**UNITED
STATES**
 **SECURITIES
AND EXCHANGE COMMISSION**
 **Washington,
D.C. 20549**
 
 **FORM
10-Q**
 
 **(Mark
One)**
 x
    **QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**
 
 **For
the Quarterly Period Ended March 31, 2005**
 
 **OR**
 
 o
    **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 0-32941**
 
 **Mpower
Holding Corporation**
 (Exact
name of registrant as specified in its charter)
 
 **DELAWARE**
    
    **52-2232143**(State
      or other jurisdiction of incorporation or organization)
    
    (I.R.S.
      Employer Identification No.)
 
 **175
Sully's Trail, Suite 300**
 **Pittsford,
NY 14534**
 (Address
of principal executive offices, including Zip Code)
 
 **(585)
218-6550**
 (Registrant's
telephone number, including area code)
 
 Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.
 YES x NO o
 
 Indicate
by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act).
 YES x NO o
 
 Indicate
by check mark whether the registrant has filed all documents and reports
required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act
of 1934 subsequent to the distribution of securities under a plan confirmed by a
court.
 YES x NO o
 
 The
number of shares outstanding of the issuer's common stock, as of May 3,
2005:
 
 Common
stock (par value $0.001 per common share)....91,431,807 shares
outstanding
  
  **MPOWER
HOLDING CORPORATION**
 
 **INDEX**
 
 **Page****No**.**PART
      I -**
    **FINANCIAL
      INFORMATION**Item
      1.
    Condensed
      Consolidated Financial Statements (Unaudited)Consolidated
      Balance Sheets - as of March 31, 2005 and December 31,
2004
    3Consolidated
      Statements of Operations - for the three months ended March 31, 2005and
      2004
    4Consolidated
      Statements of Cash Flows - for the three months ended March 31, 2005and
      2004
    5Condensed
      Notes to Unaudited Interim Consolidated Financial
    Statements
    6Item
      2.
    Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
    15Item
      3.
    Quantitative
      and Qualitative Disclosures About Market Risk
    26Item
      4.
    Controls
      and Procedures
    26**PART
      II -**
    **OTHER
      INFORMATION**Item
      1.
    Legal
      Proceedings
    27Item
      2.
    Unregistered
      Sales of Equity Securities and Use of Proceeds
    27Item
      6.
    Exhibits
    28SIGNATURES
    
    29
 
  2
  **PART
I - FINANCIAL INFORMATION**
 **Item
1.**  *Condensed
Consolidated Financial Statements (Unaudited)*
 
 **MPOWER
HOLDING CORPORATION**
 **CONSOLIDATED
BALANCE SHEETS**
 **(IN
THOUSANDS, EXCEPT PREFERRED AND COMMON SHARE AND PER COMMON SHARE
AMOUNTS)**
 **(UNAUDITED)**
 
 **March
      31**,
    
    **December
      31**,**2005**
    
    **2004****ASSETS**Current
      assets:Cash
      and cash equivalents
    
    $
    27,631
    
    $
    27,327Investments
      available-for-sale
    
    
    9,874
    
    
    8,064Accounts
      receivable, less allowance for doubtful accounts of $1,387 and$1,375
      at March 31, 2005 and December 31, 2004, respectively
    
    
    13,247
    
    
    10,140Other
      receivables
    
    
    5,061
    
    
    3,164Prepaid
      expenses and other current assets
    
    
    3,124
    
    
    3,060Total
      current assets
    
    
    58,937
    
    
    51,755Property
      and equipment, net
    
    
    61,524
    
    
    33,012Long-term
      restricted cash and cash equivalents
    
    
    9,545
    
    
    9,515Long-term
      investments available-for-sale
    
    
    260
    
    
    2,041Goodwill
    
    
    5,301
    
    
    —Intangibles,
      net of accumulated amortization of $12,499 and $11,072 atMarch
      31, 2005 and December 31, 2004, respectively
    
    
    6,360
    
    
    4,367Other
      long-term assets
    
    
    3,062
    
    
    4,274Total
      assets
    
    $
    144,989
    
    $
    104,964**LIABILITIES
      AND STOCKHOLDERS’ EQUITY**Current
      liabilities:Current
      maturities of capital lease obligations
    
    $
    378
    
    $
    —Accounts
      payable
    
    
    17,530
    
    
    20,462Accrued
      sales tax payable
    
    
    2,536
    
    
    2,190Accrued
      bonus
    
    
    741
    
    
    2,508Deferred
      revenue
    
    
    6,491
    
    
    5,059Accrued
      other expenses
    
    
    14,008
    
    
    11,756Total
      current liabilities
    
    
    41,684
    
    
    41,975Long-term
      capital lease obligations
    
    
    19,031
    
    
    —Other
      long-term liabilities
    
    
    2,177
    
    
    1,833Total
      liabilities
    
    
    62,892
    
    
    43,808Commitments
      and contingenciesStockholders’
      equity:Preferred
      stock, 49,900,000 shares authorized but unissued at March 31, 2005 and
      December 31, 2004
    
    
    —
    
    
    —Series
      A preferred stock, 100,000 shares authorized but unissued at March 31,
      2005 and December 31, 2004
    
    
    —
    
    
    —Common
      stock, $0.001 par value, 1,000,000,000 shares authorized, 91,427,745 and
      78,570,772 shares issued and outstanding at March 31, 2005 and December
      31, 2004, respectively
    
    
    91
    
    
    79Additional
      paid-in capital
    
    
    121,138
    
    
    104,054Accumulated
      deficit
    
    
    (39,132
    )
    
    (42,977
    )Total
      stockholders’ equity
    
    
    82,097
    
    
    61,156Total
      liabilities and stockholders’ equity
    
    $
    144,989
    
    $
    104,964
 
 See
accompanying condensed notes to unaudited interim consolidated financial
statements.
  3
  **MPOWER
HOLDING CORPORATION**
 **CONSOLIDATED
STATEMENTS OF OPERATIONS**
 **(IN
THOUSANDS, EXCEPT COMMON SHARE AND PER COMMON SHARE
AMOUNTS)**
 **(UNAUDITED)**
 
 **Three
      Months Ended**
      **March
      31**,
    **Three
      Months Ended**
      **March
      31**,**2005**
    **2004**Operating
      revenues:Telecommunication
      services
    $47,726
    $37,153Operating
      expenses:Cost
      of operating revenues
      (exclusive
      of depreciation and amortization shown separately below of $3,512 and
      $1,939 for the three months ended March 31, 2005 and 2004,
      respectively)
    21,835
    16,388Selling,
      general and administrative
      (exclusive
      of depreciation and amortization shown separately below of $2,089 and
      $1,962 for the three months ended March 31, 2005 and 2004,
      respectively)
    22,730
    17,588Gain
      on sale of assets, net
    (9)
    (198)Depreciation
      and amortization
    5,601
    3,90150,157
    37,679Loss
      from operations
    (2,431)
    (526)Other
      income (expense):Interest
      income
    183
    88Interest
      expense
    (1,167)
    (66)Other
      income
    7,292
    —Income
      (loss) from continuing operations
    3,877
    (504)Discontinued
      operations:(Loss)
      income from discontinued operations
    (32)
    241Net
      income (loss)
    $3,845
    $(263)Basic
      and diluted income (loss) per common share:Income
      (loss) from continuing operations
    $0.04
    $(0.01)(Loss)
      income from discontinued operations
    —
    0.01Net
      income (loss)
    $0.04
    $—Basic
      weighted average common shares outstanding
    91,331,930
    78,321,851Diluted
      weighted average common shares outstanding
    102,111,366
    78,321,851
 
 See
accompanying condensed notes to unaudited interim consolidated financial
statements.
  4
  **MPOWER
HOLDING CORPORATION**
 **CONSOLIDATED
STATEMENTS OF CASH FLOWS**
 **(IN
THOUSANDS)**
 **(UNAUDITED)**
 **Three
      Months Ended**
    **Three
      Months Ended****March
      31,****2005**
    **March
      31,****2004**Cash
      flows from operating activities:Net
      income (loss)
    $3,845
    $(263)Adjustments
      to reconcile net income (loss) to net cash provided by
      operating
      activities:Depreciation
      and amortization
    5,601
    3,901Gain
      on disposal of assets from discontinued operations
    —
    (50)Gain
      on sale of assets, net
    (9)
    (198)Bad
      debt expense
    451
    457Amortization
      of investment premiums
    37
    —Stock-based
      compensation expense
    —
    39Agent
      selling expense - warrants
    122
    —Changes
      in assets and liabilities:(Increase)
      decrease in accounts receivable
    (2,028)
    1,423(Increase)
      decrease in other receivables
    (4,276)
    1,008(Increase)
      decrease in prepaid expenses and other current assets
    (9)
    1,528Decrease
      (increase) in other long-term assets
    80
    (282)Increase
      (decrease) in accounts payable
    467
    (4,596)Decrease
      in accrued sales tax payable
    (159)
    (69)Decrease
      in accrued other expenses
    (1,172)
    (2,505)Net
      cash provided by operating activities
    2,950
    393Cash
      flows from investing activities:Purchase
      of property and equipment, net of payables
    (4,333)
    (667)Proceeds
      from sale of assets from continuing operations
    13
    205Receipt
      of escrowed amounts from sale of assets from discontinued
      operations
    1,000
    —Purchase
      of investments available-for-sale, net
    (566)
    —Sale
      of investments available-for-sale, net
    500
    —Sale
      of restricted investments
    —
    130Purchase
      of restricted investments, net
    (30)
    —Net
      cash used in investing activities
    (3,416)
    (332)Cash
      flows from financing activities:Costs
      associated with issuance of common stock
    (10)
    —Net
      proceeds under management agreement with acquired business
    85
    —Payments
      on capital lease obligations
    (1,837)
    (101)Proceeds
      from issuance of common stock
    2,532
    27Net
      cash provided by (used in) financing activities
    770
    (74)Net
      increase (decrease) in cash and cash equivalents
    304
    (13)Cash
      and cash equivalents at beginning of period
    27,327
    29,307Cash
      and cash equivalents at end of period
    $27,631
    $29,294Supplemental
      schedule of non-cash investing and financing activities:Fair
      value of assets acquired in business acquisition
    $40,629
    $—Liabilities
      assumed in business acquisition
    $(24,696)
    $—Common
      stock issued in business acquisition
    $13,533
    $—Warrants
      issued in business acquisition
    $1,246
    $—Accrued
      costs associated with business acquisition
    $274
    $—Property
      and equipment purchased under capital leases
    $64
    $—Supplemental
      cash flow information:Cash
      paid for interest
    $21
    $33
 See
accompanying condensed notes to unaudited interim consolidated financial
statements.
  5
  **MPOWER
HOLDING CORPORATION**
 **CONDENSED
NOTES TO UNAUDITED INTERIM CONSOLIDATED FINANCIAL
STATEMENTS**
 **(UNAUDITED)**
 
 **(1)
PRINCIPLES OF CONSOLIDATION AND BASIS OF PRESENTATION**
 
 The
accompanying unaudited condensed consolidated financial statements of Mpower
Holding Corporation (“Holding”), a Delaware corporation, include the accounts of
Holding and its wholly-owned subsidiary, Mpower Communications Corp.
(“Communications”) and other subsidiaries of Communications (collectively the
“Company”). All intercompany balances and transactions have been
eliminated.
 
 The
Company was one of the first facilities-based competitive local telephone
companies founded after the inception of the Telecommunications Act of 1996,
which opened up the local telephone market to competition. The Company offers
local and long distance voice services as well as high-speed Internet access and
voice over internet protocol (“VOIP”) telephony by way of a variety of broadband
product and service offerings over its network of collocations, switches and
fiber network. The Company’s services have historically been offered through
Communications primarily to small and medium-sized business customers in all of
its markets and residential customers primarily in the Las Vegas, Nevada market.
The Company’s markets include Los Angeles, California, San Diego, California,
Northern California (the San Francisco Bay area and Sacramento), Las Vegas,
Nevada and Chicago, Illinois. The Company also bills a number of major local and
long distance carriers for the costs of originating and terminating traffic on
the Company’s network for the Company’s local service customers. The Company
does not have any unbundled network element platform (“UNE-P”) revenues although
it is actively pursuing opportunities to provide network-based alternatives to
UNE-P carriers on a wholesale basis in light of recent regulatory
changes.
 
 On
January 1, 2005, the Company acquired certain assets and assumed certain
liabilities of ICG Communications, Inc. (“ICG”). The assets acquired include
ICG’s customer base and certain network assets in California. See Note 3 for
additional discussion of this acquisition.
 
 These
condensed consolidated financial statements reflect all normal recurring
adjustments, which management believes are necessary to present fairly the
financial position, results of operations, and cash flows for the Company for
the respective periods presented. Certain information and footnote disclosures
normally included in the annual consolidated financial statements prepared in
accordance with accounting principles generally accepted in the United States of
America have been condensed or omitted pursuant to the rules and regulations of
the Securities and Exchange Commission for Form 10-Q. These unaudited interim
condensed consolidated financial statements should be read in conjunction with
the audited consolidated financial statements and notes thereto included in the
Company’s annual report on Form 10-K for the year ended December 31, 2004, filed
with the Securities and Exchange Commission.
 
 The
consolidated balance sheet at December 31, 2004 was derived from the audited
consolidated financial statements of the Company.
 
 The
preparation of the financial statements in conformity with accounting principles
generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from these
estimates.
 
 The
results of operations for the three months ended March 31, 2005 and cash flows
for the three months ended March 31, 2005 are not necessarily indicative of the
results to be expected for other interim periods or for the year ending December
31, 2005.
 
 Certain
reclassifications, which have no effect on net income (loss), have been made in
the prior period financial statements to conform to the current
presentation.
 
 **Effects
of New Accounting Standards**
 
 *Share-Based
Payment*
 
 In April
2005, the effective date of Statement of Financial Accounting Standards (“SFAS”)
No. 123 (revised 2004), “Share-Based Payment”, which replaces SFAS No. 123,
“Accounting for Stock-Based Compensation,” and supersedes Accounting Principles
Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” was
deferred and will now be effective beginning with the first fiscal year that
begins after June 15, 2005, with early adoption encouraged. SFAS No. 123(R)
requires all share-based payments to employees, including grants of employee
stock options, to be recognized in the financial statements based on their fair
values. At this time the Company cannot yet estimate the effect of adopting SFAS
No. 123(R) as it has not yet selected the period of adoption, the method of
adoption or an option-pricing model and it has not yet finalized estimates of
its expected forfeitures.
 
 6
 **(2)
STOCK OPTION PLAN**
 
 The
Company measures the compensation cost of its stock option plan under the
provisions of APB Opinion No. 25, as permitted under SFAS No. 123, as amended by
SFAS No. 148, “Accounting for Stock-Based Compensation-Transition and
Disclosure.” Under the provisions of APB No. 25, compensation cost is measured
based on the intrinsic value of the equity instrument awarded. Under the
provisions of SFAS No. 123, compensation cost is measured based on the fair
value of the equity awarded.
 
 Had
compensation cost for the employee stock options been determined consistent with
SFAS No. 123, the Company’s results from operations would approximate the
following pro forma amounts for the three months ended March 31, 2005 and 2004
(in thousands, except per common share amounts):
 ****Three
      Months Ended******March
      31**,
    
    **March
      31**,**2005**
    
    **2004**Net
      income (loss), as reported
    
    $
    3,845
    
    $
    (263
    )Add:
      Stock-based compensation expense included in reported net income (loss),
      net of related income tax effects
    
    
    —
    
    
    39Deduct:
      Total stock-based compensation expense to be determined under a fair value
      based method for all awards, net of related income tax
    effects
    
    
    (2,052
    )
    
    (2,307
    )Pro
      forma net income (loss)
    
    $
    1,793
    
    $
    (2,531
    )Basic
      and diluted net income (loss) per common share, as
reported
    
    $
    0.04
    
    $
    —Basic
      and diluted net income (loss) per common share, pro forma
    
    $
    0.02
    
    $
    (0.03
    )
 
 Pro forma
amounts for the three months ended March 31, 2004 have been restated from
figures previously reported as a result of an error in the vesting periods
utilized for disclosure purposes and adjustments made to properly reflect
compensation expense under SFAS No. 123. For the three months ended March 31,
2004, such adjustments increased the pro forma stock-based compensation expense
determined under a fair value based method by $1.5 million and pro forma basic
and diluted net loss per common share by 2 cents.
 
 **(3)
ACQUISITION**
 
 On
January 1, 2005, the Company completed the acquisition of Denver-based ICG’s
retail and wholesale customers in California; a 1,412 route mile state-wide
fiber ring and 915 route miles of metropolitan fiber rings which connect 128
commercial buildings across major cities in California (“ICG California”), along
with certain network assets and assumed certain liabilities related to those
assets (the “Business”) pursuant to an Asset Purchase Agreement (“Agreement”),
dated October 22, 2004 by and among MCCC ICG Holdings, LLC (“MCCC”), ICG and the
Company. MCCC is a joint venture between Columbia Capital and M/C Venture
Partners. ICG is a nationwide communications provider focused on delivering data
and voice services to corporate customers, Internet service providers and
telecommunication carriers using a network that it owned and operated. It was a
publicly held company until October 18, 2004 when it became a private entity
through a merger transaction. As a result of this merger, MCCC owns 100% of the
voting stock of ICG.
 
 The
Company purchased these assets for $15.9 million, comprised of (i) $13.5 million
in the form of 10,740,030 shares of the Company’s common stock, (ii) $1.2
million in the form of warrants to purchase another 2,000,000 shares of the
Company’s common stock dated January 1, 2005 exercisable on or prior to the
fifth anniversary of the date of issuance at an exercise price of $1.383 per
share and (iii) $1.2 million of direct acquisition costs. The Company also
assumed certain of ICG’s capitalized leases in California, including its
long-term leases for its fiber network, which had a preliminary value of
$21.2 million as of January 1, 2005. The $13.5 million value of 10,740,030
shares of common stock was determined using a stock price of
$1.26. The fair value of the warrants was determined using the Black Scholes
method, with the following assumptions; dividend yield of 0%; expected warrant
life of 5 years; risk free interest rate of 3.35% and an expected volatility of
57%.
 
 MCCC
received one seat on the Company’s board of directors as a result of this
transaction. In connection with the acquisition, Columbia Capital and M/C
Venture Partners, through their ownership of MCCC, invested $2.5 million in cash
for an additional 1,988,894 shares of the Company’s common stock on January 5,
2005.
 
 The ICG
transaction described above involved a management services agreement and a
transition services agreement that maintained the continuity of the ICG
operations in California and prepared for the transfer of required business
functions to the Company. Under the management services agreement, the Company
is to reimburse ICG for the cost of specific services provided by ICG on the
Company’s behalf. As of March 31, 2005, the Company recognized direct
acquisition costs of $0.5 million for services and fees incurred under the
management services agreement. The agreement also provided that the operating
results of ICG’s California operations accrued to the benefit of the Company
between the date the definitive agreement was signed (October 22, 2004) and
final closing (January 1, 2005). ICG’s California operations generated operating
income of $0.3 million, which has been recorded as an offset to the gross direct
acquisition costs the Company incurred under the management services agreement.
The Company has recorded additional direct acquisition costs of $1.0 million
primarily for legal and consulting fees incurred in connection with the ICG
California acquisition. The $1.2 million of net direct acquisition costs
described above has been included as a component of the purchase price in
accordance with SFAS No. 141, “Business Combinations.”
 7
 Commencing
on the transaction closing date, January 1, 2005, certain services are being
provided by ICG to the Company under a transition services agreement. Such
services are expected to continue through the second quarter of 2005 and the
cost incurred for such services is included in the Company’s results of
operations. For the three months ended March 31, 2005, the Company incurred $0.8
million of expense, under the transition services agreement, primarily related
to billing, collections, provisioning, call center and network support services
performed by ICG on the Company’s behalf, which are included in selling, general
and administrative expenses in the Company’s consolidated statements of
operations.
 
 At March
31, 2005, approximately $4.5 million of cash has been received by ICG from
customer payments on behalf of the Company, which amounts are to be remitted to
the Company under the terms of the transition services agreement. This amount is
recorded on the accompanying consolidated balance sheets in other receivables
and is expected to be received by the Company in the second quarter of 2005, net
of amounts due to ICG under the transition services agreement and other
operating expenses paid on behalf of the Company by ICG.
 
 The
Company retained independent appraisers to assist in determining the fair value
of the assets acquired and liabilities assumed as required under SFAS No. 141,
“Business Combinations.” The final valuation is expected to be completed in the
second quarter of 2005. At March 31, 2005, certain components of the valuation
are preliminary and represent management’s best estimate of current values,
which are subject to revision due to changes in estimates of fair
value.
 
 The
following table summarizes the estimated fair values of the assets acquired and
liabilities assumed as of January 1, 2005 (in thousands):
 
 **Assets
      Acquired**Accounts
      receivable
    
    $
    1,526Other
      receivables
    
    
    301Prepaid
      expenses
    
    
    55Property
      and equipment
    
    
    29,771Goodwill
    
    
    5,301Other
      intangibles
    
    
    3,420Other
      long-term assets
    
    
    255Total
      assets acquired
    
    
    40,629**Liabilities
      Assumed**Current
      maturities of capital lease obligations
    
    
    2,077Deferred
      revenue
    
    
    1,526Accrued
      other expenses
    
    
    1,652Long-term
      capital lease obligations
    
    
    19,105Asset
      retirement obligations
    
    
    336Total
      liabilities assumed
    
    
    24,696Total
      purchase price
    
    $
    15,933
 
 Commencing
on January 1, 2005, the results of operations for the Business have been
included as part of the accompanying consolidated financial statements of the
Company. The following unaudited pro forma financial information represents the
combined results of operations for the Company and ICG California for the three
months ended March 31, 2004, assuming that the ICG California acquisition had
occurred as of January 1, 2004, after giving effect to certain adjustments
including depreciation and amortization expense, interest expense and the
issuance of common stock and warrants. These pro forma results of operations
have been prepared for comparative purposes only and are not necessarily
indicative of the results that may occur in the future or that would have
occurred had the acquisition occurred during the prior year (in thousands,
except share and per common share data):
 
 **March
      31,****2004****(pro
      forma)**Operating
      revenue
    
    $
    50,490Net
      loss
    
    $
    (3,938
    )Basic
      and diluted net loss per common share
    
    $
    (0.04
    )Basic
      and diluted weighted average common shares outstanding
    
    
    88,943,859
 
 8
 **(4)
INVESTMENTS**
 
 The
Company’s short-term and long-term investments consist of investment-grade debt
securities which are recorded at fair value and classified as available-for-sale
in accordance with the provisions of SFAS No. 115, “Accounting for Certain
Investments in Debt and Equity Securities.” Interest and amortization of
premiums for available-for-sale securities have been included in interest income
for the three months ended March 31, 2005. The Company recorded proceeds from
the sale of investments available-for-sale of $0.5 million for the three months
ended March 31, 2005. The Company does not hold these investments for
speculative or trading purposes. As of March 31, 2005 no securities were
impaired under the provisions of Emerging Issues Task Force (”EITF”)
03-1.
 
 The fair
value of investments available-for-sale as of March 31, 2005 and December 31,
2004 were as follows (in thousands):
 
 **March
      31,**
    
    **December
      31**,**2005**
    
    **2004**Short-term
      investments:Auction
      rate securities
    
    $
    6,200
    
    $
    6,150Corporate
      bonds
    
    
    2,136
    
    
    1,396U.S.
      government agency notes
    
    
    1,538
    
    
    518Total
      short-term investments
    
    $
    9,874
    
    $
    8,064Long-term
      investments:U.S.
      government agency notes
    
    $
    —
    
    $
    1,032Corporate
      bonds
    
    
    260
    
    
    1,009Total
      long-term investments
    
    $
    260
    
    $
    2,041
 
 **(5)
PROPERTY AND EQUIPMENT**
 
 Property
and equipment consists of the following (in thousands):
 
 **March
      31,**
    
    **December
      31**,**2005**
    
    **2004**Buildings
      and property
    
    $
    1,716
    
    $
    1,716Telecommunication
      and switching equipment
    
    
    53,007
    
    
    33,968Leasehold
      improvements
    
    
    6,993
    
    
    6,892Fiber
      optic network
    
    
    12,033
    
    
    —Computer
      hardware and software
    
    
    8,424
    
    
    7,638Office
      equipment and other
    
    
    2,832
    
    
    2,722Assets
      held for future use
    
    
    3,716
    
    
    3,29688,721
    
    
    56,232Accumulated
      depreciation and amortization
    
    
    (31,326
    )
    
    (27,206
    )57,395
    
    
    29,026Construction
      in progress
    
    
    4,129
    
    
    3,986Net
      property and equipment
    
    $
    61,524
    
    $
    33,012
 
 Included
in the table is $29.8 million of property and equipment acquired as a result of
the ICG California acquisition, discussed in Note 3. Depreciation expense for
the three months ended March 31, 2005 and 2004 was $4.2 million and $2.8
million, respectively.
 
 Assets
held for future use are directly related to the recovery of switch and
collocation equipment from markets cancelled or exited, primarily during 2002
and 2001, which are expected to be re-deployed throughout the Company's
remaining operating markets. These assets are continuing to be depreciated and
the net book value at March 31, 2005 and December 31, 2004 was $1.5 million and
$1.4 million, respectively.
 
 **(6)
GOODWILL AND INTANGIBLE ASSETS**
 
 The
Company accounts for its goodwill and intangible assets in accordance with the
provisions of SFAS No. 142, "Goodwill and Other Intangible Assets.” SFAS No. 142
provides that goodwill and other separately recognized intangible assets with
indefinite lives will no longer be amortized, but will be subject to at least an
annual assessment for impairment through the application of a fair-value-based
test. Intangible assets that do have finite lives will continue to be amortized
over their estimated useful lives.
 
 9
 Intangible
assets consist of the following (in thousands):
 **March
      31,**
      **2005**
    
    **December
      31,**
      **2004**Customer
      relationships
    
    $
    16,745
    
    $
    13,745Internally
      developed software
    
    
    300
    
    
    —Licensing
      agreement
    
    
    120
    
    
    —Less:
      accumulated amortization
    
    
    (12,499
    )
    
    (11,072
    )4,666
    
    
    2,673Trademark
    
    
    1,694
    
    
    1,694Intangibles,
      net
    
    $
    6,360
    
    $
    4,367
 
 Included
in the table above is $3.4 million of intangible assets acquired as a result of
the ICG California acquisition, as discussed in Note 3. Of that total amount,
approximately $3.0 million was assigned to customer relationships, which have an
estimated useful life of 3 years. Of the remainder, $0.3 million was assigned to
software and $0.1 million was assigned to a licensing agreement, which have
estimated useful lives of 3 years and 5 years, respectively.
 
 Goodwill
of $5.3 million also resulted from the ICG California acquisition as discussed
in Note 3, and was preliminarily determined based on purchase accounting
standards as the excess of purchase price over the fair value of assets acquired
and liabilities assumed.
 
 Amortization
expense related to customer relationships, software and the licensing agreement
for the three months ended March 31, 2005 and 2004 was $1.4 million and $1.1
million, respectively. The trademark was determined to have an indefinite life
and is not subject to amortization.
 
 Estimated
amortization expense for each of the next five years ending December 31,
consists of the following (in thousands):
 
 2005
    
    $
    2,3702006
    
    
    1,1242007
    
    
    1,1242008
    
    
    242009
    
    
    24$
    4,666
 
 **(7)
LINE OF CREDIT**
 
 The
Company’s agreement with a lending institution provides the Company with a
revolving line of credit facility of up to $7.5 million, secured by certain
customer accounts receivable. The agreement expires on January 24, 2006. This
credit facility bears an interest rate equal to the prime lending rate plus two
percent (2%) per annum. At March 31, 2005, the Company had $7.5 million in
availability under this agreement. Interest expense related to the line of
credit (consisting of the allocable portion of the annual commitment fee) was
$0.1 million in each of the three months ended March 31, 2005 and 2004. The
Company has not borrowed under the line of credit during 2005 and has no
outstanding balance as of March 31, 2005.
 
 **(8)
CAPITAL LEASE OBLIGATIONS**
 
 Capital
lease obligations consist of the following (in thousands):
 
 **March
      31**,**2005**Capital
      lease obligations
    
    $
    19,409Less
      current portion
    
    
    (378
    )$
    19,031
 
 Pursuant
to the acquisition of ICG California in January 2005, discussed in Note 3, the
Company assumed certain capital leases of ICG, including its long-term leases
for its fiber network, which had an estimated value of $21.2 million as of
January 1, 2005. The capital lease obligations have terms that range from 2 to
16 years. Maturities of remaining capital lease obligations for each of the next
five years ending December 31, are as follows (in thousands):
 
 10
 2005
    
    $
    2542006
    
    
    2952007
    
    
    3252008
    
    
    3892009
    
    
    448Thereafter
    
    
    17,698$
    19,409
  **(9)
ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS**
 
 The
telecommunications and data equipment the Company has acquired from ICG is
located in various leased facilities. In some cases, the Company has contractual
obligations to remove the assets associated with these lease agreements upon
termination of the agreements. SFAS No. 143, “Accounting for Asset Retirement
Obligations,” requires entities to record the fair value of a liability for an
asset retirement obligation in the period in which the legal or contractual
removal obligation is incurred. Accordingly, as part of the opening balance
sheet for the ICG California acquisition, the Company has recorded a liability
and asset for the present value of the estimated future exit costs associated
with the related asset retirement obligations. The liability was established by
calculating the present value of the asset retirement obligation using a
discount rate over a period which is representative of the estimated useful life
of the related assets. Changes in the asset retirement obligation resulting from
the passage of time are recognized as an increase in the carrying amount of the
liability and as accretion expense.
 
 The
following table is a reconciliation of the beginning and ending asset retirement
obligations (in thousands):
 
 Balance
      as of December 31, 2004
    
    $
    —Recognition
      of liability at January 1, 2005
    
    
    336Accretion
    
    
    15Balance
      as of March 31, 2005
    
    $
    351
 
 The asset
retirement obligations and associated asset are estimated based on several
assumptions. If information becomes known that is different than the assumptions
in use, revisions will be made using the more precise information. If actual
results differ from the assumptions used, the amount of the obligations will
differ, perhaps significantly, from the amounts reflected in the accompanying
consolidated financial statements.
 
 **(10)
COMMITMENTS AND CONTINGENCIES**
 
 ***Lease
Obligations and Purchase Commitments***
 
 In the
ordinary course of business, the Company enters into purchase agreements with
its vendors. As of March 31, 2005, the Company had total unfulfilled commitments
with vendors of $4.4 million. The Company also has various agreements with
certain carriers for transport, long distance and other network services. At
March 31, 2005, the Company’s minimum commitment under these agreements is $20.6
million, which expire through December 2026.
 
 On
January 1, 2005, the Company experienced significant changes in its real estate
lease obligations. In connection with the acquisition of ICG California,
discussed in Note 3, the Company assumed an additional $10.2 million of
operating lease obligations, which expire through March 2010.
 
 Additionally,
on February 10, 2005, the Company entered into an amendment to its Las Vegas,
Nevada switch site lease. In consideration for the Company’s agreement to
accelerate the expiration date of the lease to an earlier date, the landlord
paid the Company $7.7 million in cash and agreed to $0.3 million in rent
abatement from February 1, 2005 through the lease expiration at June 30, 2006.
The cash was received in February 2005. This $8.0 million settlement, net of
$0.8 million of estimated costs to exit the facility, has been included in other
income in the consolidated statement of operations for the three months ended
March 31, 2005. The impact of this early termination of the existing lease
reduced the Company’s lease obligations by approximately $0.9 million and
changed the lease expiration date from August 2011 to June 2006. The Company
entered into a lease for a new switch site with a third party during the second
quarter 2005. Over the next four to five quarters, the Company expects to use
all or a significant portion of the $7.7 million one-time payment to purchase
and install a new switch in the Las Vegas market and to cover exit
costs related to the existing switch site.
  Included
in the table below are obligations for continuing operations as of March 31,
2005 (in thousands):
 
 **2005**
    
    **2006**
    
    **2007**
    
    **2008**
    
    **2009**
    
    **Thereafter**Operating
      lease obligations
    
    $
    5,622
    
    $
    7,294
    
    $
    6,251
    
    $
    4,366
    
    $
    3,236
    
    $
    1,839Circuit
      lease obligations
    
    
    5,592
    
    
    5,771
    
    
    3,816
    
    
    1,861
    
    
    426
    
    
    3,098Purchase
      commitments
    
    
    4,356
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —Total
    
    $
    15,570
    
    $
    13,065
    
    $
    10,067
    
    $
    6,227
    
    $
    3,662
    
    $
    4,937
 
 11
 As
provided in the asset sale agreements for the Company’s discontinued markets,
the purchasers of these assets assumed the liabilities associated with the
markets acquired. However, the Company remains contingently liable for several
of the obligations in these markets. The
Company is guarantor of future lease obligations with expirations through 2015.
The guarantees arose from the assignment of leases resulting from the asset
sales. The Company is fully liable for all obligations under the terms of the
leases in the event that the assignee fails to pay any sums due under the lease.
The remaining maximum potential amount of future payments the Company could be
required to make under the guarantees is $9.1 million. No payments have been
made to date and none are expected to be required to be made in the future. In
accordance with FASB Interpretation No. 45, “Guarantor’s Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of
Indebtedness to Others,” the fair value of these obligations is limited and
accordingly no liability was recorded on the Company’s consolidated balance
sheet at March 31, 2005 or December 31, 2004.
 
 The
Company’s services are subject to varying degrees of federal, state and local
regulation. These regulations are currently subject to change by federal and
state administrative agencies, judicial proceedings, and proposals that could
change, in varying degrees, the manner in which the Company operates. The
Company cannot predict the outcome of these proceedings or their impact upon the
Company’s industry generally or upon the Company specifically.
 
 ***Litigation***
 
 From time
to time, the Company is involved in legal proceedings arising in the ordinary
course of business, including some claims asserted by the Company against
others, in which monetary damages are sought. The result of any current or
future litigation is inherently unpredictable; however, management believes
there is no litigation pending or asserted against the Company that could have,
individually or in the aggregate, a material adverse effect on its financial
position, results of operations or cash flows.
 
 On
February 17, 2005, a class action lawsuit was commenced against the Company,
alleging violations of California Labor Code Sections 2802 and 2804. The group
of plaintiffs attempting to be formed and certified as a class would include the
Company’s sales representatives in California for the past four years. The
plaintiffs are seeking to recover what they claim to be unreimbursed expenses
incurred in the performance of their duties, including additional mileage
reimbursement. The action is pending in Superior Court of the State of
California for the County of Los Angeles. The Company denies any liability,
intends to vigorously defend the action, and believes that ultimate damages
awarded, if any, will not have a material adverse effect on its financial
position, results of operations or cash flows.
 
 The
Company is party to an equipment lease dispute that has resulted in claims being
made against the Company and certain of its subsidiaries. On November 1, 2002,
the plaintiff initiated the first of several actions against the subsidiary in
the Circuit Court of St. Louis County, Missouri, and has also filed actions in
the U.S. Bankruptcy Court for the District of Delaware for recovery of claimed
damages. At March 31, 2005, the Company has recorded a contingent liability
reserve for this matter in accrued other expenses on the consolidated balance
sheets based on the amount of lease payments that were unpaid when the legal
actions commenced. The Company denies any liability, intends to vigorously
defend the action, and believes that ultimate damages awarded, if any, will not
have a material adverse effect on its financial position, results of operations
or cash flows.
 
 ***Interconnection
Agreements***
 
 In the
ordinary course of business, the Company has negotiated interconnection
agreements with SBC Corp. (with its California and Illinois subsidiaries),
Sprint Nevada and Verizon California in each of the markets in which it operates
which expired in 2004. While the parties negotiate new agreements, these
agreements continue in full force and effect under the existing terms and
conditions. These agreements specify the terms and conditions under which the
Company leases unbundled network elements (“UNEs”) including type of UNE, price,
delivery schedule, and maintenance and service levels. The Company has no
minimum purchase obligations and pays for only those UNEs it orders and
receives. While the Company has no performance requirements imposed upon it, the
incumbent carriers must perform at specified levels (generally at a parity level
with the same services provided to the incumbent's retail customers). To the
extent the services of the local exchange carriers are used, the Company and its
customers are subject to the quality of service, equipment failures and service
interruptions of the local exchange carriers.
  The
Company is dependent on the cooperation of the incumbent local exchange carriers
to provide service for the origination and termination of its local and long
distance traffic. Historically, charges for these services have made up a
significant percentage of the overall cost of providing these services. The
Company incurs cost through the use of services agreed to in the interconnection
agreements. The costs are recognized in the period in which the service is
delivered and are included as items within cost of operating
revenues.
 
 ***Sales
Tax and Property Tax Reserves***
 
 The
Company maintains reserves for estimated exposure for various sales and use
taxes that taxing jurisdictions may claim as being owed due to interpretations
of state and local regulations as well as for positions taken related to the
underlying taxable base of capital expenditures made in the past by the Company.
Similarly, reserves are maintained for positions taken on the assessment basis
used to pay certain property taxes to various state and local taxing
jurisdictions. The Company believes that all such reserves are appropriately
recorded in accordance with the provisions of SFAS No. 5, “Accounting for
Contingencies,” at March 31, 2005.
 
 12
 **(11)
STOCKHOLDERS’ EQUITY**
 
 The
Company maintains a warrant program which makes available to independent sales
agents hired by the Company warrants to purchase shares of the Company’s common
stock, with the number of warrants to be granted based on the increase in
baseline sales performance achieved by these independent sales agents. For the
three months ended March 31, 2005, the Company issued warrants to purchase
198,785 shares of common stock through this program with a weighted average
exercise price of $1.55 per common share. These warrants are exercisable at any
time and expire three years from the issuance date. For the three months ended
March 31, 2005, $0.1 million of agent selling expense was recognized as a result
of the issuance of these warrants. Agent selling expense is included as a
component of selling, general and administrative expenses in the consolidated
statements of operations. The amount of expense recognized was determined using
the Black-Scholes method to calculate fair market value, with the following
assumptions; dividend yield of 0%; expected warrant life of 3 years; risk free
interest rate ranging from 2.85% to 3.91% and an expected volatility ranging
from 54% to 57%. No warrants were issued during the three months ended March 31,
2004.
  During May 2005,
the Company filed with the Securities and Exchange Commission a registration
statement on Form S-3 for the benefit of ICG and MCCC as the selling
stockholders under the registration statement. The selling stockholders are
offering the shares of the Company’s common stock registered by the prospectus.
The registration statement includes (A) 1,988,894 shares of common stock issued
pursuant to the terms of a Subscription Agreement, dated as of January 1, 2005,
by and between the Company and MCCC, (B) 10,740,030 shares of common stock
issued pursuant to the terms of an asset purchase agreement, dated as of October
22, 2004, by and among the Company, MCCC and ICG and (C) 2,000,000 shares of
common stock issuable upon exercise of warrants issued pursuant to the asset
purchase agreement. The Company will not receive any of the proceeds from the
sale of the common shares pursuant to the registration statement.
 
 **(12)
DISCONTINUED OPERATIONS**
 
 As of
March 31, 2005, the Company has recorded $0.5 million of receivables related to
asset sales from discontinued markets. These receivables have been included in
other receivables in the consolidated balance sheets and the majority of the
balance owed is being held in escrow by a third party escrow agent. No allowance
for doubtful accounts for these receivables has been established as the Company
expects to collect all asset sales receivables. The Company received a
disbursement of $1.0 million from escrow in March 2005 and expects to receive
the remaining $0.5 million, net of expenses chargeable to the Company, in the
second quarter of 2005.
 
 The
operating revenues and expenses of the Company’s discontinued markets have been
classified as discontinued operations under
SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,”
for all periods presented. ( Loss)
income related to these discontinued markets was as follows for the three months
ended March 31, 2005 and 2004 (in thousands):
 
 **Three
      Months Ended****March
      31**,
    
    **March
      31,****2005**
    
    **2004**Operating
      expenses (income)
    
    $
    32
    
    $
    (191
    )Gain
      on disposal of assets
    
    
    —
    
    
    (50
    )(Loss)
      income from discontinued operations
    
    $
    (32
    )
    $
    241
  **(13)
INCOME (LOSS) PER COMMON SHARE**
 
 SFAS No
128, "Earnings Per Share," requires the Company to calculate its income (loss)
per common share based on basic and diluted income (loss) per common share, as
defined. Basic income (loss) per common share for the three months ended March
31, 2005 and 2004, was computed by dividing the income (loss) applicable to
common stockholders by the weighted average number of shares of common stock
outstanding during the period. Diluted income (loss) per common share for the
three months ended March 31, 2005 and 2004, was computed by dividing the income
applicable to common stockholders by the weighted average number of shares of
common stock and potential common stock outstanding during the period. The
inclusion of potential common stock in this calculation for the quarter ended
March 31, 2005 did not result in a change to the basic income (loss) per
common share amounts.
 
 As of
March 31, 2005, the Company had 1,402,206 options and warrants which were
convertible into common shares outstanding that were not included in the
calculation of diluted income per common share as the exercise prices were
greater than the average market price of the Company’s common stock during the
quarter. For the three months ended March 31, 2004, the Company incurred a loss
from continuing operations and, as a result, all 18,829,783 outstanding options
and warrants were antidilutive and not included in the calculation of
diluted loss per common share.
 
 13
 The
following table summarizes the calculation of basic and diluted income (loss)
per common share (in thousands, except common share and per common share
amounts):
 **Three
      Months Ended****March
      31**,
    
    **March
      31,****2005**
    
    **2004****Basic
      income (loss) per common share**Income
      (loss) from continuing operations
    
    $
    3,877
    
    $
    (504
    )(Loss)
      income from discontinued operations
    
    
    (32
    )
    
    241Net
      income (loss)
    
    $
    3,845
    
    $
    (263
    )Weighted
      average common shares outstanding
    
    
    91,331,930
    
    
    78,321,851Basic
      income (loss) per common share
    
    $
    0.04
    
    $
    (0.01
    )Basic
      income from discontinued operations per common share
    
    
    —
    
    
    0.01Basic
      net income (loss) per common share
    
    $
    0.04
    
    $
    —**Diluted
      income (loss) per common share**Income
      (loss) from continuing operations
    
    $
    3,877
    
    $
    (504
    )(Loss)
      income from discontinued operations
    
    
    (32
    )
    
    241Net
      income (loss)
    
    $
    3,845
    
    $
    (263
    )Weighted
      average common shares outstanding - basic
    
    
    91,331,930
    
    
    78,321,851Dilutive
      effect of warrants and options - treasury stock method
    
    
    10,779,436
    
    
    —Common
      shares and common share equivalents
    
    
    102,111,366
    
    
    78,321,851Diluted
      income (loss) from continuing operations per common share
    
    $
    0.04
    
    $
    (0.01
    )Diluted
      income from discontinued operations per common share
    
    
    —
    
    
    0.01Diluted
      net income (loss) per common share
    
    $
    0.04
    
    $
    —
 
 **(14)
OPERATING SEGMENTS**
 
 *Reportable
Segments*
 
 The
Company operates its business as one segment. The Company manages its business
as a consolidated entity managed at a national level. The Company’s products and
services have similar network operations, back-office support and technology
requirements and are sold through similar sales channels to a similar targeted
customer base. Therefore, the Company manages these services as a single segment
that are sold in geographic areas, or markets, within the United States, or that
are sold to customers with a presence across geographical markets. The Company
regularly evaluates the makeup of its business to determine whether more than a
single segment exists as its business evolves and develops.
 
 *Products
and Services*
 
 The
Company classifies its products and services offered by Communications into
various revenue categories as shown in the following table (in
thousands):
 
 **Three
      Months Ended****March
      31,**
    
    **March
      31,****2005**
    
    **2004**Plain
      old telephone service/DSL
    
    $
    21,216
    
    $
    21,926T1
      based products and services
    
    
    13,659
    
    
    7,360Private
      lines
    
    
    4,343
    
    
    —Long
      distance and other usage
    
    
    4,838
    
    
    3,484Switched
      access
    
    
    3,670
    
    
    4,383Total
      operating revenue
    
    $
    47,726
    
    $
    37,153
 14
  **Item
2.** ***Management's
Discussion and Analysis of Financial Condition and Results of
Operations***
 
 **Introduction**
 
 The
following Management's Discussion and Analysis ("MD&A") is written to help
the reader understand our company. The MD&A is provided as a supplement to,
and should be read in conjunction with, our unaudited condensed consolidated
financial statements, the accompanying condensed financial notes ("Notes")
appearing elsewhere in this report and our annual report on Form 10-K for the
year ended December 31, 2004. The overview provides our perspective on the
individual sections of MD&A, which include the following:
 
 *Executive
Summary -* an
executive review of our performance for the three months ended March 31,
2005.
 
 *Company
Overview -* a general
description of our business, the services we offer, the markets we serve, and
our January 1, 2005 acquisition of certain assets from ICG Communications, Inc.
(“ICG”).
 
 *Liquidity
and Capital Resources* - an
analysis of historical information regarding our sources of cash and capital
expenditures, the existence and timing of commitments and contingencies, changes
in capital resources and a discussion of balance sheet and cash flow items
affecting liquidity.
 
 *Results
from Continuing Operations* - an
analysis of our results of operations for the three months ended March 31, 2005
and 2004, including a review of the material items and known trends and
uncertainties.
 
 *Discontinued
Operations* - an
analysis of our discontinued operations for the three months ended March 31,
2005.
 
 *Application
of Critical Accounting Estimates* - an
overview of accounting policies that require critical judgments and
estimates.
 
 *Effects
of New Accounting Standards -* a
discussion of new accounting standards and any implications related to our
financial statements.
 
 *Forward
Looking Statements* -
cautionary information about forward-looking statements and a description of
certain risks and uncertainties that could cause our actual results to differ
materially from our historical results or our current expectations on
projections.
 
 15
 **Executive
Summary**
 
 This is
the first quarter that we have consolidated our acquisition of ICG’s California
assets and assumption of certain liabilities (“ICG California”) into our
financial results. Some of the key areas of our progress during the quarter
include:
 
 •
    With
      the acquisition of ICG California, our total revenue increased over 28%
      from the year ago quarter, and customer revenue increased over 34%. Our
      pre-ICG California revenue increased more than 6% over the year ago
      quarter. The acquired ICG California contributed a total of $8.3 million
      of revenue for the quarter ended March 31, 2005, of which $7.7 million was
      core customer revenue and $0.6 million was switched access
      revenue.•
    Our
      switched access revenue for the quarter was $3.7 million, more than 29%
      higher than the quarter ending December 31, 2004, but approximately 16%
      lower than the quarter ended March 31, 2004. Switched access revenue was
      7.7% of total revenue in this quarter versus 7.5% last quarter and 11.8%
      in the first quarter of 2004.•
    Business
      line churn increased slightly this quarter to an average of 1.9% per month
      versus 1.7% per month during the fourth quarter 2004, while average
      monthly residential line churn improved to 3.3% per month this quarter
      versus 3.5% per month during fourth quarter 2004. The increase in business
      line churn was due to relatively higher churn rates in the ICG California
      customer base, which we expected to happen and we expect to continue to
      happen for the next few quarters.•
    Cost
      of operating revenues (excluding depreciation and amortization) for the
      first quarter totaled $21.8 million, approximately 27% higher than last
      quarter and 33% higher than the first quarter of last year. As we continue
      to integrate ICG California with our business and remove redundant costs,
      we expect to see improvement in our costs going forward. This increase is
      reflective of the ICG California incremental business and various events
      described below.•
    We
      have reached an agreement in principle to resolve our switched access
      dispute (along with a variety of other miscellaneous disputes related to
      cost of operating revenues) with one of the incumbent local exchange
      carriers (“ILEC”) with whom we compete. Based on this resolution, we
      expect there should be fewer disputes as to billings to and from this ILEC
      in the future. The resolution resulted in a $0.3 million reduction in cost
      of operating revenues (excluding depreciation and amortization) in this
      quarter.•
    We
      reached a settlement with another one of the major ILECs with whom we
      compete for substantially all of our outstanding cost of operating
      revenues/vendor disputes, including resolution of the $2.7 million that we
      were required to pay as a result of a decision by the California Public
      Utility Commission that allowed this ILEC to make loop rate increases for
      DS0s retroactive back to April 2002. This net settlement with this ILEC
      has resulted in a net $0.2 million reduction in cost of operating revenues
      (excluding depreciation and amortization) in the quarter ended March 31,
      2005.•
    During
      first quarter 2005, we recognized a $0.3 million credit from another ILEC
      for a billing error they had made.•
    Our
      reported selling, general and administrative expenses (excluding
      depreciation and amortization) for the quarter were $22.7 million, an
      increase of almost 16% versus last quarter and almost 29% higher than the
      first quarter of last year. This increase is primarily reflective of the
      additional recurring costs attributable to the ICG California business we
      acquired.•
    Our
      net income for the quarter was $3.8 million versus a net loss of $2.4
      million last quarter and a loss of $0.3 million in the first quarter of
      last year. Our net income was positively impacted in the quarter ended
      March 31, 2005 by other income of $7.2 million related to a negotiated
      $7.7 million one-time payment we received in February 2005 from a casino
      operator in Las Vegas in consideration for our agreement to vacate our
      existing switch site by June 30, 2006 so that they can build a new casino
      on the site. The positive impact on net income from this transaction will
      not be recurring. Over the next four to five quarters, we expect to use
      all or a significant portion of the $7.7 million one-time payment to
      purchase and construct a new switch at a new location and expect to
      transfer our customer network in Las Vegas to that switch by
      the second quarter of 2006.•
    We
      ended the first quarter 2005 with $37.8 million of unrestricted cash and
      cash equivalents and both short and long-term investments
      available-for-sale versus $37.4 million at December 31, 2004. Our current
      assets plus long-term investments available-for-sale less current
      liabilities increased by $5.7 million due to the $7.7 million cash payment
      received from the Las Vegas casino operator as described above and other
      changes in working capital accounts.•
    During
      the quarter ended March 31, 2005, we achieved substantial increases in
      sales and installations from our agent and telemarketing channels. Our
      business continues to evolve with a bias towards alternate channels of
      distribution and larger customers.•
    Our
      pre-ICG California business reflected a 6% decrease in business plain old
      telephone service (“POTS”) lines in the quarter ended March 31, 2005
      versus the quarter ended March 31, 2004, but experienced a 47% increase in
      the same time periods in ending customer T-1 loops, which yield
      significantly higher margins. We expect that trend to
      continue.
 
 16
 Highlights
from our ICG California integration:
 
 •
    We
      have received consents to transfer existing customer contracts from ICG to
      us, covering 94% of ICG California’s revenue. We are seeking consents from
      the remaining customers, but continue to bill and collect from these
      customers through ICG under a service agreement in the
      interim.•
    We
      have integrated ICG California’s circuit billing and inventory records
      into our systems.•
    We
      have completed integrating ICG California’s network operating center
      (“NOC”) systems into ours, and now monitor network elements and trouble
      tickets for much of the ICG California operations.•
    We
      will take over customer billing effective with our June 1, 2005 billing
      cycle.•
    We
      expect to transfer the ICG business to our switches starting in June 2005
      and completion of the transfer in the quarter ending September 30,
      2005.•
    We
      have created a wholesale organization that is actively working with our
      newly acquired customers.
 
 Our
business strategy is focusing on the following areas:
 
 •
    First,
      we intend to own the network elements we use, and own them as close to our
      customers as practical. Owning switching and collocation equipment, voice
      over internet protocol (“VOIP”) technology, and fiber has allowed us to
      create more of a fixed cost network that gives us the ability to generate
      more operating cash flow out of incremental revenue from our network.
      Owning a deep dense network also allows us to control our network quality
      and to reduce the risk associated with regulatory changes affecting our
      costs and the delivering and provisioning of our
  services.We
      have built a wireless broadband capability in Las Vegas. We will use this
      capability to give us more flexibility in providing services to our
      customers without using the ILEC. By giving ourselves the ability to reach
      our customers with a wireless broadband connection that is connected to
      the other elements of our network, we may be able to move toward a
      business strategy that makes it possible for us to operate more
      independently from the ILEC. We believe this technology may be an
      important part of our future.•
    The
      second element of our strategy is to always focus on growing operating
      cash flow.•
    The
      third element of our strategy is to actively manage our risk profile. We
      seek to do that by controlling and fixing the cost of as much of our
      network as practical and by actively managing our balance sheet
      risk.•
    The
      final key element of our current strategy is to add revenue streams on our
      network by having products that can serve small, medium, and large
      customers through multiple distribution channels. We currently sell
      through a direct sales channel (which includes a growing telemarketing
      capability), a wholesale channel, an agent channel, and co-marketing
      agreements. If we can continue to create and augment new distribution
      channels, we expect to become less dependent on our direct sales force
      headcount. We also seek to add revenue on our network through acquisitions
      that we continue to evaluate.
 
 These
four key strategies shape how we run our business and how we intend to continue
to grow value for our shareholders.
 
 **Company
Overview**
 
 We were
one of the first facilities-based competitive local telephone companies founded
after the inception of the Telecommunications Act of 1996, which opened up the
local telephone market to competition. Today, we offer local and long distance
voice services as well as high-speed Internet access and IP telephony by way of
a variety of broadband product and service offerings over our own network of
collocations, switches and fiber network. On January 1, 2005 we acquired certain
assets of ICG in California. The assets acquired include ICG’s customer base and
certain network assets in California, including a 1,412 route mile state-wide
fiber ring and 915 miles of metropolitan fiber rings that connect 128 commercial
buildings. All of our services are offered through our wholly-owned subsidiary,
Mpower Communications Corp. (“Communications”) primarily to small and
medium-sized business customers in all of our markets and residential customers
primarily in the Las Vegas market. Our markets include Los Angeles, California,
San Diego, California, Northern California (the San Francisco Bay area and
Sacramento), Las Vegas, Nevada and Chicago, Illinois.
 
 As a
facilities-based provider, we own and control a substantial amount of our
network infrastructure. Our network reaches across 297 central office
collocation sites. In April 2004, we began selling T1 services to customers
using facilities that do not directly connect to these collocation sites. We
refer to this as “off-network.” Having off-network facilities increases the
number of our potential customers. With the addition of the ICG California
assets in January 2005, we have added a statewide SONET-based fiber network to
our deep collocation and switching infrastructure, which allows us to offer new
products such as private line, accelerates our speed-to-market with IP Centrex
capabilities, including VOIP, positions us as a strong player in the wholesale
market, and reduces our reliance on the ILECs.
 
 17
 As of May
2005, we have approximately 820 employees, including approximately 40 employees
who joined us from ICG. We have established working relationships with Verizon,
Sprint, and SBC (including its operating subsidiaries PacBell and
Ameritech).
 
 Our
business is to deliver integrated voice and broadband data solutions. Our
emphasis is on providing small and medium-sized and now larger size business
customers, as well as wholesale customers, with a full suite of communications
services and features, integrated on one bill, with the convenience of a single
source provider. By using
our existing equipment and interconnection agreements with incumbent carriers
and network capabilities, we are able to offer fully integrated and channelized
voice and data product and service offerings over a T1 connection. In order to
serve the largest portion of our target audience, our combined voice and data
network allows us to deliver services in several combinations over the most
favorable technology: basic phone service on the traditional phone network, SDSL
service, integrated T1 voice and data service, or data-only T1 connectivity. Our
service offerings have been increased through the acquisition of ICG California,
providing us with the ability to be a wholesale provider to large interexchange
carriers (“IXCs”), competitive local exchange carriers (“CLECs”), and internet
service providers (“ISPs”). We have established a dedicated wholesale channel to
focus on the unique needs of this customer base. With access to our
facilities-based distributed network architecture and broad range of products
and services, we offer wholesale customers opportunities to enhance or expand
their business models.
 
 We
operate our business as one segment. We manage our business as a consolidated
entity managed at a national level. Our products and services have similar
network operations, back-office support and technology requirements and are sold
through similar sales channels to a similar targeted customer base. Therefore,
we manage these services as a single segment that are sold in geographic areas,
or markets, within the United States, or that are sold to customers with a
presence across geographical markets. We regularly evaluate the makeup of our
business to determine whether more than a single segment exists as our business
evolves and develops.
 
 ***ICG
California Acquisition***
 
 On
January 1, 2005 we completed the acquisition of certain assets and assumption of
certain liabilities of ICG in California. The assets acquired include ICG’s
customer base and certain network assets in California, including a 1,412 route
mile state-wide fiber ring connecting major cities in California. We expect to
fully integrate the ICG California assets with our business throughout
2005.
 
 We
purchased these assets for $15.9 million, comprised of (i) $13.5 million in the
form of 10,740,030 shares of our common stock, (ii) $1.2 million in the form of
warrants to purchase another 2,000,000 shares of our common stock dated January
1, 2005 exercisable on or prior to the fifth anniversary of the date of issuance
at an exercise price of $1.383 per share and (iii) $1.2 million of direct
acquisition costs. We also assumed certain of ICG’s capitalized leases in
California, including its long-term leases for its fiber network. These leases
had a preliminary value of $21.2 million. The $13.5 million value of
10,740,030 shares of common stock was determined using a stock price of
$1.26. The fair value of the warrants was determined using the Black Scholes
method, with the following assumptions; dividend yield of 0%; expected warrant
life of 5 years; risk free interest rate of 3.35% and an expected volatility of
57%.
 
 Upon
completion of the ICG California acquisition, consideration was paid and we took
title to that business. We have retained independent appraisers to assist us in
determining the fair value of the assets and liabilities acquired as required
under SFAS No. 141, “Business Combinations.” The final valuation is expected to
be completed in the second quarter of 2005. At March 31, 2005, certain
components of the valuation are preliminary and represent management’s best
estimate of current values, which are subject to revision due to changes in
estimates of fair value.
  The
following are the estimated fair value of assets acquired and liabilities
assumed as of the closing date (in millions):
 **Assets
      Acquired**Accounts
      receivable
    
    $
    1.5Other
      receivables
    
    
    0.3Prepaid
      expenses
    
    
    0.1Property
      and equipment, net
    
    
    29.8Goodwill
    
    
    5.3Other
      intangibles
    
    
    3.4Other
      long-term assets
    
    
    0.2Total
      assets acquired
    
    $
    40.6**Liabilities
      Assumed**Current
      maturities of capital lease obligations
    
    $
    2.1Deferred
      revenue
    
    
    1.5Accrued
      other expenses
    
    
    1.7Long-term
      capital lease obligations
    
    
    19.1Asset
      retirement obligations
    
    
    0.3Total
      liabilities assumed
    
    
    24.7Total
      purchase price
    
    $
    15.9
 
 18
 The
assets of ICG California consist primarily of:
 
 •
    Certain
      switching and routing equipment, located both in current ICG California
      facilities and in facilities operated by one or more incumbent local
      exchange carriers;•
    Customer
      and sales agreements that constitute a majority of ICG California’s voice
      and data revenues;•
    Lit
      fiber capacity originally purchased by ICG as well as leased fiber network
      capacity which are both expansive of our current
  network.
 
 Of the
$3.4 million of acquired other intangible assets, approximately $3.0 million was
assigned to the ICG California’s customer base, which has an estimated useful
life of 3 years. Approximately $0.3 million was assigned to ICG California’s
acquired software that has an estimated useful life of 3 years and approximately
$0.1 million was assigned to a licensing agreement with a useful life of 5
years. Additionally, $5.3 million of the acquired intangible assets were
assigned to goodwill.
 
 The ICG
transaction described above involved a management services agreement and a
transition services agreement that maintained the continuity of the ICG
operations in California and prepared for the transfer of required business
functions to us. Under the management services agreement, we are required to
reimburse ICG for the cost of specific services provided by ICG on our behalf.
As of March 31, 2005, we recognized direct acquisition costs of $0.5 million for
services and fees incurred under the management services agreement. The
agreement also provided that the operating results of the ICG California
operations accrued to our benefit between the date the definitive agreement was
signed (October 22, 2004) and final closing (January 1, 2005). ICG California’s
operations generated operating income of $0.3 million during that period, which
has been recorded as an offset to the gross direct acquisition costs we incurred
under the management services agreement. We have recorded additional direct
acquisition costs of $1.0 million primarily for legal and consulting fees
incurred in connection with the ICG California acquisition. The $1.2 million of
net direct acquisition costs described above has been included as a component of
the purchase price in accordance with SFAS No. 141, “Business
Combinations.”
 
 Commencing
on the transaction closing date, January 1, 2005, certain services are being
provided by ICG to us under a transition services agreement. Such services are
expected to continue through the end of the second quarter of 2005 and the cost
incurred for such services is included in our results of operations. For the
three months ended March 31, 2005, we incurred $0.8 million of expense, under
the transition services agreement, primarily related to billing, collections,
provisioning, call center and network support services performed by ICG on our
behalf, which are included in selling, general and administrative expenses in
our consolidated statements of operations.
 
 At March
31, 2005, approximately $4.5 million of cash has been received by ICG from
customer payments on our behalf, which amounts are to be remitted to us under
the terms of the transition services agreement. This amount is recorded on the
accompanying consolidated balance sheet in other receivables and we expect to
receive this amount in the second quarter of 2005, net of amounts due to ICG
under the transition services agreement and other operating expenses paid on our
behalf by ICG.
 
 **Liquidity
and Capital Resources**
 
 We had
incurred negative cash flows from operating activities through the year ended
December 31, 2003. We believe that we now have sufficient resources and
liquidity to fund our planned operations. We have completed, and continue to
pursue, several initiatives intended to increase liquidity and better position
us to compete under current conditions and anticipated changes in the
telecommunications sector.
 
 On
February 10, 2005, we entered into an amendment to the lease with our landlord
for our switch site in Las Vegas, Nevada. Under the amendment, our landlord
agreed to pay us the sum of $7.7 million of cash and $0.3 million in rent
abatement in consideration for our agreeing to terminate our lease early and
vacate the switch site by June 30, 2006. In addition, in the event we need to
supply fiber optic cable to our new location, the landlord has agreed to
reimburse us for the actual costs incurred up to $0.5 million. We intend to
expend all or a significant portion of the $7.7 million to purchase equipment
and construct a new switch at a new lease site in Las Vegas, Nevada, so that the
new switch will be operational prior to closing the old switch and vacating the
existing premises. We received $7.7 million of cash in February 2005 related to
this agreement with the remainder ($0.3 million) to be recognized by abating our
rent obligations from February 1, 2005 through June 30, 2006. We expect that
most of the cash expenditures associated with this relocation will be completed
by December 31, 2005. A substantial portion of these expenditures will be
capital expenditures and these expenditures are in addition to our previously
forecasted non-ICG California related capital expenditures.
 
 Developing
and maintaining our network and business has required and will continue to
require us to incur capital expenditures primarily consisting of the costs of
purchasing network and customer premise equipment and maintaining our operations
support system. Cash outlays for capital expenditures for the three months ended
March 31, 2005 were $4.3 million, which is exclusive of capitalized labor of
$0.3 million for the three months ended March 31, 2005. Our current estimate of
capital expenditures for 2005 is between $17.0 and $21.0 million and for 2006
our estimate is between $11.0 and $13.0 million.
 
 19
 As of
March 31, 2005, we had $37.8 million in unrestricted cash and cash equivalents
and short and long-term investments available-for-sale. Our March 31, 2005 cash
balance included the $7.7 million payment received from the Las Vegas lease
amendment discussed above. We believe that our cash balances, when combined with
our cash flow from operations will generate enough liquidity to fully fund our
operations and our capital expenditures on a continuing basis. Based on our
current business plan, we do not expect to draw from our $7.5 million line of
credit during the remainder of 2005. Our investments available-for-sale consist
of auction rate securities, government agency notes, and corporate bonds. All
investments are made in accordance with our Investment Policy and Guidelines
approved by our board of directors.
  *Cash
Flow Discussion*
 
 In
summary, our cash flows for the three months ended March 31, 2005, were as
follows (in thousands):
 
 **Three
      Months**
      **Ended**
      **March
      31, 2005**Net
      cash provided by operating activities
    
    $
    2,950Net
      cash used in investing activities
    
    $
    (3,416
    )Net
      cash provided by financing activities
    
    $
    770
 
 The above
summary of cash flows includes cash and cash equivalents.
 
 At March
31, 2005, cash, cash equivalents and short and long-term investments
available-for-sale were $37.8 million. This balance has the following components
(in thousands):
 
 Cash
      and cash equivalents
    
    $
    27,631Investments
      available-for-sale
    
    
    9,874Long-term
      investments available-for-sale
    
    
    260Total
      at March 31, 2005
    
    $
    37,765
 
 ***Cash
Flows from Operating Activities and Investing
Activities***
 
 Our cash
flows from operating and investing activities are summarized as follows (in
thousands):
 
 **Three
      Months Ended**
      **March
      31,****2005**
    
    **2004**Net
      cash provided by operating activities
    
    $
    2,950
    
    $
    393Cash
      flows from investing activities:Purchases
      of property and equipment, net of payables
    
    $
    (4,333
    )
    $
    (667
    )Proceeds
      from sale of assets from continuing operations
    
    
    13
    
    
    205Receipt
      of escrowed amounts from sale of assets from discontinued
      operations
    
    
    1,000
    
    
    —Purchase
      of investments available-for-sale
    
    
    (566
    )
    
    —Sale
      of investments available-for-sale
    
    
    500
    
    
    —Sale
      of restricted investments
    
    
    —
    
    
    130Purchase
      of restricted investments
    
    
    (30
    )
    
    —Net
      cash used in investing activities
    
    $
    (3,416
    )
    $
    (332
    )
 
 *Operating
Activities:* Cash
flows from operating activities increased by $2.6 million for 2005 compared to
2004. The increase is primarily a result of the receipt of the $7.7 million
payment as part of the Las Vegas switch site lease amendment, offset by an
increase in accounts receivable due to the increased revenue generated from
adding the ICG California customers, a timing delay in the remittance of
certain customer receivables payments collected by ICG on our
behalf, reduced by certain costs paid by ICG that we must remit to them,
and a reduction in trade payables owed to certain ILECs. We expect to fully
collect and pay all amounts due to ICG in the second quarter of 2005. The Las
Vegas switch site lease amendment and related impact on cash will not be
recurring.
 
 20
 *Investing
Activities:* For the
three months ended March 31, 2005 we used $3.4 million in cash for investing
activities compared to $0.3 million for the three months ended March 31, 2004.
The cash used in 2005 primarily represents the investment of $4.3 million in
capital expenditures, partially offset by $1.0 million of funds received from
escrowed amounts related to previous asset sales from discontinued
operations.
  ***Cash
Flows from Financing Activities***
 **Three
      Months Ended**
      **March
      31,****2005**
    
    **2004**Cash
      flows from financing activities:Costs
      associated with issuance of common stock
    
    $
    (10
    )
    $
    —Net
      proceeds under management agreement with acquired business
    
    
    85
    
    
    —Payments
      on capital lease obligations
    
    
    (1,837
    )
    
    (101
    )Proceeds
      from the issuance of common stock
    
    
    2,532
    
    
    27Net
      cash provided by (used in) financing activities
    
    $
    770
    
    $
    (74
    )
 
 *Financing
Activities:* For the
three months ended March 31, 2005, we were provided $0.8 million of cash from
financing activities. The cash provided in 2005 primarily represents the
proceeds from the issuance of common stock to MCCC ICG Holdings, LLC (“MCCC”) in
connection with the acquisition of ICG California, offset by cash paid on
capital lease obligations. As a result of the ICG California acquisition, we
have assumed $21.2 million of capital lease obligations.
 
 *Commitments
and Contingencies*
 
 In the
ordinary course of business, we enter into purchase agreements with our vendors.
As of March 31, 2005, we had total unfulfilled commitments with vendors of $4.4
million. We also have various agreements with certain carriers for transport,
long distance and other network services. At March 31, 2005, our minimum
commitment under these agreements is $20.6 million, which expire through
December 2026.
 
 On
January 1, 2005 we experienced significant changes in our real estate lease
obligations. With the acquisition of ICG California, we assumed an additional
$10.2 million of operating lease obligations, which expire through March
2010.
 
 Additionally,
on February 10, 2005 we entered into an amendment to our Las Vegas, Nevada
switch site lease as previously discussed. In consideration for our agreement to
accelerate the expiration date of the lease to an earlier date, the landlord
paid us $7.7 million in cash and agreed to $0.3 million in rent abatement from
February 1, 2005 through the lease expiration at June 30, 2006. The cash was
received in February 2005. This $8.0 million settlement, net of $0.8 million of
estimated costs to exit the facility, has been included in other income in our
consolidated statement of operations for the three months ended March 31, 2005.
The impact of this early termination reduced our lease obligations by
approximately $0.9 million and changed our lease expiration date from August
2011 to June 2006. We entered into a lease for a new switch site with a third
party during the second quarter 2005. Over the next four to five quarters, we
expect to use all or a significant portion of the $7.7 million one-time payment
to purchase and install a new switch in the Las Vegas market and to cover
exit costs related to the existing switch site.
 
 Pursuant to the acquisition of ICG California in January
2005, we assumed certain capital leases of ICG, including its long-term leases
for its fiber network, which had an estimated value of $21.2 million as of
January 1, 2005.  The capital lease obligations have terms that range from
2 to 16 years.
 
 Included
in the table below are obligations for continuing operations as of March 31,
2005 (in thousands):
 
 **2005**
    
    **2006**
    
    **2007**
    
    **2008**
    
    **2009**
    
    **Thereafter**Operating
      lease obligations
    
    $
    5,622
    
    $
    7,294
    
    $
    6,251
    
    $
    4,366
    
    $
    3,236
    
    $
    1,839Circuit
      lease obligations
    
    
    5,592
    
    
    5,771
    
    
    3,816
    
    
    1,861
    
    
    426
    
    
    3,098Purchase
      commitments
    
    
    4,356
    
    
    —
    
    
    —
    
    
    —
    
    
    —
    
    
    —Capital
      lease obligations
    
    
    254
    
    
    295
    
    
    325
    
    
    389
    
    
    448
    
    
    17,698Total
    
    $
    15,824
    
    $
    13,360
    
    $
    10,392
    
    $
    6,616
    
    $
    4,110
    
    $
    22,635
 
 21
 As
provided in the asset sale agreements for the discontinued markets, the
purchasers of these assets assumed the liabilities associated with the markets
acquired. However, we remain contingently liable for several of the obligations
in these markets. We are
guarantor of future lease obligations with expirations through 2015. The
guarantees arose from the assignment of leases associated with the asset sales.
We are fully liable for all obligations under the terms of the leases in the
event that the assignee fails to pay any sums due under the lease. The remaining
maximum potential amount of future payments we could be required to make under
the guarantees is $9.1 million. No payments have been made to date and none are
expected to be required to be made in the future. In accordance with FASB
Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness to Others,” the fair
value of these obligations is limited and accordingly no liability was recorded
on our consolidated balance sheet at March 31, 2005 or December 31,
2004.
  **Results
from Continuing Operations**
 
 *Analysis
of Consolidated Statements of Operations* (in
millions):
 
 **Three
      Months Ended**
      **March
      31,**
    
    **Three
      Months Ended**
      **March
      31,**
    
    **Percentage
      Change Increase/****(Decrease)****2005**
    
    **%
      of****Revenue**
    
    **2004**
    
    **%
      of****Revenue**
    
    **2005
      vs.****2004**Operating
      revenuesCore
      customer trade revenue
    
    $
    44.0
    
    
    92
    %
    $
    32.8
    
    
    88
    %
    
    34
    %Switched
      access revenue
    
    
    3.7
    
    
    8
    %
    
    4.4
    
    
    12
    %
    
    (16
    )%Total
      revenue
    
    $
    47.7
    
    
    100
    %
    $
    37.2
    
    
    100
    %
    
    28
    %Cost
      of operating revenues (1)
    
    
    21.8
    
    
    46
    %
    
    16.4
    
    
    44
    %
    
    33
    %Selling,
      general and administrative expenses (2)
    
    
    22.7
    
    
    47
    %
    
    17.6
    
    
    47
    %
    
    29
    %Other
      operating expenses
    
    
    5.6
    
    
    12
    %
    
    3.7
    
    
    10
    %
    
    51
    %Loss
      from operations
    
    
    (2.4
    )
    
    *
    
    
    (0.5
    )
    
    *
    
    
    380
    %Other
      income (expense):Interest
      income
    
    
    0.2
    
    
    *
    
    
    0.1
    
    
    *
    
    
    100
    %Interest
      expense
    
    
    (1.2
    )
    
    *
    
    
    (0.1
    )
    
    *
    
    
    *Other
      income
    
    
    7.2
    
    
    *
    
    
    —
    
    
    *
    
    
    *Income
      (loss) from continuing operations
    
    
    3.8
    
    
    8
    %
    
    (0.5
    )
    
    *
    
    
    *Discontinued
      operations:(Loss)
      income from discontinued operations
    
    
    —
    
    
    *
    
    
    0.2
    
    
    *
    
    
    *Net
      income (loss)
    
    $
    3.8
    
    
    8
    %
    $
    (0.3
    )
    
    *
    
    
    14
    %
 
 *
    Calculation
      is not meaningful.(1)
    Exclusive
      of depreciation and amortization shown separately on our consolidated
      financial statements of $3,512 and $1,939 for the three months ended March
      31, 2005 and 2004, respectively.(2)
    Exclusive
      of depreciation and amortization shown separately on our consolidated
      financial statements of $2,089 and $1,962 for the three months ended March
      31, 2005 and 2004, respectively.
 
 *Quarterly
Comparison - March 31, 2005 vs. March 31, 2004*
  **Comparison
of Financial Results**
  Our
operational results for the three months ended March 31, 2005 are discussed
below. As the acquisition of the ICG California business closed on January 1,
2005, results of operations are included for the three months ended March 31,
2005, but not for three months ended March 31, 2004. In parts of our analysis we
have included some insight into how our pre-ICG California business performed in
the three months ended March 31, 2005. As we more fully integrate this acquired
business in future quarters, only consolidated results will be
reported.
 
 22
 Results
from discontinued operations have been excluded from this
comparison.
 
 ***Operating
Revenues.*** Total
revenue for the three months ended March 31, 2005 increased to $47.7 million
from $37.2 million in the same period of 2004, a 28% increase. The three month
financial results for 2005 include approximately $8.3 million of revenue from
the ICG California business. Without the revenue from the ICG California
business, our 2005 revenue for the three months ended March 31, 2005 increased
to $39.4 million from 2004 results of $37.2 million. The 28% increase in total
revenue was due to:
 •
    An
      increase of $6.0 million in our higher-end integrated voice and data
      services revenue principally resulting from an increase of average lines
      in service of about 1,900 T1 lines and approximately 460 trunk lines in
      our pre-ICG California business. ICG California revenue related to our
      higher-end integrated voice and date services revenue contributed
      approximately $2.4 million of the $6.0 million increase in
      revenue;•
    An
      increase of $4.3 million in our private line revenue as a result of our
      ICG California acquisition;•
    An
      increase of $0.9 million in our toll revenue primarily due to a 45%
      increase in minutes of use in our business prior to considering the ICG
      California acquisition. $0.4 million of the $0.9 million increase in toll
      revenue relates to ICG California acquired revenue stream for toll
      services;•
    An
      increase of $0.5 million in our other revenue due to a $0.4 million
      increase in directory assistance revenue in our business, prior to
      considering the ICG California acquisition. This increase is a result of a
      rate increase for directory assistance in the quarter ended March 31,
      2005. $0.1 million of the $0.5 million increase in revenue relates to
      other revenues generated from the ICG California
  business.
  These
increases were offset by:
 
 •
    A
      net decrease in plain old telephone service (“POTS”) revenue of $0.5
      million, driven by an $0.8 million decrease in our pre-ICG California
      revenue stream due to approximately 15,000 fewer POTS billable lines
      during the quarter ended March 31, 2005 versus the quarter ended March 31,
      2004. ICG California acquired POTS revenue was approximately $0.3 million
      in the quarter ended March 31, 2005;•
    A
      net decrease of $0.7 million in switched access revenues driven by a $1.0
      million decrease in our pre-ICG California intralata toll revenue during
      the quarter ended March 31, 2005 versus the quarter ended March 31, 2004
      resulting from an agreement with one of the incumbent carriers with whom
      we compete regarding the types of intralata toll traffic that can be
      billed and a decrease of $0.3 million primarily the result of the
      step-down in FCC mandated rates. Our ICG California switched access
      revenue was approximately $0.6 million for the quarter ended March 31,
      2005.
 
 We
estimate revenue for the year ending December 31, 2005 will be between $200 and
$208 million and 2006 revenue will be between $220 and $230
million.
 
 ***Cost
of Operating Revenues.*** Cost of
operating revenue (excluding depreciation and amortization which is stated
separately) for the quarter ended March 31, 2005 was $21.8 million as compared
to $16.4 million for the quarter ended March 31, 2004. The 33% or $5.4 million
increase was primarily due to:
 •
    An
      increase in our POTS loop expense of $0.6 million resulting from an 11%
      increase in rates for the loops charged by SBC in
    California.•
    An
      increase in our customer T1 expense of $1.9 million, which is a result of
      35% growth in the number of lines in service. $0.9 million of the increase
      in cost is related to the ICG California acquired customer T1 lines.
      Customer T1 expense will fluctuate in relationship to the variations in
      revenue related to this expense. For 2005 we anticipate this expense will
      continue to increase.•
    An
      increase of $1.2 million for network access expense. Of this increase,
      $0.5 million was for our core network access lines resulting from the
      additional higher capacity based backbone circuits needed to support the
      ICG California fiber network. $0.7 million of the increase in the quarter
      ended March 31, 2005 is the result of the acquired ICG California access
      lines.•
    An
      increase of $1.6 million in space rental for network hub costs associated
      with the acquisition of the ICG California’s network to support the fiber
      optic network and private line customers.•
    Resolution
      of disputes with two of our major ILECs and a credit for a billing error
      from a third ILEC resulted in a reduction in cost of operating revenues
      for the quarter ended March 31, 2005 of $0.8
million.
 
 ***Selling,
General and Administrative.*** For the
quarter ended March 31, 2005, selling, general and administrative expenses
(excluding depreciation and amortization which is stated separately) totaled
$22.7 million, a 29% or $5.1 million increase from the $17.6 million for the
quarter ended March 31, 2004. The increase is primarily due to:
 •
    A
      $2.0 million increase in salary, wages and benefit related expenses. This
      is primarily the result of an increase in average headcount from
      approximately 730 employees for the three months ended March 31, 2004 to
      approximately 800 employees for the three months ended March 31, 2005, due
      to the growth of our business and the impact of the ICG California
      acquisition.•
    Additional
      expenses of $0.9 million for incremental transition expenses related to
      the integration of assets as a result of the ICG California acquisition.
      We completed the acquisition of ICG’s California retail and wholesale
      customers and statewide fiber network on January 1, 2005, and expect to
      incur additional incremental transition expenses during the second and
      third quarters of 2005.•
    Additional
      expenses of $0.8 million pursuant to our transition services agreement
      with ICG in which certain services related to the acquired operations to
      ICG California are performed for us by ICG primarily related to billing,
      collections, provisioning, call center and network support. As these
      transition services are expected to continue to be provided through the
      second quarter of 2005, we anticipate incurring additional
      expenses.•
    A
      $0.6 million increase in agent commissions as a result of significant
      revenue growth within the independent agent
channel.
 
 23
 ***Gain
on Sale of Assets.*** Gain on
sale of assets was minimal for the quarters ended March 31, 2005 and
2004.
 
 ***Depreciation
and Amortization.*** For the
quarters ended March 31, 2005 and 2004, depreciation and amortization were $5.6
million and $3.9 million, respectively. The additional depreciation and
amortization was primarily attributable to the $29.8 million of property and
equipment and $3.4 million of intangibles acquired from ICG.
 
 ***Loss
from Operations.*** Our loss
from operations was $2.4 million for the quarter ended March 31, 2005 as
compared to $0.5 million for the quarter ended March 31, 2004.
 
 ***Other
Income.*** We
recorded $7.3 million of other income for the quarter ended March 31, 2005.
Other income was primarily comprised of $7.2 million related to early
termination of our Las Vegas, Nevada switch site lease, net of exit
expenses. We expect to apply the cash received ($7.7 million) to the
construction of a replacement switch site in Las Vegas during 2005. We did not
recognize any other income for the quarter ended March 31, 2004.
 
 ***Interest
Income.*** Interest
income was $0.2 million for the quarter ended March 31, 2005 as compared to $0.1
million for the quarter ended March 31, 2004. Interest income is derived
primarily from the investment of cash and cash equivalents, investments
available-for-sale, and restricted cash and cash equivalents.
 
 ***Interest
Expense.*** Gross
interest expense was $1.2 million and $0.1 million for the quarters ended March
31, 2005 and 2004, respectively. Interest expense includes commitment fees and
interest paid relating to our line of credit and interest on capital lease
commitments. The increase is primarily a result of our assumption of capital
leases in the ICG California acquisition.
  ***Income
(Loss) from Continuing Operations.*** Primarily ****** as a
result of the other income, we generated net income from continuing operations
of $3.8 million for the quarter ended March 31, 2005, compared to a net loss
from continuing operations of $0.5 million for the quarter ended March 31,
2004.
 
 ***Net
Income (Loss).*** As a
result of the above and (loss) income from discontinued operations, net income
was $3.8 million for the quarter ended March 31, 2005 compared to a net loss of
$0.3 million for the quarter ended March 31, 2004.
 
 **Discontinued
Operations**
 
 As of
March 31, 2005, we have recorded $0.5 million of receivables related to asset
sales from discontinued markets. These receivables have been included in other
receivables in the consolidated balance sheets and the majority of the balance
owed is being held in escrow by a third party escrow agent. No allowance for
doubtful accounts for these receivables has been established as we expect to
collect all receivables related to our asset sales. We ceased providing
transition services as of December 31, 2003. We received a disbursement of $1.0
million from escrow in March 2005 and we expect to receive the remaining
$0.5 million, net of expenses chargeable to us, in the second quarter of
2005.
 
 The
operating revenues and expenses of our discontinued markets have been classified
as discontinued operations under
SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,”
for all periods presented. Loss (income) related
to these discontinued markets was as follows for the three months ended March
31, 2005 and 2004 (in thousands):
 
 **Three
      Months Ended****March
      31,**
    
    **March
      31,****2005**
    
    **2004**Operating
      expenses (income)
    
    $
    32
    
    $
    (191
    )Gain
      on disposal of assets
    
    
    —
    
    
    (50
    )(Loss)
      income from discontinued operations
    
    $
    (32
    )
    $
    241
 
 24
 **Application
of Critical Accounting Estimates**
 
 Our
condensed consolidated financial statements and accompanying condensed notes are
prepared in accordance with accounting principles generally accepted in the
United States of America. Preparing consolidated financial statements requires
us to make estimates and assumptions that affect the reported amounts of assets,
liabilities, revenue and expenses. These estimates and assumptions are affected
by the application of our accounting policies. Our significant accounting
policies are described in the “Significant Accounting Policies” footnote in our
notes to consolidated financial statements included in our Form 10-K for the
year ended December 31, 2004. Critical accounting estimates are those that
require application of management’s most difficult, subjective or complex
judgments, often as a result of matters that are inherently uncertain and may
change in subsequent periods. Critical accounting estimates for us include: (i)
revenue recognition on services, (ii) allowance for doubtful accounts, (iii)
billing from network carriers, (iv) sales and property taxes, (v) deferred
income taxes, and (vi) impairment of long-lived assets. For additional
discussion of our critical accounting estimates, see our “Management’s
Discussion and Analysis of Financial Condition and Results of Operations” in our
Form 10-K for the year ended December 31, 2004.
 
 As a
result of our recent acquisition of ICG California, we now consider the
following a part of our application of critical accounting
estimates:
 
 *Business
Combinations*
 
 We
account for acquisitions in accordance with Statement of Financial Accounting
Standards (“SFAS”) No. 141, “Accounting for Business Combinations”. Accordingly,
when a business combination occurs, we allocate the cost of the acquired
enterprise to the estimated fair value of the assets acquired and liabilities
assumed. Any excess of cost over the net of the amounts assigned to assets
acquired and liabilities assumed is recognized as goodwill. Direct costs of the
acquisition are included in the cost of the acquired enterprise, while indirect
and general expenses such as salaries and overhead costs are expensed as
incurred. Costs of issuing equity securities in connection with business
combinations are deducted from the amount of additional paid-in-capital
resulting from the issuance.
  *Goodwill
and Other Intangible Assets*
 
 We
account for goodwill and other intangible assets in accordance with SFAS No.
142, “Goodwill and Other Intangible Assets”. Goodwill is evaluated for
impairment at least annually. Other intangible assets consist of customer
relationships, internally developed software, trademark and licensing
agreements. Customer relationships and internally developed software are
amortized using the straight-line method over the estimated useful lives of
three years. The trademark was determined to have an indefinite life and is not
subject to amortization, but is reviewed at least annually for impairment.
License agreements are amortized over their estimated useful lives of five
years.
 
 **Effects
of New Accounting Standards**
 
 *Share-Based
Payment*
 
 In April
2005, the effective date of SFAS No. 123 (revised 2004), “Share-Based Payment”,
which replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and
supersedes Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for
Stock Issued to Employees,” was deferred and will now be effective beginning
with the first fiscal year that begins after June 15, 2005, with early adoption
encouraged. SFAS No. 123(R) requires all share-based payments to employees,
including grants to employee stock options, to be recognized in the financial
statements based on their fair values. At this time we cannot yet estimate the
effect of adopting SFAS No. 123(R) as we have not yet selected the period of
adoption, the method of adoption or an option-pricing model and we have not yet
finalized estimates of our expected forfeitures.
  **Forward
Looking Statements**
 
 Under the
safe harbor provisions of the Private Securities Litigation Reform Act of 1995,
we caution the reader that certain statements contained in this report regarding
our and/or management’s intentions, hopes, beliefs, expectations or predictions
of the future are forward-looking statements. We wish to caution the reader
these forward-looking statements are not historical facts and are only estimates
or predictions. Actual results, including projections with respect to our future
operating performance, may differ materially from those projected as a result of
risks and uncertainties including, but not limited to, our ability to retain ICG
California customers and increase revenues from the acquired ICG California
business, our ability to effectively integrate the ICG California business into
our operations, unexpected costs of integrating the ICG California business into
our operations, future sales growth, changes in federal or state
telecommunications regulations, market acceptance of our product and service
offerings, the liquidity of our common stock, our ability to secure adequate
financing or equity capital to fund our operations and network expansion, our
ability to manage growth and maintain a high level of customer service, the
performance of our network and equipment, our ability to enter into strategic
alliances or transactions, the cooperation of incumbent local exchange carriers
in provisioning lines and interconnecting our equipment, regulatory approval
processes, the effect of regulatory decisions on our access charges and
operating costs, changes in technology, price competition and other market
conditions and risks detailed from time to time in our filings with the
Securities and Exchange Commission. We undertake no obligation to update
publicly any forward-looking statements, whether as a result of future events,
new information, or otherwise.
 
 25
 **Item
3.**  *Quantitative
and Qualitative Disclosures About Market Risk*
 
 We do not
use interest rate derivative instruments to manage our exposure to interest rate
changes. The interest rate under our line of credit floats with the prime rate
and therefore we do have exposure to interest rate changes as a result of our
line of credit agreement. As of March 31, 2005, we did not have any outstanding
borrowings under the line of credit.
 
 As a
result of the ICG acquisition in January 2005, we acquired certain capital
leases that have fixed interest rates and as a result we do not have exposure to
interest rate changes for those obligations.
 
 **Item
4.**  *Controls
and Procedures*
  (a)
    Evaluation
      of disclosure controls and procedures. As of the end of the period
      covered by this report, under the supervision and with the participation
      of our management, including our chief executive officer (“CEO”) and chief
      financial officer (“CFO”), we evaluated the design and operation of our
      disclosure controls and procedures (as defined in Rules 13a-15(e) and
      15d-15(e) of the Securities Exchange Act of 1934, as amended, or the
      “Exchange Act”). Based on this evaluation, our management, including our
      CEO and CFO, has concluded that our disclosure controls and procedures are
      designed, and are effective, to give reasonable assurance that the
      information we are required to disclose is recorded, processed, summarized
      and reported by our management on a timely basis in order to comply with
      our disclosure obligations under the Exchange Act and the SEC rules
      thereunder.(b)
    Changes
      in internal control. There were no changes in our internal control
      over financial reporting that occurred during our quarter ended March 31,
      2005, that have materially affected, or are reasonably likely to
      materially affect, our internal control over financial
      reporting.
  26
  **PART
II. OTHER INFORMATION**
 
 **Item
1.** *Legal Proceedings*
 
 From time
to time, we are involved in litigation and governmental proceedings in the
ordinary course of our business, including some claims that we have asserted
against others, in which monetary damages are sought. The result of current or
future litigation is inherently unpredictable; however, we do not believe any
asserted or pending litigation or governmental proceedings will have a material
adverse effect on our financial position, results of operations or cash flows. A
description of pending litigation and governmental proceedings is contained in
our annual report on Form 10-K for the year ended December 31, 2004. The
following updates the discussion in the Form 10-K for developments that have
occurred since January 1, 2005.
 
 **California**
 
 Subsequent
to the September 2004 UNE Reexamination which increased the UNE rates that
Southwestern Bell Corporation (“SBC”) California may charge competitive local
telephone companies, the California Public Utilities Commission (“CPUC”)
analyzed the rates further. As a result, on March 22, 2005, the CPUC revised the
UNE rates downward by approximately 2%. We do not believe that the revised rates
will have a material adverse effect on our business, financial condition or
results of operations.
 
 **Illinois**
 
 Subsequent
to the May 2004 UNE rate increase, the Illinois Commerce Commission (“ICC”)
opened a proceeding (“Imputation Docket”) to analyze whether the UNE rates
charged by SBC Illinois to competitive local telephone companies are
competitively fair in light of the rates SBC charges its retail customers. A
decision from the ICC is expected by June 30, 2005.
 
 **Triennial
Review Remand**
 
 On
February 4, 2005, the FCC issued an Order on Remand (“TRRO”) announcing that it
modified the unbundling obligations for ILECs. The FCC clarified and modified
the impairment standard adopted in its earlier Triennial Review Order (“TRO”).
The revised standard removes under certain circumstances an ILEC’s unbundling
obligations with regard to local loops, dedicated transport, and local
switching. The removal of local switching as a UNE will not affect us as we own
our own switch sites and do not rely on the ILEC. The impairment findings for
loops and transport vary based upon the capacity of the loop and availability of
competitive alternatives to the ILEC. Based upon the FCC loop and transport
criteria, relatively few of our loops and transport will be affected. In
response to an FCC request, the ILECs have identified the specific wire centers
that they contend will be affected. However, until the supporting data has been
analyzed by competitive carriers and state regulatory bodies, a definitive list
of wire centers cannot be known with certainty. Also, currently, the FCC is
reviewing a Petition to Reconsider and the D.C. Circuit is reviewing an appeal
of the TRRO. Therefore, we cannot predict the degree to which the new rules
regarding loops and transport will affect us. Regardless of the outcome, we
expect to be able to continue to purchase some network elements from competitive
local telephone companies at market rates (e.g., transport which is used to
connect parts of our network and some high capacity loops). At present, it is
not possible to predict how future rates will compare to the current TELRIC
rates but it is possible the new rules could adversely affect our cost of doing
business by increasing the cost of purchasing or leasing network facilities. The
Triennial Review Remand Order will have a significant impact on
telecommunications competition, but it is not possible at this time to predict
the full extent of its impact upon us or our competition.
 
 **Item
2.** *Unregistered
Sales of Equity Securities and Use of Proceeds*
 
 On
January 1, 2005, we acquired ICG Communications, Inc.’s (“ICG”) customer base
and certain network assets in California pursuant to an Asset Purchase
Agreement, dated October 22, 2004 (the “Agreement”). A portion of the purchase
price for these assets was (i) 10,740,030 shares of our common stock (the
“Shares”) and (ii) warrants to purchase 2,000,000 shares of our common stock
(the “Warrants”). The Warrants are exercisable on or prior to the fifth
anniversary of the date of issuance at a strike price of $1.383 per share. The
Shares and Warrants were issued to ICG. The issuance of shares of our common
stock and warrants to ICG is exempt from the registration requirements of the
Securities Act of 1933 (the “Act”) pursuant to Section 4(2) of the
Act.
    27
 **Item
6.**  *Exhibits*
 
 The
      following exhibits are filed herewith or incorporated by reference as
      indicated. Exhibit numbers refer to Item 60l of Regulation
      S-K.
 
 2.1
    Asset
      Purchase Agreement, dated October 22, 2004, by and among MCCC ICG
      Holdings, LLC, ICG Communications, Inc., Mpower Holding Corporation and
      Mpower Communications Corp. (1)3.1
    Second
      Amended and Restated Certificate of Incorporation filed with the Secretary
      of State of the State of Delaware on July 30, 2002. (2)3.2
    Second
      Amended and Restated By-laws. (2)3.3
    Rights
      Agreement between Mpower Holding Corporation and Continental Stock
      Transfer & Trust Company as Rights Agent. (3)3.4
    Certificate
      of Designation for the Series A Preferred Stock. (4)3.5
    Amendment
      of Rights Agreement and Certification of Compliance with Section 26 dated
      March 14, 2005, between Mpower Holding Corporation and Continental Stock
      Transfer & Trust Company. (5)4.1
    See
      the Second Amended and Restated Certificate of Incorporation filed as
      Exhibit 3.1 and the Second Amended and Restated By-laws filed as Exhibit
      3.2.10.1
    Subscription
      Agreement dated January 1, 2005, between MCCC ICG Holdings LLC and Mpower
      Holding Corporation. (6)10.2
    Investor
      Rights Agreement dated January 1, 2005, by and among MCCC ICG Holdings
      LLC, ICG Communications, Inc. and Mpower Holding Corporation.
      (6)10.3
    First
      Amendment to Employment Agreement dated February 3, 2005, between Mpower
      Communications Corp. and Russell A. Shipley. (5)10.4
    Employment
      Agreement dated February 2, 2005, between Mpower Communications Corp. and
      Michael Tschiderer. (5)10.5
    Amendment
      to Retention and Severance Agreement dated January 25, 2005, between
      Mpower Communications Corp. and Steven Reimer. (5)10.6
    Amendment
      to Retention and Severance Agreement dated February 4, 2005, between
      Mpower Communications Corp. and Roger Pachuta. (5)10.7
    Employment
      Agreement dated February 15, 2005 between Mpower Communications Corp. and
      James Dole. (5)10.8
    Third
      Amendment to Lease dated February 10, 2005, between Mpower Communications
      Corp. and Vista Holdings, LLC. (5)10.9
    Consulting
      Agreement dated February 18, 2005, between Mpower Communications Corp. and
      Cassara Management Group, Inc. (5)31.1
    Rule
      13a-14(a)/15d-14(a) Certification of Chief Executive
    Officer31.2
    Rule
      13a-14(a)/15d-14(a) Certification of Chief Financial
    Officer32
    Section
      1350 Certifications
 
 (1)
    Incorporated
      by reference to the Company’s Current Report on Form 8-K/A filed with the
      Commission on October 27, 2004.(2)
    Incorporated
      by reference to the Company's Registration Statement on Form 8-A filed
      with the Commission on July 30, 2002.(3)
    Incorporated
      by reference to the Company’s Registration Statement on Form 8-K (file No.
      000-32941) filed with the Commission on July 16, 2003.(4)
    Incorporated
      by reference to the Company’s Registration Statement on Form 8-A filed
      with the Commission on July 16, 2003.(5)
    Incorporated
      by reference to Mpower Holding Corporation’s Annual Report on Form 10-K
      for the year ended December 31, 2004.(6)
    Incorporated
      by reference to Mpower Holding Corporation’s Current Report on Form 8-K
      filed with the Commission on January 6, 2005.
  28
  **SIGNATURES**
 
 Pursuant
to the requirements 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.
 **MPOWER
      HOLDING CORPORATION**Date: May
      10, 2005
    By:
    /s/ Rolla P.
HuffRolla
      P. Huff*Chief
      Executive Officer and Chairman of the
Board*
  ****Date: May
      10, 2005
    By:
    /s/ S. Gregory ClevengerS.
      Gregory Clevenger*Executive
      Vice President - Chief Financial
Officer*
   
 29