
    
    
    (11,068
    )Net cash provided by (used in) operating activities
    
    
    18,282
    
    
    
    (34,867
    )INVESTING ACTIVITIES:Capital expenditures, net
    
    
    (21,573
    )
    
    
    (25,395
    )Acquisition payments
    
    
    
    
    
    
    (66,821
    )Sales of marketable securities and investments
    
    
    1,342
    
    
    
    16,825Release of escrow account
    
    
    25,430
    
    
    
    Net cash
provided by (used in) investing activities
    
    
    5,199
    
    
    
    (75,391
    )FINANCING ACTIVITIES:Repayments of long term debt and capital leases
    
    
    (853
    )
    
    
    (197,982
    )Proceeds from issuance of common stock
    
    
    
    
    
    
    197,612Proceeds from exercise of stock options
    
    
    
    
    
    
    2,583Net cash (used in) provided by financing activities
    
    
    (853
    )
    
    
    2,213Net increase (decrease) in cash and cash equivalents
    
    
    22,628
    
    
    
    (108,045
    )Cash and cash equivalents, beginning of period
    
    
    233,989
    
    
    
    478,560Cash and cash equivalents, end of period
    
    $
    256,617
    
    
    $
    370,515SUPPLEMENTAL DATA:Cash paid for interest
    
    $
    824
    
    
    $
    612
 See accompanying notes to condensed consolidated financial statements. 3




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XO Communications, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited) 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Overview XO Communications Inc., a Delaware corporation, through its subsidiaries, owns and operates an
integrated metropolitan and nationwide fiber optic network that provides a comprehensive array of
telecommunications services to business customers in over 70 United States markets. Voice services
include local and long distance services, calling card and interactive voice response systems. Data
services include Internet access, private data networking and hosting services. XO, through its
subsidiaries, also offers integrated combined voice and data services in flat rate bundled
packages. The consolidated financial statements include the accounts and activities of XO, and its
subsidiaries (collectively referred to as the Company or XO). Basis of Presentation The condensed consolidated financial statements of the Company are unaudited and have been
prepared in accordance with guidelines established for interim financial statements by the
Securities and Exchange Commissions (the Commission) instructions to Form 10-Q and U.S.
generally accepted accounting principles. Accordingly, they do not include all of the information
and footnotes required by generally accepted accounting principles in the United States for
complete financial statements. Operating results for any interim period are not necessarily indicative of the results for a
full year or for any subsequent interim period. In the opinion of management, the unaudited
condensed consolidated financial statements contain all the adjustments (consisting of those of a
normal recurring nature) considered necessary to present fairly the financial position and the
results of operations and cash flows for the periods presented in conformity with accounting
principles generally accepted in the United States applicable to interim periods. The accompanying
financial statements should be read in conjunction with the audited consolidated financial
statements of XO, included in its Annual Report on Form 10-K for the year ended December 31, 2004
(the 2004 Annual Report). On June 23, 2004 (the Closing Date), XO completed the acquisition of all of the
telecommunications services assets (the Acquired Businesses) of Allegiance Telecom, Inc. (Allegiance).
XO did not acquire Allegiances customer premises installation and maintenance business, shared
hosting business, or dedicated dial-up Internet access service business (the Unacquired
Businesses). The accompanying financial statements include the results of operations from the
Acquired Businesses since June 23, 2004. Principles of Consolidation The Companys consolidated financial statements include all of the assets, liabilities and
results of operations of subsidiaries in which the Company has a controlling interest. All
inter-company accounts and transactions among consolidated entities have been eliminated. Use of Estimates and Assumptions The preparation of consolidated financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the consolidated financial statements and the reported amounts of
revenue and expenses during the reporting period. Management periodically assesses the accuracy of
these estimates and assumptions. Actual results could differ from those estimates. Certain
reclassifications have been made to prior period amounts in order to
conform to the current year presentation. Net Income (Loss) Per Share Net income (loss) per common share, basic and diluted, is computed by dividing net income
(loss) applicable to common shares by the weighted average number of common shares outstanding for
the period. In periods of net loss, the assumed common share equivalents for options, warrants, and
the Class A convertible preferred stock are 4




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anti-dilutive, and are therefore not included in the weighted average shares balance on the
consolidated statement of operations. As of March 31, 2005, the Company has options outstanding to
purchase approximately 9.5 million shares of common stock of which 4.2 million are exercisable and
exercisable warrants to purchase shares up to an additional 23.7 million shares of common stock
that can further dilute investors, if exercised. Stock-Based Compensation As allowed by Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based
Compensation-Transition and Disclosure, (SFAS No. 148), the Company has chosen to continue to
account for compensation cost associated with its employee stock option plan in accordance with the
intrinsic value method prescribed by Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees, (APB No. 25) adopting the disclosure-only provisions of Statement of
Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, (SFAS No.
123). Under this method, no compensation expense is recorded if stock options are granted at an
exercise price equal to or greater than the fair market value of the Companys stock on the grant
date. If the Company had adopted the fair value method of accounting for its stock awards,
stock-based compensation would have been determined based on the fair value for all stock awards at
the grant date using a Black-Scholes pricing model and the following weighted average assumptions: Three months endedMarch 31,2005
    
    
    2004Expected volatility
    
    
    61.0
    %
    
    
    75.0
    %Risk free interest rate
    
    
    3.6
    %
    
    
    2.7
    %Dividend yield
    
    
    0.0
    %
    
    
    0.0
    %Expected life (range in years)
    
    
    4.0
    
    
    
    4.0Fair value per share at grant date
    
    $
    0.96
    
    
    $
    3.62
 The Companys pro forma net loss applicable to common shares, and pro forma net loss per
common share, basic and diluted, if the Company had used the fair value method would have been as
follows (dollars in thousands, except per share data): Three months ended March 31,2005
    
    
    2004Net loss applicable to common shares, as reported
    
    $
    (45,956
    )
    
    $
    (48,494
    )Add: Stock-based employee compensation expense
included in net loss, as reported
    
    
    66
    
    
    
    129Deduct: Total stock-based employee compensation
expense determined under fair value based
methods for all stock awards
    
    
    (1,649
    )
    
    
    (1,874
    )Pro forma net loss applicable to common shares
    
    $
    (47,539
    )
    
    $
    (50,239
    )Net loss per common share, basic and diluted 
as reported
    
    $
    (0.25
    )
    
    $
    (0.37
    )Net loss per common share, basic and diluted 
pro forma
    
    $
    (0.26
    )
    
    $
    (0.39
    )
 The XO Communications, Inc. 2002 Stock Incentive Plan (the 2002 Stock Incentive Plan)
was adopted in January 2003 and amended and restated in July 2003. Under the 2002 Stock Incentive
Plan, the Company is authorized to issue awards for up to 17.6 million shares of its common stock
in the form of restricted stock or options to purchase stock. The Company granted a total of
147,000 options during the three months ended March 31, 2005. 5




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Comprehensive Loss Comprehensive loss includes the Companys net loss applicable to common shares, as well as net
unrealized gains and losses on available-for-sale investments. The following table reflects the
Companys calculation of comprehensive loss for the three months ended March 31, 2005 and 2004
(dollars in thousands): Three Months EndedMarch 31,2005
    
    
    2004Net loss applicable to common shares
    
    $
    (45,956
    )
    
    $
    (48,494
    )Other comprehensive loss:Net unrealized (losses) gains on investment
    
    
    (2,092
    )
    
    
    1,394Comprehensive loss
    
    $
    (48,048
    )
    
    $
    (47,100
    )
 Other Current Assets Other current assets consist primarily of prepaid expenses as of March 31, 2005. In the first
quarter of 2005, $25.4 million previously held in escrow was released and, accordingly, was
reclassified into cash and cash equivalents. Long-Lived Assets Long-lived assets include property and equipment, broadband wireless licenses, and intangible
assets to be held and used. Long-lived assets, excluding intangible assets with indefinite useful
lives, are reviewed for impairment whenever events or changes in circumstances indicate that the
carrying amount should be addressed pursuant to Statement of Financial Accounting Standards No.
144, Accounting for the Impairment or Disposal of Long-Lived Assets, (SFAS No. 144). The
criteria for determining impairment for such long-lived assets to be held and used is determined by
comparing the carrying value of these long-lived assets to managements best estimate of future
undiscounted cash flows expected to result from the use of the assets. The Company believes that no
impairment existed under SFAS No. 144 as of March 31, 2005. In the event that there are changes in
the planned use of the Companys long-lived assets or its expected future undiscounted cash flows
are reduced significantly, the Companys assessment of its ability to recover the carrying value of
these assets under SFAS No. 144 could change. Intangible assets with indefinite useful lives are tested for impairment annually during the
fourth quarter, or more frequently if an event indicates that the asset might be impaired, in
accordance with Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible
Assets (SFAS No. 142). XO retained independent appraisers to perform a preliminary valuation of
its assets and liabilities as of December 31, 2004. This valuation was necessary as XOs fair
value, as determined by its stock price, was less than its book value. Based on this preliminary
valuation, XO recorded a $212.5 million non-cash impairment charge on its goodwill during the year
ended December 31, 2004. A full valuation was completed in the first quarter of 2005. There were no
changes to the estimate of the impairment recorded in the fourth quarter of 2004. Recent Accounting Pronouncements Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment
(SFAS No. 123R), was issued in December 2004. Once effective, this statement will require
entities to recognize compensation cost for all equity-classified awards granted, modified or
settled after the effective date using a fair-value measurement method. In addition, public
companies will recognize compensation expense for the unvested portion of awards outstanding as of
the effective date based on their grant-date fair value as calculated under the original provisions
of SFAS No. 123. The effective date for XO is the fiscal year beginning January 1, 2006. The amount
of compensation expense that XO records after the adoption of SFAS No. 123R in 2006 and beyond will
depend on the amount, timing and pricing of stock option grants. 6




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2. MARKETABLE SECURITIES AND OTHER INVESTMENTS The amortized cost, gross unrealized gains and losses and fair value of the equity securities
available-for-sale as of March 31, 2005 and December 31, 2004, are in the following table. Other
investments as of March 31, 2005 and December 31, 2004 consist of investments in the debt of
McLeodUSA, Inc. (McLeod) (dollars in thousands): GrossGross
    
    
    UnrealizedUnrealized
    
    
    HoldingFair Value
    
    
    Cost Basis
    
    
    Holding Gains
    
    
    (Losses)As of March 31, 2005Equity securities
    
    $
    4,160
    
    
    $
    1,540
    
    
    $
    2,620
    
    
    $
    Other investments
    
    
    6,515
    
    
    
    10,510
    
    
    
    
    
    
    
    Total marketable
securities and other
investments
    
    $
    10,675
    
    
    $
    12,050
    
    
    $
    2,620
    
    
    $
    As of December 31, 2004Equity securities
    
    $
    6,417
    
    
    $
    1,705
    
    
    $
    4,712
    
    
    $
    Other investments
    
    
    10,883
    
    
    
    10,883
    
    
    
    
    
    
    
    Total marketable
securities and other
investments
    
    $
    17,300
    
    
    $
    12,588
    
    
    $
    4,712
    
    
    $
    
 On March 16, 2005, McLeod announced that it is evaluating a capital restructuring due to
its inability to generate sufficient cash flow. Subsequent to this announcement, the fair value of
the McLeod debt was significantly reduced. Accordingly, XO has included a writedown of $4.0 in
investment income, net to recognize the other than temporary decline. It is not certain how, if at
all, McLeod will restructure its finances, and how that would further impact our investment. 3. LONG-LIVED ASSETS XOs long-lived assets include property and equipment, broadband wireless licenses, and
identifiable intangible assets to be held and used. Property and Equipment Property and equipment consisted of the following components (dollars in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Telecommunications networks and acquired
bandwidth
    
    $
    695,511
    
    
    $
    675,844Furniture, fixtures, equipment, leasehold
improvements and other
    
    
    253,286
    
    
    
    236,788948,797
    
    
    
    912,632Less: accumulated depreciation
    
    
    (252,448
    )
    
    
    (208,032
    )696,349
    
    
    
    704,600Construction-in-progress and undeployed assets
    
    
    95,543
    
    
    
    115,936$
    791,892
    
    
    $
    820,536
 Depreciation expense for the three months ended March 31, 2005 and 2004 was $46.3 million
and $19.2 million, respectively. Assets classified as construction-in-progress and undeployed
assets are not being depreciated as they have not yet been placed in service. During the three
months ended March 31, 2005 and 2004, XO capitalized interest on construction costs of $1.0 million
and $0.9 million, respectively. 7




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Broadband Wireless Licenses and Other Intangibles Broadband wireless licenses and other intangible assets consisted of the following components
(dollars in thousands): March 31,
    
    
    December 31,2005
    
    
    2004Broadband wireless licenses
    
    $
    59,508
    
    
    $
    59,508Customer relationships
    
    
    112,366
    
    
    
    112,366Internally developed technology
    
    
    9,521
    
    
    
    9,521Acquired trade names
    
    
    5,673
    
    
    
    5,673187,068
    
    
    
    187,068Less: accumulated amortization
    
    
    (75,957
    )
    
    
    (63,864
    )111,111
    
    
    
    123,204XO Trade name  indefinite life asset
    
    
    16,662
    
    
    
    16,662$
    127,773
    
    
    $
    139,866
 Amortization expense related to intangible assets for each of the three months ended
March 31, 2005 and 2004 was $12.1 million and $6.5 million, respectively. 4. LONG-TERM DEBT The Company has a secured credit facility (the Credit Facility) which matures on July 15,
2009. There are no additional borrowings available under the Credit Facility. At March 31, 2005,
more than 90% of the underlying loans of the Credit Facility are held by an entity controlled by
Mr. Carl C. Icahn, Chairman of the Companys Board of Directors (Mr. Icahn). At March 31, 2005,
long-term debt consisted of $368.5 million in principal and $5.7 million of accrued interest that,
if not paid, converts to principal. There are no current debt service requirements since cash
interest payments as well as automatic and permanent quarterly reductions on the principal amount
outstanding do not commence until 2009. However, in the event that consolidated excess cash flow
(as defined in the Credit Facility) for any fiscal quarter during the term of the agreement is
greater than $25.0 million, at the request of the lender, the Company will pay an amount equal to
50% of such excess cash flow greater than $25.0 million toward the reduction of outstanding
indebtedness. In addition, if the ratio of XOs consolidated earnings before interest, taxes,
depreciation and amortization (EBITDA) to consolidated interest expense for four consecutive
quarters exceeds 4:1, XO would be required to pay cash interest, unless waived by the lenders. The
Company can elect to begin paying interest in cash prior to the required date. Loans under the
Credit Facility bear interest, at the Companys option, at an alternate base rate, as defined, or a
Eurodollar rate plus, in each case, applicable margins. Once the Company begins to pay accrued
interest in cash, the applicable margins are reduced. At March 31, 2005, the annualized weighted
average interest rate applicable to outstanding borrowings under the Credit Facility was 8.7%. The security for the Credit Facility consists of all assets of XO including the stock of its
direct and indirect subsidiaries, and substantially all the assets of those subsidiaries. The
Credit Facility limits additional indebtedness, liens, dividend payments and certain investments
and transactions, and contains certain covenants with respect to EBITDA requirements, as the term
EBITDA is defined in the Credit Facility, and maximum capital expenditures. The Company was
required to achieve a minimum consolidated EBITDA of not less than $97.0 million for the
twelve-month period ended March 31, 2005. The
Company is also required under the terms of the Credit Facility to maintain an unrestricted cash
balance of $25 million at the end of each fiscal quarter. In
May of 2005, XO obtained a waiver of compliance with
the minimum consolidated EBITDA covenant
contained in the
Credit Facility through December 31, 2006. The waiver was obtained from the affiliate of Mr. Icahn which holds a
majority of the Companys loans outstanding under that agreement. In connection with that
waiver, XO agreed that in the event of a sale of the Company
and in the event of other significant sale or divestiture transactions, it will prepay
all amounts outstanding under
the
Credit Facility in
cash and offer to repurchase outstanding shares of XOs
preferred stock at their liquidation value accrued through the date of
redemption for cash or, in certain events, securities. The affiliate
of Mr. Icahn which holds a majority of such Preferred Stock has
agreed to accept that offer, to the extent it consists of cash. 5. RELATED PARTY TRANSACTIONS Various entities controlled by Mr. Icahn hold the following interests in XO: Outstanding
    
    Series A, B and CCommon Stock
    
    Warrants
    
    Credit Facility
    Preferred StockAt December 31, 2004
At March 31, 2005
    
    Greater than 50%
Greater than 50%
    
    Greater than 40%
Greater than 40%
    
    Greater than 90%
Greater than 90%
    
    95%
95%
 8




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##### 



As a result of his majority ownership, Mr. Icahn can elect all of our directors, appoint
the members of the committees of our Board of Directors, appoint key members of our executive
management team, and appoint our auditors. Currently, Mr. Icahn is Chairman of the Board of
Directors and three employees of Icahn Associates also sit on the Board of Directors and various
Committees of the Board of Directors. Under applicable law and XOs Certificate of Incorporation
and by-laws, certain actions cannot be taken without the approval of holders of a majority of our
voting stock, including, without limitation, mergers, acquisitions, the sale of substantially all
our assets, and amendments to our Certificate of Incorporation and by-laws. Mr. Icahn, through various entities that he owns or controls, has the right to require XO to
register, under the Securities Act of 1933, shares of XOs Common Stock held by such entities and
to include shares of XOs Common Stock held by them in certain registration statements filed by XO. As
of March 31, 2005, Dixon Properties, LLC (Dixon), which
is controlled by Mr. Icahn, owned the building in which
XOs headquarters is located. XO currently leases approximately 170,000 square feet of space in
that building. Pursuant to the lease agreement, XO has paid $1.0 million in lease rent to Dixon for
the three months ended March 31, 2005. In May 2005, that building
was sold to an unrelated party. The Company provides certain telecommunications services to companies affiliated with Mr.
Icahn. For each of the quarters ended March 31, 2005 and 2004, the total revenue recognized on such
services affiliated with Mr. Icahn was approximately $1.1 million and $0.2 million, respectively.
During the three months ended March 31, 2005 and 2004, the Company has purchased approximately $0.3
million in services from Icahn affiliates. During the three months ended March 31, 2005 and 2004,
the Company purchased approximately $0.1 million in hardware and services from Dell Computers, Inc.
Mr. Adam Dell, an XO director, is the brother of Mr. Michael Dell, the Chairman of Dell Computers,
Inc. 6. COMMITMENTS AND CONTINGENCIES Legal Proceedings XO is involved in lawsuits, claims, investigations and proceedings consisting of commercial,
securities, tort, and employment matters, which arise in the ordinary course of business. In
addition, disputes with respect to general unsecured claims and one administrative expense claim
against XO in the aggregate amount of approximately $2.1 million remain pending from XOs 2002
Chapter 11 proceedings. In accordance with Statement of Financial Accounting Standards 5,
Accounting for Contingencies, XO makes a provision for a liability when it is both probable that
a liability has been incurred and the amount of the loss can be reasonably estimated. XO believes
it has adequate provisions for any such matters. XO reviews these provisions at least quarterly and
adjusts these provisions to reflect the impacts of negotiations, settlements, rulings, advice of
legal counsel, and other information and events pertaining to a particular case. Litigation is
inherently unpredictable. However, XO believes that it has valid defenses with respect to legal
matters pending against it. Nevertheless, it is possible that cash flows or results of operations
could be materially and adversely affected in any particular period by the unfavorable resolution
or disposition of one or more of these contingencies. During the three months ended March 31, 2005, the Company reached a $10 million settlement
with SBC relating to charges previously incurred by XO for access to SBCs network assets. This
settlement resulted in a reduction to cost of service. Contingencies Subsequent to the Closing Date, the Unacquired Businesses as well as the ongoing Allegiance
bankruptcy claims were transferred from Allegiance to the Allegiance Telecom Liquidating Trust (the
ATLT). XO filed an administrative claim with the Bankruptcy Court in August 2004 against the
ATLT, for at least approximately $40.0 million under the Purchase Agreement and other agreements
between the parties, relating to a variety of actions allegedly taken by Allegiance and the ATLT.
Subsequently, XO informed the ATLT that the amount in dispute approximates $50.0 million. The ATLT
has asserted a counterclaim alleging that it is owed approximately $100 million in respect to
operating, working capital and other disputes that have arisen between the parties. XO is
vigorously trying its claim and believes that the ATLTs counterclaim is frivolous and completely
without merit. As of March 31, 2005, XO had $8.0 million recorded in other assets, net related to
certain payments made by XO on behalf of the Unacquired Businesses that XO believes is reimbursable
by the ATLT. Other than this amount, the accompanying financial statements do not include any
impact from the litigation. 9




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##### 



The case went to trial on May 2, 2005. Prior to the acquisition of the Acquired Businesses, XO purchased $92.5 million in face value
of unsecured Allegiance debt securities. Consequently, XO is a claimant in Allegiances bankruptcy.
It is difficult to assess how much of the claim XO will recover, or when the recovery will be paid.
This assessment could change based upon the total amount of claims the ATLT is directed to pay, the
amount of administrative costs that it incurs, and the value of its assets, including 45.4 million
shares of XOs common stock. 10




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##### 



PART I. FINANCIAL INFORMATION Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations Forward-looking and Cautionary Statements Some statements and information contained in this document are not historical facts, but are
forward-looking statements, as such term is defined in the Private Securities Litigation Reform
Act of 1995. These forward-looking statements can be identified by the use of forward-looking
terminology such as believes, expects, plans, may, will, would, could, should, or
anticipates or the negative of these words or other variations of these words or other comparable
words, or by discussions of strategy that involve risks and uncertainties. Such forward-looking
statements include, but are not limited to, statements regarding:  
    our services, including the development and deployment of data products and services
based on IP, Ethernet and other technologies and strategies to expand our targeted customer
base and broaden our sales channels;
    the operation of our network and back office systems, including with respect to the
development of IP protocols;
    liquidity and financial resources, including anticipated capital expenditures, funding
of capital expenditures and anticipated levels of indebtedness;
    trends related to and expectations regarding the results of operations in future
periods, including but not limited to those statements set forth in Managements Discussion
and Analysis of Financial Condition and Results of Operations below; and
    The impact of judicial decisions, legislation, and regulatory developments on our cost
structure, services, and marketing initiatives. All such forward-looking statements are qualified by the inherent risks and uncertainties
surrounding expectations generally and also may materially differ from our actual experience
involving any one or more of these matters and subject areas. The operation and results of our
business also may be subject to the effect of other risks and uncertainties in addition to the
relevant qualifying factors identified in the Liquidity Assessment discussions set forth below
and the Risks and Uncertainties discussion and the Risk Factors section of our 2004 Annual
Report, including, but not limited to:  
    general economic conditions in the geographic areas that we are targeting for the sale
of telecommunications services;
    the ability to achieve and maintain market penetration and average per customer revenue
levels sufficient to provide financial viability to our business;
    the quality and price of similar or comparable telecommunications services offered, or
to be offered, by our current or future competitors; and
    future telecommunications-related legislation or regulatory developments and the conduct
of incumbent carriers in reaction to such developments. Management Overview We provide a comprehensive array of telecommunications services to business customers.
We provide our services, including local and long distance voice, Internet access, private data
networking and hosting services, through our national telecommunications network, which consists of
more than 6,700 route miles of fiber optic lines connecting 953 unique Incumbent Local Exchange
Carrier, or ILEC, end-office collocations in 37 U.S. cities. In addition, we own licenses to
deliver telecommunications services via local multipoint distribution service, or LMDS, wireless
spectrum in all of the largest U.S. cities. We market our services primarily to business customers,
ranging from small and medium businesses to Fortune 500 companies to carrier and wholesale
customers. Our services offer an effective telecommunications solution for nearly any business, and
our national telecommunications network is particularly advantageous to multi-location businesses
that desire to improve telecommunications among their locations, whether within a single
metropolitan area or across the country. 11




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##### 



To serve our customers broad telecommunications needs, we operate a network comprised of
a series of rings of fiber optic cables located in the central business districts of numerous
metropolitan areas, which we refer to as metro fiber networks, that are connected primarily by a
network of numerous dedicated wavelengths of transmission capacity on fiber optic cables, which we
refer to as an intercity network. By integrating these networks with advanced telecommunications
technologies, we are able to provide a comprehensive array of telecommunications services primarily
or entirely over a network that we own or control, from the initiation of the voice or data
transmission to the point of termination, which we refer to as end-to-end service. This capability
enables us to provide telecommunications services between customers connected to our network and
among customers with multiple locations primarily or entirely over our network. With the acquisition of Allegiance Telecom, Inc.s, or Allegiances, network assets and
customer base, which we refer to as the Acquired Businesses, in June 2004, we became one of the
nations largest competitive providers of national local telecommunications and broadband services.
We own one of the largest networks of nationwide connections to the Regional Bell Operating
Companies, or RBOCs, networks, and doubled our Points of Presence (PoPs) within the 36
metropolitan areas where both XO and Allegiance operated. We believe that this extensive network
will allow the combined company to (i) improve delivery of service to customers, (ii) improve
operating results, and (iii) improve our ability to compete with other companies in the nationwide
local telecommunications services market. Management uses certain key performance indicators, or KPIs, to assess operational
effectiveness of the business, including:  
    Gross Margin
    EBITDA
    Sales, Operating and General Expenses as a Percentage of Revenue The following table outlines the measurements of these KPIs as a percentage of revenue for the
first quarter of 2005 and 2004: Three Months Ended March 31,2005
    
    
    2004Gross margin
    
    
    59.1
    %
    
    
    57.9
    %EBITDA
    
    
    6.0
    %
    
    
    (6.9
    %)Sales, operating & general expenses
    
    
    53.0
    %
    
    
    64.6
    %
 Management believes that EBITDA and gross margin are measures of operating
performance and liquidity that reflect the ongoing effectiveness of
managements sales, cost reduction and acquisition initiatives.
Sales operating and general expense is an important measure of the
efficiency with which the company sells, provisions and supports its
services, and the efficiency of its back office operations. See the further discussion of EBITDA
and gross margin in the Comparison of Financial Results section below. Recent Events In
March 2005, we retained Jefferies & Company, Inc.
(Jefferies) to present strategic alternatives based on,
among other things, the competitive environment of the
telecommunications industry, the current regulatory environment, and the recent and pending mergers and acquisitions in our
industry. We have received the Jefferies report, which addressed
potential operational improvements and disposition possibilities, and are considering all
of our strategic alternatives. On April 18, 2005, we launched the Companys initial Voice over Internet Protocol, or VoIP,
product, named XOptions Flex, in 45 markets. VoIP enables customers to utilize dynamic bandwidth
allocation to maximize the utilization of their bandwidth by allocating it for data applications
during periods when voice lines are idle. XOptions Flex bundles unlimited local and long distance
calling, dedicated Internet access and web hosting services for a flat monthly price. We have begun offering fixed broadband wireless backhaul services to
mobile wireless telecommunications carriers. In April 2005, we reached an agreement to provide fixed broadband wireless services on
a limited basis to one of the national mobile wireless carriers. The Company will continue to pursue opportunities to market and sell its
fixed wireless solution to mobile wireless carriers both for primary network connectivity and redundancy. Results of Operations The operational results of XO for the three months ended March 31, 2005 are discussed below.
As the acquisition of the Acquired Businesses closed on June 23, 2004, or the Closing Date, our
consolidated results of operations include the Acquired Businesses from the Closing Date through
March 31, 2005. Forward looking information with respect to consolidated XO is discussed at the end
of each financial results analysis. Our actual experience may differ materially from our
projections of the combined company based on many factors including, among others:  
    there are inherent uncertainties in projecting future results for any business;
    we cannot predict the outcome of future judicial decisions, telecommunications related
legislation or regulatory decisions, or the reaction by incumbent carriers to such
developments. 12




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##### 



Three Months Ended March 31, 2005 versus Three Months Ended March 31, 2004 The following table contains certain data from our unaudited consolidated and condensed
statement of operations presented in thousands of dollars and expressed as a percentage of total
revenue. The information in this table should be read in conjunction with our consolidated and
condensed financial statements, including the notes thereto, appearing elsewhere in this report
(amounts in thousands, except for share and per share data): Three Months Ended March 31,2005
    
    
    2004Revenue
    
    $
    361,504
    
    
    
    100.0
    %
    
    $
    260,945
    
    
    
    100.0
    %Costs and expenses:Cost of service (exclusive of depreciation and
amortization)
    
    
    147,922
    
    
    
    40.9
    %
    
    
    109,961
    
    
    
    42.1
    %Selling, operating and general
    
    
    191,694
    
    
    
    53.0
    %
    
    
    168,553
    
    
    
    64.6
    %Depreciation and amortization
    
    
    58,365
    
    
    
    16.1
    %
    
    
    25,697
    
    
    
    9.8
    %Total costs and expenses
    
    
    397,981
    
    
    
    110.1
    %
    
    
    304,211
    
    
    
    116.6
    %Loss from operations
    
    
    (36,477
    )
    
    
    (10.1
    %)
    
    
    (43,266
    )
    
    
    (16.6
    %)Interest income
    
    
    1,893
    
    
    
    0.5
    %
    
    
    1,705
    
    
    
    0.7
    %Investment
loss, net
    
    
    (271
    )
    
    
    (0.1
    %)
    
    
    (329
    )
    
    
    (0.1
    %)Interest expense, net
    
    
    (8,004
    )
    
    
    (2.2
    %)
    
    
    (6,604
    )
    
    
    (2.5
    %)Net loss
    
    $
    (42,859
    )
    
    
    (11.9
    %)
    
    $
    (48,494
    )
    
    
    (18.6
    %)Preferred stock accretion
    
    
    (3,097
    )
    
    
    (0.9
    %)
    
    
    
    
    
    
    0.0
    %Net loss applicable to common shares
    
    
    (45,956
    )
    
    
    (12.7
    %)
    
    
    (48,494
    )
    
    
    (18.6
    %)Net loss per common share, basic and diluted
    
    
    (0.25
    )
    
    
    
    
    
    
    (0.37
    )Weighted average shares outstanding, basic and diluted
    
    
    181,933,035
    
    
    
    
    
    
    
    129,406,599Gross margin (1)
    
    
    213,582
    
    
    
    59.1
    %
    
    
    150,984
    
    
    
    57.9
    %EBITDA (2)
    
    
    21,617
    
    
    
    6.0
    %
    
    
    (17,898
    )
    
    
    (6.9
    %)
   (1)
    
    Gross margin is defined as revenue less cost of service, and excludes depreciation and
amortization. Gross margin is not intended to replace operating income (loss), net income
(loss), cash flow and other measures of financial performance reported in accordance with
generally accepted accounting principles in the United States. Rather, gross margin is an
important measure used by management to assess operating performance of the Company.
Additionally, we believe that gross margin is a standard measure of operating performance that
is commonly reported and widely used by analysts, investors, and other interested parties in
the telecommunications industry. Gross margin as used in this document may not be comparable
to similarly titled measures reported by other companies due to differences in accounting
policies. A reconciliation between gross margin and net loss is as follows: Three Months Ended March 31,2005
    
    
    2004Net loss
    
    $
    (42,859
    )
    
    $
    (48,494
    )Selling, operating and general
    
    
    191,694
    
    
    
    168,553Interest income
    
    
    (1,893
    )
    
    
    (1,705
    )Investment
loss, net
    
    
    271
    
    
    
    329Interest expense, net
    
    
    8,004
    
    
    
    6,604Depreciation and amortization
    
    
    58,365
    
    
    
    25,697Gross margin
    
    $
    213,582
    
    
    $
    150,984
 13




---



##### 



(2)
    
    EBITDA is defined as net income or loss before depreciation, amortization, interest expense, and
interest income. EBITDA is not intended to replace operating income (loss), net income
(loss), cash flow and other measures of financial performance reported in accordance with
generally accepted accounting principles in the United States. Rather, EBITDA is an important
measure used by management to assess operating performance of the company. EBITDA as used in
this document may not be comparable to similarly titled measures reported by other companies due
to differences in accounting policies. Additionally, EBITDA as defined here does not have the
same meaning as EBITDA as defined in our secured credit facility agreement. A reconciliation
between EBITDA and net loss is as follows: Three Months Ended March 31,2005
    
    
    2004Net loss
    
    $
    (42,859
    )
    
    $
    (48,494
    )Interest income
    
    
    (1,893
    )
    
    
    (1,705
    )Interest expense, net
    
    
    8,004
    
    
    
    6,604Depreciation and amortization
    
    
    58,365
    
    
    
    25,697EBITDA
    
    $
    21,617
    
    
    $
    (17,898
    )
 Revenue. Total revenue for the three months ending March 31, 2005 increased 38.5% to
$361.5 million from $260.9 million for the three months ending March 31, 2004. Substantially all of
the increase is attributable to the inclusion of the Acquired Businesses in the results for the
three months ending March 31, 2005. We believe that revenue for the remainder of 2005 will increase in absolute dollars relative
to the first quarter of 2005 results, attributable largely to price increases that will be
implemented to offset the impacts of recently enacted FCC rules on UNE loop and transport rates
discussed in the Regulatory Overview section below. Revenue was earned from providing the following services (dollars in thousands): Three months ended March 31,% of
    
    
    
    
    
    
    % of2005
    
    
    Revenue
    
    
    2004
    
    
    Revenue
    
    
    % ChangeVoice services
    
    $
    186,298
    
    
    
    51.5
    %
    
    $
    130,921
    
    
    
    50.2
    %
    
    
    42.3
    %Data services
    
    
    108,392
    
    
    
    30.0
    %
    
    
    92,949
    
    
    
    35.6
    %
    
    
    16.6
    %Integrated voice and data services
    
    
    66,814
    
    
    
    18.5
    %
    
    
    37,075
    
    
    
    14.2
    %
    
    
    80.2
    %Total revenue
    
    $
    361,504
    
    
    
    100.0
    %
    
    $
    260,945
    
    
    
    100.0
    %
    
    
    38.5
    %
 Voice services revenue includes revenue from local and long distance voice services,
prepaid calling card processing, interactive voice response services, stand-alone long distance
services and other voice telecommunications based services. Revenue from voice services increased
$55.4 million or 42.3% as compared to the same period in 2004. Substantially all of the increase
is attributable to the inclusion of the Acquired Businesses in the results for the three months
ending March 31, 2005. Data services revenue includes revenue from Internet access, network access and web hosting
services. Revenue from data services revenue increased $15.4 million or 16.6% as compared to the
same period in 2004. Substantially all of the increase is attributable to the inclusion of the
Acquired Businesses in the results for the three months ending March 31, 2005. Integrated voice and data services revenue includes revenue from our XOptions and Total
Communications service offerings, XOs flat-rate bundled packages offering a combination of voice
and data services and integrated access. Revenue from integrated voice and data services increased
$29.7 million or 80.2% as compared to the same period in 2004. Substantially all of the increase
is attributable to the inclusion of the Acquired Businesses in the results for the three months
ending March 31, 2005. 14




---



##### 



Costs and expenses. The table below provides costs and expenses by classification and as a
percentage of revenue (dollars in thousands). Our consolidated costs and expenses in the first
quarter of 2005 include the costs to run the Acquired Businesses. Three months ended
    
    
    Three months endedMarch 31,
    
    
    March 31,% of
    
    
    
    
    
    
    % of2005
    
    
    Revenue
    
    
    2004
    
    
    Revenue
    
    
    % ChangeCosts and expenses:Cost of service (excluding
depreciation and
amortization)
    
    $
    147,922
    
    
    
    40.9
    %
    
    $
    109,961
    
    
    
    42.1
    %
    
    
    34.5
    %Selling, operating and general
    
    
    191,694
    
    
    
    53.0
    %
    
    
    168,553
    
    
    
    64.6
    %
    
    
    13.7
    %Depreciation and amortization
    
    
    58,365
    
    
    
    16.1
    %
    
    
    25,697
    
    
    
    9.8
    %
    
    
    127.1
    %Total
    
    $
    397,981
    
    
    
    110.1
    %
    
    $
    304,211
    
    
    
    116.6
    %
    
    
    30.8
    %
 Cost of service (exclusive of depreciation and amortization). Cost of service includes
expenses directly associated with providing telecommunications services to our customers. Cost of
service includes, among other items, the cost of connecting customers to our network via leased
facilities, the costs of leasing components of our network facilities and costs paid to third party
service providers for interconnect access and transport services. Cost of service as a percentage
of revenue for the three months ended March 31, 2005 decreased as compared to the same period in
2004 primarily due to a $10.0 million settlement with SBC (the SBC Settlement). Excluding this
settlement, Cost of service as a percentage of revenue increased as compared to the same period in
2004. This increase was primarily due to the impact of pricing pressures from both mandated carrier
access rate reductions and general price reductions, offset by savings from synergies associated
with the integration of Acquired Businesses. We originally estimated a potential benefit of
approximately $60.0 million in pro forma annualized network synergies for the combined companies if
our integration efforts with the Acquired Businesses were successful. We have made substantial
progress integrating the two companies and are on plan to reach our synergy targets. We believe that, excluding the SBC settlement, cost of service as a percentage of revenue for
the remainder of 2005 will remain stable relative to the first quarter of 2005 results. Cost of
service will be adversely impacted due to the recently enacted regulatory rules on unbundled
network element, or UNE, loop and transport rates as discussed in the Regulatory Overview section
below. The UNE and transport rate increases will be phased in during 2005, and we expect them to
have a total impact of approximately $70 million in 2006. However, we believe that actions we are
taking, including negotiating rate reductions, network optimization, and price increases, will
offset these increases. Selling, operating and general.Selling, operating and general expense includes expenses
related to network maintenance, sales and marketing, network operations and engineering,
information systems, general corporate office functions and collection risks. Selling, operating
and general expense for the three months ended March 31, 2005 was $191.7 million or 53.0% of
revenue versus $168.6 million or 64.6% of revenue for the three months ended March 31, 2004. The
decrease in selling, operating and general expense as a percentage of revenue for the three months
ended March 31, 2005 when compared to 2004 results is primarily due to the achievement of synergies
related to the Acquired Businesses. We originally estimated a potential benefit of approximately
$100.0 million in pro forma annualized selling, operating and general expense synergies for the
combined companies if our integration efforts with the Acquired Businesses were successful. We have
completely integrated the administrative functions and have exceeded the estimated annualized
synergies. We believe that selling, operating and general expense will decrease slightly as a percentage
of revenue during the remainder of 2005, due to the price increases discussed above and through
continued efficiencies resulting from back office infrastructure improvements. Depreciation and amortization. Depreciation and amortization expense was $58.4 million for the
three months ended March 31, 2005, and $25.7 million for the three months ended March 31, 2004. The
increase is primarily due to the inclusion of property and equipment and intangibles of the
Acquired Businesses. As of March 31, 2005, we had approximately $95.5 million of fixed assets and $23.5 million of
broadband wireless licenses that have not yet been placed into service and, accordingly, are not
currently being depreciated or amortized. We expect depreciation and amortization expense to
increase in both absolute dollars and as a percentage of revenue during 2005 as additional assets
are placed into service. 15




---



##### 



Interest
income. Interest income in the first quarter of 2005 increased to
$1.9 million from $1.7 million in the first quarter of 2004. The increase in
interest income is due to an increase in interest rates. Investment
loss, net. Investment loss, net includes any realized gains
or losses from the sale of investments. Investment loss, net was
$0.3 million for each of the three months ended March 31, 2005 and 2004. The first quarter of
2005 includes a $4.0 million impairment adjustment that was considered to be other
than temporary, offset by realized gains on other investments of $3.7 million. Interest expense, net.Interest expense, net includes interest expense on debt and capital
leases, less any amounts capitalized. The majority of interest expense in the three months ended
March 31, 2005 and 2004 is non-cash as our secured credit facility (the Credit Facility) allows
for accrued interest to be converted into principal if unpaid. Interest expense, net for the three
months ended March 31, 2005 and 2004, was $8.0 million and $6.6 million, respectively. Net Loss. Net loss decreased $5.6 million to a loss of $42.9 million for the three months
ended March 31, 2005, from a net loss of $48.5 million for the comparable period in 2004. The
decrease primarily resulted from the achievement of synergies resulting from the integration of the
Acquired Businesses, offset by additional depreciation and amortization from the inclusion of the
property and equipment and intangibles of the Acquired Businesses. Additionally, we recognized a
$10.0 million reduction in cost of service expense due to the SBC Settlement referenced above. EBITDA.
EBITDA increased to $21.6 million for the three months ended March 31, 2005 from
$(17.9) million for the comparable period in 2004. The increase primarily resulted from the
achievement of synergies resulting from the integration of the Acquired Businesses and the $10.0
million SBC Settlement referenced above. Critical Accounting Policies and Estimates Our significant accounting policies are more fully described in the notes to the consolidated
financial statements in our 2004 Annual Report. The preparation of the condensed consolidated
financial statements in accordance with accounting principles generally accepted in the United
States requires management to make judgments, estimates and assumptions regarding uncertainties
that affect the reported amounts of assets and liabilities, disclosure of contingent assets and
liabilities and the reported amounts of revenues and expenses. Management uses historical
experience and all available information to make these judgments and estimates and actual results
could differ from those estimates and assumptions that are used to prepare our financial statements
at any given time. Despite these inherent limitations, management believes that Managements
Discussion and Analysis and the accompanying condensed consolidated financial statements and
footnotes provide a meaningful and fair perspective of our financial condition and our operating
results for the current period. Managements Discussion and Analysis and Note 3 to the Consolidated
Financial Statements in the XO Communications, Inc. Annual Report on Form 10-K for the year ended
December 31, 2004 describe the significant estimates and accounting policies used in preparation of
the Condensed Consolidated Financial Statements. There have been no significant changes in our
Critical Accounting Policies or Estimates during the first quarter of 2005. Liquidity and Capital Resources Capital Resources and Liquidity Assessment During the three months ended March 31, 2005, our operating activities provided net cash of
$18.3 million, our investing activities provided net cash of $5.2 million, and our financing
activities used net cash of $0.9 million. Our balance of cash and cash equivalents increased to
$256.6 million at March 31, 2005 from $234.0 million at December 31, 2004. In the first quarter of
2005, $25.4 million previously held in escrow was released and, accordingly, reclassified into cash
and cash equivalents. We have a secured credit facility, or the Credit Facility, which matures on July 15, 2009.
There are no additional borrowings available under the Credit Facility. At March 31, 2005, more
than 90% of the underlying loans of the Credit Facility are held by an entity controlled by Mr.
Carl C. Icahn, Chairman of the Companys Board of Directors (Mr. Icahn). At March 31, 2005,
long-term debt consisted of $368.5 million in principal and $5.7 million of accrued interest that,
if not paid, converts to principal. There are no current debt service requirements since cash
interest payments as well as automatic and permanent quarterly reductions on the principal amount
outstanding do not commence until 2009. However, in the event that consolidated excess cash flow
(as defined in the Credit Facility) for any fiscal quarter during the term of the agreement is
greater than $25.0 million, at the request of the lender, the Company will pay an amount equal to
50% of such excess cash flow greater than 16




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$25.0 million toward the reduction of outstanding indebtedness. In addition, if the ratio of
XOs consolidated earnings before interest, taxes, depreciation and amortization (EBITDA), as
defined in the Credit Facility, to consolidated interest expense for four consecutive quarters
exceeds 4:1, XO would be required to pay cash interest, unless waived by the lenders. The Company
can elect to begin paying interest in cash prior to the required date. Loans under the Credit
Facility bear interest, at the Companys option, at an alternate base rate, as defined, or a
Eurodollar rate plus, in each case, applicable margins. Once the Company begins to pay accrued
interest in cash, the applicable margins are reduced. At March 31, 2005, the annualized weighted
average interest rate applicable to outstanding borrowings under the Credit Facility was 8.7%. The security for the Credit Facility consists of all assets of XO including the stock of its
direct and indirect subsidiaries, and substantially all the assets of those subsidiaries. The
Credit Facility limits additional indebtedness, liens, dividend payments and certain investments
and transactions, and contains certain covenants with respect to EBITDA requirements, as the term
EBITDA is defined in the Credit Facility, and maximum capital
expenditures. The definition of EBITDA in the Credit Facility differs
from the definition of EBITDA discussed in Results of
Operations above.  The Company was
required to achieve a minimum consolidated EBITDA of not less than $97.0 million for the
twelve-month period ended March 31, 2005. The Company is also required under the terms of the Credit Facility to maintain an unrestricted cash
balance of $25.0 million at the end of each fiscal quarter. In
May of 2005, we obtained a waiver
of
compliance with
the minimum consolidated EBITDA covenant
contained in the Credit
Facility
through December 31, 2006. The waiver was obtained
from the affiliate of Mr. Icahn which holds a majority of
the Companys loans outstanding under that agreement. In connection with that waiver, we
agreed that in the event of a sale of the Company
and in the event of other
significant sale or divestiture transactions, we will prepay all
amounts outstanding under the Credit Facility in cash
and offer to repurchase outstanding shares of our preferred
stock at their liquidation value accrued through the date of redemption
for cash or, in certain events, securities. The affiliate of Mr.
Icahn which holds a majority of such Preferred Stock has agreed to
accept that offer, to the extent it consists of cash. We project that we will make significant progress on our operating results such that we will
be cash flow positive in 2005. Our projection is based upon, among other things, our estimated
increased costs of service attributable to the recent Triennial Review Remand Order, or TRRO,
discussed in the Regulatory Overview below, and other projected operating costs that are not
entirely under our control. As a result, our 2005 projections may be incorrect if our estimates of
such costs and expenses are inaccurate. Credit Risk Financial instruments that potentially subject us to concentrations of credit risk consist
primarily of trade receivables. Although our trade receivables are geographically dispersed and
include customers in many different industries, a portion of our revenue is generated from services
provided to other telecommunications service providers. We believe that our established valuation
and credit allowances are adequate as of March 31, 2005 to cover these risks. Regulatory Overview Overview We are subject to regulation by federal, state and local government agencies. Historically,
the Federal Communications Commission, or FCC, had jurisdiction over interstate long distance
services and international services, while state regulatory commissions had jurisdiction over local
and intrastate long distance services. The Telecommunications Act of 1996, or the Telecom Act,
fundamentally changed the way telecommunications is regulated in this country. The FCC was given a
major role in writing and enforcing the rules under which new competitors could compete in the
local marketplace. Those rules, coupled with additional rules and decisions promulgated by the
various state regulatory commissions, form the core of the regulatory framework under which we
operate in providing our services. With a few limited exceptions, the FCC continues to retain exclusive jurisdiction over our
provision of interstate and international long distance services, and the state regulatory
commissions regulate our provision of intrastate local and long distance services. Additionally,
municipalities and other local government agencies may regulate limited aspects of our business,
such as use of government-owned rights-of-way, and may require permits such as zoning approvals and
building permits. The Telecom Act and the related rules governing competition issued by the FCC, as well as
pro-competitive policies already developed by state regulatory commissions, have enabled new
entrants like us to capture a portion of the ILECs market share of local services. However, there
have been numerous attempts to limit the pro-competitive policies in the local exchange services
market through a combination of proposed federal legislation, adoption of new rules by the FCC, and
ILEC challenges to existing and proposed regulations. To date, the ILECs have succeeded in
eliminating some of the market-opening regulations adopted by the FCC and the states through
numerous court challenges. In particular, the ILECs appealed, and won partial reversals of, a
series of FCC orders defining the ILEC facilities, known as UNEs, that ILECs must lease to
competitors at cost-based rates. We expect 17




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the ILECs efforts to scale back the benefits of the Telecom Act and local service competition
to continue. However, while the FCC has eliminated certain UNEs, the basic framework of local
competition for facilities-based competitors such as us, has remained intact. The successful
implementation of our business plan is predicated on the assumption that the basic competitive
framework and pro-competitive safeguards will remain in place. The passage of the Telecom Act largely preceded the explosive growth of the Internet and
Internet Protocol, or IP, communications. Congress is currently considering whether to further
amend the Telecom Act to, among other things, directly address IP communications. It is possible
that any such amendment to the Telecom Act could eliminate or materially alter the market-opening
regulatory framework of the Telecom Act in general, and the UNE regime in particular. Such a result
could adversely affect XOs business. It is not possible to predict if, when, or how the Telecom
Act will be amended. Federal Regulation The FCC exercises jurisdiction over our telecommunications facilities and services. We have
authority from the FCC for the installation, acquisition and operation of our wireline network
facilities to provide facilities-based domestic interstate and international services. In addition,
we have obtained FCC authorizations for the operation of our LMDS and 39 GHz broadband wireless
facilities. Because we are not dominant in any of our markets, unlike ILECs, we are not subject to
price cap or rate of return regulation. Thus, our pricing policies for interstate and international
end user services are only subject to the federal guidelines that charges for such services be
just, reasonable, and non-discriminatory. The FCC allows us to file interstate tariffs for our
interstate access services (rates charged by us to other carriers for access to our network). As
for domestic interstate and international long distance services, the FCC requires us to make the
terms, conditions and rates of the detariffed services available to the public on XOs web page,
and such terms, conditions, and rates are located at http://www.xo.com/legal/. Implementation of the Telecom Act  The Telecom Acts Local Competition Framework One of the key goals of the Telecom Act is to encourage competition in the provision of local
telephone service. To do this, the Telecom Act provides three means by which competitive local
exchange carriers, or CLECs, such as XO can enter the local telephone service market. The three
modes of entry are as follows:  
    Access to UNEs.ILECs are required to lease to CLECs various elements in their network
that are used individually or in combination with each other to provide local telephone
service. As discussed in more detail below, the FCC determines which facilities must be
made available by the ILECs as UNEs. The ILECs must make UNEs available at rates that are
based on their forward-looking economic costs, a pricing regime known as TELRIC, short
for Total Element Long Run Incremental Cost. For XO, the most critical UNEs are local loops
and transport, which enable us to connect our customers to our network.
    Construction of New Facilities.CLECs may also enter the local service market by
building entirely new facilities. The ILECs are required to allow CLECs to interconnect
their facilities with the ILECs facilities in order to reach all customers.
    Resale.ILECs are required to permit CLECs to purchase their services for resale to the
public at a wholesale rate that is less than the rate charged by the ILECs to their retail
customers. To facilitate competitors entry into local telephone markets using one or more of these three
methods, the Telecom Act imposes on the ILECs the obligation to open their networks and markets to
competition. When requested by competitors, ILECs are required to negotiate, in good faith,
agreements that set forth terms governing the interconnection of their network, access to UNEs, and
resale. We have negotiated interconnection agreements with the ILECs in each of the markets in
which we operate. Many of these interconnection agreements are currently being renegotiated. The following is a summary of the interconnection and other rights granted by the Telecom Act
that are important for effective local service competition and our belief as to the effect of those
requirements, if properly implemented:  
    interconnection with the networks of incumbents and other carriers, which permits our
customers to exchange traffic with customers connected to other networks; 18




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
    requirements that the ILECs make available access to their facilities for our local
loops and transport needs, thereby enabling us to serve customers not directly connected to
our networks;
    compensation obligations, which mandate reciprocal payment arrangements for local
traffic exchange between us and both incumbent and other competitive carriers and
compensation for terminating local traffic originating on other carriers networks;
    requirements concerning local number portability, which allows customers to change local
carriers without changing telephone numbers, thereby removing a significant barrier for a
potential customer to switch to our local voice services;
    access to assignment of telephone numbers, which enables us to provide telephone numbers
to new customers on the same basis as incumbent carriers; and
    collocation rights allowing us to place telecommunications equipment in ILEC central
offices, which enables us to have direct access to local loops and other network elements. Although the rights established in the Telecom Act are a necessary prerequisite to the
introduction of full local competition, they must be properly implemented and enforced to permit
competitive telephone companies like XO to compete effectively with the incumbent carriers.
Discussed below are several FCC and court proceedings relating to the application of certain FCC
rules and policies that are significant to and directly impact our operations and costs as well as
the nature and scope of industry competition.  Unbundling of Incumbent Network Elements In a series of orders and related court challenges that date back to 1996, the FCC has
promulgated rules implementing the market-opening provisions of the Telecom Act, including the
requirement that the ILECs lease UNEs to competitors at cost-based rates. At the core of the series
of FCC orders is the FCCs evolving effort to define which ILEC network facilities must be made
available as UNEs. Initially, the FCC defined a broad list of UNEs, consisting of most of the
elements of the ILECs networks. Under pressure from the ILECs, the FCC has subsequently reduced
the list, while preserving access to those network elements critical to the operation of XOs
business. The current list of UNEs was promulgated by the FCC in two orders. The first is the Triennial
Review Order, or TRO, which was released on August 21, 2003. Several carriers and other entities
appealed the FCCs TRO decision. On March 2, 2004, the U.S. Court of Appeals for the D.C. Circuit
issued its opinion in United States Telecom Association v. FCC, No. 00-1012 (USTA II
Decision). In the USTA II Decision, the court reversed and overturned many of the conclusions of
the TRO. In the aftermath of the USTA II Decision, the FCC released the second of its two currently
controlling orders, the TRRO, on February 4, 2005. Various parties, including XO, have appealed the
TRRO. The case is currently pending before the United States Court of Appeals for the D.C. Circuit.
It is not possible to predict the outcome of those appeals. It is possible that portions of the
TRRO could be overturned and that the FCC will issue new rules in their place that further restrict
access to UNEs. As of March 11, 2005, the effective date of the TRRO, the ILECs are obligated to provide as
UNEs the following network facilities used by XO to serve its customers: UNE Loops DS0 loops.A DS0 loop is a single, voice-grade channel. Typically, individual business lines
are DS0 loops. The ILECs must make DS0 loops available at UNE rates on an unlimited basis. DS1 loops.A DS1 loop is a digital loop with a total speed of 1.544 megabytes per second,
which is the equivalent of 24 DS0 circuits. Multiple voice lines and Internet access can be
provided to a customer over a single DS1 loop. We provide most of our service with DS1 loops. The
ILECs must provide DS1 loops at UNE rates at the majority of their central offices. Competitors,
however, are limited to no more than 10 DS1 loops to any particular building. DS3 loops.A DS3 loop is a digital loop with a total speed of 44.736 megabytes per second,
which is the equivalent of 28 DS1 circuits. In some cases, XO serves its large business customers
with DS3 loops. ILECs must provide DS3 loops at UNE rates at the majority of their central offices.
Competitors, however, are limited to no more than one DS3 loop to any particular building. 19




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ILECs are not required to provide optical capacity loops or dark fiber loops as UNEs. Optical
capacity loops, referred to as OCn loops, are very high-capacity digital loops ranging in capacity
from OC3 loops, which are the equivalent of three DS3s to OC192. This will not impact our costs. The ILECs are also not required to provide certain mass market broadband loop facilities and
functionality as UNEs. Under the TRO, the ILECs are not required to make newly-deployed
fiber-to-the-home, or FTTH, loops available as UNEs and are only required to provide the equivalent
of DS0 capacity on any FTTH loop built over an existing copper loop. These recent FCC orders should
only limit availability for those specific network elements, which are not material to us. It is
possible, however, that the ILECs will seek additional broadband regulatory relief in future
proceedings. UNE Transport DS1 transport.Whether transport is available as a UNE is determined on a route-by-route
basis. ILECs must make transport at UNE rates available at DS1 capacity levels between any two ILEC
central offices unless both central offices either (1) serve more than 38,000 business lines or (2)
have four or more fiber-based collocators. On routes where DS1 transport must be made available,
each individual competitor is limited to no more than 10 DS1 transport circuits per route. DS3 transport.Access to DS3 capacity-level transport is more limited than access to DS1
transport. ILECs must make transport at UNE rates available at DS3 capacity levels between any two
ILEC central offices unless both central offices either (1) serve more than 24,000 business lines
or (2) have three or more fiber-based collocators. On routes where DS3 transport must be made
available, each individual competitor is limited to no more than 12 DS1 transport circuits per
route. Dark fiber transport.Dark fiber transport is available under the same conditions as DS3
transport. ILECs are not required to provide access to transport at greater-than DS3 capacity levels.
ILECs are also not required to provide dark fiber transport at any capacity level to connect an
ILEC central office with a competitors facilities. Transitional availability where elements are no longer available as UNEs For DS1, DS3, and dark fiber loops and transport that do not meet the criteria for
availability set forth above, the FCC established a transitional period during which the ILECs must
continue to make the elements available at UNE rates to serve existing customers. For DS1 and DS3
loops and transport, the ILECs must make the elements available at 115% of the TELRIC rate for one
year beginning on March 11, 2005. For dark fiber loops and transport, the ILECs must make the
elements available at 115% of the TELRIC rate for 18 months beginning on March 11, 2005. Although these rules adopted by the FCC in the TRRO became effective on March 11, 2005, many
of the requirements imposed by the FCC in the TRO and TRRO were not self-executing. Accordingly,
the FCC made clear that carriers must follow the change of law procedures in their applicable
interconnection agreements with ILECs to implement any TRO requirements that are not self-executing
and that carriers must follow the procedures set forth in Section 252(b) of the Telecom Act to
modify interconnection agreements that are silent as to implementation of changes in law. We have
been in negotiations with ILECs to amend our interconnection agreements to implement relevant TRO
requirements and, to date, have executed amendments in several states. Additional Federal Regulations The following discussion summarizes some additional specific areas of federal regulation that
directly affect our business. VoIP.Like a growing number of carriers, we utilize IP technology for the transmission of a
portion of our network traffic. The regulatory status and treatment of IP-enabled services is
unresolved. In a recent order, the FCC held that Vonages VoIP services and similar offerings by
other providers are subject to the FCCs interstate jurisdiction, preempting state efforts to
regulate VoIP providers as intrastate telecommunications providers. Four separate state commissions
have appealed this ruling and the case is currently pending. The FCC, however, left open the
question of whether VoIP providers provide telecommunications  i.e., basic transmission services
 or enhanced information services. Under the Communications Act of 1934, as amended, or the
Communications Act, those are mutually exclusive categories. Generally, telecommunications
carriers, including traditional local and long distance telecommunications companies, are regulated
under the Communications Act; information service 20




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providers are generally unregulated. The FCC has initiated a rulemaking proceeding to address
the classification of VoIP and other IP-enabled service offerings. It is not possible to predict
the outcome of that proceeding or its effect on XOs operations. In conjunction with the rulemaking
proceeding, the FCC is considering a petition filed on February 5, 2004 by SBC Communications
requesting that the FCC forbear from applying common carrier regulation to IP-based networks. Under
the Communications Act, the FCC must act on forbearance petitions within one year, or the petition
is deemed granted, subject to a single, 90-day extension available to the FCC at its discretion. On May 5, 2005, the FCC denied SBCs petition. AT&T Declaratory Ruling Re: VoIP.On April 21, 2004, the FCC released an order, the AT&T
Order, denying AT&Ts request that the FCC find that VoIP services are exempt from switched access
charges. The FCC held that an interexchange service that uses ordinary customer premises equipment
that originates and terminates on the public switched telephone network, or PSTN, that provides no
enhanced functionality, and that undergoes no net protocol conversion, is a telecommunications
service and subject to switched access charges. The AT&T order apparently places interexchange
services similar to those VoIP services offered by AT&T in the same regulatory category as
traditional telecommunications services and, therefore, potentially subjects such VoIP services to
access charges and other regulatory obligations including Universal Service fees. Although the FCC
did not rule on the applicability of access charges for services provided prior to April 21, 2004,
the ILECs may attempt to assert claims against other telecommunications companies including us for
the retroactive payment of access charges. On April 22, 2004, SBC Communications filed a
collections lawsuit against AT&T and other carriers seeking retroactive payment of unpaid access
charges. On February 4, 2005, SBC amended an existing collection case it had filed against Global
Crossing and filed a complaint against XO. Level 3 Forbearance Petition. On December 23, 2003, Level 3 filed a petition requesting the
FCC not to apply interstate or intrastate access charges on IP traffic that originates or
terminates on the PSTN. Level 3 withdrew that petition on March 21, 2005, shortly before the FCCs
statutory deadline for acting. Some observers have interpreted Level 3s withdrawal of the
petition as a signal that the FCC was not likely to rule in Level 3s favor. The FCC may ultimately
rule on this issue either in its VoIP rulemaking proceeding or in the intercarrier compensation
reform proceeding discussed below. The issue of whether access charges apply to VoIP and other IP
traffic that originates or terminates on the PSTN is potentially significant for XO and other
carriers. ILEC Provision of Broadband Telecommunications Services and Information Services.Currently,
the ILECs, as dominant carriers, are subject to a relatively high degree of regulation with respect
to their broadband service offerings. The FCC, however, has initiated a rulemaking proceeding in
which it is considering deregulating, or applying a lower degree of regulation to, ILEC broadband
offerings. If the ILECs are largely freed from dominant carrier regulation, they will have much
greater pricing flexibility and will pose a greater competitive threat to XO. In a second, related
rulemaking, the FCC is considering whether to eliminate certain requirements it imposes on the
ILECs with respect to their broadband Internet access services. Currently, where the ILECs offer
Internet access or other information services over broadband facilities, they must (1) purchase the
underlying broadband transmission facilities from themselves at tariffed rates and (2) make the
underlying facilities available to competitors on a non-discriminatory basis. If the FCC were to
eliminate these requirements, it could result in an increase to our network costs. To date, these
deregulatory trends have been directed towards facilities used primarily by residential customers,
and not by business customers. Intercarrier Compensation Reform.Currently, telecommunications carriers are required to pay
other carriers for interstate access charges and local reciprocal compensation charges. These two
forms of intercarrier compensation have been under review by the FCC since 2001. The FCC continues
to consider a broad order reforming the intercarrier compensation system and issued a Notice of
Proposed Rulemaking on February 10, 2005 to seek further comment on intercarrier compensation
reform. Although we are unable to predict the outcome of the FCCs rulemaking procedures, inasmuch
as access charges and reciprocal compensation payments make up our largest network expense item,
the FCCs action could have a material, adverse affect on our operations and cost of doing
business. Cost-based TELRIC Pricing.On September 10, 2003, the FCC initiated a new proceeding to
consider significantly revamping the current TELRIC methodology used for the pricing of UNEs. If
the FCC reverses the methodology used for determining UNE rates to allow for rate increases, this
could substantially raise XOs costs for leasing UNEs in the future. A decision is expected
sometime in 2005. Several state commissions have also initiated proceedings to review the rates
that the ILECs charge for UNEs. An adverse ruling in these proceedings 21




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would allow the ILECs to increase UNE rates in the applicable state and this could
substantially raise our costs for leasing UNEs in the future. State and Local Regulation In general, state regulatory commissions have regulatory jurisdiction over us when our
facilities and services are used to provide local and other intrastate services. Under the Telecom
Act, state commissions continue to set the requirements for providers of local and intrastate
services, including quality of services criteria. State regulatory commissions also can regulate
the rates charged by CLECs for intrastate and local services and can set prices for interconnection
by new telecommunications service providers with the ILEC networks, in accordance with guidelines
established by the FCC. In addition, state regulatory commissions in many instances have authority
under state law to adopt additional regulations governing local competition and consumer
protection, as long as the states actions are not inconsistent with federal law or regulation. Most state regulatory commissions require companies that wish to provide intrastate common
carrier services to register or be certified to provide these services. These certifications
generally require a showing that the carrier has adequate financial, managerial and technical
resources to offer the proposed services in a manner consistent with the public interest. We are
certified in all of the states in which we conduct business. In most states, we are also required
to file tariffs setting forth the terms, conditions and prices for services that are classified as
intrastate, and to update or amend our tariffs as rates change or new products are added. We may
also be subject to various reporting and record-keeping requirements. Where we choose to deploy our own transmission facilities, we may be required, in some cities,
to obtain street opening and construction permits, permission to use rights-of-way, zoning
variances and other approvals from municipal authorities. We also may be required to obtain a
franchise to place facilities in public rights-of-way. In some areas, we may be required to pay
license or franchise fees for these approvals. We cannot provide assurances that fees will remain
at current levels, or that our competitors will face the same expenses, although the Telecom Act
requires that any fees charged by municipalities be reasonable and non-discriminatory among
telecommunications carriers. California Public Utilities Commission Proceeding. On September 23, 2004, the California
Public Utilities Commission, or the CA Commission, issued a decision that required SBC to adjust
monthly recurring rates for certain types of services offered to CLECs by SBC. As a result of that
decision, we believed that we were owed a retroactive credit. The billing adjustments and true-up
payments required by the decision had been stayed until the CA Commission could: (a) consider
mitigations to lessen the negative effect of such true-up payments; and (b) consider issues raised
by the U.S. Court of Appeals for the Ninth Circuit regarding the shared and common cost mark-up
element. After issuance of the September 23, 2004 decision, the CA Commission issued three separate
alternate draft decisions all of which proposed different true-up payment schemes and different
shared and common cost mark-up factors as well as retroactive and non-retroactive treatment of the
mark-up factor. These three alternate decisions were contentious and were being debated by the CA
Commission and various parties to the proceeding. On March 22, 2005 XO and SBC executed a
settlement agreement resolving these issues. As a result of this settlement, on March 25, 2005 SBC
made a payment to XO of approximately $10.0 million. The settlement agreement provides XO with
finality on these issues as the settlement agreement prohibits SBC from seeking rehearing before
the CA Commission or appealing to any state of federal court the true-up or payment of the true-up
monies to XO. 
 Item 3. Quantitative and Qualitative Disclosures about Market Risk We had $374.2 million in secured loans as of March 31, 2005. Currently, we do not pay
cash interest on the loans under the Credit Facility. Marketable securities and other investments at March 31, 2005 consist primarily of investments
in equity and debt investments of publicly-traded companies. The fair value of our investment in
equity and debt securities exposes us to market risk; however, if the fair value were to increase
or decrease immediately, it would not likely have a material impact on our financial position or
our results of operations. We are not currently engaged in the use of off-balance sheet derivative
financial instruments, to hedge or partially hedge interest rate exposure nor do we maintain any
other off-balance sheet arrangements for the purposes of credit enhancement, hedging transactions,
or other financial or investment purposes. 22




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Item 4. Controls and Procedures Evaluation of Disclosure Controls and Procedures The term disclosure controls and procedures is defined in Rules 13a-15(e) and 15d-15(e) of
the Securities Exchange Act of 1934. These rules refer to the controls and other procedures of a
company that are designed to ensure that information required to be disclosed by a company in the
reports that it files under the Exchange Act is recorded, processed, summarized and reported within
required time periods. Our Principal Executive Officer and our Principal Financial Officer have
evaluated the effectiveness of our disclosure controls and procedures as of the end of the period
covered by this report. Based on the evaluation, they have concluded that, as of the end of such
period, the controls and procedures were effective at ensuring that required information was
accurate and disclosed on a timely basis in our report filed under the Exchange Act. Changes in Internal Controls We maintain a system of internal accounting controls that is designed to provide reasonable
assurance that our books and records accurately reflect our transactions and that our established
policies and procedures are followed. During the first quarter of 2005, we implemented a new sales commissioning system and began
migrating certain customers to a new billing system, which resulted in changes to our internal
controls over financial reporting. Except as noted above, there were no other changes to our internal controls that have
materially affected, or are reasonably likely to materially affect, our internal controls over
financial reporting. 23




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PART II. OTHER INFORMATION Item 1. Legal Proceedings We are is involved in lawsuits, claims, investigations and proceedings consisting of
commercial, regulatory, securities, tort and employment matters, which arise in the ordinary course
of business. In accordance with Statement of Financial Accounting Standards No. 5,  Accounting
for Contingencies, we make a provision for a liability when it is both probable that a liability
has been incurred and the amount of the loss can be reasonably estimated. We believe we have
adequate provisions for any such matters. We review these provisions at least quarterly and adjust
these provisions to reflect the impacts of negotiations, settlements, rulings, advice of legal
counsel, and other information and events pertaining to a particular case. Litigation is inherently
unpredictable. However, we believe that we have valid defenses with respect to legal matters
pending against the Company. Nevertheless, it is possible that cash flows or results of operations
could be materially and adversely affected in any particular period by the unfavorable resolution
of one or more of these contingencies. We filed an administrative claim in August 2004 against the Allegiance Telecom Liquidating
Trust (the ATLT). We have claimed that we are entitled to approximately $50 million in damages
related to a variety of actions allegedly taken by Allegiance and the ATLT. The ATLT filed a
counterclaim against us on November 24, 2004 seeking damages of approximately $100.0 million, which
claim we believe to be frivolous and without merit. The case went to
trial in the United States Bankruptcy Court for the Southern District
of New York on May 2, 2005. In addition, disputes with respect to general unsecured claims and one administrative claim
against us in the amount of approximately $2.1 million remain pending from the our 2002
Chapter 11 proceedings. Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults Upon Securities None. Item 4. Submission of Matters to a Vote of Security Holders No matters were submitted to a vote of security holders during the three months ended March 31, 2005. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits  10.1
    Agreement, dated as of May 9, 2005, by and between XO Communications, Inc., Arnos Corp.,  High River   Limited Partnership, and Cardiff Holding LLC.31.1
    Rule 13a  14(a)/15(d)  14(a) Certification31.2
    Rule 13a  14(a)/15(d)  14(a) Certification32.1
    Certificate pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.32.2
    Certificate pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K None. 24




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrants have duly
caused this report to be signed on their behalf by the undersigned thereunto duly authorized. XO Communications, Inc.Date: May 9, 2005
    By:
    /s/ William GarrahanWilliam GarrahanSenior Vice President and
Acting Chief Financial Officer
(Principal Financial Officer) 25