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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 SIX MONTHS ENDED JUNE 30, 2004
 OR [  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THESECURITIES EXCHANGE ACT OF 1934 FOR 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 August
9, 2004 was approximately 37,488,207.




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PART IItem 1. Financial StatementsConsolidated Balance Sheets at June 30, 2004 and December 31, 2003
        
        1Consolidated Statements of Operations for the six months ended June 30, 2004 and 2003
        
        2Consolidated Statements of Changes in Stockholders Deficit for the six months ended June 30, 2004
        
        3Consolidated Statements of Cash Flows for the six months ended June 30, 2004 and 2003
        
        4Notes to Consolidated Financial Statements
        
        5Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
        
        14Item 3. Quantitative and Qualitative Disclosures about Market Risk
        
        30Item 4. Controls and Procedures
        
        30PART IIItem 1. Legal Proceedings
        
        30Item 2. Changes in Securities and Use of Proceeds
        
        32Item 4. Submission of Matters to a Vote of Security Holders
        
        32Item 6. Exhibits and Reports on Form 8-K
        
        32Signatures
        
        35Ex-31.1: Section 302 Certification of CEOEx-31.2: Section 302 Certification of CFOEx-32.1: Section 906 Certification of CEOEx-32.2: Section 906 Certification of CFOEx-31.1: Section 302 Certification of CEOEx-31.2: Section 302 Certification of CFOEx-32.1: Section 906 Certification of CEOEx-32.2: Section 906 Certification of CFO






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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)

June 30,
    
    December 31,2004
    
    2003AssetsCurrent assets:Cash and cash equivalents
    
    $
    8,196
    
    
    $
    12,013Accounts receivable, net of allowance for doubtful
accounts of $9,206 and $13,804
    
    
    28,672
    
    
    
    24,600Prepaid expenses and other current assets
    
    
    4,804
    
    
    
    7,664Total current assets
    
    
    41,672
    
    
    
    44,277Property and equipment, net
    
    
    34,298
    
    
    
    39,069Intangible assets, net
    
    
    1,372
    
    
    
    2,287Other assets
    
    
    3,227
    
    
    
    3,820Total assets
    
    $
    80,569
    
    
    $
    89,453Liabilities, Mandatorily Redeemable Convertible Preferred
Stock and Stockholders DeficitCurrent liabilities:Accounts payable and accrued liabilities
    
    $
    63,745
    
    
    $
    59,230Deferred revenue
    
    
    8,357
    
    
    
    11,068Current portion of long-term debt
and capital lease obligations
    
    
    2,078
    
    
    
    5,017Asset based loan
    
    
    12,619
    
    
    
    Total current liabilities
    
    
    86,799
    
    
    
    75,315Long-term deferred revenue
    
    
    221
    
    
    
    361Long-term debt and capital lease obligations
    
    
    205
    
    
    
    514Total liabilities
    
    
    87,225
    
    
    
    76,190Mandatorily redeemable convertible preferred stock, $.01 par value;
50,000,000 shares authorized; 8,855,089 issued; 8,736,337 and 8,738,422
outstanding (aggregate liquidation value of $164,998 and $158,779)
    
    
    152,366
    
    
    
    144,282Commitments and contingencies (Notes 9 and 11)Stockholders deficit:Common stock, $.01 par value; 150,000,000
shares authorized; 37,321,257 and 36,186,686 shares issued;
36,979,707 and 35,845,136 outstanding
    
    
    373
    
    
    
    362Notes receivable from stockholders
    
    
    (930
    )
    
    
    (1,121
    )Unearned stock compensation
    
    
    (984
    )
    
    
    Additional paid-in capital
    
    
    183,281
    
    
    
    189,008Accumulated deficit
    
    
    (340,374
    )
    
    
    (318,880
    )Treasury stock, 341,550 shares at cost
    
    
    (388
    )
    
    
    (388
    )Total stockholders deficit
    
    
    (159,022
    )
    
    
    (131,019
    )Total liabilities, mandatorily redeemable convertible preferred
stock and stockholders deficit
    
    $
    80,569
    
    
    $
    89,453


The accompanying notes are an integral part of these consolidated financial statements.

1



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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) For the Three
MonthsEnded June 30,
    
    For the Six
MonthsEnded June 30,2004
    
    2003
    
    2004
    
    2003Revenues
    
    $
    63,797
    
    
    $
    71,046
    
    
    $
    132,264
    
    
    $
    131,975Operating expenses:Network operations, exclusive of depreciation and
amortization shown below
    
    
    31,237
    
    
    
    32,070
    
    
    
    65,271
    
    
    
    58,852Sales and marketing
    
    
    4,450
    
    
    
    6,617
    
    
    
    8,971
    
    
    
    11,111General and administrative
    
    
    31,658
    
    
    
    31,944
    
    
    
    66,229
    
    
    
    58,850Restructuring charge
    
    
    807
    
    
    
    
    
    
    
    807
    
    
    
    Depreciation and amortization
    
    
    5,109
    
    
    
    6,002
    
    
    
    10,420
    
    
    
    12,029Total operating expenses
    
    
    73,261
    
    
    
    76,633
    
    
    
    151,698
    
    
    
    140,842Operating loss
    
    
    (9,464
    )
    
    
    (5,587
    )
    
    
    (19,434
    )
    
    
    (8,867
    )Nonoperating income (expense):Interest and other income
    
    
    491
    
    
    
    239
    
    
    
    1,352
    
    
    
    1,164Interest and other expense
    
    
    (2,138
    )
    
    
    (660
    )
    
    
    (3,412
    )
    
    
    (1,410
    )Total nonoperating expense
    
    
    (1,647
    )
    
    
    (421
    )
    
    
    (2,060
    )
    
    
    (246
    )Net loss
    
    
    (11,111
    )
    
    
    (6,008
    )
    
    
    (21,494
    )
    
    
    (9,113
    )Less mandatorily redeemable convertible
preferred stock dividends and accretion
    
    
    (3,626
    )
    
    
    (4,667
    )
    
    
    (7,991
    )
    
    
    (8,904
    )Less deemed dividend related to beneficial
conversion feature
    
    
    (47
    )
    
    
    (46
    )
    
    
    (93
    )
    
    
    (92
    )Net loss attributable to common stockholders
    
    $
    (14,784
    )
    
    $
    (10,721
    )
    
    $
    (29,578
    )
    
    $
    (18,109
    )Weighted average common shares outstanding
    
    
    36,608,703
    
    
    
    35,305,448
    
    
    
    36,337,804
    
    
    
    35,286,953Basic and diluted net loss per share
    
    $
    (0.40
    )
    
    $
    (0.30
    )
    
    $
    (0.81
    )
    
    $
    (0.51
    )
 The accompanying notes are an integral part of these consolidated financial statements. 2




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY (DEFICIT)
AND COMPREHENSIVE INCOME
(UNAUDITED)
(IN THOUSANDS, EXCEPT SHARE DATE) Common Stock
    
    NotesReceivablefrom
    
    UnearnedStock
    
    AdditionalPaid-In
    
    Accumulated
    
    Treasury
    
    TotalStockholders'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
    
    
    
    3
    
    
    
    
    
    
    
    
    
    
    
    486
    
    
    
    
    
    
    
    
    
    
    $
    489Exercise of warrants
    
    
    37,714
    
    
    
    3
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    3Issuance of common stock for settlement
    
    
    585,723
    
    
    
    5
    
    
    
    
    
    
    
    
    
    
    
    743
    
    
    
    
    
    
    
    
    
    
    $
    748Issue common restricted stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (984
    )
    
    
    1,128
    
    
    
    
    
    
    
    
    
    
    $
    144Conversion of mandatorily redeemable
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    convertible preferred stock to common
    
    
    138,654
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    Repayment of notes receivable
    
    
    
    
    
    
    
    
    
    
    191
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    191Mandatorily redeemable convertible preferred
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    stock dividends and accretion
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (8,084
    )
    
    
    
    
    
    
    
    
    
    $
    (8,084
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (21,494
    )
    
    
    
    
    
    $
    (21,494
    )Balance, June 30, 2004
    
    
    36,979,707
    
    
    $
    373
    
    
    $
    (930
    )
    
    $
    (984
    )
    
    $
    183,281
    
    
    $
    (340,374
    )
    
    $
    (388
    )
    
    $
    (159,022
    )
 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 CASH FLOWS
(UNAUDITED)
(In thousands) Six Months EndedJune 30,2004
    
    2003Cash flows from operating activities:Net loss
    
    $
    (21,494
    )
    
    $
    (9,113
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    10,418
    
    
    
    12,029Provision for bad debts
    
    
    3,017
    
    
    
    6,268Expense charged for granting of restricted stock
    
    
    888
    
    
    
    Change in operating assets and liabilities:(Increase) decrease in accounts receivable
    
    
    (7,089
    )
    
    
    (13,465
    )(Increase) decrease in prepaid expenses
    
    
    2,860
    
    
    
    930(Increase) decrease in other assets
    
    
    553
    
    
    
    (29
    )Increase (decrease) in accounts payable and accrued liabilities
    
    
    4,515
    
    
    
    (1,284
    )Increase (decrease) in deferred revenue
    
    
    (2,851
    )
    
    
    10,813Total adjustments
    
    
    12,311
    
    
    
    15,262Net cash (used in) provided by operating activities
    
    
    (9,183
    )
    
    
    6,149Cash flows from investing activities:Purchases of property and equipment
    
    
    (4,732
    )
    
    
    (5,783
    )Principal repayments received on notes receivable
    
    
    40
    
    
    
    27Net cash used in investing activities
    
    
    (4,692
    )
    
    
    (5,756
    )Cash flows from financing activities:Payments on long-term debt and capital lease obligations
    
    
    (3,248
    )
    
    
    (2,755
    )Payment of preferred stock dividends
    
    
    (3
    )
    
    
    Principal repayments received on notes receivable issued for stock
    
    
    191
    
    
    
    469Proceeds from asset based loan
    
    
    12,619
    
    
    
    Proceeds from exercise of stock options and warrants
    
    
    499
    
    
    
    60Net cash provided by (used in) financing activities
    
    
    10,058
    
    
    
    (2,226
    )Net decrease in cash and cash equivalents
    
    
    (3,817
    )
    
    
    (1,833
    )Cash and cash equivalents, beginning of period
    
    
    12,013
    
    
    
    16,037Cash and cash equivalents, end of period
    
    $
    8,196
    
    
    $
    14,204
 The accompanying notes are an integral part of these consolidated financial statements 4




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
(ALL TABLES ARE IN THOUSANDS, EXCEPT FOR SHARE AND PER SHARE DATA) 1. NATURE OF BUSINESS DESCRIPTION OF BUSINESS Z-Tel Technologies, Inc. and subsidiaries (Z-Tel or we or us)
incorporated in Delaware on January 15, 1998 as Olympus Telecommunications
Group, Inc. In March 1998, Olympus Telecommunications Group, Inc. changed its
name to Z-Tel Technologies, Inc. We are 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 basis of delivering our primary services to
our retail end users and end users of our wholesale customers. Under UNE-P we
utilize various unbundled elements of the incumbent 5




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local exchange carriers to facilitate the delivery of our services to our own
end users and the end users that are acquired and owned by our wholesale
services customers. To date, UNE-P has been the primary access method that we
have utilized in delivering our services. We introduced our voice over Internet protocol (VoIP) service offerings
during the second quarter of 2004. This service offering provides us an
alternative method to UNE-P in delivering our services to consumer and business
customers. We have tested this delivery method in two markets and have
developed a beta customer base in each market. We intend, upon the successful
completion of this initial test phase, to pursue aggressively VoIP as the
eventual preferred method whereby we will deliver our services to our end
users. We also intend to offer this new access method to our existing and
future wholesale services partners. While this is a more capital intensive
approach, this method of delivery mitigates our reliance on the incumbent local
exchange carriers. 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 June 30, 2004 of approximately $340.4 million. We also
had total liabilities recorded at June 30, 2004 of approximately $87.2 million.
We experienced positive cash flows from operations for the first time for the
year ended December 31, 2002 and again during 2003. We also had positive cash
flows from operations for the three months ended March 31, 2004, but
experienced negative cash flows from operations for the three and six months
ended June 30, 2004. Prior to 2002 we had historically been dependent on
financing from investors to sustain our operating activities. The companys reported cash position declined on a net basis for the three
months and six months ended June 30, 2004. The net cash declines for the three
and six months ended June 30, 2004 were $3.6 and $3.8 million respectively. At June 30, 2004, we had cash on hand of approximately $8.2 million. In
addition, we have an asset based loan agreement, which provides us with up to
$25 million to fund operations, of which we were utilizing $12.6 million as of
June 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. All other
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 (see Footnote 5 to our financial
statements in this report). We anticipate
that we may not generate adequate cash flow over the foreseeable
future to meet all of our operating, investing and financing requirements. We
are actively exploring potential financing arrangements to help improve our
liquidity position and to give us more flexibility in pursuing our business
plan over the foreseeable future. On
June 16, 2004, the D.C. Circuit decision to USTA II became
effective and the FCCs unbundling rules that were the subject
of the appeal were vacated. If the FCC does not write adequate
interim and final UNB rules, or if the USTA II decision is not stayed
or reversed, 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 interviewing time period. (see Footnote 11 to our
financial statements in this report). On
July 26, 2004, Sprint indicated to us that they plan on
committing less resources to the existing wholesale services
arrangement under which we currently operate. Although Sprint is not
canceling the agreement, they have indicated to us that we can expect
lower sales volumes as early as August 2004 (see Footnote 13 to
our financial statements in this report). By
letter dated July 28, 2004, the Nasdaq Stock Market Inc.
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
Rule 4310(c)(2)(B)(ii). Nasdaq has given us 30 calendar
days or until August 27, 2004 to regain compliance (see
Footnote 13 to our financial statements in this report). If actual results differ materially from our current plan or if expected financing is not available, we may have the ability
to curtail growth initiatives and spending, including the reduction of certain
discretionary capital and operating costs. These plans may include, but are
not be limited to, the implementation of a workforce reduction. There can be no
assurance, however, that we will be able to implement our strategies or obtain
additional financing under favorable terms, if at all. 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
six months ended June 30, 2004 are not necessarily indicative of the results
that may be expected for the year ending December 31, 2004. RECLASSIFICATION Certain amounts in the consolidated statements of operations for the six months
ended June 30, 2003 have been reclassified to conform to the presentation for
the six months ended June 30, 2004. 3. Significant Accounting Policies and Recent Accounting Pronouncements 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. STOCK-BASED COMPENSATION 6




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We account for our stock option plans in accordance with the provisions of APB
Opinion No. 25, Accounting for Stock Issued to Employees, and related
interpretations and comply with the disclosure provisions of SFAS No. 123,
Accounting for Stock-Based Compensation and SFAS No. 148. 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, Accounting for Stock-Based Compensation  Transition and Disclosure, an
Amendment of SFAS 123, Accounting for Stock-Based Compensation, 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 six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net loss attributable to common stockholders, as reported
    
    $
    (14,784
    )
    
    $
    (10,721
    )
    
    $
    (29,578
    )
    
    $
    (18,109
    )Add: Stock based compensation included in net loss
    
    
    145
    
    
    
    
    
    
    
    145
    
    
    
    Deduct: Total stock based employee compensation determined
under the fair value based method for all awards
    
    
    (1,043
    )
    
    
    (1,247
    )
    
    
    (1,799
    )
    
    
    (4,429
    )Net loss attributable to common stockholders, pro forma
    
    $
    (15,682
    )
    
    $
    (11,968
    )
    
    $
    (31,232
    )
    
    $
    (22,538
    )Basic and Diluted Net LossPer Common ShareAs reported
    
    $
    (0.40
    )
    
    $
    (0.30
    )
    
    $
    (0.81
    )
    
    $
    (0.51
    )Pro forma
    
    
    (0.43
    )
    
    
    (0.34
    )
    
    
    (0.86
    )
    
    
    (0.64
    )
 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 ended
    
    For the six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Discount Rate

    
    
    3.4
    %
    
    
    2.5
    %
    
    
    3.1
    %
    
    
    2.6
    %Volatility
    
    
    98.4
    %
    
    
    97.3
    %
    
    
    100.1
    %
    
    
    97.0
    %Average Option Expected Life
    
    5 years
    
    5 years
    
    5 years
    
    5 years
 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. 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 Task Force in this
Issue is effective for reporting periods beginning after March 31, 2004. We
adopted EITF Issue No. 03-06 in the quarter ended June 30, 2004. There was no
impact of the adoption on the computation of EPS during the three months and
six months ended June 30, 2004, as the effect is anti-dilutive. In periods of
net income, we will utilize the two-class method of computing EPS. 4. WHOLESALE SERVICES In February 2003, we executed an agreement providing for the resale of our
local wireline 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 are 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. We are deferring $1.0 million of revenues for pre-contract payments by
recognizing this amount ratably over the life of the agreement. As of June 30, 2004, under our contract with Sprint, we had approximately $2.2
million of deferred revenue recorded, of which 7




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$0.2 million is recorded as long-term deferred revenue. Sprint revenues were 32.3% of total revenues for the three months ended June
30, 2004, as compared to 14.9% for the prior year period. Sprint revenues
were 33.1% of total revenues for the six months ended June 30, 2004, as
compared to 9.3% for the prior year period. On
July 26, 2004 Sprint indicated to us that they plan on
committing less resources to the existing wholesale services
arrangement under which we currently operate. Although Sprint is not
canceling the agreement, they have indicated to us that we can expect
lower sales volumes as early as August 2004 (see Footnote 13 to
our financial statements in this report). 5. ACCOUNTS RECEIVABLE AGREEMENT In April 2004 we signed a three-year asset based loan agreement with Textron
Financial Corporation (Textron). This agreement eliminated our RFC accounts
receivable factoring agreement, and 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 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 while our prior arrangement with 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 financial covenants: a fixed charge coverage
ratio, accounts receivable turnover requirement and an unfunded capital
expenditures cap. The fixed charge coverage ratio requirement is measured each
quarter as of June 30, 2004. 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. All
other 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 less than 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. 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 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 $12.6 million at
June 30, 2004. 6. INTANGIBLE ASSETS In accordance with Statement of Financial Accounting Standards (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 June 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. June 30, 2004Carrying
    
    Accumulated
    
    Net IntangibleAmount
    
    Amortization
    
    AssetsIntangible assets subject to amortization:Customer list  standalone 1+
    
    $
    9,145
    
    
    $
    7,773
    
    
    $
    1,372
 The following table presents current and expected amortization expense of the
existing intangible assets as of June 30, 2004 for each of the following
periods: Aggregate amortization expense: For the six months ended June 30, 2004
    
    $
    915Expected amortization expense for the remainder of 2004
    
    $
    914Expected amortization expense for the year ending December 31, 2005
    
    $
    458
 7. RESTRUCTURING CHARGES In April 2002, we approved and implemented a restructuring to improve our
future cash flows and operating earnings. The restructuring included a
reduction in force coupled with the closure of our North Dakota call centers
and our New York sales office. In 8




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accordance with Emerging Issues Task Force (EITF) 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit
an Activity, the restructuring costs were recognized as liabilities at the
time management committed to the plan. Management determined that these costs
provided no future economic benefit to us. The restructuring charge included termination benefits in connection with the
termination of 167 employees and lease abandonment costs. In addition, we
agreed to a settlement to exit the two leases for our call centers in North
Dakota as of July 1, 2002. 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 in connection with the restructure. 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 another restructuring to improve our
future cash flows and operating earnings. The restructuring included a
reduction in force. In accordance with Financial Accounting Standards Board
(FASB) 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 $806,875
of which $40,832 was paid in the second quarter. The majority of the remainder
of termination benefits will be paid in full by the end of August 2004. SFAS No. 146 replaces the Emerging Issues Task Force (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
    
    Lease
    
    LeaseTermination
    
    Settlement
    
    AbandonmentBenefits
    
    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
    
    
    807
    
    
    
    
    
    
    
    
    
    
    
    807Lease Termination Settlement
    
    
    
    
    
    
    
    
    
    
    (210
    )
    
    
    (210
    )Cash paid
    
    
    (41
    )
    
    
    
    
    
    
    (81
    )
    
    
    (122
    )Balance at June 30, 2004
    
    $
    766
    
    
    $
    
    
    
    $
    60
    
    
    $
    826
 8. STOCK BASED COMPENSATION STOCK OPTIONS For employee stock options, the Financial Accounting Standards Board (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
Accounting Principles Board (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. 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 because the
exercise prices are less than the market price on the date of grant. We
recorded compensation expense of $0.1 million for the three and six months
ended June 30, 2004. 9. 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 9




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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 June 30, 2004, the total disputed amounts
were approximately $19.7 million. We currently have agreements with two long-distance carriers to provide
transmission and termination services for all of our long distance traffic.
These agreements generally provide for the resale of long distance services on
a per-minute basis and contain minimum volume commitments. As a result of a
settlement of a billing dispute associated with minimum volume commitments
required in one of these contracts we have agreed to pay an increased per
minute charge for minutes until the achievement of certain minimum minute
requirements. All other terms of the original agreement continue in full
force. We believe that we will be in full compliance with all minimum volume
commitments during 2004. We have accrued $0.2 million representing the
incremental increased fees we expect to pay in 2004, so that the expense
recorded per minute is consistent throughout the agreement. In connection with certain of our wholesale services agreements, all or a
portion of customer lines are provisioned using a unique code for our company.
Therefore, we are the customer of record for all Regional Bell Operating
Companies billings, including a portion actually attributable to our wholesale
services customers. It is very likely that the state commissions would require
us to continue providing services to the end user customer for at least a
90-day period, regardless of whether our wholesale relationships continue or
whether our wholesale services customers provide payment to us. We have agreed to certain service level agreements (SLAs) for providing
service under our wholesale service agreements. If we were to not fulfill the
SLAs after the phase-in period there are certain remedies including but not
limited to financial compensation. We have not paid any financial compensation
to date as a result of our not meeting any SLAs. 10. 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 six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Basic and diluted net loss per share:Net loss
    
    $
    (11,111
    )
    
    $
    (6,008
    )
    
    $
    (21,494
    )
    
    $
    (9,113
    )Less mandatorily redeemable convertible preferred
stock dividends and accretion
    
    
    (3,626
    )
    
    
    (4,667
    )
    
    
    (7,991
    )
    
    
    (8,904
    )Less deemed dividend related to beneficial conversion feature
    
    
    (47
    )
    
    
    (46
    )
    
    
    (93
    )
    
    
    (92
    )Net loss attributable to common stockholders
    
    $
    (14,784
    )
    
    $
    (10,721
    )
    
    $
    (29,578
    )
    
    $
    (18,109
    )Weighted average common shares outstanding
    
    
    36,608,703
    
    
    
    35,305,448
    
    
    
    36,337,804
    
    
    
    35,286,953Basic and diluted net loss per share
    
    $
    (0.40
    )
    
    $
    (0.30
    )
    
    $
    (0.81
    )
    
    $
    (0.51
    )
 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: Six Months endedJune 30,2004
    
    2003Unexercised stock options
    
    
    14,219,585
    
    
    
    12,848,745Unexercised warrants
    
    
    10,841,488
    
    
    
    10,580,985Mandatorily redeemable preferred stock
convertible into common shares
    
    
    35,702,810
    
    
    
    24,243,545Total potentially dilutive shares of common
stock equivalents
    
    
    60,763,883
    
    
    
    47,673,275
 11. 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 10




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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 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, Revies 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). 11




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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 have filed a Petition
for Writ of Certiorari before the United States Supreme Court, as has the State
of California and the California Public Utilities Commission. Those appeals of
the USTA II litigation are currently pending before the Supreme Court, and we
expect the Court to either grant or deny those petitions in the next several
months. 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. The
National Telecommunications and Information Administration (NTIA), has stated
that in order to avoid customer and CLEC dislocation, the FCC should implement
interim rules that would maintain the status quo in terms of UNE availability
as long as possible. It has been reported that the FCC is currently
considering adopting interim UNE rules that would maintain the status quo for a
certain period of time while the FCC attempts to write rules to replace those
vacated by the D.C. Circuit in the USTA II opinion. Z-Tel plans to be 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. If the FCC does not write adequate interim and final UNE rules, or if the USTA
II decision is not stayed or reversed, 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 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. 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 12




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have a material adverse effect on our consolidated results of operations or
financial position. 12. 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. This segment also includes our Touch 1 residential
long-distance 1+ offering that is available nationwide. We have also included
expenses that are associated with our VoIP offering that was launched for beta
customers in May 2004. 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 June 30, 2004 and 2003: Three Months ended June 30, 2004
    
    Three Months ended June 30, 2003Retail
    
    Wholesale
    
    
    
    
    
    Retail
    
    WholesaleServices
    
    Services
    
    Consolidated
    
    Services
    
    Services
    
    ConsolidatedRevenues
    
    $
    42,814
    
    
    $
    20,983
    
    
    $
    63,797
    
    
    $
    55,142
    
    
    $
    15,904
    
    
    $
    71,046Segment results
    
    $
    (8,856
    )
    
    $
    4,501
    
    
    $
    (4,355
    )
    
    $
    (2,850
    )
    
    $
    3,265
    
    
    $
    415Depreciation and amortization
    
    $
    5,073
    
    
    $
    36
    
    
    $
    5,109
    
    
    $
    5,380
    
    
    $
    622
    
    
    $
    6,002Capital expenditures
    
    $
    2,311
    
    
    $
    12
    
    
    $
    2,323
    
    
    $
    2,432
    
    
    $
    223
    
    
    $
    2,655
 The following summarizes the financial information concerning our reportable
segments for the six months ended June 30, 2004 and 2003: Six Months ended June 30, 2004
    
    Six Months ended June 30, 2003Retail
    
    Wholesale
    
    
    
    
    
    Retail
    
    WholesaleServices
    
    Services
    
    Consolidated
    
    Services
    
    Services
    
    ConsolidatedRevenues
    
    $
    88,118
    
    
    $
    44,146
    
    
    $
    132,264
    
    
    $
    103,111
    
    
    $
    28,864
    
    
    $
    131,975Segment results
    
    $
    (18,201
    )
    
    $
    9,187
    
    
    $
    (9,014
    )
    
    $
    (7,097
    )
    
    $
    10,259
    
    
    $
    3,162Depreciation and amortization
    
    $
    9,750
    
    
    $
    670
    
    
    $
    10,420
    
    
    $
    10,798
    
    
    $
    1,231
    
    
    $
    12,029Capital expenditures
    
    $
    4,691
    
    
    $
    41
    
    
    $
    4,732
    
    
    $
    5,297
    
    
    $
    486
    
    
    $
    5,783Identifiable assets
    
    $
    67,344
    
    
    $
    13,225
    
    
    $
    80,569
    
    
    $
    85,049
    
    
    $
    19,852
    
    
    $
    104,901
 The following table reconciles our segment information to the consolidated
financial information for the six months ended June 30, 2004 and 2003: All 2004 and 2003 consolidated results reconcile to the consolidated financial
information above with the exception of the segment results reconciled below: Three Months ended
    
    Six Months endedReconciliation of segment results to net loss
    
    June 30, 2004
    
    June 30, 2003
    
    June 30, 2004
    
    June 30, 2003Consolidated segment operating income (loss)
    
    $
    (4,355
    )
    
    $
    415
    
    
    $
    (9,014
    )
    
    $
    3,162Depreciation and amortization
    
    
    (5,109
    )
    
    
    (6,002
    )
    
    
    (10,420
    )
    
    
    (12,029
    )Interest and other income
    
    
    491
    
    
    
    239
    
    
    
    1,352
    
    
    
    1,164Interest and other expense
    
    
    (2,138
    )
    
    
    (660
    )
    
    
    (3,412
    )
    
    
    (1,410
    )Net loss
    
    $
    (11,111
    )
    
    $
    (6,008
    )
    
    $
    (21,494
    )
    
    $
    (9,113
    )
 13. SUBSEQUENT EVENTS On July 26, 2004 Sprint indicated to us that they plan on committing less
resources to the existing wholesale services arrangement under which we
currently operate. Although Sprint is not canceling the agreement, they have
indicated to us that we can expect lower sales volumes as early as August 2004.
We believe that it is likely that this lower monthly sales activity will lead
to an increasingly smaller wholesale subscriber base. To the extent that this
proves to be the case, we will likely reduce the workforce that is currently
dedicated to the Sprint relationship. We are compensated on a direct cost pass
through basis by Sprint for the workforce that is dedicated to servicing the
Sprint customer base. We will likely reduce this dedicated workforce in
proportion to the decline in the size 13




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of the wholesale subscriber base
attributable to Sprint. Our net fee income can be expected to decline should
the wholesale lines in
service begin to decline on an approximately proportional basis. By letter dated July 28, 2004, the Nasdaq Stock Market, Inc. 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 Rule
4310(c)(2)(B)(ii). Nasdaq has given us 30 calendar days or until August 27,
2004 to regain compliance. If compliance cannot be demonstrated by that day,
the Nasdaq staff will provide written notification that our common stock will
be delisted. At that time we may appeal the staffs determination to a Listing
Qualifications Panel. If our shares are delisted from the Nasdaq SmallCap
Market, our ability to raise additional capital may be hampered. We are
planning efforts to regain compliance, including a recapitalization of our
preferred shares. On July 28, 2004, we entered into a lease agreement with Cisco Systems Capital
Corporation for $1.8 million in hardware, software and professional fees that
supports our VoIP initiative. The majority of this equipment was implemented
during the second quarter and is currently being used to support our VoIP
customer base. The lease terms are for two years with a 25% refundable deposit
amount of $458,137 with two monthly payments (first and last) due immediately.
At the end of the lease the equipment can be purchased for fair market value.
This lease qualifies as an operating lease under the Financial Accounting
Standards Board (FASB) No. 13, Accounting for Leases. As such, we will
record and pay monthly lease amounts through the term of the lease in the
amount of $81,177 (including taxes). For the second quarter 2004, we recorded
$63,681 for professional fees and $151,733 for leased equipment expense. On October 9, 2003,
Z-Tel Communications, Inc., our wholly-owned subsidiary corporation, had filed
a lawsuit against SBC Communications, Inc. and several of its subsidiaries
(collectively, SBC) in federal court in Texas, where both SBC and we 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 had filed a motion to dismiss the
complaint. On August 6, 2004, the court denied 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. 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,
as well as 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. We launched our voice-over
Internet protocol (VoIP) service to business customers in May 2004 on a beta
testing basis and expect to have a residential offering available in certain
markets by the fourth quarter of 2004. 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. 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. For management purposes, we are organized into two reportable operating
segments: retail services and wholesale services. The nature of our business is
rapidly evolving. 14




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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. Our second quarter 2004 financial and operating results include our investments
to expand our business services unit and to prepare for our VoIP initiatives
that we expect to increasingly launch over the second half of 2004. Consistent with our plan to shift away from being an unbundled element platform
(UNE-P) only provider, 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. We focused the balance of our resources during the second quarter of 2004 on
developing additional business clients on our UNE-P platform. Retail Brand
Alliance (the parent of Brooks Brothers stores, Casual Corner
Group, Carolee, Adrienne Vittadini) and Crabtree & Evelyn stores
have recently decided to take advantage of Z-Tels Managed Local Services.
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. 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. By doing so,
we think we can mitigate our reliance of the ILECs and increase our operating
profitability through margin expansion. We may or may not be successful in
this endeavor. CONSOLIDATED RESULTS OF OPERATIONS The three and six months ended June 30, 2004 compared to the same period in the
prior year. 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 six
months ended June 30, 2004 and 2003 are as follows: For the three months
    
    Amount
    
    Percentageended June 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Results of Operations:Revenues
    
    $
    63.8
    
    
    $
    71.1
    
    
    $
    (7.3
    )
    
    
    (10.3
    )%
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    31.2
    
    
    
    32.1
    
    
    
    0.9
    
    
    
    2.8
    %
    
    
    48.9
    %
    
    
    45.1
    %Sales and marketing
    
    
    4.5
    
    
    
    6.6
    
    
    
    2.1
    
    
    
    31.8
    %
    
    
    7.1
    %
    
    
    9.3
    %General and administrative
    
    
    31.7
    
    
    
    31.9
    
    
    
    0.2
    
    
    
    0.6
    %
    
    
    49.7
    %
    
    
    44.9
    %Restructuring Charge
    
    
    0.8
    
    
    
    
    
    
    
    (0.8
    )
    
    
    (100.0
    )%
    
    
    1.2
    %
    
    
    
    %Depreciation and amortization
    
    
    5.1
    
    
    
    6.0
    
    
    
    0.9
    
    
    
    15.0
    %
    
    
    8.0
    %
    
    
    8.4
    %Total operating expenses
    
    
    73.3
    
    
    
    76.6
    
    
    
    3.3
    
    
    
    4.3
    %
    
    
    114.9
    %
    
    
    107.7
    %Operating loss
    
    
    (9.5
    )
    
    
    (5.5
    )
    
    
    (4.0
    )
    
    
    (72.7
    )%
    
    
    (14.9
    )%
    
    
    (7.7
    )%Nonoperating income (loss):Interest and other income
    
    
    0.5
    
    
    
    0.2
    
    
    
    0.3
    
    
    
    150.0
    %
    
    
    0.8
    %
    
    
    0.3
    %Interest and other expense
    
    
    (2.1
    )
    
    
    (0.7
    )
    
    
    (1.4
    )
    
    
    (200.0
    )%
    
    
    (3.3
    )%
    
    
    (1.0
    )%Total nonoperating income (loss)
    
    
    (1.6
    )
    
    
    (0.5
    )
    
    
    (1.1
    )
    
    
    220.0
    %
    
    
    (2.5
    )%
    
    
    (0.7
    )%Net loss
    
    
    (11.1
    )
    
    
    (6.0
    )
    
    
    (5.1
    )
    
    
    (85.0
    )%
    
    
    (17.4
    )%
    
    
    (8.4
    )%Less mandatorily redeemable convertible
preferred stock dividends and accretion
    
    
    (3.6
    )
    
    
    (4.6
    )
    
    
    1.0
    
    
    
    21.7
    %
    
    
    (5.6
    )%
    
    
    (6.5
    )%Less deemed dividend related to beneficial
conversion feature
    
    
    (0.1
    )
    
    
    (0.1
    )
    
    
    
    
    
    
    
    %
    
    
    (0.2
    )%
    
    
    (0.1
    )%Net loss attributable to common stockholders
    
    $
    (14.8
    )
    
    $
    (10.7
    )
    
    $
    (4.1
    )
    
    
    (38.3
    )%
    
    
    (23.2
    )%
    
    
    (15.0
    )%Cash Flow Data:Net cash used in operating activities
    
    $
    (12.4
    )
    
    $
    1.0
    
    
    $
    (13.4
    )
    
    
    (1,340.0
    )%
    
    
    
    *
    
    
    
    *Net cash used in investing activities
    
    
    (2.3
    )
    
    
    (2.6
    )
    
    
    0.3
    
    
    
    11.5
    %
    
    
    
    *
    
    
    
    *Net cash provided by financing activities
    
    
    11.1
    
    
    
    (1.2
    )
    
    
    12.3
    
    
    
    (1,025.0
    )%
    
    
    
    *
    
    
    
    *Net decrease in cash and cash equivalents
    
    $
    (3.6
    )
    
    $
    (2.8
    )
    
    $
    (0.8
    )
    
    
    28.6
    %
    
    
    
    *
    
    
    
    *
 15




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For the six months
    
    Amount
    
    Percentageended June 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Results of Operations:Revenues
    
    $
    132.3
    
    
    $
    132.0
    
    
    $
    0.3
    
    
    
    0.2
    %
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    65.3
    
    
    
    58.9
    
    
    
    (6.4
    )
    
    
    (10.9
    )%
    
    
    49.4
    %
    
    
    44.6
    %Sales and marketing
    
    
    9.0
    
    
    
    11.1
    
    
    
    2.1
    
    
    
    18.9
    %
    
    
    6.8
    %
    
    
    8.4
    %General and administrative
    
    
    66.2
    
    
    
    58.9
    
    
    
    (7.3
    )
    
    
    (12.4
    )%
    
    
    50.0
    %
    
    
    44.6
    %Restructuring Charge
    
    
    0.8
    
    
    
    
    
    
    
    (0.8
    )
    
    
    (100.0
    )%
    
    
    0.6
    %
    
    
    
    %Depreciation and amortization
    
    
    10.4
    
    
    
    12.0
    
    
    
    1.6
    
    
    
    13.3
    %
    
    
    7.9
    %
    
    
    9.1
    %Total operating expenses
    
    
    151.7
    
    
    
    140.9
    
    
    
    (10.8
    )
    
    
    (7.7
    )%
    
    
    114.7
    %
    
    
    106.7
    %Operating loss
    
    
    (19.4
    )
    
    
    (8.9
    )
    
    
    (10.5
    )
    
    
    (118.0
    )%
    
    
    (14.7
    )%
    
    
    (6.7
    )%Nonoperating income (loss):Interest and other income
    
    
    1.3
    
    
    
    1.2
    
    
    
    0.1
    
    
    
    8.3
    %
    
    
    1.0
    %
    
    
    0.9
    %Interest and other expense
    
    
    (3.4
    )
    
    
    (1.4
    )
    
    
    (2.0
    )
    
    
    (142.9
    )%
    
    
    (2.6
    )%
    
    
    (1.1
    )%Total nonoperating income (loss)
    
    
    (2.1
    )
    
    
    (0.2
    )
    
    
    (1.9
    )
    
    
    (950.0
    )%
    
    
    (1.6
    )%
    
    
    (0.2
    )%Net loss
    
    
    (21.5
    )
    
    
    (9.1
    )
    
    
    (12.4
    )
    
    
    (136.3
    )%
    
    
    (16.3
    )%
    
    
    (6.9
    )%Less mandatorily redeemable convertible
preferred stock dividends and accretion
    
    
    (8.0
    )
    
    
    (8.9
    )
    
    
    0.9
    
    
    
    10.1
    %
    
    
    (6.0
    )%
    
    
    (6.7
    )%Less deemed dividend related to beneficial
conversion feature
    
    
    (0.1
    )
    
    
    (0.1
    )
    
    
    
    
    
    
    
    %
    
    
    (0.1
    )%
    
    
    (0.1
    )%Net loss attributable to common stockholders
    
    $
    (29.6
    )
    
    $
    (18.1
    )
    
    $
    (11.5
    )
    
    
    (63.5
    )%
    
    
    (22.4
    )%
    
    
    (13.7
    )%Cash Flow Data:Net cash used in operating activities
    
    $
    (9.2
    )
    
    $
    6.1
    
    
    $
    (15.3
    )
    
    
    (250.8
    )%
    
    
    
    *
    
    
    
    *Net cash used in investing activities
    
    
    (4.7
    )
    
    
    (5.7
    )
    
    
    1.0
    
    
    
    17.5
    %
    
    
    
    *
    
    
    
    *Net cash provided by financing activities
    
    
    10.1
    
    
    
    (2.2
    )
    
    
    12.3
    
    
    
    (559.1
    )%
    
    
    
    *
    
    
    
    *Net decrease in cash and cash equivalents
    
    $
    (3.8
    )
    
    $
    (1.8
    )
    
    $
    (2.0
    )
    
    
    111.1
    %
    
    
    
    *
    
    
    
    *
 (*) Not meaningful Revenues. Revenues decreased by $7.3 million to $63.8 million for the three
months ended June 30, 2004, compared to $71.1 million the prior year. The
decrease in revenues was primarily a result of the decline in residential UNE-P
lines in service by approximately 58,000 lines. This decrease was in line
with our intent to make less investment in traditional consumer subscribers,
instead focusing on the growth of our business and VoIP services. Revenues increased by $.3 million to $132.3 million for the six months ended
June 30, 2004, compared to $132.0 million the prior year. We experienced a
decrease in consumer related revenues over this period, compared to the prior
year, but this decrease was offset by a similar increase in wholesale and
business revenues over the period. The following table provides a break-down of our revenues and changes for the
three and six months ended June 30, 2004 compared to the same period in 2003: Revenues for the three
    
    Amount
    
    Percentagemonths ended June 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Residential Services
    
    $
    36.0
    
    
    $
    52.0
    
    
    $
    (16.0
    )
    
    
    (30.8
    )%
    
    
    56.4
    %
    
    
    73.1
    %Business Services
    
    
    4.9
    
    
    
    0.6
    
    
    
    4.3
    
    
    
    716.7
    %
    
    
    7.7
    %
    
    
    0.8
    %1+ Long Distance Services
    
    
    1.9
    
    
    
    2.6
    
    
    
    (0.7
    )
    
    
    (26.9
    )%
    
    
    3.0
    %
    
    
    3.7
    %Wholesale Services
    
    
    21.0
    
    
    
    15.9
    
    
    
    5.1
    
    
    
    32.1
    %
    
    
    32.9
    %
    
    
    22.4
    %Total
    
    $
    63.8
    
    
    $
    71.1
    
    
    $
    (7.3
    )
    
    
    (10.3
    )%
    
    
    100.0
    %
    
    
    100.0
    %
 16




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Revenues for the six
    
    Amount
    
    Percentagemonths ended June 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Residential Services
    
    $
    76.1
    
    
    $
    96.5
    
    
    $
    (20.4
    )
    
    
    (21.1
    )%
    
    
    57.5
    %
    
    
    73.1
    %Business Services
    
    
    8.2
    
    
    
    1.0
    
    
    
    7.2
    
    
    
    720.0
    %
    
    
    6.2
    %
    
    
    0.8
    %1+ Long Distance Services
    
    
    3.9
    
    
    
    5.6
    
    
    
    (1.7
    )
    
    
    (30.4
    )%
    
    
    3.0
    %
    
    
    4.2
    %Wholesale Services
    
    
    44.1
    
    
    
    28.9
    
    
    
    15.2
    
    
    
    52.6
    %
    
    
    33.3
    %
    
    
    21.9
    %Total
    
    $
    132.3
    
    
    $
    132.0
    
    
    $
    0.3
    
    
    
    0.2
    %
    
    
    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 endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Residential Services
    
    
    185,631
    
    
    
    244,345
    
    
    
    181,344
    
    
    
    256,007Business Services
    
    
    39,554
    
    
    
    4,680
    
    
    
    46,514
    
    
    
    5,9421+ Long Distance Services
    
    
    55,737
    
    
    
    95,539
    
    
    
    49,451
    
    
    
    90,003Wholesale Services
    
    
    347,821
    
    
    
    108,201
    
    
    
    355,912
    
    
    
    157,800Total
    
    
    628,743
    
    
    
    452,765
    
    
    
    633,221
    
    
    
    509,752
 Average lines in service
    
    Ending lines in servicefor the six months ended
    
    for the six months endedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Residential Services
    
    
    193,051
    
    
    
    229,730
    
    
    
    181,344
    
    
    
    256,007Business Services
    
    
    34,054
    
    
    
    2,971
    
    
    
    46,514
    
    
    
    5,9421+ Long Distance Services
    
    
    61,935
    
    
    
    98,328
    
    
    
    49,451
    
    
    
    90,003Wholesale Services
    
    
    326,368
    
    
    
    106,662
    
    
    
    355,912
    
    
    
    157,800Total
    
    
    615,408
    
    
    
    437,691
    
    
    
    633,221
    
    
    
    509,752
 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 because of the gross accounting method used to record our wholesale
services revenue which makes ARPU for wholesale services a largely meaningless
business measure. We believe ARPU, which calculates the average revenue per
average line in service, is a useful measure to evaluate our past revenues and
to assist in forecasting our future retail revenues. We also believe that this
measure provides a gauge to compare and contrast our revenue streams and to
compare our revenues to other communication providers that have significantly
more or less subscribers than we have. The following table provides a summary
of our ARPU: Average revenue per unit in servicefor the three months ended
    
    Amount
    
    PercentageJune 30,
    
    Change
    
    ChangeFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)Residential Services
    
    $
    64.64
    
    
    $
    70.94
    
    
    $
    (6.30
    )
    
    
    (8.9
    )%Business Services
    
    $
    41.29
    
    
    $
    42.74
    
    
    $
    (1.45
    )
    
    
    (3.4
    )%1+ Long Distance Services
    
    $
    11.36
    
    
    $
    9.07
    
    
    $
    2.29
    
    
    
    25.3
    %Wholesale Services
    
    
    
    *
    
    
    
    *
    
    
    
    *
    
    
    
    *
 17




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##### Table of Contents



Average revenue per unit in servicefor the six months ended
    
    Amount
    
    PercentageJune 30,
    
    Change
    
    ChangeFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)Residential Services
    
    $
    65.70
    
    
    $
    70.01
    
    
    $
    (4.31
    )
    
    
    (6.2
    )%Business Services
    
    $
    40.13
    
    
    $
    56.10
    
    
    $
    (15.97
    )
    
    
    (28.5
    )%1+ Long Distance Services
    
    $
    10.49
    
    
    $
    9.49
    
    
    $
    1.00
    
    
    
    10.5
    %Wholesale Services
    
    
    
    *
    
    
    
    *
    
    
    
    *
    
    
    
    *
 (*) Not meaningful The overall change in our revenues for the three and six months ended June 30,
2004 compared to the same prior year period was largely driven by our continued
focus in 2004 on growing our wholesale and retail business services, preparing
for the launch of our VoIP services, and to reduce our investment in the
traditional consumer business. Residential UNE-P and 1+ long distance service
revenues combined to decrease $16.7 and $22.1 million for the three and six
months ended June 30, 2004, respectively. This was a result of our continued
shift away from actively investing in our residential UNE-P business, a trend
that began during mid-2003. With respect to our existing revenue streams, we
intend to focus the majority of our sales and marketing investment on our
business services segment and in marketing our emerging VoIP based services. We also anticipate that our ARPU will continue to decline, perhaps materially,
into the foreseeable future, primarily due to the
competitive climate and planned reductions in access fees. To the extent that
we are able to develop more and/or new service offerings, such as our PVA
and/or Digital Subscriber Line (DSL), we may have some opportunity to
mitigate any fundamental decrease in general levels of ARPU. We intend to
invest in sales and marketing activities to attract select business customers. Negative legal and regulatory outcomes could restrict or increase the costs of
our access to ILEC networks. We would expect to respond by substantially
curtailing or perhaps fully eliminating our marketing of UNE-P based services
and focusing primarily on offering VoIP services, thereby reducing our reliance
on the ILEC networks. We may or may not be successful in this endeavor. As of July 21, 2004 we have approximately 43 VoIP customers in beta test with a
total of 338 lines. We continue to target companies with large existing
consumer and business customer bases for various forms of partnership
opportunities, and we are also exploring additional distribution arrangements
and delivery opportunities for our current and future services. We are also
seeking additional wholesale service relationships and expect to focus our
business sales on large national multi-locations business customers because we
believe that our service offering is most attractive to these types of
customers. Network Operations. Network operations expense decreased by $.9 million to
$31.2 million for the three months ended June 30, 2004, compared to $32.1
million the prior year. The decrease in network operations expense was
primarily the result of having an overall smaller average number of lines in
service for the three months ended June 30, 2004 compared to the same prior
year period. Network operations expense increased by $6.4 million to $65.3 million for the
six months ended June 30, 2004, compared to $58.9 million the prior year. The
overall increase was due to wholesale line growth outstripping the residential
line falloff especially during the first quarter of 2004 as compared to the
prior year. Our network operations expense primarily consists of fixed and
variable transmission expenses for the leasing of the UNE-P components from the
ILECs, domestic and international charges from service level agreements with
IXCs, the Universal Service Fee and certain other regulatory charges to be
consistent with industry practice. 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 ofJune 30,
    
    Change
    
    Change
    
    Network OperationsFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Residential & Business Services
    
    $
    21.3
    
    
    $
    24.1
    
    
    $
    2.8
    
    
    
    11.6
    %
    
    
    68.2
    %
    
    
    75.1
    %1+ Long Distance Services
    
    
    0.3
    
    
    
    0.7
    
    
    
    0.4
    
    
    
    57.1
    %
    
    
    1.0
    %
    
    
    2.2
    %Wholesale Services
    
    
    9.6
    
    
    
    7.3
    
    
    
    (2.3
    )
    
    
    (31.5
    )%
    
    
    30.8
    %
    
    
    22.7
    %Total
    
    $
    31.2
    
    
    $
    32.1
    
    
    $
    0.9
    
    
    
    2.8
    %
    
    
    100.0
    %
    
    
    100.0
    %
 18




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##### Table of Contents



Network Operations for thesix months ended
    
    Amount
    
    Percentage
    
    Percentage ofJune 30,
    
    Change
    
    Change
    
    Network OperationsFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Residential & Business Services
    
    $
    43.5
    
    
    $
    46.0
    
    
    $
    2.5
    
    
    
    5.4
    %
    
    
    66.6
    %
    
    
    78.1
    %1+ Long Distance Services
    
    
    0.8
    
    
    
    1.4
    
    
    
    0.6
    
    
    
    42.9
    %
    
    
    1.2
    %
    
    
    2.4
    %Wholesale Services
    
    
    21.0
    
    
    
    11.5
    
    
    
    (9.5
    )
    
    
    (82.6
    )%
    
    
    32.2
    %
    
    
    19.5
    %Total
    
    $
    65.3
    
    
    $
    58.9
    
    
    $
    (6.4
    )
    
    
    (10.9
    )%
    
    
    100.0
    %
    
    
    100.0
    %
 Our network operations expense as a percentage of revenues increased to 48.9%
for three months ended June 30, 2004 compared to 45.1% in the prior year. Our
network operations expense as a percentage of revenues increased to 49.4% for
the six months ended June 30, 2004 compared to 44.6% in the prior year. The
increase in network operations expense was primarily a result of the increase
in wholesale lines in service. The following tables provide a detail of network operations expense as a
percentage of revenues by the respective revenue types. Network operations as a% of revenues for the
    
    Amountthree months ended June 30,
    
    ChangeFavorable2004
    
    2003
    
    (Unfavorable)Residential & Business Services
    
    
    52.1
    %
    
    
    45.8
    %
    
    
    (6.3
    )%1+ Long Distance Services
    
    
    15.8
    %
    
    
    26.9
    %
    
    
    11.1
    %Wholesale Services
    
    
    45.7
    %
    
    
    45.9
    %
    
    
    0.2
    %
 Network operations as a% of revenues for the
    
    Amountsix months ended June 30,
    
    ChangeFavorable2004
    
    2003
    
    (Unfavorable)Residential & Business Services
    
    
    51.6
    %
    
    
    47.2
    %
    
    
    (4.4
    )%1+ Long Distance Services
    
    
    20.5
    %
    
    
    25.0
    %
    
    
    4.5
    %Wholesale Services
    
    
    47.6
    %
    
    
    39.8
    %
    
    
    (7.8
    )%
 We also analyze the average expense per unit (AEPU) for network operations
expense, similar to the ARPU calculation for revenues. AEPU is calculated by
taking total network operations expense divided by the number of months in the
period and is divided by the average lines in service during the respective
period. We believe AEPU, which calculates the average network operations
expense per average line in service, is a useful measure to evaluate our past
network operations expense and to assist in forecasting our future retail
network operations expense. We also believe that this measure provides a gauge
to compare our network operations expense to other communications providers
that have significantly more or less subscribers than we have. The following
details AEPU for retail network operations expense: Average network operationsexpense per unit for thethree months ended
    
    Amount
    
    PercentageJune 30,
    
    Change
    
    ChangeFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)Residential & Business Services
    
    $
    31.53
    
    
    $
    32.26
    
    
    $
    0.73
    
    
    
    2.3
    %1+ Long Distance Services
    
    $
    1.79
    
    
    $
    2.44
    
    
    $
    0.65
    
    
    
    26.6
    %Wholesale Services
    
    
    
    *
    
    
    
    *
    
    
    
    *
    
    
    
    *
 19




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##### Table of Contents



Average network operationsexpense per unit for thesix months ended
    
    Amount
    
    PercentageJune 30,
    
    Change
    
    ChangeFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)Residential & Business Services
    
    $
    31.92
    
    
    $
    32.95
    
    
    $
    1.03
    
    
    
    3.1
    %1+ Long Distance Services
    
    $
    2.15
    
    
    $
    2.37
    
    
    $
    0.22
    
    
    
    9.3
    %Wholesale Services
    
    
    
    *
    
    
    
    *
    
    
    
    *
    
    
    
    *
 (*) Not meaningful Similar to the ARPU analysis, this table excludes an analysis of wholesale
services because management does not look at this measure, given that network
expenses related to wholesale services are intended to be zero-margin direct
cost pass-through in nature. We do expect increases to our AEPU as a result of increased end user usage,
continued geographical dispersion of customers to more expensive UNE-P pricing
zones and states, an increased proportion of business lines which have a higher
network operations expense per unit, and probable increased costs due to
uncontrollable change within the regulatory arena relative to the rules under
which we gain access to the various UNE-P elements today. We will attempt to
ensure that the pricing and availability of UNE-P is conducive to our desire to
compete; however, we recognize the wide-range of possibilities that could
occur, including the possibility of an immediate and material adverse effect
upon our business. We will also begin to experience additional fixed facility
charges and additional network operation expenses as we develop and grow our
VoIP offering. As stated above negative legal and regulatory outcomes could
increase the costs of, or restrict altogether, gaining access to ILEC networks.
We would expect to respond by substantially curtailing, or perhaps fully
eliminating, our marketing of UNE-P-based services and focusing primarily on
VoIP services, thereby mitigating our reliance on ILEC networks. Sales and Marketing. Sales and marketing expense decreased $2.1 million to $4.5
million for the three months ended June 30, 2004 compared to $6.6 million the
prior year. Sales and marketing expense decreased $2.1 million to $9.0
million for the six months ended June 30, 2004 compared to $11.1 million 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. Although the sales and marketing expense decreased for the six months ended
June 30, 2004 compared to the same prior year period there were several
significant changes in certain line items that compose this expense as detailed
below:  
    
    $2.0 million increase in payroll and related expense as a result of
significantly growing our
internal sales force to grow our business and VoIP offerings;
    
    $3.5 million decrease to other discretionary marketing such as telemarketing,
direct mail, and
other brand awareness items;
    
    $.5 million decrease in one-time and recurring commissions to independent sales contractors. This
is mainly due to the corresponding decrease in residential lines. We expect to leverage our in-house sales team in the coming months as we have
grown this team to drive growth in our business and VoIP offerings and expect
to reduce the use of our independent sales contractors to sell business
services over the coming quarters. Our business and VoIP sales efforts may
become more localized in areas in which we expect to make a substantial
investment in VoIP facilities. We believe that by focusing our investment in
certain areas we will maximize our network economies in making a transition
from a UNE-P based access delivery method to a VoIP solution. We intend to
offer additional VoIP based enhanced services, and to reduce our reliance on
the incumbent local exchange carriers. Now that we have built a core in-house
sales team we expect business sales to provide lower acquisition costs than we
have previously experienced. As stated above, legal and regulatory matters
could continue to cause us to substantially curtail or fully eliminate the
marketing of our UNE-P based services. General and Administrative. 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. General and administrative expense decreased $.2 million to $31.7 million for
the three months ended June 30, 2004, compared to $31.9 million in the prior
year period. General and administrative expense as a percentage of revenue
increased by 4.8% to 49.7% for the three months ended June 30, 2004, compared
to 44.9% in the prior year period. The decrease in our general and administrative expense for the three months
ended June 30, 2004 was primarily a result of improved collection rates that
resulted in decreases to bad debt expense of $2.8 million compared to the same
period in the prior year. These 20




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##### Table of Contents



were partially offset by increases in sales
and use tax expense of $1.0 million as well as additional legal fees due of
$1.1 million for outstanding legal matters and efforts to support our position
on contested regulatory issues related to UNE-P. We also had an increase in
health insurance expense of $.4 million. General and administrative expense increased $7.3 million to $66.2 million for
the six months ended June 30, 2004, compared to $58.9 million in the prior year
period. General and administrative expense as a percentage of revenue increased
by 5.4% to 50.0% for the six months ended June 30, 2004, compared to 44.6% in
the prior year period. The specific significant changes in general and administrative expense line
items for the six months ended June 30, 2004 from the same prior year period
were as follows:  
    
    Increase in legal and professional fees - $2.3 million
    
    Increase in sales and use tax expense - $1.9 million
    
    Increase in stock expense for issuance of restricted stock - $0.2 million
    
    Increase in wholesale service costs - $1.4 million
    
    Reduction in ILEC performance credits - $2.6 million
    
    Settlement for litigation related to Metro Nashville - $1.8 million
    
    Accrual for payroll bonus and related expenses - $1.1 million
    
    Increase in health insurance expense - $0.6 million
    
    Reduction in bad debt expense - $3.5 million
    
    Reduction in support fees (telephone & verification expense) - $0.9 million
    
    Reduction due to New York lease settlement - $0.2 million The increase in general and administrative expense as a percentage of revenue
is partially the result of our continued investment in technology personnel and
the dedication of existing resources to the continued development and expansion
of our VoIP offering. We also spent significantly more on legal and regulatory
fees for the six months ended June 30, 2004 compared to the prior year period
due primarily to the Metro Nashville lawsuit against us, our continued
anti-trust lawsuit against SBC Communications and a continued
investment in supporting the legal and regulatory arguments for the continuance
of the current UNE-P rules as mandated by the 1996 Telecommunications Act. We anticipate general and administrative expenditures will continue to increase
in total to support our planned expansion of service offerings for VoIP. We
will continue to evaluate our operations for efficiencies and our employee
staffing requirements as they relate to increased efficiencies or needs to
expand our outsource services. As stated above legal and regulatory matters could significantly increase the
costs of our access to ILEC networks, if not fully eliminate our access. We
would likely respond with a reduction in the number of our employees to reduce
general and administrative expenses and help enable us to invest in VoIP
operations. Depending on the final resolution of these regulatory matters as
they relate to the pricing that we pay to other network providers, we may or
may not be able to reduce enough General and Administrative expense to remain a
going concern. Restructuring Charge. We recorded a restructuring charge in the amount of $.8
million for the three and six months ending June 30, 2004 as compared to the
prior year. The primary measure as part of a set of initiatives that we
implemented in early June 2004 was a reduction in force of 102 employees, which
in aggregate, earned a total salary of approximately $3.5 million. The
reduction in force triggered the WARN Act and therefore employees received a
severance of at least two months salary and benefits. We recorded the total
charge for this initiative in the period ended June 30, 2004 (see Footnote 7 to
our financial statements in this report). Depreciation and Amortization. Depreciation and amortization expense decreased
$.9 million to $5.1 million for the three months ended June 30, 2004, compared
to $6.0 million the prior year period. Depreciation and amortization expense
decreased $1.6 million to $10.4 million for the six months ended June 30, 2004,
compared to $12.0 million the prior year period. Depreciation expense
decreased during the three months and six months ending June 30, 2004 due to
some of our equipment reaching the end of its fully depreciable life. We have
generally been recording more depreciation expense than capital expenditures
for several years, and consequently our depreciable capital asset base is
smaller than it has been historically. We expect to purchase additional computer equipment, switching equipment,
furniture and leasehold improvements as a result of our intended VoIP
expansion. We will also continually evaluate our depreciation policy with
respect to our current and future network 21




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##### Table of Contents



plans and the associated purchases of
capital equipment. Depending on a variety of matters, including but not
limited to, our success in transitioning from UNE-P to VoIP, we may or may not
write-off certain assets in the future. Interest and Other Income. Interest and other income was $0.5 million as
compared to $0.2 million for the three months ending June 30, 2004 and 2003,
respectively. Interest and other income was $1.3 million as compared to $1.2
million for the six months ending June 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 $1.4 million
to $2.1 million for the three months ended June 30, 2004, compared to $0.7
million the prior year period. Interest and other expense increased $2.0
million to $3.4 million for the six months ended June 30, 2004, compared to
$1.4 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. The overall increase in
interest and other expense for the three and six months ended June 30, 2004
compared to the prior year period was the result of increased late payment
charges on vendor payments. We anticipate that interest expense may increase
due to the additional availability that may be created from our new asset based
loan with Textron Financial Corporation. We also expect to finance as much of
our VoIP related capital expenditures as possible and we are seeking and
considering additional debt offerings and other financing options in an effort
to improve our liquidity in order to fund our growth initiatives for 2004. 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 six months ended June 30, 2004 and the same 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 offering. In mid-2003 we shifted to focusing on
growing our business bundled service lines, and to only passively investing in
our consumer UNE-P business. We have continued to fully harvest the 1+
long-distance stand-
alone offering for maximum cash flow since its acquisition in April 2000. The
following tables, in millions, summarize the results for our retail services
business segment for the three and six months ended June 30, 2004, respectively
compared to the prior year period: Retail Services SegmentFor the three months
    
    Amount
    
    Percentageended June 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003RevenuesBundled residential services
    
    $
    36.0
    
    
    $
    52.0
    
    
    $
    (16.0
    )
    
    
    (30.8
    )%
    
    
    84.1
    %
    
    
    94.2
    %Bundled business services
    
    
    4.9
    
    
    
    0.6
    
    
    
    4.3
    
    
    
    716.7
    %
    
    
    11.5
    %
    
    
    1.1
    %1+ long-distance services
    
    
    1.9
    
    
    
    2.6
    
    
    
    (0.7
    )
    
    
    (26.9
    )%
    
    
    4.4
    %
    
    
    4.7
    %Total Revenues
    
    
    42.8
    
    
    
    55.2
    
    
    
    (12.4
    )
    
    
    (22.5
    )%
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    21.6
    
    
    
    24.8
    
    
    
    3.2
    
    
    
    12.9
    %
    
    
    50.5
    %
    
    
    44.9
    %Sales and marketing
    
    
    4.4
    
    
    
    6.6
    
    
    
    2.2
    
    
    
    33.3
    %
    
    
    10.3
    %
    
    
    12.0
    %Restructure Charge
    
    
    0.8
    
    
    
    
    
    
    
    (0.8
    )
    
    
    (100.0
    )%
    
    
    1.9
    %
    
    
    
    %General and administrative
    
    
    24.8
    
    
    
    26.7
    
    
    
    1.9
    
    
    
    7.1
    %
    
    
    57.9
    %
    
    
    48.4
    %Total operating expenses
    
    
    51.6
    
    
    
    58.1
    
    
    
    6.5
    
    
    
    11.2
    %
    
    
    120.6
    %
    
    
    105.3
    %Segment results
    
    $
    (8.8
    )
    
    $
    (2.9
    )
    
    $
    (5.9
    )
    
    
    (203.4
    )%
    
    
    (20.6
    )%
    
    
    (5.3
    )%
 22




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##### Table of Contents



Retail Services SegmentFor the six months
    
    Amount
    
    Percentageended June 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003RevenuesBundled residential services
    
    $
    76.0
    
    
    $
    96.5
    
    
    $
    (20.5
    )
    
    
    (21.2
    )%
    
    
    86.3
    %
    
    
    93.6
    %Bundled business services
    
    
    8.2
    
    
    
    1.0
    
    
    
    7.2
    
    
    
    720.0
    %
    
    
    9.3
    %
    
    
    1.0
    %1+ long-distance services
    
    
    3.9
    
    
    
    5.6
    
    
    
    (1.7
    )
    
    
    (30.4
    )%
    
    
    4.4
    %
    
    
    5.4
    %Total Revenues
    
    
    88.1
    
    
    
    103.1
    
    
    
    (15.0
    )
    
    
    (14.5
    )%
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    44.3
    
    
    
    47.4
    
    
    
    3.1
    
    
    
    6.5
    %
    
    
    50.3
    %
    
    
    46.0
    %Sales and marketing
    
    
    8.8
    
    
    
    11.0
    
    
    
    2.2
    
    
    
    20.0
    %
    
    
    10.0
    %
    
    
    10.7
    %General and administrative
    
    
    52.4
    
    
    
    51.8
    
    
    
    (0.6
    )
    
    
    (1.2
    )%
    
    
    59.5
    %
    
    
    50.2
    %Restructure Charge
    
    
    0.8
    
    
    
    
    
    
    
    (0.8
    )
    
    
    (100.0
    )%
    
    
    0.9
    %
    
    
    
    %Total operating expenses
    
    
    106.3
    
    
    
    110.2
    
    
    
    3.9
    
    
    
    3.5
    %
    
    
    120.7
    %
    
    
    106.9
    %Segment results
    
    $
    (18.2
    )
    
    $
    (7.1
    )
    
    $
    (11.1
    )
    
    
    (156.3
    )%
    
    
    (20.7
    )%
    
    
    (6.9
    )%
 Revenues. Revenues decreased by $12.4 million to $42.8 million for the three
months ended June 30, 2004, compared to $55.2 million the prior year period.
The net revenue decline in our retail business of $16.7 million is primarily
related to our reduction in residential and 1+ long distance lines, for the
three months ending June 30, 2004 as compared to the prior period. This was
partially offset by a $4.3 million increase in our business services revenue. Revenues decreased by $15.0 million to $88.1 million for the six months ended
June 30, 2004, compared to $103.1 million the prior year period. The net
revenue decline in our retail business of $22.2 million is primarily related to
our reduction in residential and 1+ long distance lines, for the six months
ending June 30, 2004 as compared to the prior period. This was partially
offset by a $7.2 million increase in our business services revenue. Additionally, our ARPU per bundled consumer UNE-P line decreased by $6.30 to
$64.64 for the three months ended June 30, 2004, compared to $70.94 in the
prior year period. Our ARPU per bundled consumer UNE-P line decreased by $4.31
to $65.70 for the six months ended June 30, 2004, compared to $70.01 in the
prior year period. There were two significant factors that contributed to this
change in ARPU. First, another decrease in access rates (charges that we bill
to other carriers for carrying their traffic to our customers) was effective in
June of 2003 but would not have been fully reflected in the second quarter 2003
numbers as compared to 2004. (A further decrease occurred in June of 2004.)
Secondly, in order to react to the highly competitive telecommunication market
and pricing trends we have seen significant line increases in our unlimited
bundle service offerings to consumer customers. The unlimited service has a
lower ARPU than some of our historical pricing plans because it includes for a
fixed price, unlimited domestic and local calling, in addition to all of our
enhanced services. We expect business service lines to continue to increase throughout the year as
we leverage our in-house business sales staff. Our 1+
long-distance revenue is expected to continually decrease and we expect to have
some VoIP revenues, although not any meaningful amounts, during 2004.
Therefore, we expect that consumer related services will continue to generate
the majority of our overall revenue and cash flow during 2004, due to the size
of the embedded customer base relative to the other lines of business and the
rate at which they may grow. Network Operations. Network operations expense decreased by $3.2 million to
$21.6 million for the three months ended June 30, 2004, compared to $24.8
million the prior year period. Our network operations as a percentage of
revenue increased by 5.6% to 50.5% for the three months ended June 30, 2004,
compared to 44.9% the prior year. Network operations expense decreased by $3.1 million to $44.3 million for the
six months ended June 30, 2004, compared to $47.4 million the prior year
period. Our network operations as a percentage of revenue increased by 4.3% to
50.3% for the six months ended June 30, 2004, compared to 46.0% the prior year. The increase in network operations expense as a percentage of revenue was a
result of increased long distance usage from the growth in our unlimited
service offerings and increases in certain network cost elements as a result of
our customer base being spread across more states and zones within those states
that have less favorable pricing when compared to the states in which we had
customers in the prior year period. These increases were offset by reductions
to network operations expense as a result of the overall decrease in our
overall retail lines in service at June 30, 2004 compared to the prior year
period. We expect network operations expense to increase in the near term as we begin
to incur more VoIP expenditures and believe that the current regulatory
environment surrounding UNE-P will likely result in increased per unit
recurring and non-recurring costs, perhaps significantly. The expected growth
across all of our service offerings will most likely drive increases to our
network operations expense in 2004 and beyond. We believe that over the
longer-term, however, our network costs may decrease on a per unit basis as we 23




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move from a UNE-P LEC dependent based model to a VoIP model. Sales and Marketing. Sales and marketing expense was $4.4 million for the three
months ended June 30, 2004 compared to $6.6 million for the prior year period.
Sales and marketing expense was $8.8 million for the six months ended June 30,
2004 compared to $11.0 for the prior year period. The changes in our sales and
marketing focus are discussed in the consolidated operations. We expect to invest in additional headcount for our in-house business sales
force and reduce our reliance on a large independent sales contractor agreement
for some of our business services line growth which should result in reductions
to our acquisition costs for business lines. We also expect to add more sales
force related headcount in certain markets as we initiate our VoIP efforts. We
anticipate an increasingly localized sales effort in certain markets as VoIP is
utilized as the preferred delivery method of our service to end users. General and Administrative. General and administrative expense decreased $1.9
million to $24.8 million for the three months ended June 30, 2004, compared to
$26.7 million in the prior year. As a percentage of revenues general and
administrative expense increased by 9.5% to 57.9% of revenues for the three
months ended June 30, 2003 compared to 48.4% the prior year period. The decrease in the general and administrative expense for the three months
ended June 20, 2004 was primarily the result of improved collection rates that
resulted in decreases to bad debt expense of $2.8 million and a decrease in
ILEC performance credits received of $1.8 million as compared to the same
period in the prior year. These were partially offset by increases in sales
and use tax expense of $1.0 million as well as additional legal fees due of
$1.1 million for outstanding legal matters and efforts to support our position
on contested regulatory issues related to UNE-P. We also had an increase in
health insurance expense of $.4 million. General and administrative expense increased $0.6 million to $52.4 million for
the six months ended June 30, 2004, compared to $51.8 million the prior year.
As a percentage of revenues general and administrative expense increased by
9.3% to 59.5% of revenues for the six months ended June 30, 2003 compared to
50.2% the prior year period. The overall increase in general and administrative expense for the six months
ended June 30, 2004 mirrors the consolidated increases and decreases except
that the ILEC gateway expenses are lower as a result of less overall
residential lines which is driven by lower residential line acquisition and
some decrease in cost per transaction. The specific significant changes in general and administrative expense line
items for the six months ended June 30, 2004 from the prior year period:  
    
    Increase in legal and professional fees - $2.3 million
    
    Increase in sales and use tax expense - $1.9 million
    
    Increase in stock expense for issuance of restricted stock - $0.2 million
    
    Increase in hardware and software support - $0.8 million
    
    Reduction in ILEC performance credits - $2.6 million
    
    Settlement for litigation related to Metro Nashville - $1.8 million
    
    Accrual for payroll bonus and related expenses - $1.1 million
    
    Reduction in bad debt expense - $3.5 million
    
    Reduction in support fees related to provisioning - $5.3 million
    
    Reduction due to New York lease settlement - $0.2 million
    
    Reduction to billing and collection expense - $1.3 million Included in the retail services general and administrative expense are all
employee benefits, occupancy, insurance, and other indirect or overhead-related
expenses, as only directly assignable costs are recorded within our wholesale
services business segment. We are in the process of reviewing and possibly
adopting a methodology for internal reporting purposes that would allocate a
portion of these indirect and overhead related expenses to the respective
operating segments or possibly separating these expenses from each segment. We are planning for overall line and revenue growth in 2005, and therefore
expect general and administrative expense to decrease as a percentage of
revenues over the longer term as a result of the leveraging of certain elements
of our fixed cost structure, although we do expect an increase in overall
administrative expense in raw dollars as we incur more charges for provisioning
new customers and incremental administrative costs such as billing,
collections, and customer care related expenses during the latter part of 2004
and into 2005. 24




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##### Table of Contents



Our overall general and administrative expenses are somewhat dependent on
operational improvements to our retail customer economics. The most significant
improvement over the past year was in our bad debt expense, which improved due
to our improvements in our customer treatment programs which have been applied
consistently to problem accounts and by targeting higher quality customers from
a sales and marketing perspective. These improvements helped allow us to invest
more rapidly into our business services line of business. We expect to continue
focusing on growth for our business and VoIP service offerings which will
likely contribute to increased general and administrative expense. 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 six months ended June 30, 2004, respectively compared to the prior
year period: Wholesale Services SegmentFor the three months
    
    Amount
    
    Percentageended June 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003RevenuesSprint
    
    $
    20.6
    
    
    $
    10.6
    
    
    $
    10.0
    
    
    
    94.3
    %
    
    
    98.1
    %
    
    
    66.7
    %MCI
    
    
    
    
    
    
    5.1
    
    
    
    (5.1
    )
    
    
    (100.0
    )%
    
    
    
    %
    
    
    32.1
    %Other
    
    
    0.4
    
    
    
    0.2
    
    
    
    0.2
    
    
    
    100.0
    %
    
    
    1.9
    %
    
    
    1.2
    %Total Revenues
    
    
    21.0
    
    
    
    15.9
    
    
    
    5.1
    
    
    
    32.1
    %
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    9.6
    
    
    
    7.4
    
    
    
    (2.2
    )
    
    
    (29.7
    )%
    
    
    45.7
    %
    
    
    46.6
    %General and administrative
    
    
    6.9
    
    
    
    5.3
    
    
    
    (1.6
    )
    
    
    (30.2
    )%
    
    
    32.9
    %
    
    
    33.3
    %Total operating expenses
    
    
    16.5
    
    
    
    12.7
    
    
    
    (3.8
    )
    
    
    (29.9
    )%
    
    
    78.6
    %
    
    
    79.9
    %Segment results
    
    $
    4.5
    
    
    $
    3.2
    
    
    $
    1.3
    
    
    
    40.6
    %
    
    
    21.4
    %
    
    
    20.1
    %
 Wholesale Services SegmentFor the six months
    
    Amount
    
    Percentageended June 30,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003RevenuesSprint
    
    $
    43.7
    
    
    $
    12.3
    
    
    $
    31.4
    
    
    
    255.3
    %
    
    
    98.9
    %
    
    
    42.6
    %MCI
    
    
    0.1
    
    
    
    16.2
    
    
    
    (16.1
    )
    
    
    (99.4
    )%
    
    
    0.2
    %
    
    
    56.0
    %Other
    
    
    0.4
    
    
    
    0.4
    
    
    
    
    
    
    
    
    %
    
    
    0.9
    %
    
    
    1.4
    %Total Revenues
    
    
    44.2
    
    
    
    28.9
    
    
    
    15.3
    
    
    
    52.9
    %
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    21.0
    
    
    
    11.5
    
    
    
    (9.5
    )
    
    
    (82.6
    )%
    
    
    47.5
    %
    
    
    39.8
    %Sales and marketing
    
    
    0.1
    
    
    
    
    
    
    
    (0.1
    )
    
    
    100.0
    %
    
    
    0.3
    %
    
    
    
    %General and administrative
    
    
    13.8
    
    
    
    7.1
    
    
    
    (6.7
    )
    
    
    (94.4
    )%
    
    
    31.2
    %
    
    
    24.6
    %Total operating expenses
    
    
    34.9
    
    
    
    18.6
    
    
    
    (16.3
    )
    
    
    (87.6
    )%
    
    
    79.0
    %
    
    
    64.4
    %Segment results
    
    $
    9.3
    
    
    $
    10.3
    
    
    $
    (1.0
    )
    
    
    (9.7
    )%
    
    
    21.0
    %
    
    
    35.6
    %
 Revenues. Revenues increased by $5.1 million to $21.0 million for the three
months ended June 30, 2004, compared to $15.9 million the prior year period.
Our wholesale service revenues increased to 32.9% of consolidated revenues for
the three months ended June 30, 2004, compared to 22.4% in the prior year
period. We signed our wholesale services agreement with Sprint in February of
2003. Sprint contributed $20.6 million of revenue for the three months ended
June 30, 2004 and was our primary wholesale customer during that period. MCI,
a former wholesale services customer, contributed of $5.1 million of wholesale
revenues during the three months ended June 30, 2003. 25




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Revenues increased by $15.3 million to $44.2 million for the six months ended
June 30, 2004, compared to $28.9 million the prior year period. Our wholesale
service revenues increased to 33.4% of consolidated revenues for the six months
ended June 30, 2004, compared to 21.9% in the prior year period. Sprint
contributed $43.7 million of revenue for the six months ended June 30, 2004 and
was our primary wholesale customer during that period. MCI, a former wholesale
services customer, contributed $16.2 million of wholesale revenues during the
six months ended June 30, 2003. On July 26, 2004 Sprint indicated to us that they plan on committing fewer
resources to the existing wholesale services arrangement under which we
currently operate. Although Sprint is not canceling the agreement, they have
indicated to us that we can expect lower sales volumes as early as August 2004.
We believe that it is likely that this lower monthly sales activity will lead
to an increasingly smaller wholesale subscriber base. To the extent that this
proves to be the case, we will likely reduce the workforce that is currently
dedicated to the Sprint relationship. This workforce is currently compensated
by Sprint at approximately our cost, in proportion to the decline in the size
of the wholesale subscriber base. Our net fee income can be expected to
decline should the wholesale lines in service begin to decline on an
approximately proportional basis. Network Operations. Network operations expense increased by $2.2 million to
$9.6 million for the three months ended June 30, 2004, compared to $7.4 million
in the prior year period. Network operations expense increased by $9.5 million
to $21.0 million for the six months ended June 30, 2004, compared to $11.5
million in the prior year period. The increases in network operations expenses for the three and six month
periods were mostly attributable to an increase in Sprint wholesale lines in
service in the latter part of 2003 and into 2004. In late 2003, Sprint decided to become the customer of record for billing
purposes from the ILECs for all future customers. This transition was
completed by January 2004. As churn impacts the number of lines implemented
before January 2004, we will expect network operations expense, and revenue, to
decrease. Although, it should still be larger than the amounts reported during
2003 for part of the year as a result of the increased total lines that we are
still receiving ILEC billings for. This decrease should have little to no
impact on our reported segment results. General and Administrative. General and administrative expense increased by
$1.6 million to $6.9 million for the three months ended June 30, 2004, compared
to $5.3 million in the prior year period. General and administrative expense
increased by $6.7 million to $13.8 million for the six months ended June 30,
2004, compared to $7.1 million in the prior year period. 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. The increase in general and
administrative expense is a result of increased wholesale lines in service as a
result of growth attributable to Sprint. The increase in general and administrative expense is the result of increased
payroll expense, the outsourcing of certain functions to limit our cost
exposure and increased non-recurring provisioning expenses to establish service
for our wholesale customers. Due to the expectation that Sprint will commit
less resources to the existing wholesale services arrangement under which we
currently operate, we expect general and administrative expense to decrease
over the remainder of 2004. We will continue to monitor our
wholesale services and determine the appropriate bad debt methodology based on
each individual wholesale contract, but we do not expect any material changes
to our current approach. 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 also now developing
a VoIP initiative, 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. We will continue providing our
UNE-P based services, but our focus will increasingly move towards utilizing
VoIP as an access method whereby we will provide service to our own end users.
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, software development, 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 June
30, 2004, we had an accumulated deficit of $340.4 million, a net tax operating
loss carry forward of approximately $280.8 million, and $8.2 million in cash
and cash equivalents. We have funded our expenditures primarily through
operating revenues, private securities offerings, an asset based loan agreement
and an initial public offering that raised net proceeds of $109.1 million, and
working capital facilities. 26




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##### Table of Contents



We anticipate that we may not generate adequate cash flow over the near future
to meet all of our operating, investing and financing requirements. We are
actively exploring potential financing arrangements to help improve our
liquidity position and to give us more flexibility in pursuing our business
plan over the near future. We have the ability and intent to curtail growth
initiatives and spending, including the reduction of certain discretionary
capital and marketing costs or the implementation of a workforce reduction, in
order to continue as a going-concern. There can be no assurance, however, that
we will be able to implement our strategies or obtain additional financing
under favorable terms, if at all. Net cash used in operating activities decreased by $15.3 million to $9.2
million for the six months ended June 30, 2004, compared to $6.1 million in the
prior year period. The decrease was primarily a result of the termination of
our RFC agreement in favor of a new asset based loan obtained from Textron
Financial Corporation in April 2004. 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 $1.0 million to $4.7
million for the six months ended June 30, 2004, compared to $5.7 million the
prior year period. The decrease was primarily attributable to the reduction
in property and equipment purchases for the six months ended June 30, 2004
compared to the prior year period. We expect our capital expenditures to
increase during the last half of 2004, as we plan to increasingly transition
our services to a VoIP platform which is a more capital intensive service
platform than UNE-P has been. We will attempt to obtain financing for these
purchases, but may be unsuccessful in doing so. Our net cash provided by financing activities increased $12.3 million to $10.1
million for the six months ended June 30, 2004 compared to $2.2 million the
prior year period. The increase was primarily attributable to the execution of
the Textron Financial Corporation asset based loan agreement. We expect our total debt to increase during 2004 because of our new asset based
loan that we obtained from Textron Financial in April 2004 and due to our
intent to finance as much of our capital expenditures as possible over the
balance of 2004 and into 2005. The Textron agreement replaced the factoring
agreement that we had in place with Textrons subsidiary company, RFC. This
new agreement will be a loan as opposed to a factoring facility and will
therefore be recorded as a financing transaction. The old RFC agreement had
been reflected as an operating cash flow item. The new asset based loan will
include more of our accounts receivable in the borrowing base calculation than
was historically the case with RFC, therefore, likely providing us with some
additional liquidity. This increase in financing activities will be only
partially off-set by most of our existing term debt being retired by the end of
third quarter of 2004. We are also attempting to obtain some type of
subordinated debt agreement to provide additional financing to support our
growth and new service initiatives for 2004. We may or may not be successful
in doing so. We currently have agreements with two long-distance carriers to provide
transmission and termination services for all of our long distance traffic.
These agreements generally provide for the resale of long distance services on
a per-minute basis and contain minimum volume commitments. As a result of a
settlement of a billing dispute associated with minimum volume commitments
required in one of the contracts we have agreed to pay an increased per minute
charge for minutes until the achievement of certain minimum minute
requirements. Once we meet the new agreed upon minimum minutes we will revert
to the terms of our original agreement. All other terms of the original
agreement continue in full force. We believe that we will be fully in
compliance with all minimum volume commitments during 2004. 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 $17.2 and $35.0 million for the three
and six months ended June 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 expect to continue actively investing in the growth of our business services
unit which could provide an increasingly positive contribution to our company
by late 2004. Finally, we are continuing our revenue and access
diversification as we roll-out our VoIP services, in an effort to ultimately
provide services that are not largely dependent on the incumbent local exchange
carriers as is the case with UNE-P. We expect to invest in this business
throughout 2004 and beyond, without any significant positive net cash
contribution until 2005. We believe that this increasingly diversified
business model provides us with more avenues for growth opportunity and less
dependence on any one model (service, access or end user) for success. We also
recognize the importance of managing the timing and ongoing economics of this
growth as it relates to our overall cash and financial position. Our ongoing capital requirements will depend on several factors, including
market acceptance of our services, the amount of resources that we devote to
investments in our networks and facilities, the build-out of additional
enterprise management centers, the ongoing 27




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development of services and brand
promotions, the resources that we devote to the sales and marketing of our
services, and many other factors including access to acceptable forms of lease
financing. We will continue to provide our back-office services and the
technology that we have developed to other companies seeking the capability of
offering residential and small business telecommunications services on a
private label basis to their own customers. As growth and opportunities arise,
we expect to make strategic investments in technology and our network
architecture and enter potential strategic alliances or partnerships with other
entities. We expect to continue to finance our capital expenditures partly
from internally generated cash flow and from existing facilities. We expect to
see an overall increase in fixed assets across nearly all categories during
2004. 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 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. In May 2004 we signed a settlement agreement with Metro Nashville to settle
certain litigation, as discussed in Footnote 11. Legal and Regulatory
Proceedings. CASH MANAGEMENT We have a significant amount of corporate expenditures and other non-essential
headcount and related expenses which would not be necessary if we were to
reduce our operations to a purely maintenance approach. This would include but
not necessarily be limited to the termination of spending on certain new
service offerings or new business opportunities, other technological focused
initiatives and investments in legal and regulatory related activities. 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 initiates 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. We expect the next six months of 2004 to be very challenging from
a cash management perspective. We currently carry a total accounts payable
balance greater than we have historically and we also expect to increase our
capital expenditures over historical levels. We may also incur a variety of
front-end loaded expenses as we increasingly transition to VoIP, and we expect
that negative cash flows may result over the short term, but should become
positive during the last quarter of 2004 or
during the first quarter of 2005. We will continue to finance significant
capital expenditures internally, but we are working with certain vendors to
obtain more generous payment terms that will provide us with more flexibility
during this period. We may or may not be successful in these endeavors. If we
are able to generate free cash flow we will likely reinvest this cash back into
our business to fund our capital expenditures for VoIP, any additional
head-count requirement and any related costs for growing certain potions of our
business. In September of 2003, we decided to postpone a company-wide salary increase.
This increase was scheduled to take place in April of 2004. We have announced a
plan to provide a bonus to employees that will average 5% of their pay. We
currently intend to pay this bonus in December of 2004. We have been
considering this as an alternative to a general increase in salaries to help
coincide with the expected increased cash flows available in December of 2004.
We also have used non-cash compensation such as a company-wide granting of
stock options and certain key employees have received restricted stock as a way
to assist with deferring the cash impact of increases in salary expenses. DEBT INSTRUMENTS Asset-Based Loan In April 2004 we signed a three-year asset based loan agreement with Textron
Financial Corporation. This agreement eliminated the RFC accounts receivable
factoring agreement, and provides us with an availability 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. All other 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 28




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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 less than 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. There are also common disposition of assets limitations, capital expenditure
limitations of $9.0 million per year, 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 believe that this agreement may provide
some help in improving our overall working capital position. If the expected
growth in our business is realized we may still have additional liquidity needs
that would have to be obtained through additional financings. 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 but 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 the larger capital
expenditures for network bandwidth which reduces future incremental costs. Term Debt We have $1.4 million of remaining principal term debt as of June 30, 2004, of
which all but $0.1 million is currently scheduled to be fully retired in
September 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 that are still being presented on a bill to 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 June 30, 2004
totaled $19.7 million. These disputes are summarized in the following table: OutstandingDisputes atJune 30, 2004(In millions)Alternatively billed services
    
    $
    8.1MCI fixed facility charges
    
    
    2.3Verizon back-billing of installation charges
    
    
    2.4Late fees for non-payment of disputed charges
    
    
    3.9All others
    
    
    3.0$
    19.7
 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. We have received
communications from MCI that these charges are not valid and in August 2004 we
have 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. 29




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The late fees are accumulating from all of our disputes as we do not pay for
disputed items and therefore incur and accumulate late fees for these disputed
billings. The remaining $3.0 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 $19.7 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. 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, D.
Gregory Smith, 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. Smith and
Mr. Davis have 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. 30




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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 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 have declined to appeal the case, and U.S.
Supreme Court Justice William Rehnquist has refused to issue a stay of the
decision. We and other Competitive Local Exchange Carriers have appealed the
case to the U.S. Supreme Court. This Circuit Court decision could have a
material adverse effect on our business. 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, 31




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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. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS On May 18, 2004, we issued 585,723 shares of our common stock to Metropolitan
Nashville Employee Benefit Board in private placement pursuant to the exemption
from registration afforded by Section 4(2) of the Securities Act of 1933, as
amended. The shares were issued in settlement of a lawsuit. At the time of
issuance, the shares had a market value of approximately $749,725. No
discounts or commissions were allowed. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the Annual Meeting of Shareholders held on May 20, 2004, the following
proposal was adopted by the margins indicated: 1. To elect the following individuals to the Board of Directors to
hold office until their successors are elected and qualified: Number of SharesNominee
    
    For
    
    WithheldCharles D. McDonough
    
    
    34,461,062
    
    
    
    21,278Richard F. LaRoche, Jr.
    
    
    34,461,027
    
    
    
    21,278W. Andrew Krusen
    
    
    34,461,062
    
    
    
    21,243
 The terms of office of the following other directors continued after the
meeting.  D. Gregory Smith
Jeffrey A. Bowden (Mr. Bowden subsequently resigned)
Lawrence C. Tucker
John K. Aurell
Andrew C. Cowen
Charles D. Hyman  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. Incorporated by reference to the
correspondingly numbered exhibit to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2001, filed on
August 13, 2001.3.2
    
    Amended and Restated Bylaws of Z-Tel. 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, 1999.4.1
    
    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.
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EXHIBITNUMBER
    
    
    
    DESCRIPTIONIncorporated 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.4.16
    
    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,
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EXHIBITNUMBER
    
    
    
    DESCRIPTION2001 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.10.2.1
    
    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 shares10.3
    
    Employment Agreement of D. Gregory Smith, dated July 30, 2002. Incorporated by reference to the correspondingly
numbered exhibit to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2002, filed on November 14,
2002.10.4
    
    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, 2001.10.6
    
    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, 2003.10.7
    
    Employment Agreement of J. Bryan Bunting, dated August 14, 2002. Incorporated by reference to the correspondingly
numbered exhibit to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2002, filed on November 14,
2002.
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##### Table of Contents



EXHIBITNUMBER
    
    
    
    DESCRIPTION10.8
    
    Employment Agreement of Charles W. McDonough, dated August 14, 2002. Incorporated by reference to the correspondingly
numbered exhibit to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2002, filed on November 14,
2002.10.9
    
    Employment Agreement of Robert A. Curtis, dated July 30, 2002. Incorporated by reference to the correspondingly
numbered exhibit to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2002, filed on November 14,
2002.10.11
    
    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 May 13, 2004, we filed a Form 8-K in connection with our earnings
release and earnings conference call on that date. On June 11, 2004, we filed
a Form 8-K to disclose a cost reduction initiative. 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
12th day of
August 2004. Z-TEL TECHNOLOGIES, INC.
(Registrant) By: /s/ Horace J. Davis IIISenior Vice-President  Chief Financial Officer(Authorized officer of Registrant and principal financial and accounting officer)
 35