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SECURITIES AND EXCHANGE COMMISSION  FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004
 OR [  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934FOR THE TRANSITION PERIOD FROM          TO COMMISSION FILE NUMBER: 000-28467 Z-TEL TECHNOLOGIES, INC.  DELAWARE
(State or other jurisdiction of
incorporation or organization)
    
    59-3501119
(I.R.S. Employer
Identification Number)
 601 SOUTH HARBOUR ISLAND BOULEVARD, SUITE 220
TAMPA, FLORIDA 33602
(813) 273-6261
(Address, including zip code, and
telephone number including area code, of
Registrants principal executive offices) SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK,
PAR VALUE $.01 PER SHARE, PREFERRED STOCK PURCHASE RIGHTS 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 in Rule 12B-2 of the Exchange Act) Yes [  ] No [X] The number of shares of the Registrants Common Stock outstanding as of
November 11, 2004 was approximately 41,711,821.




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TABLE OF CONTENTS PART IItem 1. Financial StatementsConsolidated Balance Sheets at September 30, 2004 and December 31, 2003
    
    
    3Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and 2003
    
    
    4Consolidated Changes in Stockholders Deficit for the nine months ended September 30, 2004
    
    
    5Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and 2003
    
    
    6Notes to Consolidated Financial Statements
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    17Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    27Item 4. Controls and Procedures
    
    
    28PART IIItem 1. Legal Proceedings
    
    
    28Item 6. Exhibits and Reports on Form 8-K
    
    
    30Signatures
    
    
    33Ex-3.1 Amended/Restated Certificate of IncorporationEx-3.2 Amended/Restated Bylaws of Z-TelEx-31.1 Section 302 CEO CertificationEx-31.2 Section 302 CFO CertificationEx-32.1 Section 906 CEO CertificationEx-32.2 Section 906 CFO Certification
  2




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS
 (UNAUDITED)
 September 30,
    
    December 31,2004
    
    2003AssetsCurrent assets:Cash and cash
equivalents
    
    $
    4,739
    
    
    $
    12,013Accounts receivable, net of allowance for doubtful
accounts of $10,086 and $13,804
    
    
    24,192
    
    
    
    24,600Prepaid expenses and other current assets
    
    
    2,605
    
    
    
    7,664Total current assets
    
    
    31,536
    
    
    
    44,277Property and equipment, net
    
    
    28,247
    
    
    
    39,069Intangible assets, net
    
    
    915
    
    
    
    2,287Other assets
    
    
    3,947
    
    
    
    3,820Total assets
    
    $
    64,645
    
    
    $
    89,453Liabilities, Mandatorily Redeemable Convertible Preferred
Stock and Stockholders DeficitCurrent liabilities:Accounts payable and accrued liabilities
    
    $
    57,305
    
    
    $
    59,230Deferred revenue
    
    
    7,750
    
    
    
    11,068Current portion of long-term debt
and capital lease obligations
    
    
    6,430
    
    
    
    5,017Asset based loan
    
    
    12,539
    
    
    
    Total current liabilities
    
    
    84,024
    
    
    
    75,315Long-term deferred revenue
    
    
    133
    
    
    
    361Long-term debt and capital lease obligations
    
    
    54
    
    
    
    514Total liabilities
    
    
    84,211
    
    
    
    76,190Mandatorily redeemable convertible preferred stock, $.01 par value;
50,000,000 shares authorized; 8,855,089 issued; 8,143,561 and 8,738,422
outstanding (aggregate liquidation value of $158,491 and $158,779)
    
    
    146,661
    
    
    
    144,282Commitments and contingencies (Notes 10 and 13)Stockholders deficit:Common stock, $.01 par value; 150,000,000
shares authorized; 39,126,893 and 36,186,686 shares issued;
38,751,343 and 35,845,136 outstanding
    
    
    391
    
    
    
    362Notes receivable from stockholders
    
    
    (3,870
    )
    
    
    (1,121
    )Unearned stock
compensation
    
    
    (525
    )
    
    
    Additional paid-in
capital
    
    
    188,880
    
    
    
    189,008Accumulated deficit
    
    
    (350,715
    )
    
    
    (318,880
    )Treasury stock, 341,550 shares at cost
    
    
    (388
    )
    
    
    (388
    )Total stockholders
deficit
    
    
    (166,227
    )
    
    
    (131,019
    )Total liabilities, mandatorily redeemable convertible preferred
stock and stockholders deficit
    
    $
    64,645
    
    
    $
    89,453
 The accompanying notes are an integral part of these consolidated financial statements. 3




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (UNAUDITED)
 For the Three Months Ended
    
    For the Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Revenues
    
    $
    60,912
    
    
    $
    82,716
    
    
    $
    193,176
    
    
    $
    214,691Operating expenses:Network operations, exclusive of depreciation and
amortization shown below
    
    
    30,427
    
    
    
    39,738
    
    
    
    95,699
    
    
    
    98,590Sales and marketing
    
    
    4,689
    
    
    
    3,589
    
    
    
    14,319
    
    
    
    14,700General and administrative
    
    
    27,274
    
    
    
    35,621
    
    
    
    92,776
    
    
    
    94,471Restructuring charge
    
    
    3,223
    
    
    
    
    
    
    
    4,029
    
    
    
    Depreciation and amortization
    
    
    5,032
    
    
    
    5,837
    
    
    
    15,452
    
    
    
    17,866Total operating expenses
    
    
    70,645
    
    
    
    84,785
    
    
    
    222,275
    
    
    
    225,627Operating loss
    
    
    (9,733
    )
    
    
    (2,069
    )
    
    
    (29,099
    )
    
    
    (10,936
    )Nonoperating income (expense):Interest and other income
    
    
    712
    
    
    
    494
    
    
    
    1,993
    
    
    
    1,658Interest and other expense
    
    
    (1,321
    )
    
    
    (978
    )
    
    
    (4,729
    )
    
    
    (2,388
    )Total nonoperating expense
    
    
    (609
    )
    
    
    (484
    )
    
    
    (2,736
    )
    
    
    (730
    )Net loss
    
    
    (10,342
    )
    
    
    (2,553
    )
    
    
    (31,835
    )
    
    
    (11,666
    )Less mandatorily redeemable convertible
preferred stock dividends and accretion
    
    
    (5,198
    )
    
    
    (3,707
    )
    
    
    (13,189
    )
    
    
    (12,611
    )Less deemed dividend related to beneficial
conversion feature
    
    
    (90
    )
    
    
    (46
    )
    
    
    (183
    )
    
    
    (138
    )Net loss attributable to common stockholders
    
    $
    (15,630
    )
    
    $
    (6,306
    )
    
    $
    (45,207
    )
    
    $
    (24,415
    )Weighted average common shares outstanding
    
    
    37,650,231
    
    
    
    35,368,759
    
    
    
    36,778,508
    
    
    
    35,340,089Basic and diluted net loss per share
    
    $
    (0.42
    )
    
    $
    (0.18
    )
    
    $
    (1.23
    )
    
    $
    (0.69
    )
 The accompanying notes are an integral part of these consolidated financial statements. 4




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY (DEFICIT)
AND COMPREHENSIVE INCOME
 (UNAUDITED)
 Common Stock
    
    Notes Receivable
    
    Unearned
    
    Additional
    
    
    
    
    
    
    
    
    
    Totalfrom
    
    Stock
    
    Paid-In
    
    Accumulated
    
    Treasury
    
    StockholdersShares
    
    Par Value
    
    Stockholders
    
    Compensation
    
    Capital
    
    Deficit
    
    Stock
    
    DeficitBalance, December 31, 2003
    
    
    35,845,136
    
    
    $
    362
    
    
    $
    (1,121
    )
    
    $
    
    
    
    $
    189,008
    
    
    $
    (318,880
    )
    
    $
    (388
    )
    
    $
    (131,019
    )Exercise of stock options
    
    
    372,480
    
    
    
    4
    
    
    
    
    
    
    
    
    
    
    
    486
    
    
    
    
    
    
    
    
    
    
    
    490Exercise of warrants
    
    
    37,714
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Issuance of common stock for settlement
    
    
    585,723
    
    
    
    6
    
    
    
    
    
    
    
    
    
    
    
    743
    
    
    
    
    
    
    
    
    
    
    
    749Issue common restricted stock
    
    
    365,000
    
    
    
    4
    
    
    
    
    
    
    
    (525
    )
    
    
    1,036
    
    
    
    
    
    
    
    
    
    
    
    515Conversion of mandatorily redeemable convertible preferred stock to common
    
    
    1,545,290
    
    
    
    15
    
    
    
    
    
    
    
    
    
    
    
    10,036
    
    
    
    
    
    
    
    
    
    
    
    10,051Repayment of notes receivable
    
    
    
    
    
    
    
    
    
    
    251
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    251Issuance of notes receivable (SipStorm)
    
    
    
    
    
    
    
    
    
    
    (3,000
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,000
    )Mandatorily redeemable convertible preferred stock dividends and accretion
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (12,429
    )
    
    
    
    
    
    
    
    
    
    
    (12,429
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (31,835
    )
    
    
    
    
    
    
    (31,835
    )Balance, September 30, 2004
    
    
    38,751,343
    
    
    $
    391
    
    
    $
    (3,870
    )
    
    $
    (525
    )
    
    $
    188,880
    
    
    $
    (350,715
    )
    
    $
    (388
    )
    
    $
    (166,227
    )
 The accompanying notes are an integral part of these consolidated financial statements 5




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (UNAUDITED)
 Nine Months EndedSeptember 30,2004
    
    2003Cash flows from operating activities:Net loss
    
    $
    (31,835
    )
    
    $
    (11,666
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    15,452
    
    
    
    17,866Provision for bad debts
    
    
    5,017
    
    
    
    12,009Expense charged for granting of restricted stock
    
    
    1,255
    
    
    
    (Gain) loss on sale of equipment
    
    
    
    
    
    
    44Expense charged for granting stock options
    
    
    
    
    
    
    123Change in operating assets and liabilities:(Increase) decrease in accounts receivable
    
    
    (4,549
    )
    
    
    (10,443
    )(Increase) decrease in prepaid expenses
    
    
    5,059
    
    
    
    670(Increase) decrease in other assets
    
    
    (167
    )
    
    
    781Increase (decrease) in accounts payable and accrued liabilities
    
    
    (1,925
    )
    
    
    1,912Increase (decrease) in deferred revenue
    
    
    (3,546
    )
    
    
    (1,258
    )Total adjustments
    
    
    16,596
    
    
    
    21,704Net cash (used in) provided by operating activities
    
    
    (15,239
    )
    
    
    10,038Cash flows from investing activities:Purchases of property and equipment
    
    
    (6,258
    )
    
    
    (7,731
    )Principal repayments received on notes receivable
    
    
    40
    
    
    
    27Net cash used in investing activities
    
    
    (6,218
    )
    
    
    (7,704
    )Cash flows from financing activities:Payments on long-term debt and capital lease obligations
    
    
    (4,047
    )
    
    
    (4,285
    )Payment of preferred stock dividends
    
    
    (3
    )
    
    
    (72
    )Principal repayments received on notes receivable issued for stock
    
    
    191
    
    
    
    468Proceeds from asset based loan
    
    
    12,539
    
    
    
    Proceeds from stand by credit facility
    
    
    5,000
    
    
    
    Proceeds from exercise of stock options and warrants
    
    
    503
    
    
    
    62Net cash provided by (used in) financing activities
    
    
    14,183
    
    
    
    (3,827
    )Net decrease in cash and cash equivalents
    
    
    (7,274
    )
    
    
    (1,493
    )Cash and cash equivalents, beginning of period
    
    
    12,013
    
    
    
    16,037Cash and cash equivalents, end of period
    
    $
    4,739
    
    
    $
    14,544
 The accompanying notes are an integral part of these consolidated financial statements 6




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (UNAUDITED)
 NOTE 1. NATURE OF BUSINESS (a) Description of Business Z-Tel Technologies, Inc. and
subsidiaries (Z-Tel, we or us)
is a provider of advanced, integrated telecommunications services targeted
to consumer (residential) and business subscribers. We offer local and long
distance telephone services in combination with enhanced communications
features accessible through the telephone, the Internet and certain personal
digital assistants. We offer our Z-LineHOME® and Z-LineBUSINESS® services in
forty-nine states. Our customers are primarily concentrated in ten states. We
also provide long-distance telecommunications services to
customers nationally. We introduced our wholesale services during the first quarter of 2002. This
service provides other companies with the opportunity to provide local,
long-distance and enhanced telephone service to their own residential and
business end user customers on a private label basis by utilizing our telephone
exchange services, enhanced services platform, infrastructure and back-office
operations. Historically we have utilized the unbundled network elements platform (UNE-P)
as the primary basis of delivering our services to our retail end users and end
users of our wholesale customers. Under UNE-P we utilize various unbundled
elements of the incumbent local exchange carriers to facilitate the delivery of
our services to end users. (b) Liquidity and capital resources We have a limited operating history and our operations are subject to certain
risks and uncertainties, particularly related to the evolution of the
regulatory environment, which impacts our access to and cost of the network
elements that we utilize to provide services to our customers, access to
adequate financing, and competition within the industry. We have incurred significant losses since our inception, resulting in an
accumulated deficit at September 30, 2004 of approximately $350.7 million. We
also had total liabilities recorded at September 30, 2004 of approximately
$84.2 million. We experienced positive cash flows from operations for the three
months ended March 31, 2004, but experienced negative cash flows from
operations for the past two quarters. The companys reported cash position declined on a net basis for the three
months and nine months ended September 30, 2004 by approximately $3.4 and $7.3
million respectively. At September 30, 2004, we had cash on hand of approximately $4.7 million. In
addition, we have an asset based loan facility with Textron Financial
Corporation (Textron), which provides us with up to $25 million to fund
operations. We were utilizing $12.5 million as of September 30, 2004, which
was approximately the maximum then available to us under the loan availability
calculation. We did not meet the fixed charge coverage ratio for the quarter
ended June 30, 2004 or September 30, 2004. All other financial covenants have
been met per our agreement with Textron. Per the agreement, Textron can
cancel the loan arrangement with us; however, we believe that it is unlikely
that Textron would take such measures. We are working to resolve this
issue without triggering a cancellation of the agreement. At current
collection rates, we will collect the total amount outstanding under
this facility in just over a month. We believe that Textron is
adequately secured under this facility. In addition, we have already
disclosed to Textron the cost saving measures recently implemented that would allow us to meet the fixed charge
coverage ratio required in future quarters. Textron has advised us that additional
interest at a rate of 300 basis points per annum will be effective as of
October 4, 2004. On August 24, 2004, we entered into a $15 million Standby Credit Facility
Agreement with The 1818 Fund III, L.P., which is one of a family of funds
managed by Brown Brothers Harriman. On August 25, 2004, we were advanced $5
million pursuant to the credit facility. Loans under the credit facility are
represented by a Senior Unsecured Promissory Note bearing interest at 9.95%
annually. The note matures March 31, 2006, but under certain circumstances may
be extended by the company until August, 2006. As of the quarter ended
September 2004, we did not meet a cross-default covenant
due to the non-compliance with the Textron asset based loan facility.
Per the standby credit facility agreement, this could trigger an
immediate demand of payment upon notice by The 1818 Fund. Upon
discussions with The 1818 Fund a waiver was signed that indicates
they will not require immediate payment within the next 90 days. This
loan has been reclassified to short term on the balance sheet. A Nasdaq Listing
Qualifications Hearing Panel has granted us a temporary exception
from shareholders' equity/$35 million market value of listed
securities/net income and minimum bid price requirements for
continued listing on The Nasdaq SmallCap Market, subject to certain
conditions, including submission of documentation indicating
compliance with all the requirements for continued listing on the
SmallCap Market before expiration of the exception. The exception
expires December 1, 2004. If Z-Tel meets the terms of the exception,
our shares will continue to be listed on the SmallCap Market. We have
plans in place, including a tender offer to our preferred
shareholders and a reverse stock split, to meet the terms of the
exception, but we cannot assure the success of those plans.
Commencing Monday November 8, 2004 and for the duration of the
exception, the trading symbol for Z-Tels shares will be
ZTELC. As a result of these current negative
impacts there may be a significant doubt about our ability to continue as a
going concern. (c) Change of Management On August 25, 2004, then president and chief executive officer and Board member
D. Gregory Smith and then chief technology officer and Board member Charles W.
McDonough resigned from their positions to found a new company. Messrs. Smith
and McDonough intend to pursue certain product and business initiatives that
were under development in our Atlanta technology center at 7




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the time of their
resignation. Z-Tels Board of Directors authorized us to negotiate an
agreement with Messrs. Smith and McDonough defining the specific activities,
assets and personnel to be transferred to the new company and other terms of
the transaction. The Board has appointed Trey Davis as Acting Chief Executive
Officer and Executive Vice President. Mr. Davis will retain his present duties
as Chief Financial Officer. The Board also appointed Frank Grillo as Acting
Chief Operating Officer and Executive Vice President. Subsequent to the change of management, several actions have been initiated to
improve the overall operating cash flow of the
company. The most significant was a change in our direction that reduced
the focus on enhanced services development and increased the focus on building
our customer base, revenue streams and continuing VoIP deployment plans. This
involved a reduction in force that occurred in September 2004 to
help align our cost structure with our new direction. NOTE 2. BASIS OF PRESENTATION The accompanying unaudited consolidated financial statements have been prepared
by us in accordance with accounting principles generally accepted in the United
States of America for interim financial information and are in the form
prescribed by the Securities and Exchange Commissions (SEC) instructions to
Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include
all of the information and footnotes for complete financial statements as
required by accounting principles generally accepted in the United States of
America. The interim unaudited financial statements should be read in
conjunction with our audited financial statements as of and for the year ended
December 31, 2003, included in our Annual Report on Form 10-K filed with the
SEC on March 30, 2004. In the opinion of management, all adjustments considered
necessary for a fair presentation have been included. Operating results for the
nine months ended September 30, 2004 are not necessarily indicative of the
results that may be expected for the year ending December 31, 2004. (a) Reclassification Certain amounts in the consolidated statements of operations for the three and
nine months ended September 30, 2003 have been reclassified to conform to the
presentation for the three and nine months ended September 30, 2004. NOTE 3. SIGNIFICANT ACCOUNTING POLICIES AND RECENT ACCOUNTING PRONOUNCEMENTS (a) Significant Accounting Policies Our significant accounting policies are included in the Notes to Consolidated
Financial Statements in our Annual Report on Form 10-K for the year ended
December 31, 2003. (b) Stock-based compensation We account for our stock option plans in accordance with the provisions of
Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock
Issued to Employees, and related interpretations and comply with the
disclosure provisions of Statements of Financial Accounting Standards (SFAS)
No. 123, Accounting for Stock-Based Compensation and SFAS No. 148 Accounting
for Stock-Based Compensation  Transition and Disclosure, an Amendment of SFAS
123, Accounting for Stock-Based Compensation. As such, we record compensation
expense on the date of grant only if the current market price of the underlying
stock exceeds the exercise price. Additionally, if a modification is made to
an existing grant, any related compensation expense is calculated on the date
both parties accept the modification and recorded on the date the modification
becomes effective. The following table illustrates, in accordance with the provisions of SFAS No.
148, the effect on net loss and earnings per share if we had applied the fair
value recognition provisions of SFAS No. 123 to stock-based employee
compensation (encompassing the impacts of both stock option and restricted
stock grants). For the three months ended
    
    For the nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Net loss attributable to common stockholders, as reported
    
    $
    (15,630
    )
    
    $
    (6,306
    )
    
    $
    (45,207
    )
    
    $
    (24,415
    )Add: Stock based compensation included in net loss
    
    
    371
    
    
    
    
    
    
    
    516
    
    
    
    Deduct: Total stock based employee compensation determined
under the fair value based method for all awards
    
    
    (744
    )
    
    
    (791
    )
    
    
    (2,543
    )
    
    
    (5,188
    )Net loss attributable to common stockholders, pro forma
    
    $
    (16,003
    )
    
    $
    (7,097
    )
    
    $
    (47,234
    )
    
    $
    (29,603
    )Basic and Diluted Net LossPer Common ShareAs reported
    
    $
    (0.42
    )
    
    $
    (0.18
    )
    
    $
    (1.23
    )
    
    $
    (0.69
    )Pro forma
    
    $
    (0.43
    )
    
    $
    (0.20
    )
    
    $
    (1.28
    )
    
    $
    (0.84
    )
 8




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We calculated the fair value of each grant on the date of grant using the
Black-Scholes option pricing model. In addition to there being no payments of
dividends on our common stock, the following assumptions were used for each
respective period: For the three months
    
    For the nine monthsended September 30,
    
    ended September 30,2004
    
    2003
    
    2004
    
    2003Discount Rate
    
    
    N.A.
    
    
    
    2.5
    %
    
    
    3.1
    %
    
    
    2.6
    %Volatility
    
    
    N.A.
    
    
    
    97.3
    %
    
    
    98.3
    %
    
    
    97.0
    %Average Option Expected Life
    
    5 years
    
    5 years
    
    5 years
    
    5 years
 There were no stock option grants in the third quarter of 2004 so the discount
rate and volatility percentage are shown as Not Applicable (N.A).
Incremental shares of common stock equivalents are not included in the
calculation of net loss per share as the inclusion of such equivalents would be
anti-dilutive. (c) Recent Accounting Pronouncements In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on
EITF Issue No. 03-6, Participating Securities and the Two-Class Method under
Financial Accounting Standards Board (FASB) Statement No. 128, Earnings per
Share. EITF 03-6 clarifies what constitutes a participating security and
provides further guidance in applying the two-class method of calculating
earnings per share (EPS). The consensus reached by the EITF in this Issue is
effective for reporting periods beginning after March 31, 2004. We adopted
EITF Issue No. 03-06 during the quarter ended June 30, 2004. There was no
impact of the adoption on the computation of EPS, as the effect is
anti-dilutive. In periods of net income, we will utilize the two-class method
of computing EPS. NOTE 4. WHOLESALE SERVICES In February 2003, we executed an agreement providing for the resale of our
local wire line telecommunications services and for the provisioning of
ancillary services with Sprint. Under this agreement, we provide Sprint access
to our Web-integrated, enhanced communications platform and operational support
systems. We are the primary obligor for certain underlying expenses that are
incorporated into our pricing in connection with the agreement and therefore,
are recording revenues using a gross presentation. This accounting method
results in revenue being recorded for certain per-line, per-minute, and direct
costs and the corresponding expenses being recorded in the appropriate operating
expense line. As a result of this accounting treatment, increases or decreases
in pricing or volume that impact certain direct costs that are incurred in
connection with this agreement would have little or no impact on net income, as
the amount is recorded in an equivalent amount in both revenue and expense. Our
wholesale services agreement with Sprint is non-exclusive in nature. As of September 30, 2004, under our contract with Sprint, we had approximately
$1.9 million of deferred revenue recorded, of which $0.1 million is recorded as
long-term deferred revenue. Sprint revenues were 30.9% of total revenues for the three months ended
September 30, 2004, as compared to 27.5% for the prior year period. Sprint
revenues were 32.3% of total revenues for the nine months ended September 30,
2004, as compared to 16.3% for the prior year period. NOTE 5. ACCOUNTS RECEIVABLE AGREEMENT In April 2004, we signed a three-year asset based loan facility with Textron
Financial Corporation (Textron). This agreement provides us with an
availability to borrow up to $25 million at a 6% interest rate. Our overall
availability is based on the eligibility of our accounts receivable, subject to
certain limitations and advance rates. The new asset based loan facility is
expected to provide us with additional liquidity because it includes
residential, business and wholesale accounts receivable while our prior
arrangement with RFC Capital Corporation (RFC) only included certain portions
of our accounts receivable. We believe that this new agreement may provide us
with additional working capital financing flexibility to help facilitate the
growth of our business, to the extent growth materializes in our business. This agreement has three primary quarterly financial covenants: a fixed charge
coverage ratio, accounts receivable turnover requirement and an unfunded
capital expenditures cap. The ratio requirements begin low and increase each
quarter through December 31, 2004 and then remain constant. We did not meet
the fixed charge coverage ratio for the quarters ended June 30, 2004 and
September 30, 2004. All other financial covenants have been met per our
agreement with Textron. Per the agreement, Textron can cancel the loan
arrangement with us; however, we believe that it is unlikely that Textron would
take such measures. At current collection rates, we will collect the total
amount outstanding under this facility in just over a month. We believe that
Textron is adequately secured under this facility. Textron notified us on
October 1, 2004 that they would be charging an additional interest rate of 300
basis points starting on October 4, 2004 due to the fixed charge coverage ratio
not being met. There are also disposition of asset limitations, limits on change of control,
certain notification requirements, change in management limitations and certain
other restrictions. There are also certain limitations on our ability to access
subordinated debt within the 9




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confines of the agreement; however, we believe the
agreement will provide us with flexibility for future debt financing
alternatives. Under the amended asset based loan structure with Textron, we
had an outstanding loan balance to Textron of approximately $12.5 million at
September 30, 2004. NOTE 6. STANDBY CREDIT FACILITY On August 24, 2004, we entered into a $15 million Standby Credit Facility
Agreement with The 1818 Fund III, L.P. (The 1818 Fund), which is one of a
family of funds managed by Brown Brothers Harriman. On August 25, 2004, we were
advanced $5 million pursuant to the credit facility. Loans under the credit
facility are represented by a Senior Unsecured Promissory Note bearing interest
at 9.95% annually. The note matures March 31, 2006, but under certain
circumstances may be extended by the company until August, 2006. As of September 2004, we did not meet a cross-default
covenant due to the non-compliance with the Textron asset based loan facility.
Per the standby credit facility agreement, this could trigger an immediate
demand of payment upon notice by The 1818 Fund. Upon discussions with The
1818 Fund, a waiver was signed that indicates they will not require immediate
payment within the next 90 days. This loan has been reclassified to short
term on the balance sheet. NOTE 7. INTANGIBLE ASSETS In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, we
reassessed the expected useful lives of existing intangible assets. This
reassessment resulted in no changes to the expected useful lives of our
intangible assets. We only have one intangible asset as of September 30, 2004. Summarized below is our only recorded intangible asset that will continue to be
amortized under SFAS No. 142. It is a customer list that was acquired in April
of 2000 in connection with our acquisition of Touch 1 Communications, Inc.
(Touch1). September 30, 2004Carrying
    
    Accumulated
    
    Net IntangibleAmount
    
    Amortization
    
    AssetsIntangible asset subject to amortization:Customer list  standalone 1+
    
    $
    9,145
    
    
    $
    8,230
    
    
    $
    915
 The following table presents current and expected amortization expense of the
existing intangible asset as of September 30, 2004 for each of the following
periods: Aggregate amortization expense:For the nine months ended September 30, 2004
    
    $
    1,372Expected amortization expense for the remainder of 2004
    
    $
    457Expected amortization expense for the year ending December 31, 2005
    
    $
    458
 NOTE 8. RESTRUCTURING CHARGES On May 17, 2004, a termination agreement was signed for our New York office
lease on which we had previously recorded a lease abandonment charge. The settlement included a $90,000 payment in
lieu of the remaining balance of $299,545 previously recorded as a lease
abandonment charge. The settlement payment consisted of a one-time payment of
$30,000, paid at the time of agreement, and three promissory notes of $20,000
payable on November 1, 2004, May 1, 2005 and August 30, 2005, respectively.
All other expenses associated with this restructuring have been paid in full. In June 2004, we approved and implemented a restructuring to improve our future
cash flows and operating earnings. The restructuring included a reduction in
work force. In accordance with SFAS No. 146 Accounting for Costs Associated
with Exit or Disposal Activities the restructuring costs were considered a
One-Time Termination Benefit and as such we recognized the restructuring
costs as a liability at the communication date of June 8, 2004. The
restructuring charge included termination benefits in connection with the
reduction in force of 102 employees. The total charge taken in the second
quarter of 2004 was $0.8 million of which approximately $40,000 was paid in the
second quarter. The majority of the remainder of termination benefits were
paid in full at the end of August 2004. In September 2004, we approved and implemented a restructuring based on the
change in management that occurred on August 25, 2004 and the subsequent change
in business focus. The restructuring included a reduction in force of 152
employees and a write-off of certain assets. This restructuring is expected to
reduce payroll expense by 25 percent. In accordance with SFAS No. 146 10




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Accounting for Costs Associated with Exit or Disposal Activities the
restructuring costs were considered a One-Time Termination Benefit and as
such we recognized the restructuring costs as a liability at the communication
date of September 1, 2004. The total charge taken in the third quarter of
2004 was approximately $3.2 million. SFAS No. 146 replaces the EITF 94-3, Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity, used with
the 2002 restructuring plan. The following table shows the restructuring charges and related accruals
recognized under the plans and the effect on our consolidated financial
position: Employee
    
    Asset
    
    Lease
    
    LeaseTermination
    
    Retirement
    
    Settlement
    
    AbandonmentBenefits
    
    Costs
    
    Costs
    
    Costs
    
    TotalBalance at January 1, 2002
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Plan Charges
    
    
    913
    
    
    
    
    
    
    
    325
    
    
    
    623
    
    
    
    1,861Cash paid
    
    
    (913
    )
    
    
    
    
    
    
    (325
    )
    
    
    (72
    )
    
    
    (1,310
    )Balance at December 31, 2002
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    551
    
    
    
    551Cash paid
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (200
    )
    
    
    (200
    )Balance at December 31, 2003
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    351
    
    
    
    351Plan Charges
    
    
    3,755
    
    
    
    40
    
    
    
    
    
    
    
    235
    
    
    
    4,030Lease Termination Settlement
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (210
    )
    
    
    (210
    )Cash paid
    
    
    (1,375
    )
    
    
    
    
    
    
    
    
    
    
    (81
    )
    
    
    (1,456
    )Balance at September 30, 2004
    
    $
    2,380
    
    
    $
    40
    
    
    $
    
    
    
    $
    295
    
    
    $
    2,715
 NOTE 9. STOCK BASED COMPENSATION (a) Stock Options For employee stock options, the FASB issued SFAS No. 123, Accounting for
Stock-Based Compensation, requiring entities to recognize as an expense, over
the vesting period, the fair value of the options or utilize the accounting for
employee stock options used under APB Opinion No. 25. We apply the provisions
of APB Opinion No. 25 and consequently recognize compensation expense over the
vesting period for grants made to employees and directors only if, on the
measurement date, the market price of the underlying stock exceeds the exercise
price. We do provide the pro forma net loss and earnings per share disclosures
as required under SFAS No. 123 for grants made as if the fair value method
defined in SFAS No. 123 had been applied. We recognize expense over the vesting
period of the grants made to non-employees based on utilizing the Black-Scholes
stock valuation model to calculate the value of the option on the measurement
date. (b) Restricted Stock In March and April 2004, our compensation committee approved the granting of
403,000 shares of restricted stock with a then approximate value of $1.1
million to certain executive officers and key employees. Consideration paid for
this stock is par value of $0.01 and continued employment. We apply the
provisions of APB Opinion No. 25 and consequently recognize compensation
expense over the vesting period for grants made to employees. NOTE 10. COMMITMENTS AND CONTINGENCIES We have disputed billings and access charges from certain inter-exchange
carriers (IXCs) and incumbent local exchange carriers (ILECs). We contend
that these billings are not in accordance with the interconnection, service
level, or tariff agreements between us and certain IXCs and ILECs. We have not
paid these disputed amounts and, while we can make no guarantee, management
believes that we will prevail or mostly prevail in these disputes. At September
30, 2004, the total disputed amounts were approximately $19.0 million. 11




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NOTE 11. RELATED PARTY TRANSACTIONS On September 29, 2004 we signed an agreement with SipStorm, Inc., a company
formed by our former Chief Executive officer, D. Gregory Smith, and former
Chief Technology Officer, Charles McDonough. Under this agreement we have
transferred selected computer hardware, software and intellectual property
rights to SipStorm. These non-core assets are mainly related to our second
generation enhanced service products. SipStorm will continue development of
these applications and will provide us with access to the developed product
over the course of the next 15 months. Relative to the purchase, SipStorm has
assumed responsibility for certain accounts payable, future maintenance
payments and provided a promissory note in the amount of $2.8 million. The
promissory note is secured by shares of our preferred stock held by
Messrs.
Smith and McDonough. In the third quarter, we wrote-off approximately $1.9
million in outstanding accounts payable, $2.7 million in
capitalized software
and $0.4 million in computer hardware as a result of this transaction and the
discontinued operations that resulted from management's change in
business focus. The agreement reached with
SipStorm is a related party transaction as Mr. D.
Gregory Smith, former Z-Tel Chief Executive Officer and company founder of
SipStorm, still has a substantial investment in Z-Tel with
approximately 17% of
common shares outstanding, 11% of Series D preferred stock and 16% of Series G
preferred stock. All the Series D and G preferred stock is pledged as
collateral for the promissory note mentioned in Note 10 for the SipStorm sale. NOTE 12. COMPUTATION OF NET LOSS PER SHARE Basic net loss per share is computed by dividing net loss attributable to
common stockholders by the weighted average number of
common shares outstanding during the period. Incremental shares of common stock
equivalents are not included in the calculation of net loss per share as the
inclusion of such equivalents would be anti-dilutive. Net loss per share is calculated as follows: For the three months ended
    
    For the nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Basic and diluted net loss per share:Net loss
    
    $
    (10,342
    )
    
    $
    (2,553
    )
    
    $
    (31,835
    )
    
    $
    (11,666
    )Less mandatorily redeemable convertible preferred
stock dividends and accretion
    
    
    (5,198
    )
    
    
    (3,707
    )
    
    
    (13,189
    )
    
    
    (12,611
    )Less deemed dividend related to beneficial conversion feature
    
    
    (90
    )
    
    
    (46
    )
    
    
    (183
    )
    
    
    (138
    )Net loss attributable to common stockholders
    
    $
    (15,630
    )
    
    $
    (6,306
    )
    
    $
    (45,207
    )
    
    $
    (24,415
    )Weighted average common shares outstanding
    
    
    37,650,231
    
    
    
    35,368,759
    
    
    
    36,778,508
    
    
    
    35,340,089Basic and diluted net loss per share
    
    $
    (0.42
    )
    
    $
    (0.18
    )
    
    $
    (1.23
    )
    
    $
    (0.69
    )
 Basic and diluted net loss per share are the same for each of the periods
presented. The following table includes potentially dilutive items that were
not included in the computation of diluted net loss per share for all periods
presented because to do so would be anti-dilutive in each case: Nine Months endedSeptember 30,2004
    
    2003Unexercised stock options
    
    
    11,633,836
    
    
    
    13,803,391Unexercised warrants
    
    
    9,871,284
    
    
    
    10,580,985Mandatorily redeemable preferred stock
convertible into common shares
    
    
    36,276,265
    
    
    
    30,454,848Total potentially dilutive shares of common
stock equivalents
    
    
    57,781,385
    
    
    
    54,839,224
 NOTE 13. LEGAL AND REGULATORY PROCEEDINGS During June and July 2001, three separate class action lawsuits were filed
against us, certain of our current and former directors and officers (the
D&Os) and firms engaged in the underwriting (the Underwriters) of our
initial public offering of stock (the IPO). The lawsuits, along with
approximately 310 other similar lawsuits filed against other issuers arising
out of initial public offering allocations, have been assigned to a Judge in
the United States District Court for the Southern District of New York for
pretrial coordination. The lawsuits against us have been consolidated into a
single action. A consolidated amended complaint was filed on April 20, 2002. A
Second Corrected Amended Complaint (the Amended Complaint), which is the
operative complaint, was filed on July 12, 2002. The Amended Complaint is based on the allegations that our registration
statement on Form S-1, filed with the Securities and Exchange Commission
(SEC) in connection with the IPO, contained untrue statements of material
fact and omitted to state facts necessary to make the statements made not
misleading by failing to disclose that the underwriters allegedly had received
additional, excessive and undisclosed commissions from, and allegedly had
entered into unlawful tie-in and other arrangements with, certain customers to
whom they allocated shares in the IPO. The plaintiffs in the Amended Complaint
assert claims against us and the D&Os pursuant to Section 11 of the Securities
Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule
10b-5 promulgated by the SEC there under. The plaintiffs in the Amended
Complaint assert claims against the D&Os pursuant to Sections 11 and 15 of the
Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange
Act of 1934 and Rule 10b-5 promulgated by the SEC there under. The plaintiffs
seek an undisclosed amount of damages, as well as pre-judgment and
post-judgment interest, costs and expenses, including attorneys fees, experts
fees and other costs and disbursements. Initial discovery has 12




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begun. We believe
we are entitled to indemnification from our Underwriters. A settlement has been reached by the respective lawyers for the plaintiffs, the
issuers and insurers of the issuers. The principal terms of the proposed
settlement are (i) a release of all claims against the issuers and their
officers and directors, (ii) the assignment by the issuers to the plaintiffs of
certain claims the issuers may have against the Underwriters and (iii) an
undertaking by the insurers to ensure the plaintiffs receive not less than $1
billion in connection with claims against the Underwriters. Hence, under the
terms of the settlement our financial obligations will likely be covered by
insurance. Our board of directors has approved the settlement. To be binding,
the settlement must be executed by the parties and thereafter submitted to and
approved by the court. The settlement will not be binding upon any plaintiffs
electing to opt-out of the settlement. The Metropolitan Government of Nashville and Davidson County, Tennessee, on
behalf of the Metropolitan Nashville Employee Benefit Board (collectively
Metro Nashville), filed the foregoing lawsuit against us on September 20,
2002. The lawsuit asserted
claims under Delaware Law, the Uniform Commercial Code, and state law and
sought actual damages of $18 million, punitive damages of $18 million,
interest, and court costs. Metro Nashville alleged that we wrongfully and
improperly delayed delivery of a stock certificate, preventing Metro Nashville
from selling or taking other steps to protect the value of their shares while
the market price of our stock declined significantly. On May 18, 2004, we
entered into a settlement agreement whereby we paid Metro Nashville $800,000 in
cash and delivered to Metro Nashville 585,723 shares of our common stock. We
also agreed to file on Metro Nashvilles behalf a registration statement on
Form S-3 allowing resale of those shares. That registration statement became
effective July 15, 2004. On October 9, 2003, Z-Tel Communications, Inc., our wholly-owned subsidiary
corporation, filed a lawsuit against SBC Communications, Inc. and several of
its subsidiaries (collectively, SBC) in federal court in Texas, where both
SBC and Z-Tel do business. The lawsuit alleges SBCs violation of the federal
antitrust laws, the Racketeering Influenced Corrupt Organizations Act (RICO),
the Lanham Act, and other federal and state laws. The complaint seeks damages
and an injunction against SBC. On November 20, 2003, SBC filed a motion to
dismiss the complaint. On August 6, 2004, the court denied in part, and
granted in part, SBCs motion to dismiss the complaint, allowing certain
antitrust, RICO, and Lanham Act claims to proceed. Although we intend to pursue
our claims against SBC vigorously, we cannot predict the outcome of this
litigation with any certainty. Susan Schad, on behalf of herself and all others similarly situated, filed a
class action lawsuit against Z-Tel Communications, Inc., our wholly-owned
subsidiary corporation, on May 13, 2004. The lawsuit alleges that our
subsidiary has engaged in a pattern and practice of deceiving consumers into
paying amounts in excess of their monthly rates by deceptively labeling certain
line-item charges as government-mandated taxes or fees when in fact they were
not. The complaint seeks to certify a class of plaintiffs consisting of all
persons or entities who contracted with Z-Tel for telecommunications services
and were billed for particular taxes or regulatory fees. The complaint asserts
a claim under the Illinois Consumer Fraud and Deceptive Businesses Practices
Act and seeks unspecified damages, attorneys fees and court costs. On June
22, 2004, our subsidiary filed a notice of removal in the state circuit court
action, removing the case to the federal district court for the Northern
District of Illinois, Eastern Division, C.A. No. 4 C 4187. On July 26, 2004,
Plaintiff filed a motion to remand the case to the state circuit court.
Plaintiffs motion is still pending. Although we believe the plaintiffs
allegations are without merit and intend to defend the lawsuit vigorously, we
cannot predict the outcome of this litigation with any certainty. The availability to Z-Tel of unbundled network elements pursuant to section 251
of the Telecommunications Act of 1996 is currently subject to considerable
legal uncertainty and litigation. In particular, our access to unbundled
analog switching  a key component of the Unbundled Network Element Platform
combination of elements, or UNE-P  is the subject of litigation by our Bell
company competitors and other incumbent local exchange carriers. In 2003, in
the Triennial Review Order, the Federal Communications Commission (FCC) ruled
that entrants like Z-Tel would be able to purchase analog switching and
dedicated transport on an unbundled basis, subject to state-by-state review of
whether such unbundling was needed in their states. Carriers were involved in
those state-by-state proceedings when, on March 2, 2004, the D.C. Circuit Court
of Appeals overturned the FCCs decision as an improper delegation of authority
to state public utility commissions. See Report and Order and Order on Remand
and Further Notice of Proposed Rulemaking, Review of Section 251 Unbundling
Obligations of Incumbent Local Exchange Carriers, 18 FCC Rcd 16978 (2003)
(Triennial Review Order), revd in part and remanded, United States Telecom
Assn v. FCC, Nos. 00-1012, 00-1015, 03-1310 et al. (D.C. Cir. March 2, 2004)
(USTA II). The D.C. Circuit ordered that the unbundled transport and switching rules be
vacated as of June 15, 2004. Both the U.S. Solicitor General and the FCC
declined to appeal the case, and U.S. Supreme Court Justice William Rehnquist
denied the request of Z-Tel and other CLECs for a stay of the decision. Z-Tel
and a number of other competitive local exchange carriers filed a Petition for
Writ of Certiorari before the United States Supreme Court, as did the State of
California and the California Public Utilities Commission. Those appeals of
the USTA II litigation were denied by when the Supreme Court denied certiorari
on October 12, 2004. On June 16, 2004, the D.C. Circuit decision in USTA II became effective and the
FCCs unbundling rules that were the subject of the appeal were vacated.
Shortly thereafter, the largest four Bell operating companies (Verizon,
BellSouth, SBC and Qwest) made several statements about their intent as to
whether to continue to provide CLECs like Z-Tel access to unbundled switching
(a critical component of the Unbundled Network Element Platform, or UNE-P) in
certain circumstances, high-capacity loops, dedicated transport, and EELs. To
varying degrees, we depend upon access to UNE-P, high capacity loops, transport
and EELs to provide our services, including our new VoIP services. On August 20, 2004, the Commission issued an Order and Notice of Proposed
Rulemaking (NPRM) implementing interim rules in response to the D.C.
Circuits vacatur in United States Telecom Assn v. FCCand seeking comment on
permanent unbundling rules to 13




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implement obligations under section 251(c)(3) of
the Act. The Commission Order set forth a two-phase plan to govern the
provision of unbundled network elements (UNEs) while the Commission considers
permanent rules. Under the first phase of the interim plan, ILECs must
continue to make available dedicated transport, mass market switching and
enterprise loops in accordance with the rates, terms and conditions set forth
in their interconnection agreements as of June 15, 2004. Under the second
phase of the plan, ILECs would be required for an additional six months to
continue to provide such UNEs to requesting carriers for the embedded customer
base subject to the rate increases specified in the Commissions Order. In its
NPRM, the Commission sought comment on how to establish sustainable new
unbundling rules in response to the D.C. Circuits decision. Specifically, the
Commission sought comment on how various ILEC offerings and obligations fit
into the unbundling framework, how best to define the relevant markets to
develop unbundling rules and how to make determinations on access to individual
network elements. In conjunction with CompTel and Pace Industry Associations,
Z-Tel has participated in responding to the FCCs request for comments in this
proceeding. Z-Tel plans to remain active in these FCC proceedings, as it was
during the Triennial Review proceeding in 2002 and 2003. Several state
commissions are also considering options as to whether to impose unbundling
obligations under state law, in the absence of federal requirements. Z-Tel
intends to participate in those state proceedings to the extent that such state
policies could have a material impact on Z-Tels operations. On August 23, 2004, USTA, Qwest and Verizon filed a petition for mandamus at
the D.C. Circuit. Among other things, they asked that the court retain
jurisdiction of any TRO related cases, and that the Court order that the
interim rules be vacated if the FCC does not produce impairment findings by
December 31st. The FCC responded and indicated that it plans to finish the
Triennial rules by year-end. The D.C. Circuit has now issued an order to hold
consideration of the mandamus petition pending further order of the court.
Parties must file motions to govern further proceedings by January 4th. In
effect, this gives the FCC the opportunity to finish the rules by year-end
without action by the court, but leaves the door open for the court to act if
the FCC does not complete the job. By holding this motion in abeyance rather
than rejecting it, the court has made it easier for itself to retain
jurisdiction of the case. While it is to be expected that appeals of the final
rules will be filed in various appeals circuits, this open mandamus petition
makes it likely that they will be heard at the D.C. Circuit. That is
significant, because it means that the final rules will be judged under the
D.C. Circuits interpretation of the Telecom Act. Given the D.C. Circuits
ruling on the TRO and statements made by various commissioners at the time the
interim rules were issued and since then, it is our expectation that the FCC
will produce final rules on at least some of the Triennial issues by
year end. If the FCC does not write adequate final UNE rules or if state commissions do
not take action under state law, there could be an immediate, significant,
adverse and material impact upon our business. ILECs might utilize the
reversal of the unbundling rules to deny us access to their local networks or
sharply increase the price of that access. We believe that in the event the
vacated unbundling rules are not replaced by either the FCC or the state
commissions, we have interconnection agreements with our principal ILEC
suppliers (including Verizon, SBC, BellSouth and Qwest) that will permit us to
obtain access to local network elements during the intervening time period.
However, several of these Bell companies have provided us notice that they wish
to renegotiate those agreements to take into account the vacating of the
unbundling rules. Negotiation and arbitration of those terms is likely to take
some time and could result in uncertainty as to our legal rights in the
interim. It is also possible that while those negotiations are pending, any or
all of those incumbent local telephone company suppliers will refuse to abide
by the terms of the existing agreements or terminate those agreements outright.
Z-Tel is currently evaluating all of its legal options to ensure that we can
continue to meet the needs of our existing and future customers. We believe we
have legal rights to purchase these elements pursuant to state law and under
section 271 of the telecommunications Act of 1996, which the FCC has ruled to
be a separate, alternative legal requirement for Bell companies to provide
wholesale network access. However, enforcing those rights could be costly and
require simultaneous litigation throughout our multi-state service area, and
the final result of such litigation may or may not assure us of these
alternative means of access. Therefore, there is considerable uncertainty about the rates, terms and
conditions by which we will be able to access the local networks of the ILECs
at this time. This legal uncertainty can harm our business and could affect
our ability to secure financing for our ongoing operations and our investment
in new facilities and equipment. The uncertainty also harms our business by
making it more difficult to sell our services. If ILECs attempt to impose
wholesale price increases and regulators or courts do not act to stop such
action, it may become uneconomic for Z-Tel to offer service in many, if not
all, of the territories where we currently offer services. Z-Tel is actively
considering all of its options in response to this uncertainty, which may
include retail price increases, limitation or scaling back of our current
business plan, reductions in overhead or staffing, as well as litigation or
regulatory actions. We have and will continue to communicate these challenges
to regulators and policymakers throughout the United States Government and the
states. With regard to pricing of network elements, states and the FCC are currently
re-evaluating the pricing of network elements. As a result, it is possible that
some states could increase or lower rates from existing levels. Currently, the
incumbent local exchange carriers Verizon, BellSouth, SBC and Qwest have rate
cases pending before state regulatory commissions in at least one state in each
of their respective territories. Our intent is to be an active participant in
many of these rate cases and any others that might be critical to our
operations. The FCC is also currently reevaluating its prescribed methodology
for calculating unbundled network element rates. In the 2002 Verizon v. FCC
decision, the U.S. Supreme Court affirmed the FCCs current pricing
methodology, called Total Element Long Run Incremental Cost, or TELRIC. The
current FCC rulemaking proposes to modify the TELRIC methodology by mandating
that states set prices based upon the forward-looking costs of operating the
existing network architecture of incumbent local telephone company networks. In
many instances, modifying the TELRIC methodology in this way could increase the
rates we pay for certain elements and result in lower rates for other elements.
We believe that the FCCs proposals to modify TELRIC are inconsistent with the
Supreme Courts decision in the Verizon case, meaning that new FCC TELRIC rules
may be subject to considerable litigation 14




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##### Table of Contents



if they are adopted. Finally, all
four Bell companies also have pending before the FCC petitions asking that the
FCC forbear from application of the TELRIC pricing rules for UNE-P access.
Z-Tel has opposed those petitions, but by operation of law, the FCC is required
to address those petitions by the end of this year. During the pendency of the Triennial Reviewproceeding described above, Verizon
filed a petition requesting that the FCC forbear from applying items four
through six and ten of the Telecommunication Acts section 271 checklist once
the corresponding elements no longer need to be unbundled under section
251(d)(2). Immediately prior to the Commissions statutory deadline to rule on
its petition, Verizon submitted a letter requesting that the Commission limit
the pending forbearance petition to the broadband elements that the Commission
found on a national basis in the Triennial Reviewproceeding do not have to be
unbundled under section 251. The FCC denied that petition, and Verizon sought
judicial review of the Commissions order. In an opinion released in July
2004, the Court of Appeals for the D.C. Circuit found that the Commission had
failed adequately to explain its decision not to grant Verizons
original petition, and remanded the matter to the Commission. BellSouth, SBC
and Qwest then filed petitions seeking similar relief to that sought by
Verizon. On October 27, 2004, the FCC released an Order in which the
Commission forbear from enforcing the requirements of section 271, for all four
petitioners (the Bell Operating Companies (BOCs)), with regard to the broadband
elements that the Commission, on a national basis, relieved from unbundling in
the TRO. The elements identified by the FCC which no longer require
availability under Section 271s checklist are fiber-to-the-home loops (FTTH
loops), fiber-to-the-curb loops (FTTC loops), the packetized functionality of
hybrid loops, and packet switching. At this time, the impact of the FCCs
October 27th Order in this proceeding upon Z-Tels future service offerings has
yet to be determined. In the ordinary course of business, we are involved in legal and regulatory
proceedings, disputes and tax audits at the federal, state and local level that
are generally incidental to our ongoing operations. In addition, from time to
time, we are the subject of customer and vendor complaints filed with the state
utility commissions of the states in which they operate or the Federal
Communications Commission. Most complaints are handled informally and at this
time there are no formal proceedings pending. While there can be no assurance
of the ultimate disposition of incidental legal proceedings or customer
complaints, we do not believe their disposition will have a material adverse
effect on our consolidated results of operations or financial position. NOTE 14. SEGMENT REPORTING We have two reportable operating segments: Retail Services and Wholesale
Services. The retail services segment
includes our Z-LineHOME® and Z-LineBUSINESS® services
that offer bundled local and long-distance telephone services in combination
with enhanced communications features accessible, through the telephone, the
Internet and certain personal digital assistants. We offer Z-LineHOME and
Z-LineBUSINESS in forty-nine states. Our customers are primarily concentrated
within metropolitan areas in ten states for both our Z-LineHOME and
Z-LineBUSINESS services. The top five states with approximate customer
concentrations are: New York 34%, Michigan 9%, Illinois 9%, Georgia 7% and
Texas 6%. This segment also includes our Touch 1 residential long-distance 1+
offering that is available nationwide as well as our VoIP offering that was
launched for beta customers in May 2004. The SipStorm sale was
part of our retail services segment. The wholesale services segment allows companies to offer telephone exchange and
enhanced services to residential and small business customers. This service is
currently available in forty-nine states and Sprint is our primary customer
within this line of business. Management evaluates the performance of each business unit based on segment
results. It is also important to note that we only record directly assignable
expenses against the wholesale services business segment and therefore, all
employee benefits, occupancy, insurance, and other indirect or corporate
related expenses are reflected in the retail services business segment. The following summarizes the financial information concerning our reportable
segments for the three months ended September 30, 2004 and 2003: Three Months ended September 30, 2004
    
    Three Months ended September 30, 2003Retail
    
    Wholesale
    
    
    
    
    
    Retail
    
    WholesaleServices
    
    Services
    
    Consolidated
    
    Services
    
    Services
    
    ConsolidatedRevenues
    
    $
    41,229
    
    
    $
    19,683
    
    
    $
    60,912
    
    
    $
    54,055
    
    
    $
    28,661
    
    
    $
    82,716Segment results
    
    $
    (6,114
    )
    
    $
    4,636
    
    
    $
    (1,478
    )
    
    $
    (5,066
    )
    
    $
    8,834
    
    
    $
    3,768Depreciation and amortization
    
    $
    4,994
    
    
    $
    38
    
    
    $
    5,032
    
    
    $
    5,207
    
    
    $
    630
    
    
    $
    5,837Capital expenditures
    
    $
    1,567
    
    
    $
    
    
    
    $
    1,567
    
    
    $
    1,685
    
    
    $
    263
    
    
    $
    1,948
 The following summarizes the financial information concerning our reportable
segments for the nine months ended September 30, 2004 and 2003: 15




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##### Table of Contents



Nine Months ended September 30, 2004
    
    Nine Months ended September 30, 2003Retail
    
    Wholesale
    
    
    
    
    
    Retail
    
    WholesaleServices
    
    Services
    
    Consolidated
    
    Services
    
    Services
    
    ConsolidatedRevenues
    
    $
    129,347
    
    
    $
    63,829
    
    
    $
    193,176
    
    
    $
    157,166
    
    
    $
    57,525
    
    
    $
    214,691Segment results
    
    $
    (23,440
    )
    
    $
    13,822
    
    
    $
    (9,618
    )
    
    $
    (11,971
    )
    
    $
    18,901
    
    
    $
    6,930Depreciation and amortization
    
    $
    14,744
    
    
    $
    708
    
    
    $
    15,452
    
    
    $
    16,004
    
    
    $
    1,862
    
    
    $
    17,866Capital expenditures
    
    $
    6,218
    
    
    $
    40
    
    
    $
    6,258
    
    
    $
    7,265
    
    
    $
    466
    
    
    $
    7,731Identifiable assets
    
    $
    51,420
    
    
    $
    13,225
    
    
    $
    64,645
    
    
    $
    80,931
    
    
    $
    12,320
    
    
    $
    93,251
 The following table reconciles our segment information to the consolidated
financial information for the three and nine months ended September 30, 2004
and 2003: Three Months ended
    
    Nine Months endedReconciliation of segment results to net loss
    
    September 30, 2004
    
    September 30, 2003
    
    September 30, 2004
    September 30, 2003Consolidated segment operating income (loss)
    
    $
    (1,478
    )
    
    $
    3,768
    
    
    $
    (9,618
    )
    
    $
    6,930Depreciation and amortization
    
    
    (5,032
    )
    
    
    (5,837
    )
    
    
    (15,452
    )
    
    
    (17,866
    )Restructuring Charge
    
    
    (3,223
    )
    
    
    
    
    
    
    (4,029
    )Interest and other income
    
    
    712
    
    
    
    494
    
    
    
    1,993
    
    
    
    1,658Interest and other expense
    
    
    (1,321
    )
    
    
    (978
    )
    
    
    (4,729
    )
    
    
    (2,388
    )Net loss
    
    $
    (10,342
    )
    
    $
    (2,553
    )
    
    $
    (31,835
    )
    
    $
    (11,666
    )
 NOTE 15. SUBSEQUENT EVENTS In October 2004, we reached an agreement with Qwest Corporation that would
allow us to continue to provide our enhanced wire line and broadband
telecommunications services in the Qwest service territory regardless of the
outcome of pending regulatory proceedings. Under the agreement, Qwest has
committed to provide Z-Tel with access to its Qwest Platform Plus Service (QPP)
as a replacement to todays Unbundled Network Element Platform (UNE-P)
throughout its 14-state service area until July 2008. QPP offers Z-Tel access
to the same network elements, features and functions as Z-Tel purchases today
from Qwest. In October 2004, we
issued a tender offer to exchange our three outstanding series of convertible preferred stock
as follows:  
    
    For our Series D Convertible Preferred Stock, which as of September
27, 2004 3,976,723 shares with a liquidation preference of $16.55 per
share and a conversion price of $8.47 per share were outstanding, to
exchange 25.69030 shares of our common stock, for each share of our
Series D Preferred Stock (representing an exchange price of
approximately $0.644 per share);  
    
    For our 8% Convertible Preferred Stock, Series E, which as of
September 27, 2004 4,166,667 shares with a liquidation preference of
$16.26 per share and a conversion price of $8.08 per share were
outstanding, to exchange 25.24216 shares of our common stock, for each
share of our Series E Preferred Stock (representing an exchange price of
approximately $0.644 per share); and  
    
    For our 12% Junior Redeemable Convertible Preferred Stock, Series G,
which as of September 27, 2004 171.214286 shares outstanding with had a
liquidation preference of $144,974.90 per share and conversion price of
$1.28 per share were outstanding, to exchange 161,469.4 shares of our
common stock, for each share of our Series G Preferred Stock
(representing an exchange price of approximately $0.898 per share). A vote on this offer, along with certain related matters, is scheduled at the
shareholders meeting planned for November 19, 2004. The offer and related
conversions is expected to be completed by the end of November 2004. If all
of the holders of the outstanding preferred stock elect to exchange their
shares, on a fully diluted basis, the holders of the Series D Preferred Stock
will own approximately 34.0% of Z-Tels outstanding common stock, the holders
of the Series E Preferred Stock approximately 35.0%, the holders of the Series
G Preferred Stock approximately 9.2%, the existing holders of the common stock
approximately 13.8% and approximately 8.0% will be available for issuance under
a new management equity incentive plan. A Nasdaq Listing
Qualifications Hearing Panel has granted us a temporary exception
from shareholders' equity/$35 million market value of listed
securities/net income and minimum bid price requirements for
continued listing on The Nasdaq SmallCap Market, subject to certain
conditions, including submission of documentation indicating
compliance with all the requirements for continued listing on the
SmallCap Market before expiration of the exception. The exception
expires December 1, 2004. If Z-Tel meets the terms of the exception,
our shares will continue to be listed on the SmallCap Market. We have
plans in place, including a tender offer to our preferred
shareholders and a reverse stock split, to meet the terms of the
exception, but we cannot assure the success of those plans.
Commencing Monday November 8, 2004 and for the duration of the
exception, the trading symbol for Z-Tels shares will be
ZTELC. 16




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##### Table of Contents



Effective October 29, 2004, Chuck Hyman resigned from our Board of
Directors. 
 ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. You should read the following discussion together with the Selected
Consolidated Financial Data, financial statements and related notes included
in this document. This discussion contains forward-looking statements that
involve risks and uncertainties. Our actual results may differ materially from
those projected in the forward-looking statements as a result of certain
factors, including, but not limited to, those discussed in Item 1. Business,
Cautionary Statements Regarding Forward-Looking Statements, and
Risks Related to our Financial Condition and our Business included in our
Form 10-K filed with the Securities and Exchange Commission on March 30, 2004.
Factors that may affect our results of operations include, but are not limited
to, our limited operating history and cumulative losses, uncertainty of
customer demand, potential software failures and errors, potential network and
interconnection failure, dependence on local exchange carriers, dependence on
third party vendors, success and profitability of our
wholesale services, dependence on key personnel, uncertainty of government
regulation, legal and regulatory uncertainties, and competition. We disclaim
any obligation to update information contained in any forward-looking
statement. OVERVIEW We are an emerging provider of advanced, integrated telecommunications services
targeted to residential and business customers. For management purposes, we are
organized into two reportable operating segments: retail services and wholesale
services. In addition to providing our services on a retail basis, we are also
providing these services on a wholesale basis. Our wholesale service offering
allows other companies to have the ability to utilize our telephone exchange
services, enhanced services platform, and even our infrastructure and
back-office operations to provide services on a retail basis to their own end
users under their own private label brand. Under such an arrangement our
wholesale services customer owns the resulting base of end users and we simply
earn a cost plus fee from our wholesale services customer typically structured
on a per month per line in service basis. The nature of our business is rapidly
evolving. Historically we have utilized the unbundled network elements platform (UNE-P)
as the basis of delivering our primary services to our retail end users and end
users of our wholesale customers. Under UNE-P we utilize various elements of
the incumbent local exchange carriers to facilitate the delivery of our
services to our own end users and the end users of our wholesale services
customers. Our current business strategy is to maintain our existing retail UNE-P base
while deploying our own facility-based network for voice-over Internet protocol
(VoIP) services. We launched our VoIP service to business customers in May
2004 in Florida and Georgia. We expect to have a residential offering
available in Florida and New York during the fourth quarter of 2004. To
support the residential offering, the network deployments will consist of
collocating equipment in the ILECs end offices. We also intend to
increasingly convert our residential customer base from the UNE-P platform to
the VoIP platform as we turn up more markets. This should reduce our
dependence on the ILECs and provide additional cost savings to increase our
operating profitability with greater product flexibility. We may or may not
be successful in this endeavor. As our facility-based networks are deployed, we are ramping up on sales and
marketing efforts in order to drive customer growth. We concentrated our
efforts during the second quarter on preparing for our full scale VoIP launch
in the Tampa and Atlanta markets. We have a full in-house sales force operating
in Tampa and Atlanta. During the fourth quarter, this sales force will be
expanded to New York and will continue to expand based on our network
deployment schedules. Our fourth quarter 2004 financial and operating results
will include our investments to expand our business services unit and to
prepare for our VoIP initiatives we expect to increasingly expand through 2005. We focused the balance of our resources during the third quarter of 2004 on
growing our residential and business UNE-P base. Although some of the cost
will be seen in the third quarter financial results, the line count impact will
mainly be seen in the fourth quarter. Importantly, we are obtaining clients
within this part of our business services unit that we can potentially convert
to our VoIP platform as we turn up various markets. On September 29, 2004 we
signed an agreement with SipStorm, Inc., a company formed by our
former Chief Executive Officer, D. Gregory Smith and former Chief
Technology Officer, Charles McDonough. Under this agreement, we have
transferred selected computer hardware, software and intellectual
property rights to SipStorm. These non-core assets are mainly related
to our second generation enhanced service products. SipStorm will
continue development of these applications and will provide us with
access to the developed product over the course of the next 15
months. Relative to the purchase, SipStorm has assumed responsibility
for certain accounts payable, future maintenance payments and provided
a promissory note in the amount of $2.8 million. The
promissory note is secured by shares of our preferred stock held by
Messrs. Smith and McDonough. In the third quarter, we wrote-off
approximately $1.9 million in outstanding accounts payable,
$2.7 million in capitalized software and $0.4 million in
computer hardware as a result of this transaction and the
discontinued operations that resulted from managements change
in business focus. In evaluating our financial condition and operating performance the most
important matters on which we focus are lines in service, revenue per unit,
cost per unit, bad debt expense, expenses as a percentage of revenues and
results by operating segment. These measures and other analysis are discussed
in detail throughout the following paragraphs and provide insight into how we
analyze and review our business. Because of significant uncertainty in the
regulatory environment in which we operate (created by a recent court case, See
Part II, Item I, Legal Proceedings), we must monitor and respond to any
negative regulatory developments. CONSOLIDATED RESULTS OF OPERATIONS The three and nine months ended September 30, 2004 compared to the same period
in the prior year. 17




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The following consolidated Managements Discussion and Analysis of Financial
Condition and Results of Operations should be read in conjunction with results
by segment. Key selected financial and operating data for the three and nine
months ended September 30, 2004 and 2003 are as follows: For the three months
    
    Amount
    
    Percentageended September 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Results of Operations:Revenues
    
    $
    60.9
    
    
    $
    82.7
    
    
    $
    (21.8
    )
    
    
    (26.4
    )%
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    30.4
    
    
    
    39.7
    
    
    
    9.3
    
    
    
    23.4
    %
    
    
    49.9
    %
    
    
    48.0
    %Sales and marketing
    
    
    4.7
    
    
    
    3.6
    
    
    
    (1.1
    )
    
    
    (30.6
    )%
    
    
    7.7
    %
    
    
    4.4
    %General and administrative
    
    
    27.3
    
    
    
    35.6
    
    
    
    8.3
    
    
    
    23.3
    %
    
    
    44.8
    %
    
    
    43.0
    %Restructuring Charge
    
    
    3.2
    
    
    
    
    
    
    
    (3.2
    )
    
    
    (100.0
    )%
    
    
    5.3
    %
    
    
    
    %Depreciation and amortization
    
    
    5.0
    
    
    
    5.8
    
    
    
    0.8
    
    
    
    13.8
    %
    
    
    8.2
    %
    
    
    7.0
    %Total operating expenses
    
    
    70.6
    
    
    
    84.7
    
    
    
    14.1
    
    
    
    16.7
    %
    
    
    115.9
    %
    
    
    102.4
    %Operating loss
    
    
    (9.7
    )
    
    
    (2.0
    )
    
    
    (7.7
    )
    
    
    (385.0
    )%
    
    
    (15.9
    )%
    
    
    (2.4
    )%Nonoperating income (loss):Interest and other income
    
    
    0.7
    
    
    
    0.5
    
    
    
    0.2
    
    
    
    40.0
    %
    
    
    1.1
    %
    
    
    0.6
    %Interest and other expense
    
    
    (1.3
    )
    
    
    (1.0
    )
    
    
    (0.3
    )
    
    
    (30.0
    )%
    
    
    (2.1
    )%
    
    
    (1.2
    )%Total nonoperating income (loss)
    
    
    (0.6
    )
    
    
    (0.5
    )
    
    
    (0.1
    )
    
    
    (20.0
    )%
    
    
    (1.0
    )%
    
    
    (0.6
    )%Net loss
    
    
    (10.3
    )
    
    
    (2.5
    )
    
    
    (7.8
    )
    
    
    (312.0
    )%
    
    
    (16.9
    )%
    
    
    (3.0
    )%Less mandatorily redeemable convertible
preferred stock dividends and accretion
    
    
    (5.2
    )
    
    
    (3.7
    )
    
    
    (1.5
    )
    
    
    (40.6
    )%
    
    
    (8.5
    )%
    
    
    (4.5
    )%Less deemed dividend related to beneficial
conversion feature
    
    
    (0.1
    )
    
    
    (0.1
    )
    
    
    
    
    
    
    
    %
    
    
    (0.2
    )%
    
    
    (0.1
    )%Net loss attributable to common stockholders
    
    $
    (15.6
    )
    
    $
    (6.3
    )
    
    $
    (9.3
    )
    
    
    (147.6
    )%
    
    
    (25.7
    )%
    
    
    (7.6
    )%Cash Flow Data:Net cash (used in) provided by operating activities
    
    $
    (6.1
    )
    
    $
    3.9
    
    
    $
    (10.0
    )
    
    
    (256.4
    )%
    
    
    *
    
    
    
    *Net cash provided by (used in) investing activities
    
    
    (1.5
    )
    
    
    (1.9
    )
    
    
    0.4
    
    
    
    21.1
    %
    
    
    *
    
    
    
    *Net cash provided by (used in) financing activities
    
    
    4.1
    
    
    
    (1.6
    )
    
    
    5.7
    
    
    
    356.3
    %
    
    
    *
    
    
    
    *Net (decrease) increase in cash and cash equivalents
    
    $
    (3.5
    )
    
    $
    0.4
    
    
    $
    (3.9
    )
    
    
    (975.0
    )%
    
    
    *
    
    
    
    *
 For the nine months
    
    Amount
    
    Percentageended September 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Results of Operations:Revenues
    
    $
    193.2
    
    
    $
    214.6
    
    
    $
    (21.4
    )
    
    
    (10.0
    )%
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    95.7
    
    
    
    98.5
    
    
    
    2.8
    
    
    
    2.8
    %
    
    
    49.5
    %
    
    
    45.9
    %Sales and marketing
    
    
    14.3
    
    
    
    14.7
    
    
    
    0.4
    
    
    
    2.8
    %
    
    
    7.4
    %
    
    
    6.8
    %General and administrative
    
    
    92.8
    
    
    
    94.5
    
    
    
    1.7
    
    
    
    1.8
    %
    
    
    48.1
    %
    
    
    44.0
    %Restructuring Charge
    
    
    4.0
    
    
    
    
    
    
    
    (4.0
    )
    
    
    (100.0
    )%
    
    
    2.1
    %
    
    
    
    %Depreciation and amortization
    
    
    15.5
    
    
    
    17.9
    
    
    
    2.4
    
    
    
    13.4
    %
    
    
    8.0
    %
    
    
    8.3
    %Total operating expenses
    
    
    222.3
    
    
    
    225.6
    
    
    
    3.3
    
    
    
    1.5
    %
    
    
    115.1
    %
    
    
    105.1
    %Operating loss
    
    
    (29.1
    )
    
    
    (11.0
    )
    
    
    (18.1
    )
    
    
    (164.6
    )%
    
    
    (15.1
    )%
    
    
    (5.1
    )%Nonoperating income (loss):Interest and other income
    
    
    2.0
    
    
    
    1.7
    
    
    
    0.3
    
    
    
    17.7
    %
    
    
    1.1
    %
    
    
    0.8
    %Interest and other expense
    
    
    (4.7
    )
    
    
    (2.4
    )
    
    
    (2.3
    )
    
    
    (95.9
    )%
    
    
    (2.5
    )%
    
    
    (1.2
    )%Total nonoperating income (loss)
    
    
    (2.7
    )
    
    
    (0.7
    )
    
    
    (2.0
    )
    
    
    (285.8
    )%
    
    
    (1.4
    )%
    
    
    (0.4
    )%Net loss
    
    
    (31.8
    )
    
    
    (11.7
    )
    
    
    (20.1
    )
    
    
    (171.8
    )%
    
    
    (16.5
    )%
    
    
    (5.5
    )%Less mandatorily redeemable convertible
preferred stock dividends and accretion
    
    
    (13.2
    )
    
    
    (12.6
    )
    
    
    (0.6
    )
    
    
    (4.8
    )%
    
    
    (6.9
    )%
    
    
    (5.9
    )%Less deemed dividend related to beneficial
conversion feature
    
    
    (0.2
    )
    
    
    (0.1
    )
    
    
    (0.1
    )
    
    
    (100.0
    )%
    
    
    (0.1
    )%
    
    
    (0.0
    )%Net loss attributable to common stockholders
    
    $
    (45.2
    )
    
    $
    (24.4
    )
    
    $
    (20.8
    )
    
    
    (85.2
    )%
    
    
    (23.5
    )%
    
    
    (11.4
    )%Cash Flow Data:Net cash (used in) provided by operating activities
    
    $
    (15.3
    )
    
    $
    10.0
    
    
    $
    (25.3
    )
    
    
    (253.0
    )%
    
    
    *
    
    
    
    *Net cash (used in) investing activities
    
    
    (6.2
    )
    
    
    (7.7
    )
    
    
    1.5
    
    
    
    19.5
    %
    
    
    *
    
    
    
    *Net cash provided by (used in) financing activities
    
    
    14.2
    
    
    
    (3.8
    )
    
    
    18.0
    
    
    
    473.7
    %
    
    
    *
    
    
    
    *Net (decrease) in cash and cash equivalents
    
    $
    (7.3
    )
    
    $
    (1.5
    )
    
    $
    (5.8
    )
    
    
    (386.7
    )%
    
    
    *
    
    
    
    *
 (*) Not meaningful 18




---



##### Table of Contents



Revenues.The decrease in revenue for the third quarter 2004 from the third
quarter 2003 was primarily a result of the decline in residential UNE-P lines,
access fee revenue declines and the loss of MCI as a wholesale services
customer. Revenues decreased by $21.8 million to $60.9 million for the three
months ended September 30, 2004, compared to $82.7 million the prior year.
Revenues decreased by $21.4 million to $193.2 million for the nine months ended
September 30, 2004, compared to $214.6 million the prior year. The following table provides a break-down of our revenues and changes for the
three and nine months ended September 30, 2004
compared to the same period in 2003: Revenues for the three
    
    Amount
    
    Percentagemonths ended September 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Residential Services
    
    $
    34.1
    
    
    $
    50.6
    
    
    $
    (16.5
    )
    
    
    (32.6
    )%
    
    
    56.0
    %
    
    
    61.2
    %Business Services
    
    
    5.3
    
    
    
    1.0
    
    
    
    4.3
    
    
    
    430.0
    %
    
    
    8.7
    %
    
    
    1.2
    %1+ Long Distance Services
    
    
    1.8
    
    
    
    2.4
    
    
    
    (0.6
    )
    
    
    (25.0
    )%
    
    
    3.0
    %
    
    
    2.9
    %Wholesale Services
    
    
    19.7
    
    
    
    28.7
    
    
    
    (9.0
    )
    
    
    (31.4
    )%
    
    
    32.3
    %
    
    
    34.7
    %Total
    
    $
    60.9
    
    
    $
    82.7
    
    
    $
    (21.8
    )
    
    
    (26.4
    )%
    
    
    100.0
    %
    
    
    100.0
    %
 Revenues for the nine
    
    Amount
    
    Percentagemonths ended September 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Residential Services
    
    $
    110.2
    
    
    $
    147.1
    
    
    $
    (36.9
    )
    
    
    (25.1
    )%
    
    
    57.0
    %
    
    
    68.6
    %Business Services
    
    
    13.5
    
    
    
    2.0
    
    
    
    11.5
    
    
    
    575.0
    %
    
    
    7.0
    %
    
    
    0.9
    %1+ Long Distance Services
    
    
    5.7
    
    
    
    8.0
    
    
    
    (2.3
    )
    
    
    (28.8
    )%
    
    
    3.0
    %
    
    
    3.7
    %Wholesale Services
    
    
    63.8
    
    
    
    57.5
    
    
    
    6.3
    
    
    
    11.0
    %
    
    
    33.0
    %
    
    
    26.8
    %Total
    
    $
    193.2
    
    
    $
    214.6
    
    
    $
    (21.4
    )
    
    
    (10.0
    )%
    
    
    100.0
    %
    
    
    100.0
    %
 Two significant drivers impact our revenues: lines in service and average
monthly revenue per unit (ARPU.) The more significant driver impacting our
changes in revenue is the amount of lines in service. The following table
provides a break-down of our lines in service: Average lines in service
    
    Ending lines in servicefor the three months ended
    
    for the three months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Residential Services
    
    
    172,197
    
    
    
    240,813
    
    
    
    163,050
    
    
    
    225,618Business Services
    
    
    46,869
    
    
    
    8,810
    
    
    
    47,224
    
    
    
    11,6781+ Long Distance Services
    
    
    46,826
    
    
    
    85,703
    
    
    
    44,200
    
    
    
    81,402Wholesale Services
    
    
    346,165
    
    
    
    190,667
    
    
    
    336,418
    
    
    
    223,533Total
    
    
    612,057
    
    
    
    525,993
    
    
    
    590,892
    
    
    
    542,231
 Average lines in service
    
    Ending lines in servicefor the nine months ended
    
    for the nine months endedSeptember 30,
    
    September 30,2004
    
    2003
    
    2004
    
    2003Residential Services
    
    
    183,904
    
    
    
    214,536
    
    
    
    163,050
    
    
    
    225,618Business Services
    
    
    34,409
    
    
    
    5,839
    
    
    
    47,224
    
    
    
    11,6781+ Long Distance Services
    
    
    59,310
    
    
    
    94,027
    
    
    
    44,200
    
    
    
    81,402Wholesale Services
    
    
    316,621
    
    
    
    139,528
    
    
    
    336,418
    
    
    
    223,533Total
    
    
    594,244
    
    
    
    453,930
    
    
    
    590,892
    
    
    
    542,231
 19




---



##### Table of Contents



ARPU provides a business measure of the average monthly revenue generation
attributable to each line in service. ARPU is calculated by taking total
revenues divided by the number of months in the period and is divided by the
average lines in service during the period. We use this measure when analyzing
our retail services revenue, but not when assessing our wholesale services
revenue. This is due to the gross accounting method used to record our
wholesale services revenue which makes the ARPU calculation for wholesale
services a largely meaningless business measure. The following table provides
a summary of our ARPU: Average revenue per unit in servicefor the three months ended
    
    Amount
    
    PercentageSeptember 30,
    
    Change
    
    ChangeFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)Residential Services
    
    $
    66.01
    
    
    $
    70.04
    
    
    $
    (4.03
    )
    
    
    (5.8
    )%Business Services
    
    $
    37.69
    
    
    $
    37.84
    
    
    $
    (0.15
    )
    
    
    (0.4
    )%1+ Long Distance Services
    
    $
    12.81
    
    
    $
    9.33
    
    
    $
    3.48
    
    
    
    37.3
    %Wholesale Services
    
    
    *
    
    
    
    *
    
    
    
    *
    
    
    
    *
 Average revenue per unit in servicefor the nine months ended
    
    Amount
    
    PercentageSeptember 30,
    
    Change
    
    ChangeFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)Residential Services
    
    $
    66.58
    
    
    $
    76.19
    
    
    $
    (9.61
    )
    
    
    (12.6
    )%Business Services
    
    $
    43.59
    
    
    $
    38.06
    
    
    $
    5.53
    
    
    
    14.5
    %1+ Long Distance Services
    
    $
    10.68
    
    
    $
    9.45
    
    
    $
    1.23
    
    
    
    13.1
    %Wholesale Services
    
    
    *
    
    
    
    *
    
    
    
    *
    
    
    
    *
 (*) Not meaningful Network Operations. Network operations expense decrease in the third quarter
2004 compared to the third quarter 2003 was primarily a result of a decrease in
residential lines and a reduction in new customers being added by Sprint.
Network operations expense decreased by $9.3 million to $30.4 million for the
three months ended September 30, 2004, compared to $39.7 million the prior
year. Network operations expense decreased by $2.8 million to $95.7 million
for the nine months ended September 30, 2004, compared to $98.5 million the
prior year. The following tables provide a detailed break-down and analysis of changes in
network operations expense: Network Operations for thethree months ended
    
    Amount
    
    Percentage
    
    Percentage ofSeptember 30,
    
    Change
    
    Change
    
    Network OperationsFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Residential & Business Services
    
    $
    21.2
    
    
    $
    26.6
    
    
    $
    5.4
    
    
    
    20.3
    %
    
    
    69.7
    %
    
    
    67.0
    %1+ Long Distance Services
    
    
    0.3
    
    
    
    0.7
    
    
    
    0.4
    
    
    
    57.2
    %
    
    
    1.0
    %
    
    
    1.8
    %Wholesale Services
    
    
    8.9
    
    
    
    12.4
    
    
    
    3.5
    
    
    
    28.3
    %
    
    
    29.3
    %
    
    
    31.2
    %Total
    
    $
    30.4
    
    
    $
    39.7
    
    
    $
    9.3
    
    
    
    23.4
    %
    
    
    100.0
    %
    
    
    100.0
    %
 Network Operations for thenine months ended
    
    Amount
    
    Percentage
    
    Percentage ofSeptember 30,
    
    Change
    
    Change
    
    Network OperationsFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Residential & Business Services
    
    $
    64.7
    
    
    $
    72.5
    
    
    $
    7.8
    
    
    
    10.8
    %
    
    
    67.6
    %
    
    
    73.6
    %1+ Long Distance Services
    
    
    1.1
    
    
    
    2.1
    
    
    
    1.0
    
    
    
    47.7
    %
    
    
    1.1
    %
    
    
    2.2
    %Wholesale Services
    
    
    29.9
    
    
    
    23.9
    
    
    
    (6.0
    )
    
    
    (25.1
    )%
    
    
    31.3
    %
    
    
    24.2
    %Total
    
    $
    95.7
    
    
    $
    98.5
    
    
    $
    2.8
    
    
    
    2.8
    %
    
    
    100.0
    %
    
    
    100.0
    %
 The following tables provide a detail of network operations expense as a
percentage of revenues by the respective revenue types. 20




---



##### Table of Contents



Network operations as a% of revenues for the three
    
    Amountmonths ended September 30,
    
    ChangeFavorable2004
    
    2003
    
    (Unfavorable)Residential & Business Services
    
    
    53.8
    %
    
    
    51.6
    %
    
    
    (2.2
    )%1+ Long Distance Services
    
    
    16.7
    %
    
    
    29.2
    %
    
    
    12.5
    %Wholesale Services
    
    
    45.2
    %
    
    
    43.2
    %
    
    
    (2.0
    )%
 Network operations as a% of revenues for the nine
    
    Amountmonths ended September 30,
    
    ChangeFavorable2004
    
    2003
    
    (Unfavorable)Residential & Business Services
    
    
    52.3
    %
    
    
    48.6
    %
    
    
    (3.7
    )%1+ Long Distance Services
    
    
    19.3
    %
    
    
    26.3
    %
    
    
    7.0
    %Wholesale Services
    
    
    46.9
    %
    
    
    41.6
    %
    
    
    (5.3
    )%
 Our network operations expense as a percentage of revenues increased to 50.0%
for three months ended September 30, 2004, compared to 48.0% in the prior year.
Network operations expense as a percentage of revenue increased to 49.6% for
the nine months ended September 30, 2004, compared to 45.9% in the prior year.
The increase in network operations expense as a percent of revenue was
primarily a result of shrinking margins with UNE-P business customers and
access revenue along with increases in ILEC fees for UNE-P customers. In
addition, there has been an increase in long distance charges as a result of
renegotiated prices with our vendor. Sales and Marketing. The sales and marketing expense increased for the three
months ended September 30, 2004 due to our new focus on maintaining our UNE-P
base while growing our in-house sales team to support our VoIP deployments.
Sales and marketing expense increased $1.1 million to $4.7 million for the
three months ended September 30, 2004 compared to $3.6 million the prior year. The sales and marketing expense decreased for the nine months ended September
30, 2004 due to reduced spending during 2004 compared 2003. Sales and
marketing expense decreased $0.4 million to $14.3 million for the nine months
ended September 30, 2004, compared to $14.7 million in the prior year. Sales and marketing expense primarily consists of the costs of telemarketing,
sending direct mail, advertising and independent sales representative
commissions, sales salaries and benefits. Sales and marketing includes all
salary and benefits costs paid to employees directly engaged in sales and
marketing activities. General and Administrative. The decrease in our general and administrative
expense for the three and nine months ended September 30, 2004 was primarily a
result of the reduction in force completed in June 2004 and improved collection
efforts. In addition, we recorded one-time expense reductions in September
2004 of approximately $1.9 million due to the SipStorm sale (see Footnote 10 to
this financial statement report) and approximately $1.4 million related to the
elimination of a 5% company-wide bonus plan in favor of a 3% raise implemented
November 1, 2004. General and administrative expense decreased $8.3 million to $27.3 million for
the three months ended September 30, 2004, compared to $35.6 million in the
prior year period. General and administrative expense decreased $1.7 million
to $92.8 million for the nine months ended September 30, 2004, compared to
$94.5 million in the prior year period. General and administrative expense primarily consists of employee salaries and
benefits, outsourced services, bad debt expense, billing and collection costs,
occupancy costs, legal, regulatory and provisioning costs. Restructuring Charge. We recorded a restructuring charge in the amount of
$3.2 million for the three months ended September 30, 2004 as compared to the
prior year. For the nine months ended September 30, 2004 the restructuring
charge was approximately $4.0 million. These charges are the result of two
reduction in work force initiatives which triggered the WARN Act. Employees
received a severance of at least two months salary and benefits. We recorded
approximately $0.8 million in the second quarter 2004 and $3.2 million in the
third quarter 2004. (see Footnote 8 to our financial statements in this
report). Depreciation and Amortization. Depreciation expense decreased during the three
months ended September 30, 2004 due to some of our equipment reaching the end
of its fully depreciable life and the write-off of assets due to the sale to
SipStorm (see Footnote 10 to our financial statements in this report).
Depreciation and amortization expense decreased $0.8 million to $5.0 million
for the three months ended September 30, 2004, compared to $5.8 million the
prior year period. Depreciation and amortization expense decreased $2.4
million to $15.5 million for the nine months ended September 30, 2004, compared
to $17.9 million the prior year period. Interest and Other Income. Interest and other income was $0.7 million as
compared to $0.5 million for the three months ended 21




---



##### Table of Contents



September 30, 2004 and
2003, respectively. Interest and other income was $2.0 million as compared to
$1.7 million for the nine months ended September 30, 2004 and 2003,
respectively. Interest and other income consists of interest charged to our
bundled consumer and business customers for not paying their bills on time and
income from interest earned from our cash balance. Interest and Other Expense. Interest and other expense increased for the three
and nine months ended September 30, 2004 primarily due to increased late
payments on vendor payments. Interest and other expense increased $0.3 million
to $1.3 million for the three months ended September 30, 2004, compared to $1.0
million the prior year period. Interest and other expense increased $2.3
million to $4.7 million for the nine months ended September 30, 2004, compared
to $2.4 million the prior year period. Our interest expense includes late fees
for vendor payments and charges related to our working capital facility,
capital leases and our other term debt obligations. Income Tax Benefit. No provision for federal or state income taxes has been
recorded due to the full valuation allowance recorded against the net deferred
tax asset for the three and nine months ended September 30, 2004 and the same
for prior year period. RESULTS OF OPERATIONS BY SEGMENT Our reportable segments reflect strategic business units that offer similar
products and service. We have two reportable segments:  
    
    Retail Services
    
    Wholesale Services Management evaluates the performance of each business unit based on segment
results. See our Segment footnote to our consolidated financial statements for
a reconciliation of segmented results to the consolidated financial
information. The following discussions highlight our performance within the context of these
segments. Retail Services Segment Our retail services operating segment includes our consumer and business
bundled service lines of business. This segment also includes our 1+
long-distance stand-alone and VoIP offerings. The following tables, in
millions, summarize the results for our retail services business segment for
the three and nine months ended September 30, 2004, respectively compared to
the prior year period: Retail Services SegmentFor the three months
    
    Amount
    
    Percentageended September 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003RevenuesBundled residential services
    
    $
    34.1
    
    
    $
    50.6
    
    
    $
    (16.5
    )
    
    
    (32.6
    )%
    
    
    82.8
    %
    
    
    93.7
    %Bundled business services
    
    
    5.3
    
    
    
    1.0
    
    
    
    4.3
    
    
    
    430.0
    %
    
    
    12.9
    %
    
    
    1.9
    %1+ long-distance services
    
    
    1.8
    
    
    
    2.4
    
    
    
    (0.6
    )
    
    
    (25.0
    )%
    
    
    4.3
    %
    
    
    4.4
    %Total Revenues
    
    
    41.2
    
    
    
    54.0
    
    
    
    (12.8
    )
    
    
    (23.7
    )%
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    21.5
    
    
    
    27.3
    
    
    
    5.8
    
    
    
    21.2
    %
    
    
    52.1
    %
    
    
    50.5
    %Sales and marketing
    
    
    4.7
    
    
    
    3.9
    
    
    
    (0.8
    )
    
    
    (20.6
    )%
    
    
    11.4
    %
    
    
    7.2
    %General and administrative
    
    
    21.1
    
    
    
    27.8
    
    
    
    6.7
    
    
    
    24.1
    %
    
    
    51.3
    %
    
    
    51.5
    %Total operating expenses
    
    
    47.3
    
    
    
    59.0
    
    
    
    11.7
    
    
    
    19.8
    %
    
    
    114.8
    %
    
    
    109.2
    %Segment results
    
    $
    (6.1
    )
    
    $
    (5.0
    )
    
    $
    (1.1
    )
    
    
    (22.0
    )%
    
    
    (14.8
    )%
    
    
    (9.2
    )%
 22




---



##### Table of Contents



Retail Services SegmentFor the nine months
    
    Amount
    
    Percentageended September 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003RevenuesBundled residential services
    
    $
    110.2
    
    
    $
    147.1
    
    
    $
    (36.9
    )
    
    
    (25.1
    )%
    
    
    85.2
    %
    
    
    93.6
    %Bundled business services
    
    
    13.5
    
    
    
    2.0
    
    
    
    11.5
    
    
    
    575.0
    %
    
    
    10.4
    %
    
    
    1.3
    %1+ long-distance services
    
    
    5.7
    
    
    
    8.0
    
    
    
    (2.3
    )
    
    
    (28.8
    )%
    
    
    4.4
    %
    
    
    5.1
    %Total Revenues
    
    
    129.4
    
    
    
    157.1
    
    
    
    (27.7
    )
    
    
    (17.6
    )%
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    65.8
    
    
    
    74.6
    
    
    
    8.8
    
    
    
    11.8
    %
    
    
    50.9
    %
    
    
    47.4
    %Sales and marketing
    
    
    14.1
    
    
    
    15.4
    
    
    
    1.3
    
    
    
    8.5
    %
    
    
    10.9
    %
    
    
    9.8
    %General and administrative
    
    
    72.9
    
    
    
    79.0
    
    
    
    6.1
    
    
    
    7.8
    %
    
    
    56.4
    %
    
    
    50.3
    %Total operating expenses
    
    
    152.8
    
    
    
    169.0
    
    
    
    16.2
    
    
    
    9.6
    %
    
    
    118.2
    %
    
    
    107.5
    %Segment results
    
    $
    (23.4
    )
    
    $
    (11.9
    )
    
    $
    (11.5
    )
    
    
    (96.7
    )%
    
    
    (18.2
    )%
    
    
    (7.5
    )%
 Revenues. The decrease in residential revenue was primarily due to a decrease
of approximately 62,500 residential lines along with a decrease in access
revenue. Revenues decreased by $12.8 million to $41.2 million for the three
months ended September 30, 2004, compared to $54.0 million the prior year
period. Revenues decreased by $27.7 million to $129.4 million for the nine
months ended September 30, 2004, compared to $157.1 million the prior year
period. Network Operations.The Network operations expense decrease was primarily a
result of the decrease in residential lines. Network operations expense
decreased by $5.8 million to $21.5 million for the three months ended September
30, 2004, compared to $27.3 million the prior year period. Our network
operations as a percentage of revenue increased by 1.6% to 52.1% for the three
months ended September 30, 2004, compared to 50.5% the prior year. Network operations expense decreased by $8.8 million to $65.8 million for the
nine months ended September 30, 2004, compared to $74.6 million the prior year
period. Our network operations as a percentage of revenue increased by 3.5% to
50.9% for the nine months ended September 30, 2004, compared to 47.4% the prior
year. Sales and Marketing. Sales and marketing expense was $4.7 million for the three
months ended September 30, 2004 compared to $3.9 million for the prior year
period. Sales and marketing expense was $14.1 million for the nine months
ended September 30, 2004 compared to $15.4 for the prior year period. The
changes in our sales and marketing focus are discussed in the consolidated
operations. General and Administrative. The decrease in our general and administrative
expense for the three and nine months ended September 30, 2004 was primarily a
result of the reduction in force completed in June 2004 and improved collection
efforts. General and administrative expense decreased $6.7 million to $21.1
million for the three months ended September 30, 2004, compared to $27.8
million in the prior year. As a percentage of revenues general and
administrative expense decreased by .2% to 51.3% of
revenues for the three months ended September 30, 2004 compared to 51.5% the
prior year period. General and administrative expense decreased $6.1 million to $72.9 million for
the nine months ended September 30, 2004, compared to $79.0 million the prior
year. As a percentage of revenues general and administrative expense increased
by 6.1% to 56.4% of revenues for the nine months ended September 30, 2004
compared to 50.3% the prior year period. WHOLESALE SERVICES SEGMENT Our wholesale services operating segment includes services that we provide to
other companies giving them the ability to offer bundled telephony and enhanced
services on a private label basis to their own residential and business
customers using us as their primary platform for delivery. Our largest current
customer for this service is Sprint. The following tables, in millions,
summarizes the results for our wholesale services business segment for the
three and nine months ended September 30, 2004, respectively compared to the
prior year period: 23




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##### Table of Contents



Wholesale Services SegmentFor the three months
    
    Amount
    
    Percentageended September 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003RevenuesSprint
    
    $
    18.8
    
    
    $
    22.7
    
    
    $
    (3.9
    )
    
    
    (17.2
    )%
    
    
    95.5
    %
    
    
    79.1
    %MCI
    
    
    
    
    
    
    5.9
    
    
    
    (5.9
    )
    
    
    (100.0
    )%
    
    
    
    %
    
    
    20.6
    %Other
    
    
    0.9
    
    
    
    0.1
    
    
    
    0.8
    
    
    
    800.0
    %
    
    
    4.5
    %
    
    
    0.3
    %Total Revenues
    
    
    19.7
    
    
    
    28.7
    
    
    
    (9.0
    )
    
    
    (31.4
    )%
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    8.9
    
    
    
    12.4
    
    
    
    3.5
    
    
    
    28.3
    %
    
    
    45.2
    %
    
    
    43.2
    %General and administrative
    
    
    6.2
    
    
    
    7.4
    
    
    
    1.2
    
    
    
    16.3
    %
    
    
    31.5
    %
    
    
    25.8
    %Total operating expenses
    
    
    15.1
    
    
    
    19.8
    
    
    
    4.7
    
    
    
    23.8
    %
    
    
    76.7
    %
    
    
    69.0
    %Segment results
    
    $
    4.6
    
    
    $
    8.9
    
    
    $
    (4.3
    )
    
    
    (48.4
    )%
    
    
    23.3
    %
    
    
    31.0
    %
 Wholesale Services SegmentFor the nine months
    
    Amount
    
    Percentageended September 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003RevenuesSprint
    
    $
    62.3
    
    
    $
    34.9
    
    
    $
    27.4
    
    
    
    78.6
    %
    
    
    97.7
    %
    
    
    60.7
    %MCI
    
    
    0.2
    
    
    
    22.1
    
    
    
    (21.9
    )
    
    
    (99.1
    )%
    
    
    0.3
    %
    
    
    38.4
    %Other
    
    
    1.3
    
    
    
    0.5
    
    
    
    0.8
    
    
    
    160.0
    %
    
    
    2.0
    %
    
    
    0.9
    %Total Revenues
    
    
    63.8
    
    
    
    57.5
    
    
    
    6.3
    
    
    
    11.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    29.9
    
    
    
    23.9
    
    
    
    (6.0
    )
    
    
    (25.1
    )%
    
    
    46.9
    %
    
    
    41.6
    %Sales and marketing
    
    
    0.3
    
    
    
    0.1
    
    
    
    (0.2
    )
    
    
    (200.0
    )%
    
    
    0.5
    %
    
    
    0.2
    %General and administrative
    
    
    19.8
    
    
    
    14.6
    
    
    
    (5.2
    )
    
    
    (35.7
    )%
    
    
    31.0
    %
    
    
    25.4
    %Total operating expenses
    
    
    50.0
    
    
    
    38.6
    
    
    
    (11.4
    )
    
    
    (29.6
    )%
    
    
    78.4
    %
    
    
    67.2
    %Segment results
    
    $
    13.8
    
    
    $
    18.9
    
    
    $
    (5.1
    )
    
    
    (27.0
    )%
    
    
    21.6
    %
    
    
    32.8
    %
 Revenues. The wholesale revenues declined by $9.0 million to $19.7 million for
the three months ended September 30, 2004, compared to $28.7 million for the
third quarter ended September 30, 2003. Our wholesale service revenues
decreased to 32.4% of consolidated revenues for the three months ended
September 30, 2004, compared to 34.7% in the prior year period. This decrease is mainly due to the loss of MCI as a wholesale customer.
Approximately $6.0 million of the decline was due to losing MCI. Although the
majority of lines were already migrated back to MCI at the end of third quarter
2003, Z-Tel had recognized approximately $4.7 million in deferred revenue from
the software license agreement. This recognition was accelerated in August
2003. Sprint revenues have declined approximately $3.0 million mainly due
to all new customers now being added under Sprints operating company number
(OCN) so they are directly responsible to the ILECs for these costs. This
in effect reduces the average ILEC cost per line since all one-time
installation costs associated with new customers are now being charged to
Sprint directly. This decrease has been partially offset by increases in ILEC
UNE-P costs. Wholesale revenue increased $6.3 million to $63.8 million for the nine months
ended September 30, 2004, compared to $57.5 million in the prior year period.
Wholesale revenue increased to 33.1% of consolidated revenues for the nine
months ended September 30, 2004, compared to 26.8% in the prior year period.
Revenues primarily increased due to the increase in wholesale lines. Network Operations.Network operations expense decreased by $3.5 million to
$8.9 million for the three months ended September 30, 2004, compared to $12.4
million in the prior year period. This decrease is primarily related to
provisioning all new customers to Sprints operating company number with the
ILEC. Network operations expense increased by $6.0 million to $29.9 million for the
nine months ended September 30, 2004, compared to $23.9 million in the prior
year period. This increase is primarily related to the increase in wholesale
lines. 24




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General and Administrative.General and administrative expense decreased by
$1.2 million to $6.2 million for the three months ended September 30, 2004,
compared to $7.4 million in the prior year period. The decrease in general and
administrative expenses is a result of a reduction in Sprint lines over the
third quarter 2004 compared to line growth in the third quarter 2003. General and administrative expense increased by $5.2 million to $19.8 million
for the nine months ended September 30, 2004, compared to $14.6 million in the
prior year period. The increase in general and administrative expense is a
result of increased wholesale lines in service in 2004 compared to 2003. The significant components of this expense are very similar to the
administrative expenses incurred on the retail side of our business; however,
we only isolate as wholesale expenses those expenses that are directly
associated with our wholesale services activity. Therefore, we have not
allocated any indirect or corporate (i.e. traditional overhead) expenses, such
as certain employee benefits, occupancy expenses, insurance expenses or other
similar expenses to the wholesale services business segment. These expenses are
all currently included within the retail services business segment. LIQUIDITY AND CAPITAL RESOURCES The competitive local telecommunications service business has traditionally
been considered to be a relatively capital intensive business, owing to the
significant investments required in fiber optic communication networks and in
the collocation of switching and transmission equipment in incumbent local
exchange carriers central offices. Although we have historically utilized
UNE-P to provide our services to our own end users, we are now increasingly
focused on developing a VoIP facilities-based offering, an alternative access
method by which we can provide our services to end users. VoIP will likely
involve more capital investment than the UNE-P based model typically has
required. In the second quarter of 2004, we launched VoIP in two markets:
Tampa, Florida and Atlanta, Georgia. We expect to significantly expand this
offering over the coming years. We expect that we will continue to devote
significant amounts of our capital resources to continued operations, new
service offerings and marketing efforts in order to achieve an acceptable level
of penetration in the markets that we target. We have incurred accumulated losses since our inception as a result of
developing our business, performing ongoing research and development, building
and maintaining our network infrastructure and technology, the sale and
promotion of our services, and ongoing administrative expenditures. As of
September 30, 2004, we had an accumulated deficit of $350.7 million, a net tax
operating loss carry forward of approximately $280.8 million, and $4.7 million
in cash and cash equivalents. We have funded our expenditures primarily through
operating revenues, private securities offerings, an asset based loan facility
and an initial public offering that raised net proceeds of $109.1 million, and
working capital facilities. Net cash used in operating activities decreased by $25.3 million to $15.3
million for the nine months ended September 30, 2004, compared to $10.0 million
provided by operating activities in the prior year period. The decrease was
primarily a result of the termination of our agreement with RFC Capital
Corporation (RFC) in favor of a new asset based loan obtained from Textron in
April 2004 (see Footnote 5 to these financial reports). As a result of this
change, net cash from operations decreased while net cash from financing
activities increased. Our net cash used in investing activities decreased by $1.5 million to $6.2
million for the nine months ended September 30, 2004, compared to $7.7 million
the prior year period. The decrease was primarily attributable to the
reduction in property and equipment purchases for the nine months ended
September 30, 2004 compared to the prior year period. Our net cash provided by financing activities increased by $18.0 million to
$14.2 million for the nine months ended September 30, 2004 compared to $3.8
million used in financing activities in the prior year period. The increase
was primarily attributable to the execution of the Textron asset based loan
facility (see Footnote 5). ANTICIPATED SOURCES AND USES OF CASH When we discuss cash flow throughout this section we are referring to the cash
inflows and cash outflows, exclusive of fixed and overhead operating costs such
as administrative payroll expenses, non-operations related payroll expenses,
occupancy costs, and other costs that are of a corporate or overhead nature.
These corporate overhead expenses were $14.4 and $49.4 million for the three
and nine months ended September 30, 2004, respectively. We believe that it is
appropriate to present this information in order to help the reader understand
our individual operating contribution streams, while realizing that these
contribution streams must in aggregate
provide enough cash flow to fund our corporate overhead expenditures. Our retail residential UNE-P service currently generates the majority of our
cash from operations. We also continue to utilize the 1+ long-distance service
as a positive cash generating business, primarily because of our policy of not
actively investing in it, other than the ongoing maintenance costs associated
with this line of business. Our wholesale services business is also a good
source of cash flow. Although not as significant in terms of overall
contribution or per line operating metrics as our residential business, it
provides a healthy net cash contribution on a per line basis without causing us
to incur traditionally significant upfront sales and marketing costs as is
typically the case with most retail marketing activities. We are currently under audit by the State of New York for our sales and use and
franchise taxes. In July of 2004, we received an 25




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updated summary from the State
of New York stating that we owe them $2.7 million in sales and use and
franchise taxes, before any possible interest or penalties, primarily due to
their position that 100% of the bundled services we offer are taxable. Although
this process is still on-going, we currently disagree with the State of New
Yorks calculation of the sales and use tax due on our bundled products and we
believe that certain portions of the bundle are not subject to sales and use
taxes. Our goal is to obtain an acceptable settlement with the state, and we
believe that our methodology is appropriate, reasonable, and in compliance with
the State of New Yorks sales and use taxes laws. We have made accruals based
on our best estimates of the facts, but are unable to determine the final
outcome of this matter at this time. CASH MANAGEMENT Our overall cash position over the balance of 2004 will be dependent upon a
variety of factors including, but not limited to, the actual line count levels
and reported revenues over the remainder of the year, the speed with which we
deploy VoIP related capital expenditures, our ability to secure reasonable
forms of lease financing, and whether various operating initiatives are
implemented in an effort to enhance cash flows. We recognize that our growth
will need to be managed very closely from a liquidity standpoint prior to
achieving these expected free cash flows, as we are operating with negative
working capital and expect to be concurrently pursuing several growth
initiatives. Our accounts payable balances
decreased approximately $6.4 million to $57.3
million for the third quarter ending September 30, 2004 compared
to $63.7
million for the quarter ending June 30, 2004. The $5 million received from
the standby credit facility agreement with the 1818 Fund III, L.P. was used to
reduce our accounts payable balance. In addition, the SipStorm sale further
reduced our accounts payable balances by approximately $1.9 million. Our
current portion of long term debt was reduced by approximately $0.8 million due
to the retirement of the remaining Chapter 11 exit strategy debt from the
Touch1 acquisition. In second quarter 2004 we announced a plan to provide a bonus to employees that
will average 5% of their pay. We began accruing for this bonus expense in the
second quarter 2004. In September 2004, we announced that we would implement a
3% increase for most employees as of November 1, 2004 instead of the bonus
originally announced. Based on this announcement, the bonus expense being
accrued was reversed in September 2004. This resulted in a reduction to
general and administrative expense of approximately $1.4 million. DEBT INSTRUMENTS Asset-Based Loan In April 2004 we signed a three-year asset based loan facility with Textron
Financial Corporation. This agreement eliminated the RFC accounts receivable
factoring agreement, and provides us with the ability to borrow up to $25
million. Our overall availability is based on the eligibility of our accounts
receivables, subject to certain limitations and advance rates. The new
asset-based loan agreement is expected to provide us with additional liquidity
because it includes residential, business and wholesale accounts receivable
that were not included in our prior arrangement with RFC. The RFC factoring
agreement only considered residential accounts receivable as its collateral. We
believe that this new agreement will provide us with additional working capital
financing flexibility to help facilitate the growth of our business. This
agreement has three primary financial covenants: a fixed charge coverage ratio,
accounts receivable turnover requirement and an unfunded capital expenditures
cap. The fixed charge coverage ratio requirement begins June 30, 2004 and is
measured each quarter thereafter with various look-back time periods. The ratio
requirements begin low and increase each quarter through December 31, 2004 and
then remain constant. We did not meet the fixed charge coverage ratio for the quarter ended June 30,
2004 or September 30, 2004. All other financial covenants have been met per
our agreement with Textron. Per the agreement, Textron can cancel the loan
arrangement with us; however, we believe that it is unlikely that Textron would
take such measures. We are working to resolve this issue without triggering a
cancellation of the agreement. At current collection rates, we will collect
the total amount outstanding under this facility in just over a month. We
believe that Textron is adequately secured under this facility. In addition,
we have already disclosed to Textron the cost saving measures recently
implemented to make improvements that would allow us to meet the fixed charge
coverage ratio required in future quarters. Textron has advised us
that additional interest at a rate of 300 basis points per annum will
be effective as of October 4, 2004. There are also common disposition of assets limitations, unfunded capital
expenditure limitations, limits on change of control, certain notification
requirements, change in management limitations and certain other restrictions.
There are also certain limitations on our ability to access subordinated debt
within the confines of the agreement, however; we believe the agreement
provides us with flexibility for future debt financing alternatives. We believe that this new agreement will help us to manage our short and
long-term cash needs, although we are still exploring other alternatives for
obtaining additional funding, including but not limited to subordinated debt
and certain equity transactions. We also may need additional funds for our VoIP
initiative which will be much more capital intensive than the UNE-P business
model has been historically. The availability of cash will somewhat dictate the
speed in which we will be able to roll this access method out to new markets,
as there is an initial cost of at least $0.5 million in capital expenditures to
establish service in each major metropolitan area. After this initial cost
there are the additional costs of the customer premise equipment and
installation and provisioning costs to get customers onto the service but these
costs are mostly success based and will likely move in tandem with the addition
of new customers. Our VoIP initiative will require larger up-front payments
than we currently experience to get a customer successfully provisioned under
the UNE-P platform; however, in the longer-term the network costs for these
customers are much lower because of 26




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the larger capital expenditures for network
bandwidth which reduces future incremental costs. Term Debt We have $0.1 million of remaining principal term debt as of September 30, 2004.
This debt was assumed in the purchase of Touch 1 Communications, Inc., our
wholly owned subsidiary, in April 2000. All of this debt is paid monthly and is
at a fixed interest rate of 6.0%. ILEC, IXC AND RELATED DISPUTED CHARGES Since our existence we have disputed and continue to dispute significant
charges from the various ILECs, IXCs, and certain other carriers providing us
network services. We have a policy of treating all charges that we believe to
be without merit as disputes, regardless of the age of the dispute. We believe
that the majority of these charges are without merit; however, we accrue for
any charges that we believe represent valid charges against us. Our
outstanding disputes at September 30, 2004 totaled $19.0 million. These
disputes are summarized in the following table: OutstandingDisputes atSeptember 30, 2004(In millions)Alternatively billed services
    
    $
    8.1MCI fixed facility charges
    
    
    1.1Verizon back-billing of installation charges
    
    
    2.4Late fee disputes
    
    
    4.5All others
    
    
    2.9$
    19.0
 Alternatively billed services are primarily charges for certain in-collect and
information service calls. These disputes are largely historic in nature. We
settled certain of these disputes in Texas with Southwestern Bell Telephone
Company. We remit all monies collected associated with these services but do
not pay the charges unless we collect from our customers. We believe that our
liability related to these charges should be capped at the amount remitted by
our end users, however, some of our settlements have included payments in
excess of payments from our customers. The MCI fixed facility charge dispute is over 3 years old. In August 2004 we
started to receive credits for these disputed amounts. So far, the total
amount of credit received is $1.2 million on total disputes of $2.3 million
relating to incorrect billings, taxes, surcharges and late payment fees. We received a billing for $2.4 million from Verizon relating to the
back-billing of dispatch charges believed to relate to the period from August
2000 to February 2002 and from March 2003 to September 2003. We do not know if
this is the entire amount they will bill related to these back-billed charges.
Our policy is to dispute items that are billed without the necessary underlying
detail records and therefore, we have disputed these charges. We expect that if
any of these charges are valid, a portion of these charges may be subject to
being billed to our wholesale services customers for services that we provided
under our contracts with them. We have not received sufficient detail related
to these charges from Verizon and therefore, are unable to determine their
validity. We dispute all late payment charges that accumulate either from late payments
on invoices or from disputes that are eventually denied. The remaining $2.9 million of disputes relates to various disputes primarily
with ILECs for incorrect billing rates, duplicate billing problems, charges for
customers for whom we are no longer providing service and other various billing
errors. While we can make no guarantee, we believe that we are adequately reserved for
our disputes and attempt to manage our cash position to ensure that we have the
necessary availability of cash to make payments which may arise out of the loss
of disputes that we believe are at risk. Therefore, we believe our maximum cash
exposure for these charges is $19.0 million. However, we do not believe that
these charges are valid and intend to continue our dispute and non-payment of
these charges. We may or may not be successful in resolving these issues
satisfactorily. 
 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We do not enter into financial instruments for trading or speculative purposes
and do not currently utilize derivative financial instruments. Our operations
are conducted primarily in the United States and as such are not subject to
material foreign currency exchange rate risk. The fair value of our investment portfolio or related income would not be
significantly impacted by either a 100 basis point increase or decrease in
interest rates due mainly to the short-term nature of the major portion of our
investment portfolio. We have no material future earnings or cash flow exposures from changes in
interest rates on our long-term debt obligations, as substantially all of our
long-term debt obligations are fixed rate obligations. 27




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##### Table of Contents



ITEM 4. CONTROLS AND PROCEDURES We maintain disclosure controls and procedures designed to ensure that material
information related to us, including our consolidated subsidiaries, is
recorded, processed, summarized and reported in accordance with SEC rules and
forms. Our management, with the participation of Chief Executive Officer and
Chief Financial Officer, Horace J. Davis, III, has evaluated the effectiveness
of our disclosure controls and procedures as of the end of the period covered
by this report. Based upon that evaluation, Mr. Davis has concluded that our
disclosure controls and procedures are effective in causing material
information to be recorded, processed, summarized, and reported so as to ensure
the quality and timeliness of our public disclosures in compliance with SEC
rules and forms. There was no change in our internal control over financial reporting that
occurred during our most recent fiscal quarter that has materially affected, or
is reasonably likely to materially affect our internal control over financial
reporting. 
 Part II 
 ITEM 1. LEGAL PROCEEDINGS  1.
    
    Master File Number 21 MC 92; In re Initial Public Offering Securities
Litigation., in the United States District Court for the Southern
District of New York (filed June 7, 2001) During June and July 2001, three separate class action lawsuits were filed
against us, certain of our current and former directors and officers (the
D&Os) and firms engaged in the underwriting (the Underwriters) of our
initial public offering of stock (the IPO). The lawsuits, along with
approximately 310 other similar lawsuits filed against other issuers arising
out of initial public offering allocations, have been assigned to a Judge in
the United States District Court for the Southern District of New York for
pretrial coordination. The lawsuits against us have been consolidated into a
single action. A consolidated amended complaint was filed on April 20, 2002. A
Second Corrected Amended Complaint (the Amended Complaint), which is the
operative complaint, was filed on July 12, 2002. The Amended Complaint is based on the allegations that our registration
statement on Form S-1, filed with the Securities and Exchange Commission
(SEC) in connection with the IPO, contained untrue statements of material
fact and omitted to state facts necessary to make the statements made not
misleading by failing to disclose that the underwriters allegedly had received
additional, excessive and undisclosed commissions from, and allegedly had
entered into unlawful tie-in and other arrangements with, certain customers to
whom they allocated shares in the IPO. The plaintiffs in the Amended Complaint
assert claims against us and the D&Os pursuant to Section 11 of the Securities
Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule
10b-5 promulgated by the SEC there under. The plaintiffs in the Amended
Complaint assert claims against the D&Os pursuant to Sections 11 and 15 of the
Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange
Act of 1934 and Rule 10b-5 promulgated by the SEC there under. The plaintiffs
seek an undisclosed amount of damages, as well as pre-judgment and
post-judgment interest, costs and expenses, including attorneys fees, experts
fees and other costs and disbursements. Initial discovery has begun. We believe
we are entitled to indemnification from our Underwriters. A settlement has been reached by the respective lawyers for plaintiffs, the
issuers and insurers of the issuers. The principal terms of the proposed
settlement are (i) a release of all claims against the issuers and their
officers and directors, (ii) the assignment by the issuers to the plaintiffs of
certain claims the issuers may have against the Underwriters and (iii) an
undertaking by the insurers to ensure the plaintiffs receive not less than $1
billion in connection with claims against the Underwriters. Hence, under the
terms of the settlement our financial obligations will likely be covered by
insurance. Our board of directors has approved the settlement. To be binding,
the settlement must be executed by the parties and thereafter submitted to and
approved by the court. The settlement will not be binding upon any plaintiffs
electing to opt-out of the settlement.  2.
    
    Case No 8:02 CV 1708 T 27 MS The Metropolitan Government of Nashville
and Davidson County, Tennessee, suing on behalf of Metropolitan
Nashville Employee Benefit Board v Z-Tel Technologies, Inc. in the
United States District Court for the Middle District of Florida filed
September 20, 2002. The Metropolitan Government of Nashville and Davidson County, Tennessee, on
behalf of the Metropolitan Nashville Employee Benefit Board (collectively
Metro Nashville), filed the foregoing lawsuit against us on September 20,
2002. The lawsuit asserted claims under Delaware Law, the Uniform Commercial
Code, and state law and sought actual damages of $18 million, punitive damages
of $18 million, interest, and court costs. Metro Nashville alleged that we
wrongfully and improperly delayed delivery of a stock certificate, preventing
Metro Nashville from selling or taking other steps to protect the value of
their shares while the market price of our stock declined significantly. On May
18, 2004, we entered into a settlement agreement whereby we paid Metro
Nashville
$800,000 in cash and delivered to Metro Nashville 585,723 shares of our common
stock. We also agreed to file on Metro Nashvilles behalf a registration
statement on Form S-3 allowing resale of those shares. That registration
statement became effective July 15, 2004.  3.
    
    C.A. No5:03CV229, Z-Tel Communications Inc. v. SBC Communications,
Inc., in the United States District Court for the Eastern District of
Texas, filed October 9, 2003. On October 9, 2003, Z-Tel Communications, Inc., our wholly-owned subsidiary
corporation, filed a lawsuit against SBC Communications, Inc. and several of
its subsidiaries (collectively, SBC) in federal court in Texas, where both
SBC and Z-Tel do 28




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business. The lawsuit alleges SBCs violation of the federal
antitrust laws, the Racketeering Influenced Corrupt Organizations Act (RICO),
the Lanham Act, and other federal and state laws. The complaint seeks damages
and an injunction against SBC. On November 20, 2003, SBC filed a motion to
dismiss the complaint. On August 6, 2004, the court denied in part, and
granted in part, SBCs motion to dismiss the complaint, allowing certain
antitrust, RICO, and Lanham Act claims to proceed. Although we intend to pursue
our claims against SBC vigorously, we cannot predict the outcome of this
litigation with any certainty.  4.
    
    Report and Order on Remand and Further Notice of Proposed Rulemaking,
Review of Section 251 Unbundling Obligations of Incumbent Local
Exchange Carriers, 18 FCC Rcd 16978 (2003) (Triennial Review Order),
revd in part and remanded, United States Telecom Assn v. FCC, Nos.
00-1012, 00-1015, 03-1310 et al. (D.C. Cir. March 2, 2004) (USTA II) In September 2003, the Federal Communications Commission (FCC) released its
final decision in the Triennial Review proceeding. Among numerous other
matters, the FCC ruled that entrants like us would be able to purchase
dedicated transport (utilized in enhanced extended loops or EELs) and analog
switching (utilized in UNE-P) on an unbundled basis, subject to state-by-state
review by state public utility commissions of whether such unbundling was
needed in their states. On March 2, 2004, the D.C. Circuit Court of Appeals
overturned the FCCs decision as an improper delegation of authority to state
public utility commissions. The D.C. Circuit ordered that the unbundled
transport and switching rules be vacated as of June 15, 2004. Both the U.S.
Solicitor General and the FCC declined to appeal the case, and U.S. Supreme
Court Justice William Rehnquist refused to issue a stay of the decision. We
and other Competitive Local Exchange Carriers appealed the case to the U.S.
Supreme Court. On October 12, 2004, the Supreme Court denied cert in this case
effectively denying our appeal. For additional information see Footnote 11 to
our financial statements in this report and the sections entitled Government
Regulation and Risks Relating to Our Financial Condition and Our Business
contained in our Annual Report on Form 10-K for the year ended December 31,
2003 filed March 30, 2004.  5.
    
    C.A. No. 04CH07882, Susan Schad, on behalf of herself and all others
similarly situated, v. Z-Tel Communications, Inc., In the Circuit Court of
Cook County, Illinois, Illinois County Department, Chancery Division,
filed May 13, 2004;C.A. No. 4 C 4187, Susan Schad, on behalf of herself and all others similarly
situated, v. Z-Tel Communications, Inc., In the United States District Court
for the Northern District of Illinois, Eastern Division. Susan Schad, on behalf of herself and all others similarly situated, filed a
class action lawsuit against Z-Tel Communications, Inc., our wholly-owned
subsidiary corporation, on May 13, 2004. The lawsuit alleges that our
subsidiary has engaged in a pattern and practice of deceiving consumers into
paying amounts in excess of their monthly rates by deceptively labeling certain
line-item charges as government-mandated taxes or fees when in fact they were
not. The complaint seeks to certify a class of plaintiffs consisting of all
persons or entities who contracted with Z-Tel for telecommunications services
and were billed for particular taxes or regulatory fees. The complaint asserts
a claim under the Illinois Consumer Fraud and Deceptive Businesses Practices
Act and seeks unspecified damages, attorneys fees and court costs. On June
22, 2004, our subsidiary filed a notice of removal in the state circuit court
action, removing the case to the federal district court for the Northern
District of Illinois, Eastern Division, C.A. No. 4 C 4187. On July 26, 2004,
Plaintiff filed a motion to remand the case to the state circuit court.
Plaintiffs motion is still pending. Although we believe the plaintiffs
allegations are without merit and intend to defend the lawsuit vigorously, we
cannot predict the outcome of this litigation with any certainty. 29




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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) The following exhibits are filed as part of this report: EXHIBITNUMBER
    
    DESCRIPTION3.1
    
    Amended and Restated Certificate of Incorporation of Z-Tel, as amended.3.2
    
    Amended and Restated Bylaws of
Z-Tel, as amended.4.1
    
    Form of Common Stock Certificate. Incorporated by reference to the correspondingly numbered exhibit to our
Registration Statement on Form S-1 (File No. 333-89063), originally filed October 14, 1999, as amended and as
effective December 14, 1999.4.2
    
    See Exhibits 3.1 and 3.2 of this Form for provisions of the Amended and Restated Certificate of Incorporation, as
amended, and our Bylaws defining rights of security holders.4.3
    
    Stock Purchase Agreement, dated July 6, 2000, by and between us and the various purchasers of our Series D
Convertible Preferred Stock. Incorporated by reference to the correspondingly numbered exhibit to our Quarterly
Report on Form 10-Q for the quarter ended June 30, 2000, filed on August 14, 2000.4.4
    
    Certificate of Designations, Preferences and Relative Rights, Qualifications, Limitations and Restrictions relating
to our Series D Convertible Preferred Stock, as amended March 13, 2003. Incorporated by reference to Exhibit 4.4 to
our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2000, filed on August 14, 2000, and (the
amendment) to Exhibit 4.20 of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2003, filed on May
15, 2003.4.5
    
    From of Registration Rights Agreement by and between us and each of the purchasers of our Series D Convertible
Preferred Stock. Incorporated by reference to the correspondingly numbered exhibits to our Quarterly Report on Form
10-Q for the quarter ended June 30, 2000, filed on August 14, 2000.4.6
    
    Form of Warrant for the purchase of shares of our common stock by each of the purchasers of our Series D Convertible
Preferred Stock. Incorporated by reference to the correspondingly numbered exhibit to our Quarterly Report on Form
10-Q for the quarter ended June 30, 2000, filed on August 14, 2000.4.7
    
    Stock and Warrant Purchase Agreement, dated October 19, 2000, by and among us and The 1818 Fund III, L.P.
Incorporated by reference to the correspondingly numbered exhibit to our Quarterly Report on Form 10-Q for the
quarter ended September 30, 2000, filed on November 14, 2000.4.8
    
    Amended and Restated Certificate of Designation of 8% Convertible Preferred Stock, Series E, Setting Forth the
Powers, Preferences, Rights, Qualifications, Limitations and Restrictions of Such Series of Preferred Stock, as
amended March 13, 2003. Incorporated by reference to Exhibit 4.8 to our Quarterly Report on Form 10-Q for the quarter
ended June 30, 2001, filed on August 13, 2001, and (the amendment) to Exhibit 4.21 of our Quarterly Report on Form
10-Q for the quarter ended March 31, 2003, filed on May 15, 2003.4.9
    
    Registration Rights Agreement between and among us and The 1818 Fund III, L.P. Incorporated by reference to the
correspondingly numbered exhibit to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2000, filed
on November 14, 2000.4.10
    
    Warrant issued to The 1818 Fund III, L.P. for the purchase of shares of our common stock. Incorporated by reference
to the correspondingly numbered exhibit to our Quarterly Report on Form 10-Q for the quarter ended September 30,
2000, filed on November 14, 2000.4.11
    
    Certificate of Designation of Series F Junior Participating Preferred Stock. Incorporated by reference to the
correspondingly numbered exhibit to our Annual Report on Form 10-K for the year ended December 31, 2000, filed on
March 30, 2001.4.12
    
    Rights Agreement dated as of February 19, 2001 between us and American Stock Transfer Trust Company, as Rights Agent.
Incorporated by reference to the correspondingly numbered exhibit to our Annual Report on Form 10-K for the year
ended December 31, 2000, filed on March 30, 2001. The agreement was amended July 2, 2001 to reflect the issuance of
the Series G Preferred Stock.4.13
    
    Stock and Warrant Purchase Agreement, dated as of July 2, 2001, by and between us, D. Gregory Smith, and others.
Incorporated by reference to Exhibit 1 to Amendment No. 1 of the Schedule 13D filed July 12, 2001 with respect to our
common stock by, among other persons, The 1818 Fund III, L.P.4.14
    
    Warrant for the Purchase of Shares of Common Stock of Z-Tel, dated as of July 2, 2001. Incorporated by reference to
Exhibit 2 to Amendment No. 1 of the Schedule 13D filed July 12, 2001 with respect to our common stock by, among other
persons, The 1818 Fund III, L.P.4.15
    
    Certificate of Designation for the Series G Preferred Stock. Incorporated by reference to Exhibit 3 to Amendment No.
1 of the Schedule 13D filed July 12, 2001 with respect to our common stock by, among other persons, The 1818 Fund
III, L.P.
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EXHIBITNUMBER
    
    DESCRIPTION4.16
    
    Backup Purchase Agreement, dated as of July 2, 2001, by and among Z-Tel Communications, Inc., a Delaware corporation
and our wholly owned subsidiary, Touch 1 Communications, Inc., an Alabama corporation and our wholly owned
subsidiary, D. Gregory Smith and others. Incorporated by reference to Exhibit 4 to Amendment No. 1 of the Schedule
13D filed July 12, 2001 with respect to our common stock by, among other persons, The 1818 Fund III, L.P.4.17
    
    Additional Investor Registration Rights Agreement, dated as of July 2, 2001, between Z-Tel, D. Gregory Smith and
others. Incorporated by reference to Exhibit 5 to the Schedule 13D filed July 24, 2001 with respect to our common
stock by, among other persons, D. Gregory Smith.4.18
    
    Voting Agreement, dated as of June 29, 2001, between us and certain of our stockholders. Incorporated by reference to
Exhibit 5 to Amendment No. 1 of the Schedule 13D filed July 12, 2001 with respect to our common stock by, among other
persons, The 1818 Fund III, L.P.4.19
    
    Employee Stock Restriction Agreement, dated September 1, 1998, by and between us and D. Gregory Smith. Incorporated
by reference to Exhibit 7 to the Schedule 13D filed July 24, 2001 with respect to our common stock by, among other
persons, D. Gregory Smith.10.1
    
    Standby Credit Facility Agreement, dated August 24, 2004, by and among Z-Tel Technologies, Inc. and The 1818 Fund
III, L.P.. Incorporated by reference to Form 8-K filed on August 26, 2004.10.2.1
    
    1998 Equity Participation Plan. Incorporated by reference to the correspondingly numbered exhibit to our Registration
Statement on Form S-1 (File No. 333-89063), originally filed October 14, 1999, as amended and as effective December
14, 1999.10.2.2
    
    2000 Equity Participation Plan. Incorporated by reference to Appendix B to our Preliminary Proxy Statement filed on
April 14, 2000, with the following amendment effective May 31, 2001:Section 2.1(a) of the Plan is hereby amended in its entirety to read as follows:The shares of stock subject to Options,
awards of Restricted Stock, Performance
Awards, Dividend Equivalents, awards of
Deferred Stock, Stock Payments or Stock
Appreciation Rights shall be Common
Stock, initially shares of the
Companys Common Stock, par value $0.01
per share. The aggregate number of such
shares which may be issued upon
exercise of such options or rights or
upon any such awards under the Plan
shall be Four Million Five Hundred
Thousand (4,500,000) plus an annual
increase to be added on the first day
of the Companys fiscal year beginning
in 2001 equal to the lesser of (i)
Three Million (3,000,000) shares of the
Companys Common Stock, (ii) 6% of the
outstanding shares on such date, or
(iii) a lesser amount determined by the
Board. The shares of Common Stock
issuable upon exercise of such options
or rights or upon any such awards may
be either previously authorized but
unissued shares or treasury shares10.4
    
    Loan and Security Agreement, dated April 22, 2004, by and between Textron Financial Corporation and Z-Tel.
Incorporated by reference to Exhibit 10.2 of our Registration Statement on Form S-3 (File No. 333-116747), originally
filed June 22, 2004, as amended and as effective July 15, 2004.10.5
    
    Form of Indemnification Agreement for our executive officers and directors. Incorporated by reference to the
correspondingly numbered exhibit to our Annual Report on Form 10-K for the year ended December 31, 2000, filed on
March 30, 2001.
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EXHIBITNUMBER
    
    DESCRIPTION10.6
    
    Employment Agreement of Horace J. Trey Davis III, dated August 14, 2002. Incorporated by reference to the
correspondingly numbered exhibit to our Quarterly Report on Form 10-Q for the quarter ended March 31, 2004, filed on
May 17, 2004. By resolution of the Compensation Committee of the Board of Directors Mr. Davis annual salary was
increased to $200,000 effective May 6, 2003.10.11
    
    Promissory Note, dated September 10, 1999, from Touch 1 Communications, Inc. and William F. Corman (First Revocable
Trust). Incorporated by reference to the correspondingly numbered exhibits to our Annual Report on Form 10-K for the
year ended December 31, 2000, filed on March 30, 2001.10.12
    
    Promissory Note, dated September 10, 1999, from Touch 1 Communications, Inc. and James F. Corman. Incorporated by
reference to the correspondingly numbered exhibits to our Annual Report on Form 10-K for the year ended December 31,
2000, filed on March 30, 2001.10.13
    
    Agreement for Resale of Local Wireline Telecommunications Services and Provision of Ancillary Services, dated
February 4, 2003, between Z-Tel Communications, Inc. and Sprint Communications L.P. Incorporated by reference to
Exhibit 10.14 of our Annual report on Form 10-K for the year ended December 31, 2003, filed March 30, 2004. Portions
of this exhibit have been omitted pursuant to a request for confidential treatment31.1
    
    Certification of the Chief Executive Officer31.2
    
    Certification of the Chief Financial Officer32.1
    
    Written Statement of the Chief Executive Officer Pursuant to 18 U.S.C.ss.135032.2
    
    Written Statement of the Chief Financial Officer Pursuant to 18 U.S.C.ss.1350
 (b) Reports on Form 8-K On July 2, 2004, we filed a Form 8-K to announce Jeffrey A. Bowden, one of our
founders, has resigned from our Board of Directors. Also, Robert A. Curtis, our
Senior Vice-President  Strategic Planning and President of Z-Tel Network
Services, Inc., has resigned those offices to take a position with a large
consulting firm. On July 27, 2004, we filed a Form 8-K to announce our business plans. On August 2, 2004, we filed a Form 8-K to announce that we had received a
letter from Nasdaq notified us that for 10 consecutive days the market value of
our listed securities was below $35 million as required for continued inclusion
by Nasdaq Marketplace Rule4310(c)(2)(B)(ii).. On August 10, 2004, we filed a Form 8-K in connection with our earnings release
for the quarter ended June 30, 2004. On August 26, 2004, we filed a Form 8-K to announce the following:  1.
    
    that we entered into a $15 million Standby Credit
Facility Agreement with The 1818 Fund III, L.P.,2.
    
    The Nasdaq Stock Market informed us that for the last
30 consecutive business days, the bid price of our common stock
has closed below the minimum $1.00 per share requirement for
continued inclusion under marketplace Rule 4310(c)(4). We have
been provided 180 calendar days, or until February 22, 2005, to
regain compliance.3.
    
    D. Gregory Smith, our chairman, president and chief
executive officer, and Charles W. McDonough, a director and our
senior vice president  chief technology officer, have resigned
from their offices and the Board of Directors. Our board of
directors that same day appointed Horace J. Davis, III as Acting
Chief Executive Officer and Executive Vice President. Mr. Davis
retained his present duties as Chief Financial Officer. The Board
also appointed Frank M. Grillo as Executive Vice President and
Acting Chief Operating Officer.4.
    
    We amended our by-laws to eliminate the requirement
that the company have a president. Wherever the bylaws refer to
the president, the words or chief executive officer have been
inserted. On September 1, 2004, we filed a Form 8-K to announce the Nasdaq Stock Market
has informed us that we have failed to comply with Nasdaqs $35 million market
value of listed securities requirement for continued listing on the Nasdaq
SmallCap Market (Rule 4310(c)(2)(B)(ii)) and consequently are subject to
delisting from that market beginning September 9, 2004. On September 7, 2004, we filed a Form 8-K to announce we initiated a
reduction in force which terminated the employment of approximately 152 of our
employees. We expect to incur a one-time charge during this quarter of
approximately $3 million consisting primarily of post termination wages and
salaries we intend to pay to those employees and the associated payroll taxes.
Substantially all of those post termination wages will be paid within 60 days
following the reduction in force. 32




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SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized, as of the 15th day of
September 2004. Z-TEL TECHNOLOGIES, INC.
(Registrant) By:
    
    /s/ Horace J. Davis III
 Chief Executive Officer and Chief Financial Officer
(Authorized officer of Registrant and principal financial and accounting officer) 33