##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 Washington, DC 20549
 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2004 Commission file number: 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 August 6, 2004, the number of shares of common stock of XO
Communications, Inc. issued and outstanding was 181,933,035 and the number of
shares of 6% Class A Convertible Preferred Stock of XO Communications, Inc.
issued and outstanding was 4,000,000.




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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 June 30, 2004 (unaudited) and December 31, 2003
    
    
    1Condensed Consolidated Statements of Operations for the Three Months
Ended June 30, 2004 and June 30, 2003 (unaudited)
    
    
    2Condensed Consolidated Statements of Operations for the Six Months
Ended June 30, 2004 and June 30, 2003 (unaudited)
    
    
    3Condensed Consolidated Statements of Cash Flows for the Six Months
Ended June 30, 2004 and June 30, 2003 (unaudited)
    
    
    4Notes to Condensed Consolidated Financial Statements (unaudited)
    
    
    5Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    13Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    28Item 4. Controls and Procedures
    
    
    28Part II. Other InformationItem 1. Legal Proceedings
    
    
    29Item 2. Changes in Securities and Use of Proceeds
    
    
    29Item 3. Defaults Upon Securities
    
    
    29Item 4. Submission of Matters to a Vote of Security Holders
    
    
    29Item 5. Other Information
    
    
    29Item 6. Exhibits and Reports on Form 8-K
    
    
    30Signatures
    
    
    31Certifications
    
    
    32
 i




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PART I. FINANCIAL INFORMATION 
 Item 1. Financial Statements XO Communications, Inc. and Subsidiaries 
 Condensed Consolidated Balance Sheets
 (Amounts in thousands, except for share and per share data)
 June 30,
    
    December 31,2004
    
    2003(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    36,334
    
    
    $
    478,560Marketable and other securities
    
    
    18,263
    
    
    
    42,052Accounts receivable, net of allowance for doubtful
accounts of $44,170 at June 30, 2004 and $32,986,
at December 31, 2003, respectively
    
    
    117,073
    
    
    
    93,958Other current assets
    
    
    43,811
    
    
    
    12,421Total current assets
    
    
    215,481
    
    
    
    626,991Investment in acquired businesses
    
    
    680,936
    
    
    
    Property and equipment, net
    
    
    498,607
    
    
    
    485,984Broadband wireless licenses and other intangibles, net
    
    
    96,433
    
    
    
    109,515Other assets, net
    
    
    16,482
    
    
    
    42,675Total assets
    
    $
    1,507,939
    
    
    $
    1,265,165LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    75,109
    
    
    $
    63,064Accrued liabilities
    
    
    205,961
    
    
    
    208,353Total current liabilities
    
    
    281,070
    
    
    
    271,417Long-term debt and accrued interest payable
    
    
    352,064
    
    
    
    536,791Other long-term liabilities
    
    
    71,454
    
    
    
    76,532Total liabilities
    
    
    704,588
    
    
    
    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:181,933,035
and 96,274,140 shares issued and
outstanding on June 30, 2004 and December 31,
2003, respectively
    
    
    994,573
    
    
    
    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
    
    
    (753
    )
    
    
    (839
    )Accumulated other comprehensive income
    
    
    4,399
    
    
    
    1,378Accumulated deficit
    
    
    (194,868
    )
    
    
    (102,554
    )Total stockholders equity
    
    
    803,351
    
    
    
    380,425Total liabilities and stockholders equity
    
    $
    1,507,939
    
    
    $
    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 ended
    
    Three months endedJune 30,
    
    June 30,2004
    
    2003Revenue
    
    $
    278,183
    
    
    $
    283,918Costs and expenses:Cost of service
    
    
    118,822
    
    
    
    104,898Selling, operating, and general
    
    
    164,149
    
    
    
    165,042Depreciation and amortization
    
    
    30,065
    
    
    
    27,238Total costs and expenses
    
    
    313,036
    
    
    
    297,178Loss from operations
    
    
    (34,853
    )
    
    
    (13,260
    )Investment income (loss), net
    
    
    (3,121
    )
    
    
    5,111Interest expense, net
    
    
    (5,846
    )
    
    
    (11,687
    )Net loss
    
    $
    (43,820
    )
    
    $
    (19,836
    )Net loss per common share, basic and diluted
    
    $
    (0.31
    )
    
    $
    (0.21
    )Weighted average shares, basic and diluted
    
    
    140,538,159
    
    
    
    95,129,610
 See accompanying notes to the unaudited condensed consolidated financial statements. 2




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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)
 Six months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003Revenue
    
    $
    539,128
    
    
    $
    570,011Costs and expenses:Cost of service
    
    
    228,783
    
    
    
    212,404Selling, operating, and general
    
    
    332,702
    
    
    
    331,277Depreciation and amortization
    
    
    55,762
    
    
    
    53,605Total costs and expenses
    
    
    617,247
    
    
    
    597,286Loss from operations
    
    
    (78,119
    )
    
    
    (27,275
    )Investment income (loss), net
    
    
    (1,745
    )
    
    
    8,321Interest expense, net
    
    
    (12,450
    )
    

    
    (21,370
    )Net loss
    
    $
    (92,314
    )
    
    $
    (40,324
    )Net loss per common share, basic and diluted
    
    $
    (0.67
    )
    
    $
    (0.42
    )Weighted average shares, basic and diluted
    
    
    137,591,467
    
    
    
    95,071,784
 See accompanying notes to the unaudited condensed consolidated financial statements. 3




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XO Communications, Inc. and Subsidiaries 
 Condensed Consolidated Statements of Cash Flows
 (Amounts in thousands)
 (Unaudited)
 Six months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003OPERATING ACTIVITIES:Net loss
    
    $
    (92,314
    )
    
    $
    (40,324
    )Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:Depreciation and amortization
    
    
    55,762
    
    
    
    53,605Accrual of interest
    
    
    12,886
    
    
    
    21,234Stock-based compensation
    
    
    226
    
    
    
    Non-cash loss on sale of investments
    
    
    5,665
    
    
    
    Changes in assets and liabilities:Accounts receivable
    
    
    (23,115
    )
    
    
    11,310Other assets
    
    
    (15,198
    )
    
    
    6,057Accounts payable
    
    
    9,118
    
    
    
    (120
    )Accrued liabilities
    
    
    (7,722
    )
    
    
    (30,010
    )Net cash (used in) provided by operating activities
    
    
    (54,692
    )
    
    
    21,752INVESTING ACTIVITIES:Capital expenditures, net
    
    
    (49,124
    )
    
    
    (38,994
    )Cash paid for acquired businesses
    
    
    (361,517
    )
    
    
    Sales of marketable securities and investments
    
    
    21,144
    
    
    
    312,232Purchases of marketable securities and investments
    
    
    
    
    
    
    (251,030
    )Net cash (used in) provided by investing activities
    
    
    (389,497
    )
    
    
    22,208FINANCING ACTIVITIES:Repayments of capital leases
    
    
    (751
    )
    
    
    (541
    )Repayments of long term debt
    
    
    (197,612
    )
    
    
    Proceeds from issuance of common stock
    
    
    197,612
    
    
    
    Proceeds from exercise of stock options
    
    
    2,714
    
    
    
    3,704Net cash provided by (used in) financing activities
    
    
    1,963
    
    
    
    3,163Net increase (decrease) in cash and cash equivalents
    
    
    (442,226
    )
    
    
    47,123Cash and cash equivalents, beginning of period
    
    
    478,560
    
    
    
    314,038Cash and cash equivalents, end of period
    
    $
    36,334
    
    
    $
    361,161SUPPLEMENTAL DATA:Cash paid for interest
    
    $
    1,140
    
    
    $
    1,235Stock issued for acquired businesses
    
    $
    311,307
    
    
    $
    
 See accompanying notes to the unaudited condensed consolidated financial statements. 4




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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.
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 U.S.
generally accepted accounting principles. Accordingly, they do not include all
of the information and footnotes required by generally accepted accounting
principles in the United States for complete financial statements. Operating
results for the three and six months ended June 30, 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). XO emerged from bankruptcy on January 17, 2003 and applied Fresh Start
Accounting as of January 1, 2003. As a result of the reorganization, XO
recognized a gain of approximately $3.0 billion. The operations of the
predecessor XO, which includes the reorganized gain, has not been presented as
it is not comparative. (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) 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 June 30, 2004, the Company has options outstanding to
purchase approximately 9.5 million shares of common stock of which 4.2 million
are exercisable and exercisable warrants to purchase up to an additional 23.7
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 5




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recorded if stock options are granted at an exercise price equal to or
greater than the fair market value of the Companys stock on the grant date. If
the Company had adopted the fair value method of accounting for its stock
awards, stock-based compensation would have been determined based on the fair
value for all stock awards at the grant date using a Black-Scholes pricing
model and the following weighted average assumptions noted below. 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 ended
    
    Three months endedJune 30, 2004
    
    June 30, 2003Net loss, as reported
    
    $
    (43,820
    )
    
    $
    (19,836
    )Add: Stock-based employee compensation expense included in
net loss, as reported
    
    
    97
    
    
    
    Deduct: Total stock-based employee compensation expense
determined under fair value based methods for all stock
awards
    
    
    (2,227
    )
    
    
    (3,957
    )Pro forma net loss
    
    $
    (45,950
    )
    
    $
    (23,793
    )Net loss per common share, basic and diluted:Net loss per common share, basic and diluted  as reported
    
    $
    (.31
    )
    
    $
    (0.21
    )Net loss per common share, basic and diluted  pro forma
    
    $
    (.33
    )
    
    $
    (0.25
    )Black Scholes Assumptions:Expected volatility
    
    
    63.0
    %
    
    
    75.0
    %Risk free interest rate
    
    
    2.8
    %
    
    
    2.4
    %Dividend yield
    
    
    0.0
    %
    
    
    0.0
    %Expected life (range in years)
    
    
    4.0
    
    
    
    4.0Weighted average fair value per share at grant date
    
    $
    2.76
    

    
    $
    2.73
 Six months ended
    
    Six months endedJune 30, 2004
    
    June 30, 2003Net loss, as reported
    
    $
    (92,314
    )
    
    $
    (40,324
    )Add: Stock-based employee compensation expense included in
net loss, as reported
    
    
    226
    
    
    
    Deduct: Total stock-based employee compensation expense
determined under fair value based methods for all stock
awards
    
    
    (4,101
    )
    
    
    (7,995
    )Pro forma net loss
    
    $
    (96,189
    )
    
    $
    (48,319
    )Net loss per common share, basic and diluted:Net loss per common share, basic and diluted  as reported
    
    $
    (0.67
    )
    
    $
    (0.42
    )Net loss per common share, basic and diluted  pro forma
    
    $
    (.70
    )
    
    $
    (0.51
    )Black Scholes Assumptions:Expected volatility
    
    
    63.0
    %
    
    
    75.0
    %Risk free interest rate
    
    
    2.7
    %
    
    
    2.6
    %Dividend yield
    
    
    0.0
    %
    
    
    0.0
    %Expected life (range in years)
    
    
    4.0
    
    
    
    4.0Weighted average fair value per share at grant date
    
    $
    3.23
    
    
    $
    2.83
 The XO Communications, Inc. 2002 Stock Incentive Plan (the 2002 Stock
Incentive Plan) was adopted in January 2003 and amended and restated in July
2003. Under the 2002 Stock Incentive Plan, the Company is authorized to issue
awards for up to 17.6 million shares of its common stock in the form of
restricted stock or options to purchase stock. The Company granted a total of
1,158,882 options during the six months ended June 30, 2004. 6




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(f) Comprehensive Loss Comprehensive loss includes the Companys net loss, 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 six
months ended June 30, 2004 and 2003 (dollars in thousands): Three Months Ended June 30,2004
    
    2003Net loss
    
    $
    (43,820
    )
    
    $
    (19,836
    )Other
comprehensive loss:Net
unrealized gains on investment
    
    
    1,627
    
    
    
    Comprehensive loss
    
    $
    (42,193
    )
    
    $
    (19,836
    )
 Six Months Ended June 30,2004
    
    2003Net loss
    
    $
    (92,314
    )
    
    $
    (40,324
    )Other comprehensive loss:Net unrealized gains on investment
    
    
    3,021
    
    
    
    Comprehensive loss
    
    $
    (89,293
    )
    
    $
    (40,324
    )
 2. BUSINESS COMBINATION On June 23, 2004 (the Closing Date), XO completed the acquisition of all
of the local exchange carrier businesses (the Acquired Businesses) under the
terms of the Asset Purchase Agreement ( the Purchase Agreement) entered into
on February 18, 2004 by and among the Company, Allegiance Telecom, Inc. (ATI)
and Allegiance Telecom Company Worldwide (together with ATI, Allegiance), and
approved by the United States Bankruptcy Court for the Southern District of New
York on February 19, 2004. Allegiance and its direct and
indirect subsidiaries had
operated as debtors-in-possession under the Bankruptcy Code since May 14, 2003.
Allegiance was a facilities-based national local exchange carrier that provided
integrated telecommunications services to business, government and other
institutional users in 36 major metropolitan areas across the United States.
Allegiances service offerings included voice, data, and integrated
communications services. XO did not acquire Allegiances customer premises
installation and maintenance business, shared hosting business, or dedicated
dial-up access service business. Under the Asset Purchase Agreement, XO paid approximately $635.0 million
for the Acquired Businesses consisting of approximately $324.0 million of cash,
including $13.0 million of adjustments for working capital, and 45,380,000
shares of XO common stock valued at approximately $311.0 million using XOs
common stock market price for a reasonable period before and after the
Allegiance acquisition was announced. The amount of cash consideration paid may
be adjusted based on changes in the Acquired Businesses working capital,
customer base or assumed bankruptcy cure amounts. On April 13, 2004 (the Early Funding Date), XO entered into an Operating
Agreement that allowed it to manage the operations and receive or fund the net
receipts or disbursements of the Acquired Businesses from the Early Funding
Date to the Closing Date. Under the terms of the Operating Agreement, the
Allegiance estate would invoice/remit to XO the monthly net
disbursements/receipts of the Acquired Businesses. The Allegiance estate has
submitted April, May and June invoices requesting reimbursement for
approximately $6.0 million of net disbursements. XO has notified Allegiance
that it disputes these invoices as XOs analysis indicates that the Acquired
Businesses were cash flow positive during that time. This contingency has
not been reflected in the accompanying consolidated financial statements. XO
cannot be certain that, if
arbitrated, any such dispute will be resolved favorably to XO. Upon the Closing Date, the $635.0 million consideration was paid to
Allegiance and XO took title to the Acquired Businesses. XO has retained
independent appraisers to determine fair value the assets and liabilities
acquired as required under SFAS No. 141 Business Combinations. This appraisal
is in process and is expected to be completed in the third quarter of 2004.
Accordingly, the accompanying consolidated balance sheet reflects the
investment in Allegiance which consists of $635.0 million of purchase price of
the Acquired Businesses, $36.4 million of unsecured Allegiance debt securities,
plus direct transaction costs as of June 23, 2004. 7




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The results of operations for the Acquired Businesses are included in the
accompanying consolidated financial statements from the Closing Date through
June 30, 2004. The following is unaudited pro forma financial information of
the Company assuming the Allegiance acquisition had occurred at the beginning
of the periods presented (dollars in thousands, except share and per share data): Three Months EndedJune 30, 2004
    
    June 30, 2003Revenue
    
    $
    385,351
    
    
    $
    417,926Net loss
    
    
    (62,293
    )
    
    
    (79,045
    )Net loss per share  basic and diluted
    
    $
    (0.34
    )
    
    $
    (0.56
    )Weighted
average shares - basic and diluted
    
    
    181,928,708
    
    
    
    140,509,610
 Six Months EndedJune 30, 2004
    
    June 30, 2003Revenue
    
    $
    768,461
    
    
    $
    834,442Net loss
    
    
    (146,188
    )
    
    
    (164,943
    )Net loss per share  basic and diluted
    
    $
    (.81
    )
    
    $
    (1.17
    )Weighted
average shares - basic and diluted
    
    
    180,976,742
    
    
    
    140,451,784
 3. MARKETABLE AND OTHER SECURITIES The amortized cost, gross unrealized gains and losses and fair value of
the equity securities available-for-sale as of June 30, 2004 and December 31,
2003, are in the following table. Other securities as of June 30, 2004 and
December 31, 2003 consist of debt securities, carried at cost, and mature in
2007. (dollars in thousands): Gross Unrealized
    
    Gross UnrealizedFair Value
    
    Cost Basis
    
    Holding Gains
    
    Holding (Losses)As of June 30, 2004Equity securities
    
    $
    6,252
    
    
    $
    1,853
    
    
    $
    4,399
    
    
    $
    Other securities
    
    
    12,011
    
    
    
    12,011
    
    
    
    
    
    
    
    Total marketable and other securities
    
    $
    18,263
    
    
    $
    13,864
    
    
    $
    4,399

    
    
    $
    As of December 31, 2003Equity securities
    
    $
    30,041
    
    
    $
    28,663
    
    
    $
    3,001
    
    
    $
    (1,623
    )Other securities
    
    
    12,011
    
    
    
    12,011
    
    
    
    
    
    
    
    Total marketable and other securities
    
    $
    42,052
    
    
    $
    40,674
    
    
    $
    3,001
    
    
    $
    (1,623
    )
 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): June 30,
    
    December 31,2004
    
    2003Telecommunications networks and acquired
bandwidth
    
    $
    425,419
    
    
    $
    407,747Furniture, fixtures, equipment, and other
    
    
    93,103
    
    
    
    77,783518,522
    
    
    
    485,530Less: accumulated depreciation
    
    
    (116,473
    )
    
    
    (79,501
    )402,049
    
    
    
    406,029Construction-in-progress
    
    
    96,558
    
    
    
    79,955$
    498,607
    
    
    $
    485,984
 8




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##### 



Depreciation expense related to property and equipment for the three and
six months ended June 30, 2004 was $22.8 million and $42.0 million
respectively, and for the three and six months ended June 30, 2003 was $20.7
million and $40.5 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): June 30,
    
    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
    
    
    (39,245
    )
    
    
    (26,163
    )79,771
    
    
    
    92,853XO Trade name  indefinite life asset
    
    
    16,662
    
    
    
    16,662$
    96,433
    
    
    $
    109,515
 Amortization expense related to intangible assets for each of the three
and six months ended June 30, 2004 was $7.2 million and $13.8 million,
respectively and for the three and six months ended June 30, 2003 was $6.5
million and $13.1 million, respectively. As of June 30, 2004, approximately
$23.5 million of fixed wireless licenses are not being amortized as commercial
services have not been deployed in the licenses geographic area. 5. 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 June 30, 2004, long-term debt consisted of $347.8
million in principal and $4.3 million of accrued interest that, if not paid,
converts to principal. There are no current debt service requirements since
cash interest payments as well as automatic and permanent quarterly reductions
on the principal amount outstanding do not commence until 2009. However, in the
event that consolidated excess cash flow (as defined in the Credit Facility)
for any fiscal quarter during the term of the agreement is greater than $25
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,
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. In addition, the Company was required to achieve a
minimum consolidated EBITDA of not less than $10.0 million for the four-quarter
period ended June 30, 2004.

As of August 3, 2004 the lender has waived the applicability of the minimum EBITDA
covenant for each quarter from March 31, 2004 through December 31, 2005. Actual consolidated EBITDA
loss for the four-quarter period ended June 30, 2004 was $51.3 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. On June 23, 2004, as part of the
closing of the Allegiance acquisition, the Company obtained the waiver and
consent of the lenders with respect to the following covenants contained in the
Credit Facility and subject to XO providing updated collateral descriptions and
legal opinions not later than August 16, 2004: (i) the $25.0 limitation on the
incurrence of permitted indebtedness, permitted equipment financings, acquired
debt, and capital leases; (ii) the limitation on the incurrence of additional
liens with respect to liens on the Allegiance assets that remained in place
following the effective date of the Allegiance plan of reorganization; (iii)
the restriction on making acquisitions in excess of $50.0 million; (iv) the
requirement that accounts acquired as part of the Allegiance acquisition be subject to control agreements until
August 16, 2004; and (v) any noncompliance arising from the entering into of
the Operating Agreement. 9




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##### 



At June 30, 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 June 30, 2004, the annualized weighted
average interest rate applicable to outstanding borrowings under the Credit
Facility was 7.37%. 6. 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 June 30, 2004, approximately
181.9 million shares of its Common Stock had been issued, approximately 50% 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 $197.6
million. Subsequent to closing, these net proceeds were used to pay down the
Companys Credit Facility. As discussed in Note 2, the Company issued 45,380,000 shares on June 23,
2004 as part of the purchase price for the Acquired Businesses of Allegiance. On August 6, 2004, the Company issued 4.0 million shares of 6% Class A
Convertible Preferred Stock in a private placement for aggregate consideration
of $200.0 million. See Note 10 for additional information. 7. OPERATING SEGMENTS Reportable Segments The Company operates its business as one telecommunications segment. The
Companys telecommunications segment includes all of its products and services
including voice, data, and integrated voice and data. 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
telecommunications services segment into voice services, data services, and
integrated voice and data services (dollars in thousands): Three months ended
    
    Six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Voice services
    
    $
    141,679
    
    
    $
    150,020
    
    
    $
    272,600
    
    
    $
    300,743Data services
    
    
    95,612
    
    
    
    97,321
    
    
    
    188,561
    
    
    
    199,298Integrated voice and data services
    
    
    40,892
    
    
    
    36,577
    
    
    
    77,967
    
    
    
    69,970Total revenue
    
    $
    278,183
    
    
    $
    283,918
    
    
    $
    539,128
    
    
    $
    570,011
 10




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##### 



8. RELATED PARTY TRANSACTIONS Various entities controlled by Mr. Icahn hold the following interests in
XO: Outstanding CommonStock
    
    Warrants
    
    Credit FacilityAt December 31, 2003
    
    Greater than 80%
    
    Greater than 40%
    
    Greater than 90%At June 30, 2004
    
    Greater than 50%
    
    Greater than 40%
    
    Greater than 90%
 On August 6, 2004, XO completed a private
placement of $200 million of XOs 6%  Class A Convertible
Preferred Stock. Affiliates of Carl C. Icahn, XOs chairman and
holder of approximately 50.2% of XOs common stock, purchased 95% of
the shares sold in the offering, and affiliates of Amalgamated Gadget, L.P., holder
of approximately 9.4% of XOs common stock, purchased the
remaining five percent. See note 10 for further information. On June 21, 2004, prior to the closing of the Allegiance acquisition, Mr.
Icahn filed a schedule 13D amendment disclosing that he exercised the option to purchase
6.25 million shares of previously issued XO common stock from a third party at
a strike price of $4.25 per share, and disclosed his beneficial ownership of
68.7%. As a result of his significant majority ownership, Mr. Icahn can elect all
of our directors, appoint the members of the committees of XOs Board of
Directors, appoint key members of XOs executive management team, and appoint
XOs 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 the Companys voting stock,
including, without limitation, mergers, acquisitions, the sale of substantially
all our assets, and amendments to XOs 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 and $2.0 million in lease rent to
Dixon for the three and six months ended June 30, 2004, respectively and XO is
obligated to pay approximately $13.9 million to Dixon through the expiration of
the initial term of the lease, which is November 30, 2007. 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 the three and six months ended June 30, 2004,
the total revenue recognized on such services affiliated with Mr. Icahn was
approximately $.5 million and $.7 million, respectively. During the three and
six months ended June 30, 2004, the Company has purchased approximately $0.1
million and $0.4 million, respectively, in services from Icahn affiliates. During the six months ended June 30, 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 of Dell Computers. XO provided telecommunications services to Allegiance during the second
quarter of 2004 through the Closing Date. Total revenue recognized for those
services was approximately $1.7 million. 11




---



##### 



9. 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 $21.5 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. On July 23, 2004, we responded to the informal inquiry of the Securities and Exchange Commission regarding the public reporting of
customers and access lines in the telecommunications industry.
 We have included disclosure in Part II, Item 5 addressing certain
matters that we described in our response to the SEC inquiry. 10. SUBSEQUENT EVENTS On August 6, 2004, XO completed a private placement of $200 million for 4 million
shares of 6% Class A Convertible Preferred Stock.
 Affiliates of Carl C. Icahn, XOs chairman and owner
of approximately 50.2% of XOs outstanding common stock,
purchased 95% of the preferred shares sold
 in the offering, and an affiliate of Amalgamated Gadget, L.P.,
 holder of approximately 9.4% of XOs outstanding common stock, purchased the remaining five percent.
We refer to this offering as the Preferred Stock Offering. The Preferred Stock Offering was reviewed and approved by a special committee of XOs Board of Directors
consisting of XO independent directors, Messrs. Dell, Gradin and Knauss. The
special committee selected its own counsel and financial advisor. The special committee and the Company received
the opinion of Jefferies & Company, Inc., the special
committees financial advisor, that subject to specified qualifications,
assumptions and limitations, the material terms of the 6% Class A Convertible
Preferred Stock were fair to XO, from a financial point of view, at the time of
issuance. As a result of the Preferred Stock Offering and assuming the
conversion of all of the outstanding 6% Class A Convertible Preferred Stock,
Mr. Icahn acquired beneficial ownership of approximately 59% of XO outstanding common
stock. Proceeds of the Preferred Stock Offering will be used for general
working capital purposes and to fund possible future acquisitions that would add
additional scale and synergies to XOs business. The Class A Preferred Stock ranks senior to the Companys common stock. Holders of
the Class A Preferred Stock are not entitled to receive annual dividends, however, the liquidation
preference of the Class A Preferred Stock automatically increases at a rate of 1.5% each quarter
through the maturity date, January 15, 2010. The Company is required to redeem the then-outstanding
shares of Class A Preferred Stock on the maturity date at 100% of their aggregate
liquidation preference, including compounded accretion through that date, unless earlier
redeemed or converted into common stock. If all of the shares of Class A Preferred Stock were
to remain outstanding on the maturity date, and assuming the accretion of all the required
increases to the liquidation preference thereof, holders of the Class A Preferred Stock would be
entitled to the redemption of 59,868,561 shares of common stock then issuable upon conversion
of the Class A Preferred Stock and would have an aggregate liquidation preference of
approximately $276.6 million. The Company may also, at its sole option, redeem the Class A
Preferred Stock at any time after the third anniversary of the issue date of such  shares if the
average market price of the Companys common stock for the 20 days prior to such redemption is
equal to or greater than 250% of the conversion price of the Class A Preferred Stock. Each
holder of the Class A Preferred Stock  shall be entitled to one vote for each share of common
stock then-issuable upon the conversion of the shares  of Class A Preferred Stock. Both the
conversion ratio and the voting power of each share of Class A Preferred Stock will be
automatically increased each quarter as the liquidation preference increases at the rate of 1.5%
each quarter. The holders of Class A Preferred Stock also have anti-dilution protection in the
event that the Company issues shares of common stock at a price below the then-prevailing
market price of the Companys common stock. 12




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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 judicial decisions, telecommunications-related legislation
and/or regulatory developments and the conduct of incumbent carriers in
reaction to such developments. Overview We provide a comprehensive array of voice and data telecommunications
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. 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 13




---



##### 



with advanced telecommunications technologies, we are able to provide a
comprehensive array of telecommunications services primarily or entirely over a
network that we own or control, from the initiation of the voice or data
transmission to the point of termination, which we refer to as end-to-end
service. This capability enables us to provide telecommunications services
between customers connected to our network and among customers with multiple
locations primarily or entirely over our network. With the acquisition of Allegiances network assets and customer base
discussed below, XO is one of the nations largest competitive providers of
national local telecommunications and broadband services. We own one of the
largest networks of nationwide connections to the RBOCs networks, and doubled
our 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 FCC Rulemaking The
Federal Communications Commission, or FCC, has indicated that it
intends to issue interim rules with respect to the requirements that the
Incumbent Local Exchange Carriers, or ILECs, make available Unbundled Network
Elements, or UNEs, to competitive carriers like us. Current UNE rules require
that the ILECs lease their network assets to competitive carriers like us at
cost-based rates. Network assets that we obtain as UNEs comprise a material
portion of our total cost of service. We anticipate that the interim rules will
provide that, unless the FCC adopts final rules prior to March 2005, (i) the
ILECs can increase the price of existing UNEs by 15%, and (ii) require that new
orders for the use of the ILEC network assets formerly available as UNEs are to
be leased by competitive carriers at special access, or retail, rates. If the
FCC adopts the interim rules as we anticipate, and does not adopt final rules
prior to 2005 that alter the interim rules, XOs financial condition and
results of operations would be materially and adversely affected. The proposed
FCC rulemaking is discussed in greater detail below under the heading
Regulatory Overview. New Board Members We appointed Fredrik G. Gradin and Robert L. Knauss to our Board of
Directors in July 2004. Both Mr. Gradin and Mr. Knauss join the board as
independent directors and will serve on the Boards Audit Committee. Mr. Knauss
is the chairman of our Audit Committee. Mr. Gradin has been president and CEO of Explorer Group Inc., an
investment management company, since its inception in 1998. Prior to founding
Explorer Group Inc., Mr. Gradin served as president of Spectron Energy, Inc., a
leading energy brokerage company. Mr. Gradin holds a Bachelor of Arts degree
from Rice University. Mr. Knauss currently serves as an independent director on the boards of
the NYSE-traded investment funds Equus II, Inc. and The Mexico Fund, Inc. In
the past twenty years Mr. Knauss has served on the boards of seven public
companies. He previously served as chairman of Philip Services Corporation from
1998 to 2000 and from 2002 to 2003. Mr. Knauss also previously served as the
dean of the University of Houston Law Center and Vanderbilt University Law
School. Mr. Knauss holds a J.D. degree from the University of Michigan and a
Bachelor of Arts degree from Harvard College. 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 was
promoted to 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. Business Combination On June 23, 2004, the Closing Date, we completed the acquisition of all of
the local exchange carrier businesses, which we refer to as the Acquired
Businesses, previously agreed to under the terms of the Asset Purchase
Agreement entered into on February 18, 2004 between us, Allegiance Telecom,
Inc. and Allegiance Telecom Company Worldwide, collectively referred to as
Allegiance, and approved by the United States 14




---



##### 



Bankruptcy Court for the Southern District of New York
 on February 19,
2004. Allegiance and its direct and indirect subsidiaries
operated as debtor-in-possession under the Bankruptcy Code
 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 telecommunications services. The assets of the Acquired Businesses consist primarily of:  
    
    switching and routing equipment, located both in current
Allegiance facilities and in facilities operated 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. Under the Purchase Agreement, we paid approximately $635.0 million for the
Acquired Businesses, consisting of approximately $324.0 million of cash,
including $13.0 million of adjustments for working capital, and 45,380,000
shares of our common stock valued at approximately $311.0 million using our
common stock market price for a reasonable period before and after the
Allegiance acquisition was announced. The amount of cash consideration may be
adjusted based on changes in the Acquired Businesses working capital, customer
base or assumed bankruptcy cure amounts. On April 13, 2004, the Early Funding Date, we entered into an operating
agreement that allowed us to manage the operations and receive or fund the net
receipts or disbursements of the Acquired Businesses from the Early Funding
Date to the Closing Date. Under the terms of the operating agreement, the
Allegiance estate would invoice/remit to us the monthly net
disbursements/receipts of the Acquired Businesses. The Allegiance estate has
submitted April, May and June invoices requesting reimbursement for
approximately $6.0 million of net disbursements. We have notified Allegiance
that we dispute these invoices as our analysis indicates that the Acquired
Businesses were cash flow positive during that time frame. This contingency has
not been reflected in the accompanying consolidated financial statements. We
cannot be certain that, if
arbitrated,  any such dispute will be resolved favorably to us. Upon the Closing Date, the $635.0 million of consideration was paid to
Allegiance and we took title to the Acquired Businesses. We have retained
independent appraisers to determine fair value of the assets and liabilities
acquired as required under SFAS No. 141 Business Combinations. This appraisal
is in process and will be completed in the third quarter of 2004, accordingly,
the accompanying consolidated balance sheet reflects the investment in
Allegiance which consists of the $635.0 million purchase price of the Acquired
Businesses, $36.4 million of unsecured Allegiance debt securities, plus direct
transaction costs as of June 23, 2004. In addition, the consolidated results of
operations for the Acquired Businesses for the period of June 23, 2004 through
June 30, 2004 are reported in the Companys accompanying Statement of
Operations. Comparison of Financial Results The operational results of XO for the three and six months ended June 30,
2004 are discussed below. As the acquisition of the Aquired Businesses closed
June 23, 2004, results of operations are included from the Closing Date through
June 30, 2004. Forward looking information with respect to the combined company
of XO and Allegiance is discussed at the end of each financial results
analysis. Our actual experience may differ materially from our projections of
the combined company, based on many factors including, among others:  
    
    there are inherent uncertainties in projecting future results for any business;
    
    we may not successfully integrate the Acquired Businesses; 15




---



##### 




    
    while Allegiances consolidated financial position and results of
operations have been audited through December 31, 2003, stand alone
financial information with respect to the Acquired Businesses has not
been audited; and
    
    we cannot predict the outcome of future judicial decisions,
telecommunications related legislation and/or regulatory developments
or the reaction by incumbent carriers to such developments. Three and Six Months Ended June 30, 2004 versus Three and Six Months Ended
June 30, 2003 Revenue. Total revenue for the three months ending June 30, 2004 decreased
2.0% to $278.2 million from $283.9 million in the same period of 2003 while
total revenue for the six months ended June 30, 2004 decreased 5.4% to $539.1
million from $570.0 million for the same period of 2003. The three and six
month financial results for 2004 include approximately $9.1 million of revenue
from the Acquired Businesses. Our 2004 revenue decreased from 2003 results
 due
to declines in carrier revenue, competitive pricing pressure and FCC mandated
reductions in carrier access billing rates. XO revenue, exclusive of revenue
from the Acquired Businesses, of $269.1 million for the three months ended June
30, 2004, showed growth compared to revenue for the three months ended March
31, 2004 of $261.0 million due to settlements and other one time
items, and growth in our
core retail business. Based on our review and analysis, 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 and
retain the Acquired Businesses customers and sales forces. Revenue was earned from providing the following services (dollars in
thousands): Three months ended June 30,2004
    
    % of Revenue
    
    2003
    
    % of Revenue
    
    % ChangeVoice services
    
    $
    141,679
    
    
    
    50.9
    %
    
    $
    150,020
    
    
    
    52.8
    %
    
    
    (4.6
    %)Data services
    
    
    95,612
    
    
    
    34.4
    %
    
    
    97,321
    
    
    
    34.3
    %
    
    
    (1.8
    %)Integrated voice and data services
    
    
    40,892
    
    
    
    14.7
    %
    
    
    36,577
    
    
    
    12.9
    %
    
    
    11.8
    %Total revenue
    
    $
    278,183
    
    
    
    100.0
    %
    
    $
    283,918
    
    
    
    100.0
    %
    
    
    (1.5
    %)
 Six months ended June 30,2004
    
    % of Revenue
    
    2003
    
    % of Revenue
    
    % ChangeVoice services
    
    $
    272,600
    
    
    
    50.5
    %
    
    $
    300,743
    
    
    
    52.7
    %
    
    
    (8.9
    %)Data services
    
    
    188,561
    
    
    
    35.0
    %
    
    
    199,298
    
    
    
    35.0
    %
    
    
    (5.4
    %)Integrated voice and data services
    
    
    77,967
    
    
    
    14.5
    %
    
    
    69,970
    
    
    
    12.3
    %
    
    
    11.4
    %Total revenue
    
    $
    539,128
    
    
    
    100.0
    %
    
    $
    570,011
    
    
    
    100.0
    %
    
    
    (5.2
    %)
 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. Our three and six month financial results for 2004 include
approximately $5.0 million of voice revenue from the Acquired Businesses. Voice
services revenue in the second quarter of 2004 decreased to $141.7 million from
$150.0 million for the same period of 2003 and for the first half of 2004
decreased to $272.6 million from $300.7 million for the same period in 2003.
The year over year decrease is primarily attributable to carrier customer
declines during 2003 driven by churn and competitive pricing pressures. In
addition, 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. Our three and six month financial
results for 2004 includes approximately $1.6 million of data
services revenue from the
Acquired Businesses. Data services revenue in the second quarter of 2004
decreased to $95.6 million from $97.3 million for the same period of 2003 and
for the first half of 2004 decreased to $188.6 million from $199.3 million for
the same period in 2003. Second quarter data services revenue was relatively stable with
first quarter 2004 results of $92.9 million. The majority of the year over year
decline was attributable to carrier customer churn during 2003 due to
network downsizing. XO data services revenue, exclusive of revenue from
the Acquired Businesses, of $94.0 million was relatively stable with first
quarter 2004 results of $92.9 million. 16




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##### 



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. Our three and six month financial results for 2004
include approximately $2.5 million of integrated voice and data revenue from
the Acquired Businesses. Integrated voice and data services in the second
quarter and first half of 2004 increased to $40.9 million and $78.0 million,
respectively, from $36.6 million and $70.0 million in the
second quarter and first half of 2003, respectively, due to growth
in our XOptions bundled package service and $2.5 million of revenue from the
Acquired Businesses. Integrated voice and data services continue to show growth
when compared to the first quarter 2004 results of $37.1 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 June 30,2004
    
    % of Revenue
    
    2003
    
    % of Revenue
    
    % ChangeCosts and expenses:Cost of service
    
    $
    118,822
    
    
    
    42.7
    %
    
    $
    104,898
    
    
    
    36.9
    %
    
    
    13.3
    %Selling, operating and general
    
    
    164,149
    
    
    
    59.0
    %
    
    
    165,042
    
    
    
    58.1
    %
    
    
    (0.5
    %)Depreciation and amortization
    
    
    30,065
    
    
    
    10.8
    %
    
    
    27,238
    
    
    
    9.6
    %
    
    
    10.4
    %Total
    
    $
    313,036
    
    
    
    
    
    
    $
    297,178
    
    
    
    
    
    
    
    5.3
    %
 Six months ended June 30,2004
    
    % of Revenue
    
    2003
    
    % of Revenue
    
    % ChangeCosts and expenses:Cost of service
    
    $
    228,783
    
    
    
    42.4
    %
    
    $
    212,404
    
    
    
    37.3
    %
    
    
    7.7
    %Selling, operating and general
    
    
    332,702
    
    
    
    61.7
    %
    
    
    331,277
    
    
    
    58.1
    %
    
    
    0.4
    %Depreciation and amortization
    
    
    55,762
    
    
    
    10.3
    %
    
    
    53,605
    
    
    
    9.4
    %
    
    
    4.0
    %Total
    
    $
    617,247
    
    
    
    
    
    
    $
    597,286
    
    
    
    
    
    
    
    3.3
    %
 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. Our three and six month financial results for
2004 include $3.3 million of cost of service expenses from the Acquired
Businesses. Cost of service for the three and six months ended June 30, 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 reduced
settlements, a more expensive traffic mix and the inclusion of the Acquired
Businesses from the Closing Date through June 30, 2004. Based on our review and analyses, we believe that, on a pro forma basis,
cost of service as a percentage of revenue for the combined companies will
remain relatively stable. We originally estimated a potential benefit of
approximately $60.0 million in pro forma annualized cost of service expense
synergies for the combined companies if our integration efforts were
successful. We have made progress integrating the two companies and
are on plan to reach our synergy targets. Cost of service as a
percentage of revenue may be adversely impacted if we do not successfully
integrate the Acquired Businesses. 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,
business taxes and collection risks. Our three and six month financial results
for 2004 include $4.9 million of selling, operating and general expenses from
the Acquired Businesses. Selling, operating and general expense for the quarter
ended June 30, 2004 was $164.1 million or 59.0% of revenue compared to $165.0
million or 58.1% of revenue for the quarter ended June 30, 2003. Selling,
operating and general expense for the six months ended June 30, 2004 was $332.7
million or 61.7% of revenue compared to $331.3 million or 58.1% of revenue for
the six months ended June 30, 2003. The increase in selling, operating and
general expense as a percentage of revenue is due to the reduction of revenues
due to factors discussed above, with no offsetting direct
expense reductions. 17




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##### 



Based on our review and analyses we believe that, on a pro forma basis,
selling, operating and general expense for the combined company will increase
in absolute dollars with the addition the Acquired Businesses, but decrease as
a percentage of revenue by the end of 2004 as we integrate the organizations.
We originally estimated a potential benefit of approximately $100.0 million in
pro forma annualized selling, operating and general expense synergies for the
combined companies if our integration efforts were successful.

We have made progress integrating the two companies and are on plan to
reach our synergy targets.
This projection would be adversely affected if we
do not successfully integrate the Acquired Businesses in a timely manner. Depreciation and amortization. Our three and six month financial results
for 2004 include $3.1 million of depreciation and amortization expense based on
our early estimate of the fair value of the fixed assets and intangibles of the
Acquired Businesses. This estimate could change upon completion of the purchase
price allocation as required by SFAS 141 Business Combinations. Depreciation
expense was $22.8 million for the three months ended June 30, 2004, compared to
$20.7 million for the same period in 2003 and $42.0 million for the six months
ended June 30, 2004, compared to $40.5 million for the same period in 2003.
Amortization expense includes the amortization of fixed wireless licenses and
other intangible assets with definite useful lives. Total amortization expense
was $7.2 million for the second quarter of 2004 and $6.5 million for the second
quarter of 2003 and was $13.7 million in the first half of 2004 and $13.1
million in the first half of 2003. The increase in absolute dollars is due to
the inclusion of an estimate of the fair value of the fixed assets and
intangibles of the Acquired Businesses. As of June 30, 2004, we had
approximately $96.6 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 and the valuation
required by SFAS 141 will assign book values to intangibles not previously
recorded by Allegiance. Investment income (loss), net. Investment income (loss), net includes
interest income on investments and realized gains or losses on the sale of
investments. For the three months ended June 30, 2004 we reported a net
investment loss of $3.1 million while we reported net investment income of $5.1
million for the same period of 2003. Investment loss, net for the six months
ended June 30, 2004 was $1.7 million while we had net investment income of $8.3
million for the same period in 2003. The decrease in investment income is due
primarily to the recognized losses on the sale of marketable securities during
2004. 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 June 30, 2004 and 2003 was $5.8 million and
$11.7 million, respectively. Interest expense, net for the six months ended
June 30, 2004 and 2003 was $12.5 million and $21.4 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 June 30, 2004 and 2003, we
capitalized interest on construction costs of $1.0 million and $1.3 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. 18




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##### 



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 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 half of 2004, amortization expense would have increased by approximately
$2.2 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. 19




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##### 



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 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 credit and valuation allowances were
adequate as of June 30, 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 first half of 2004, our operating activities used net cash of
$54.7 million, our investing activities used net cash of $389.5 million
primarily to effect the Allegiance acquisition discussed under the heading Recent Events, and our
financing activities provided net cash of $2.0 million. Our balance of cash and
cash equivalents decreased to $36.3 million at June 30,
2004 from $478.6 million at
December 31, 2003. On August 6, 2004, XO completed a private placement of
$200 million shares of our 6% Class A Convertible Preferred Stock.
Affiliates of Carl C. Icahn, XOs chairman and owner of approximately 50.2%
 of XOs outstanding common stock, purchased 95% of the
preferred shares sold in the offering,
and an affiliate of Amalgamated Gadget, L.P., holder of approximately
9.4% of XOs outstanding common stock, purchased the remaining five percent.

 Proceeds of the Preferred Stock Offering
will be used for general working capital purposes and to fund
possible future acquisitions that would add additional scale and synergies to our business. Based on our review and analyses of the Acquired Businesses and giving
effect to the consummation of the Preferred Stock Offering, we believe

we will not be required to raise additional capital to fund our
current business plan, subject to the funding requirements of
possible future acquisitions. This projection could be negatively impacted if
we are unsuccessful 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, if unfavorable judicial,
regulatory, or legislative developments adversely impact our pricing and/or
cost of service under the heading if there are further downturns in the industry or the economy. We cannot predict at this time what impact the
regulatory changes discussed under the heading Recent
Events may have on our financial position
and projections. 20




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##### 



The outstanding balance on the Credit Facility as of June 30, 2004 was
$352.1 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.
In addition, the Company was required to achieve a minimum consolidated EBITDA
of not less than $10.0 million for the four-quarter period ended June 30, 2004.
As of August 3, 2004 the
lender has waived the applicability of the minimum EBITDA covenant for each quarter
from March 31, 2004 through December 31, 2005. Actual consolidated EBITDA loss for the four-quarter
period ended June 30, 2004 was $51.3 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. On June 23, 2004, as part of the closing of the
Allegiance acquisition, we obtained the waiver and consent of the lenders with
respect to the following covenants contained in the Credit Facility and subject
to our providing updated collateral descriptions and legal opinions not later
than August 16, 2004: (i) the $25.0 limitation on the incurrence of permitted
indebtedness, permitted equipment financings, acquired debt, and capital
leases; (ii) the limitation on the incurrence of additional liens with respect
to liens on the Allegiance assets that remained in place following the
effective date of the Allegiance plan of reorganization; (iii) the restriction
on making acquisitions in excess of $50.0 million; (iv) the requirement that
accounts acquired as part of the Allegiance acquisition be subject to control
agreements until August 16, 2004; and (v) any noncompliance arising from the
entering into of the Operating Agreement. Credit Risk Financial instruments that potentially subject us to concentrations of
credit risk consist primarily of trade receivables. Although our trade
receivables are geographically dispersed and include customers in many
different industries, a portion of our revenue is generated from services
provided to other telecommunications service providers. We believe that our
established allowances are adequate as of June 30, 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 a Regional
Bell Operating Company or 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 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. 21




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##### 



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 and constructed
our networks to take advantage of the provisions 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 and pro-competitive safeguards 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 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. 22




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##### 



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 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. 23




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
    
    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 set forth in section 252(b) of the
Telecom Act to modify interconnection agreements that are silent as to
implementation of changes in law. We have been in negotiations with 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 and any such increase could have a
material and adverse effect on our cost of services. The USTA Decision was stayed by the U.S. Court of Appeals for the D.C.
Circuit until June 16, 2004. XO has sought review of the USTA Decision at the
Supreme Court. The FCC will address the issues reversed and vacated by the USTA
Decision and develop new rules governing local competitors use of UNEs (New
UNE Rules). In August 2004, the FCC is expected to release the text of interim rules
(Interim UNE Rules) which the FCC has indicated will temporarily put in place
UNE rules while the FCC completes a more comprehensive proceeding to develop
the New UNE Rules. The Interim UNE Rules dictate that the RBOCs will make
available all UNEs at their current cost-based rates for a six month period
ending in March 2005. Beginning on a date to be determined in March 2005,
RBOCs can charge the current cost-based UNE rate plus an additional 15% for
those UNEs that were vacated by the USTA decision. Additionally, the RBOCs can
charge retail rates for new orders of UNEs vacated by the USTA decision
beginning on that same date in March 2005. Also, under the Interim UNE Rules,
beginning six months after the March 2005 date, the RBOCs can charge retail
rates for all UNEs vacated by the USTA decision. The FCC has indicated that it expects to complete New UNE Rules in March 2005 that allows the RBOC to increase UNE prices. If the New UNE
Rules are completed we believe that the FCC will again make 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. We believe that when the FCC completes its New
UNE rules, our access to the vast majority of unbundled loops that we use today
will remain available at UNE rates. If the FCC does not complete its New UNE Rules in a timely fashion and the
price increases contemplated by the Interim UNE Rules go into effect, 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. It is our understanding that 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. The incumbent carriers have many
petitions pending with the FCC that have not been acted on at this time. 24




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Incumbent carriers may seek to lobby the FCC to act on these petitions. 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 FCC rulemaking proceedings
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 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 FCC 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 25




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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 intercarrier compensation have been under review by the FCC since
2001. The FCC continues to consider a broad order reforming the intercarrier
compensation system and 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. On May 18, 2004,
the FCC issued an order in response to various petitions for reconsideration of
its competitive carrier access charge order. Among other things, the FCC
clarified that competitive carriers may only charge other carriers switched
access charge elements for the specific functions that they provide to them.
This decision could result in some reduction in the access charge revenue that
we can collect from interexchange carriers. 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 Universal Service fees. AT&T has filed another petition
asking the FCC to declare that certain of its enhanced prepaid calling card
services are exempt from access charges, but the FCC has not yet ruled on that
request. 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 also recently succeeded in convincing a federal court
in New York to set aside a decision of the New York PSC seeking to regulate the
companys services. Vonage provides VoIP origination services to its customers
and Vonage claims that it is therefore a provider of information services 26




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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. On February 12, 2004, the FCC initiated a rulemaking 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 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 Internet 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 originate. The FCCs reciprocal compensation decision was
reversed and remanded to the FCC for further consideration by the U.S. Court of
Appeals for the DC Circuit, but the rules were not vacated and remain effective while
the FCC reconsiders them. 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. If we are no longer able to
generate reciprocal compensation revenue, we believe that such a development
will have a material and adverse effect on our revenue. 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 could
substantially 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 could substantially raise our
costs for leasing unbundled network elements in the future. Broadband Wireless Auction. On July 28, 2004, the FCC conducted 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, were 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
broadband wireless service. 27




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Item 3. Quantitative and Qualitative Disclosures about Market Risk We had $352.1 million in secured loans as of June 30, 2004. Currently, we
do not pay cash interest on the loans under the Credit Facility and accrued
interest converts to principle ratably throughout the loan period. As interest
accrues at variable rates, our Credit Facility subjects us to interest rate
risks. Marketable
and other securities, available for sale, at June 30, 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. As of June 23, 2004, we assumed financial reporting control over the
Acquired Businesses from Allegiance. The Acquired Businesses books and records
are recorded on a different accounting system. We applied the same level of
internal controls over financial reporting on the Acquired Businesses as we
applied to our legacy businesses. 28




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PART II. OTHER INFORMATION 
 Item 1. 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 $21.5 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. 
 On July 23, 2004, we responded to the informal inquiry of the Securities and Exchange Commission regarding the public reporting of customers and
access lines in the telecommunications industry. We have included disclosure in part II, Item 5 addressing certain matters that we described in our response to the SEC inquiry. Item 2. Changes in Securities and Use of Proceeds The Board of Directors adopted a Certificate of Designations on August 5,
2004, designating 4.0 million shares of the 200.0 million shares of authorized
Preferred Stock of the Company as shares of 6% Class A Convertible Preferred
Stock, or the Class A Preferred Stock. The
Class A Preferred Stock ranks senior to the Companys common
stock. Holders of the Class A Preferred Stock are not entitled to receive
annual dividends, however, the liquidation preference of the Class A
Preferred Stock automatically increase at a rate of 1.5% each quarter
through the maturity date, January 15, 2010. The Company is required to redeem
the then-outstanding shares of Class A Preferred Stock on the maturity date at
100% of their aggregate liquidation preference, including compounded
accretion through that date, unless earlier redeemed or converted into
common stock. If all of the shares of Class A Preferred Stock were to remain
outstanding on the maturity date, and assuming the accretion of all of the
required increases to the liquidation preference therof, holders of the Class A
Preferred Stock would be entitled to the redemption of 59,868,561 shares of
common stock then issuable upon conversion of the Class A
Preferred Stock and would have an aggregate liquidation preference of
$276.6 million. The
Company may also, at its sole option, redeem the Class A Preferred Stock at any
time after the third anniversary of the issue date of such shares if the
average market price of the Companys common stock for the 20 days prior to
such redemption is equal to or greater than 250% of the conversion price of the
Class A Preferred Stock. Each holder of the Class A Preferred Stock shall be
entitled to one vote for each share of common stock then-issuable upon the
conversion of the shares of Class A Preferred Stock of such holder. The holders
of Class A Preferred Stock are initially entitled to convert any or all of their
outstanding shares of Class A Preferred Stock into shares of common stock at a
ratio of 10.82251 shares of common stock for each share of Class A Preferred
Stock. Both the conversion ratio and the voting power of each share of Class A
Preferred Stock will be automatically increased each quarter as the liquidation preference increases
at the rate of 1.5% each quarter. The holders of Class A Preferred Stock
also have anti-dilution protection in the event that the Company issues
shares of common stock at a price below the then-prevailing market price of the
Companys common stock. 
 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 June 30, 2004. 
 Item 5. Other Information On July 23, 2004, XO responded to the Securities and Exchange Commission
informal inquiry related to the methodology employed by telecommunications
companies to count customers and access lines. During the course of reviewing
its 2004 press releases and 2003 Annual Report on Form 10-K in connection with
preparing such response, XO determined to clarify certain disclosures made in
those press releases and filings, as follows. 29




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In a February 13, 2004 press release, XO reported that it anticipated
having a total of approximately 330,000 customers after the acquisition of
Allegiance Telecom, Inc. Subsequently, as reported in its 2003 Annual Report,
XO projected that it would have a total of approximately 250,000 customers as a
result of the acquisition of Allegiance. The disclosure contained in XOs 2003 Annual Report was
intended to correct the disclosure contained in the February 13, 2004 press
release. In connection with the estimates of the combined total of Allegiance and XO customers made in our February 2004 press
releases and our 2003 Annual Report on Form 10-K, we included shared web hosting and consumer dial-up customers of both businesses, along with the voice and high speed data customers
that we consider to be our core customers, since Allegiance customer counts were, at the time, available only on that combined basis.  As a result, these
combined customer totals were not comparable to the XO core customer counts disclosed in prior press releases. 
 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits  3.1(i)
    
    Certificate of Designations, adopted by XOs Board of
Directors and duly filed the Secretary of Sate of the State of
Delaware, setting forth the rights and preferences of the Class A
Preferred Stock.10.1
    
    Registration Rights Agreement, dated as of August 6,
2004, by and among XO Communications, Inc. and Amalgamated
Gadget, L.P.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 June 29, 2004, XO filed a Current Report on Form 8-K
announcing the closing of the acquisition of substantially all of
the assets of Allegiance Telecom, Inc. 30




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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: Aug 9, 2004
    
    By:
    
    /s/ William GarrahanWilliam GarrahanSenior Vice President and Acting Chief Financial Officer(Principal Financial Officer)
 31