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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 THREE MONTHS ENDED MARCH 31, 2004
 OR [   ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION
PERIOD FROM             TO
 COMMISSION FILE NUMBER: 000-28467 Z-TEL TECHNOLOGIES, INC.  DELAWARE
    
    59-3501119(State or other jurisdiction of
    
    (I.R.S. Employerincorporation or organization)
    
    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 May 13,
2004 was approximately 36,307.432.




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TABLE OF CONTENTS  
 PART IItem 1. Financial StatementsConsolidated Balance Sheets at March 31, 2004 and December 31, 2003
    
    
    3Consolidated Statements of Operations for the three months ended March 31, 2004 and 2003
    
    
    4Consolidated Changes in Stockholders Deficit for the three months ended March 31, 2004
    
    
    5Consolidated Statements of Cash Flows for the three months ended March 31, 2004 and 2003
    
    
    6Notes to Consolidated Financial Statements
    
    
    7Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    14Item 3. Quantitative and Qualitative Disclosures about Market Risk
    
    
    27Item 4. Controls and Procedures
    
    
    27PART IIItem 1. Legal Proceedings
    
    
    27Item 2. Exhibits and Reports on Form 8-K
    
    
    28Signatures
    
    
    31Ex-10.6 Employment AgreementEx-31.1 302 Certification of CEOEx-31.2 302 Certification of CFOEx-32.1 906 Certification of CEOEx-32.2 906 Certification of CFO
  2




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS
 (UNAUDITED)
 March 31,
    
    December 31,2004
    
    2003AssetsCurrent assets:Cash and cash
equivalents
    
    $
    11,862
    
    
    $
    12,013Accounts receivable, net of allowance for doubtful
accounts of
$13,129 and $13,804
    
    
    18,601
    
    
    
    24,600Prepaid expenses and other current assets
    
    
    4,397
    
    
    
    7,664Total current assets
    
    
    34,860
    
    
    
    44,277Property and equipment, net
    
    
    36,625
    
    
    
    39,069Intangible assets, net
    
    
    1,829
    
    
    
    2,287Other assets
    
    
    3,709
    
    
    
    3,820Total assets
    
    $
    77,023
    
    
    $
    89,453Liabilities, Mandatorily Redeemable Convertible Preferred
Stock and Stockholders DeficitCurrent liabilities:Accounts payable and accrued liabilities
    
    $
    60,688
    
    
    $
    59,230Deferred revenue
    
    
    8,502
    
    
    
    11,068Current portion of long-term debt
and capital lease obligations
    
    
    3,634
    
    
    
    5,415Total current
liabilities
    
    
    72,824
    
    
    
    75,713Long-term deferred revenue
    
    
    390
    
    
    
    361Long-term debt and capital lease obligations
    
    
    356
    
    
    
    116Total liabilities
    
    
    73,570
    
    
    
    76,190Mandatorily redeemable convertible preferred stock, $.01 par value;
50,000,000 shares authorized; 8,855,089 issued; 8,738,422 and 8,855,089
outstanding (aggregate liquidation value of $161,579 and $158,779)
    
    
    148,459
    
    
    
    144,282Commitments and contingencies (Notes 9 and 12)Stockholders deficit:Common stock, $.01 par value; 150,000,000
shares authorized; 36,648,232 and 36,186,686 shares issued;
36,306,682 and 35,845,136 outstanding
    
    
    365
    
    
    
    362Notes receivable from stockholders
    
    
    (930
    )
    
    
    (1,121
    )Additional paid-in
capital
    
    
    185,211
    
    
    
    189,008Accumulated deficit
    
    
    (329,264
    )
    
    
    (318,880
    )Treasury stock, 341,550 shares at cost
    
    
    (388
    )
    
    
    (388
    )Total stockholders
deficit
    
    
    (145,006
    )
    
    
    (131,019
    )Total liabilities, mandatorily redeemable convertible preferred
stock and stockholders deficit
    
    $
    77,023
    
    
    $
    89,453
 The accompanying notes are an integral part of these consolidated financial statements. 3




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF OPERATIONS
 (UNAUDITED)
  For the Three Month EndedMarch 31,2004
    
    2003Revenues
    
    $
    68,467
    
    
    $
    60,929Operating expenses:Network operations, exclusive of depreciation and
amortization shown below
    
    
    34,035
    
    
    
    26,782Sales and marketing
    
    
    4,521
    
    
    
    4,494General and administrative
    
    
    34,571
    
    
    
    26,906Depreciation and amortization
    
    
    5,311
    
    
    
    6,027Total operating expenses
    
    
    78,438
    
    
    
    64,209Operating loss
    
    
    (9,971
    )
    
    
    (3,280
    )Nonoperating income (expense):Interest and other income
    
    
    861
    
    
    
    925Interest and other expense
    
    
    (1,274
    )
    
    
    (750
    )Total nonoperating income (expense)
    
    
    (413
    )
    
    
    175Net loss
    
    
    (10,384
    )
    
    
    (3,105
    )Less mandatorily redeemable convertible
preferred stock dividends and accretion
    
    
    (4,365
    )
    
    
    (4,237
    )Less deemed dividend related to beneficial
conversion feature
    
    
    (46
    )
    
    
    (46
    )Net loss attributable to common stockholders
    
    $
    (14,795
    )
    
    $
    (7,388
    )Weighted average common shares outstanding
    
    
    36,066,905
    
    
    
    35,268,253Basic and diluted net loss per share
    
    $
    (0.41
    )
    
    $
    (0.21
    )
 The accompanying notes are an integral part of these consolidated financial statements. 4




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY (DEFICIT)
 AND COMPREHENSIVE INCOME
 (UNAUDITED)
  Common
    
    Stock
    
    Notes Receivablefrom
    
    AdditionalPaid-In
    
    Accumulated
    
    Treasury
    
    TotalStockholdersShares
    
    Par Value
    
    Stockholders
    
    Capital
    
    Deficit
    
    Stock
    
    DeficitBalance, December 31, 2003
    
    
    35,845,136
    
    
    $
    362
    
    
    $
    (1,121
    )
    
    $
    189,008
    
    
    $
    (318,880
    )
    
    $
    (388
    )
    
    $
    (131,019
    )Exercise of stock options
    
    
    285,178
    
    
    
    3
    
    
    
    
    
    
    
    383
    
    
    
    
    
    
    
    
    
    
    
    386Exercise of warrants
    
    
    37,714
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Conversion of mandatorily redeemable
convertible preferred stock to
common
    
    
    138,654
    
    
    
    
    
    
    
    
    
    
    
    231
    
    
    
    
    
    
    
    
    
    
    
    231Repayment of notes receivable
    
    
    
    
    
    
    
    
    
    
    191
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    191Mandatorily redeemable convertible
preferred
stock dividends and accretion
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (4,411
    )
    
    
    
    
    
    
    
    
    
    
    (4,411
    )Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (10,384
    )
    
    
    
    
    
    
    (10,384
    )Balance, March 31, 2004
    
    
    36,306,682
    
    
    $
    365
    
    
    $
    (930
    )
    
    $
    185,211
    
    
    $
    (329,264
    )
    
    $
    (388
    )
    
    $
    (145,006
    )
 The accompanying notes are an integral part of these consolidated financial statements 5




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS
 (UNAUDITED)
  Three Months EndedMarch 31,2004
    
    2003Cash flows from operating activities:Net loss
    
    $
    (10,384
    )
    
    $
    (3,105
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    5,311
    
    
    
    6,027Provision for bad debts
    
    
    1,644
    
    
    
    2,396Change in operating assets and liabilities:(Increase) decrease in accounts receivable
    
    
    4,355
    
    
    
    (3,948
    )(Increase) decrease in prepaid expenses
    
    
    3,267
    
    
    
    (211
    )Decrease in other assets
    
    
    71
    
    
    
    198(Increase) decrease in accounts payable and accrued liabilities
    
    
    1,458
    
    
    
    (2,157
    )(Increase) decrease in deferred revenue
    
    
    (2,537
    )
    
    
    5,941Total adjustments
    
    
    13,569
    
    
    
    8,246Net cash provided by operating activities
    
    
    3,185
    
    
    
    5,141Cash flows from investing activities:Purchases of property and equipment
    
    
    (2,409
    )
    
    
    (3,128
    )Principal repayments received on notes receivable
    
    
    40
    
    
    
    Net cash used in investing activities
    
    
    (2,369
    )
    
    
    (3,128
    )Cash flows from financing activities:Payments on long-term debt and capital lease obligations
    
    
    (1,541
    )
    
    
    (1,454
    )Proceeds from exercise of stock options and warrants
    
    
    386
    
    
    
    Principal repayments received on notes receivable issued for stock
    
    
    191
    
    
    
    469Payment of preferred stock dividends
    
    
    (3
    )
    
    
    Net cash used in financing activities
    
    
    (967
    )
    
    
    (985
    )Net increase (decrease) in cash and cash equivalents
    
    
    (151
    )
    
    
    1,028Cash and cash equivalents, beginning of period
    
    
    12,013
    
    
    
    16,037Cash and cash equivalents, end of period
    
    $
    11,862
    
    
    $
    17,065
 The accompanying notes are an integral part of these consolidated financial statements 6




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES 
 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 (UNAUDITED)
  1. NATURE OF BUSINESS DESCRIPTION OF BUSINESS Z-Tel Technologies, Inc. and subsidiaries (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 an emerging 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 communication
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 small
business end user customers on a private label basis by utilizing our telephone
exchange services, enhanced services platform, infrastructure and back-office
operations. We plan to introduce our voice over Internet protocol (VoIP) service
offerings during the second quarter of 2004. 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 used 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 March 31, 2004 of approximately
$329.3 million. We also had debt outstanding of approximately
$4.0 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. Prior to 2002, we had
historically been dependent on financing from investors to sustain
our operating activities. At
March 31, 2004, we had cash on hand of approximately
$11.9 million. In addition, we had an accounts receivable
factoring agreement, which provides us with up to $25 million to
fund operations, of which we were utilizing $11.7 million, which
was the maximum available to us under the availability calculation as
of March 31, 2004. We have replaced this agreement with an
asset-based loan, further discussed in footnote
14. Subsequent Events. We anticipate generating,
through normal operations, the remaining cash flows necessary to meet
our operating, investing and financing requirements. We also are
exploring potential subordinated debt arrangements and financing of
certain capital expenditures. If actual results differ materially
from our current plan or if expected financing is not available, 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. 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
three months ended March 31, 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 three
months ended March 31, 2003 have been reclassified to conform to the
presentation for the three months ended March 31, 2004. 3. MARKETING AGREEMENT In March 2004, we signed an agreement with America Online, Inc. (AOL). This
agreement is essentially a marketing arrangement in which we will pay a monthly
recurring commission and certain other fees based on retail customers added to
our end user base during the term of the agreement. The agreement is a trial
and only includes certain states. The agreement is structured so that AOL
subscribers have the opportunity to obtain our services at a substantial
discount. We will own the end user and will consequently be responsible for
providing all services and incurring all expenses associated with any resulting
customers, similar to our existing retail unbundled element network platform
(UNE-P) business. This agreement has no minimum requirements and the success
of the agreement cannot be predicted, nor can the actual duration or likelihood
that this agreement will become a wholesale agreement. 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. This contract includes various per-minute,
per-line, and other charges that are being recorded as revenue as earned. 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 7




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results in certain
per-line, per-minute and direct costs being recorded as revenues and the
corresponding expenses being recorded in the appropriate operating expense
line. As a result of this accounting treatment, increases or decreases in
pricing or volume that impact certain direct costs that are incurred in
connection with this agreement would have 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 March 31, 2004, under our contract with Sprint, we had approximately $2.5
million of deferred revenue, of which $0.3 million is recorded as long-term
deferred revenue. 5. ACCOUNTS RECEIVABLE AGREEMENT In July 2000, we entered into an accounts receivable agreement with RFC Capital
Corporation, (RFC) a division of Textron, Inc., providing for the sale of
certain of our accounts receivable to RFC. The RFC agreement provided for the
purchase of up to $25 million of certain of our accounts receivable, subject to
selection criteria as defined in the contract. In July 2002, we extended our
agreement with RFC under substantially similar terms for an additional two
years. The purchase of the receivables was at the option of RFC and they
utilized selection criteria to determine which receivables would be purchased.
Our collection percentage for receivables sold to RFC had been over 90% since
the inception of the agreement. We received an additional payment from RFC for
servicing the assets in an amount equal to every dollar collected over the
advance rate, less certain fees. The accounts receivable agreement did not have
a minimum receivable sales requirement. We sold approximately $25.8 and $21.6 million of receivables to RFC, for net
proceeds of approximately $20.9 and $17.1 million, during the three months
ended March 31, 2004 and 2003, respectively. A net receivable servicing asset
of approximately $12.1 million is included in the accounts receivable balance
at March 31, 2004. We recorded costs related to the agreement of approximately
$0.3, and $0.2 million for the three months ended March 31, 2004 and 2003,
respectively. Included in accounts payable and accrued liabilities are advances
for unbilled receivables in the amount of $3.5 million at March 31, 2004. We
were responsible for the continued servicing of the receivables sold. 6. INTANGIBLE ASSETS In accordance with Statement of Financial Accounting Standards (SFAS) No.
142, we reassessed the expected useful lives of existing intangible assets.
This reassessment resulted in no changes to the expected useful lives of our
customer lists. We only have one intangible asset as of Mach 31, 2004. Summarized below is our only intangible asset, as a result of our acquisition
of Touch 1 in April of 2000 that will continue to be amortized under SFAS No.
142. We do not have any intangible assets that will not be amortized: March 31, 2004Carrying
    
    Accumulated
    
    Net IntangibleAmount
    
    Amortization
    
    AssetsIntangible assets subject to amortization:Customer related intangible assets
    
    $
    9,145
    
    
    $
    7,316
    
    
    $
    1,829
 The following table presents current and expected amortization expense of the
existing intangible assets as of March 31, 2004 for each of the following
periods: Aggregate amortization expense: For the three months ended March 31, 2004
    
    $
    458Expected amortization expense for the remainder of 2004
    
    
    1,371Expected amortization expense for the year ending December 31, 2005
    
    
    458
 7. RESTRUCTURING CHARGES In April of 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 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. 8




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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. We have recorded a lease abandonment charge
representing the future lease payments for our New York office as a liability
and we are scheduled to make payments through 2005, although we are currently
in negotiations to settle this lease. All other expenses associated with this
restructuring have been paid in full.


The following table shows the restructuring charges and related accruals
recognized under the plan 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
    
    
    
    351Cash paid
    
    
    
    
    
    
    
    
    
    
    (51
    )
    
    
    (51
    )Balance at March 31, 2004
    
    $
    
    
    
    $
    
    
    
    $
    300
    
    
    $
    300
 8. STOCK BASED COMPENSATION Stock Options For employee stock options, the Financial Account 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. 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. For the three months endedMarch 31,2004
    
    2003Net loss attributable to common stockholders, as reported
    
    $
    (14,795
    )
    
    $
    (7,388
    )Add: Stock based compensation included in net loss
    
    
    
    
    
    
    Deduct:
Total stock based employee compensation determined
under the fair value based method for all awards
    
    
    (756
    )
    
    
    (3,160
    )Net loss attributable to common stockholders, pro forma
    
    $
    (15,551
    )
    
    $
    (10,548
    )Basic and Diluted Net LossPer Common ShareAs reported
    
    $
    (0.41
    )
    
    $
    (0.21
    )Pro forma
    
    
    (0.43
    )
    
    
    (0.30
    )
 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 monthsended March 31,2004
    
    2003Discount Rate
    
    
    2.8%
    
    
    
    3.1
    %Volatility
    
    
    97.2
    
    
    
    92.6
    %Average Option Expected Life
    
    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. 9




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Restricted Stock In March 2004, our compensation committee approved the granting of 285,000
shares of restricted stock with an approximate value of $0.8 million to certain
executive officers and key employees. The cost of the stock is $0.01, par
value, per share and vests one-third after one year and one thirty-sixth each
month thereafter. 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 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 March 31,
2004, the total disputed amounts were approximately $19.1 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 which we expect to meet in the first half of 2004. 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 in full compliance with all minimum volume commitments
during 2004. We have accrued $0.3 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 the 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. RELATED PARTY TRANSACTIONS In February 2004, we received from two employees an aggregate payment of $0.2
million for repayment of notes receivable. 11. 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 endedMarch 31,2004
    
    2003Basic and diluted net loss per share:Net loss
    
    $
    (10,384
    )
    
    $
    (3,105
    )Less mandatorily redeemable convertible preferred
stock dividends and accretion
    
    
    (4,365
    )
    
    
    (4,237
    )Less deemed dividend related to beneficial conversion feature
    
    
    (46
    )
    
    
    (46
    )Net loss attributable to common stockholders
    
    $
    (14,795
    )
    
    $
    (7,388
    )Weighted average common shares outstanding
    
    
    36,066,905
    
    
    
    35,268,253Basic and diluted net loss per share
    
    $
    (0.41
    )
    
    $
    (0.21
    )
 10




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##### Table of Contents



For each of the periods presented, basic and diluted net loss per share are the
same. 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: March 31,2004Unexercised stock options
    
    
    13,557,294Unexercised warrants
    
    
    10,687,383Mandatorily redeemable preferred stock
convertible into common shares
    
    
    32,287,321Total potentially dilutive shares of common
stock equivalents
    
    
    56,531,998
 12. LEGAL AND REGULATORY PROCEEDINGS During June and July 2001, three separate class action lawsuits were filed
against us, certain of our current and former directors and officers (the
D&Os) and firms engaged in the underwriting (the Underwriters) of our
initial public offering of stock (the IPO). The lawsuits, along with
approximately 310 other similar lawsuits filed against other issuers arising
out of initial public offering allocations, have been assigned to a Judge in
the United States District Court for the Southern District of New York for
pretrial coordination. The lawsuits against us have been consolidated into a
single action. A consolidated amended complaint was filed on April 20, 2002. A
Second Corrected Amended Complaint (the Amended Complaint), which is the
operative complaint, was filed on July 12, 2002. The Amended Complaint is based on the allegations that our registration
statement on Form S-1, filed with the 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 thereunder. 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
thereunder. 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 memorandum of understanding has been reached by lawyers for the plaintiffs,
the issuers and insurers of the issuers. The memorandum sets forth the terms of
a proposed settlement, the principal components of which 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. Our board of directors has approved the
memorandum of understanding. To be binding, the settlement must be approved by
substantially all the issuers 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 a lawsuit against us on September 20, 2002. The
lawsuit asserts claims under Delaware Law, the Uniform Commercial Code, and
state law and seeks actual damages of $18 million, punitive damages of $18
million, interest, and court costs. Metropolitan Nashville Employee Benefit
Board is our common shareholder. Metro Nashville alleges 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 price of our stock declined significantly. The court has scheduled trial to
begin on May 17, 2004. We have entered into a memorandum of understanding
whereby we expect to pay Metro Nashville $800,000 in cash and approximately
$800,000 in our common stock in full settlement of this matter. 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 us 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. This motion is pending before the court. We cannot
predict the outcome of this litigation with any certainty. 11




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##### Table of Contents



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. See 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). The
D.C. Circuit ordered that the unbundled transport and switching rules be
vacated after sixty days or upon denial of a petition for rehearing, whichever
occurs later. A majority of the FCC has indicated that it will support an
appeal of this decision. On April 14, 2004, upon the request made by the FCC
and the United States, the DC Circuit stayed the mandate in USTA II until June
15, 2004. This decision could, if no further stays are issued or the case is not
reversed, have immediate, significant, adverse and material impact upon our
business. For example, ILECs might utilize the reversal of the unbundling rules
to deny us access to their local networks, particularly the dedicated transport
and switching network elements that we depend upon to provide our services. We
depend upon such access to provide our services to our customers. ILECs may
also attempt to unilaterally increase the prices they seek to charge us for
those network elements. We believe we have legal rights to purchase these
elements pursuant to existing interconnection agreements we have with ILECs,
under state law, and under section 271 of the Communications Act, which the FCC
has ruled to be a separate, alternative legal requirement for Bell companies to
provide us wholesale network access. However, enforcing those rights could be
costly and require simultaneous litigation throughout our multi-state
footprint, 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 that we will be able to access the local networks of the ILECs on
and after June 15, 2004, the date the USTA II decision becomes effective.
There is the possibility that the FCC or states may adopt interim rules or
policies before or after that date; such rules may have the impact of limiting
our ability to purchase network elements from ILEC, or increase the price of
such access. The FCC has requested that CLECs and ILECs engage in negotiations
over the terms of such access; on April 2, 2004, we proposed to all four Bell
companies a $20 flat-rate price for UNE-P nationwide. At this time, we do not
believe that these negotiations will succeed by the June 15, 2004 effective
date. The 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 service. If ILECs attempt to impose wholesale price
increases and regulators or courts do not act to stop such action, it may
become uneconomic for us to offer service in many, if not all, of our current
footprint. We also may need to increase reserves in the event ILECs send us
higher bills for wholesale local network access, even if we believe that such
price increases are unlawful. Those increased reserves could impact one or
more covenants that we maintain with regard to our credit and debt facilities.
We are actively considering all of our 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
prices in 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. In particular, ongoing rate
cases in Illinois, Ohio, Indiana and Michigan could significantly raise the
existing rates for some network elements and network element combinations. Our
intent is to be an active participant in many of these rate cases and any
others that might be critical to our operations. We anticipate joining other
competitive service providers in arguing that existing rates and rates proposed
by the incumbents are overstated and do not reflect the true total element long
run incremental costing principles required by the FCC and the
Telecommunications Act. The FCC, is 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. In the ordinary course of business, we are involved in legal and regulatory
proceedings, disputes and tax audits at the federal, state and local level that
are generally incidental to our ongoing operations. In addition, from time to
time, we are the subject of customer and vendor complaints filed with the state
utility commissions of the states in which they operate or the Federal
Communications Commission. Most complaints are handled informally and at this
time there are no formal proceedings pending. While there can be no assurance
of the ultimate disposition of incidental legal proceedings or customer
complaints, we do not believe their disposition will have a material adverse
effect on our consolidated results of operations or financial position. 12




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13. 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 communication 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
in metropolitan areas in ten states for both our Z-LineHOME and Z-LineBUSINESS
services. This segment also includes our Touch 1 residential long-distance
offering that is available nationwide. We have also included expenses that are
associated with our VoIP offering that is expected to be launched during the
second quarter of 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 for
this offering. 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 overhead
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 March 31, 2004 and 2003: March 31,Retail Services
    
    2004
    
    2003Revenues
    
    $
    45,304
    
    
    $
    47,968Depreciation and amortization
    
    $
    4,673
    
    
    $
    5,429Segment results
    
    $
    (9,286
    )
    
    $
    (4,448
    )Capital expenditures
    
    $
    2,380
    
    
    $
    2,865Identifiable assets
    
    $
    66,406
    
    
    $
    94,985
 March 31,Wholesale Services
    
    2004
    
    2003Revenues
    
    $
    23,163
    
    
    $
    12,961Depreciation and amortization
    
    $
    638
    
    
    $
    598Segment results
    
    $
    4,626
    
    
    $
    7,195Capital expenditures
    
    $
    29
    
    
    $
    263Identifiable Assets
    
    $
    10,617
    
    
    $
    11,420
 The following table reconciles our segment information to the consolidated
financial information for the three months ended March 31, 2004 and 2003: March 31,2004
    
    2003Segment results:Total segment results
    
    $
    (4,660
    )
    
    $
    2,747Depreciation and amortization
    
    
    (5,311
    )
    
    
    (6,027
    )Total consolidated operating loss
    
    $
    (9,971
    )
    
    $
    (3,280
    )
 14. SUBSEQUENT EVENTS In April 2004, our compensation committee approved the granting of 118,000
shares of restricted stock with an approximate value of $0.3 million to certain
key employees and one non-employee consultant. The cost of the stock is $0.01,
par value, per share and vests one-third after one year and one thirty-sixth
each month thereafter. In April 2004 we signed a three-year asset based loan agreement with Textron
Financial Corporation (Textron). 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
while our prior arrangement with RFC only included our residential accounts
receivable. 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 13




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##### Table of Contents



thereafter with various look-back time periods. The ratio requirements begin
low and increase each quarter through December 31, 2004 and then remain
constant. There are also common disposition of assets 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. 
 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, anticipated rapid expansion, 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 offer local and long distance telephone services in combination with
enhanced communication features accessible through the telephone or the
Internet. Our enhanced service offerings include Personal Voice Assistant
(PVA), Find-Me, Notify-Me, caller identification, call waiting and speed
dialing. PVA allows users to store contacts in a virtual address book and then
access and utilize that information by voice from any telephone. PVA users can
also send voice e-mails. 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 by the fourth quarter of 2004. 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 fee from our wholesale
services customer for the expense that we incur plus a fee, 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. In evaluating our financial condition and operating performance the most
important matters on which we focus are lines under management, revenue per
unit, cost per unit, bad debt expense, expenses as a percentage of revenues and
results by 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 first quarter 2004 financial and operating results reflect our investments
to expand our wholesale and business units and to prepare for our VoIP
initiatives that we expect to launch during the second quarter of 2004. In
addition, we invested to expand our human resources to meet the anticipated
demands of our new partnership with America Online, Inc, (AOL). Consistent
with our plan to shift away from being a unbundled element platform (UNE-P)
only provider, we concentrated our efforts during the first quarter on
preparing for our VoIP launch in the Tampa and Atlanta markets. We have a full
in-house sales force operating in Tampa and soon will have our Atlanta sales
force staffed. We focused the balance of our resources during the first
quarter of 2003 on developing additional business clients on our UNE-P
platform. We have recently had the success of landing Circuit City Stores and
Michaels Stores to utilize of our Managed Local Service product at their
locations and that Choice Hotels has selected us as their endorsed local
services vendor. 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 expect to use residential business (UNE-P and 1+
long-distance) will increasingly be used as a vehicle to fund our growth and
development into our business services, wholesale and VoIP businesses. By doing
so, we think we can expand into these businesses at a more rapid rate than
would otherwise be the case and, in the case of our VoIP initiatives,
potentially move from cash drain to a cash generator more quickly. Another key
achievement that occurred after the 1st quarter 2004 was the completion of our
$25 million asset based loan agreement with Textron Financial. 14




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##### Table of Contents



CONSOLIDATED RESULTS OF OPERATIONS The three months ended March 31, 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 months
ended March 31, 2004 and 2003 are as follows: For the three months
    
    Amount
    
    Percentageended March 31,
    
    ChangeFavorable
    
    ChangeFavorable
    
    Percentage of Revenues2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Results of Operations:Revenues
    
    $
    68.5
    
    
    $
    60.9
    
    
    $
    7.6
    
    
    
    12.5
    %
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    34.0
    
    
    
    26.8
    
    
    
    (7.2
    )
    
    
    (26.9
    )%
    
    
    49.6
    %
    
    
    44.0
    %Sales and marketing
    
    
    4.5
    
    
    
    4.5
    
    
    
    
    
    
    
    
    %
    
    
    6.6
    %
    
    
    7.4
    %General and administrative
    
    
    34.6
    
    
    
    26.9
    
    
    
    (7.7
    )
    
    
    (28.6
    )%
    
    
    50.5
    %
    
    
    44.1
    %Depreciation and amortization
    
    
    5.3
    
    
    
    6.0
    
    
    
    0.7
    
    
    
    11.7
    %
    
    
    7.7
    %
    
    
    9.9
    %Total operating expenses
    
    
    78.4
    
    
    
    64.2
    
    
    
    (14.2
    )
    
    
    (22.1
    )%
    
    
    114.4
    %
    
    
    105.4
    %Operating loss
    
    
    (9.9
    )
    
    
    (3.3
    )
    
    
    (6.6
    )
    
    
    (200.0
    )%
    
    
    (14.4
    )%
    
    
    (5.4
    )%Nonoperating income (loss):Interest and other income
    
    
    0.9
    
    
    
    0.9
    
    
    
    
    
    
    
    
    %
    
    
    1.3
    %
    
    
    1.4
    %Interest and other expense
    
    
    (1.3
    )
    
    
    (0.7
    )
    
    
    (0.6
    )
    
    
    (85.7)
    %
    
    
    (1.9
    )%
    
    
    (1.1
    )%Total nonoperating income (loss)
    
    
    (0.4
    )
    
    
    0.2
    
    
    
    (0.6
    )
    
    
    (300.0
    )%
    
    
    (0.6
    )%
    
    
    0.3
    %Net loss
    
    
    (10.3
    )
    
    
    (3.1
    )
    
    
    (7.2
    )
    
    
    (232.3
    )%
    
    
    (15.0
    )%
    
    
    (5.1
    )%Less mandatorily redeemable convertible
preferred stock dividends and accretion
    
    
    (4.4
    )
    
    
    (4.2
    )
    
    
    (0.2
    )
    
    
    (4.8)
    %
    
    
    (6.4
    )%
    
    
    (6.9
    )%Less deemed dividend related to beneficial
conversion feature
    
    
    (0.1
    )
    
    
    (0.1
    )
    
    
    
    
    
    
    
    %
    
    
    (0.2
    )%
    
    
    (0.2
    )%Net loss attributable to common stockholders
    
    $
    (14.8
    )
    
    $
    (7.4
    )
    
    $
    (7.4
    )
    
    
    (100.0
    )%
    
    
    (21.6
    )%
    
    
    (12.2
    )%Cash Flow Data:Net cash provide by operating activities
    
    $
    3.2
    
    
    $
    5.1
    
    
    $
    (1.9
    )
    
    
    (37.3)
    %
    
    
    *
    
    
    
    *Net cash used in investing activities
    
    
    (2.4
    )
    
    
    (3.1
    )
    
    
    0.7
    
    
    
    22.6
    %
    
    
    *
    
    
    
    *Net cash used in financing activities
    
    
    (1.0
    )
    
    
    (1.0
    )
    
    
    
    
    
    
    
    %
    
    
    *
    
    
    
    *Net increase (decrease) in cash and cash equivalents
    
    $
    (0.2
    )
    
    $
    1.0
    
    
    $
    (1.2
    )
    
    
    (120.0
    )%
    
    
    *
    
    
    
    *
 (*) Not meaningful Revenues. Revenues increased by $7.6 million to $68.5 million for the three
months ended March 31, 2004, compared to $60.9 million the prior year. The
increase in revenues was primarily a result of our wholesale services
increasing by $10.2 million during the period. This increase was primarily a
result of increased revenues from our wholesale contract with Sprint, signed in
February 2003, contributing an additional $23.0 million for the three months
ended March 31, 2004, and was partially offset by a decrease of $12.8 million
in MCIs wholesale service revenues compared to the prior year period. The
following table provides a break-down of our revenues and changes for the three
months ended March 31, 2004 compared to the same period in 2003: Revenues for the three
    
    Amount
    
    Percentagemonths ended March 31,
    
    ChangeFavorable
    
    ChangeFavorable
    
    Percentage of RevenuesType of Revenues
    
    2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Residential Services
    
    $
    39.9
    
    
    $
    44.5
    
    
    
    (4.6
    )
    
    
    (10.3
    )%
    
    
    58.2
    %
    
    
    73.1
    %Business Services
    
    
    3.3
    
    
    
    0.4
    
    
    
    2.9
    
    
    
    725.0
    %
    
    
    4.8
    %
    
    
    0.7
    %1+ Long Distance Services
    
    
    2.1
    
    
    
    3.0
    
    
    
    (0.9
    )
    
    
    (30.0
    )%
    
    
    3.1
    %
    
    
    4.9
    %Wholesale Services
    
    
    23.2
    
    
    
    13.0
    
    
    
    10.2
    
    
    
    78.5
    %
    
    
    33.9
    %
    
    
    21.3
    %Total
    
    $
    68.5
    
    
    $
    60.9
    
    
    $
    7.6
    
    
    
    12.5
    %
    
    
    100.0
    %
    
    
    100.0
    %
 15




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##### Table of Contents



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: Average lines in service
    
    Ending lines in servicefor the three months ended
    
    for the three months endedMarch 31,
    
    March 31,Type of Revenues
    
    2004
    
    2003
    
    2004
    
    2003Residential Services
    
    
    197,338
    
    
    
    218,069
    
    
    
    189,918
    
    
    
    232,684Business Services
    
    
    27,093
    
    
    
    2,746
    
    
    
    32,593
    
    
    
    3,4171+ Long Distance Services
    
    
    68,221
    
    
    
    117,538
    
    
    
    62,022
    
    
    
    101,075Wholesale Services
    
    
    318,277
    
    
    
    57,063
    
    
    
    339,729
    
    
    
    58,603Total
    
    
    610,929
    
    
    
    395,416
    
    
    
    624,262
    
    
    
    395,779
 ARPU provides a business measure of the average monthly revenue generation
attributable to each line in service, by revenue stream. ARPU is calculated by
taking total revenues divided by the number of months in the period presented
to calculate the average revenue per month and this total is divided by the
average lines in service. 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 revenue which makes ARPU for
wholesale services a measure we do not use as we believe it is not useful for
analyzing our wholesale revenues. We believe ARPU, which calculates
the average revenue per average line in service, is a useful measure
to evaluate our past revenues and assist in forecasting our future
revenues. We also believe that this measure provides a gauge to
compare and contrast our revenue streams and compare our revenues to
other communication providers that have significantly more or less
subscribers than we have. The following table provides a detail of our
ARPU: Average revenue per unit in servicefor the three months ended
    
    Amount
    
    PercentageMarch 31,
    
    ChangeFavorable
    
    ChangeFavorableType of Revenues
    
    2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)Residential Services
    
    $
    67.40
    
    
    $
    68.02
    
    
    $
    (0.62
    )
    
    
    (0.9
    )%Business Services
    
    $
    40.60
    
    
    $
    48.56
    
    
    $
    (7.96
    )
    
    
    (16.4
    )%1+ Long Distance Services
    
    $
    10.26
    
    
    $
    8.51
    
    
    $
    1.75
    
    
    
    20.6
    %Wholesale Services
 (*) Not meaningful The overall change in our revenues for the three months ended March 31, 2004
compared to the same prior year period was our continued focus in 2004 to grow
our wholesale and business services. Residential and 1+ long distance service
revenues combined to decrease $5.5 million for the three months ended March 31,
2004 compared to the same prior year period. This was a result of our
continued shift away from actively investing in our residential business, a
trend that began during the second half of 2003. With respect to our existing
revenue streams, we intend to focus the majority of our sales and marketing
investment into the business and wholesale services business. The one
exception to this is the marketing agreement that we recently signed with AOL.
We believe that this agreement could have the potential to positively change
the dynamics of our traditional residential business, and this agreement will
be one of the few areas in which we intend to actively invest in the
residential business over the remainder of 2004. This AOL agreement is a test
marketing agreement, with an initial term of four months but has renewable
terms and no minimum commitments, which provide an opportunity for significant
residential line growth with the expectation that if it is successful the
agreement could be transformed into a traditional wholesale services agreement
that could resemble our existing wholesale services agreement with Sprint. We also anticipate that our ARPU will continue to decline into the foreseeable
future, primarily due to the competitive climate, our reduced pricing in our
AOL offering and planned reductions in access revenue fees that will occur
later this year. 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 expect residential, business and wholesale lines in service
to grow significantly during the remainder of 2004. We believe that the
economics of our business and wholesale services are currently more attractive
for active investment than is the traditional residential business. Therefore,
we will invest in sales and marketing activities to attract business customers
while relying on our AOL agreement to be the primary driver in our residential
related revenues. However, 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 our marketing
of UNE-P based Services and focusing primarily on VoIP services, thereby mitigating our reliance on the ILEC networks. We recently provisioned our very first beta VoIP customer and have already made
sales of this new service offering and expect to formally launch this offering
in the second quarter of 2004. 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 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. 16




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##### Table of Contents



Network Operations. Network operations expense increased by $7.2 million to
$34.0 million for the three months ended March 31, 2004, compared to $26.8
million 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 increase in
network operation expense was primarily the result of having an overall larger
average number of lines under management in service for the three months ended
March 31, 2004 compared to the same prior year period. The following table
provides a detailed break-down and analysis of changes in network operations
expense: Network Operations for thethree months ended
    
    Amount
    
    Percentage
    
    Percentage ofMarch 31,
    
    ChangeFavorable
    
    ChangeFavorable
    
    Network OperationsType of Revenues
    
    2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003(In Millions)Residential & business services
    
    $
    22.2
    
    
    $
    22.0
    
    
    $
    (0.2
    )
    
    
    (0.9
    )%
    
    
    65.3
    %
    
    
    82.1
    %1+ long distance services
    
    
    0.4
    
    
    
    0.7
    
    
    
    0.3
    
    
    
    42.9
    %
    
    
    1.2
    %
    
    
    2.6
    %Wholesale services
    
    
    11.4
    
    
    
    4.1
    
    
    
    (7.3
    )
    
    
    (178.0
    )%
    
    
    33.5
    %
    
    
    15.3
    %Total
    
    $
    34.0
    
    
    $
    26.8
    
    
    $
    (7.2
    )
    
    
    (26.9
    )%
    
    
    100.0
    %
    
    
    100.0
    %
 Our network operations expense as a percentage of revenues, increased to 49.6%
for three months ended March 31, 2004 compared to 44.0% in the prior year. The
increase in network operations expense was primarily a result of the impact of
the gross accounting treatment applied to the wholesale services business
segment. The following table provides a detail of network operations expense as
a percentage of revenues by the respective revenue types. 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. Network operations as a% of revenues for the
    
    Amountthree months ended March 31,
    
    ChangeFavorable2004
    
    2003
    
    (Unfavorable)Residential & business services
    
    
    51.4
    %
    
    
    49.0
    %
    
    
    (2.4
    )%1+ long distance services
    
    
    19.0
    %
    
    
    23.3
    %
    
    
    4.3
    %
 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 presented to calculate the average network operations expense per month
and this total is divided by the average lines in service. 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 assist in forecasting our future
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 network operations expense: Average network operationsexpense per unit for thethree months ended
    
    Amount
    
    PercentageMarch 31,
    
    ChangeFavorable
    
    ChangeFavorableType of Revenues
    
    2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)Residential & business services
    
    $
    32.97
    
    
    $
    33.21
    
    
    $
    0.24
    
    
    
    0.7
    %1+ long distance services
    
    $
    1.95
    
    
    $
    1.99
    
    
    $
    0.04
    
    
    
    2.0
    %
 The overall increase in network operations expense was primarily driven by our
increase in wholesale lines in service from our contract with Sprint and an
increase in average business lines in service. These increases were partially
off-set by a reduction of nearly 21,000 lines in the average bundled
residential service lines and to a lesser extent a reduction of just under
50,000 average 1+ long distance service lines. The increase in the overall
average lines in service was the primary driver for the increase in network
operations expense because the AEPU only had a very small change for the three
months ended March 31, 2004 compared to the same prior year period. We expect network operations expense to increase in 2004 as we are currently
anticipating an increase in overall lines in service. We also expect increases
to our AEPU as a result of increased 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 17




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and possible 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 be focusing our efforts on insuring 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 restrict
or increase the costs of gaining access to ILEC networks. We would
expect to respond by substantially curtailing 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 was $4.5 million for both the
three months ended March 31, 2004 and 2003. Sales and marketing expense
primarily consists of the costs of performing telemarketing, sending direct
mail, advertising and incurring the costs of independent sales representative
commissions and 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 was the same for the three months
ended March 31, 2004 compared to the same prior year period there were several
significant changes in certain line items that compose this expense as detailed
below:  
    
    $1.0 million increase in payroll and related expense as a result of
significantly growing our internal sales force to grow our business
and VoIP offerings;
    
    $0.3 million decrease in one-time and recurring commissions to
independent sales contractors. The one-time bounties decreased by $0.8
million while recurring commissions increased by $0.5 million. This
change is a result of our continued investment in business growth for
the three months ended March 31, 2004 compared to residential growth in
the prior year period. Also, this change was a result of adding a net
of just under 4,000 bundled and business lines for the three months
ended March 31, 2004 compared to 41,000 net lines for the prior year
period;
    
    $0.7 million decrease to other discretionary marketing such as
telemarketing, direct mail, and other brand awareness items. Although we have focused our primary efforts on business and VoIP for retail
line growth from a sales and marketing perspective during the last nine months,
we expect that the most significant driver of sales and marketing expense for
the remainder of the year will result from our marketing agreement with AOL
which could result in increased commissions expense for the acquisition of new
consumer customers. 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 will likely focus on leveraging our national footprint
by offering local, long-distance and enhanced services on a consolidated
billing for multi-location businesses. We have found this to be a successful
sales channel with the recent additions of large customers such as Circuit City
to our service platform. This is also intended to further diversify our
service offerings, revenue streams and cash flow streams beyond the consumer and wholesale services businesses. 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 cause us to substantially curtail marketing
our UNE-P based services. General and Administrative. General and administrative expense increased $7.7
million to $34.6 million for the three months ended March 31, 2004, compared to
$26.9 million in the prior year period. General and administrative expense
primarily consists of employee salaries and benefits, outsourced services, bad
debt expense, billing and collection costs, occupancy costs, legal, regulatory
and provisioning costs. The increase in general and administrative expense was primarily related to the
growth of our wholesale services for the three months ended March 31, 2004
compared to the prior year same period. We also had some increased legal fees
due to outstanding litigation issues and efforts to support our position on
contested regulatory issues related to UNE-P. We also recorded an accrual for
a settlement of the Metro Nashville lawsuit during 2004 and the increased cost
of maintaining and supporting overall increased lines and employees. The
specific significant general and administrative expense line items that
increased for the three months ended March 31, 2004 compared to the same prior
year period were as follows:  
    
    Accrual for proposed settlement for litigation related to Metro Nashville - $1.8 million
    
    Sales and use tax expense - $1.0 million
    
    Dispatch charges from the ILECs - $1.0 million
    
    Reduction in ILEC performance credits for failure to meet certain service levels - $0.8 million
    
    Legal expenses associated with our outstanding litigation items and regulatory issues
pertaining to the D.C. Circuit decision pertaining to UNE-P - $0.8 million
    
    Customer billing costs - $0.7 million
    
    Payroll and related expenses - $0.7 million 18




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##### Table of Contents




    
    Charges from our ILEC gateway provided to establish and change customers services - $0.7 million
    
    Outsourcing of customer service and collections - $0.6 million
    
    Hardware and software support - $0.4 million The decreases in general and administrative expense were a result of improved
operating and subscriber management activities which resulted in significant
decreases to bad debt expense. The remaining change of $0.2 million was related to various other net changes
in individual general and administrative expense line items. General and
administrative expense as a percentage of revenue increased by 6.4% to 50.5%
for the three months ended March 31, 2004, compared to 44.1% in the prior year
period. Included in this increase were the following items:  
    
    Accrual for proposed settlement for litigation related to Metro Nashville - $1.8 million
    
    Tax accruals for various tax audits and other potential future tax liabilities - $0.6 million Excluding these above items for the three months ended March 31, 2004 results
in an increase to general and administrative expense of $5.3 million to $32.2
million. General and administrative expense as a percentage of revenue
increased by 3.0% to 47.1% for the three months ended March 31, 2004. This increase in general and administrative expense was a primary result of the
overall increase in lines under management. The increase in general and
administrative expense as a percentage of revenue is a result of our continued
investment in technology personnel and the dedication of existing resources to
our VoIP offering, and due to our decision to maintain a level of
headcount above what is currently required in order to support the current
lines under management in order to provide support for our anticipated line
growth over the remainder of the year. We have also spent significantly more
on legal and regulatory fees for the three months ended March 31, 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 into the future to support our planned expansion of service offerings,
specifically VoIP, and our expected increase in consumer, business and
wholesale lines in service during 2004. 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. We
expect to see improvement of general and administrative expense as a percentage
of total reported revenue in 2004 relative to 2003. As
stated above legal and regulatory matters could restrict or increase
the costs of our access to ILEC networks. 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. Depreciation and Amortization. Depreciation and amortization expense decreased
$0.7 million to $5.3 million for the three months ended March 31, 2004,
compared to $6.0 million the prior year period. We anticipate an increase to
our fixed asset purchases in the coming year as we introduce our VoIP service,
which is more capital intensive than our UNE-P offering. We also expect to
purchase additional computer equipment, switching equipment, furniture and
leasehold improvements as a result of our expected growth across all lines of
service. We will also continually evaluate our depreciation policy with
respect to our current and future network plans and the associated purchases of
capital equipment. Interest and Other Income. Interest and other income was $0.9 million for both
the three months ended March 31, 2004 and the prior year period. 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 decreased $0.6 million
to $1.3 million for the three months ended March 31, 2004, compared to $0.7
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 decrease in interest
and other expense for the three months ended March 31, 2004 compared to the
prior year period was the result less outstanding term debt obligations, which
has contributed to lower interest payments. We anticipate that interest expense
may increase due to the additional availability that may be created from our
new asset-based line of credit with Textron Financial. 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 three months ended March 31, 2004 and the same prior year
period. 19




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##### Table of Contents



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 in the context of these
segments. RETAIL SERVICES SEGMENT Our retail services segment includes our consumer and business bundled service
lines of business. This segment also includes our 1+ long-distance stand-alone
offering. In 2004 we shifted to focusing on growing our business bundled
services, passively investing in our consumer business and harvesting the 1+
long-distance offering for maximum cash flow. The following table, in millions,
summarizes our retail services business segments: Retail Services SegmentFor the three months
    
    Amount
    
    Percentageended March 31,
    
    ChangeFavorable
    
    ChangeFavorable
    
    Percentage of Revenues2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003RevenuesBundled residential services
    
    $
    39.9
    
    
    $
    44.5
    
    
    $
    (4.6
    )
    
    
    (10.3
    )%
    
    
    88.1
    %
    
    
    92.9
    %Bundled business services
    
    
    3.3
    
    
    
    0.4
    
    
    
    2.9
    
    
    
    725.0
    %
    
    
    7.3
    %
    
    
    0.8
    %1+ long-distance services
    
    
    2.1
    
    
    
    3.0
    
    
    
    (0.9
    )
    
    
    (30.0
    )%
    
    
    4.6
    %
    
    
    6.3
    %Total Revenues
    
    
    45.3
    
    
    
    47.9
    
    
    
    (2.6
    )
    
    
    (5.4)
    %
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    22.6
    
    
    
    22.7
    
    
    
    0.1
    
    
    
    0.4
    %
    
    
    49.9
    %
    
    
    47.4
    %Sales and marketing
    
    
    4.5
    
    
    
    4.5
    
    
    
    
    
    
    
    
    %
    
    
    9.9
    %
    
    
    9.4
    %General and administrative
    
    
    27.5
    
    
    
    25.2
    
    
    
    (2.3
    )
    
    
    (9.1)
    %
    
    
    60.7
    %
    
    
    52.6
    %Total operating expenses
    
    
    54.6
    
    
    
    52.4
    
    
    
    (2.2
    )
    
    
    (4.2)
    %
    
    
    120.5
    %
    
    
    109.4
    %Segment results
    
    $
    (9.3
    )
    
    $
    (4.5
    )
    
    $
    (4.8
    )
    
    
    (106.7
    )%
    
    
    (20.5
    )%
    
    
    (9.4
    )%
 Revenues. Revenues decreased by $2.6 million to $45.3 million for the three
months ended March 31, 2004, compared to $47.9 million the prior year period.
The revenue growth in our business lines was not enough to overcome the $4.6
million decrease in bundled residential service and the $0.9 million decrease
in the 1+ long-distance services experienced for the three months ended March
31, 2004, compared to the prior year period. Additionally, our ARPU per bundled
consumer line decreased by $0.62 to $67.40 for the three months ended March 31,
2004, compared $68.02 in the prior year period. There were two significant
factors that contributed to this change in ARPU. First, a decrease in the
access rates (charges that we bill to other carriers for carrying their traffic
to our customers) went into effect in June of 2003. (A further decrease will
occur in June of 2004.) Also in order to react to the highly competitive
telecommunication market and pricing trends we have seen significant 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. The trend in our bundled residential service during the first three months of
2004 provides some insight into the likely trend of our ARPU over the balance
of the year. With the planned carrier access rate reduction and reduced future
pricing plans associated with the AOL agreement we will likely see further
reductions to ARPU in the coming quarter and expect to see a continued downward
pressure on ARPU. However in total raw dollars, we may experience an increase
in our bundled residential service revenues in the coming quarters due to our
AOL agreement. This could reverse the trend of lower residential service lines
that we have been experiencing during the last three quarters. 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 contributions 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 due to the possible
incremental growth from our new AOL arrangement. Network Operations. Network operations expense decreased by $0.1 million to
$22.6 million for the three months ended March 31, 2004, compared to $22.7
million the prior year period. Our network operations as a percentage of
revenue increased by 2.5% to 49.9% for the three months ended March 31, 2004,
compared to 47.4% the prior year. The increase in network operations expense as
a 20




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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 as a result of the overall decrease
in our overall retail lines in service at March 31, 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. The expected growth across the board of all
of our service offerings will also 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 move from a
UNE-P LEC dependent based model to a standalone VoIP model. Sales and Marketing. Sales and marketing expense was $4.5 million for both the
three months ended March 31, 2004 and the prior year period. The changes in
our sales and marketing are discussed in the consolidated operations. We expect sales and marketing expenses to increase significantly as a result of
the agreement with AOL which we expect to significantly increase our commission
payments. We also 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. General
and Administrative. General and administrative expense increased $2.3
million to $27.5 million for the three months ended March 31, 2004, compared to
$25.2 million the prior year. As a percentage of revenues general and
administrative expense increased by 8.1% to 60.7% of revenues for the three
months ended March 31, 2003 compared to 52.6% the prior year period. The
overall increase in general and administrative expense for the three months
ended March 31, 2004 mirrors the consolidated increases except that the payroll
and ILEC gateway expenses are significantly lower as a result of less overall
residential lines which is driven by lower residential line acquisition and
some decrease in cost per transaction. We have also decreased residential
payroll expense dedicated to supporting the residential subscriber base, as we
have reallocated some of our personnel to our wholesale services business. Increases to general and administrative expense for the three months ended
March 31, 2004 compared to the prior year period:  
    
    Accrual for proposed settlement for litigation related to Metro Nashville - $1.8 million
    
    Sales and use tax expense - $1.0 million
    
    Reduction in ILEC performance credits for failure to meet certain service levels - $0.8 million
    
    Legal expenses associated with our outstanding litigation items and regulatory issues
pertaining to the D.C. Circuit decision pertaining to UNE-P - $0.8 million
    
    Dispatch charges from the ILECs - $0.7 million
    
    Hardware and software support - $0.4 million Decreases to general and administrative expense for the three months ended
March 31, 2004 compared to the prior year period:  
    
    Charges from our ILEC gateway provided to establish and change customers services - $1.6 million
    
    Payroll and related expenses - $0.6 million
    
    Bad debt expense - $0.6 million The remaining change of $0.4 million was primarily the result of the decreases
associated with having fewer average lines in service for the three months
ended March 31, 2004 compared to the prior year period. 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 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 during 2004, and therefore
expect general and administrative expense to decrease as a percentage of
revenues 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 2004. 21




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Our overall general and administrative expenses are somewhat dependent on
operational and fiscal 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 to 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 segment. We expect
to continue focusing on growth for our business and VoIP service offerings
which will likely contribute to increased general and administrative expense.
We expect our residential services to grow rapidly if our recent marketing
agreement with AOL is as successful as we expect that it could be. This
agreement has no minimums and is success based, with AOL being responsible for
providing customers, therefore, its success is dependent on AOLs efforts to
offer our services to its end users and our ability to deliver services for the
resulting demand. WHOLESALE SERVICES SEGMENT Our wholesale services segment includes services that we provide to other
companies giving them the ability to offer telephone exchange 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 table, in millions, provides
our wholesale services business segment for the three months ended March 31,
2004 compared to the prior year period: Wholesale Services SegmentFor the three months
    
    Amount
    
    Percentageended March 31,
    
    ChangeFavorable
    
    ChangeFavorable
    
    Percentage of Revenues2004
    
    2003
    
    (Unfavorable)
    
    (Unfavorable)
    
    2004
    
    2003RevenuesSprint
    
    $
    23.0
    
    
    $
    
    
    
    $
    23.0
    
    
    
    100.0
    %
    
    
    99.2
    %
    
    
    
    %MCI
    
    
    0.1
    
    
    
    12.9
    
    
    
    (12.8
    )
    
    
    (99.2
    )%
    
    
    0.4
    %
    
    
    99.2
    %Other
    
    
    0.1
    
    
    
    0.1
    
    
    
    
    
    
    
    
    %
    
    
    0.4
    %
    
    
    0.8
    %Total Revenues
    
    
    23.2
    
    
    
    13.0
    
    
    
    10.2
    
    
    
    78.5
    %
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    11.4
    
    
    
    4.1
    
    
    
    (7.3
    )
    
    
    (178.0
    )%
    
    
    49.1
    %
    
    
    31.5
    %General and administrative
    
    
    7.1
    
    
    
    1.7
    
    
    
    (5.4
    )
    
    
    (317.6
    )%
    
    
    30.6
    %
    
    
    13.1
    %Total operating expenses
    
    
    18.5
    
    
    
    5.8
    
    
    
    (12.7
    )
    
    
    (219.0
    )%
    
    
    79.7
    %
    
    
    44.6
    %Segment results
    
    $
    4.7
    
    
    $
    7.2
    
    
    $
    (2.5
    )
    
    
    (34.7
    )%
    
    
    20.3
    %
    
    
    55.4
    %
 Revenues. Revenues increased by $10.2 million to $23.2 million for the three
months ended March 31, 2004, compared to $13.0 million the prior year period.
Our wholesale service revenues increased to 33.9% of consolidated revenues for
the three months ended March 31, 2004, compared to 21.3% in the prior year
period. We signed our wholesale services agreement with Sprint in February of
2003. Sprint contributed $23.0 million of revenue for the three month ended
March 31, 2004 and was our primary wholesale customer during that period
compared to MCI in the prior year period and the contribution of $12.9 million
of wholesale revenues. Our business development group is actively pursuing other potential wholesale
partners and is working to develop new wholesale services. We expect that our
wholesale lines in service will continue to steadily increase during 2004.
This, however, does not automatically translate into increased revenue. We
employ the gross accounting method for recognizing revenue within the wholesale
service business segment; therefore, we record revenue for certain services
that we provide to Sprint at our cost and record the off-setting expense in one
of the respective operating cost lines within our income statement. These
revenues (and cost pass-through items) result in no contribution to operating
income. Therefore, to the extent that Sprint decides to take over certain
services that we currently provide to them, such as becoming the customer of
record for the ILEC bills associated with their customer base, which is
occurring to an increasing extent, a decrease in reported revenues (and a
decrease in the off-setting operating expense) will result. This action will
have no direct impact on the overall profitability of the contract. Revenue per
line under management will decrease but the operating contribution generated on
a per line basis will stay the same. Also, our stated accounts payable will
decrease, as we will no longer be incurring this liability. In February 2004, we signed a new wholesale services agreement with Working
Assets Funding Services, Inc. Although the expected growth from this
relationship will be significantly less than that with our existing Sprint
agreement, it should provide some additional revenue growth for 2004. While we expect wholesale lines in service to grow in a meaningful manner
during 2004, we cannot predict a corresponding increase in reported wholesale
revenue, and reported wholesale services revenue may indeed be flat to slightly
down despite the anticipated increase in wholesale lines in service due to the
inherent uncertainties associated with the nature of having to apply the gross
accounting treatment to the wholesale services business segment. The primary
reason for this is that the charges for ILEC services are 22




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the largest revenue component of our wholesale services and with Sprint
increasingly becoming the customer of record for these bills our reported
revenue will decrease while we expect income to continue to increase during
2004. Network Operations. Network operations expense increased by $7.3 million to
$11.4 million for the three months ended March 31, 2004, compared to $4.1
million in the prior year period. As stated in the revenue paragraph, Sprint
has decided to become the customer of record for billing purposes from the
ILECs, and we therefore expect network operations expense to decrease
significantly over the remainder of 2004 relative to the current quarter,
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. General and Administrative. General and administrative expense increased by
$5.4 million to $7.1 million for the three months ended March 31, 2004,
compared to $1.7 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 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. We expect to steadily increase headcount to
support our existing wholesale customers and the possible addition of new
wholesale customers. We may transfer existing employees from our retail
businesses to our wholesale business segment on an as needed basis. As a result
of this growth, we expect general and administrative expense to increase in
total dollars and as a percentage of our consolidated expenses. We have not
recorded any bad debt expense for wholesale services and have not had any
material write-offs of receivables. 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 our 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 2004, we plan to launch VoIP in at least 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 March
31, 2004, we had an accumulated deficit of $329.3 million, a net tax operating
loss carryforward of $280.8 million, and $11.9 million in cash and cash
equivalents. We have funded our expenditures primarily through operating
revenues, private securities offerings, a sale-leaseback credit facility, an
accounts receivable factoring facility and an initial public offering that
raised net proceeds of $109.1 million. We intend to continue building our
organization in anticipation of future growth and we believe that our operating
expenditures will also continue to increase. We
anticipate generating, through normal operations, the remaining cash
flows necessary to meet our operating, investing and financing
requirements. We also are exploring potential subordinated debt
arrangements and financing of certain capital expenditures. If an
unfavorable outcome results from the current uncertain regulatory
environment, further discussed in our Form 10-K filed March 30,
2004 with the SEC and updated in Part II, Item 1. Legal
Proceedings #4 in this document, or if expected financing and line
growth does not materialize, our expected results could differ materially
from our current plan. 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 provided by operating activities decreased by $1.9 million to $3.2
million for the three months ended March 31, 2004, compared to $5.1 million in
the prior year period. The decrease was primarily a result of our net loss
after excluding non-cash items, which decreased by $3.0 million while overall
working capital decreased by $0.2 million. The RFC agreement, which was terminated in April 2004 as a result of our
executing a new asset backed credit facility discussed below in the Debt
Instruments section, allowed us to sell up to $25 million of receivables,
subject to the selection criteria utilized by RFC for the receivables they
agree to purchase. Under the agreement we were responsible for the continued
servicing of the receivables and any amount collected over the discount rate
was paid to us by RFC for providing the servicing less certain fees. Our net cash used in investing activities improved by $0.7 million to $2.4
million for the three months ended March 31, 2004, compared to $3.1 million the
prior year period. The improvement was primarily attributable to the purchasing
of less property and equipment for the three months ended March 31, 2004
compared to the prior year period. We expect our capital expenditures to
increase during 2004; however, we will attempt to obtain financing for these
purchases. As we move toward a VoIP model from our UNE-P model our capital
expenditures are expected to increase in the coming years due to the increased
capital requirements of VoIP. Also, the expected growth in our retail and
wholesale business will also contribute to increase capital expenditures. Our net cash used in financing activities was $1.0 million for both the three
months ended March 31, 2004 and the same period the prior year. This is
primarily a result of having similar amounts of debt and capital lease
payments and the same combined amount of 23




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proceeds from related party notes receivable payments and options exercises for
the three months ended March 31, 2004 and the same period the prior year. We expect our total debt to increase during 2004 because of a new asset based
loan that we obtained from Textron Financial in April 2004. This agreement
replaced the accounts receivable agreement that we had in place with Textrons
subsidiary company, RFC, for almost four years. This new agreement will be 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 off-set by most of our existing
term debt being paid off 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 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
which we expect to meet in the first half of 2004. 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 positive cash flow throughout this section we are referring to
the cash inflows and incremental 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 $17.8 million for the
three months ended March 31, 2004. 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 residential 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 volume as our residential
business, it provides a healthy net cash contribution on a per line basis
without causing us to incur traditional upfront sales and marketing costs as is
typically the case with traditional retail marketing activities. We expect to continue actively investing in the growth of our business services
unit, which should provide a positive cash flow in 2004. Finally, we are
continuing our revenue and access diversification as we roll-out our VoIP, 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 we may be well
positioned for incremental growth during 2004 within the consumer business, and
possibly in the form of wholesale services growth, as a result of our AOL
marketing agreement. We also expect to expand our wholesale services
business over the balance of the year. We believe that this increasingly
diversified business model provides us with more avenues for growth opportunity
and less dependence on any one model 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 development of services and brand
promotions, the resources that we devote to the sales and marketing of our
services, and many other factors. 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 mostly 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 in discussions with a vendor to
finance the purchase of $2.7 million of equipment that would be used for our
VoIP initiatives. We are currently under audit by the State of New York for our sales and use
taxes. In January of 2004, we received a preliminary summary from the State of
New York stating that we owe them $2.0 million in sales and use 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 their 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, but 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. 24




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We have signed a proposed settlement agreement with Metro Nashville to settle
certain litigation, as discussed in footnote 12. Legal and Regulatory
Proceedings, that if the proposed settlement receives all the necessary
approvals by Metro Nashville we will have to make an immediate payment of $0.8
million in cash. 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. We believe that if the line growth materializes similar to managements
expectations over the course of 2004, we will generate overall free cash flow
without any reductions to the aforementioned corporate expenditures. However,
we also 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 challenging from a cash management perspective as we maximize the management
of our accounts payables and the expected increased capital expenditures
resulting from expected growth in all lines of our business and investment in
our VoIP offering. These expenses are primarily front-end loaded and we expect
will result in negative cash flows over the short term, but should become
positive during the last quarter of 2004 to the first quarter of 2005. We will
continue to finance significant capital expenditures and 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 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 our
wholesale and retail service business segments. Looking to the future, arguably the most significant issue we need to address
is the mandatorily redeemable preferred stock which has a current collective
liquidation value of $161.6 million, that either will need to be redeemed or
converted in some fashion into common stock or some other type of instrument.
The redemption of this stock is not definite, as it can be converted at the
option of the holder or under certain conditions the conversion may be forced
by us. However, this would not likely occur until our common stock price
increases significantly. We recognize the importance of exploring various
options and alternatives to address a possible redemption that may occur as
early as 2006 for a part of the preferred stock. We also realize that these
instruments may hinder our ability to obtain additional financing in the
future, unless we have a viable plan to convert or redeem these securities in
part or in full. 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
expect this bonus to be paid in December of 2004. We have 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. There are also common disposition of assets
limitations, limits on change of control, certain notification requirements,
change in management limitations and certain other restrictions. There are
also certain limitations on our ability to access subordinated debt within the
confines of the agreement, however, we believe the agreement provides us with
flexibility for future debt financing alternatives. We believe that this new agreement will help us to manage our short and
long-term cash needs, although we are still exploring other alternatives for
obtaining additional funding, including but not limited to subordinated debt
and certain equity transactions. We believe that an asset based loan agreement
will provide some immediate help to improve our overall working capital
position but the expected growth in our business may still result in additional
liquidity needs that would have to be obtained through additional financings.
Specifically, our recently signed agreement with AOL could cause our
residential service business to operate in a negative cash flow position until
the fourth quarter of 2004. 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 25




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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 $2.8 million of remaining principal term debt as of March 31, 2004, of
which all but $0.1 million will be paid off by 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 March 31, 2004
totaled $19.1 million. These disputes are summarized in the following table: OutstandingDisputes atMarch 31, 2004(In millions)Alternatively billed services
    
    $
    8.0MCI fixed facility charges
    
    
    2.7Verizon back-billing of installation charges
    
    
    2.4Late fees for non-payment of disputed charges
    
    
    3.0All others
    
    
    3.0$
    19.1
 Alternatively billed services are primarily charges for certain 1-800, 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. Although we have
received communications from MCI that these charges are not valid, they have
never removed these charges from their billings to us. 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. 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. 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 $19.1 million. However, we do not believe that these charges are
valid and intend to continue our dispute and non-payment of these charges. RELATED PARTY TRANSACTIONS In February 2004, we received from two employees an aggregate payment of $0.2
million for repayment of notes receivable. 26




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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 thereunder. 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 thereunder. 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 memorandum of understanding has been reached by lawyers for the plaintiffs,
the issuers and insurers of the issuers. The memorandum sets forth the terms of
a proposed settlement, the principal components of which 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. Our board of directors has approved the
memorandum of understanding. To be binding, the settlement must be approved by
substantially all the issuers 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 27




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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 asserts claims under Delaware Law, the Uniform Commercial
Code, and state law and seeks actual damages of $18 million, punitive damages
of $18 million, interest, and court costs. Metropolitan Nashville Employee
Benefit Board is a Z-Tel common shareholder. Metro Nashville alleges 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 price of our stock declined significantly. We have
entered into a memorandum of understanding whereby we expect to pay Metro
Nashville $800,000 in cash and approximately $800,000 in our common stock in
full settlement of this matter.  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. This motion is pending before the court. 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 after sixty days or upon denial of a
petition for rehearing, whichever occurs later. On April 14, 2004, upon the
request made by the FCC and the United States, the DC Circuit stayed the
mandate in USTA II until June 15, 2004. This decision could have a material
adverse effect on our business. For additional information see Footnote 12 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. 
 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.
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EXHIBITNUMBER
    
    DESCRIPTION4.3
    
    Stock Purchase Agreement, dated July 6, 2000, by and between us and the various purchasers of our Series D
Convertible Preferred Stock. Incorporated by reference to the correspondingly numbered exhibit to our Quarterly
Report on Form 10-Q for the quarter ended June 30, 2000, filed on August 14, 2000.4.4
    
    Certificate of Designations, Preferences and Relative Rights, Qualifications, Limitations and Restrictions relating
to our Series D Convertible Preferred Stock, as amended March 13, 2003. Incorporated by reference to Exhibit 4.4 to
our Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2000, filed on August 14, 2000, and (the
amendment) to Exhibit 4.20 of our Quarterly Report on Form 10-Q for the quarter ended March 31, 2003, filed on May
15, 2003.4.5
    
    From of Registration Rights Agreement by and between us and each of the purchasers of our Series D Convertible
Preferred Stock. Incorporated by reference to the correspondingly numbered exhibits to our Quarterly Report on Form
10-Q for the quarter ended June 30, 2000, filed on August 14, 2000.4.6
    
    Form of Warrant for the purchase of shares of our common stock by each of the purchasers of our Series D Convertible
Preferred Stock. Incorporated by reference to the correspondingly numbered exhibit to our Quarterly Report on Form
10-Q for the quarter ended June 30, 2000, filed on August 14, 2000.4.7
    
    Stock and Warrant Purchase Agreement, dated October 19, 2000, by and among us and The 1818 Fund III, L.P.
Incorporated by reference to the correspondingly numbered exhibit to our Quarterly Report on Form 10-Q for the
quarter ended September 30, 2000, filed on November 14, 2000.4.8
    
    Amended and Restated Certificate of Designation of 8% Convertible Preferred Stock, Series E, Setting Forth the
Powers, Preferences, Rights, Qualifications, Limitations and Restrictions of Such Series of Preferred Stock, as
amended March 13, 2003. Incorporated by reference to Exhibit 4.8 to our Quarterly Report on Form 10-Q for the quarter
ended June 30, 2001, filed on August 13, 2001, and (the amendment) to Exhibit 4.21 of our Quarterly Report on Form
10-Q for the quarter ended March 31, 2003, filed on May 15, 2003.4.9
    
    Registration Rights Agreement between and among us and The 1818 Fund III, L.P. Incorporated by reference to the
correspondingly numbered exhibit to our Quarterly Report on Form 10-Q for the quarter ended September 30, 2000, filed
on November 14, 2000.4.10
    
    Warrant issued to The 1818 Fund III, L.P. for the purchase of shares of our common stock. Incorporated by reference
to the correspondingly numbered exhibit to our Quarterly Report on Form 10-Q for the quarter ended September 30,
2000, filed on November 14, 2000.4.11
    
    Certificate of Designation of Series F Junior Participating Preferred Stock. Incorporated by reference to the
correspondingly numbered exhibit to our Annual Report on Form 10-K for the year ended December 31, 2000, filed on
March 30, 2001.4.12
    
    Rights Agreement dated as of February 19, 2001 between us and American Stock Transfer Trust Company, as Rights Agent.
Incorporated by reference to the correspondingly numbered exhibit to our Annual Report on Form 10-K for the year
ended December 31, 2000, filed on March 30, 2001. The agreement was amended July 2, 2001 to reflect the issuance of
the Series G Preferred Stock.4.13
    
    Stock and Warrant Purchase Agreement, dated as of July 2, 2001, by and between us, D. Gregory Smith, and others.
Incorporated by reference to Exhibit 1 to Amendment No. 1 of the Schedule 13D filed July 12, 2001 with respect to our
common stock by, among other persons, The 1818 Fund III, L.P.4.14
    
    Warrant for the Purchase of Shares of Common Stock of Z-Tel, dated as of July 2, 2001. Incorporated by reference to
Exhibit 2 to Amendment No. 1 of the Schedule 13D filed July 12, 2001 with respect to our common stock by, among other
persons, The 1818 Fund III, L.P.
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EXHIBITNUMBER
    
    DESCRIPTION4.15
    
    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, 2001 with respect to our common stock by, among other persons, The 1818 Fund III, L.P.4.17
    
    Additional Investor Registration Rights Agreement, dated as of July 2, 2001, between Z-Tel, D. Gregory Smith and
others. Incorporated by reference to Exhibit 5 to the Schedule 13D filed July 24, 2001 with respect to our common
stock by, among other persons, D. Gregory Smith.4.18
    
    Voting Agreement, dated as of June 29, 2001, between us and certain of our stockholders. Incorporated by reference to
Exhibit 5 to Amendment No. 1 of the Schedule 13D filed July 12, 2001 with respect to our common stock by, among other
persons, The 1818 Fund III, L.P.4.19
    
    Employee Stock Restriction Agreement, dated September 1, 1998, by and between us and D. Gregory Smith. Incorporated
by reference to Exhibit 7 to the Schedule 13D filed July 24, 2001 with respect to our common stock by, among other
persons, D. Gregory Smith.10.2.1
    
    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 shares.
 10.3
    
    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
    
    Receivables Sales Agreement dated as of July 27, 2000 by and between Z-Tel Communications, Inc., as seller and
subservicer, Touch 1 Communications, Inc., as seller and subservicer, and RFC Capital Corporation, as purchaser.
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, with an amendment extending the agreement until July 27, 2004.10.5
    
    Form of Indemnification Agreement for our executive officers and directors. Incorporated by reference to the
correspondingly numbered exhibit to our Annual Report on Form 10-K for the year ended December 31, 2000, filed on
March 30, 2001.
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EXHIBITNUMBER
    
    DESCRIPTION10.6
    
    Employment Agreement of Horace J. Trey Davis III, dated August 14, 2002. 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,
2002.10.8
    
    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, 2004.31.1
    
    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 January 14, 2004, we furnished a Form 8-K disclosing a transcript of
comments made by our chief executive officer during the Sixth Annual Needham
Growth Conference. On February 20, 2004, we furnished a Form 8-K and an
amended Form 8-K in connection with our earnings release on that date. On
February 24, 2004 we furnished a Form 8-K with the transcript of our earnings
conference call held February 20, 2004. 
 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 17th day of May
2004. Z-TEL TECHNOLOGIES, INC.
(Registrant) By:
    
    /s/ Horace J. Davis IIISenior Vice-President  Chief Financial Officer(Authorized officer of Registrant and principal financial officer)
 31