##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549   FORM 10-Q x
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended March 31, 2004 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 [X] NO [  ] Indicate by check mark whether the Registrant is an accelerated filer (as
defined by Rule 12b-2 of the Exchange Act.). YES [X] NO [  ] 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 [X] NO [  ] As of May 3, 2004, the number of shares of common stock of XO
Communications, Inc. issued and outstanding was 136,553,035 (excluding 45,380,000
shares of common stock deposited into escrow pending the consummation
of our acquisition of the assets of Allegiance Telecom, Inc.).




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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, 2004 and December 31, 2003
    
    
    1Condensed Consolidated Statements of Operations for the Three Months
Ended March 31, 2004 and March 31, 2003
    
    
    2Condensed Consolidated Statements of Cash Flows for the Three Months
Ended March 31, 2004 and March 31, 2003
    
    
    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
    
    
    25Item 4. Controls and Procedures
    
    
    25Part II. Other InformationItem 1. Legal Proceedings
    
    
    26Item 2. Changes in Securities and Use of Proceeds
    
    
    26Item 3. Defaults Upon Securities
    
    
    26Item 4. Submission of Matters to a Vote of Security Holders
    
    
    26Item 5. Other Information
    
    
    26Item 6. Exhibits and Reports on Form 8-K
    
    
    26Signatures
    
    
    28Certifications
    
    
    29




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PART I. FINANCIAL INFORMATION  XO Communications, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(Amounts in thousands, except for share and per share data) March 31,
    
    December 31,2004
    
    2003(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    370,515
    
    
    $
    478,560Marketable securities
    
    
    26,292
    
    
    
    42,052Accounts receivable, net of allowance for doubtful
accounts of $39,582 at March 31, 2004 and $32,986,
at December 31, 2003, respectively
    
    
    97,034
    
    
    
    93,958Other current assets
    
    
    46,902
    
    
    
    12,421Total current assets
    
    
    540,743
    
    
    
    626,991Property and equipment, net
    
    
    491,715
    
    
    
    485,984Broadband wireless licenses and other intangibles, net
    
    
    102,974
    
    
    
    109,515Other assets, net
    
    
    83,354
    
    
    
    42,675Total assets
    
    $
    1,218,786
    
    
    $
    1,265,165LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    65,737
    
    
    $
    63,064Accrued liabilities
    
    
        199,123
    
    
    
    208,353Total current liabilities
    
    
        264,860
    
    
    
    271,417Long-term debt and accrued interest payable
    
    
    345,882
    
    
    
    536,791Other long-term liabilities
    
    
    74,036
    
    
    
    76,532Total liabilities
    
    
        684,778
    
    
    
    884,740Commitments and contingenciesStockholders equity:Preferred stock: par value $0.01 per share,
200,000,000 shares authorized: none issued
    
    
    
    
    
    
    Warrants and common stock, par value $0.01 per
share, 1,000,000,000 shares authorized:136,526,785
and 96,274,140 shares issued and outstanding on
March 31, 2004 and December 31, 2003, respectively
    
    
    683,134
    
    
    
    482,440Subscription rights exercised, 32,503,234 shares
authorized: none issued and outstanding
    
    
    
    
    
    
    162,516Subscription rights receivable, 32,503,234 shares
authorized: none issued and outstanding
    
    
    
    
    
    
    (162,516
    )Deferred compensation
    
    
    (850
    )
    
    
    (839
    )Accumulated other comprehensive income
    
    
    2,772
    
    
    
    1,378Accumulated deficit
    
    
        (151,048
    )
    
    
    (102,554
    )Total stockholders equity
    
    
        534,008
    
    
    
    380,425Total liabilities and stockholders equity
    
    $
    1,218,786
    
    
    $
    1,265,165
 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 31,2004
        
        2003Revenue
        
        $
        260,945
        
        
        $
        286,093Costs and expenses:Cost of service (exclusive
            of depreciation and amortization)
        
        
        109,961
        
        
        
        107,506Selling, operating,
            and general
        
        
        168,553
        
        
        
        166,235Depreciation and
            amortization
        
        
        25,697
        
        
        
        26,367Total costs and expenses
        
        
        304,211
        
        
        
        300,108Loss from operations
        
        
        (43,266
        )
        
        
        (14,015
        )Investment income,
            net
        
        
        1,376
        
        
        
        3,210Interest expense,
            net
        
        
        (6,604
        )
        
        
        (9,683
        )Net loss
        
        $
        (48,494
        )
        
        $
        (20,488
        )Net loss per common
            share, basic and diluted
        
        $
        (0.37
        )
        
        $
        (0.22
        )Weighted average
            shares, basic and diluted
        
        
        129,406,599
        
        
        
        95,000,001
 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 31,2004
    
    2003OPERATING ACTIVITIES:Net loss
    
    $
        (48,494
    )
    
    $
    (20,488
    )Adjustments to reconcile net loss to net cash
provided by (used in) operating activities:Depreciation and amortization
    
    
    25,697
    
    
    
    26,367Accrual of interest
    
    
    6,704
    
    
    
    9,897Stock-based compensation
    
    
    129
    
    
    
    Non-cash loss on sale of investments
    
    
    328
    
    
    
    Changes in assets and liabilities:Accounts receivable
    
    
    (3,076
    )
    
    
    15,176Other assets
    
    
    (8,340
    )
    
    
    982Accounts payable
    
    
    3,253
    
    
    
    (4,586
    )Accrued liabilities
    
    
        (11,068
    )
    
    
    (3,158
    )Net cash provided by (used in) operating activities
    
    
    (34,867
    )
    
    
    24,190INVESTING ACTIVITIES:Capital expenditures, net
    
    
    (25,395
    )
    
    
    (21,377
    )Acquisition payments
    
    
    (66,821
    )
    
    
    Sales of marketable securities and investments
    
    
    16,825
    
    
    
    30,825Purchases of marketable securities and investments
    
    
    
    
    
    
    (58,693
    )Net cash provided by (used in) investing activities
    
    
    (75,391
    )
    
    
    (49,245
    )FINANCING ACTIVITIES:Repayments of capital leases
    
    
    (370
    )
    
    
    (219
    )Repayments of long term debt
    
    
    (197,612
    )
    
    
    Proceeds from issuance of common stock
    
    
    197,612
    
    
    
    Proceeds from exercise of stock options
    
    
    2,583
    
    
    
    Net cash provided by (used in) financing activities
    
    
    2,213
    
    
    
    (219
    )Net increase (decrease) in cash and cash equivalents
    
    
    (108,045
    )
    
    
    (25,274
    )Cash and cash equivalents, beginning of period
    
    
    478,560
    
    
    
    314,038Cash and cash equivalents, end of period
    
    $
    370,515
    
    
    $
    288,764SUPPLEMENTAL DATA:Cash paid for interest
    
    $
    612
    
    
    $
    213
 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. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Presentation The condensed consolidated financial statements of XO Communications, Inc.
(XO Parent) and its subsidiaries (together with its predecessors,
collectively referred to as the Company or XO) 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 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 the three months ended March 31,
2004 are not necessarily indicative of the results that may be expected for any
subsequent quarterly period, or for the year ending December 31, 2004. 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, 2003
(the 2003 Annual Report). (b) 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. (c) 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. (d) 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 and warrants are anti-dilutive,
and are therefore not included in the weighted average shares balance on the
consolidated statement of operations. As of March 31, 2004, the Company has
options outstanding to purchase approximately 9.8 million shares of common
stock of which 3.6 million are exercisable and exercisable warrants to purchase
shares up to an additional 23.75 million shares of common stock that can
further dilute investors, if exercised. (e) Stock-Based Compensation As allowed by SFAS 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 plan in accordance with the intrinsic value method prescribed by
APB No. 25, Accounting for Stock Issued to Employees, (APB No. 25) adopting
the disclosure-only provisions of SFAS 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. 4




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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 31,2004
    
    2003Expected volatility
    
    
    75.0
    %
    
    
    75.0
    %Risk free interest rate
    
    
    2.7
    %
    
    
    2.6
    %Dividend yield
    
    
    0.0
    %
    
    
    0.0
    %Expected life (range in years)
    
    
    4.0
    
    
    
    4.0Fair value per share at grant date
    
    $
    3.62
    
    
    $
    2.85
 The Companys pro forma net loss, 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 endedMarch 31,2004
    
    2003Net loss, as reported
    
    $
        (48,494
    )
    
    $
    (20,488
    )Add: Stock-based employee
compensation expense
included in net loss, as
reported
    
    
    129
    
    
    
    Deduct: Total stock-based
employee compensation
expense determined under
fair value based methods
for all stock awards, net
of related tax effects
    
    
    (1,874
    )
    
    
    (4,038
    )Pro forma net loss
    
    $
        (50,239
    )
    
    $
    (24,526
    )Net loss per common share,
basic and diluted  as
reported
    
    $
        (0.37
    )
    
    $
    (0.22
    )Net loss per common share,
basic and diluted  pro
forma
    
    $
        (0.39
    )
    
    $
    (0.26
    )
 The XO Communications, Inc. 2002
Stock Incentive Plan (the 2002 Stock
Incentive Plan) was adopted in January 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 643,882 options during the quarter ended
March 31, 2004. In June 2003, XO filed a registration statement covering the offer and
sale of stock options and stock appreciation rights (SARs) to be granted in
conjunction with the 2003 Employee Retention and Incentive Plan (the Retention
Plan) for an aggregate award of 1.9 million shares of its common stock. During
the quarter ended March 31, 2004, XO granted 324,720 options and 18,999 SARs
under the Retention Plan. (f) 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, 2004 and 2003 (dollars
in thousands): Three Months Ended March 31,2004
    
    2003Net loss applicable to common shares
    
    $
        (48,494
    )
    
    $
    (20,488
    )Other comprehensive loss:Net unrealized gains (losses) on investment
    
    
    1,394
    
    
    
    (198
    )Comprehensive loss
    
    $
        (47,100
    )
    
    $
    (20,686
    )
 5




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2. PENDING BUSINESS COMBINATION On February 19, 2004, the
United States Bankruptcy Court for the Southern
District of New York approved the Asset Purchase Agreement entered into on
February 18, 2004 between the Company, Allegiance Telecom, Inc. and Allegiance
Telecom Company Worldwide (Allegiance). Allegiance and its direct and
indirect subsidiaries had been in bankruptcy since May 14, 2003. Allegiance is
a facilities-based national local exchange carrier that provides integrated
telecommunications services to business, government and other institutional
users in 36 major metropolitan areas across the United States. Allegiances
service offerings include voice, data, and integrated communications services.
Under the Asset Purchase Agreement, XO will purchase all of Allegiances local
exchange carrier businesses (the Acquired Businesses) for approximately
$311.0 million of cash and 45.4 million shares of XO common stock. The amount of
cash consideration may be adjusted based on changes in the Acquired Businesses working capital,
customer base, or assumed bankruptcy cure amounts, as provided in the Asset Purchase Agreement. XO
will not
acquire Allegiances customer premises installation and maintenance business,
their shared hosting business, or their dedicated dial-up access service
business. Upon the beginning of the bid process in February 2004, the Company placed
into escrow a deposit of $30.0 million under a purchase price escrow agreement
with Allegiance that served as an earnest money deposit on the purchase. Upon
the receipt of certain regulatory approvals, on April 13, 2004 (the Early
Funding Date) the Company placed into escrow the additional cash consideration
of $282.5 million and the common stock consideration for the purchase of the
Acquired Businesses. On the Early Funding Date, XO entered into an operating
agreement that allows it to manage and fund the Acquired Businesses. Closing
under the Asset Purchase Agreement is anticipated to occur following the
receipt of state regulatory approvals and the confirmation of Allegiances Plan
of Reorganization which is currently expected to be in June 2004. Upon closing,
the consideration in escrow will be distributed and XO will take title to the
Acquired Businesses. The Company also purchased $36.4 million of unsecured
Allegiance debt securities with a face value of $92.5 million during the first
quarter of 2004. After Allegiances Plan of Reorganization is confirmed by the
Bankruptcy Court and becomes effective, XO will be entitled to receive its pro
rata share of the distribution made to unsecured creditors. Both the deposit and debt security payments are included in other long-term assets in the accompanying balance sheet. The consolidated results of Allegiance, as disclosed in their 10-K for the
year ending December 31, 2003 and 2002 are shown in the table below. As noted
above, XO will only be acquiring a substantial portion of the consolidated
business. The information given below is presented for information purposes
only and is not necessarily indicative of the results of future operations
(dollars in thousands): December 31,2003
    
    2002Total assets
    
    $
    1,135,521
    
    
    $
    1,441,218Total liabilities
    
    
    1,448,992
    
    
    
    1,397,494
 Year ending December 31,2003
    
    2002Revenues
    
    $
    776,870
    
    
    $
    770,982Operating expenses
    
    
    1,052,278
    
    
    
    1,242,193Net loss
    
    
    (359,989
    )
    
    
    (572,670
    )
 3. MARKETABLE SECURITIES The amortized cost, gross unrealized gains and losses and fair value of
the investment securities available-for-sale as of March 31, 2004 and December
31, 2003, are as follows (dollars in thousands): 6




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GrossGross
    
    UnrealizedUnrealized
    
    HoldingFair Value
    
    Cost Basis
    
    Holding Gains
    
    (Losses)As of March 31, 2004Equity securities
    
    $
    14,281
    
    
    $
    11,509
    
    
    $
    6,562
    
    
    $
    (3,790
    )Debt securities
    
    
    12,011
    
    
    
    12,011
    
    
    
    
    
    
    
    Total marketable securities
    
    $
    26,292
    
    
    $
    23,520
    
    
    $
    6,562
    
    
    $
    (3,790
    )As of December 31, 2003Equity securities
    
    $
    30,041
    
    
    $
    28,663
    
    
    $
    3,001
    
    
    $
    (1,623
    )Debt securities
    
    
    12,011
    
    
    
    12,011
    
    
    
    
    
    
    
    Total marketable securities
    
    $
    42,052
    
    
    $
    40,674
    
    
    $
    3,001
    
    
    $
    (1,623
    )
 Debt securities as of March 31, 2004 mature in 2007. 4. LONG-LIVED ASSETS XOs long-lived assets include property and equipment, fixed wireless
licenses, and identifiable intangible assets to be held and used. Depreciation
is calculated on a straight-line basis over the estimated useful lives of the
assets. The estimated useful lives of telecommunications networks and acquired
bandwidth are 3 to 20 years and 5 to 7 years for furniture fixtures, equipment
and other. These useful lives are determined based on historical usage with
consideration given to technological changes and trends in the industry that
could impact the network architecture and asset utilization. Costs of additions
and improvements are capitalized and repairs and maintenance are charged to
expense as incurred. Direct external and internal costs of constructing property and equipment are
capitalized including interest costs related to construction. Property and Equipment Property and equipment consisted of the following components (dollars in
thousands): March 31,
    
    December 31,2004
    
    2003Telecommunications networks and acquired
bandwidth
    
    $
    414,969
    
    
    $
    407,747Furniture, fixtures, equipment, and other
    
    
    87,641
    
    
    
    77,783502,610
    
    
    
    485,530Less: accumulated depreciation
    
    
    98,245
    
    
    
    79,501404,365
    
    
    
    406,029Network construction-in-progress
    
    
    87,350
    
    
    
    79,955$
    491,715
    
    
    $
    485,984
 Depreciation expense related to property and equipment for the three
months ended March 31, 2004 and 2003 was $19.2 million and $19.9 million
respectively. Assets classified as construction-in-progress are not being
depreciated as they are not currently ready for their intended use. Broadband Wireless Licenses and Other Intangibles Broadband wireless licenses and other intangible assets consisted of the
following components (dollars in thousands): March 31,
    
    December 31,2004
    
    2003Broadband wireless licenses
    
    $
    59,508
    
    
    $
    59,508Customer relationships
    
    
    49,987
    
    
    
    49,987Internally developed technology
    
    
    9,521
    
    
    
    9,521119,016
    
    
    
    119,016Less: accumulated amortization
    
    
    (32,704
    )
    
    
    (26,163
    )86,312
    
    
    
    92,853XO Trade name  indefinite life asset
    
    
    16,662
    
    
    
    16,662$
    102,974
    
    
    $
    109,515
 Amortization expense related to intangible assets for each of the three
months ended March 31, 2004 and 2003 was $6.5 million. As of March 31, 2004,
approximately $23.5 million of fixed wireless 7




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##### 



licenses are not being amortized as commercial services have not been
deployed in the licenses geographic area. 5. RESTRUCTURING CHARGES As of March 31, 2004, the remaining restructuring accrual resulting from
restructuring of the Companys business operations initiated in prior years
including divesting the Companys European operations, reducing the Companys
discretionary spending, capital expenditure and workforce was $55.3 million,
which relates primarily to payments due to landlords on exited leased
facilities. The restructuring accrual has decreased from $60.0 million as of
December 31, 2003, primarily due to $4.1 million in payments associated with
exited leased facilities. 6. 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, 2004, long-term debt of $339.2 million and
$6.7 million of accrued interest that, if not paid, converts to principal, was
outstanding on the Credit Facility. 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 million, at the request of the lender, the Company will pay an
amount equal to 50% of such excess cash flow greater than $25 million toward
the reduction of outstanding indebtedness. In addition, if the ratio of XOs
consolidated earnings before interest, taxes, depreciation and amortization to
interest expense for the four consecutive quarters exceeds 4:1, XO would be
required to pay cash interest, unless waived by the lenders. The security for the Credit Facility consists of all assets of XO Parent,
including the stock of its direct and indirect subsidiaries, and the assets of
virtually all 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 (earnings
before interest, taxes, depreciation and amortization) requirements and maximum
capital expenditures. The Company was required to achieve a minimum
consolidated EBITDA loss of not more than $12.0 million for the quarter ended
March 31, 2004. Prior to the end of the first quarter of 2004, the lender
waived the applicability of the minimum consolidated EBITDA covenant for the
two fiscal quarters ending March 31, 2004 and June 30, 2004. Actual
consolidated EBITDA loss for the quarter ended March 31, 2004 was $17.6
million. 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 March 31,
2004 and each fiscal quarter thereafter during the term. At March 31, 2004, 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). As discussed above, the Company is not
required to pay cash interest accrued on the principal amount under the Credit
Facility until it meets certain financial ratios; however, 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, 2004, the annualized weighted
average interest rate applicable to outstanding borrowings under the Credit
Facility was 7.5%. 7. STOCKHOLDERS EQUITY Pursuant to the Companys Certificate of Incorporation, the Company has
the authority to issue 1,000.0 million shares of Common Stock and 200.0 million
shares of undesignated preferred stock. As of March 31, 2004, approximately
136.5 million shares of its Common Stock had been issued, more than 60% of
which were owned by entities controlled by Mr. Icahn. The Company initiated a rights offering (the Rights Offering) during the
fourth quarter of 2003 offering 40.0 million shares of its common stock at a
price of $5.00 per share. The Rights Offering closed on January 5, 2004. An
aggregate of 39.7 million shares were issued, yielding net proceeds of 8




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##### 



$197.6 million. Subsequent to closing, these net proceeds were used to pay
down the Companys Credit Facility. 8. OPERATING SEGMENTS Reportable Segments The Company operates its business as one telecommunications segment. The
Companys communications segment includes all of its products and services
including data, voice, integrated voice and data, and other services. These
services have similar network operations and technology requirements and are
sold through similar sales channels to a similar targeted customer base.
Therefore, the Company manages these services as a single segment that are sold
in geographic areas, or markets, within the United States, or that are sold to
customers with a presence across geographical markets. Products and Services The Company classifies its products and services revenues offered by its
communications services segment into voice services, data services, integrated
voice and data services, and other services (dollars in thousands): Three months endedMarch 31,2004
    
    2003Voice services
    
    $
    130,921
    
    
    $
    150,723Data services
    
    
    92,949
    
    
    
    101,977Integrated voice and data services
    
    
    37,075
    
    
    
    33,393Total revenue
    
    $
    260,945
    
    
    $
    286,093
 9. RELATED PARTY TRANSACTIONS Various entities controlled by Mr. Icahn hold the following interests in
XO: OutstandingCommon Stock
    
    Warrants
    
    Credit FacilityAt December 31, 2003
    
    Greater than 80%
    
    Greater than 40%
    
    Greater than 90%At March 31, 2004
    
    Greater than 60%
    
    Greater than 40%
    
    Greater than 90%
 In addition, entities controlled by Mr. Icahn have acquired an option to
purchase 6.25 million additional shares of XOs Common Stock from Franklin
Mutual Advisors, LLC at a strike price of $4.25 per share, which expires June
21, 2004. 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. Dixon Properties, LLC (Dixon), which is controlled by Mr. Icahn, owns
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
quarter ended March 31, 2004 and XO is obligated to pay approximately $14.7
million to Dixon through the expiration of the initial term of the lease, which
is November 30, 2007. 9




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XO has entered into a Tax Allocation Agreement, dated January 16, 2003,
between XO and Starfire Holding Corporation (Starfire), the parent entity of
the affiliated group of corporations controlled by Mr. Icahn. XO and Starfire
will file consolidated returns during the period in which Mr. Icahns ownership
of XO was equal to or greater than 80%, as required by the Internal Revenue
Code. Upon the closing of the Rights Offering in January 2004, Mr. Icahns
ownership percentage fell below 80%. Consequently, XO will no longer be
included as part of Starfires consolidated group after January 2004. Upon
deconsolidation, the Tax Allocation Agreement generally provides that Starfire
will reimburse XO each year going forward for the excess of XOs actual income
tax expense over the income tax that would have been owed if the net operating
losses or other tax attributes used in prior periods by the Starfire
consolidated group excluding XO, if any, were still available to XO. The Company provides certain telecommunications services to companies
affiliated with Mr. Icahn. For each of the quarters ended March 31, 2004 and
2003, the total revenue recognized on such services affiliated with Mr. Icahn
was approximately $0.2 million. During the quarters ended March 31, 2004 and
2003, the Company has purchased approximately $0.3 million and $0.2 million,
respectively, in services from Icahn affiliates. During the quarter ended March
31, 2004, the Company purchased $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 and Chief Executive Officer of Dell Computers. 10. 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 two administrative expense claims against XO in
the aggregate amount of approximately $23.0 million remain pending from XOs
2002 Chapter 11 proceedings. In accordance with SFAS No. 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 affected
in any particular period by the unfavorable resolution or disposition of one or
more of these contingencies. 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; and
    
    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. 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 2003 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. Overview We provide a comprehensive array of voice and data communications services
to business customers. Our voice services include local and long distance
services, both bundled and standalone, other voice-related services such as
conferencing, domestic and international toll free services and voicemail, and
transactions processing services for prepaid calling cards. Our data services
include Internet access, private data networking, including dedicated
transmission capacity on our networks, virtual private network services,
Ethernet services, and web hosting services. We also combine many of these
services in flat rate service packages. These services are offered to a variety
of customers, including small, medium and large retail businesses,
multi-location businesses and carrier or wholesale customers. 11




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To serve our customers broad and expanding 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 substantially all of Allegiances network assets
and customer base discussed below, XO will become one of the nations largest
competitive independent providers of national local telecommunications and
broadband services. The company will own one of the largest network of nationwide
connections to the RBOCs networks, more than any other competitive local
exchange carrier, or CLEC, and will double its Points of Presence (PoPs) within
the 36 metropolitan areas where both XO and Allegiance operate. We believe that
this extensive network will allow the combined company to (i) improve delivery
of service to customers (ii) reduce network costs (iii) improve operating
results and (iv) improve our ability to compete with other companies in the
nationwide local telecommunications services market. Recent Events Announcement of Acting Chief Financial Officer appointment On April 14, 2004, we announced that we had appointed William Garrahan as
Acting Chief Financial Officer. Mr. Garrahan replaces Wayne Rehberger, who has
taken the position of Chief Operating Officer of XO. From July 2001 to March
2004, Mr. Garrahan served as our Vice President and Senior Vice President,
Corporate Development and Strategic Planning. From September 1996 to February
2001, he was Senior Vice President with Lehman Brothers in its equity research
department. Pending Business Combination On February 19, 2004, the
United States Bankruptcy Court for the Southern
District of New York approved the Asset Purchase Agreement by and between XO,
Allegiance Telecom, Inc. and Allegiance Telecom Company Worldwide,
collectively referred to as Allegiance. Allegiance and its direct and indirect
subsidiaries had been in bankruptcy since May 14, 2003. Allegiance is a
facilities-based national local exchange carrier that provides integrated
telecommunications services to business, government and other institutional
users in 36 major metropolitan areas across the United States. Allegiances
service offerings include voice, data, and integrated communications services.
Under the Asset Purchase Agreement, XO will purchase all of Allegiances local
exchange carrier businesses, referred to as the Acquired Businesses, for
approximately $311.0 million in cash and 45.4 million shares of XO common
stock. The amount of cash consideration may be increased or decreased, based on changes in
the Acquired Businesses working capital, customer base, or assumed bankruptcy cure amounts,
provided in the Asset Purchase Agreement. We currently estimate that the purchase price could
increase by as much as $25.0 million based on the resolution of certain outstanding items.
XO will not acquire Allegiances customer premises installation and
maintenance business, their shared hosting business, or their dedicated dial-up
access service business. The assets of the Acquired Businesses consist primarily of:  
    
    switching and routing equipment, located both in current
Allegiance facilities and in facilities operating by one or more
incumbent local exchange carriers;
    
    physical points of presence in the form of network
operations centers, data centers, central offices, and sales offices
located in 36 major metropolitan areas;
    
    customer and sales agreements and receivables that
constitute a majority of Allegiances voice and data revenues;
    
    leased intercity and metro fiber network capacity that is
both redundant to and expansive of XOs current network; and
    
    billing, provisioning, and other back-office information
technology platforms. 12




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Upon the beginning of the bid process, in February 2004 we placed into
escrow a deposit of $30.0 million under a purchase price escrow agreement with
Allegiance that served as an earnest money deposit on the purchase. Upon the
receipt of specified regulatory approvals, on April 13, 2004, the Early Funding
Date, we placed into escrow the additional cash of $282.5 million and the
common stock consideration for the purchase of the Acquired Businesses. On the
Early Funding Date, we entered into an operating agreement that allows us to
manage and fund the Acquired Businesses. Closing under the Asset Purchase
Agreement is anticipated to occur following state regulatory approvals and the
confirmation of Allegiances Plan of Reorganization, which we currently expect
to occur in June 2004. Upon closing, the consideration in escrow will be
distributed and we will take title to the Acquired Businesses. Comparison of Financial Results The operational results of XO for the three months ended March 31, 2004
are discussed below. Because the acquisition of Allegiance is expected to
close in the second quarter of 2004, forward looking information for XOs stand
alone business is not deemed indicative of future trends and is not provided
below. However, forward looking information with respect to the combined
company of XO and Allegiance is discussed at the end of the 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, and we have only been managing the Acquired Businesses
since April 13, 2004 under the terms of an operating agreement approved by the Bankruptcy Court, which further limits our ability to make accurate
projections;
    
    we may not successfully integrate the Acquired Businesses as
efficiently as expected; and
    
    while Allegiances consolidated financial position and results of
operations have been audited, stand alone financial information with
respect to the Acquired Businesses is not audited. Three Months Ended March 31, 2004 versus Three Months Ended March 31, 2003 Revenue. Total revenue for the three months ending March 31, 2004
decreased 8.8% to $260.9 million from $286.1 million in the same period of 2003.
Customer churn of 2.4% during 2003 exceeded acquisition revenue, particularly
in the carrier customer base due to downsizing network requirements and
competitive pricing pressures. Revenue for the three months ended March 31,
2004, was relatively consistent with revenue for the three months ended
December 31, 2003 of $261.0 million, as commercial offerings to middle market
businesses have begun to show slight growth. Based on our preliminary review
and analyses and our initial role in managing Allegiance, we
believe that on a pro forma basis, the annualized revenue of the combined
company will be approximately $1.5 billion. If current business and industry trends
continue, we would expect that the revenue for the combined company will be
relatively stable during the year following the acquisition, although it may
fluctuate quarter to quarter. This projection could be negatively impacted if
we do not successfully integrate the Acquired Businesses customers, billing
systems and sales forces. Revenue for XO services was earned from providing the following services
(dollars in thousands): Three months ended March 31,% of
    
    
    
    
    
    % of2004
    
    Revenue
    
    2003
    
    Revenue
    
    % ChangeVoice services
    
    $
    130,921
    
    
    
    50.2
    %
    
    $
    150,723
    
    
    
    52.7
    %
    
    
    (13.2
    %)Data services
    
    
    92,949
    
    
    
    35.6
    %
    
    
    101,977
    
    
    
    35.6
    %
    
    
    (8.9
    %)Integrated voice and data services
    
    
    37,075
    
    
    
    14.2
    %
    
    
    33,393
    
    
    
    11.7
    %
    
    
    11.0
    %Total revenue
    
    $
    260,945
    
    
    
    100.0
    %
    
    $
    286,093
    
    
    
    100.0
    %
    
    
    (8.8
    %)
 Voice services revenue includes revenue from local and long distance voice
services, prepaid calling card processing, and other voice telecommunications
based services, interactive voice response services and stand-alone long
distance services. Voice services revenue in the first quarter of 2004 13




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decreased to $130.9 million from $150.7 million for the same period of
2003 but was relatively stable with fourth quarter 2003 results of $131.6
million. The year over year decrease is primarily attributable to carrier
customer declines driven by churn from competitive pricing pressures. In
addition, as costs for services declined we reduced our prices for certain
services. Finally, the FCC mandated certain rate reductions in carrier access
billings. Data services revenue includes revenue from Internet access, network
access and web applications hosting services. Data services revenue in the
first quarter of 2004 decreased to $92.9 million from $102.0 million for the
same period of 2003 but was relatively stable with fourth quarter 2003 results
of $92.4 million. The majority of the year over year decline was attributable
to carrier customer churn due to network downsizing. Integrated voice and data services revenue is generated largely from our
XOptions service offerings, a flat-rate bundled package offering a combination
of voice and data services. Integrated voice and data services in the first
quarter of 2004 increased to $37.1 million from $33.4 million for the same
period in 2003, but was relatively stable with fourth quarter 2003 results of
$37.0 million. Costs and expenses. The table below provides costs and expenses by
classification and as a percentage of revenue (dollars in thousands): Three months ended March 31,% of
    
    
    
    
    
    % of2004
    
    Revenue
    
    2003
    
    Revenue
    
    % ChangeCosts and expenses:Cost of service
    
    $
    109,961
    
    
    
    42.1
    %
    
    $
    107,506
    
    
    
    37.6
    %
    
    
    2.3
    %Selling, operating and general
    
    
    168,553
    
    
    
    64.6
    %
    
    
    166,235
    
    
    
    58.1
    %
    
    
    1.4
    %Depreciation and amortization.
    
    
    25,697
    
    
    
    9.8
    %
    
    
    26,367
    
    
    
    9.2
    %
    
    
    (2.5
    %)Total
    
    $
    304,211
    
    
    
    
    
    
    $
    300,108
    
    
    
    
    
    
    
    1.4
    %
 Cost
    of service. 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 networks
    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 for the three months ended March 31, 2004
    increased in absolute dollars and increased as a percentage of revenue compared
    to the same period in 2003. The absolute dollar increase is due to increased
    customer volume. The increase as a percentage of revenue was due primarily
    to reduced revenue resulting from pricing reductions discussed above with
    no offsetting direct expense reductions. Based
    on our preliminary review and analyses and our initial role in managing the
    Acquired Businesses we believe that, on a pro forma basis, cost of service
    as a percentage of revenue for the combined company will increase initially,
    since the Acquired Businesses has a higher cost of service as a percentage
    of revenue than XO. We believe that if our integration of the combined companys
    networks succeeds as expected, that this percentage will decrease thereafter
    and should approximate XO historical levels by the end of 2004. We estimate
    a potential benefit of approximately $60.0 million in annual cost of service
    expense synergies if our integration efforts are successful. Cost of service
    as a percentage of revenue will be adversely impacted if we do not successfully
    integrate the Allegiance networks and systems in a timely manner. Selling, operating and general.Selling, operating and general expense
includes expenses related to sales and marketing, internal network operations
and engineering, information systems, general corporate office functions and
collection risks. Selling, operating and general expense for the quarter ended
March 31, 2004 was $168.6 million or 64.6% of revenue compared to $166.2
million or 58.1% of revenue for the quarter ended March 31, 2003. Selling,
operating and general expense increased in absolute dollars due to increased
levels of temporary contract labor required to fully implement new back office
systems and procedures, offset by savings from headcount reductions in the
network operations, sales and information technology groups, and the
renegotiation of certain contracts. The increase in selling, operating and
general expense as a percentage of revenue for the quarter ended March 31, 2004
when compared to the percentage for fiscal 2003 results is due to the large
reduction of revenues due to price reductions discussed above, with no
associated offsetting direct expense reductions. 14




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##### 



Based on our preliminary review
and analyses and our inital role in managing the Acquired Businesses,
on a pro forma basis we
expect that selling, operating and general expense
for the combined company will increase in absolute dollars, but decrease as a
percentage of revenue by the end of 2004 as we integrate the organizations. We
estimate a potential benefit of approximately $100.0 million in annual selling,
operating and general expense synergies if our integration efforts are
successful. This projection would be adversely affected if we do not
successfully integrate the Acquired Businesses. Depreciation and amortization. Depreciation expense decreased to $19.2
million for the three months ended March 31, 2004, compared to $19.9 million
for the same period in 2003. The decrease is due to certain IT systems
becoming fully depreciated in late 2003. Amortization expense includes the
amortization of fixed wireless licenses and other intangible assets with
definite useful lives. Total amortization expense remained constant at $6.5
million for the three months ended March 31, 2004 and 2003, respectively. As
of March 31, 2004, we had approximately $87.4 million of
construction-in-progress plus $23.5 million of fixed wireless licenses that are
not currently ready for their intended use or placed into service and,
accordingly, are not currently being depreciated or amortized. Depreciation and amortization expense will increase, as the Acquired
Businesses include a significant amount of fixed assets. In addition, as we will
apply SFAS 141, Business Combinations, we may identify intangibles within the
Acquired Businesses not previously recorded by Allegiance. Investment income, net. Investment income for the three months ended March
31, 2004 decreased to $1.4 million from $3.2 million for the same period in
2003. The decrease in investment income is due primarily to reduced interest
rates on lower invested balances. Interest expense, net.Interest expense, net includes interest expense on
debt and capital leases, less any amounts capitalized for construction efforts.
The majority of interest expense in 2004 is non-cash as the Credit Facility
allows for accrued interest to be converted into principal if unpaid. Interest
expense, net for the quarter ended March 31, 2004 and 2003 was $6.6 million and
$9.7 million, respectively. The significant reduction for 2004 was due to the
repayment of outstanding principal under the Credit Facility with the proceeds
of the Rights Offering in January 2004. During the three months ended March 31,
2004 and 2003, XO capitalized interest on construction costs of $0.9 million
and $0.7 million, respectively. Critical Accounting Policies Our significant accounting policies are more fully described in the notes
to the consolidated financial statements in our 2003 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 believes the following critical accounting
policies represent the more significant judgments and estimates used in the
preparation of our condensed consolidated financial statements included in this
Quarterly Report on Form 10-Q. Long-Lived Assets Our long-lived assets include property and equipment, fixed wireless
licenses, and identifiable intangible assets to be held and used. Depreciation
is calculated on a straight-line basis over the estimated useful lives of the
assets. The estimated useful lives of telecommunications networks and acquired
bandwidth are 3 to 20 years and 5 to 7 years for furniture fixtures, equipment
and other. These useful lives are determined based on historical usage with
consideration given to technological changes and trends in the industry that
could impact the network architecture and asset utilization. This latter
assessment is significant because we operate within an industry in which new
technological changes could render some or all of our network related equipment
obsolete requiring application of a 15




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##### 



shorter useful life or, in certain circumstances, a write-off of the
entire value of the asset. Accordingly, in making this assessment, we consider
our planned use of the assets, the views of experts both from internal and
outside sources regarding the impact of technological advances and trends in
the industry on the value and useful lives of our network assets. Costs of
additions and improvements are capitalized and repairs and maintenance are
charged to expense as incurred. Direct external and internal costs of constructing property and
equipment are capitalized including interest costs related to construction. Investments in broadband wireless licenses are amortized over the license
period of 10 years as determined by the Federal Communications Commission. In
order to receive an extension on the original license term from the FCC, we are
required to show substantial service in the license area within ten years of
being licensed. Failure to meet this requirement could result in forfeiture of
the license. Approximately $23.5 million in book value of these licenses have
not yet been placed into service. Had these licenses been in service during the
first quarter of 2004, amortization expense would have increased by
approximately $1.1 million. If we fail to show substantial service in the
licensed geographic area at the end of the original ten year period and are not
granted an extension or renewal from the FCC, we would forfeit the right to
offer such services in that market, and write-off the impaired asset. XO is
evaluating recent improvements in the price and performance of broadband
wireless equipment, and is developing a plan to meet the FCCs substantial
service test in all its licensed areas before the licenses are due for renewal
proceedings. Other intangibles consist of customer relationships, internally developed
technology and XOs trade name. The customer relationships and internally
developed technology are being amortized using the straight-line method over
the estimated useful lives of three years. The XO trade name was determined to
have an indefinite life and is not being amortized, but is reviewed at least
annually for impairment, as required under Statement of Financial Accounting
Standards, or SFAS, No. 142 Goodwill and Other Intangible Assets, or SFAS No.
142. Depreciation or amortization of the long-lived asset begins when the asset
is substantially complete or placed into service. Long-lived assets are reviewed for impairment whenever events or changes
in circumstances indicate that the carrying amount should be addressed pursuant
to SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets, or SFAS No. 144. The criteria for determining impairment for
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 and their
eventual disposition. We believe that no impairment existed under SFAS No. 144
as of December 31, 2003. In the event that there are changes in the planned use
of our long-lived assets or our expected future undiscounted cash flows are
reduced significantly, our assessment of our ability to recover the carrying
value of these assets under SFAS No. 144 could change. Revenue Recognition Revenues from telecommunications services are recognized when the services
are performed, evidence of an arrangement exists, the fee is fixed and
determinable and collectibility is probable. In circumstances when these
criteria are not met, revenue recognition is deferred until resolution occurs.
For example, if a customer files for protection under bankruptcy, we believe
the probability of collection is weakened. Consequently, under such
circumstances, although we continue to bill the customer for all services
provided, we do not recognize revenue until cash is received. In addition,
telecommunications customers often dispute the amounts that we invoice them due
to regulatory issues, late payment fees, and early termination charges based on
differences of opinion regarding contract terms or service levels. Accordingly,
as these billings are not considered fixed and determinable and collection of
such amounts is not considered probable while these amounts are disputed,
revenue recognition is deferred until the dispute is resolved and the cash is
collected. Service discounts and incentives related to telecommunications services
are recorded as a reduction of revenue when granted or ratably over a contract
period. Fees billed in connection with customer installations and other
non-recurring fees are deferred and recognized ratably over the 16




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estimated customer life. The estimated customer life is
calculated by
analyzing customer disconnects as a percentage of revenue. This calculation is
reviewed every quarter. We establish an
allowance for collection of doubtful accounts and other
sales credit adjustments. Allowances for sales credits are established through
a charge to revenue, while allowances for doubtful accounts are established
through a charge to selling, operating and general expenses. We assess the
adequacy of these reserves monthly by considering general factors, such as the
length of time individual receivables are past due, historical collection
experience, the economic and competitive environment, and changes in the credit
worthiness of our customers. As considered necessary, we also assess the
ability of specific customers to meet their financial obligations to us and
establish specific valuation allowances based on the amount we expect to
collect from these customers. We can and have experienced material changes to
our reserve requirements on a month to month basis as significant customers
have in the past unexpectedly filed for bankruptcy or otherwise became
insolvent. We believe that our established valuation allowances were adequate
as of March 31, 2004. If circumstances relating to specific customers change or
economic conditions worsen such that our past collection experience and
assessment of the economic environment are no longer valid, our estimate of the
recoverability of our trade receivables could be changed. If this occurs, we
would adjust our valuation allowance in the period the new information is
known. Cost of Service Cost of service includes
expenses directly associated with providing
telecommunications services to customers, including, among other items, the
cost of connecting customers to our networks via leased facilities, the costs
of leasing components of our network facilities and costs paid to third party
providers for local access and transport services. All such costs are expensed
as incurred. We accrue for the expected costs of services received from third
party telecommunications providers during the period the services are rendered.
Invoices received from the third party telecommunications providers are often
disputed due to billing discrepancies. We accrue for all invoiced amounts, even
amounts in dispute, as these amounts represent contingent liabilities that are
considered probable and measurable. Disputes resolved in our favor may reduce
cost of service in the period the dispute is settled and typically reflect
costs paid in prior periods. As the period of time required to resolve these
types of disputes often lapses over several quarters, the benefits associated
with the favorable resolution of such disputes normally are realized in periods
subsequent to the accrual of the disputed invoice. Liquidity and Capital Resources Capital Resources and Liquidity Assessment During the quarter ended March 31, 2004, our operating activities used net
cash of $34.9 million, our investing activities used net cash $75.4 million,
and our financing activities provided net cash of $2.2 million. Our balance of
cash and cash equivalents decreased to $370.5 million at March 31, 2004 from
$478.6 million at December 31, 2003. On April 14, 2004, we transferred the final cash installment of $282.5
million into an escrow account as part of the total consideration for the
Acquired Businesses. After the acquisition, we expect that the combined company
will continue to use cash for operating and investing activities, but at a
reduced rate as compared to our first quarter results. Based on current trends,
our preliminary review and analyses, and our initial management of the
Acquired Businesses, after funding the Allegiance acquisition, we believe we have
sufficient cash to fund our needs through to the point we expect to become free
cash flow positive, in 2005. However, our cash could be negatively impacted if
there is a material purchase price adjustment, if we are
not successful in properly integrating XO and the Acquired Businesses in a
timely manner, if we see unexpected customer losses during the integration
period, if integration costs are higher than expected or if there are further
downturns in the industry or the economy. In addition, we continue to
investigate potential acquisitions to add additional scale and synergies to our
business. Effecting any such acquisitions would likely require additional cash.
For all 17




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of these reasons we are currently considering raising additional capital
through the issuance of debt and/or equity securities. We raised net proceeds of $197.6 million in January 2004 upon the
consummation of our Rights Offering, and applied these proceeds to the
outstanding balance on the credit facility, reducing the amount outstanding
from $536.8 million as of December 31, 2003 to $339.2 million. We have no
current debt service requirements since cash interest payments as well as
automatic and permanent quarterly reductions of the principal amount
outstanding under the Credit Facility do not commence until 2009. There are no
additional borrowings available under our Credit Facility. 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, XO 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 our consolidated
earnings before interest, taxes depreciation and amortization for the four
consecutive quarters exceeds 4:1, we would be required to pay cash interest,
unless waived by the lenders. Our Credit Facility limits additional indebtedness, liens, dividend
payments and certain investments and transactions, and contains certain
covenants with respect to EBITDA requirements and maximum capital expenditures.
The Company was required to achieve a minimum consolidated EBITDA loss of not
more than $12.0 million for the quarter ended March 31, 2004. Prior to the end
of the first quarter of 2004, the lender waived the applicability of the
minimum consolidated EBITDA covenant for the two fiscal quarters ending March
31, 2004 and June 30, 2004. Actual consolidated EBITDA loss for the quarter
ended March 31, 2004 was $17.6 million. 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 March 31, 2004 and each fiscal quarter thereafter during
the term. 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. Several of these
companies have filed for protection under Chapter 11 of the Bankruptcy Code. We
believe that our established valuation and credit allowances are adequate as of
March 31, 2004 to cover these risks. Regulatory Overview Overview The Telecommunications Act of 1996, or the Telecom Act, which
substantially revised the Communications Act of 1934, established the
regulatory framework for the introduction of competition for local
telecommunications services throughout the United States by new competitive
independent entrants such as us. Prior to the passage of the Telecom Act,
states typically granted an exclusive franchise in each local service area to a
single dominant carrier - often a former subsidiary of AT&T known as an RBOC -
which owned the entire local exchange network and operated a virtual monopoly
in the provision of most local exchange services in most locations in the
United States. The Regional Bell Operating Companies (RBOCs), following some
recent consolidation, now consist of the following companies: BellSouth,
Verizon, Qwest Communications and SBC Communications. Among other things, the Telecom Act preempts state and local governments
from prohibiting any entity from providing telecommunications service, which
has the effect of eliminating prohibitions on entry that existed in almost half
of the states at the time the Telecom Act was enacted. At the same time, the
Telecom Act preserved state and local jurisdiction over many aspects of local
telephone service and, as a result, we are subject to varying degrees of
federal, state and local regulation. Consequently, federal, state, and local
regulation, and other legislative and judicial actions relating to the
telecommunications industry could significantly affect our business. We believe that the Telecom Act provided the opportunity to accelerate the
development of competition at the local level by, among other things, requiring
the incumbent carriers to cooperate with competitors entry into the local
exchange market. We have developed our business and designed 18




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and constructed our networks to take advantage of the features of the
Telecom Act that require cooperation from the incumbent carriers, and believe
that the continued viability of the pro-competitive statutory provisions is
critical to the success of the competitive framework contemplated by the
Telecom Act. Although 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 incumbent carriers market share of local services, there have
been numerous attempts to limit or eliminate the basic framework for
competition in the local exchange services market through a combination of
federal legislation, adoption of new rules by the FCC, and RBOC challenges to
existing and proposed regulations. We expect these efforts to limit the
benefits of the Telecom Act to continue. Successful implementation of our
business plan is predicated on the assumption that the basic competitive
framework will remain in place. 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. Unlike incumbent carriers, we are not currently subject to price
cap or rate of return regulation, which leaves us free to set our own pricing
policies for end user services subject only to the general federal guidelines
that our charges for interstate and international services be just, reasonable,
and non-discriminatory. The FCC allows us to file interstate tariffs for
interstate access services (rates charged by carriers for access to their
networks). The FCC, however, required that, with only minor exception, we
withdraw our tariffs for interstate domestic long distance services and
international long distance services. We, however, are still required to make
the terms, conditions and rates of the detariffed services available to the
public on our Company web page, and such terms, conditions, and rates are
located at http://www.xo.com/legal/. 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 the 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;
    
    local loop and transport unbundling, which allows us to selectively
gain access at cost-based rates to incumbent carriers facilities and
wires that connect the incumbent carriers central offices and/or
customer premises, thereby enabling us to serve customers not directly
connected to our networks;
    
    reciprocal compensation, which mandates arrangements for local
traffic exchange between us and both incumbent and competitive carriers
and compensation for terminating local traffic originating on other
carriers networks, thereby improving our margins for local service;
    
    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 phone numbers, which mandates assignment of new telephone
numbers to our customers, thereby enabling us to provide telephone
numbers to new customers on the same basis as incumbent carriers; and
    
    collocation of telecommunications equipment in incumbent carrier
central offices, which enables us to have direct access to unbundled
loops and other network elements and facilitates for efficient
integration with our switching and other network facilities. In January 1999, the U.S. Supreme Court, in a decision that was generally
favorable to competitive telephone companies such as us, upheld key provisions
of the FCC rules implementing the Telecom Act. In finding that the FCC has
general jurisdiction to implement the Telecom Acts local 19




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competition provisions, the Court confirmed the FCCs role in establishing
national telecommunications policy, and thereby created greater certainty
regarding the rules governing local service competition on a going forward
basis. 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 us 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
as well as the nature and scope of industry competition. Unbundling of Incumbent Network Elements On August 21, 2003, the FCC released its Triennial Review Order (TRO).
Under the TRO, our ability to obtain access to certain unbundled network
elements (UNEs) and incumbent network upgrades may be curtailed or more
costly in the future. Also, the TRO delegated to the states the overall
responsibility for deciding whether certain unbundled elements should remain
available to competitors like us in local markets of each of the respective
states. Delegation of these determinations created the risk that some states
may decide to limit or eliminate certain unbundled network elements to which we
have access today and that we would be faced with different sets of rules and
costs if states issue inconsistent decisions. The following Triennial Review Order matters directly impact us and many
of our competitors:  
    
    Curtailed Access to Broadband: The TRO adopted new rules that, for
certain very small customers restrict competitive carriers from leasing
as unbundled elements certain upgrades that the incumbent carriers make
to their networks, such as the deployment of new optical fiber or
upgrades from copper to optical fiber. For example, a new fiber loop to
a very small customer that replaces an existing copper loop could be
exempt from unbundling, except that incumbents must continue to
unbundle the pre-existing copper loop or provide a voice channel for us
on the new fiber loops that is equivalent to the old copper loop.
Although the imposition of any restrictions on our access to the
incumbents broadband networks is not a favorable development for us,
we believe that the adverse impact is partially mitigated by the fact
that incumbents are required to continue to provide us with basic
access to those facilities that we currently lease from them to serve
many of our customers.
    
    Unbundled Local Loops: The Order made a general, national finding
that, with the exception of optical carrier (OC) level loops,
competitive carriers should have access to unbundled loops of the
incumbent carriers at cost-based rates. The states, however, may remove
competitive carriers access to certain non-OC level high capacity and
unlit capacity loops based on the results of specified competitive
analyses. Incumbent carriers will no longer be required to provide
competitive carriers with access to OC level loops as UNEs. We believe
that the net result of these changes will not have a significant impact
on us because the access to the vast majority of unbundled loops that
we use today will be preserved.
    
    Unbundled Dedicated Transport: The TRO has changed the definition
of dedicated transport in such a way that competitive carriers have
to purchase certain transport facilities at higher rates. The TRO
maintained unbundled access to many types of transport between
incumbent facilities, such as transport between incumbent central
offices, but it redefines dedicated transport to eliminate the
unbundling of other transport. The TRO also sets forth a test that the
states must follow in considering whether certain non-OC level high
capacity transport should be available as UNEs in local markets within
the states. The FCC also ruled that OC level transport would no longer
be available as an unbundled element and that shared transport would be
unavailable as an unbundled element in most business markets. We
believe that it is likely that this determination will raise our costs
for transport services in the future.
    
    Enhanced Extended Links and Co-Mingling: The TRO enhances the
ability of competitive carriers like us to obtain a combination of
unbundled loop and transport elements known as 20




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enhanced extended links, provided that the underlying loop and
transport elements are individually available on an unbundled basis. The
FCC created new rules that permit competitive carriers to mix services
that they lease from the incumbent carriers. We will now be able to mix
incumbent carrier unbundled network elements with services purchased from
the wholesale tariff (e.g., switched and special access services) instead
of being required to artificially segregate unbundled network elements
from such wholesale services. Because we currently lease both wholesale
services and unbundled network elements from the incumbent carriers, we
believe that these developments will result in cost savings for us.
    
    Calculation of Unbundled Element Rates: The TRO will allow
incumbent carriers to utilize a higher cost of capital and shorter
depreciation lives to establish rates for unbundled elements. We
believe that these modifications could raise our costs for leasing
unbundled network elements in the future. Although the rules adopted by the FCC in the Triennial Review Order became
effective on October 2, 2003, many of the requirements imposed by the FCC in
the TRO were not self-executing. Accordingly, the FCC made clear that carriers
must follow the change of law procedures in their applicable interconnection
agreements to implement any TRO requirements that are not self-executing and
that carriers must follow the procedures et 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 incumbent
carriers to amend our interconnection agreements to implement relevant TRO
requirements and to date have executed amendments in several states. 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 in Washington,
D.C. issued its opinion in United States Telecom Association v. FCC, No.
00-1012 (USTA Decision). In the USTA Decision, the court reversed and vacated
many of the conclusions of the TRO. Specifically, the court found that the FCC
improperly delegated to the states the overall responsibility for deciding
whether certain unbundled elements should remain available to competitive
carriers in each of the respective states. The FCCs determination in the TRO
that competitive carriers should have access to switching platform services as
a UNE (UNE-P) was vacated by the court. The court also vacated the portions
of the TRO which held that competitive carriers should have access to high
capacity non-OC level unbundled dedicated transport at cost-based UNE rates. In
addition, a number of RBOCs have taken the position that they believe the USTA
Decision vacates portions of the TRO holding that competitors should have
access to certain non-OC level high capacity loops at cost-based UNE rates
although we disagree with this interpretation of the USTA Decision. If the
RBOCs prevail on their position, our costs for purchasing high capacity local
loops can be expected to increase depending on final determinations by
regulatory agencies and/or the courts. XO does not rely on ILEC facilities to switch the majority of its
customers traffic and, therefore, will not be affected by the courts decision
pertaining to UNE-P service. Additionally, with the pending acquisition of
Allegiance and its hundreds of collocation sites, we believe XO will lease less
unbundled dedicated transport facilities from the ILECs. We expect these
factors to help mitigate the effects of any potential increases in the costs of
leasing transport capacity that may result if the USTA decision is not further
stayed or reversed. Finally, it is our position that incumbent carriers are
required to make unbundled network elements impacted by the USTA Decision
available at cost-based UNE rates under state and federal laws, independent of
the TRO. The USTA Decision has been stayed by the U.S. Court of Appeals for the
D.C. Circuit until June 15, 2004. Parties will seek review of the USTA Decision
at the Supreme Court and will also seek a further stay of the decision. If the
USTA Decision does go into effect and reverses and vacates large portions of
the TRO, our ability to obtain access to certain unbundled network elements and
incumbent network upgrades may be curtailed or become more costly in the
future. The FCC has urged competitive carriers and incumbent carriers to engage
in good faith commercial negotiations to agree upon rates, terms and conditions
for the continued availability of UNEs impacted by the USTA Decision. We are
engaged in such commercial negotiations with several incumbent carriers but, at
this time, cannot predict the outcome of these negotiations or whether they
will result in preserving existing UNE rates. 21




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Many incumbent carriers will continue to seek to institute follow-on
administrative proceedings with the FCC and state regulatory agencies, and
lobby the United States Congress, all in an effort to affect laws and
regulations in a manner even more favorable to them and against the interests
of competitive carriers. At the same time, we anticipate that competitive
carriers will endeavor to improve their positions and access to the incumbents
networks through similar means. The final outcome of the appellate review and
implementation process remains unknown at this time, but it is possible that
further changes to the rules could adversely affect our cost of doing business
by increasing the cost of purchasing or leasing network facilities from the
incumbent carriers. Regulation of the RBOCs Ability to Provide Long Distance Service The FCC has primary jurisdiction over the implementation of Section 271 of
the Telecom Act, which provides that the RBOCs cannot offer in-region long
distance services until they have demonstrated that:  
    
    they have entered into an approved interconnection agreement with a
facilities-based competitive telephone company or that no such
competitive telephone company has requested interconnection as of a
statutorily determined deadline;
    
    they have satisfied a 14-element checklist designed to ensure that
the RBOC is offering access and interconnection to all local exchange
carriers on competitive terms; and
    
    the FCC has determined that allowing the RBOC to offer in-region,
long distance services is consistent with the public interest,
convenience and necessity. As of December 15, 2003, the FCC granted all of the RBOCs the authority to
provide long distance service in every state in which they operate. All of the
RBOCs now have the authority to bundle in-region long distance services with
in-region local services. RBOC authorization to provide in-region long distance
services could have an adverse affect on our ability to compete if effective
post-approval safeguards are not enforced to ensure that the RBOCs continue to
comply with the market-opening requirements. Provision of Broadband Telecommunications Services and Information Services Current federal and state regulation places certain restrictions and
conditions on the provision of advanced telecommunications services, or
broadband services, such as data and DSL services, by the RBOCs. Furthermore,
the network elements that RBOCs must make available under the FCCs unbundling
rules to competitors may be used for the provision of broadband services.
However, at the urging of the RBOCs and other incumbent carriers, the FCC, in
the TRO, appears to have greatly curtailed the extent to which the incumbents
must unbundled the broadband portion of their networks for their competitors.
The RBOCs continue to push for further deregulation through federal and state
legislative efforts. In addition, it is anticipated that deregulatory
legislation will be pursued by the RBOCs in Congress. In addition to possible
legislation, the FCC has initiated another pending proceeding that could relax
incumbent carriers obligation to make unbundled network elements that are used
for certain broadband or information services available to us. The FCC has
issued a Notice of Proposed Rulemaking entitled Appropriate Framework for
Broadband Access to the Internet Over Wireline Facilities that requests
comments on the proper classification of broadband access services as either
regulated telecommunications services or unregulated information services. The
TRO decision, in conjunction with a decision in this proceeding, a legislative
change or a court ruling further broadening the definition of what constitutes
unregulated information services could have the effect of allowing RBOCs to
provide terms, conditions and pricing to their own affiliates that provide data
or information services that are better than those made available to
competitive carriers such as us. Such developments could also be expected to
adversely affect our cost of doing business by increasing the cost of
purchasing or leasing such facilities from the RBOCs. Universal Service In 1997, the FCC established a significantly expanded federal
telecommunications subsidy regime known as universal service. Specifically,
the FCC established new subsidies for services provided to 22




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qualifying schools and libraries and rural health care providers, and
expanded existing subsidies to low income consumers. Most telecommunications
companies, including us, must pay for these programs based on their share of
interstate and international telecommunications end user revenues. On March 5,
2004, the Wireline Competition Bureau released a public notice announcing that
the proposed universal service contribution factor for the second quarter of
2004 will remain at 8.7 percent. The FCC has taken further steps to modify the
system for assessment and recovery of universal service funds. In a December
2002 Notice of Proposed Rulemaking, the FCC asked many broad-ranging questions
regarding universal service, including whether to change its method of
assessing contributions due from carriers by basing it on the number and
capacity of connections they provide, rather than on interstate and
international end user revenues they earn. At this time, we are unable to
predict whether the FCCs rulemaking or legislative initiatives will increase
the size of our subsidy payments, the scope of the subsidy program, or our
costs of calculating, collecting and remitting the universal service related
payments. 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 Intermarried compensation have been under review by the FCC since
2001. The FCC continues to consider a broad order reforming the Intercarrier
compensation system and the following specific proceedings also impact
Intercarrier compensation issues for us. Access Charges.Long distance carriers pay local facilities-based
carriers, including us, interstate access charges for both originating and
terminating the interstate calls of long distance customers on the local
carriers networks. Historically, the incumbent carriers set access charges
higher than cost and justified this pricing to regulators as a subsidy to the
cost of providing local telephone service to higher cost customers. With the
establishment of an explicit and competitively neutral universal service
subsidy mechanism, however, the FCC is under increasing pressure to revise the
current access charge regime to bring the charges closer to the actual cost of
providing access. In response, the FCC issued a decision in 2001 setting
interstate rates that competitive local carriers charge to long distance
carriers at a level that will gradually decrease over three years from a
maximum of $0.025 per minute to the rates charged by incumbent carriers. As
long as we are in compliance with the FCCs rate schedule, the FCCs order
forbids long distance carriers from challenging our interstate access rates.
Although this FCC decision lowering access charges will reduce our access
charge revenues over time, we do not expect that such a reduction will have a
material impact on our total revenues or financial position. In 2001, the FCC
also issued a declaratory ruling that commercial mobile radio service (CMRS)
providers are not permitted to collect switched access charges from long
distance carriers absent a contract between the parties that imposes a payment
obligation on the long distance carrier. In November 2003, the United States
Court of Appeals for the District of Columbia denied petitions for review of
the FCCs declaratory ruling on CMRS access charges. Sprint PCS and AT&T are
currently litigating in federal district court in Missouri the issue of
whether, in the absence of a written contract, Sprint PCS can charge AT&T for
switched access services. We are unable to determine how the court will
ultimately rule; however, if Sprint PCS prevails in this lawsuit against AT&T,
it may encourage CMRS providers to attempt to collect switched access charges
from us even in the absence of a written contract. AT&T Declaratory Ruling Re: VoIP.AT&T petitioned the FCC to find that
voice over Internet protocol (VoIP) services, including phone to phone
services, are exempt from switched access charges. On April 21, 2004, the FCC
released an Order denying AT&Ts petition (the AT&T Order). The FCC held
that an interexchange service that uses ordinary customer premises equipment
that originates and terminates on the public switched telephone network, that
provides no enhanced functionality, and that undergoes no net protocol
conversion, is a telecommunications service and subject to switched access
charges. The FCC did not make a determination regarding the retroactive
applicability of access charges to the foregoing type of interexchange service.
While the AT&T Order addressed a limited fact pattern, the order places
interexchange services similar to those VoIP services offered by AT&T in the
same regulatory category as traditional telecommunications services and,
therefore, subjects such VoIP services to access charges and other regulatory
obligations including 23




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Universal Service fees. Like a growing number of carriers, we utilize
Internet protocol technology for the transmission of a portion of our network
traffic. The FCC has now made clear that, to the extent such services share the
same characteristics as those addressed in the AT&T Order, they will be treated
as regulated services subject to access charges going forward. Although the
FCC did not rule on the applicability of access charges for services prior to
April 21, 2004, the RBOCs 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 seeking retroactive payment of unpaid access charges. Vonage Petition. On September 22, 2003, Vonage Holdings, Inc. (Vonage)
filed a petition requesting that the FCC preempt an order of the Minnesota
Public Utilities Commission (PUC) requiring Vonage to comply with state laws
governing providers of telephone service. The Minnesota PUC decision has been
overturned by a Minnesota state court and now Vonage is seeking Federal
preemption so that no future rulings of the Minnesota PUC can subject Vonage to
state regulation. Vonage provides VoIP origination services to its customers
and Vonage claims that it is therefore a provider of information services and
not subject to traditional common carrier regulations. Specifically, Vonage
asks that the FCC find that certain specific E911 requirements imposed by the
Minnesota PUC are in conflict with federal policies. Further, Vonage states
that preemption is necessary because of the impossibility of separating the
Internet, or any service offered over it, into intrastate and interstate
components. Until the FCC issues its ruling, it is unclear how VoIP offerings
by XO and other companies will be regulated. Level (3) Forbearance Petition. On December 23, 2003, Level(3) filed a
petition for forbearance requesting the FCC to forbear from application of
interstate or intrastate access charges on Internet protocol (IP) traffic that
originates or terminates on the public switched telephone network (PSTN). If
the FCC were to rule in Level (3)s favor, we would expect that there would be
reductions in network and regulatory costs associated with the termination of
certain IP-to-PSTN and PSTN-to-IP traffic. Pulver.Com Ruling. On February 12, 2004, the FCC ruled that Pulver.Coms
Free World Dialup (FWD) offering will remain a minimally regulated VoIP
service. The Pulver.com Order made clear that IP-to-IP calls that do not
transit over any portion of the PSTN will be largely free of regulation. Almost
all of the calls carried by XO do transit some portion of the PSTN. FCC VoIP NPRM. On February 12, 2004, the FCC initiated a major proceeding
seeking public comment on a variety of issues based on the premise that
Internet services and VoIP should remain largely free of regulatory burdens. In
connection with this proceeding, the FCC will address VoIP-related
Communications Assistance for Law Enforcement (CALEA) issues to address the
technical aspects of enabling law-enforcement access to IP-enabled services. At
this time it is unclear how, if at all, the FCC will regulate IP-enabled
service including VoIP. Local Reciprocal Compensation Charges.Local telephone companies such as
us that originate traffic that is terminated on the network of other carriers
typically compensate the other local carriers for terminating that traffic.
These payments flow in both directions between any two carriers. First, when we
terminate traffic for another local carrier to a customer on our network, we
collect compensation. Second, when we send our customers traffic to another
carrier for termination, we pay compensation. Some competitors, however, have a
customer base that generates many more minutes of terminating traffic from
other carriers than originating traffic destined for other carriers. For
example, a competitor that has a customer base that has many information
service providers typically will have a large amount of compensation being paid
to it by other carriers, while it will owe very little reciprocal compensation
to other carriers. The FCC revamped the local reciprocal compensation structure
in 2001 on an interim basis for three years to eliminate or reduce the
opportunity for carriers to take advantage of an imbalance of originating and
terminating traffic flows due to traffic terminated to information service
providers. The FCC also initiated a rulemaking to examine inter-carrier
compensation more comprehensively. Under the decision, at the election of the
incumbent carrier, terminating traffic that is out-of-balance by a ratio of
more than 3 to 1 can be compensated at a lower rate, or in some cases, at no
charge. This ruling allows us to continue to collect reciprocal compensation
payments from other carriers since we have an imbalance in the amount of
traffic we terminate versus the amount we 24




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originate. Going forward, an adverse ruling in the general intercarrier
compensation reform proceeding could end reciprocal compensation payments and
eliminate this line of revenue for us. TELRIC Proceeding.On September 10, 2003, the FCC initiated a new
proceeding to consider significantly revamping the current Total Element Long
Run Incremental Cost (TELRIC) methodology used for the pricing of unbundled
network elements. An adverse ruling in the new proceeding will allow the
incumbent carriers to increase unbundled network element rates and this would
raise our costs for leasing unbundled network elements in the future. A
decision is expected sometime in 2004. Several State Commissions have also
initiated proceedings to review the rate levels that the incumbent carriers
charge for unbundled network elements. An adverse ruling in these proceedings
would allow the incumbent carriers to increase unbundled network element rates
in the applicable state and this would raise our costs for leasing unbundled
network elements in the future. LMDS Auction. On July 28, 2004, the FCC plans to initiate an auction of
spectrum in the 24 GHz band. The 24 GHz band consists of the bands 24.25-24.45
GHz and 25.05-25.25 GHz. Five licenses, each with two paired 40 MHz blocks,
will be offered in each of 176 geographic areas. Stations in the 24 GHz Service
may render any kind of digital fixed communications service. Auction winners
will be required to protect incumbent licensees. Virtually all of the incumbent
licenses are held by Teligent, Inc. in a variety of areas throughout the
country. The winning bidder for the 24 GHz service may use these stations to
provide services in competition with those offered by XO, although the 24 GHz
bands consist of less spectrum than that for which XO is licensed to provide
LMDS service. Item 3. Quantitative and Qualitative Disclosures about Market Risk We had $345.9 million in secured loans as of March 31, 2004. Currently, we
do not pay cash interest on the loans under the Credit Agreement. Marketable securities, available for sale, at March 31, 2004 consist
primarily of investments in equity and debt securities 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. 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 are designed to
provide reasonable assurance that our books and records accurately reflect our
transactions and that our established policies and procedures are followed. For
the three months ended March 31, 2004, there were no changes to our internal
control over financial reporting that have materially affected, or are reasonably
likely to materially affect, our internal control over financial reporting. 25




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PART II. OTHER INFORMATION  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 two administrative expense claims against XO in
the aggregate amount of approximately $23.0 million remain pending from XOs
2002 Chapter 11 proceedings. In accordance with SFAS No. 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 affected
in any particular period by the unfavorable resolution or disposition of one or
more of these contingencies. 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 quarter
ended March 31, 2004. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 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  (1)
    
    On January 8, 2004, XO filed a Current Report on Form
8-K disclosing that XO concluded its $200
million rights offering of 40 million shares of XO common stock,
$0.01 par value, at a purchase price of $5.00 per share,
yielding gross proceeds to XO of approximately $198.6 million.(2)
    
    On January 23, 2004, XO filed a Current Report on
Form 8-K disclosing that XO had issued all of the 39.7 million shares of XO common stock in accordance with the terms of XOs
Rights Offering that had concluded on January 6, 2004.(3)
    
    On February 24, 2004, XO filed a Current Report on
Form 8-K announcing the order issued by the U.S Bankruptcy court
for the Southern District of New York approving that certain
Asset Purchase Agreement, dated as of February 18, 2004, by and
among Allegiance Telecom, Inc., Allegiance Telecom Company
Worldwide, and XO, and the proposed purchase of
substantially all of the assets of Allegiance Telecom, Inc. by
XO pursuant to the terms thereof. 26




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(4)
    
    On March 8, 2004, XO filed a Current Report on Form
8-K announcing that XO had issued a press release responding to
the decision of the U.S. Court of Appeals for the District of
Columbia Circuits ruling with respect to the FCC Triennial
Review Order on local telephone competition. 27




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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 10, 2004
    By:
    /s/   William GarrahanWilliam GarrahanSenior Vice President and Acting Chief 
Financial Officer
(Principal Financial Officer) 28