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SECURITIES AND EXCHANGE COMMISSION  FORM 10-K  [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
 FOR THE YEAR ENDED DECEMBER 31, 2003
 OR [  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO
 COMMISSION FILE NUMBER: 000-28467 Z-TEL TECHNOLOGIES, INC.  DELAWARE
(State or other jurisdiction of
incorporation or organization)
    
    59-3501119
(I.R.S. Employer
Identification Number)
 601 SOUTH HARBOUR ISLAND BOULEVARD, SUITE 220
TAMPA, FLORIDA 33602
(813) 273-6261
(Address, including zip code, and
telephone number including area code, of
Registrants principal executive offices) SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON
STOCK, PAR VALUE $.01 PER SHARE, PREFERRED STOCK PURCHASE RIGHTS Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [  ] Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12B-2 of the Exchange Act) Yes [  ] No [X] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrants knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to
this Form
10-K [  ]. The aggregate market value of the Registrants Common Stock held by
non-affiliates of the Registrant on March 29, 2004 (assuming solely for these
purposes that only directors, executive officers and beneficial owners of
greater than 10% of the Registrants Common Stock are affiliates), based on the
closing price of the Common Stock on the Nasdaq SmallCap Market as of such
date, was approximately $60,964,111. The number of shares of the Registrants Common Stock outstanding as of March
30, 2004 was approximately 36,168,028. DOCUMENTS INCORPORATED BY REFERENCE Portions of the registrants proxy statement relating to its 2004 Annual
Meeting of Stockholders, to be filed subsequently, are incorporated by
reference into Part III of this Report. 1




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TABLE OF CONTENTS PART I.Item 1.
    
    Business

2Item 2.
    
    Properties

19Item 3.
    
    Legal Proceedings

19Item 4.
    
    Submission of Matters to a Vote of Security Holders

20PART II.Item 5.
    
    Market for the Registrant's Common Equity and Related Stockholder Matters

21Item 6.
    
    Selected Consolidated Financial Data

22Item 7.
    
    Management's Discussion and Analysis of Financial Condition and Results of Operations

24Item 7A.
    
    Quantitative and Qualitative Disclosures about Market Risk

52Item 8.
    
    Financial Statements and Supplementary Data

F-1Item 9.
    
    Changes in and
Disagreements with Accountants on Accounting and Financial Disclosure

53Item 9A.
    
    Controls and Procedures

53PART III.Item 10.
    
    Directors and Executive Officers of the Registrant

54Item 11.
    
    Executive Compensation

54Item 12.
    
    Security Ownership of Certain Beneficial Owners and Management

54Item 13.
    
    Certain Relationships and Related Transactions

54Item 14.
    
    Principal Accountant Fees and Services

54PART IV.Item 15.
    
    Exhibits, Financial Statement Schedules, and Reports on Form 8-K

54Signatures
    
    

55Ex-10.14 February 4, 2003 Sprint Resale AgreementEx-21 SubsidiariesEx-23 Accountants' ConsentEx-31.1 Section 302 CEO CertificationEx-31.2 Section 302 CFO CertificationEx-32.1 Section 906 CEO CertificationEx-32.2 Section 906 CFO Certification
  
 ITEM 1. BUSINESS GENERAL Z-Tel Technologies, Inc. is a communications service provider. We provide
innovative and cost effective telecommunications services to consumers,
business and other communications companies by integrating our own enhanced
communications systems and advanced operational support systems with access to
communication networks. Our systems have the capability to integrate with
wireline, wireless, cable, Internet and other communications transport
networks. Our current generation of services relies primarily on access to
local and long distance telephone networks. A recent court ruling has created
legal uncertainty regarding our access to local telephone networks. See
sections of this report entitled Government Regulation and Risks Relating to
Our Financial Condition and Our Business. We plan to launch a new generation
of services using voice over Internet protocol (VoIP) in 2004. We provide services on both a retail and wholesale basis. Our principal retail
services are Z-LineHOME®, Z-LineBUSINESS® and Touch 1 Long Distance.
Z-LineHOME and Z-LineBUSINESS are residential and business versions,
respectively, of our flagship offering, the Z-Line®. The Z-Line is local
telephone service, typically bundled with long distance and enhanced features,
including a suite of our proprietary Internet-accessible and voice-activated
functions. The enhanced features include voicemail, Find Me call forwarding
and our recently introduced Personal Voice Assistant, or PVA, which
utilizes voice-recognition technology so that users can access secure, online
address books from any phone using simple voice commands in order to send voice
emails, find contact information and dial numbers, among other things. Touch 1
long distance is a residential long distance telephone service. We have approximately 190,000 Z-LineHOME® lines and 32,000 Z-LineBUSINESS®
lines under management and approximately 65,000 Touch 1 Long Distance
customers. We gained nearly all of the Touch 1 Long Distance customers with
our acquisition of Touch 1 Communications, Inc. in April 2000. We plan to launch VoIP-based services in 2004, focusing initially on the
small-to-medium business market and multiple dwelling units such as
condominiums, apartment buildings and hotels in Georgia and Florida. Our VoIP
initiative is in the testing phase.
At the wholesale level, we provide telephone services, enhanced communications
services and operational support services to other telephone companies for
their use in providing telephone services and enhanced communications services
to their own end user customers. Our principal wholesale customer is Sprint
Communications Company (Sprint), which became a wholesale customer in
February 2003. An agreement for wholesale services with MCIWORLDCOM (MCI)
was terminated in October 2003. We have approximately 330,000 end user lines
under management in connection with our wholesale relationships. 2




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We have invested heavily in our enhanced communications platform and our
operational support systems. Our enhanced communications platform enables us
to offer distinctive Web integrated and voice activated features, including
PVA. Our advanced operational support systems are functionally integrated to
support the entire customer life cycle including price quotation, order entry
and processing, ILEC interaction, customer care, billing and subscriber
management. We believe our operational systems are scalable, both vertically
and horizontally, and give us reliable, flexible, low-cost operational
capabilities. Our current generation of local telephone services, which produces
approximately 95% of our revenue, relies on access to local telephone networks.
Our access to these networks is based upon the Telecommunications Act of 1996
(the Telecommunications Act) which imposes a variety of duties upon the
traditional local telephone companies (incumbent local exchange carriers or
ILECs), including the duty to provide competitive local exchange companies
(CLECs), like us, with access to the individual components of their networks.
The Federal Communications Commission ("FCC") has issued various rules regarding access to these components,
including access to transport and switching. A recent court ruling, however,
has created considerable legal uncertainty regarding this access. In United
States Telecom Assn v. FCC, Nos. 00-1012, 00-1015, 03-1310 et al.(D.C. Cir.
March 2, 2004) (USTA II), the D.C. Circuit Court ordered that the FCCs
unbundled transport and switching rules be vacated after sixty days or upon
denial of a petition for rehearing, whichever occurs later. Although a
majority of the FCC has indicated that it will support an appeal and we believe
there are substantial arguments in favor of such an appeal, this ruling and the
uncertainty it has created could have material, adverse effects upon us and our
operations, including, among other matters, our ability to obtain financing,
our relationships with major customers and prospective customers, our
relationships with major marketing partners and prospective marketing partners,
the pricing, credit and other terms we receive from the ILECs, long distance
companies and other vendors and an increase in legal expenditures. See
sections of this report entitled Government Regulation and Risks Relating to
Our Financial Condition and Our Business. Our planned 2004 launch of a new
generation of VoIP services could, over time, mitigate our reliance on access
to ILEC networks. SEGMENT FINANCIAL INFORMATION We utilize two segments for internal reporting purposes: retail services and
wholesale services. Financial information relating to our retail services
segment and our wholesale services segment (including information relating to
the revenue contributed by our services) is set forth in Item 7, Managements
Discussion and Analysis of Financial Condition and Results of Operations and
footnote 22 Segment Reporting in the Notes to the Consolidated Financial
Statements. INDUSTRY BACKGROUND The Telecommunications Act of 1996 (the Telecommunications Act) was enacted
principally to foster competition in the local telecommunications markets. The
Telecommunications Act imposes a variety of duties upon the ILECs, including
the duty to provide other communications companies, like us, with access to the
individual components of their networks, called network elements, on an
unbundled basis at any feasible point and at rates and on terms and conditions
that are just, reasonable and nondiscriminatory. A network element is a
facility or piece of equipment of the ILECs network or the features, functions
or capabilities such facility or equipment provides. Pursuant to the
Telecommunications Act, the Federal Communications Commission (FCC) has
mandated that incumbent local exchange carriers provide access to a set of
unbundled network elements including, among other elements, local loops (i.e.
the wires that reach from the ILEC central office to the end users premises),
switching, transport and signaling. This set of elements is referred to as the
unbundled network element platform or UNE-P. Moreover, the FCC has mandated
that ILECs must provide the unbundled network element platform at rates based
on a forward-looking, total long-run incremental cost methodology. A recent
court ruling has overturned, in part, FCC decisions relating to UNE-P. This
ruling could have immediate, material, adverse effects upon our business. See
sections entitled Government Regulation and Risks Relating to Our Financial
Condition and Our Business. The Telecommunications Act also establishes procedures by which the regional
Bell operating companies (Bell operating companies) are allowed to handle
in-region long distance calls, that is, calls that originate from within
their telephone service areas and terminate outside their service areas. The
1984 court order that divided AT&T prohibited Bell operating companies from
providing in-region long distance telephone service. Under the
Telecommunications Act, Bell operating companies can provide such in-region
service if they demonstrate to the FCC and state regulatory agencies that they
have complied with a 14-point regulatory checklist, including offering
interconnection to other communications companies, like us, and providing those
companies access to their unbundled network elements on terms approved by a
state public service commission. Bell operating companies have received
authority to provide in-region long distance services in all 47 applicable
states. However, the Section 271 checklist is a continuing obligation
pursuant to section 271(d)(6) of the Telecommunications Act. See section of
this report entitled Government Regulation. RETAIL SERVICES We provide telephone services at both the retail and wholesale level. At the
retail level our principal services are Z-LineHOME, Z-LineBUSINESS and Touch 1
Long Distance. We plan to launch a new generation of VoIP-based services in
2004. 3




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Z-LineHOME® Z-LineHOME is local residential telephone service bundled with long distance
(1+) telephone service, calling card services and enhanced features, including
our own proprietary, Internet-accessible voicemail, Find Me, Notify Me and
voice-activated services, as well as caller identification, call forwarding,
three-way calling, call waiting and speed dialing, all for a single flat
monthly price. We offer various plans, including our Unlimited Plan which
includes unlimited, nationwide, direct-dialed long distance calling toll-free
and lower priced plans that include a limited number of long distance minutes
at no additional charge. Bell operating company customers switching to
Z-LineHOME keep their existing phone numbers. We currently offer Z-LineHOME in
every state except Alaska, in areas served by Bell operating
companies and selected areas served by Sprint or formerly served by GTE. Z-LineHOME includes unique Z-Line features, all of which can be accessed and
manipulated by telephone or Internet. Our proprietary voicemail enables
Z-LineHOME subscribers to retrieve and listen to their voice-mail messages via
telephone or the Internet. Our voicemail system also enables users to forward
voicemails via e-mail, as attachments. Our Find-Me feature forwards an
incoming call to as many as three additional numbers. Our Notify Me feature
notifies the subscriber via e-mail, pager or ICQ Internet Chat (instant
messaging) when a new voice mail message arrives. Both Find Me and Notify Me
are accessible via the Internet so that users may easily enable, disable or
otherwise alter the functions. Personal Voice Assistant or PVA allows
users to store contacts in a virtual address book and then access and utilize
that information through voice commands from any telephone. Users say call
and the contacts name, call John Doe, for example, and PVA connects the
call. PVA users can also send voice e-mails. Users record a message via
telephone and instruct PVA to deliver the message to a contact. PVA then
attaches the voice message to an e-mail and sends the e-mail to the contact. We market and sell Z-LineHOME primarily through joint marketing efforts with
entities that have access to large numbers of consumers, independent sale
contractors (including multi-level marketing companies) and referral programs.
We also use, but have reduced our reliance upon, direct mail and traditional
advertising media such as billboards, radio and television. Z-LineBUSINESS® Z-LineBUSINESS is our complementary service to Z-LineHOME targeted to small and
medium sized businesses (typically having four or fewer lines) and businesses
having multiple units. Z-LineBUSINESS, like Z-LineHOME, is local telephone
service bundled with long distance (1+) telephone service, calling card
services and enhanced features, including our proprietary features. Because we
offer service in nearly every state, Z-LineBUSINESS is particularly valuable to
firms having multiple locations in various states. With us, they deal with only
one telephone company. We began offering Z-LineBUSINESS in 2002. We offer
Z-LineBUSINESS in every state but Alaska, in areas served by a Bell operating
company or formerly served by GTE. Current customers include Darden
Restaurants, Compass, Foot Locker, Metromedia Restaurant Group and Rand McNally
Stores. We market and sell Z-LineBUSINESS primarily through our own in-house sales
personnel and independent sale contractors. Touch 1 Long Distance Touch 1 Long Distance is a usage-based service that allows customers to use us
as their primary long distance calling provider to complete their residential
long distance (1+) calls. Touch 1 Long Distance is available nationwide. We do
not actively market the service. We acquired Touch 1 Communications, Inc.
("Touch 1") in April 2000. VoIP Services We plan to launch an offering of broadband voice and data services in 2004. We
expect to focus initially on the small-to-medium business market and multiple
dwelling units, such as condominiums, apartment buildings and hotels, in
Georgia and Florida. Our VoIP services will be integrated with our enhanced
communications services platform so that in addition to increased bandwidth and
service flexibility, our customers will enjoy features such as PVA, our
voice-activated virtual address book. We expect to utilize Cisco technology and
services in providing these services. Billing and Collection We have three primary methods for billing and collecting from our retail
customers. For our Z-LineHOME customers, we can (1) direct bill by mail and
receive payment through a check or money order by mail; (2) charge a credit
card account or (3) set up an automatic withdrawal from a checking account.
Currently, we bill the majority of our customers by mail and receive payment
through checks delivered by mail. WHOLESALE SERVICES At the wholesale level, we offer a comprehensive package of communications and
advanced support services to other communications companies for their use in
providing services to their own retail customers. Among the wholesale services
we offer are local exchange telephone services, long distance telephone
services, our proprietary enhanced features, supplemental features 4




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we acquire from incumbent local exchange carriers, ordering, provisioning (i.e.
the process by which a telephone company is established as the end users
primary telephone company), inbound sales, fulfillment, billing, collections
and customer care. Our enhanced communications platform has the capability to
integrate with most communications transport networks, including wireless,
cable, and Internet networks. We intend to pursue wholesale relationships
with, among others, wireless telephone companies, Internet service providers,
cable television operators, electrical utilities and others having access to
large consumer bases. To provide telephone services these entities must be
properly licensed by regulatory authorities of the states in which they
operate. On February 4, 2003, we signed a non-exclusive, wholesale services agreement
with the Sprint Communications Company L.P. (Sprint). The agreement gives
Sprint access to our telephone exchange services and our Web-integrated,
enhanced communications platform and operational support systems in connection
with Sprints local residential telephone service. Sprint is our primary
wholesale services customer. On March 20, 2002, we entered into a four-year contract with MCI WORLDCOM
Communications, Inc. (MCI) whereby we agreed to provide local exchange
services, enhanced features and operational and support services and licenses
to use certain of our proprietary technology, all for MCIs use in providing
telecommunications services to residential and small business customers. MCI
filed for bankruptcy protection on July 21, 2002. On November 1, 2002, we
significantly amended the terms of our agreement to alter the fee structure and
to eliminate certain exclusivity provisions. MCI terminated the agreement
effective October 15, 2003. OPERATIONS SUPPORT SYSTEMS We have invested heavily in our operations systems and support platform. The
platform integrates ordering, provisioning, customer care and billing
functionality throughout the customer lifecycle and consequently gives us (and
our wholesale customers) reliable, flexible, low-cost operational capabilities.
We believe our operational systems are scalable, both vertically and
horizontally. They have the capability to integrate with wireline, wireless,
cable, Internet and other communications transport networks Our current generation of telephone services requires access to ILEC networks.
To facilitate interaction with the ILECs, we have established, with outside
integration and consulting assistance, electronic gateways, software and a
standard internal provisioning interface. Our systems can interact with the
ordering systems of multiple incumbent local exchange carriers. They reduce the
number of steps required to provision a customer and consequently reduces costs
and increases accuracy. Provisioning is the process by which we (or our
wholesale customers) are established as the end user's primary local exchange
and long distance telephone service provider. Our systems also support
mediation, network administration and revenue assurance. BUSINESS STRATEGY Our basic business strategy is to   
    
    Increase lines under management and leverage our existing facilities
and infrastructure by establishing wholesale and joint marketing
relationships with organizations having access to large consumer bases,
particularly those having the capability to bundle communication
services  
    
    Reduce bad debt and customer churn by focusing our retail marketing
efforts on business customers and select groups of qualified consumers  
    
    Initiate VoIP-based services for consumers and businesses. Material changes in the regulatory environment in which we operate,
particularly in light of a recent court ruling overturning, in part, FCC rules,
could cause us to dramatically alter our business strategy. See sections
entitled Government Regulation and Risks Relating to Our Financial Condition
and Our Business. GOVERNMENT REGULATION Overview Some of our services are regulated and some are not. In providing enhanced
features services such as voice mail, Find-Me notification and directory
services, we operate as an unregulated provider of information services, as
that term is defined in the Communications Act of 1934 (the Communications
Act), as amended by the Telecommunications Act of 1996 (the
Telecommunications Act), and as an enhanced service provider, as that term is
defined in the FCC rules. These operations currently are not regulated by the
FCC or the states in which we operate. In providing Z-LineHOME and our long
distance services, we are regulated as a common carrier at the state and
federal level and are subject to additional rules and policies not applicable
to providers of information services alone. We are certificated as a
competitive local exchange carrier in 5




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49 states (Alaska excluded) and the District of Columbia. Z-Tel is
certificated as a long-distance reseller in all fifty states and the District
of Columbia. The local and long distance telecommunications services we provide are
regulated by federal, state, and, to some extent, local government authorities.
The FCC has jurisdiction over all telecommunications common carriers to the
extent they provide interstate or international communications services. Each
state regulatory commission has jurisdiction over the same carriers with
respect to intrastate communications services. The extent of federal or state
regulation of information services depends upon the nature of the service
offered. Local governments sometimes seek to impose franchise requirements on
telecommunications carriers and regulate construction activities involving
public rights-of-way. Changes to the regulations imposed by any of these
regulators could have a material adverse effect on our business, operating
results and financial condition. In recent years, the regulation of the telecommunications industry has been in
a state of flux as the United States Congress and various state legislatures
have passed laws seeking to foster greater competition in telecommunications
markets. The FCC and state utility commissions have adopted many new rules to
implement this legislation and encourage competition. These changes, which are
still incomplete, have created new opportunities and challenges for us and our
competitors. The following summary of regulatory developments and legislation
is intended to describe the most important, but not all, present and proposed
federal, state and local regulations and legislation affecting the
telecommunications industry. Some of these and other existing federal and state
regulations are the subject of judicial proceedings and legislative and
administrative proposals that could change, in varying degrees, the manner in
which our industry operates. We cannot predict the outcome of any of these
proceedings or their impact on the telecommunications industry at this time.
Some of these future legislative, regulatory or judicial changes may have a
material adverse impact on our business. While Z-Tels regulatory environment continues to be dynamic and complex, there
are two overriding issues that substantially drive our business: (1) our
ability to access the local networks of incumbent local telephone companies
(like Verizon, SBC, BellSouth and Qwest) and (2) the price we pay for that
access. Both of those issues  network access and pricing  are currently
subject to significant legal uncertainty. With regard to network access rules, as discussed more fully below, access to
ILEC unbundled network elements pursuant to Section 251 of the
Telecommunications Act is currently subject to considerable legal uncertainty.
In particular, our access to unbundled analog switching, a key component of the
Unbundled Network Element Platform combination of elements, or UNE-P, is the
subject of litigation by our Bell company competitors and other incumbent local
exchange carriers. We are dependent upon use of UNE-P for approximately 95% of
our revenue. In 2003, in the Triennial Review Order,the Federal Communications Commission
(FCC) ruled that entrants like Z-Tel would be able to purchase analog
switching and dedicated transport on an unbundled basis, subject to
state-by-state review of whether such unbundling was needed in their states.
While those state-by-state proceedings were taking place, on March 2, 2004, the
D.C. Circuit Court of Appeals overturned the FCCs decision as an improper
delegation of authority to state public utility commissions. SeeReport and
Order and Order on Remand and Further Notice of Proposed Rulemaking, Review of
Section 251 Unbundling Obligations of Incumbent Local Exchange Carriers, 18 FCC
Rcd 16978 (2003) (Triennial Review Order), revd in part and remanded, United
States Telecom Assn v. FCC, Nos. 00-1012, 00-1015, 03-1310 et al.(D.C. Cir.
March 2, 2004) (USTA II). The D.C. Circuit ordered that the unbundled
switching and transport rules be vacated the later of sixty days or upon denial
of a petition for rehearing, whichever is later. A majority of the FCC has
indicated it will support an appeal of this decision. Z-Tel is weighing its
legal options with regard to this opinion, as are other competitive carriers.
If the USTA IIdecision is not stayed or reversed, it could have immediate,
significant, adverse and material impact upon our business, and ILECs might
utilize the reversal of the unbundling rules to deny us access to their local
networks. We depend upon such access to provide our services to our
customers. We believe that in the event the rules are vacated without any
replacement by either the FCC or the state commissions, we have interconnection
agreements with our principal incumbent local telephone company suppliers
(including Verizon, SBC, BellSouth and Qwest) that will permit us to continue
to obtain access to local network elements during any intervening time period.
However, it is possible that any or all of those incumbent local telephone
company suppliers will refuse to abide by the terms of those agreements or
terminate those agreements. Z-Tel is currently evaluating all of its legal
options to ensure that we can continue to meet the needs of our existing and
future customers. See section entitled Risks Relating to Our Financial
Condition and Our Business. With regard to pricing, states and the FCC are currently re-evaluating the
pricing of network elements. As a result, it is possible that prices in some
states could increase or lower rates from existing levels. Currently, the
incumbent local exchange carriers Verizon, BellSouth, SBC and Qwest have rate
cases pending before state regulatory commissions in at least one state in each
of their respective territories. In particular, ongoing rate cases in Illinois,
Ohio and Michigan could significantly raise the existing rates for
some network elements and network element combinations. Our intent is to be an
active participant in many of these rate cases and any others that might be
critical to our operations. We anticipate joining other competitive service
providers in arguing that existing rates and rates proposed by the incumbents
are overstated and do not reflect the true total element long run incremental
costing principles required by the FCC and the Telecommunications Act. The FCC,
in Docket No. 03-173 is currently reevaluating its prescribed methodology for
calculating unbundled network element rates. In the 2002 Verizon v. FCC
decision, the U.S. Supreme Court affirmed the FCCs current pricing
methodology, called Total Element Long Run Incremental Cost, or 6




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TELRIC. The current FCC rulemaking proposes to modify the TELRIC methodology
by mandating that states set prices based upon the forward-looking costs of
operating the existing network architecture of incumbent local telephone
company networks. In many instances, modifying the TELRIC methodology in this
way could increase the rates we pay for certain elements and result in lower
rates for other elements. We believe that the FCCs proposals to modify TELRIC
are inconsistent with the Supreme Courts decision in the Verizoncase, meaning
that new FCC TELRIC rules may be subject to considerable litigation if they are
adopted. While the prevailing productivity trends within the industry would predict the
adoption of lower rates in association with the provision of unbundled network
elements and network element combinations, we cannot predict the outcome of any
pending or potential rate case or judicial proceeding. Increases or decreases
in rate levels charged by incumbent local exchange carriers as a result of
regulatory and/or judicial review through rate case, court case or arbitration
proceedings could significantly impact our business plans. FEDERAL REGULATION FCC Policy on Enhanced, Information Services and Internet Protocol-Enabled
Services (such as Voice over Internet Protocol) On March 10, 2004, the FCC released a Notice of Proposed Rulemaking that seeks
to establish a comprehensive regulatory framework for Internet
Protocol-Enabled Services, or IP-Enabled Services. IP-Enabled Services
include Voice over Internet Protocol services and other services that Z-Tel
intends to deploy or may in the future deploy. The FCC proposed that
IP-Enabled Services be subject to limited regulation and that inconsistent
state and local regulation would be preempted. Under the FCCs proposal, the
regulation that survives would be tied to the particular functionality offered
by the service provider. For example, the application of emergency 9-1-1
services may be different for dial tone-like services than for the voice
capabilities of interactive computer games. The FCC IP-Enabled Services proceeding builds upon several decades of precedent
in which the FCC has largely sought to wall-off from regulation certain
enhanced or information services. In 1980, the FCC created a distinction
between basic telecommunications services, which it regulates as common
carrier services, and enhanced services, which remain unregulated. The FCC
exempted enhanced service providers from federal regulations governing common
carriers, including the obligation to pay access charges for the origination or
termination of calls on carrier networks and the obligation to contribute to
the universal service fund. The Telecommunications Act of 1996 established a
similar distinction between telecommunications services and information
services. The distinction between information services and common carrier services is
important in many respects. Federal (tariffs), state (certification
requirements) and even local regulation (franchise or rights of way fees) apply
to common carrier services but not necessarily all information services.
Under FCC rules, interstate common carriers must contribute a percentage of
revenue to federal universal service support systems; information service
providers do not make such a contribution. At the same time, common carriers
are granted certain rights that information service providers do not
have  for
example, only common carriers have the ability to colocate equipment and
purchase unbundled network elements from incumbent local telephone companies
pursuant to Section 251 of the Telecommunications Act. Interexchange common carriers (e.g.,
long-distance providers) generally have to pay access charges to local
exchange companies for long-distance calls that originate or terminate on a
local exchange carriers local network. Information service providers (such as
an Internet service provider) do not pay these access charges when their
customers utilize local exchange carrier networks to utilize the information
service providers service. As discussed above, since Z-Tel offers both common
carrier and information services to its customers, these distinctions have an
important impact upon our business. Changing technology and changing market conditions, however, sometimes make it
difficult to discern the boundary between unregulated and regulated services.
In particular, the ability to place and route voice communications over
information service provider networks (e.g. the Internet) has called into
question the FCCs common carrier/information service provider distinction. In
1998, the FCC outlined in a Report to Congressits belief that voice over
Internet services should be classified and regulated, if at all, on a
case-by-case basis. Since that report, several companies have filed petitions
seeking declarations from the FCC as to the regulatory status of VoIP services.
In February 2004, the FCC ruled that Pulver.coms Free World Dialup service
was an information service and not a regulated common carrier service
because Free World Dialup did not offer its users the ability to transmit calls
for a fee. Currently pending before the FCC is a petition by AT&T requesting
that certain of its long-distance services that utilize IP technology be
regulated as an information service, and therefore not be subject to pay access
charges to local exchange carriers. Also pending before the FCC is a petition
by Level(3) Communications that seeks forbearance of certain access charge
rules that have certain of Level(3)s IP-enabled services pay local termination
rates rather than interstate access charges. In general, information services are value-added services that use regulated
transmission facilities only as part of a service package that also includes
network or computer software to change or enhance the information transmitted.
We believe that most of the enhanced features we provide, including voice mail,
Find-Me notification, and directory services, are information services under
the FCCs definition. Because the regulatory boundaries in this area are
somewhat unclear and subject to dispute, however, the FCC could seek to
characterize some of our information services as telecommunications services
or subject them to certain types 7




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of regulation applicable to common carrier telecommunications services. If
that happens, those services would become subject to FCC regulation, although
the impact of that reclassification is difficult to predict. In addition, certain of Z-Tels planned VoIP-based services could be classified
as information services in a way that could potentially limit our ability to
access the local networks of incumbent local telephone companies. As described
above, only common carriers have rights to colocate or purchase unbundled
network elements from incumbent local telephone companies. It is unclear how
or when the FCC IP-Enabled Services proceeding will conclude. On February 14, 2002, the FCC adopted a Notice of Proposed Rulemaking in CC
Docket No. 02-42 that proposed to classify ILEC wireline broadband Internet
access services as information services and regulate the provision of such
services pursuant to Title I of the Communications Act of 1934. In addition,
the FCC sought comment on its Computer II/Computer IIIrules, which govern
access to incumbent networks by third parties to provide information services.
The proposed rules could, if adopted without adequate assurances for
competitive access, limit the ability of new entrants to access and utilize the
networks of incumbent local exchange carriers to provide advanced, broadband
Internet access and could therefore harm Z-Tels ability to provide services to
its customers. FCC Regulation of Common Carrier Services In general, the FCC does not regulate the rates, services, and market entry and
exit of non-dominant telecommunications carriers, but does require them to
contribute to universal service and comply with other regulatory requirements.
We are currently regulated as a non-dominant carrier with respect to both our
local and long distance telephone services. As a result, we currently are not subject to rate of return regulation at the
federal level and are not currently required to obtain FCC authorization for
the installation, acquisition or operation of our domestic exchange or
interexchange network facilities. However, we must comply with the requirements
of common carriage under the Communications Act of 1934. We are subject to the
general requirement that our charges and terms for our telecommunications
services be just and reasonable and that we not make any unjust or
unreasonable discrimination in our charges or terms. The FCC has jurisdiction
to act upon complaints against any common carrier for failure to comply with
its statutory obligations. We are also subject to FCC rules that limit our
ability to discontinue providing certain interstate services; however, the FCC
has implemented a process that generally permits a company to discontinue such
interstate services on an expedited basis. Comprehensive amendments to the Communications Act of 1934 were made by the
Telecommunications Act of 1996, which was signed into law on February 8, 1996.
The Telecommunications Act effected changes in regulation at both the federal
and state levels that affect virtually every segment of the telecommunications
industry. The stated purpose of the Telecommunications Act is to promote
competition in all areas of telecommunications. Interconnection and Unbundling Requirements.The Telecommunications Act greatly
expands the interconnection requirements applicable to the incumbent local
exchange carriers, i.e., generally, those existing local exchange carriers
that, in the past, enjoyed virtual or legal monopoly status. The
Telecommunications Act requires the incumbent local exchange carriers
in connection with common carriers to   
    
    provide physical colocation, which allows companies such as us and
other competitive local exchange carriers to install and maintain our
own network termination equipment in incumbent local exchange carrier
central offices or, if requested or if physical colocation is
demonstrated to be technically infeasible, virtual colocation;  
    
    offer components of their local service networks on an unbundled
basis so that other providers of local service can use these elements in
their networks to provide a wide range of local services to customers;
and  
    
    establish wholesale rates for their services to promote resale by
competitive local exchange carriers. In addition, all local exchange carriers must   
    
    interconnect with the facilities of other carriers;  
    
    establish number portability, which will allow customers to retain
their existing phone numbers if they switch from the local exchange
carrier to a competitive local service provider;  
    
    provide nondiscriminatory access to telephone poles, ducts, conduits
and rights-of-way; and 8




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
    
    compensate other local exchange carriers on a reciprocal basis for
traffic originated by one local exchange carrier and terminated by
another local exchange carrier. The FCC is charged with establishing national guidelines to implement certain
portions of the Telecommunications Act. The FCCs implementation of those
provisions of the Act has been the subject of ongoing litigation that continues
to this day. The litigation has focused upon two fundamental issues presented
by the Act: the parts of the incumbent telephone networks that companies like
Z-Tel can purchase on an unbundled basis, and the price such companies pays for
those network elements. This section provides a history of that litigation and
the risks that this ongoing litigation presents to us. The FCC issued its first interconnection order on August 8, 1996. The FCC
addressed both the unbundled access and pricing rules in this proceeding. In
particular, among other decisions, the FCC established a list of seven network
elements, comprising most of the significant facilities, features,
functionalities, or capabilities of the network that the incumbent local
exchange carriers must unbundle. It is possible for competitors to provide
competitive local exchange service using only these unbundled network elements,
by means of a combination that later became known as the Unbundled Network
Element Platform, or UNE-P. In addition, the FCC mandated a particular forward
looking pricing methodology for these network elements that produces relatively
low element prices that are favorable to competitors. Incumbent local telephone companies and state commissions appealed the FCCs
1996 Order to the United States Court of Appeals for the Eighth Circuit. In
general, the Eighth Circuit addressed the FCCs pricing rules separately from
the network access rules. On July 18, 1997, the Eighth Circuit issued a
decision vacating the FCCs pricing rules, as well as certain other portions of
the FCCs interconnection rules, on the grounds that the FCC had improperly
intruded into matters reserved for state jurisdiction. On January 25, 1999, the
Supreme Court, in AT&T Corp. v Iowa Utilities Board, largely reversed the
Eighth Circuits holding that the FCC has general jurisdiction to
implement the local competition provisions of the Telecommunications Act. In so
doing, the Supreme Court stated that the FCC has authority to set pricing
guidelines for unbundled network elements, to prevent incumbent local exchange
carriers from physically separating existing combinations of network elements,
and to establish pick and choose rules regarding interconnection agreements.
Pick and choose rules permit a carrier seeking interconnection to pick and
choose among the terms of service from other interconnection agreements between
the incumbent local exchange carriers and other competitive local exchange
carriers. This Supreme Court action reestablished the validity of many of the
FCC rules vacated by the Eighth Circuit. Although the Supreme Court affirmed the FCCs authority to develop pricing
guidelines, the Supreme Court did not evaluate the specific forward-looking
pricing methodology mandated by the FCC and remanded the case to the Eighth
Circuit for further consideration. Some incumbent local exchange carriers
argued that this pricing methodology does not allow adequate compensation for
the provision of unbundled network elements. The Eighth Circuit upheld the
FCCs use of forward-looking incremental costs as the basis for establishing
rates for interconnection and unbundled network elements. The Eighth Circuit
further agreed with the FCCs interpretation of the Telecommunications Act as
rejecting historical costs as the basis for setting rates. However, the
Eighth Circuit vacated the FCCs regulation, codified at 47 C.F.R. Sec.
51.505(b), setting forth the FCCs approach to computing forward-looking
incremental costs, and directed the FCC to review its approach so that it is
based on the costs incurred by the incumbent local exchange carrier to provide
the actual facilities and equipment that will be used by the requesting carrier
instead of the lowest cost based on the most efficient technologies currently
available. In 2001, the United States Supreme Court granted a writ of
certiorari to the Eighth Circuit decision, and in 2002, the Supreme Court
upheld the FCCs pricing rules. Court consideration of the unbundled access rules followed a parallel track.
In its January 25, 1999 AT&T Corp. v. Iowa Utilities Boardruling, the Supreme
Court also remanded the list of unbundled network elements to the FCC for
further consideration of the necessity of each one under the Telecommunications
Acts statutory standard for unbundling. On November 5, 1999, the FCC released
an order (referred to as the UNE Remand Order)that retained many of its
original list of unbundled network elements, but providing further explanation
of the need for such unbundling and eliminated the requirement that incumbent
local exchange carriers provide unbundled access to operator services and
directory assistance and limiting unbundled access to local switching in
certain geographic areas. With regard to operator services and directory
assistance, the FCC concluded that the market has developed since 1996 such
that competitors can and do self-provision these services, or acquire them from
alternative sources. The FCC also noted that incumbent local exchange carriers
remain obligated under the non-discrimination requirements of the
Communications Act of 1934 to comply with the reasonable request of a carrier
that purchases these services from the incumbent local exchange carriers to
rebrand or unbrand those services, and to provide directory assistance listings
and updates in daily electronic batch files. With regard to unbundled local
switching, the FCC concluded that, notwithstanding the incumbent local exchange
carriers general duty to provide unbundled local circuit switching, an
incumbent local exchange carrier is not required to unbundle local circuit
switching for competitors in connection with end-users having four or more
lines in certain high population density locations within the top 50
Metropolitan Statistical Areas, provided that the incumbent local exchange
carrier provides nondiscriminatory access to combinations of unbundled loops
and transport (also known as Enhanced Extended Links or EELs) throughout the
high density area. For operator services and directory assistance, as well as
for unbundled local switching, the FCC noted that the competitive checklist
contained in Section 271 of the Communications Act of 1934 requires Bell
operating companies to provide nondiscriminatory access to these services.
Thus, Bell operating companies must continue to provide these services to
competitors; however, Bell operating companies may charge different rates for
these offerings. 9




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The FCCs 1999 UNE Remand Orderwas appealed by several parties to the United
States Court of Appeals for the D.C. Circuit, including incumbent local
exchange carriers, USTA v. FCC. In addition, competitive carriers sought
reconsideration of that decision, including the FCCs limitation on the
availability of unbundled local switching, before the FCC. While that appeal
was pending, the FCC, on December 20, 2001, released a Notice of Proposed
Rulemaking in CC Dockets No. 01-338, 96-98 and 98-147 as part of its
comprehensive Triennial Review of the 1999 UNE Remand Order. The FCC
proposed to reexamine the availability of all unbundled network elements and to
analyze that availability on a more specific basis. The FCC issued
its Triennial Review order in September 2003. While the Triennial Review proceeding was pending before the FCC, the D.C.
Circuit ruled in the USTAappeal of the 1999 UNE Remand Order.The D.C. Circuit
reversed the UNE Remand Orderon the courts belief that the FCC had not taken
into sufficient account the availability of substitutes for unbundled network
elements from outside incumbent local telephone networks. The court called
upon the FCC to engage in a detailed granular review as to whether any
particular network element should be unbundled, based upon a specific analysis
as to whether competitors could obtain comparable elements from other sources
or whether a network element possessed natural monopoly characteristics. In
addition, the D.C. Circuit required that the FCC balance the benefits of
unbundling for competitors and consumers against the costs that unbundling
might impose upon incumbent local telephone companies. Competitors filed for
review of the USTAdecision before the United States Supreme Court, but the
U.S. Government and the FCC opposed that review, noting that while the
Government and FCC believed that the USTAdecision was inconsistent with the
1996 Act and the Supreme Courts Verizondecision, the proper course of action
would be for the FCC to complete its already-pending Triennial Review
rulemaking first. The Supreme Court denied the competitors request for an
appeal. In September 2003, the FCC released its final decision in the Triennial Review
proceeding. In the Triennial Review Order,the FCC also ruled that entrants
would no longer be able to access network elements utilized by incumbent local
telephone companies to provide broadband services, such as
fiber-to-the-premises loops, high-capacity (OCx) transport, packet switching,
line-sharing for DSL services, and fiber-fed next-generation digital loop
carrier (NGDLC) loops. These limitations on unbundled access could have a
significant impact upon our business; if incumbent carriers deploy
next-generation architectures as a replacement for their existing local plant,
there is the significant possibility that our ability to provide services to
our customers will be eliminated or severely restricted in such situations.
The FCC did reaffirm incumbent local telephone company obligations to provide
unbundled access to Enhanced Extended Links (EELs, a combination of loop and
transport) and the Unbundled Network Element Platform (UNE-P) combination in
particular circumstances, subject to review by state public utility
commissions. In particular, the FCC ruled that entrants like Z-Tel would be
able to purchase dedicated transport (utilized in EELs) and analog switching
(utilized in UNE-P) on an unbundled basis, subject to state-by-state review of
whether such unbundling was needed in their states. Carriers were involved in those state-by-state proceedings when, on March 2,
2004, the D.C. Circuit Court of Appeals overturned the FCCs decision as an
improper delegation of authority to state public utility commissions. See
Report and Order and Order on Remand and Further Notice of Proposed Rulemaking,
Review of Section 251 Unbundling Obligations of Incumbent Local Exchange
Carriers, 18 FCC Rcd 16978 (2003) (Triennial Review Order), revd in part and
remanded, United States Telecom Assn v. FCC, Nos. 00-1012, 00-1015, 03-1310 et
al.(D.C. Cir. March 2, 2004) (USTA II). The D.C. Circuit ordered that the
unbundled transport and switching rules be vacated after sixty days or upon
denial of a petition for rehearing, whichever occurs later. A majority of the
FCC has indicated that it will support an appeal of this decision. Z-Tel is
weighing its legal options with regard to this opinion, as are other
competitive carriers. If the USTA IIdecision is not stayed or reversed, it
could have immediate, significant, adverse and material impact upon our
business. For example, ILECs might utilize the reversal of the unbundling
rules to deny us access to their local networks. We depend upon such access to
provide our services to our customers. See section of this report entitled
Risks Relating to Our Financial Condition and Our Business. We believe that in the event the rules are vacated without any replacement by
either the FCC or the state utility commissions, we have interconnection
agreements with our principal ILEC vendors that will permit us to continue to
obtain access to local network elements during any intervening time period.
However, it is possible that any or all of those ILECs will refuse to abide by
the terms of those agreements or seek to terminate those agreements. We are
evaluating our legal options to ensure that we continue to meet the needs of
our existing and future customers. Other pending matters before the FCC also could impact our business. In
particular, on December 20, 2001, the FCC issued a Notice of Proposed
Rulemaking in CC Docket No. 01-337 in which the FCC sought comment on
regulatory requirements for incumbent local exchange carrier provision of
broadband telecommunications services. In this proceeding, the FCC is
considering whether it should remove regulatory safeguards and common carrier
obligations, including unbundling regulations, on incumbent local exchange
carrier broadband networks. An FCC decision limiting unbundling or deregulating
incumbent local exchange carrier broadband networks could have a significant
and material adverse impact on our business. For example, incumbent local
exchange carriers may be able to offer consumers deregulated broadband network
packages of local exchange, information 10




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services and broadband service (such as DSL) that Z-Tel would not be able to
offer because Z-Tel would not have unbundled access to that broadband network.
In addition, because the incumbent local exchange carrier broadband network
in most instances utilizes the same network facilities as the current incumbent
local exchange dial tone network, limitations on unbundling or deregulation of
that broadband network could make it difficult, more costly, or even
impossible for Z-Tel to provide its current telecommunications and information
services to consumers. These and other FCC determinations are likely to be the subject of further
appeals or reconsideration. Thus, while the Supreme Court has resolved many
issues, including aspects of the FCCs jurisdictional authority, other issues
remain subject to further consideration by the courts and the FCC. We cannot
predict the ultimate disposition of these matters. Interconnection Agreements.The Telecommunications Act obligates incumbent
local exchange carriers to negotiate with us in good faith to enter into
interconnection agreements. Competitive local exchange carriers like us can
purchase unbundled network elements under such an agreement or under a tariff
or a Statement of Generally Available Terms filed with the state regulators.
Interconnection agreements are the principal means of obtaining access to the
incumbent local exchange carriers unbundled network elements
and providing the connectivity to our network necessary to provision local exchange services,
including Z-LineHOME. To this end, we have entered into interconnection
agreements with the Bell operating company in all states where we currently
offer local exchange services. To ensure that it obtains interconnection and unbundled access at the
best-available terms, Z-Tel currently is reviewing available contracts or
negotiating new contracts in a number of states. However, at any point in time
our interconnection agreement may not contain the best-available terms offered
to our competitors, a situation that could adversely affect our ability to
compete in the market. In addition, several of our interconnection agreements
with Verizon, SBC and BellSouth have expired. However, the terms of those
contracts provide for the agreements to continue on a month-to-month basis
until a replacement is executed. Section 252 of the Telecommunications Act of 1996 contains a specific process
for negotiating and arbitrating interconnection agreements with incumbent local
telephone companies. If we cannot reach a voluntary interconnection agreement
with an incumbent local exchange carrier on acceptable terms, either side may
petition the applicable state commission to arbitrate remaining disagreements.
These arbitration proceedings can last for a substantial period of time and can
require substantial resources to litigate. Moreover, state commission approval
of any interconnection agreement resulting from negotiation or arbitration is
required, and any party may appeal an adverse decision by the state commission
to federal district court. The incentive of the incumbent local exchange
carrier to negotiate fair or proper interconnection agreement terms is a
function of the willingness and authority of state commissions and the FCC to
enforce rules and policies promulgated under the Telecommunications Act. The
potential cost in resources and delay from this interconnection agreement
negotiation and arbitration process could harm our ability to compete in
certain markets, and there is no guarantee that a state commission would
resolve disputes, including pricing disputes, in our favor. The ability of a new entrant like Z-Tel to enforce interconnection agreements
with incumbent local exchange carriers or appeal state commission arbitrations
regarding such agreements is currently subject to considerable legal
uncertainty. A January 2002 decision by the United States Circuit Court for the
Eleventh Circuit ruled that the Georgia state commission did not have authority
to enforce interconnection agreements between incumbent local exchange carriers
and new entrants. This decision is in apparent conflict with decisions by other
United States Circuit Courts. As a result of this decision, our costs
associated with litigating enforcement of interconnection agreements in state
or federal courts in the Eleventh Circuit and elsewhere could substantially
increase. A November 2003 decision by the United States Circuit Court for the
Fifth Circuit ruled that state commission jurisdiction to arbitrate terms and
conditions of access pursuant to section 252 may relate only to items
specifically-related to section 251 of the 1996 Act and other items voluntarily
negotiated by the parties. That decision could limit our ability to arbitrate
acceptable interconnection terms with incumbent local telephone companies
before state commissions; at the same time, that decision could enhance our
ability to resist inclusion of clauses in our contracts by those incumbents
that we deem unacceptable. Colocation.The FCC has adopted rules designed to make it easier and less
expensive for competitive local exchange carriers to colocate equipment at
incumbent local exchange carriers central offices by, among other things,
restricting the incumbent local exchange carriers ability to prevent certain
types of equipment from being colocated and requiring incumbent local exchange
carriers to offer alternative colocation arrangements. Restrictions and
impediments to colocation could harm our business as they make it more
difficult if not impossible for us to obtain alternatives to unbundled network
elements we purchase from incumbent local exchange carriers. On March 17, 2000, the United States Court of Appeals for the District of
Columbia Circuit vacated portions of the FCCs colocation rules. Specifically,
the court found that the FCCs interpretations of the statutory terms
necessary and physical colocation were impermissibly broad, and remanded
those portions of the order to the FCC for reconsideration. On August 8, 2001,
the FCC released an order on remand in response to this D.C. Circuit decision
in CC Docket 98-147. The FCC decided that competitors may colocate equipment in
incumbent local exchange carrier central offices if the competitor, as a
practical, economic or operational matter would be precluded form obtaining
equal in quality interconnection or nondiscriminatory access to unbundled
network elements. The FCC limited which multi-functional equipment competitors
may colocate. The FCC also 11




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decided that incumbent local exchange carriers must comply with reasonable
requests for competitors to install and maintain cross-connections with
colocated equipment of other competitors. The FCC also decided that incumbent
local exchange carriers may decide where colocated equipment may be placed
within its premises as long as the incumbent local exchange carrier acts
reasonably and non-discriminatorily. The FCC also determined that except in
limited circumstances, an incumbent local exchange carrier may separate the
space colocators. The FCCs new colocation rules could increase the cost and
time for competitors to colocate equipment in incumbent local exchange carrier
central offices and could have a substantial and material impact on Z-Tels
future business prospects. This FCC Colocation Remand Order is currently on
appeal to the D.C. Circuit. The outcome of that subsequent appeal is uncertain
and could impact Z-Tels business. Line Sharing and Line Splitting. On November 18, 1999, the FCC adopted an
order requiring incumbent local exchange carriers to provide line sharing,
which is a method in which a competitive local exchange carrier offers data
services over the same line that a consumer uses for voice services without the
competitive local exchange carriers having to provide the voice service. In an
Order on Reconsideration, issued January 19, 2001, the FCC reaffirmed its prior
decision to support line sharing for provision of digital subscriber line (DSL)
services. In addition, in this January 19, 2001 decision, the FCC stated that
incumbent local exchange carriers must permit competitive local exchange
carriers to engage in line splitting arrangements, where a competitive local
exchange carrier provides voice and another provides data service to end-users
over a split loop purchased as an unbundled network element from the
incumbent local exchange carrier. While we expect that the FCCs rules will be
beneficial to competitive local exchange carriers, we cannot be certain that
these rules will be implemented by the incumbent local exchange carrier in a
timely or favorable manner. As a result, Z-Tels ability to offer its customers
DSL service and voice service by use of line-splitting and the unbundled
network element platform combination is restricted significantly by incumbent
local exchange carriers. That restriction could harm our business and our
ability to match the service packages and bundles offered by our competitors.
Moreover, in light of the FCCs Further Notice of Proposed Rulemaking issued in
conjunction with its January 19, 2001 Order on Reconsideration, several key
issues regarding line sharing, including the provision of line sharing in
instances where loop facilities have fiber components and where remote
terminals do not have sufficient space for colocation, remain. Any decision by the FCC in these proceedings could limit Z-Tels unbundled
access to the incumbent local exchange carrier networks in a manner that could
have a substantial and material impact on our current or future business. Bell Operating Company Entry into the Long Distance Market.The
Telecommunications Act permitted the Bell operating companies to provide long
distance services outside their local service regions immediately, and permits
them to provide in-region long distance service upon demonstrating to the FCC
that they have adhered to the Telecommunication Acts Section 271 14-point
competitive checklist. The FCC must also find that granting the application
would be in the public interest. As of this writing, Bell companies had
received long-distance authority in all 48 states within the continental U.S.
Z-Tel is currently appealing the FCCs grant of authority to SBC/Ameritech for
Illinois, Wisconsin, Indiana and Ohio on the basis that SBCs application and
the FCCs approval was predicated upon the availability of UNE-P and the
availability of unbundled switching throughout all of those states. Z-Tels
appeal is pending before the D.C. Circuit and consideration of that appeal is
currently being held in abeyance, at Z-Tels request, pending resolution of the
USTA IIdecision. Now that the D.C. Circuit has ruled in USTA II, we expect
that our appeal of the SBC/Ameritech Section 271 authorizations will proceed
expeditiously. Z-Tel believes that because the D.C. Circuit vacated the FCCs
unbundled local switching rules in USTA II, the D.C. Circuit should reverse the
FCCs grant of long-distance authority to SBC/Ameritech in these states, as the
FCCs grant was predicated upon the availability of unbundled local switching
to entrants in those states. With Bell operating companies authorized to provide long-distance service
nationwide, it is generally expected that competition for Z-Tels local and
long-distance services will increase. Section 271 entry permits the Bell
operating company to offer a bundle of local, long-distance and enhanced
services comparable to Z-Tels services and therefore could increase
competition and harm our business, especially if we cannot obtain adequate
access to unbundled network elements from that same Bell operating company. At the same time, the Section 271 process also provides an important ongoing
incentive for Bell operating companies to comply with the unbundling and
interconnection requirements of the Telecommunications Act. The section 271
competitive checklist specifically requires Bell companies to provide
competitors access to loop transmission, switching, transport and
signaling. In the Triennial Review Order, the FCC ruled that these section
271 checklist requirements were independent legal obligations with which Bell
companies must comply, regardless of the status of the unbundling rules under
section 251. In the USTA IIdecision, the D.C. Circuit characterized this
independent legal obligation as a reasonable approach. We will vigorously
enforce its rights to access to Bell company networks pursuant to the
independent legal authority that the section 271 checklist requires. Universal Service.In May 1997, the FCC released an order establishing a
significantly expanded universal service regime to subsidize the cost of
telecommunications service to high cost areas, as well as to low-income
customers and qualifying schools, libraries and rural health care providers.
Providers of interstate telecommunications services, like us, as well as
certain other entities, must pay for these programs. We are also eligible to
receive funding from these programs if we meet certain requirements. 12




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Our share of the payments into these subsidy funds is based on our share of certain
defined interstate telecommunications end-user
revenues. Currently, the FCC is assessing such payments on the basis of a
providers revenue for the previous year. The FCC adjusts payment requirements
and levels periodically. Various states are also in the process of implementing
their own universal service programs. We are currently unable to quantify the
amount of subsidy payments that we will be required to make to individual
states. On July 30, 1999, the United States Court of Appeals for the Fifth Circuit
overturned certain of the FCCs rules governing the basis on which the FCC
collects subsidy payments from telecommunications carriers and recovery of
those payments by incumbent local exchange carriers. In October 1999, on
remand, the FCC issued new universal service rules. Other changes to
the universal service program could affect our costs. The FCC rules are pending review before the Fifth Circuit. The outcome of that
litigation and subsequent and forthcoming FCC and state determinations could
adversely impact or delay our ability to obtain universal service funding for
our services or our ability to compete with carriers that do obtain such
funding. The FCC is also seeking comment on how to assess and collect funds
from carriers to support the universal service system. Changes to this support
program could adversely affect our costs, our ability to separately-list these
charges on end-user bills, and our ability to collect these fees from our
customers. Interstate Tariffs and Rates.Beginning July 31, 2001, interstate domestic long
distance companies were no longer allowed to file interstate long-distance
end-user tariffs with the FCC. This regulatory change requires that Z-Tel
make its long-distance service information directly available to customers
pursuant to private contracts. In March 1999, the FCC adopted rules that
require interexchange (long distance) carriers like Z-Tel to make specific
disclosures on their web sites of their rates, terms and conditions for
domestic interstate services. On April 27, 2001, the FCC limited the ability of nondominant, competitive
local exchange carriers, including Z-Tel, to file tariffs for interstate
switched access services. In doing so, the FCC effectively regulates the rates
Z-Tel charges long-distance companies for interstate switched access services.
Local exchange carriers (like Z-Tel) provide interstate switched access
services to interexchange long-distance companies (like AT&T, MCI and Sprint,
as well as Z-Tel) when a state-to-state long distance call is made to or placed
by a local telephone customer. Given the large number of interstate
long-distance companies, these interstate switched access services are provided
generally through FCC interstate tariffs. Prior to this April 27, 2001
decision, the FCC had refrained from any price regulation of the interstate
access rates of competitive local exchange companies like Z-Tel. With the April
27, 2001 Report and Order in CC Docket No. 96-262, the FCC ruled that it would
not accept for filing any interstate switched access tariff filing by a
competitive local exchange carrier if the per-minute rate exceeded an FCC
benchmark. The FCC benchmark varies by metropolitan statistical area. In
metropolitan statistical areas (MSAs) that a competitive local exchange
carrier began to provide service after June 20, 2001 (the effective date of the
Order), the FCC benchmark rate is the interstate switched access rate for the
competing incumbent local exchange carrier, which is established pursuant to
publicly-filed tariffs before the FCC. For MSAs in which a carrier was
providing local service as of June 20, 2001, the FCC benchmark rate from
June 20, 2001 through June 19, 2002 was 2.5 cents per minute or the competing
incumbent local exchange carrier rate, whichever is higher. For those same
MSAs, the FCC benchmark rate from June 20, 2002 through June 19, 2003 was 1.8
cents per minute or the competing incumbent local exchange carrier rate,
whichever is higher. For those same MSAs, the FCC benchmark rate from June 20,
2003 through June 19, 2004 is 1.2 cents per minute or the competing incumbent
local exchange carrier rate, whichever is higher. Beginning on June 20, 2004,
the FCC benchmark rate for those MSAs will be the switched access rate of the
competing incumbent local exchange carrier. As of June 20, 2001, Z-Tel was
providing local service in most of the MSAs in its current footprint; as a
result, the FCC benchmark rates for Z-Tels interstate switched access charges
in those MSAs will, through June 20, 2004, be considerably higher than the FCC
benchmark rate for Z-Tels competitors that began to provide service in those
MSAs after June 20, 2001. AT&T and Sprint have appealed the FCCs April 2001 CLEC Access Charge Order
before the United States Circuit Court for the District of Columbia, arguing
that the FCCs benchmark rates are too high and that competitive local exchange
carriers like Z-Tel should be required to provide interstate switched access
services at the competing incumbent local exchange carrier rate immediately.
Z-Tel has intervened in that court proceeding against those long-distance
companies. Two competitive local exchange carriers have also appealed the FCC
decision, and several competitive carriers have sought reconsideration or
clarification of the FCCs decision. In addition, Z-Tel has sought a waiver of
FCC rules requiring it to tariff interstate switched access services at the
competing incumbent local exchange carrier rate for several dozen smaller MSAs
that Z-Tel did not have any local subscribers in as of June 20, 2001, arguing
to the FCC that the cost to Z-Tel to provide interstate switched access
services at two different rate levels in the same state would impose
unnecessary costs on Z-Tel that is inconsistent with the public interest. These
appeals, reconsiderations, and the waiver request are all pending. The outcome
of any of these determinations could have a significant and material impact on
Z-Tels business. In 2001, Z-Tel settled pending litigation with AT&T and Sprint over their
nonpayment of access charges to Z-Tel. Z-Tel provides interstate and intrastate
switched access services to both of those long-distance carriers pursuant to
switched access service 13




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agreements. Based on history of nonpayment of both of
these long-distance carriers to Z-Tel, there is a risk that either or both of
these long-distance companies could fail to pay Z-Tel for switched access
services. While Z-Tel has in the past and will in the future adamantly litigate
and defend its position against these carriers, nonpayment could have a
substantial and material adverse impact on our business. Numbering and Number Portability.In August 1997, the FCC issued rules
transferring responsibility for administering and assigning local telephone
numbers from the Bell operating companies and other incumbent local exchange
carriers to a neutral entity in each geographic region in the United States. In
August 1996, the FCC issued new numbering regulations that prohibit states from
creating new area codes that could unfairly hinder competitive local exchange
carriers by requiring their customers to use 10 digit dialing while existing
incumbent local exchange carrier customers use seven digit dialing. In
addition, each carrier is required to contribute to the cost of numbering
administration through a formula based on net telecommunications revenues.
Beginning in March 2000, contributions for this purpose were based on end-user
telecommunications revenues and have been submitted in association with FCC
Lifeline, Universal Service and the Schools and Libraries Funds. In July 1996, the FCC released rules requiring all local exchange carriers to
have the capability to permit both residential and business consumers to retain
their telephone numbers when switching from one local service provider to
another, known as number portability. Number portability has been implemented
in most of the areas in which we provide service, but has not been implemented
everywhere in the United States. Some carriers have obtained waivers of the
requirement to provide number portability, and others have delayed
implementation by obtaining extensions of time before compliance is required.
Lack of number portability in a given market could adversely affect our ability
to attract customers for our competitive local exchange service offerings,
particularly business customers, should we seek to provide services to such
customers in those markets. In 2003, the FCC established number portability
rules for wireless carriers that require landline telephone companies to port
numbers to customers wireless services. Wireless number portability has been
implemented in most major U.S. metropolitan areas and FCC rules require that it
be implemented nationwide. The FCC has also proposed rules that would require
wireless carriers to port numbers to landline carriers like Z-Tel. If the
FCC does not implement congruent porting rules on wireless carriers that are
currently applicable to landline carriers, our ability to compete with wireless
carriers in providing bundles or packages of wireline and wireless services
could be adversely affected. In May 1999, the FCC also initiated a proceeding to address the problem of the
declining availability of area codes and phone numbers. On December 29, 2000,
the FCC issued a Further Notice of Proposed Rulemaking in CC Dockets No. 96-98
and 99-200 that proposed adoption of a market-based approach for optimizing
number resources. In that Further Notice the FCC seeks input on its tentative
conclusion that, through the introduction of charges associated with the
allocation of number resources, carriers might be better incentivized to take
and retain only as many numbers as they need. If a market-based approach to
number allocation is introduced, as the FCC has proposed, it could result in
added administrative expenses for us. Restrictions on Bundling.Current FCC rules prohibit dominant carriers from
bundling their non-competitive regulated telecommunications services with their
unregulated enhanced or information services. To our knowledge, the FCC has not
enforced this rule with respect to competitive local exchange carriers and has
proposed eliminating the rule for all carriers. Slamming.A customers choice of local or long distance telecommunications
company is encoded in a customer record, which is used to route the customers
calls so that the customer is served and billed by the desired company. A user
may change service providers at any time, but the FCC and some states regulate
this process and require that specific procedures be followed. When these
procedures are not followed, particularly if the change is unauthorized or
fraudulent, the process is known as slamming. Slamming is such a significant
problem that it has been addressed in detail by Congress in the
Telecommunications Act, by some state legislatures, and by the FCC in recent
orders. The FCC has levied substantial fines for slamming. The risk of
financial damage, in the form of fines, penalties and legal fees and costs, and
to business reputation from slamming is significant. Even one slamming
complaint could cause extensive litigation expenses for us. The FCC recently
decided to apply its slamming rules (which originally covered only long
distance) to local service as well. Z-Tel is also subject to state rules and
regulations regarding slamming, cramming, and other consumer protection
regulation. Network Information.Section 222 of the Communications Act of 1934 and FCC
rules protect the privacy of certain information about telecommunications
customers that a telecommunications carrier such as us acquires by providing
telecommunications services to such customers. Such protected information,
known as Customer Proprietary Network Information (CPNI), includes information
related to the quantity, technological configuration, type, destination and the
amount of use of a telecommunications service. The FCCs original rules
prevented a carrier from using CPNI acquired through one of its offerings of a
telecommunications service to market certain other services without approval of
the affected customer. The United States Court of Appeals for the Tenth Circuit
overturned a portion of the FCCs rules established in CC Docket No. 96-115
regarding the use and protection of CPNI. In response to the Tenth Circuit decision, in October 2001, in CC Docket No.
96-115, the FCC clarified that the Tenth Circuit reversal was limited and that
most of the FCCs CPNI rules remained in effect. The FCC sought further comment
on what method of customer consent offered by a carrier (either an opt-in or
opt-out approach) would serve the governmental interest in Section 222 and be
consistent with the First Amendment. The final determination of this issue and
other FCC rules regarding 14




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handling of CPNI could result in significant administrative expense to Z-Tel in
modifying internal customer systems to meet these requirements. Intercarrier Compensation (Interstate Access Charges and Reciprocal
Compensation).Because Z-Tel, as a competitive local exchange carrier, passes
and receives local and toll calls to and from other local exchange carriers and
long-distance companies, the rates for intercarrier compensation for these
calls has a significant and substantial impact on the profitability of our
business. In addition, the rates that our competitors, especially the incumbent
local exchange carriers, are permitted to charge end-users, other local
exchange carriers, and long-distance companies for originating, transmitting,
and terminating telecommunications traffic can have a substantial impact on our
ability to offer services in competition with those carriers. The current regulatory (and intercarrier compensation) status of dial-up calls
to Internet service providers is in dispute and litigation. The FCC has
determined that both continuous access and dial-up calls from a customer to an
Internet service provider are interstate, not local, calls, and, therefore, are
subject to the FCCs jurisdiction. The FCC has initiated a proceeding to
determine the effect that this regulatory classification will have on the
obligation of local exchange carriers to pay reciprocal compensation for
dial-up calls to Internet service providers that originate on one local
exchange carrier network and terminate on another local exchange carrier
network. Moreover, many states have or are considering this issue, and several
states have held that local exchange carriers do not need to pay reciprocal
compensation for calls terminating at Internet service providers. A majority of
state commissions have ruled that reciprocal compensation should be paid on
such traffic. On March 24, 2000, the Court of Appeals for the District of
Columbia remanded for reconsideration the FCCs determination that calls to
Internet service providers are interstate for jurisdictional purposes rather
than local. Specifically, the Court indicated that the FCC has not provided a
satisfactory explanation why calls to Internet service providers are not local
telecommunications traffic and why such traffic is exchange access rather than
telephone exchange service. We cannot predict the effect that the FCCs
resolution of these issues will have on our business. Since passage of the Telecommunications Act of 1996, the FCC has fundamentally
restructured the access charges that incumbent local exchange carriers charge
to interexchange carriers and end-user customers to connect to the incumbent
local exchange carriers network. The FCC revised access charges for the
largest incumbent local exchange carriers in May 1997, reducing per-minute
access charges and increasing flat-rated monthly charges paid by both
long-distance carriers and end-users. Further changes in access charges were
effected for the largest incumbent local exchange carriers when the FCC adopted
the Coalition for Affordable Local and Long-Distance Service ("CALLS") proposal
in May 2000. CALLS, which reflected a negotiated settlement between AT&T and
most of the Bell operating companies, reduced per-minute charges by 60 percent.
It further increased flat-rated monthly charges to end-users, in particular,
multi-line business users. The CALLS plan also attempted to remove implicit
universal service subsidies paid for by long-distance companies in interstate
access rates and place those funds into the federal universal service support
system, where they would be recovered from all interstate carriers. Most of the
reductions in the CALLS plan resulted from shifting access costs away from
interexchange carriers onto end-user customers. Last year, the Fifth Circuit
reversed and remanded portions of the CALLS plan back to the FCC for further
consideration of the issue as to the size of the subsidy for universal service
should be removed from the interstate access charges and placed into the
federal interstate universal service support system. The outcome of this
litigation could impact the contributions Z-Tel, as an interstate carrier, must
pay to support the federal universal service support system. In addition, as discussed above, the rates that Z-Tel and other
competitive local exchange carriers may charge for interstate switched access
services are regulated pursuant to the FCCs April 2001 CLEC Access Charge
Order. In April 2001, the FCC released a Notice of Proposed Rulemaking in CC Docket
No. 01-92 in which it proposed a fundamental re-examination of all currently
regulated forms of intercarrier compensation. The FCC proposed that carriers
transport and terminate local traffic on a bill-and-keep basis, rather than
per-minute reciprocal compensation charges. The FCC regards the CALLS Order and
the CLEC Access Charge Order as well as its reciprocal compensation rules to be
3-year "transitional intercarrier compensation regimes." After completion of
that three-year transition, a new interstate intercarrier compensation regime
based upon bill-and-keep or another alternative may be in place. Because Z-Tel
both makes payments to and receives payments from other carriers for exchange
of local and long-distance calls, at this time we cannot predict the effect
that the FCCs determination in CC Docket No. 01-92 may have upon our business. Potential Legislation. Changes to the market-opening and enforcement provisions
of the Communications Act of 1934 or the Telecommunications Act of 1996 could
adversely affect our ability to provide competitive services and could harm our
business. No substantial re-write of either Act has been introduced before the
U.S. Congress as of this writing. Other Issues.There are a number of other issues and proceedings that could
have an effect on our business in the future, including the following facts.  
    
    The FCC has adopted rules to require telecommunications service
providers to make their services accessible to individuals with
disabilities, if readily achievable.
    
    In March, 2004, the Department of Justice filed a rulemaking petition
before the FCC that asks for new rules to 15




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implement the Communications
Assistance with Law Enforcement Act ("CALEA"). CALEA requires
telecommunications providers to design and engineer their networks to
permit law enforcement agencies to wiretap and obtain customer service
information (e.g., call trace, call records). The Department of
Justice CALEA Petition
proposes to extend many of those requirements to information services
as well. Implementation of the proposed CALEA rules could have a
significant impact upon our ability to provide both regulated common
carrier and information services to our customers. Such rules could
increase the cost of equipment we purchase to deploy our services and
such rules could also delay the availability of equipment we need. We
cannot predict any such delays or the potential cost at this time.
Current FCC rules require telecommunications service providers to
provide law enforcement personnel with a sufficient number of ports
and technical assistance in connection with wiretaps. We cannot
predict the cost to us of complying with these rules at this time.
    
    The FCC has adopted new rules designed to make it easier for customers
to understand the bills of telecommunications carriers. These
Truth-in-Billing rules establish certain requirements regarding the
formatting of bills and the information that must be included on
bills.
    
    We are subject to annual regulatory fees assessed by the FCC, and must
file an annual employment report to comply with the FCCs Equal
Employment Opportunity policies.
    
    The FCC has adopted an order granting limited pricing flexibility to
large incumbent local exchange carriers, and is considering granting
additional pricing flexibility and price deregulation options. These
actions could increase competition for some of our services. The foregoing is not an exhaustive list of proceedings or issues that could
materially affect our business. We cannot predict the outcome of these or any
other proceedings before the courts, the FCC, legislative bodies, or state or
local governments. STATE REGULATION To the extent that we provide telecommunications services that originate and
terminate within the same state, we are subject to the jurisdiction of that
states public service commission. As our local service business and product
lines expand, we will offer more intrastate services and may become
increasingly subject to state regulation. The Telecommunications Act maintains
the authority of individual state utility commissions to preside over rate and
other proceedings, and to impose their own regulation on local exchange and
intrastate interexchange services, so long as such regulation is not
inconsistent with the requirements of federal law. For instance, states may
require us to obtain a Certificate of Public Convenience and Necessity before
commencing service in the state. We have obtained such authority in all states
in which we operate, and, as a prelude to market entry in additional states, we
have obtained such authority to provide local service in 49 states and the District of Columbia. In addition to requiring certification, state regulatory authorities may impose
tariff and filing requirements, consumer protection measures, and obligations
to contribute to universal service and other funds. State commissions also have
jurisdiction to approve negotiated rates, or establish rates through
arbitration, for interconnection, including rates for unbundled network
elements. Changes in those rates for unbundled network elements could have a
substantial and material impact on our business. We are subject to requirements in some states to obtain prior approval for, or
notify the state commission of, any transfers of control, sales of assets,
corporate reorganizations, issuance of stock or debt instruments and related
transactions. Although we believe such authorizations could be obtained in due
course, there can be no assurance that state commissions would grant us
authority to complete any of these transactions. We are also subject to state laws and regulations regarding slamming,
cramming, and other consumer protection and disclosure regulations. These rules
could substantially increase the cost of doing business in any one particular
state. State commissions have issued or proposed several substantial fines
against competitive local exchange companies for slamming or cramming. The risk
of financial damage, in the form of fines, penalties and legal fees and costs,
and to business reputation from slamming is significant. Even one slamming
complaint before a state commission could cause extensive litigation expenses
for us. In addition, state law enforcement authorities may utilize their powers
under state consumer protection laws against us in the event legal requirements
in that state are not met. Z-Tels rates for intrastate switched access services, which Z-Tel provides to
long-distance companies to originate and terminate in-state toll calls, are
subject to the jurisdiction of the state commissions in which the call
originated and terminated. State commissions may, like Texas, directly regulate
or prescribe this intrastate switched access rate. Such regulation by other
states could materially and adversely affect Z-Tels revenues and business
opportunities within that state. The Telecommunications Act generally preempts state statutes and regulations
that restrict the provision of competitive services. As a result of this
preemption, we will be generally free to provide the full range of local, long
distance, and data services in any state. While this action greatly increases
our potential for growth, it also increases the amount of competition to which
we may be subject. States, however, may still restrict Z-Tels ability to provide
competitive services in some rural areas. In addition, the cost 16




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of enforcing federal preemption against certain state policies and programs may be large and
may cause considerable delay. As we roll out new services on a state-by-state
basis, we anticipate that the incumbent local exchange carrier will provide the
unbundled network element platform components in a manner similar to that
provided in states where we currently operate. However, pricing and terms and
conditions adopted by the incumbent local exchange carrier in each of these
states may preclude our ability to offer a competitively viable and profitable
product within these and other states on a going-forward basis.
In order to enter new markets, we may be required to negotiate
interconnection agreements with incumbent local exchange carriers on an
individual state basis. To continue to provide service, we also need to
renegotiate interconnection agreements with incumbent local exchange carriers.
While current FCC rules and regulations require the incumbent provider to
provide the network elements on an individual and combined basis necessary for
us to provision end-user services, no assurance can be made that the individual
local exchange providers will provide these components in a manner and at a
price that will support competitive operations. If the incumbent providers do
not readily provide network functionality in the manner required, we have
regulatory and legal alternatives, including arbitration before state public
service commissions, to force provision of services in a manner required to
support our service offerings. However, if we are forced to litigate in order
to obtain the combinations of network elements required to support our service,
we are likely to incur significant incremental costs and delays in entering
such markets. In addition, as discussed above, there is considerable legal
uncertainty as to how interconnection agreements are to be enforced before
state commissions and where appeals of state commission interconnection
agreement determinations may be heard. State legislatures also may impact our business. In 2003, the Illinois General
Assembly passed a law that ordered the Illinois Commerce Commission to increase
unbundled network elements rates. Z-Tel and several other competitive carriers
filed a lawsuit and injunction against that law, on the basis that the
Telecommunications Act of 1996 ordered state commissions  not state
legislatures  to establish rates for network elements. The U.S. District
Court for the Northern District of Illinois and, subsequently, the United
States Circuit Court of Appeals for the Seventh Circuit, agreed and ordered a
permanent injunction against the Illinois statute. Nevertheless, incumbent
local telephone companies actively lobby and support legislation that would
curtail the roles of state public utility commissions, limit competitive access
laws that may exist at the state level that may go beyond the Telecommunications Act, or otherwise limit the ability of competitive companies
like Z-Tel to compete against incumbents or obtain access to local networks at
just, reasonable and nondiscriminatory rates. At any point in time, several
such bills are pending before the state legislatures of states in which we do
business, and passage of such legislation could have a significant and
material effect on our ability to do business in that particular state. LOCAL GOVERNMENT REGULATION In some of the areas where we provide service, we may be subject to
municipal franchise requirements requiring us to pay license or franchise fees
either on a percentage of gross revenue, flat fee or other basis. We may be
required to obtain street opening and construction permits from municipal
authorities to install our facilities in some cities. The Telecommunications
Act prohibits municipalities from discriminating among telecommunications
service providers in imposing fees or franchise requirements. In some
localities, the FCC has preempted fees and other requirements determined to be
discriminatory or to effectively preclude entry by competitors, but such
proceedings have been lengthy and the outcome of any request for FCC preemption
would be uncertain. COMPETITION Overview The telecommunications industry is highly competitive. However, at present, we
believe few telecommunications carriers provide the type of bundled service
packages that include the range of services and features that we offer, but
various competitors offer one or more of the services that make up our service
offerings. Competition in the local telephone services market arises primarily
from the ILECs and alternative transport systems such as wireless, cable and
the Internet. Competition in the long distance and information services
markets, which have fewer entry barriers, is already intense and is expected to
remain so. We believe the principal competitive factors affecting our business will be the
quality and reliability of our services, customer confidence, innovation,
customer service and price. Our ability to compete effectively will depend upon
our continued ability to offer innovative, high-quality, market-driven services
at prices generally equal to or below those charged by our competitors and to
instill confidence in prospective customers as to our long-term viability and
the viability of our access to ILEC and other networks. Many of our current
and potential competitors have far greater financial, marketing, personnel and
other resources than we do, as well as other competitive advantages. Local Telephone Service Incumbent Local Exchange Carriers.In each of our target markets, we will
compete with the incumbent local exchange carrier serving that area, which may
be one of the Bell operating companies. The incumbent local exchange carriers
have long-standing relationships with their customers, have financial,
technical and marketing resources substantially greater than ours, have the
potential to subsidize services that compete with our services with revenue
from a variety of other unregulated businesses, and currently benefit from certain existing regulations that favor the incumbent
local exchange carriers over us in certain respects. 17




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Also as stated above
under Government Regulation, a recent court ruling has created uncertainty in
the ILECs and our regulatory environment. This uncertainty favors the ILECs
and may enable them to raise fees they charge to us, thereby causing us to
raise our rates to non-competitive levels. Regulations that allow competitive local exchange carriers, such as us, to
interconnect with incumbent local exchange carrier facilities and acquire and
combine the unbundled network elements of an incumbent local exchange carrier
provide increased business opportunities for us. However, such interconnection
opportunities have been, and will likely continue to be, accompanied by
increased pricing flexibility and relaxation of regulatory oversight for the
incumbent local exchange carriers. Competitive Local Exchange Carriers.We face competition in local telephone
services from numerous competitive local exchange carriers, including our own
wholesale customer Sprint. Interexchange (long distance) carriers such as AT&T,
MCI and Sprint have entered the local telephone market. These companies have
name recognition, standing relationships with their customers and financial,
technical and marketing resources substantially greater than we have. The
Telecommunications Act radically altered the market opportunity for competitive
local exchange carriers. With the required unbundling of the incumbent local
exchange carriers networks, competitive local exchange carriers are able to enter the market more rapidly by leasing switches, trunks and loop
capacity until traffic volume justifies building substantial facilities. Newer
competitive local exchange carriers, like us, will not have to replicate
existing facilities and can be more opportunistic in designing and implementing
networks, which could have the effect of increasing competition for local
exchange services. Cable Television Operators.Cable television operators are also entering the
telecommunications market by upgrading their networks with fiber optics and
installing facilities to provide fully interactive transmission of broadband
voice, video and data communications. These companies have standing
relationships with their customers and generally have financial, technical and
marketing resources substantially greater than we have. Wireless Telephone Companies.Wireless telephone systems are seen by many
consumers as a substitute for traditional wireline local telephone service.
Wireless companies have name recognition, standing relationships with their
customers and financial, technical and marketing resources substantially
greater than we have. VoIP Providers.The Internet is being used by a limited number of consumers as
a substitute for traditional wireline local and long distance telephone
service. The number of VoIP users could expand rapidly in the near future. We
intend to offer our own VoIP services. Other entrants into this market may
include ILECs, cable television operators and Internet service providers as
well as new entrants. New Entrants.We could face competition from new entrants into the local
exchange market. Because the Telecommunications Act requires the unbundling of
the incumbent local exchange carriers networks, new entrants are able to enter
the market by leasing switches, trunks and loop capacity in lieu of expending
funds building substantial facilities. This lower barrier to entry could have
the effect of increasing competition for local exchange services. Moreover, a
continuing trend toward consolidation of telecommunications companies and the
formation of strategic alliances within the telecommunications industry, as
well as the development of new technologies, could give rise to significant new
competitors. Long Distance Telephone Service The long distance telecommunications industry has numerous entities competing
for the same customers and a high average churn rate because customers
frequently change long distance providers in response to the offering of lower
rates or promotional incentives by competitors. Our primary competitors in the
long distance market include major interexchange carriers such as AT&T, MCI and
Sprint, certain incumbent local exchange carriers and resellers of long
distance services. We believe that pricing levels are a principal competitive
factor in providing long distance telephone service. We hope to avoid direct
price competition by bundling long distance telephone service with a wide array
of value-added, enhanced communications services. We believe that incumbent local exchange carriers that offer a package of
local, long distance telephone and information services will be particularly
strong competitors. Incumbent local exchange carriers, including Verizon,
BellSouth, Qwest and SBC Communications, are currently providing both long
distance and local services as well as certain enhanced telephone services that
we offer. We believe that the Bell operating companies will attempt to offset
market share losses in their local markets by attempting to capture a
significant percentage of the long distance market. Enhanced Communications Services We compete with a variety of enhanced service companies. Enhanced
communications services markets are highly competitive, and we expect that
competition will continue to intensify. Our competitors in these markets
include Internet service providers, Web-based communications service providers
and other telecommunications companies, including the major interexchange
carriers, incumbent local exchange carriers, competitive local exchange
carriers and wireless carriers. 18




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Wholesale Services We believe we are the sole competitive local exchange carrier offering local
exchange services on a wholesale basis. Our chief competitor on the wholesale
level in each territory is the incumbent local exchange carrier, usually a Bell
operating company. Our competitive advantage is our knowledge and experience in
dealing with incumbent local exchange carriers, our knowledge and experience in
offering local services, our proprietary enhanced features and our operational
support systems. Bell operating companies, in general, do not promote and
market their ability to offer wholesale services, preferring to minimize
competition in the local telephone services market. We offer our wholesale
customers a full suite of services for their use in providing telephone
services to their customers. We face competition from a variety of companies
that offer particular services such as provisioning services, billing services
and enhanced communications services (such as voicemail) or that offer
technologies related to such services. RESEARCH AND DEVELOPMENT ACTIVITIES For the fiscal years ended December 31, 2003, 2002 and 2001, we invested
approximately $6.0, $7.4, and $8.9 million, respectively, in company-sponsored
research and development activities. EMPLOYEES As of March 25, 2004, we
had approximately 1189 employees. None of our
employees is covered under collective bargaining agreements. ACCESS TO INFORMATION The public may read and copy any materials we file with the Securities and
Exchange Commission at the SECs Public Reference Room at 450 Fifth Street
N.W., Washington, D.C. 20549. The public may obtain information on the
operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
The SEC maintains an Internet site that contains reports, proxy and information
statements, and other information regarding issuers that file electronically
with the SEC. The address of that site is http://www.sec.gov. Reports we file electronically with the SEC including annual reports on Forms
10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and
amendments to those filings are available free of charge soon after each filing
at the following Web site: http://www.z-tel.com. Select Investor Relations
from the drop down menu under Learn. 
 ITEM 2. PROPERTIES We currently lease our principal executive offices in Tampa, Florida and our
principal engineering offices in Atlanta, Georgia. We own our offices in
Atmore, Alabama. Our principal network facilities, which house our enhanced communications
services and operational support systems, reside in our Tampa offices. We
estimate the current hardware can support 1.7 million end user lines. With
additional equipment we estimate the maximum capacity of the facility (because
of space constraints) to be approximately 2.2 million lines. Anticipated
technology improvements could expand that capacity. Both of our business segments utilize the foregoing offices and facilities. 
 ITEM 3. LEGAL PROCEEDINGS We are a party to various administrative and judicial proceedings dealing with
the regulatory environment in which we operate. For more information, please refer
to the section entitled Item 1. Business-Government Regulation. 1. Master File Number 21 MC 92; In re Initial Public Offering Securities
Litigation., in the United States District Court for the Southern District of
New York (filed June 7, 2001) During June and July 2001, three separate class action lawsuits were filed
against us, certain of our current and former directors and officers (the
D&Os) and firms engaged in the underwriting (the Underwriters) of our
initial public offering of stock (the IPO). The lawsuits, along with
approximately 310 other similar lawsuits filed against other issuers arising
out of initial public offering allocations, have been assigned to a Judge in
the United States District Court for the Southern District of New York for
pretrial coordination. The lawsuits against us have been consolidated into a
single action. A consolidated amended complaint was filed on April 20, 2002. A
Second Corrected Amended Complaint (the Amended Complaint), which is the
operative complaint, was filed on July 12, 2002. The Amended Complaint is based on the allegations that our registration
statement on Form S-1, filed with the Securities and Exchange Commission
(SEC) in connection with the IPO, contained untrue statements of material
fact and omitted to state facts necessary to make the statements made not
misleading by failing to disclose that the underwriters allegedly had received
additional, excessive and undisclosed commissions from, and allegedly had
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with, certain customers to whom they allocated shares in the IPO. The plaintiffs in the Amended Complaint
assert claims against us and the D&Os pursuant to Section 11 of the Securities
Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule
10b-5 promulgated by the SEC thereunder. The plaintiffs in the Amended
Complaint assert claims against the D&Os pursuant to Sections 11 and 15 of the
Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange
Act of 1934 and Rule 10b-5 promulgated by the SEC thereunder. The plaintiffs
seek an undisclosed amount of damages, as well as pre-judgment and
post-judgment interest, costs and expenses, including attorneys fees, experts
fees and other costs and disbursements. Initial discovery has begun. We believe
we are entitled to indemnification from our Underwriters. A memorandum of understanding has been reached by lawyers for the plaintiffs,
the issuers and insurers of the issuers. The memorandum sets forth the terms of
a proposed settlement, the principal components of which are (i) a release of
all claims against the issuers and their officers and directors, (ii) the
assignment by the issuers to the plaintiffs of certain claims the issuers may
have against the Underwriters and (iii) an undertaking by the insurers to
ensure the plaintiffs receive not less than $1 billion in connection with
claims against the Underwriters. Our board of directors has approved the
memorandum of understanding. To be binding, the settlement must be approved by
substantially all the issuers and thereafter submitted to and approved by the
court. The settlement will not be binding upon any plaintiffs electing to
opt-out of the settlement.  2.
    
    Case No 8:02 CV 1708 T 27 MS The Metropolitan Government of Nashville
and Davidson County, Tennessee, suing on behalf of Metropolitan
Nashville Employee Benefit Board v Z-Tel Technologies, Inc. in the
United States District Court for the Middle District of Florida filed
September 20, 2002. The Metropolitan Government of Nashville and Davidson County, Tennessee, on
behalf of the Metropolitan Nashville Employee Benefit Board (collectively
Metro Nashville), filed the foregoing lawsuit against us on September 20,
2002. The lawsuit asserts claims under Delaware Law, the Uniform Commercial
Code, and state law and seeks actual damages of $18 million, punitive damages
of $18 million, interest, and court costs. Metropolitan Nashville Employee
Benefit Board is a Z-Tel common shareholder. Metro Nashville alleges that we
wrongfully and improperly delayed delivery of a stock certificate, preventing
Metro Nashville from selling or taking other steps to protect the value of
their shares while the price of our stock declined significantly. The court
denied our motion to dismiss on January 20, 2003 and denied our motion for
summary judgment on January 21, 2004. We filed a motion for reconsideration of
the Order Denying Summary Judgment on February 6, 2004. This motion is still
pending before the court. The court has scheduled trial to begin on May 17,
2004. We believe the lawsuit is without merit and intend to oppose the
allegations vigorously; however, we cannot predict the outcome of this
litigation with any certainty.  3. PUC Docket No. 26417 Before the Public Utility Commission of Texas. Z-Tel
Communications, Inc. Complaint for Post-Interconnection Agreement Dispute
Resolution, Request for Expedited Ruling, And Request for Interim Ruling
Against Southwestern Bell Telephone Company. On August 6, 2002, we filed a complaint against Southwestern Bell Telephone
Company (SWBT) before the Public Utility Commission of
Texas ("PUCT"),
requesting that the PUCT enjoin SWBT from disconnecting our access to customers
in Texas on the basis of a billing dispute between the parties. The billing
dispute centered on whether we owed SWBT certain amounts for collect calls from
SWBT retail customers to Z-Tel retail customers. On August 23, 2002, the PUCT
issued in part the injunctive relief requested by Z-Tel, making clear that
service not be interrupted. Since that injunction, Z-Tel and SWBT have been
involved in a dispute resolution process over these and other billing disputes
between SWBT and SBC affiliates of SWBT.  4.
    
    C.A. No5:03CV229, Z-Tel Communications Inc. v. SBC Communications,
Inc., in the United States District Court for the Eastern District of
Texas, filed October 9, 2003. On October 9, 2003, Z-Tel Communications, Inc., our wholly-owned subsidiary
corporation, filed a lawsuit against SBC Communications, Inc. and several of
its subsidiaries (collectively, SBC) in federal court in Texas, where both
SBC and Z-Tel do business. The lawsuit alleges SBCs violation of the federal
antitrust laws, the Racketeering Influenced Corrupt Organizations Act (RICO),
the Lanham Act, and other federal and state laws. The complaint seeks damages
and an injunction against SBC. On November 20, 2003, SBC filed a motion to
dismiss the complaint. This motion is pending before the court. We cannot
predict the outcome of this litigation with any certainty. 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS None. 20




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PART II 
 ITEM 5. MARKET FOR OUR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION The Companys common shares are traded on the Nasdaq SmallCap Market under the
symbol ZTEL. The following table sets forth, for the periods indicated, the
range of high and low closing sale prices for the common shares, as reported on
the Nasdaq National Market or the Nasdaq SmallCap Market, as the case may be. HIGH
    
    LOWFISCAL YEAR 2002:First Quarter
    
    $
    2.98
    
    
    $
    1.25Second Quarter
    
    $
    2.25
    
    
    $
    0.35Third Quarter
    
    $
    1.55
    
    
    $
    0.41Fourth Quarter
    
    $
    1.37
    
    
    $
    0.70FISCAL YEAR 2003:First Quarter
    
    $
    1.60
    
    
    $
    0.60Second Quarter
    
    $
    2.99
    
    
    $
    1.58Third Quarter
    
    $
    3.25
    
    
    $
    1.70Fourth Quarter
    
    $
    3.08
    
    
    $
    1.40
 HOLDERS As of March 26, 2004, there were approximately 242 registered holders of our
common stock. DIVIDENDS We have not paid dividends on our common stock since our inception and do not
intend to pay any cash dividends for the foreseeable future but instead intend
to retain earnings, if any, for the future operation and expansion of our
business. Any determination to pay dividends in the future will be at the
discretion of our Board of Directors and will be dependent upon our results of
operations, our financial condition, restrictions imposed by applicable law and
other factors deemed relevant by the Board of Directors. In addition, our
ability to pay cash dividends is limited by provisions of our Series D, E, and
G Convertible Preferred Stock, which have dividend preferences over our common
stock. SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS Number of securitiesremaining availableNumber of securities
    
    
    
    
    
    for future issuanceto be issued upon
    
    Weighted-average
    
    under equityexercise of
    
    exercise price of
    
    compensation plansoutstanding options,
    
    outstanding options,
    
    (excluding securitiesPlan category

    
    warrants and rights
    
    warrants and rights
    
    reflected in column(a)
    
    (b)
    
    (a)(c)Equity
compensation plans approved by
security holders
    
    
    12,565,624
    
    
    $
    4.14
    
    
    
    1,437,778
    (1)(2)Equity compensation
plans not approved by
security holdersTotal
    
    
    12,565,624
    
    
    $
    4.14
    
    
    
    1,437,778
 (1) Restricted stock, dividend equivalents, deferred stock and stock
appreciation rights may be awarded under our equity participation plan in
addition to option grants. (2) Unless the board of directors sets a lesser number, the aggregate number
of shares of common stock subject to our equity participation plan increases
automatically on the first day of each fiscal year by a number of shares equal
to the lesser of (i) 3,000,000 or (ii) 6% of the outstanding common shares on
that date. 21




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ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA HISTORY OF OPERATIONS We were founded in January of 1998. In our first year of operations, we focused
primarily on research and development activities, recruiting personnel,
purchasing operating assets, and developing our service offerings and marketing
plans. In the fourth quarter of 1998 we launched our first service offering
composed of an access card to make long-distance calls from any phone coupled
with enhanced services, such as voice mail, Find-me call forwarding, and
community messaging. In 1998 our revenues totaled $0.1 million. During June of 1999 we launched our primary service offering Z-Line Home
Edition (currently called Z-LineHOME) in New York. This is our bundled
telecommunications service providing integrated local, long-distance and
enhanced services targeted at residential customers. Our revenues for 1999
increased to $6.6 million. On December 15, 1999, we filed our initial public offering of 6.9 million
shares. This offering resulted in net proceeds to us of approximately $109.1
million. This offering provided us with the opportunity, at the potential
expense of profitability, to accelerate our investments in the building of our
network, the continuation of our research and development, the acceleration of
sales and marketing activities, and the development of our administrative
infrastructure. We purchased Touch 1 Communications, Inc. (Touch 1) in April
2000 in an effort to facilitate our planned growth. These investments lead to
our revenues growing to $177.7 million in 2000. Nevertheless, these investments
also significantly increased our operating and cash expenditures. This growth was slowed during 2001 as we moved our focus from growth to
profitability. We focused on lowering customer acquisition costs, improving
operating efficiencies, and attracting and maintaining a higher quality
customer, which initiatives resulted in a charge of $29.9 million relating to
the write-off of certain accounts receivables and a $59.2 million impairment of
assets relating to the sale of certain assets, primarily telemarketing centers.
We also experienced a reduction in overall headcount in 2001 through a
workforce reduction, attrition and the sale of the majority of the operations
and assets of the telemarketing centers that we acquired in 2000. In 2001, we
had revenues of $280.4 million and incurred a net loss of $146.1 million
compared to a net loss of $88.0 million in 2000. We continued our focus on operating improvement and cash management during
2002. We also decided to diversify our services and revenues streams by
offering wholesale services to other telephone companies. We signed a contract
with MCI WORLDCOM Communications, Inc. (MCI) at the end of the first quarter
of 2002. We recorded $238.4 million of revenues and net loss of $19.6 million
during 2002. Our wholesale services represented 12.9% of total reported
revenues for the year ended December 31, 2002. Although the results of 2003 appear to be very similar to those reported for
2002, there were several significant changes that occurred during 2003. We
signed an agreement with Sprint Communications, LP (Sprint) in February of
2003. This agreement provided us with a wholesale customer that has grown to
nearly 300,000 lines in the first 10 months of our relationship. This
agreement provided significant positive cash and operating results and
eliminated the impact of the MCI wholesale agreement that was terminated in
October of 2003. The MCI wholesale contract was an agreement that essentially
from its outset had a large amount of uncertainty due to MCIs bankruptcy
proceedings. We also invested in a large amount of sales and marketing during
the first half of 2003 to help increase our retail lines. After looking at the
results of these efforts and the increased competition and pricing pressure
that has continued to occur in the residential telephone market we decided to
shift our growth initiatives to our business and wholesale services during the
second half of 2003. We
still anticipate that residential service will account for the
largest portion of our overall revenue steam and our operating cash
flow in 2004. We spent the second half of 2003 building our business
services, and we expect to see significant growth in this offering during 2004.
We expect wholesale services to consistently grow during the year. Any new
agreements within this line of business would provide additional opportunities
for growth. We are also planning to launch our Voice over Internet Protocal
(VoIP) services sometime during the second quarter of 2004. Our new VoIP
offerings may provide additional revenues, but will not likely contribute
meaningfully to positive operations or be of a significant nature until at
least 2005. The following selected historical consolidated financial data has been derived
from our consolidated financial statements and should be read in conjunction
with the financial statements, related notes and other financial information
contained in this document. You should also read Managements Discussion and
Analysis of Financial Condition and Results of Operations, presented later in
this document. Historical results are not necessarily indicative of future
results. 22




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Years Ended December 31,2003
    
    2002
    
    2001
    
    2000(7)
    
    1999(In thousands, except share and per share data)Revenues
    
    $
    289,180
    
    
    $
    238,397
    
    
    $
    280,350
    
    
    $
    177,668
    
    
    $
    6,615Operating expenses:Network operations(8)
    
    
    135,097
    
    
    
    94,474
    
    
    
    159,617
    
    
    
    107,077
    
    
    
    6,518Sales and marketing
    
    
    18,753
    
    
    
    12,327
    
    
    
    31,243
    
    
    
    45,018
    
    
    
    8,898General and administrative (3)
    
    
    127,018
    
    
    
    122,579
    
    
    
    156,107
    
    
    
    99,606
    
    
    
    20,055Asset impairment charge(2)
    
    
    
    
    
    
    1,129
    
    
    
    59,247
    
    
    
    
    
    
    
    Wholesale development costs (5)
    
    
    
    
    
    
    1,018
    
    
    
    
    
    
    
    
    
    
    
    Restructuring charge(6)
    
    
    
    
    
    
    1,861
    
    
    
    
    
    
    
    
    
    
    
    Depreciation and amortization
    
    
    23,449
    
    
    
    23,936
    
    
    
    23,277
    
    
    
    17,166
    
    
    
    4,372Total operating expenses
    
    
    304,317
    
    
    
    257,324
    
    
    
    429,491
    
    
    
    268,867
    
    
    
    39,843Operating loss
    
    
    (15,137
    )
    
    
    (18,927
    )
    
    
    (149,141
    )
    
    
    (91,199
    )
    
    
    (33,228
    )Nonoperating income (loss):Interest and other income
    
    
    2,086
    
    
    
    3,509
    
    
    
    6,862
    
    
    
    5,475
    
    
    
    608Interest and other expense
    
    
    (3,076
    )
    
    
    (4,137
    )
    
    
    (3,789
    )
    
    
    (2,313
    )
    
    
    (3,351
    )Total nonoperating income (loss)
    
    
    (990
    )
    
    
    (628
    )
    
    
    3,073
    
    
    
    3,162
    
    
    
    (2,743
    )Net loss
    
    
    (16,127
    )
    
    
    (19,555
    )
    
    
    (146,068
    )
    
    
    (88,037
    )
    
    
    (35,971
    )Less mandatorily redeemable convertible
preferred stock dividends and accretion
    
    
    (17,480
    )
    
    
    (15,589
    )
    
    
    (15,059
    )
    
    
    (3,644
    )
    
    
    (1,654
    )Less deemed dividend related to beneficial
conversion feature
    
    
    (186
    )
    
    
    (186
    )
    
    
    (9,356
    )
    
    
    (20,027
    )
    
    
    Net loss attributable to common stockholders
    
    $
    (33,793
    )
    
    $
    (35,330
    )
    
    $
    (170,483
    )
    
    $
    (111,708
    )
    
    $
    (37,625
    )Weighted average common shares outstanding
    
    
    35,396,922
    
    
    
    34,951,720
    
    
    
    33,908,374
    
    
    
    33,066,538
    
    
    
    15,099,359Basic and diluted net loss per share
    
    $
    (0.95
    )
    
    $
    (1.01
    )
    
    $
    (5.03
    )
    
    $
    (3.38
    )
    
    $
    (2.49
    )Consolidated Balance Sheet DataCash and cash equivalents (1) (4)
    
    $
    12,013
    
    
    $
    16,037
    
    
    $
    18,892
    
    
    $
    46,650
    
    
    $
    101,657Working capital (deficit)
    
    
    (31,038
    )
    
    
    (19,380
    )
    
    
    (11,983
    )
    
    
    59,245
    
    
    
    95,315Total assets
    
    
    89,453
    
    
    
    106,711
    
    
    
    116,737
    
    
    
    246,461
    
    
    
    137,677Total debt
    
    
    5,531
    
    
    
    10,144
    
    
    
    15,766
    
    
    
    20,417
    
    
    
    14,134Mandatorily convertible redeemable preferred stock (4)
    
    
    144,282
    
    
    
    127,631
    
    
    
    112,570
    
    
    
    84,585
    
    
    
    Total stockholders equity (deficit)
    
    
    (131,019
    )
    
    
    (99,284
    )
    
    
    (67,172
    )
    
    
    89,100
    
    
    
    114,378Other Financial DataNet cash provided by (used in) operating activities
    
    
    11,956
    
    
    
    18,399
    
    
    
    (21,846
    )
    
    
    (96,862
    )
    
    
    (32,681
    )Net cash used in investing activities
    
    
    (10,996
    )
    
    
    (15,600
    )
    
    
    (15,615
    )
    
    
    (40,602
    )
    
    
    (5,182
    )Net cash provided by (used in) financing activities
    
    
    (4,984
    )
    
    
    (5,654
    )
    
    
    9,701
    
    
    
    82,455
    
    
    
    131,547
 Significant items impacting 2003 results In August 2003, we received notice that MCI WorldCom Communications, Inc. was
terminating the wholesale services agreement effective
October 15, 2003. This agreement was entered into in March 2002. In February
2003, we signed a wholesale services agreement with Sprint Communications
Company, LP. (1) Included in the December 31, 1999 cash balance was approximately $109.1
million of net proceeds from our December 15, 1999 initial public offering.
This cash was obtained through the sale of 6,900,000 shares (including the
underwriters over- allotment option) of our common stock at $17.00 per share. 23




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(2) We recorded a $1.1 and $59.2 million expense related to impaired assets in
2002 and 2001, respectively. This expense was the result of managements
decision to reduce various customer growth initiatives, most notably
telemarketing activity levels. In 2001, a majority of the operations and assets
of telemarketing centers acquired from Touch 1 was either voluntarily closed
or sold. In addition to the goodwill impairment of $54.9 million, we recorded a
$4.3 million charge associated with the impairment of assets, composed of $3.0
million relating to unrealizable software and development projects, $0.9
million of a worthless telemarketing property and equipment, and $0.4 million
of securities deemed to be worthless. As a result of managements decision in
the second quarter of 2002 to enhance future cash flow and operating earnings,
we closed the remaining call centers in North Dakota and recorded a $1.1
million asset impairment. We also incurred restructuring charges as a result of
this decision during 2002 as discussed in item (7). (3) Included in the 2001 general and administrative expense was a write-off of
accounts receivable that resulted in $29.9 million of additional bad debt
expense. (4) During 2000, we issued Series D and E preferred stock for approximately
$56.3 and $50.0 million, respectively. During 2001 we issued Series G preferred
stock for approximately $17.5 million. (5) During 2002, we began to provide our services on a wholesale basis. We
recorded start-up costs for developing this new service offering of
approximately $1.0 million. All wholesale related costs after our initial
wholesale services contract signed on March 20, 2002 are included in the
operating expenses line items, rather than being segregated. (6) During 2002, we closed two call centers in North Dakota and our New York
sales office. As discussed in Item 2 above, these expenses consisted primarily of
termination benefits, lease abandonment and lease settlement costs. (7) We
completed the acquisition of Touch 1,
on April 14, 2000. We used the purchase accounting method for our acquisition
of Touch 1. Therefore, our discussions of the results of operations and
liquidity and capital resources do not include any discussions regarding Touch
1 prior to our acquisition of Touch 1, which is treated as being closed for
accounting purposes, on April 1, 2000. (8) During 2002, we received a $9.0 million retroactive rate reduction for the
unbundled network elements we acquire from Verizon as a result of a
settlement approved by the
New York Public Service Commission. 
 ITEM 7. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS. You should read the following discussion together with the Selected
Consolidated Financial Data, financial statements and related notes included
in this document. This discussion contains forward-looking statements that
involve risks and uncertainties. Our actual results may differ materially from
those projected in the forward-looking statements as a result of certain
factors, including, but not limited to, those discussed in Item 1. Business,
as well as Cautionary Statements Regarding Forward-Looking
Statements, and Risks
Related to our Financial Condition and our Business, below, and other factors relating to our business and us that are
not historical facts. Factors that may affect our results of operations
include, but are not limited to, our limited operating history and cumulative
losses, uncertainty of customer demand, anticipated rapid expansion, potential software
failures and errors, potential network and interconnection failure, dependence
on local exchange carriers, dependence on third party vendors, success and
profitability of our wholesale services, dependence on key personnel,
uncertainty of government regulation, legal and regulatory uncertainties, and
competition. We disclaim any obligation to update information contained in any
forward-looking statement. OVERVIEW We offer local and long distance telephone services in combination with
enhanced communication features accessible through the telephone or the
Internet. These features include Personal Voice Assistant
(PVA), Find-Me, Notify-Me, caller identification, call waiting and speed dialing. PVA allows
users to store contacts in a virtual address book and then access and utilize
that information by voice from any telephone. PVA users can also send voice
e-mails. We are an emerging provider of advanced, integrated telecommunications
services targeted to residential and business customers. In addition to
providing our services on a retail basis, we are also providing these services
on a wholesale basis. Our wholesale services provide other companies the
ability to utilize our telephone exchange services, enhanced services platform,
infrastructure and back-office operations to provide services to retail and
business customers on a private label basis. For management purposes, we are
organized into two reportable operating segments: retail services and wholesale
services. The nature of our business is rapidly evolving, and we have a limited
operating history. 24




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Economic and Industry-Wide Factors The overall telecommunication industry is experiencing an enormous amount of
competition. Although telecommunications has always been relatively
competitive, it seems that competitive pressures are even further intensifying,
as incumbent and new providers continue to undercut each other in price while
offering more and new services. In order to promote new services, providers
usually provide immediate discounts and enticements. This generally
makes prospective customers more willing perhaps to switch telecommunication
providers and experiment with new service offerings. The industry is also
receiving entrants from other industries, which is creating various bundling
and pricing opportunities. Not only are end user prices generally decreasing,
but customers are also receiving more minutes, features, options, and
partnering advantages than has been typically available in the past. The
industry is also experiencing increased churn as service providers in the
wireline, wireless, VoIP, cable, internet, satellite, and other markets compete
for and in some cases target each-others customer bases with various
marketing and partnering opportunities. The overlapping of markets is also
driving the desire of companies to be the sole provider of services across many
communication markets, which provides additional margins and an incentive to
customers to stay with the provider as a result of discounts for receiving
multiple services. The
1996 Telecommunications Act and the establishment of the unbundled
network element platform (UNEP) and total element long
run incremental cost (TELRIC)
pricing have been consumed in either regulatory uncertainty or in the court
system as the ILECs continue to argue for the elimination of UNE-P or at a
very minimum the need to increase pricing of UNE-P. This consistent status of
flux and uncertainty has become more significant recently. The uncertainty is
a result of the D.C. Circuit decision that vacates certain Federal
Communication Commission (FCC) rules related to UNE-P
60 days from March 2, 2004, or upon denial of a petition
for rehearing, whichever is later, primarily as a result of what, in the courts
opinion, is the mishandling of the 1996 Telecommunications Act by the
FCC. Therefore, the competitive carriers have appealed to the U.S. Supreme Court to
review the case. This uncertainty could make it extremely difficult to operate our
business as we must work even more diligently to convince the market,
customers, partners, vendors, lenders and other constituents that this issue
will pass and we will be able to continue to successfully pursue our business
plan. We believe that UNE-P will continue to exist into the foreseeable
future, but we do not know the exact time-frame. We will also continue to
pursue our VoIP initiatives, as this is our planned longer-term solution to
mitigating or perhaps fully eliminating our risk from the uncertainty of UNE-P. We believe that there are significant opportunities to grow our business,
especially through marketing partnerships. We believe that the establishment of bundled
service offerings as being the standard will further drive the convergence of
services across all telecommunication service offerings and even across
markets. We believe that this will only increase as customers increasingly
recognize the value of bundled services. We expect further partnering and
potential consolidation in the telecommunications industry during the coming years as competition continues, the
regulatory environment becomes clearer and the availability of service
offerings expands. There is also significant risk with these factors as the
intense competition from a price and service perspective will force continued
operational and financial pressures on operating margins and perhaps other
measurements. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in
the United States of America (GAAP). The preparation of these financial
statements requires us to make estimates and judgments that affect the reported
amounts of assets, liabilities, revenues and expenses, and related disclosure
of contingent assets and liabilities. On an on-going basis, we evaluate our
critical accounting policies and estimates, including those related to revenue
recognition, disputed payables related to network operations expense, valuation
of accounts receivable, property, plant and equipment, long-lived and
intangible assets, restructuring reserves, tax related accruals and
contingencies. We base our estimates on experience and on various other
assumptions that we believe to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources.
Actual results may materially differ from these estimates under different
assumptions or conditions.  Furthermore, accounting treatment of
assets, liabilities, revenues, and expenses may differ from
telecommunication regulatory treatment of these same items. We believe the following critical accounting policies affect the more
significant judgments and estimates used in the preparation of our consolidated
financial statements. Revenue Recognition.Revenues are recognized when earned. Revenues related to
long distance, carrier access service and certain other usage driven charges
are billed monthly in arrears and the associated revenues are recognized during
the month of service. We record an estimate for this amount. Subscription
services are billed monthly in advance and we recognize revenues for this
service ratably over the service period. We defer certain installation charges
and recognize this revenue ratably over the estimated life of our customer. Our
wholesale services revenues are derived from contractual arrangements. We
perform a review of each contract and determine the appropriate timing of
revenue recognition depending on the facts and circumstances of each individual
item within the contract. We are currently deferring certain revenues over the
life of our arrangements, rather than recognizing these revenues up-front. In
instances where we are the primary obligor for costs incurred we use the gross
method to record our 25




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revenues for wholesale services. We operate in a heavily regulated industry;
therefore, our pricing is subject to both state and federal regulatory
commission oversight. Such oversight could result in changes to the amount we
bill our customers in current and future periods. The gross accounting presentation for our wholesale services business segment
requires the understanding that certain recorded revenues are actually direct
cost pass-through. For instance, under our Sprint contract we charge to
Sprint, with a zero mark-up, certain charges that we receive from the incumbent
local exchange carriers (ILECs) that are attributable to lines that are owned
by Sprint under the aforementioned agreement. However, late in the third
quarter of 2003 Sprint established its own billing codes with the ILECs and has
been adding all new customers to these codes. This had the effect of reducing
our gross monthly billings to Sprint, yet has no impact on the profitability of
the contract. Indeed, Sprints lines under the wholesale services agreement
were actually increasing significantly during the period in reference. This
action also has the impact of increasing total margins, even though the
profitability of the contract on a per line basis was unchanged. This is why
we chose to focus on the net income per wholesale services line in service,
as opposed to stated revenues or margins per se. Disputed Payables Related to Network Operations and General and Administrative
Expense.Network operations expenses are primarily charges from the ILECs for
the leasing of their lines, utilizing the UNE-P, made available to us as a
result of the Telecommunication Act of 1996, and long distance and other
charges from inter-exchange carriers (IXCs). We record certain charges such
as up-front set-up fees, incorrect dispatch, and change and modification
charges in the general and administrative expense line item. We typically have
disputed billings with IXCs and ILECs as a matter of normal business
operations. Certain of these disputed amounts are recorded as an expense at the
time of dispute, but we do not pay any of our disputes until they are resolved
and it is determined that we indeed owe part or all of the dispute. Our
disputes are for various reasons including but not limited to incorrect billing
rates, alternatively billed services, duplicate billing errors, and costs
associated with line loss. This pricing is subject to both state and federal
oversight and therefore, our pricing is subject to change. Any such change
could have a material impact on our business. Management recognizes as disputes any billing that is continued to be presented
as a past-due amount on invoices that we receive. This approach results in the
disclosure of certain disputes that management does not believe are of a
significant risk to us, primarily due to the age and/or the dispute,
but believe it is appropriate to disclose the amounts as they have not been
resolved and continue to be billed to us as past-due amounts. Valuation of Accounts Receivable.Considerable judgment is required to assess
the ultimate realization of receivables, including assessing the probability of
collection and the current credit-worthiness of our customers. We regularly
analyze our approach as we gain additional experience or new events and
information are identified to determine if any change to our methodology is
warranted. Our current allowance methodology is directly related to the age of
a customers receivable and the belief that the older the receivable is, the
less likely a customer is to pay. Additionally, we have performed liquidation
and other collection analyses to make necessary changes in reporting our
accounts receivable in a reasonable and prudent fashion. The impact
of changing the percentages we use for each aging bucket in the
calculation of our allowance for doubtful accounts by 5% would
result in a $0.5 million change to our bad debt expense. Property, Plant and Equipment.Changes in technology or changes in the intended
use of property, plant and equipment may cause the estimated period of use or
the value of these assets to change. We utilize straight-line depreciation for
property and equipment. We perform an annual analysis to confirm the
appropriateness of estimated economic useful lives for each category of current
property, plant and equipment. Estimates and assumptions are used in both
setting depreciable lives for various asset classes and in testing for
recoverability. These estimates and assumptions require considerable
judgment. The effect of a one year change in the useful lives of our
switching and computer equipment, software and software development
would result in a change of $5.3 million to our depreciation expense. Tax Related Accruals. Our estimates of deferred and current income taxes and
the significant items giving rise to the deferred assets and liabilities are
shown in Footnote 15 - Income Taxes to our consolidated financial statements.
These reflect our assessment of actual current and future estimated income
taxes to be paid on items reflected in the financial statements, giving
consideration to both timing and probability of actual realization. Currently
we have placed a 100% valuation allowance on all net deferred tax assets. A
valuation allowance to reduce deferred tax assets is required if the weight of
evidence it is more likely than not that the deferred tax assets will not be
realized. We also are subject to various tax audits from various federal,
state, and local jurisdictions and make estimates based on available
information and after consultation with experts, where necessary. We believe
that our estimates are reasonable based on facts known now; however, they may change materially in the
future due to new developments. Contingencies. We are subject to proceedings, lawsuits, audits and other claims
related to lawsuits and other legal and regulatory proceedings that arise in
the ordinary course of business. We are required to assess the likelihood of
any adverse judgments or outcomes to these matters as well as potential ranges
of probable losses. A determination of the amount of loss accrual required, if
any, for these contingencies are made after careful analysis of each individual
issue. We consult with legal counsel and other experts where necessary in
connection with our assessment of any contingencies. The required accrual for
any such contingency may change materially in the future due to new
developments in each matter. 26




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##### Table of Contents



CONSOLIDATED RESULTS OF OPERATIONS YEAR ENDED DECEMBER 31, 2003 COMPARED TO YEAR ENDED DECEMBER 31, 2002The
following consolidated Managements Discussion and Analysis of Financial
Condition and Results of Operations should be read in conjunction with results
by segment. Key selected financial and operating data for the years ended
December 31, 2003 and 2002 are as follows: Amount
    
    PercentageFor the year ended
    
    Change
    
    ChangeDecember 31,
    
    Favorable
    
    Favorable
    
    Percentage of Revenues2003
    
    2002
    
    (Unfavorable)
    
    (Unfavorable)
    
    2003
    
    2002(In Millions)Results of Operations:Revenues
    
    $
    289.2
    
    
    $
    238.4
    
    
    $
    50.8
    
    
    
    21.3
    %
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    135.1
    
    
    
    94.5
    
    
    
    (40.6
    )
    
    
    (43.0
    )%
    
    
    46.7
    %
    
    
    39.6
    %Sales and marketing
    
    
    18.8
    
    
    
    12.3
    
    
    
    (6.5
    )
    
    
    (52.8
    )%
    
    
    6.5
    %
    
    
    5.2
    %General and administrative
    
    
    127.0
    
    
    
    122.6
    
    
    
    (4.4
    )
    
    
    (3.6
    )%
    
    
    43.9
    %
    
    
    51.4
    %Asset impairment charge
    
    
    
    
    
    
    1.1
    
    
    
    1.1
    
    
    
    100.0
    %
    
    
    
    %
    
    
    0.5
    %Wholesale development costs
    
    
    
    
    
    
    1.0
    
    
    
    1.0
    
    
    
    100.0
    %
    
    
    
    %
    
    
    0.4
    %Restructuring expense
    
    
    
    
    
    
    1.9
    
    
    
    1.9
    
    
    
    100.0
    %
    
    
    
    %
    
    
    0.8
    %Depreciation and amortization
    
    
    23.4
    
    
    
    23.9
    
    
    
    0.5
    
    
    
    2.1
    %
    
    
    8.1
    %
    
    
    10.0
    %Total operating expenses
    
    
    304.3
    
    
    
    257.3
    
    
    
    (47.0
    )
    
    
    (18.3
    )%
    
    
    105.2
    %
    
    
    107.9
    %Operating loss
    
    
    (15.1
    )
    
    
    (18.9
    )
    
    
    3.8
    
    
    
    20.1
    %
    
    
    (5.2
    )%
    
    
    (7.9
    )%Nonoperating income (expense):Interest and other income
    
    
    2.1
    
    
    
    3.5
    
    
    
    (1.4
    )
    
    
    (40.0
    )%
    
    
    0.7
    %
    
    
    1.4
    %Interest and other expense
    
    
    (3.1
    )
    
    
    (4.1
    )
    
    
    1.0
    
    
    
    24.4
    %
    
    
    (1.0
    )%
    
    
    (1.7
    )%Total nonoperating expense
    
    
    (1.0
    )
    
    
    (0.6
    )
    
    
    (0.4
    )

    
    
    (66.7
    )%
    
    
    (0.3
    )%
    
    
    (0.3
    )%Net loss
    
    
    (16.1
    )
    
    
    (19.5
    )
    
    
    3.4
    
    
    
    17.4
    %
    
    
    (5.5
    )%
    
    
    (8.2
    )%Less mandatorily redeemable convertible
preferred stock dividends and accretion
    
    
    (17.5
    )
    
    
    (15.6
    )
    
    
    (1.9
    )
    
    
    (12.2
    )%
    
    
    (6.1
    )%
    
    
    (6.5
    )%Less deemed dividend related to beneficial
conversion feature
    
    
    (0.2
    )
    
    
    (0.2
    )
    
    
    
    
    
    
    
    %
    
    
    (0.1
    )%
    
    
    (0.1
    )%Net loss attributable to common stockholders
    
    $
    (33.8
    )
    
    $
    (35.3
    )
    
    $
    1.5
    
    
    
    4.2
    %
    
    
    (11.7
    )%
    
    
    (14.8
    )%Cash Flow Data:Net cash provided by operating activities
    
    $
    12.0
    
    
    $
    18.4
    
    
    $
    (6.4
    )
    
    
    (34.8
    )%
    
    
    *
    
    
    
    *Net cash used in investing activities
    
    
    (11.0
    )
    
    
    (15.6
    )
    
    
    4.6
    
    
    
    29.5
    %
    
    
    *
    
    
    
    *Net cash used in financing activities
    
    
    (5.0
    )
    
    
    (5.7
    )
    
    
    0.7
    
    
    
    12.3
    %
    
    
    *
    
    
    
    *Net decrease in cash and cash equivalents
    
    $
    (4.0
    )
    
    $
    (2.9
    )
    
    $
    (1.1
    )
    
    
    (37.9
    )%
    
    
    *
    
    
    
    *
 (*) Not meaningful Revenues. To be consistent with emerging industry practices, the revenues for
all periods presented have been changed to reflect the billing to our customers
of the Universal Service Fund (USF) and other regulatory fees and the related
payments into the associated regulatory funds as network operations expense.
Operating income and net income for all periods presented were unaffected. The
additional revenues and expenses recorded were $4.2 and $3.1 million for the
years ended December 31, 2003 and 2002, respectively. Revenues increased by
$50.8 million to $289.2 million for the year ended December 31, 2003, compared 27




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to $238.4 million the prior year. The increase in revenues was primarily a
result of an increase of $53.3 million in our wholesale services revenue. This
increase was primarily a result of increased revenues from our wholesale
contract with Sprint, signed in February 2003, contributing an additional $60.0
million in 2003, and was partially offset by a decrease of $6.3 million in
MCIs wholesale service revenues compared to the prior year. The below
table provides a break-down of our revenues and changes for 2003 compared to
2002: Revenues for the years ending
    
    Amount
    
    PercentageDecember 31,
    
    ChangeFavorable
    
    ChangeFavorable
    
    Percentage of RevenuesType of Revenues
    
    2003
    
    2002
    
    (Unfavorable)
    
    (Unfavorable)
    
    2003
    
    2002(In Millions)Bundled residential services
    
    $
    190.7
    
    
    $
    190.5
    
    
    $
    0.2
    
    
    
    0.1
    %
    
    
    65.9
    %
    
    
    79.9
    %Bundled business services
    
    
    3.7
    
    
    
    0.3
    
    
    
    3.4
    
    
    
    1,133.3
    %
    
    
    1.3
    %
    
    
    0.1
    %1+ long distance services
    
    
    10.7
    
    
    
    16.8
    
    
    
    (6.1
    )
    
    
    (36.3
    )%
    
    
    3.7
    %
    
    
    7.1
    %Wholesale services
    
    
    84.1
    
    
    
    30.8
    
    
    
    53.3
    
    
    
    173.1
    %
    
    
    29.1
    %
    
    
    12.9
    %Total
    
    $
    289.2
    
    
    $
    238.4
    
    
    $
    50.8
    
    
    
    21.3
    %
    
    
    100.0
    %
    
    
    100.0
    %
 Two significant drivers impact our revenues: lines in service and average
(monthly) revenue per unit (ARPU.) The more significant driver impacting of
our changes in revenue is the amount of lines in service. The table below
provides a detail break-down of our lines: Average lines in service
    
    Ending lines in servicefor the years ending
    
    for the years endingDecember 31,
    
    December 31,Type of Revenues
    
    2003
    
    2002
    
    2003
    
    2002Bundled residential services
    
    
    232,827
    
    
    
    224,049
    
    
    
    204,758
    
    
    
    203,453Bundled business services
    
    
    8,017
    
    
    
    
    
    
    
    21,593
    
    
    
    1+ long distance services
    
    
    90,584
    
    
    
    134,000
    
    
    
    74,419
    
    
    
    106,652Wholesale services
    
    
    158,199
    
    
    
    35,796
    
    
    
    296,824
    
    
    
    55,523Total lines under management
    
    
    489,627
    
    
    
    393,845
    
    
    
    597,594
    
    
    
    365,628
 ARPU provides us with a business measure as to the average monthly revenue
generation attributable to each line in service, by business segment. ARPU is
calculated by taking total revenues divided by 12 to calculate the average
revenue per month and this total is divided by the average lines in service. We
use this measure when analyzing our retail services businesses, but not when
assessing our wholesale services business for reasons discussed earlier in this
section under the Critical Accounting Policies and Estimates within the Revenue
Recognition section. The following table provides a detail of our ARPU: Average revenue per unit in servicefor the years ending
    
    Amount
    
    PercentageDecember 31,
    
    ChangeFavorable
    
    ChangeFavorableType of Revenues
    
    2003
    
    2002
    
    (Unfavorable)
    
    (Unfavorable)Bundled Residential Services
    
    $
    68.26
    
    
    $
    70.86
    
    
    $
    (2.60
    )
    
    
    (3.7
    )%Bundled Business Services
    
    $
    38.46
    
    
    
    N/A
    
    
    
    *
    
    
    
    *
    %1+ Long Distance Services
    
    $
    9.84
    
    
    $
    10.45
    
    
    $
    (0.61
    )
    
    
    (5.9
    )%
 (*) Not meaningful The overall change in our revenues in 2003 compared to the prior year was
driven by our focus on growing our wholesale and business services during the
last half of 2003. Residential services revenues grew during the first half of
2003 but with our shift in focus mid-year we ended nearly flat compared to the
prior year. We expect the trend of focusing on growing our bundled business
and wholesale services while the signing of a partnering agreement
has the potential to increase our bundled residential services in 2004. We also expect that our ARPU will stay relatively flat to slightly
lower into the foreseeable future, primarily due to the competitive climate and
due to reductions in access 28




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fees. To the extent that we are able to develop
more and/or new service offerings, such as our PVA and/or Digital Subscriber
Line (DSL), we may have some opportunity to mitigate any decrease in general
levels of ARPU. We expect residential, business and wholesale lines in
service to grow significantly during 2004. We believe that the economics of our
business and wholesale services are currently more attractive for active
investment than is the traditional residential business. Therefore, we will
invest in sales and marketing activities to attract business customers and look
to  marketing partnership opportunities to be the primary driver in our residential
revenues. In March 2004, we entered into a marketing partnership with
a large communication company. This new offering is expected to be launched in May 2004. We expect to launch our Voice over Internet Protocol (VoIP) services in the
second quarter of 2004, but we do not expect a significant amount of revenue
from this new service offering during 2004. We continue to target companies
with large existing residential and business customer bases for various forms
of partnership opportunities, and we are also exploring additional distribution and
delivery opportunities for our services. We are also seeking additional wholesale
services relationships. Network Operations. Network operations expense increased by $40.6 million to
$135.1 million for the year ended December 31, 2003, compared to $94.5 million
the prior year. Our network operations expense primarily consists of fixed and
variable transmission expenses for the leasing of the UNE-P components from the
ILECs, domestic and international charges from service level agreements with
IXCs, and the USF and certain other regulatory charges to be consistent with
industry practice. The increase in network operation expense was primarily
the result of having an overall larger average number of lines under management
in service for the year ended 2003 compared to the prior year. The following
table provides a detailed break-down and analysis of changes in network
operations expense: Network Operations for theyears ending
    
    Amount
    
    Percentage
    
    Percentage ofDecember 31,
    
    ChangeFavorable
    
    ChangeFavorable
    
    Network Operations2003
    
    2002
    
    (Unfavorable)
    
    (Unfavorable)
    
    2003
    
    2002(In Millions)Bundled residential & business services
    
    $
    95.1
    
    
    $
    80.3
    
    
    $
    (14.8
    )
    
    
    (18.4
    )%
    
    
    70.4
    %
    
    
    85.0
    %1+ long distance services
    
    
    2.6
    
    
    
    3.5
    
    
    
    0.9
    
    
    
    25.7
    %
    
    
    1.9
    %
    
    
    3.7
    %Wholesale services
    
    
    37.4
    
    
    
    10.7
    
    
    
    (26.7
    )
    
    
    (249.5
    )%
    
    
    27.7
    %
    
    
    11.3
    %Total
    
    $
    135.1
    
    
    $
    94.5
    
    
    $
    (40.6
    )
    
    
    (43.0
    )%
    
    
    100.0
    %
    
    
    100.0
    %
 Our network operations expense as a percentage of revenues, increased to 46.7%
for 2003 compared to 39.6% in the prior year. We recorded a reduction to
network operations expense for certain retroactive rate reductions and billing
errors in the amounts of $2.5 million and $9.0 million
recorded in 2003 and 2002, respectively. Excluding the
impact of these retroactive rate reductions, the consolidated network costs, as
a percentage of revenues were 47.6 % for 2003 compared to 43.4% in the prior
year. The increase in network operations is primarily a result of the impact of
the gross accounting used to account for our wholesale service. The following
table provides a detail of network operations expense as a percentage of
revenues by the respective revenue types. This table excludes an analysis of
wholesale services because management does not look at this measure, given that
network expenses related to wholesale services are intended to be zero-margin
direct cost pass-through in nature. Network operations as a% of revenues for the
    
    Amountyears ended December 31,
    
    ChangeFavorable2003
    
    2002
    
    (Unfavorable)Bundled residential & business services
    
    
    48.9
    %
    
    
    42.1
    %
    
    
    (6.8
    )%1+ long distance services
    
    
    24.3
    %
    
    
    20.8
    %
    
    
    (3.5
    )%
 We also analyze the average expense per unit (AEPU) for network operations,
similar to the ARPU calculation for revenues. AEPU is calculated by taking
total network operations expense divided by 12 to calculate the
average network operations expense
per month and this total is divided by the average lines in service. The
following details AEPU for network operations expense. 29




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##### Table of Contents



Average network operationsexpense per unit for theyears ended
    
    Amount
    
    PercentageDecember 31,
    
    ChangeFavorable
    
    ChangeFavorableType of Revenues
    
    2003
    
    2002
    
    (Unfavorable)
    
    (Unfavorable)Bundled residential & business services
    
    $
    32.91
    
    
    $
    29.87
    
    
    $
    (3.04
    )
    
    
    (10.2
    )%1+ long distance services
    
    $
    2.39
    
    
    $
    2.18
    
    
    $
    (0.21
    )
    
    
    (9.6
    )%
 Excluding the $2.5 million and $9.0 million retroactive rate reductions for
2003 and 2002, respectively, the bundled residential and business services
network operations expense as a percentage of revenue would have been 50.4% for
the year ended December 31, 2003 compared to 46.8% in the prior year.
Performing this same analysis for the bundled residential & business services
would have resulted in AEPU increasing by 2.1% to $33.77 in 2003, compared to
$33.21 in the prior year. The overall increase in network operations expense was primarily driven by our
increase in wholesale lines in service from our contract with Sprint. The
increase of approximately 8,000 lines in the average bundled residential and
business service lines also contributed to the increased expense. Our 1+ long
distance services provided a small off-set to these services. In addition to
an increase in the overall average lines in service, we also experienced a
small increase in the AEPU which also contributed to our increase in network
operations expense. This increase was primarily the net result of three
contributing factors: (1) increased usage as a result of our customer choosing
our unlimited product which generally results in increased domestic
long-distance charges; (2) increased per line costs as our customer base
continues to become more geographically diverse resulting in some small changes
to the average cost experienced as a result of having more lines in more expensively priced UNE-P states and zones; reduced by (3) our
auditing and analysis of network operations and improving the synchronization
of our billing systems to help reduce network costs on a per unit basis. We expect network operations expense to increase in 2004 as we plan for an
increase in the overall lines in service. We also expect continued increases
to our AEPU as a result of increased usage, continued geographical dispersion
of customers to more expensive UNE-P pricing zones and states, increased
proportion of business lines which have a higher network operations expense per
unit and possible increased costs due to the risk in the regulatory arena relative to
the costs of leasing the UNE-P elements. We will be focusing our efforts on
insuring that the pricing and availability of UNE-P is conducive to our desire
to compete; however, we recognize the wide-range of possibilities that could
occur, including the possibility of an immediate and material adverse
effect upon our business. Sales and Marketing. Sales and marketing expense increased $6.5 million to
$18.8 million for the year ended December 31, 2003, compared to $12.3 million
the prior year. The sales and marketing expense primarily consists of
telemarketing, direct mail, brand awareness advertising and independent sales
representative commissions and salaries and benefits paid to employees engaged
in sales and marketing activities. The increase in sales and marketing expense is directly attributable to
increased payments of one-time and recurring commissions to independent sales
contractors, which increased by $8.2 million in 2003 compared to the prior
year. This increase was partially off-set by expenses associated with our
telemarketing centers that were closed in 2002 but resulted in $2.3 million of
expenses being recorded prior to their closure. The remaining increase was
in general advertising activities. We continue to treat our sales and marketing expense as a discretionary
spending item in the management of our cash flow. We significantly decreased
sales and marketing activity levels during 2002 by closing our telemarketing
centers and focusing on conserving cash. During the first half of 2003, we
increased our sales and marketing efforts to attract residential lines. As a
result of intense competition and the economics of a residential customer
relative to a business customer, we elected to shift our primary focus of time
and monetary resources to the marketing of our newly introduced business
services. This was achieved primarily through the addition of an in-house
sales team. We have also recruited master independent sale contractors to
assist with growing this line of business. This focus has provided us with the
ability to leverage our national footprint by offering prospective end users a
consolidating billing solution and by providing local and long distance
services to multi-location businesses. This is also intended to further
diversify our service offerings, revenue streams and cash flow streams beyond
only retail residential services
and wholesale services. Our business service has provided lower acquisition
cost on a per line basis in some cases, depending on the type of account
acquired. Fundamentally however, we believe that the limited amount of sales
and marketing dollars and resources that we have had and currently have access
to are best spent by being focused on acquiring business customers due to lower
churn rates, extended customer lives and lower ongoing services costs,
including but not limited to reduced rates of bad debt. We will continue to
invest in our residential base but in smaller amounts than we have
historically, however, our decision to enter certain partnering
opportunities may result in increased sales and marketing expense. We continue our use of the PVA as a component of our sales strategy. We
believe that PVA is a service differentiator for our residential and business
service offerings. We continue to expand our traditional retail sales
approach of offering our services in retail 30




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##### Table of Contents



electronics and recently wireless stores in an effort to provide them with the
ability to offer a complete wireless and wireline service for customers. We
believe that this approach may allow us to reduce our total acquisition costs
by creating opportunities to partner with organizations that can provide us
with attractive distribution economics. Additionally, we have introduced new
bundles and pricing points in an effort to expand the marketability of our
offerings to consumers including variations of PVA on a stand-alone basis. We
also expect to launch our VoIP initiative during the second quarter of 2004,
and have already hired a sales force to begin supporting the sale of this new
service on a pre-sale basis. We will continue to build the overall awareness
of our Z brand and explore alliances and ventures with other companies. We
expect sales and marketing expense to increase significantly during 2004 as a
result of a new agreement that we have signed with a large communications
provider, which likely will increase commission payments, however, we are still
assessing the final accounting for this contract and its accounting
impact on our future results. We will continue to manage
sales and marketing expense as a discretionary item to assist with managing our
overall cash position, including in determining which agreements we decide to
pursue. General and Administrative. General and administrative expense increased $4.4
million to $127.0 million for the year ended December 31, 2003, compared to
$122.6 million the prior year. General and administrative expense primarily
consists of employee salaries and benefits, outsourced services, bad debt
expense, billing and collection costs, occupancy costs, legal and provisioning
costs. The increase in general and administrative expense was primarily related to the
growth of our wholesale services during 2003 and the increased cost of
maintaining and supporting lines and employees. The significant general and
administrative expense line items that increased in 2003 compared, to 2002 were
as follows:  
    
    Payroll and related expenses  - $11.8 million  
    
    Charges from our ILEC gateway provided to establish and change customers services  - $3.1 million  
    
    Outsourcing of customer service and collections  - $1.9 million  
    
    Dispatch charges from the ILECs  - $1.7 million  
    
    Contract development costs  - $1.5 million  
    
    Insurance for general coverage and employee health costs  - $1.2 million  
    
    Set-up fees from the ILECs to establish service for new customers  - $1.1 million The decreases in general and administrative expense were a result of improved
operating and subscriber management activities which resulted in significant
decreases to bad debt expense. We also reduced various general and tax audit
accruals during 2003 compared to the accruing of such expenses in 2002. The
significant general and administrative expenses that decreased in 2003 compared
to 2002 were as follows:  
    
    Bad debt expense  - $9.9 million  
    
    Sales and use tax expense - $8.4 million  
    
    ILEC performance credits for failure to meet certain service levels  - $2.3 million The remaining increase of $2.7 million was primarily related to the volume
driven incremental costs associated with additional employees and active lines
in service. General and administrative expense as a percentage of revenue
decreased by 7.5% to 43.9% for the year ended December 31, 2003, compared to
51.4% in the prior year. This decrease was primarily driven by the gross
accounting treatment that is applied to the wholesale services segment of our
business that results in our recording certain costs, including but not limited
to payroll, provisioning, ILEC, billing and collection costs, that are recorded
in general and administrative expense even though we are charging these costs
through with zero or very little mark-up. We have improved our operating costs and overall operations, which has
contributed to improved per line cost factors. Additionally, as our business
services market continues to increase as a percentage of our overall retail
sales, we expect the overall general and administrative cost per total retail line in service to continue
to decrease, as the cost to maintain a business service line is typically less
than the cost to maintain a residential line. We anticipate general and
administrative expenditures will continue to increase in total into the future
to support our planned expansion of service offerings and our expected increase
in residential, business and wholesale lines during 2004. We will continue to
evaluate our operations for efficiencies and our employee staffing requirements
as they relate to increased efficiencies or needs to expand or outsource
services. We expect to see continued improvements to the reductions of general
and administrative expense as a percentage of total reported revenue in 2004
relative to 2003. Depreciation and Amortization. Depreciation and amortization expense decreased
$0.5 million to $23.4 million for the year ended December 31, 2003, compared to
$23.9 million the prior year. We anticipate an increase to our fixed asset
purchases in the coming year as we introduce our VoIP service which is more
capital intensive than our UNE-P offering. We also expect to purchase
additional computer equipment, switching equipment, furniture and leasehold
improvements as a result of our expected growth across all lines of service. 31




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Interest and Other Income. Interest and other income decreased $1.4 million to
$2.1 million for the year ended December 31, 2003, compared to $3.5 million the
prior year. Interest and other income consists of interest charged to our
bundled residential and business customers for not paying their bills on time
and income from interest earned from our cash balance. The decrease in 2003 was
primarily due to having fewer late charges attributable to our increased subscriber
management activities. Interest and Other Expense. Interest and other expense decreased $1.0 million
to $3.1 million for the year ended December 31, 2003, compared to $4.1 million
the prior year. Our interest expense includes late fees for vendor payments,
charges related to our RFC Capital Corporation (RFC) accounts receivable
agreement, capital leases and our other debt obligations. The overall decrease
in interest and other expense for the year ended December 31, 2003 compared to
2002 was the result of our overall increased liquidity for part of 2003
compared to the prior year period that allowed us to make more timely payments
of our operating expenses while simultaneously reducing our reliance on our RFC
accounts receivable facility during the middle of 2003. We also have less
outstanding term debt obligations, which has contributed to lower interest
payments. We anticipate that interest expense will increase due to the
increased utilization of our RFC accounts receivable agreement and our
expectation of converting our current agreement to an traditional asset-based
loan. We also are seeking and considering additional debt offerings and
other financing options in an effort to improve our liquidity to fund our
growth initiatives for 2004. Income Tax Benefit. No provision for federal or state income taxes has been
recorded due to the full valuation allowance recorded against the net deferred
tax asset for the years ended December 31, 2003 and 2002. Net Loss Attributable to Common Stockholders. Our net loss attributable to
common stockholders improved $1.5 million to $33.8 million for the year ended
December 31, 2003, compared to $35.3 million the prior year. This decrease was
primarily discussed above, however, there was also an increase of $1.9 million
for the preferred stock dividends and accretion during 2003 as a result of the
additional accrual of dividends on the unpaid dividends. RESULTS OF OPERATIONS BY SEGMENT Our reportable segments reflect strategic business units that offer similar
products and service. We have two reportable segments:  
    
    Retail Services  
    
    Wholesale Services Management evaluates the performance of each business unit based on segment
results, exclusive of adjustments for unusual items that may arise. Unusual
items are transactions or events that are included in our reported consolidated
results but are excluded from segment results due to their nonrecurring or
non-operational nature. See our Segment footnote to our consolidated
financial statements for a reconciliation of segmented results to the
consolidated financial information. The following discussion highlights our performance in the context of these
segments. RETAIL SERVICES SEGMENT Our retail services segment includes our residential and business bundle
service lines of business. This segment also includes our 1+ long-distance
stand-alone offering. In 2003 we shifted to focusing on growing our business
bundled services, passively investing in our residential services and
harvesting the 1+ long-distance offering for maximum cash flow. The following
table, in millions, summarizes our retail services business segment for 2003
compared to 2002: Retail Services SegmentFor the years ended
    
    Amount
    
    PercentageDecember 31,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2003
    
    2002
    
    (Unfavorable)
    
    (Unfavorable)
    
    2003
    
    2002RevenuesBundled residential services
    
    $
    190.7
    
    
    $
    191.2
    
    
    $
    0.5
    
    
    
    0.3
    %
    
    
    93.0
    %
    
    
    91.8
    %Bundled business services
    
    
    3.7
    
    
    
    0.3
    
    
    
    3.4
    
    
    
    1,133.3
    %
    
    
    1.8
    %
    
    
    0.1
    %1+ long-distance services
    
    
    10.7
    
    
    
    16.8
    
    
    
    (6.1
    )
    
    
    (36.3
    )%
    
    
    5.2
    %
    
    
    8.1
    %Total Revenues
    
    
    205.1
    
    
    
    208.3
    
    
    
    (3.2
    )
    
    
    (1.5
    )%
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    100.6
    
    
    
    92.7
    
    
    
    (7.9
    )
    
    
    (8.5
    )%
    
    
    49.1
    %
    
    
    44.5
    %Sales and marketing
    
    
    18.7
    
    
    
    12.3
    
    
    
    (6.4
    )
    
    
    (52.0
    )%
    
    
    9.1
    %
    
    
    5.9
    %General and administrative
    
    
    104.7
    
    
    
    111.9
    
    
    
    7.2
    
    
    
    6.4
    %
    
    
    51.0
    %
    
    
    53.7
    %Total operating expenses
    
    
    224.0
    
    
    
    216.9
    
    
    
    (7.1
    )
    
    
    (3.3
    )%
    
    
    109.2
    %
    
    
    104.1
    %Segment results
    
    $
    (18.9
    )
    
    $
    (8.6
    )
    
    $
    (10.3
    )
    
    
    (119.8
    )%
    
    
    (9.2
    )%
    
    
    (4.1
    )%
 Revenues. Revenues decreased by $3.2 million to $205.1 million for the year
ended December 31, 2003, compared to $208.3 million the prior year. The
revenue growth in our residential and business lines was not enough to overcome
the $6.1 million decrease in our 1+ long-distance services experienced in 2003,
compared to the prior year. Additionally, our ARPU decreased by $2.60 to
$68.26 for the year ended December 31, 2003, compared $70.86 in the prior year.
There were two significant factors that contributed to this change in ARPU.
First, a decrease in the access rates (charges that we bill to other carriers
for carrying their traffic to our customers) went into effect in June
of 2003. (A further decrease will occur in June of 2004.) Also, during 2003, to
address pricing trends and to react to the highly competitive telecommunication
market, we actively marketed our unlimited bundle service offering to
residential customers. The unlimited service has a lower ARPU than some of our
historical pricing plans, because it includes for a fixed price, unlimited
domestic and local calling, in addition to all of our enhanced services. 32




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The trend in our bundled residential service during 2003 provides some insight
into the fluctuations in our revenues during the course of the year as well as
points to our plans for 2004. Our average bundled residential service lines
and ending lines were relatively the same for both the years ended December 31,
2003 and the prior year. During the first half of 2003, we were almost
exclusively focused on growing our residential services to the exclusion of any
of our other lines of business. However, at mid
year management made the decision to redirect sales and marketing
investment to the newly formed business services line of business, as well as
to the new wholesale services relationship with Sprint, neither of which existed
in a meaningful fashion during most of the first half of 2003. Management
judged that the retail business services and wholesale services lines of
business offered a superior return on investment when compared to the
traditional retail residential consumer business. In 2002, we decided to slow
our residential line growth and we were solely dependent on our wholesale
services business (primarily MCI at the time) for overall line growth. In
2003, we had diversified into business services to provide us with more
opportunities to achieve retail line growth. In
March 2004, we signed a marketing contract with a large communications
concern that has a significant embedded base of customers. This agreement
provides our marketing partner the opportunity to market our telecommunication services
to their users under a fixed and variable commissioning structure. There are
no minimums in this contract, but the success of this relationship could provide
a significant growth in our retail lines in service. If this contract does not
provide a large amount of new customers we will continue to focus our retail
efforts primarily on business services. Residential services will continue to
generate the majority of our overall revenue and cash flow during
2004, due to the size of the embedded customer base relative to the other lines
of business even if it stays relatively flat or decreases in line count over
the course of 2004. Network Operations. Network operations expense increased by $7.9 million to
$100.6 million for the year ended December 31, 2003, compared to $92.7 million
the prior year. Our network operations as a percentage of revenue increased by
4.6% to 49.1% for the year ended December 31, 2003, compared to
44.5% the prior year. Excluding a retroactive rate reduction of $2.5 million in 2003 and $9.0
million in 2002, network expense increased by $1.4 million and
1.5% as a percentage of revenue during 2003 relative to 2002. The increase in network
operations expense after excluding retroactive rate reductions was a result of
increased long distance usage from the growth in our unlimited service offering
and the mix of our customer base being spread across more states that had less
favorable pricing when compared to the states in which we had customers in the
prior year. These increases have been partially offset by reductions to network
operations as a result of improved internal operations and processes to
minimize our network operations costs. Sales and Marketing. Sales and marketing expense increased $6.4 million to
$18.7 million for the year ended December 31, 2003, compared to $12.3 million
the prior year. We elected to aggressively grow residential lines during the
first half of the year, and we also incurred various startup expenses related
to the introduction of our business services line of business during mid 2003.
Although we slowed residential line growth during the second half of 2003, the
significant investment during the first half of the year, coupled with the
launch of the business services caused overall sales and marketing expense to
increase during 2003 when compared to 2002. Specifically, the increase in our
sales and marketing for the year ended December 31, 2003 compared to the prior
year was a result of increased commission payments of $8.2 million in 2003. This increase is primarily a result of the increased use of independent sales
contractors during 2003 compared to the prior year. A large portion of our
business services lines are a result of an independent sales contractor
agreement that requires that we pre-pay the full 12 months of the commission 33




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per line sold, however, if a customer they provided discontinues service before
being a customer for 12 months we reduce their payment by the pro-rata portion
of the 12 month payment. In accordance with accounting rules and industry
practice the entire payment is expensed when paid. This increase was offset by
a decrease of $2.2 million in savings in 2003 compared to 2002, as a result of
closing our call centers in North Dakota. The remaining increase in sales and
marketing expense was a result of increased advertising, primarily during the
first half of 2003. Historically, we have used advertising and independent sales contractors to
drive the growth of our retail residential lines. We have also been growing an
internal sales force to increase sales in our business services and our VoIP
offering. We also expect a recently signed agreement with a large company with
millions of existing consumer customers to drive growth for our residential
service offering. This agreement involves a commission and gross profit sharing
arrangement that is success based. We expect that this agreement could
significantly increase commission payments. We continue to explore new
opportunities of selling our service including our efforts to leverage the use
of our PVA product as a distribution medium and by pursuing partnering
opportunities. To the extent possible, we will treat sales and marketing as a
discretionary item to assist with managing our overall financial results and
cash flow. We do expect sales and marketing will increase significantly during
2004 over that reported during 2003. General
and Administrative. General and administrative expense decreased $7.2
million to $104.7 million for the year ended December 31, 2003, compared to
$111.9 million the prior year. As a percentage of revenues general and
administrative expense decreased by 2.7% to 51.0% of revenues in 2003 compared
to 53.7% the prior year. The overall decrease in general and administrative expense for the year ended
December 31, 2003 was primarily a result of the following items:  
    
    $6.8 million increase in payroll expenses as a result of adding
employees to support our increased lines in service and our new
business services and less work dedicated to internally
designed software development that can be capitalized;  
    
    $2.3 million increase in contract development for work on new
products and various improvements and updates to our retail
service offerings;  
    
    $1.3 million increase in health insurance and other general
insurance, as a result of the increased cost for employee
health benefits and insurance for being a publicly traded
company.  
    
    $1.1 million increase in incorrect dispatch charges.  
    
    $9.9 million decrease to bad debt expense as result of our
improved customer acceptance process and subscriber management
activities and the sale of previously written-off receivables,
which resulted in a reduction to our bad debt expense of $1.0
million;  
    
    $2.3 million decrease in ILEC credits that we received on ILEC
bills for the failure of the ILECs to meet certain regulatory
requirements for the service provided to unbundled network
element platform customers;  
    
    $8.4 million decrease in tax expense for certain tax accruals
made in the prior year and certain reduction to these accruals
during 2003;  
    
    $1.0 million decrease in billing expense as a result of
renegotiating various rates in our billing contracts as a
result of increased volumes and improved billing practices;  
    
    $1.6 million decrease in provisioning expenses as a result of
renegotiating the minimums in our contract with an outside
vendor; and The
remaining $4.5 million increase was primarily the result of the increases
associated with increased payroll expenses and having more average lines in
service in 2003 compared to 2002. Included
in the retail services general and administrative expense are all
employee benefits, occupancy, insurance, and other indirect or overhead-related
expenses as only direct costs are recorded in our wholesale services
segment. We are in the process of reviewing and possibly adopting a
methodology for internal reporting purposes that would allocate these indirect
and overhead related expenses to the respective segments or possibly
separating these expenses from each segment. 34




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We are planning for overall line and revenue growth during 2004, and therefore
expect general and administrative expense to decrease as a percentage of
revenues as a result of the leveraging of certain elements of our fixed cost
structure, although we do expect an increase in overall administrative expense
in raw dollars as we incur more charges for provisioning new
customers and incremental administrative costs
such as billing, collections, and customer care related expense
during 2004. Our overall general and administrative expenses are associated with operational
and fiscal improvements to our retail customer economics. The most significant
improvement was in our bad debt expense, which improved due to our improvements
to customer treatments that have been applied consistently and by targeting
higher quality customers from a sales and marketing perspective. These
improvements allowed us to invest in our business services segment which was
primarily responsible for the increased payroll expenses in 2003. We expect to
continue focusing on our retail growth and specifically our business services.
We expect our residential services to grow rapidly if our recent
marketing agreement with a large communications concern is very successful.
This agreement has no minimums and is success based, with the partner being
responsible for providing customers, therefore, its initial success is
dependent on our partners efforts to offer our services to its end users. WHOLESALE SERVICES SEGMENT Our wholesale services segment includes services that we provide to other
companies giving them the ability to offer telephone exchange and enhanced
services to their own residential and business customers on a private label
basis using us as their primary platform for delivery. Our largest customers
for this service during 2003 were MCI and Sprint. Sprint is currently our
primary wholesale services customer, as MCI cancelled their agreement
in October 2003.
The following table, in millions, provides our wholesale services business
segment for 2003 compared to 2002: Wholesale Services SegmentFor the years ended
    
    Amount
    
    PercentageDecember 31,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2003
    
    2002
    
    (Unfavorable)
    
    (Unfavorable)
    
    2003
    
    2002Revenues:Sprint
    
    $
    59.7
    
    
    $
    
    
    
    $
    59.7
    
    
    
    100.0
    %
    
    
    71.0
    %
    
    
    
    %MCI
    
    
    23.9
    
    
    
    30.2
    
    
    
    (6.3
    )
    
    
    (20.9
    )%
    
    
    28.4
    %
    
    
    98.1
    %Other
    
    
    0.5
    
    
    
    0.6
    
    
    
    (0.1
    )
    
    
    (16.7
    )%
    
    
    0.6
    %
    
    
    1.9
    %Total Revenues
    
    
    84.1
    
    
    
    30.8
    
    
    
    53.3
    
    
    
    173.1
    %
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    37.0
    
    
    
    10.8
    
    
    
    (26.2
    )
    
    
    (242.6
    )%
    
    
    44.0
    %
    
    
    35.1
    %Sales and marketing
    
    
    0.1
    
    
    
    
    
    
    
    (0.1
    )
    
    
    (100.0
    )%
    
    
    0.1
    %
    
    
    
    %General and administrative
    
    
    22.3
    
    
    
    8.7
    
    
    
    (13.6
    )
    
    
    (156.3
    )%
    
    
    26.5
    %
    
    
    28.2
    %Total operating expenses
    
    
    59.4
    
    
    
    19.5
    
    
    
    (39.9
    )
    
    
    (204.6
    )%
    
    
    70.6
    %
    
    
    63.3
    %Segment results
    
    $
    24.7
    
    
    $
    11.3
    
    
    $
    13.4
    
    
    
    118.6
    %
    
    
    29.4
    %
    
    
    36.7
    %
 35




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Revenues. Revenues increased by $53.3 million to $84.1 million for the year
ended December 31, 2003, compared to $30.8 million the prior year. Our
wholesale service revenues increased to 29.1% of consolidated revenues in 2003,
compared to 12.9% in the prior year. We signed our wholesale services agreement
with Sprint in February of 2003. Sprint contributed $59.7 million of revenue
for the year ended December 31, 2003 and was our primary wholesale customer
during 2003, replacing MCI. On August 15, 2003, MCI provided us with notice
that they were terminating the contract effective October 15, 2003. As a result
of this notice we accelerated the recognition of $4.7 million of deferred
revenue due to the new termination date of October 15, 2003. Prior to MCIs
decision to terminate the agreement early, this revenue was being recognized
ratably over the life of the agreement, in accordance with GAAP, with an
original termination date of December 31, 2005. As a result of this treatment,
our revenues related to MCI increased; however, there was no increase to our
cash flow, as the cash had already been paid in the prior year. Our business development group is actively pursuing other potential wholesale
partners and is working to develop new wholesale services. We expect that our
wholesale lines in service will continue to steadily increase during 2004.
This, however, does not automatically translate into increased
revenue. We employ the gross accounting method for recognizing revenue within
the wholesale service business segment; therefore, we record revenue for
certain services that we provide to Sprint at our cost and record the
off-setting expense in one of the respective operating cost lines within our
income statement. These revenues (and cost pass-through items) result in no
contribution to operating profit. Therefore, to the
extent that Sprint decides to take over certain services that we currently
provide to them, such as becoming the customer of record for the ILEC bills associated with
their customer base, which is occurring to an increasing extent, a decrease in
reported revenues (and a decrease in the off-setting operating expense) will
result. This action will have no direct impact on the overall profitability of
the contract. Revenue per line under management will decrease but the
operating contribution generated on a per line basis will stay the same. Also,
our stated accounts payable will decrease, as we will no longer be incurring
this liability. In February 2004, we signed a new wholesale services agreement with
Working Assets Funding Services, Inc. Although the expected growth from this
relationship will be significantly less than that with our existing Sprint
agreement, it will provide some additional growth in 2004. While we expect wholesale lines in service to grow in a meaningful manner
during 2004, we predict wholesale revenue will be relatively flat, however
this may change appreciably given the inherent uncertainties associated with
the nature of having to apply the gross accounting treatment to the wholesale
services business segment. The primary reason for this is that the charges
for ILEC services are the largest revenue component of our wholesale services
and with Sprint becoming the customer of record for these bills our revenue
will decrease while we expect income to continue to increase during 2004. Network Operations. Network operations expense increased by $26.2 million to
$37.0 million for the year ended December 31, 2003, compared to $10.8 million
in the prior year. As stated in the revenue paragraph, Sprint has decided to
become the customer of record for billing purposes from the ILECs, therefore,
we expect the network operations expense to decrease significantly during 2004
relative to 2003. General and Administrative. General and administrative expense increased by
$13.6 million to $22.3 million for the year ended December 31, 2003, compared
to $8.7 million in the previous year. The significant components of this
expense are very similar to the administrative expenses incurred on the retail
side of our business; however, we only isolate as wholesale expense those
expenses that are directly associated with our wholesale services activity.
Therefore, we have not allocated any indirect or corporate (i.e. traditional
overhead) expenses, such as certain employee benefits, occupancy expenses, insurance
expenses or other similar expenses to the wholesale services business segment.
These expenses are all currently included in the retail services segment. The
increase in general and administrative expense is a result of increased
wholesale lines in service as a result of growth attributable to Sprint. The increase in general and administrative expense is the result of increased
payroll expense, the outsourcing of certain functions to limit our cost
exposure and increased non-recurring provisioning expenses to establish service
for our wholesale customers. We expect to steadily increase headcount to
support our existing wholesale customers and the possible addition of new
wholesale customers. We may transfer existing employees from our retail
services to wholesale services. As a result of this growth, we expect general
and administrative expense to increase in total dollars and as a percentage of
our consolidated expenses. We have not recorded any bad debt expense for
wholesale services and have not had any material write-offs of receivables. We
will continue to monitor our wholesale services and determine the appropriate
bad debt methodology based on each individual wholesale contract, but we do not
expect any material changes to our current approach. 36




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##### Table of Contents



YEAR ENDED DECEMBER 31, 2002 COMPARED TO YEAR ENDED DECEMBER 31, 2001 The following consolidated Managements Discussion and Analysis of Financial
Condition and Results of Operations should be read in conjunction with results
by segment. Key selected financial and operating data for the years ended
December 31, 2002 and 2001 are as follows: For the years ended
    
    Amount
    
    PercentageDecember 31,
    
    Change
    
    Change
    
    Percentage of RevenuesFavorable
    
    Favorable2002
    
    2001
    
    (Unfavorable)
    
    (Unfavorable)
    
    2002
    
    2001(In Millions)Results of Operations:Revenues
    
    $
    238.4
    
    
    $
    280.3
    
    
    $
    (41.9
    )
    
    
    (14.9
    )%
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    94.5
    
    
    
    159.6
    
    
    
    65.1
    
    
    
    40.8
    %
    
    
    39.6
    %
    
    
    56.9
    %Sales and marketing
    
    
    12.3
    
    
    
    31.2
    
    
    
    18.9
    
    
    
    60.6
    %
    
    
    5.2
    %
    
    
    11.1
    %General and administrative
    
    
    122.6
    
    
    
    156.1
    
    
    
    33.5
    
    
    
    21.5
    %
    
    
    51.4
    %
    
    
    55.7
    %Asset impairment charge
    
    
    1.1
    
    
    
    59.2
    
    
    
    58.1
    
    
    
    98.1
    %
    
    
    0.5
    %
    
    
    21.1
    %Wholesale development costs
    
    
    1.0
    
    
    
    
    
    
    
    (1.0
    )
    
    
    (100.0
    )%
    
    
    0.4
    %
    
    
    
    %Restructuring Charge
    
    
    1.9
    
    
    
    
    
    
    
    (1.9
    )
    
    
    (100.0
    )%
    
    
    0.8
    %
    
    
    
    %Depreciation and amortization
    
    
    23.9
    

    
    
    23.3
    
    
    
    (0.6
    )
    
    
    (2.6
    )%
    
    
    10.0
    %
    
    
    8.3
    %Total operating expenses
    
    
    257.3
    
    
    
    429.4
    
    
    
    172.1
    
    
    
    40.1
    %
    
    
    107.9
    %
    
    
    153.1
    %Operating loss
    
    
    (18.9
    )
    
    
    (149.1
    )
    
    
    130.2
    
    
    
    87.3
    %
    
    
    (7.9
    )%
    
    
    (53.1
    )%Nonoperating income (loss):Interest and other income
    
    
    3.5
    
    
    
    6.9
    
    
    
    (3.4
    )
    
    
    (49.3
    )%
    
    
    1.5
    %
    
    
    2.4
    %Interest and other expense
    
    
    (4.1
    )
    
    
    (3.8
    )
    
    
    (0.3
    )
    
    
    (7.9
    )%
    
    
    (1.7
    )%
    
    
    (1.4
    )%Total nonoperating income (loss)
    
    
    (0.6
    )
    
    
    3.1
    
    
    
    (3.7
    )
    
    
    (119.4
    )%
    
    
    (0.2
    )%
    
    
    1.0
    %Net loss
    
    
    (19.5
    )
    
    
    (146.0
    )
    
    
    126.5
    
    
    
    86.6
    %
    
    
    (8.1
    )%
    
    
    (52.1
    )%Less mandatorily redeemable convertible
preferred stock dividends and accretion
    
    
    (15.6
    )
    
    
    (15.1
    )
    
    
    (0.5
    )
    
    
    (3.3
    )%
    
    
    (6.6
    )%
    
    
    (5.4
    )%Less deemed dividend related to beneficial
conversion feature
    
    
    (0.2
    )
    
    
    (9.4
    )
    
    
    9.2
    
    
    
    97.9
    %
    
    
    (0.1
    )%
    
    
    (3.3
    )%Net loss attributable to common stockholders
    
    $
    (35.3
    )
    
    $
    (170.5
    )
    
    $
    135.2
    
    
    
    79.3
    %
    
    
    (14.8
    )%
    
    
    (60.8
    )%Cash Flow Data:Net cash provide by (used in) operating activities
    
    $
    18.4
    
    
    $
    (21.8
    )
    
    $
    40.2
    
    
    
    184.4
    %
    
    
    *
    
    
    
    *Net cash used in investing activities
    
    
    (15.6
    )
    
    
    (15.6

    )
    
    
    
    
    
    
    
    %
    
    
    *
    
    
    
    *Net cash provided by (used in) financing activities
    
    
    (5.7
    )
    
    
    9.7
    
    
    
    (15.4
    )
    
    
    (158.8
    )%
    
    
    *
    
    
    
    *Net decrease in cash and cash equivalents
    
    $
    (2.9
    )
    
    $
    (27.7
    )
    
    $
    24.8
    
    
    
    89.5
    %
    
    
    *
    
    
    
    *
 (*) Not meaningful The following is a summary of special items that management believes are
important to be identified and discussed separately in our discussion of
comparing our results for 2002 to 2001. - Retroactive reduction to network access rates. During 2002, we received a
$9.0 million retroactive rate reduction for the unbundled network elements from
Verizon as a result of their settlement with the New York Public Service
Commission. 37




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##### Table of Contents



- Restructuring charge. During 2002, we closed two call centers in North Dakota
and our New York sales office. We recorded $1.9 million for termination
benefits, lease abandonment and lease settlement costs. - Asset impairment. We recorded $1.1 and $59.2 million of expenses related to
impaired assets in 2002 and 2001, respectively. This expense was the result of
managements decision to reduce telemarketing activity levels. In 2001, a
majority of the operations and assets of telemarketing centers acquired from
Touch 1 during the prior year were either voluntarily closed or sold. In
addition to the goodwill impairment of $54.9 million, we recorded a $4.3
million charge associated with the impairment of assets, composed of $3.0
million relating to unrealizable software and development projects, $0.9
million of a worthless telemarketing property and equipment, and $0.4 million
of securities deemed to be worthless. As a result of managements decision in
the second quarter of 2002 to stabilize its future operating cash flows and
operating earnings, we closed the remaining call centers in North Dakota and
recorded a $1.1 million asset impairment charge. - MCI bankruptcy. During 2002, we recorded $1.3 million for possible bad debt
exposure to carrier receivables as a result of MCIs bankruptcy filing. We
reversed $0.6 million of previously recorded revenue and recorded an additional
$0.7 million of additional bad debt expense. - Wholesale development costs. During 2002, we began to provide wholesale
telephone service. In connection with development activities, we recorded
start-up costs associated with this new line of business of approximately $1.0
million. - Write-down of accounts receivable. Included in the 2001 general and
administrative expense was a write-off of accounts receivable that resulted in
$29.9 million of additional bad debt expense. Revenues. Revenues decreased by $41.9 million to $238.4 million for the year
ended December 31, 2002, compared to $280.3 million the prior year. The
decrease was primarily attributable to the average Z-LineHOME and
Z-LineBUSINESS customer count of 224,000 for the year ended December 31,
2002, compared to 297,000 for the prior year. Additionally, the decrease in
Touch 1 (1+) long distance lines in service contributed an additional decrease
of $6.1 million to our 2002 revenues. The following table outlines the
approximate number of subscriber lines for Z-LineHOME and Touch 1 (1+) long
distance services as of the end of each period: TYPE OF SERVICE
    
    DECEMBER 31, 2002
    
    DECEMBER 31, 2001Z-LineHOME and Z-LineBUSINESS
    
    
    203,000
    
    
    
    254,000Touch 1 (1+) Long Distance Services
    
    
    107,000
    
    
    
    160,000
 The reduction in lines in service was a result of our effort to slow growth for
the first three quarters of 2002, while eliminating poor paying customers and
increasing the quality of our embedded subscriber base with respect to payment
experience. These decreases were somewhat off-set by the introduction of our
wholesale services line of business which contributed $30.8 million to our
revenues for the nine-months that we offered this service during 2002. The following table, in millions, provides a summary of our revenues for the
years ended 2002 and 2001: TYPE OF REVENUES
    
    2002
    
    2001Z-LineHOME and Z-LineBUSINESS
    
    $
    190.8
    
    
    $
    257.4Touch 1 (1+) Long Distance Services
    
    
    16.8
    
    
    
    22.9Wholesale Services
    
    
    30.8
    
    
    
    -0-Total
    
    $
    238.4
    
    
    $
    280.3
 Our service offerings, Z-LineHOME and Z-LineBUSINESS, accounted for 80.0% of
our total revenues in 2002, compared to 91.8% the prior year. Network Operations. Network operations expense decreased by $65.1 million to
$94.5 million for the year ended December 31, 2002, compared to $159.6 million
during the prior year. Our network operations as a percentage of revenues
decreased to 39.6% for the year ended December 31, 2002, compared to 56.9% the
prior year. The decrease in network operation expenses was primarily the result
of having an overall lower average number of subscriber lines in service for
the year ended 2002 compared to the prior year. 38




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##### Table of Contents



In addition, in early 2002, the New York Public Service Commission (the
Commission) approved a settlement, which reduced the prices that we and other
competitive local exchange carriers paid for unbundled network elements and
expanded the availability of those elements. Specifically, rates for the
elements comprising the unbundled network element platform were reduced by
approximately $8 to $9 per month per subscriber, on average. These rate
decreases were effective March 1, 2002. In addition, the Commission directed
Verizon to provide bill credits to us in the amount of $9.0 million to
implement retroactive rate decreases for unbundled local switching. We recorded
this credit during 2002 and had received the entire credit from Verizon as of
December 31, 2002. Sales and Marketing. Sales and marketing expense decreased $18.9 million to
$12.3 million for the year ended December 31, 2002, compared to $31.2 million
the prior year. Our continued decrease in sales and marketing expense was
largely attributable to our primary focus on conserving cash and focusing on
improving internal operating performance and increasing the overall quality of
our subscriber base. As a component of this effort, we decreased marketing
activity levels which contributed to a decrease in active lines of 54,000, or
about 20% during 2002. Our primary source of sales in 2002 was from independent
sales representatives. It was not until the last quarter of 2002 that we
amended our approach to once again pursue line growth. At that time we began
a multi-faceted marketing campaign in Atlanta, Georgia that combined radio,
billboard, and television advertising to launch our new service offering, PVA.
In addition to our marketing campaign we also contracted with several
independent sales representatives during the latter half of 2002 that
contributed to our fourth quarter net line growth. General and Administrative. General and administrative expense decreased $33.5
million to $122.6 million for the year ended December 31, 2002, compared to
$156.1 million during prior year. The decrease in general and administrative
expense was primarily related to the write-off of accounts receivables in 2001
that resulted in the recognition of $29.9 million of additional bad debt
expense. Excluding the $29.9 million of bad debt expense, general and
administrative expense decreased only $3.6 million during 2002 and represented
52.4% of revenues in 2002, compared to 45.0% in 2001. This increase as a
percentage of revenues was largely the result of our decision in 2002 to
continue focusing on improving internal operations, our product offerings and
on subscriber economics, rather than investing in line growth for most of the
year. Excluding the 2001 write-off, our decreased line count and increased
focus on internal operations resulted in lower bad debt expense, decreased
billing and collection expenses and less salary and benefit expenses, all of
which contributed to our reduced general and administrative expenses in 2002
compared to 2001. Asset Impairment Charge. Asset impairment charges decreased $58.1 million to
$1.1 million for the year ended December 31, 2002, compared to $59.2 million
the prior year. The decrease in asset impairment is the result of the closure
of the remaining North Dakota call centers in 2002 after closing substantially
all of the centers in 2001. As a result of managements decision in the second quarter of 2002 to enhance
future cash flow and operating earnings, we decided to close the remaining call
centers in North Dakota acquired in our acquisition of Touch 1. In April of
2002, we announced a restructuring plan that included a reduction in force and
the closure of the North Dakota call centers resulting in an asset impairment
charge totaling $1.1 million for property, plant, and equipment sold in
conjunction with the settlement of the leases in these locations, in the second
quarter of 2002. Wholesale development costs. Wholesale development costs were $1.0 million in
2002. We incurred these costs, related to the initiation of our wholesale
services offerings, during the first quarter of 2002. Restructuring Charge. We recorded a restructuring charge of $1.9 million in
2002. In April of 2002, we approved and implemented a restructuring to enhance our
future cash flows and operating earnings. The restructuring included a
reduction of force coupled with the closure of our North Dakota call centers
and our New York sales office. In accordance with EITF 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit
an Activity, the restructuring costs were recognized as liabilities at the
time management committed us to the plan. Management determined that these
costs provided no future economic benefit to us. The restructuring charge includes termination benefits and lease abandonment
costs. In addition, we agreed to a settlement to exit
the two leases for our call centers in North Dakota as of July 1, 2002. All
termination benefits and settlements to exit the leases in North Dakota were
paid as of December 31, 2002. We have recorded a lease abandonment charge
representing the future lease payments for the New York office as a liability
and payments exist through August 2005. Depreciation and Amortization. Depreciation and amortization expense increased
$0.6 million to $23.9 million for the year ended December 31, 2002, compared to
$23.3 million the prior year. The slight increase in depreciation and
amortization is a function of the amount of capital investment that we record
relative to the amount of depreciation that we record against our embedded
fixed assets. There has been relatively little change in the amount of capital
investment that we have made over the past several years, nor have we
significantly altered our depreciation policy over this time. 39




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##### Table of Contents



Interest and Other Income. Interest and other income decreased $3.4 million to
$3.5 million for the year ended December 31, 2002, compared to $6.9 million the
prior year. Interest and other income consists of interest charged to our
Z-LineHOME customers for not paying their bills on-time and income from
interest earned from our cash balance and any gains from the sale of
investments or securities. The decrease for 2002 was primarily due to our
having an overall average of fewer customers in service in 2002 compared to
2001, and due to our more effective treatment of poor paying customers
resulting in fewer delinquencies and more timely payments by customers. Interest and Other Expense. Interest and other expense increased $0.3 million
to $4.1 million for the year ended December 31, 2002, compared to $3.8 million
the prior year. Our interest expense is a result of late fees for vendor
payments, charges related to our RFC Capital Corporation (RFC) accounts
receivable agreement, capital leases and other debt obligations. The overall
increase in interest expense was a result of $1.0 million of increased late
payment fees paid for network costs in 2002 compared to 2001. This increase was
offset by reduced interest expense on our debt obligations. The charges for the
utilization of our accounts receivable arrangement with RFC during 2002
remained consistent with the prior year expenses, although we decreased our
sale of receivables during the second half of 2002 Income Tax Benefit. No provision for federal or state income taxes has been
recorded due to the full valuation allowance recorded against the deferred tax
asset for the years ended December 31, 2002 and 2001. RESULTS OF OPERATIONS BY SEGMENT Management evaluates the performance of each business unit based on segment
results, exclusive of adjustments for special items. Special items are
transactions or events that are included in our reported consolidated results
but are excluded from segment results due to their nonrecurring or
non-operational nature. See our Segment footnote to our consolidated financial
statements for a reconciliation of segmented results to the consolidated
financial information. In addition, when changes in our business affect the
comparability of current versus historical results, we will adjust historical
operating information to reflect the current business structure. The following tables, in millions, provide our reportable segments in total
dollars and as a percentage of our consolidated results. These tables will
facilitate our discussion of our results by segment. YEAR ENDED DECEMBER 31, 2002
    
    YEAR ENDED DECEMBER 31, 2001RETAIL
    
    WHOLESALE
    
    CONSOLIDATED
    
    RETAIL
    
    WHOLESALE
    
    CONSOLIDATEDSERVICES
    
    SERVICES(1)
    
    RESULTS
    
    SERVICES
    
    SERVICES
    
    RESULTSRevenues
    
    $
    208.3
    
    
    $
    30.8
    
    
    $
    239.1
    
    
    $
    280.3
    
    
    $
    
    
    
    $
    280.3Operating expenses:Network operations
    
    
    92.7
    
    
    
    10.8
    
    
    
    103.5
    
    
    
    159.6
    
    
    
    
    
    
    
    159.6Sales and marketing
    
    
    12.3
    
    
    
    
    
    
    
    12.3
    
    
    
    31.2
    
    
    
    
    
    
    
    31.2General and administrative
    
    
    111.9
    
    
    
    8.7
    
    
    
    120.6
    
    
    
    126.2
    
    
    
    
    
    
    
    126.2Total operating expenses
    
    
    216.9
    
    
    
    19.5
    
    
    
    236.4
    
    
    
    317.0
    
    
    
    
    
    
    
    317.0Segment results
    
    $
    (8.6
    )
    
    $
    11.3
    
    
    $
    2.7
    
    
    $
    (36.7
    )
    
    $
    
    
    
    $
    (36.7
    )
 REVENUES AND OPERATING EXPENSE AS A %OF CONSOLIDATED SEGMENT RESULTSYEAR ENDED DECEMBER 31, 2002
    
    YEAR ENDED DECEMBER 31, 2001RETAIL
    
    WHOLESALE
    
    RETAIL
    
    WHOLESALESERVICES
    
    SERVICES
    
    SERVICES
    
    SERVICESRevenues
    
    
    87.1
    %
    
    
    12.9
    %
    
    
    100.0
    %
    
    
    
    %Operating expenses:
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Network operations
    
    
    89.6
    %
    
    
    10.4
    %
    
    
    100.0
    %
    
    
    
    %Sales and marketing
    
    
    100.0
    %
    
    
    
    %
    
    
    100.0
    %
    
    
    
    %General and administrative
    
    
    92.8
    %
    
    
    7.2
    %
    
    
    100.0
    %
    
    
    
    %Depreciation and amortization
    
    
    93.7
    %
    
    
    6.3
    %
    
    
    100.0
    %
    
    
    
    %Total operating expenses
    
    
    91.9
    %
    
    
    8.1
    %
    
    
    100.0
    %
    
    
    
    %
 40




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##### Table of Contents



(1) We began our wholesale services business in April of 2002. Therefore, there
are only nine months of activity for this business segment. (2) For a detail of the special items please refer to the Special Items
Reconciliation at the beginning of this section. RETAIL SERVICES SEGMENT The following table, in millions, provides our retail services segment for 2002
compared to 2001. This was the first annual discussion of our results by
business segment because prior to 2002 we had only one segment, retail
services. Therefore, the 2001 retail services segment is the same as our
consolidated 2001 results, excluding special items. RETAIL SERVICES SEGMENTFOR THE YEARS ENDED
    
    AMOUNT
    
    PERCENTAGEDECEMBER 31,
    
    CHANGE
    
    CHANGE
    
    PERCENTAGE OF REVENUESFAVORABLE
    
    FAVORABLE2002
    
    2001
    
    (UNFAVORABLE)
    
    (UNFAVORABLE)
    
    2002
    
    2001Revenues
    
    $
    208.3
    
    
    $
    280.3
    
    
    $
    (72.0
    )
    
    
    (25.7
    )%
    
    
    100.0
    %
    
    
    100.0
    %Operating expenses:Network operations
    
    
    92.7
    
    
    
    159.6
    
    
    
    66.9
    
    
    
    41.9
    %
    
    
    44.5
    %
    
    
    56.9
    %Sales and marketing
    
    
    12.3
    
    
    
    31.2
    
    
    
    18.9
    
    
    
    60.6
    %
    
    
    5.9
    %
    
    
    11.1
    %General and administrative
    
    
    111.9
    
    
    
    126.2
    
    
    
    14.3
    
    
    
    11.3
    %
    
    
    53.7
    %
    
    
    45.0
    %Total operating expenses
    
    
    216.9
    
    
    
    317.0
    
    
    
    100.1
    
    
    
    31.6
    %
    
    
    104.1
    %
    
    
    113.1
    %Segment results
    
    $
    (8.6
    )
    
    $
    (36.7
    )
    
    $
    28.1
    
    
    
    76.6
    %
    
    
    (4.1
    )%
    
    
    (13.1
    )%
 Revenues. Revenues decreased by $72.0 million to $208.3 million for the year
ended December 31, 2002, compared to $280.3 million the prior year. The
decrease was primarily attributable to a decline in Z-LineHOME customers in
2002 compared to 2001. The decrease in Touch 1 (1+) long distance lines in
service contributed an additional decrease of $6.1 million to our 2002
revenues. These decreases were a result of focusing our efforts primarily on
establishing and growing our wholesale services, which were launched during
2002, which partially reduced our focus from our retail services business.
Therefore, retail services revenues decreased as a percentage of consolidated
revenues to 87.1% for 2002, compared to 100% during the prior year. We changed
our focus to once again increasing the line growth within our retail business
segment during the final quarter of 2002. Network Operations. Network operations expense decreased by $66.9 million to
$92.7 million for the year ended December 31, 2002, compared to $159.6 million
the prior year. Our gross margin percentage increased to 55.5% for the year
ended December 31, 2002, compared to 43.1% the prior year. Excluded from this
improved gross margin for 2002 is a $9.0 million retroactive reduction to
network access rates in New York; including this item, network operations
expense would have decreased by $75.9 million from 2001 and gross margin, as a
percentage of retail services revenues would have been 59.8% for 2002. Our
network operations expense as a percentage of revenues decreased primarily as a
result of decreases in the unbundled network element platform rates that we
paid to lease lines from the ILECs in the states in which we were operating and
more specifically the rate reduction in New York, our then largest market with
46% of our 2002 Z-LineHOME and Z-LineBUSINESS revenues. Other reductions
resulted from improvements we made to internal operations and processes that
mitigated our network operations costs. Sales and Marketing. Sales and marketing expense decreased $18.9 million to
$12.3 million for the year ended December 31, 2002, compared to $31.2 million
the prior year. We continued to more actively conserve cash during 2002, which
resulted in less than historically reported sales and marketing expenses in
2002. General and Administrative. General and administrative expense decreased $14.3
million to $111.9 million for the year ended December 31, 2002, compared to
$126.2 million the prior year. As a percentage of revenue, general and
administrative expense
increased by 8.7% to 53.7% of revenues in 2002 compared to 45.0% the prior
year. This increase excluded special items in 2002 of $0.7 million of bad debt
expense related to the WorldCom bankruptcy and the 2001 accounts receivable
write-down totaling $29.9 million of bad debt expense. Including these special
items, general and administrative expense decreased by $43.5 million during
2002 and was 54.1% of revenues compared to 55.7% for the prior year. The
increase as a percentage of revenues before special items was the result of our
decision in 2002 to focus on improving internal operations, expanding product
offerings and improving subscriber economics rather than investing in line
growth for most of 2002. During 2002 retail services was 92.8% of consolidated
segment general and administrative expense. Included in the retail services
general and administrative expense is all employee benefits, occupancy,
insurance, and other indirect or overhead-related expenses, as only direct
costs are recorded in our wholesale services segment. 41




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##### Table of Contents



WHOLESALE SERVICES SEGMENT This was the first annual discussion of our results by segment because prior to
April 1, 2002 we had only one business segment, retail services. Therefore, the
2001 wholesale services segment has no results. The following table, in
millions, provides our wholesale services segment for 2002 compared to 2001 to
facilitate our discussion of results for our wholesale services segment: WHOLESALE SERVICES SEGMENTFOR THE YEARS ENDED
    
    AMOUNT
    
    PERCENTAGEDECEMBER 31,
    
    CHANGE
    
    CHANGE
    
    PERCENTAGE OF REVENUESFAVORABLE
    
    FAVORABLE2002
    
    2001
    
    (UNFAVORABLE)
    
    (UNFAVORABLE)
    
    2002
    
    2001Revenues
    
    $
    30.8
    
    
    $
    
    
    
    $
    30.8
    
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    
    %Operating expenses:Network operations
    
    
    10.8
    
    
    
    
    
    
    
    (10.8
    )
    
    
    (100.0
    )%
    
    
    35.1
    %
    
    
    
    %General and administrative
    
    
    8.7
    
    
    
    
    
    
    
    (8.7
    )
    
    
    (100.0
    )%
    
    
    28.2
    %
    
    
    
    %Depreciation and amortization
    
    
    1.5
    
    
    
    
    
    
    
    (1.5
    )
    
    
    (100.0
    )%
    
    
    4.9
    %
    
    
    
    %Total operating expenses
    
    
    21.0
    
    
    
    
    
    
    
    (21.0
    )
    
    
    (100.0
    )%
    
    
    68.2
    %
    
    
    
    %Segment results
    
    $
    9.8
    
    
    $
    
    
    
    $
    9.8
    
    
    
    100.0
    %
    
    
    31.8
    %
    
    
    
    %
 Revenues.
Revenues were $30.8 million, or 12.9% of consolidated revenue for
2002. These revenues were primarily from our wholesale contract with MCI. Network Operations. Network operations expense was $10.8 million, or 10.4% of
consolidated network operations expense. This expense will vary depending on
each individual wholesale services contract. General and Administrative. General and administrative expense was $8.7
million, or 7.2% of consolidated general and administrative expense. The
significant components of this expense are similar to our consolidated
expenses, however, we only record the direct expenses associated with our
wholesale services within the wholesale business segment. Therefore, we have
not allocated any indirect or corporate (i.e. overhead related) expenses such
as employee benefits, occupancy costs , insurance expenses or other
administrative expenses to the wholesale services business segment. These
expenses are all included in the retail services segment. We received
pre-prepayments from MCI for our wholesale services as a result of their
bankruptcy filing on a post petition basis, and did not record any bad debt
expense for the wholesale services portion of our overall relationship. LIQUIDITY AND CAPITAL RESOURCES The competitive local telecommunications service business is traditionally
considered to be a relatively capital intensive business, owing to the
significant investments required in fiber optic communication networks and in
the collocation of switching and transmission equipment in incumbent local
exchange carriers central offices. Although we have historically utilized
UNE-P to provide our services to our own end users, we are also now working on
a VoIP initiative which will likely involve more capital expenditures than the
UNE-P based model has typically required. We will continue providing our UNE-P
based services, but our focus will increasingly move towards utilizing VoIP as
an access method whereby we will provide service to our own end users. In
2004, we plan to launch VoIP in at least two markets: Tampa, Florida and
Atlanta, Georgia. We expect to significantly expand this offering over the
coming years. We will continue to devote significant amounts of our capital
resources to continued operations, software development, new service offerings
and the marketing efforts that we have designed to achieve penetration of
our target markets. We have incurred accumulated losses since our inception as a result of
developing our business, performing ongoing research and development, building
and maintaining our network infrastructure and technology, the sale and
promotion of our services, and ongoing administrative expenditures. As of
December 31, 2003, we had an accumulated deficit of $318.9 million, a net tax
operating loss carryforward of $280.8 million, and $12.0 million in cash and
cash equivalents. We have funded our expenditures primarily through operating
revenues, private securities offerings, a sale-leaseback credit facility, an
accounts receivable factoring facility and an initial public offering that
raised net proceeds of $109.1 million. We intend to continue building our
organization in anticipation of future growth and we believe that our operating
expenditures will also continue to increase. 42




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##### Table of Contents



Net cash provided by operating activities decreased by $6.4 million to $12.0
million for the year ended December 31, 2003, compared to $18.4 million in the
prior year. The decrease was a result of our net loss after excluding non-cash
items, which increased by $8.1 million while overall working capital only
improved by $1.7 million. Included
in our net cash operating activities was the sale of $138.2 and $135.2
million of receivables, for net proceeds of $111.9 and $107.3 million, as of
December 31, 2003 and 2002, respectively. A net receivable servicing asset of
$13.2 and $8.5 million is included in accounts receivable and $4.2 and $3.4
million of advances on unbilled receivables are included in accounts payable
and accrued liabilities as of December 31, 2003 and 2002, respectively. The
costs relating to the agreement of $1.0, $1.3 and 1.1 million is included in
interest and other expense for years ended December 31, 2003, 2002 and 2001,
respectively. The
RFC agreement allows us to sell up to $25 million of receivables, subject to
the selection criteria utilized by RFC for the receivables they agree to
purchase. There were no minimum sales requirements under this agreement. RFC
purchased our receivables from us at a discount of 23%; prior to March 2002,
RFC purchased our receivables at a 32% discount rate. Our collection
percentages during 2003 and 2002 were 98.5% and 92.9%, respectively. Under the
agreement we were responsible for the continued servicing of the receivables
and any amount collected over the discount rate was paid to us by RFC for
providing the servicing less certain fees. Our net cash used in investing activities improved by $4.6 million to $11.0
million for the year ended December 31, 2003, compared to $15.6 million the
prior year. Nearly all the improvement was attributable to the purchasing of
less property and equipment during 2003 and the financing of $1.3 million of
equipment purchases in 2003. We expect our capital expenditures to increase during
2004, however, we expect to obtain financing for these purchases. As we move
toward a VoIP business model from our UNE-P model our capital expenditures are
expected to increase in the coming years due to the more capital intense
requirements of VoIP. Also, the expected growth in our retail and wholesale
business will increase capital expenditures. Our net cash used in financing activities improved by $0.7 million to $5.0
million for the year ended December 31, 2003, compared to $5.7 million the
prior year. This improvement is primarily a result of receiving the repayment
of $0.5 million from an executive who is also a member of the board of
directors in fulfillment of a note payable for the issuance of common stock and
$0.5 million for the exercise of stock options. These increased financing
inflows were reduced by a $0.3 million increase to the payments on long-term
debt and capital leases. We
expect our total debt to increase during 2004 because of a new asset based
loan agreement we expect to obtain in the near term. We expect that this
agreement will replace the accounts receivable agreement that we have with RFC.
This new agreement should be reported as a loan and therefore, will be
recorded as a financing transaction, as opposed to the RFC agreement, which is
recorded as an operating cash flow (it is a factoring facility as opposed to a
traditional asset based loan). As it is currently contemplated the new asset
based loan will include more of our accounts receivable in the borrowing base
calculation than was historically the case with RFC, therefore, proving us with
some additional liquidity. We also have received payments on related party
notes receivable and additional exercises of stock options during 2004 which
will provided additional improvement to our liquidity position for
2004. We currently have agreements with two long-distance carriers to provide
transmission and termination services for all of our long distance traffic.
These agreements generally provide for the resale of long distance services on
a per-minute basis and contain minimum volume commitments. As a
result of a settlement of a billing dispute associated with minimum
volume commitments required in one of the contracts we
have agreed to pay an increased per minute charge for minutes until the
achievement of certain minimum minute requirements which we expect to meet in
the first half of 2004. Once we meet the new agreed upon minimum minutes we
will revert to the terms of our original agreement. All other terms of the
original agreement continue in full force. We believe that we will be fully in
compliance with all minimum volume commitments during 2004. As of December 31,
2003 had recorded an accrual for $0.2 million, our estimated of the remaining
estimated payments. ANTICIPATED SOURCES AND USES OF CASH We diversified our sources and uses of cash during 2003 and will continue to do
so during 2004. When we discuss positive cash flow throughout this section we
are referring to the cash inflows and incremental cash outflows, exclusive of
fixed and overhead operating costs such as administrative payroll expenses,
non-operations related payroll expenses, occupancy costs, and other costs that
are of a corporate or overhead nature. These corporate overhead expenses were
$46.8 million for the year ended December 31, 2003. We believe it is
appropriate to have this discussion in order to understand our individual
contribution streams, while realizing that these streams must provide enough
cash flow to fund our corporate overhead. Our residential service provides
most of our cash from operations. We also continue to utilize the 1+
long-distance service as a positive cash generating business, primarily because
of our policy of not actively investing in it, other than the ongoing
maintenance costs associated with this line of business. Our wholesale
services business is also a good source of cash flow. Although not as
significant in volume as our 43




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residential business, it provides a healthy net
cash contribution on a per line basis without causing us to incur traditional
upfront sales and marketing costs, out of pocket, as is typically the case with
traditional retail activities. We expect to spend most of 2004 investing in the growth of our business
services, which should provide a positive cash flow in 2004. Finally, we are
continuing our access method diversification into VoIP, in an effort to provide
services that are not largely dependent on UNE-P. We expect to invest in this
business throughout 2004, without any significant positive net cash
contribution until 2005. We believe we are well positioned for growth during
2004 because of these diversified business models which provide us with more
avenues for growth opportunity and less dependence on any one model for
success. We also recognize the importance of managing the timing and ongoing
economics of this growth as it relates to our overall cash and financial
position. Our ongoing capital requirements will depend on several factors, including
market acceptance of our services, the amount of resources that we devote to
investments in our networks and facilities, the build-out of additional
enterprise management centers, the ongoing development of services and brand
promotions, the resources that we devote to the sales and marketing of our
services, and many other factors. We will continue to provide our back-office
services and the technology that we have developed to other companies seeking
the capability of offering residential and small business telecommunications
services on a private label basis to residential and business customers. As
growth and opportunities arise, we expect to make strategic investments in
technology and our network architecture and enter potential strategic alliances
or partnerships with other entities. We expect to continue to finance our
capital expenditures mostly from internally generated cash flow and from
existing facilities. We expect to see an overall increase in fixed assets
across nearly all categories during 2004. We
 are currently under audit by the State of New York for our sales and use
taxes. In January of 2004, we received a preliminary summary from the State of
New York stating that we owe them $2.0 million in sales and use taxes, before
any possible interest or penalties, primarily due to their position that 100% of
the bundled services we offer are taxable. Although this process is still
on-going, we currently disagree with their calculation of the sales and use tax
due on our bundled products and we believe that certain portions of the bundle
are not subject to sales and use taxes. Our goal is to obtain an acceptable
settlement with the state, but we believe that our methodology is appropriate,
reasonable, and in compliance with the State of New Yorks sales and use taxes
calculation. We have made accruals based on our best estimates of the facts,
but are unable to determine the final outcome at this time. CASH MANAGEMENT We had about $46.8 million in corporate expenditures during 2003, of which
$19.2 million relates to non-essential headcount and related expenses which
would not be necessary if we were to reduce our operations to a purely
maintenance approach and discontinued spending on any development of new
service offerings or new business opportunities, other technological focused
initiatives and investments in legal and regulatory related
activities. We believe that if the line growth materializes similar to managements
expectations over the course of 2004, we will generate overall free cash flow
without any reductions to the aforementioned corporate expenditures. We
expect to reinvest this free cash flow into the business and to fund our
capital expenditures for VoIP, any additional head-count requirement and any
related costs for growing our wholesale and retail service business segments.
We expect the next six months of 2004 to be challenging from a cash management
perspective, however the expected closing of an asset based loan agreement will provide
additional liquidity that will help us manage our payables and expected
increased capital expenditures resulting from expected growth in all lines of
our business. These expenses are primarily front-end loaded and should result
in negative cash flows over the short term, but should
become positive during the last quarter of 2004. We will continue to finance
significant capital expenditures and are working with certain vendors to obtain
more generous payment terms that will provide us with more flexibility during
this period. We may or may not be successful in these endeavors. Looking to the future, the most significant issue we need to address is the
mandatorily redeemable preferred stock which has a current collective
liquidation value of $154.0 million, that either will need to be redeemed or
converted in some fashion into common stock or some other type of instrument.
The redemption of this stock is not definite, as it can be converted at the
option of the holder or under certain conditions the conversion may be forced
by us. However, this would not likely occur until our
common stock price increases significantly. We recognize the importance of exploring
various options and alternatives to address a possible redemption that may
occur as early as 2006 for a part of the preferred stock. We also realize that
these instruments may hinder our ability to obtain additional financing in the
future, unless we have a viable plan to convert or redeem these securities in
part or in full. In September of 2003, we decided to postpone a company-wide salary increase.
This increase was scheduled to take place in April of 2004, however, we are
still assessing if this increase will be further postponed. We are also
exploring the possibility of granting certain employees with restricted stock
in lieu of payroll increases. 44




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DEBT INSTRUMENTS Asset-Based Loan We
believe we are close to signing three-year revolving credit agreement, which we expect
to be completed in the next 15 days. We expect that this agreement will
provide us with an availability to borrow up to $25.0 million. Our overall
availability is based on the eligibility of our accounts receivables, subject
to certain limitations and advance rates. This agreement will replace our RFC
accounts receivable agreement which terminates on July 27, 2004. This new
agreement is expected to provide us with additional liquidity as it encompasses
certain accounts receivable that were not included in our prior arrangement
with RFC, which was based only on our residential accounts receivable. We
believe that this new agreement will provide us with the necessary flexibility
to grow our business and should include less restrictive covenants during the
first three quarters of 2004. We also, as the deal is currently contemplated,
have agreed to acceptable terms that we believe will provide us with the
ability to access subordinated debt within the confines of the agreement, which
we believe provide us with additional flexibility for future debt financing
alternatives. Although we expect that we will have this agreement completed in
the next 15 days we can not assure that the agreement will be closed and that we
will obtain all of the terms and conditions we discussed, in the final
agreement. We believe that this new agreement will help us to manage our short and
long-term cash needs, although we are still exploring other alternatives for
obtaining additional funding, including but not limited to subordinated debt and
certain equity transactions. We believe that an asset based loan agreement
will immediately help to improve our overall working capital position but the
expected grown in our business may still result in additional liquidity needs
that would have to be obtained through additional financings. Specifically,
our recently signed agreement with a large communications concern with a
significant embedded customer base may result in our residential service
operating at a cash flow negative position until the fourth quarter of 2004.
We also may need additional funds for our VoIP initiative which will likely be
much more capital intensive than the UNE-P business model has been
historically. The availability of cash will somewhat dictate the speed in
which we will be able to roll this access method out to new cities, as there is
an initial cost of about $0.5 million in capital expenditures to establish
service in a major metropolitan areas. After this initial cost there are the
additional costs of the customer premise equipment and installation and
provisioning costs to get customers onto the service but these costs are
success based and will move in tandem with new customers but will require
larger up-front payments than we currently experience to get a customer up and
running with UNE-P services. However, in the longer-term the network costs for
these customers are much lower because of the larger capital expenditures for
network bandwidth which reduces future incremental costs. Term Debt We
have $4.1 million of remaining principal term debt as of December 31, 2003,
of which all but $0.1 million will be paid off by September 2004. This debt
was assumed in the purchase of Touch 1 Communications, Inc., our wholly owned
subsidiary, in April 2000. All of this debt is paid monthly and is at a fixed
interest rate of 6.0%. ILEC, IXC AND RELATED DISPUTED CHARGES Since our existence we have disputed and continue to dispute significant
charges from the various ILECs, IXCs, and certain other carriers providing us
services. We have a policy of treating all charges, that we believe are
without merit, that are still being presented on a bill to us on a regular
basis as disputes, regardless of the age of the dispute. We believe that the
majority of these charges are without merit, however, we accrue for
any
the charges we believe represent valid charges against us. Our outstanding
disputes at December 31, 2003 totaling $18.2 million. These
disputes are summarized in the following table: OustandingDisputes atDecember 31, 2003(In millions)Alternatively billed services
    
    $
    7.8MCI fixed facility charges
    
    
    2.8Verizon back-billing of installation charges

    
    
    2.4Late fees for non-payment of disputed charges
    
    
    2.4All others
    
    
    2.8$
    18.2
 45




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Alternatively billed services are primarily charges for certain 1-800, collect
and information service calls. These disputes are largely historic in nature.
We settled certain of these disputes in Texas with Southwestern Bell Telephone
Company. We remit all monies collected associated with these services but do
not pay the charges unless we collect from our customers. We believe that our
liability related to these charges should be capped at the amount remitted by
our end users, however, some of our settlements have included payments in
excess of payments from our customers. Therefore, we have accrued $1.7 million
for alternatively billed services as of December 31, 2003. The MCI fixed facility charge dispute is over 3 years old. Although we have
received communications from MCI that these charges are not valid, they have
never removed these charges from their billings to us. We received a billing for $2.3 million from Verizon relating to the
back-billing of dispatch charges believed to relate to the period from August
2000 to February 2002 and from March 2003 to September 2003. We do not know if
this is the entire amount they will bill related to these back-billed
charges. Our policy is to dispute items that are billed without the necessary
underlying detail records and therefore, we have disputed these charges. We
expect that if any of these charges are valid, a portion of these charges may
be subject to being billed to our wholesale services customers for services
that we provided under our contracts with them. We have not received sufficient
detail related to these charges from Verizon and therefore, are unable to
determine their validity. The late fees are accumulating from all of our disputes as we do not pay for
disputed items and therefore incur and accumulate late fee for these disputed
billings. The remaining $2.8 million of disputes relates to various disputes primarily
with ILECs for incorrect rates, duplicate billing, charges for
customers for whom we are no longer providing service and other billing errors. We believe that we are adequately reserved for our disputes and manage our cash
position to insure that we have the necessary availability of cash to make
payments which may arise out of the loss of disputes that we believe are at
risk. Therefore, we believe our maximum cash exposure for these charges is
$18.2 million. However, we do not believe that these charges are valid and
intend to continue our dispute and non-payment of these charges. CONTRACTUAL OBLIGATIONS The
 following table, in thousands, discloses aggregate information about our contractual
obligations and the periods in which payments are due: LESS THAN
    
    
    
    
    
    
    
    
    
    AFTERCONTRACTUAL OBLIGATIONS
    
    TOTAL
    
    1 YEAR-
    
    1-3 YEARS
    
    4-5 YEARS
    
    5 YEARSLong-term debt
    
    $
    4,050
    
    
    $
    3,992
    
    
    $
    58
    
    
    $
    
    
    
    $
    Operating leases
    
    
    10,271
    
    
    
    2,939
    
    
    
    4,907
    
    
    
    2,425
    
    
    
    Capital leases
    
    
    1,660
    
    
    
    1,245
    
    
    
    415
    
    
    
    
    
    
    
    Mandatorily redeemable
preferred stock redemption
    
    
    158,779
    
    
    
    
    
    
    
    23,314
    
    
    
    135,465
    
    
    
    Unconditional purchase
obligations
    
    
    17,421
    
    
    
    14,919
    
    
    
    141
    
    
    
    1,154
    
    
    
    1,207Total contractual cash
obligations
    
    $
    192,181
    
    
    $
    23,095
    
    
    $
    28,835
    
    
    $
    139,044
    
    
    $
    1,207
 We have no other significant off-balance sheet items. RELATED PARTY TRANSACTIONS In January 2001, we accelerated the vesting of 50,000 stock options granted to
an executive as part of his severance agreement. This acceleration resulted in
the employee being fully vested in stock options with a strike price of $3.64
when the stock was trading at $4.50. We recorded approximately $0.1 million in
general and administrative expense as a result of this transaction. 46




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In January 2002, we accelerated the vesting of 96,471 stock options
granted to an executive as part of his severance agreement. This acceleration
resulted in the employee being fully vested in stock options with a strike
price of $1.30 per share when the stock was trading at $1.80 per share. The
employee forfeited 76,471 of his vested options in return for the exercise of
20,000 shares of stock. We recorded approximately $0.1 million in general and
administrative expense as a result of this transaction. In February 2003 we received a payment to $0.5 million from an executive
officer who is also on our Board of Directors in fulfillment of an outstanding
note receivable to us. In August 2003, we accelerated the vesting of 122,223 stock options granted to
an executive as part of his severance agreement. This acceleration resulted in
the employee being fully vested in stock options with a strike price of $1.30
per share when the stock was trading at $2.02 per share. As a result of this
transaction we recorded approximately $0.1 million in general and
administrative expense. At December 31, 2003, we have approximately $1.7 million of notes receivable
from employees and former employees for various reasons. We have recorded
approximately $1.1 million of these loans as contra equity, as the loans were
for the purchase of stock. The remaining $0.6 million loans were more of a
personal nature and we have made an accrual for $0.5 million as some of these
loans are to former employees and the likelihood of collection and lack of
collateral make it likely that these amounts will not be collectable. These
notes are primarily due by December 2004 with approximately $0.8 million due by
that date. Only two notes are due beyond this date, one is a note in the
amount of approximately $0.8 million, due in June 2005, and the other is
approximately $0.1 million and is a demand note that currently has no specific
due date. We paid interest on our related party term debt in the amount of
$0.3, $0.4 and $0.6 million for the years ended December 31, 2003,
2002 and 2001, respectively. NEW ACCOUNTING PRONOUNCEMENTS In November 2002, the Emerging Issues Task Force (EITF) of the Financial
Accounting Standards Board (FASB) reached a consensus on EITF No. 00-21,
Accounting for Revenue Arrangements with Multiple Element Deliverables. EITF No. 00-21 addresses how to account for arrangements
that may involve the delivery or performance of multiple products, services
and/or rights to use assets. Revenue arrangements with multiple deliverables
should be divided into separate units of accounting if the deliverables in the
arrangement meet certain criteria. Arrangement consideration should be
allocated among the separate units of accounting based on their relative fair
values. The Issue also supersedes certain guidance set forth in Staff
Accounting Bulletin No. 101 (SAB 101), Revenue Recognition in Financial
Statements. The final consensus is applicable to agreements entered into in
quarters beginning after June 15, 2003, with early adoption permitted.
Additionally, companies are permitted to apply the consensus guidance to all
existing arrangements as a cumulative effect of a change in accounting
principle. We adopted this new pronouncement effective July 1, 2003, on a
prospective basis. This adoption did not have a material impact on our
consolidated financial statements. In May 2003, the FASB issued Statement of Financial Accounting Standards
(SFAS) No. 150, Accounting for Certain Financial Instruments with
Characteristics of Both Liabilities and Equity. This statement establishes
standards for how an issuer classifies and measures certain financial
instruments with characteristics of both liabilities and equity. This statement
is effective for financial instruments entered into or modified after May 31,
2003, and otherwise is effective for quarters beginning July 1, 2003. We
reviewed this new pronouncement and have concluded that none of our mandatorily
redeemable convertible preferred stock presented in the mezzanine section of
our balance sheet is within the scope of SFAS No. 150. This conclusion is
based on the facts that there is not an unconditional obligation requiring the
redemption of the securities because they are convertible into common at the
option of the holder and the conversion option is substantial. We recognize
that the FASB is in the process of possibly promulgating additional rules in
the future related to securities similar to the ones that we have in the
mezzanine section, but are unable to determine what any future rules impact
might have on our consolidated financial statements. In December 2003, the Securities and Exchange Commission released Staff
Accounting Bulletin no. 104 SAB 104), Revenue Recognition. SAB 104
clarifies existing guidance regarding revenues for contracts which contain
multiple deliverables to make it consistent with EITF No. 00-21. The adoption
of the provisions of EITF 00-21 and SAB 104 had no effect on our results of
operations. In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities (FIN 46 ). FIN 46 requires an investor with a
majority of the variable interests in a variable interest entity to consolidate
the entity and also requires majority and significant variable interest
investors to provide certain disclosures. A variable interest entity is an
entity that has (1) equity investment at risk that is insufficient to finance
the entitys activities without receiving additional subordinated financial
support from the other parties, (2) a group of equity owners that are unable to
make substantive decisions about the entitys activities, or (3) equity that
does not absorb the entitys losses or receive the benefits of the entity. FIN
46 is effective for all new variable 47




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interest entities created or acquired after January 31, 2003. We do not have
any variable interest entities and experienced no impact from the adoption of
FIN 46. CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS The report contains forward-looking statements relating to events anticipated
to happen in the future. These forward-looking statements are based on the
beliefs of our management, as well as assumptions made by and information
currently available to our management. Forward-looking statements also may be
included in other written and oral statements made or released by us. You can
identify forward-looking statements by the fact that they do not relate
strictly to historical or current facts. The words believe, anticipate,
intend, expect, estimate, project and similar expressions are intended
to identify forward-looking statements. Forward-looking statements describe our
expectations today of what we believe is most likely to occur or may be
reasonably achievable in the future, but they do not predict or assure any
future occurrence and may turn out to be wrong. Forward-looking statements are
subject to both known and unknown risks and uncertainties and can be affected
by inaccurate assumptions we might make. Consequently, no forward-looking
statement can be guaranteed. Actual future results may vary materially. We do
not undertake any obligation to publicly update any forward-looking statements
to reflect new information or future events or occurrences. These statements
reflect our current views with respect to future events and are subject to
risks and uncertainties about us, including, among other things:  
    
    our reliance on ILEC local networks;
    
    the outcome of legal and regulatory proceedings;
    
    our ability to market our services successfully to new subscribers;
    
    our ability to retain a high percentage of our customers;
    
    the possibility of unforeseen capital expenditures and other upfront
investments required to deploy new technologies or to effect new
business initiatives;
    
    our ability to access markets and finance network developments and operations;
    
    our expansion, including consumer acceptance of new price plans and bundled offerings;
    
    additions or departures of key personnel;
    
    competition, including the introduction of new products or services by our competitors;
    
    existing and future laws or regulations affecting our business and our ability to comply with these laws or regulations;
    
    our reliance on the Regional Bell operating companys systems and provisioning processes;
    
    technological innovations;
    
    general economic and business conditions, both nationally and in the regions in which we operate; and
    
    other factors described in this document, including those described in more detail below. We caution you not to place undue reliance on these forward-looking statements,
which speak only as of the date of this document. RISKS RELATED TO OUR FINANCIAL CONDITION AND OUR BUSINESS Availability and Favorable Pricing of Unbundled Network Components. Our
business strategy depends on a continued availability of ILEC unbundled network
components and on states maintaining and adopting favorable pricing rules for
ILEC unbundled network components. Approximately 95% of our revenues are
derived from the use of ILEC networks. The FCC has issued rules regarding
access to key components of the ILEC networks, including transport and
switching. A recent court ruling, however, has created considerable legal
uncertainty regarding this access. In United States Telecom Assn v. FCC, Nos.
00-1012, 00-1015, 03-1310 et al.(D.C. Cir. March 2, 2004) (USTA II), the
D.C. Circuit Court ordered that the FCCs unbundled transport and switching
rules be vacated after sixty days or upon denial of a petition for rehearing,
whichever occurs later. Although a majority of the FCC has indicated that it
will support an appeal, this ruling and the uncertainty it has created could
have material, adverse 48




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effects upon us and our operations. Certain potential adverse effects from
this ruling and the uncertainty is has created are set forth below. This list
is not exhaustive as a listing of all the potential adverse effects would
impossible. See also the section of this report entitled Government
Regulation.  
    
    ILECs, after some period of time, could deny us access to their
networks in violation of interconnection agreements and essentially
destroy our ability to provide our services.
    
    ILECs could refuse new service orders, including repair and change
orders. We would not be able to add new customers. Our business would
diminish because of normal customer churn, that is, the normal loss of
existing customers over time.
    
    Our customer churn could increase as our customers return to ILEC
services in response to the uncertainty.
    
    ILECs could significantly raise the prices they charge for access to
their networks. We would be forced to raise our rates to
non-competitive levels.
    
    Vendors, including long distance companies, could alter the terms
under which they do business with us, such as credit terms, thereby
increasing our costs and diminishing our cash flow and liquidity.
    
    We may be unable to obtain new financing at acceptable rates. We
have already encountered difficulty in attempting to obtain financing
from one particular lender.
    
    We may lose prospective customers that otherwise would have become
our customers. We believe we have already lost at least one large
prospective customer (over 5,000 lines) because of the uncertainty.
    
    Our wholesale customers may decline to expend marketing resources to
increase their customer bases.
    
    We could lose major marketing partners and potential marketing
partners as they decline to expend resources in marketing our services.
    
    We could lose key personnel, as they seek security in offers from
other prospective employers.
    
    The cost of litigation and of participation in administrative
proceedings relating to interconnection agreements and new regulations
could be excessively burdensome. The availability of favorable pricing rules for unbundled network components is
another key element of our business strategy. The public utilities commissions
of certain states have adopted pricing rules for unbundled network components.
In general, ILECs are required to provide us with access to their networks at
forward-looking, long-run incremental cost-based prices. However, we cannot be
certain that unbundled network components will continue to be available at
favorable prices in those states or that other states will ever adopt favorable
pricing, particularly in light of the recent D.C. Circuit Court ruling referred
to above. Emerging Industry Sector. We are in a new, emerging sector of the
telecommunications industry. Our experience, as well as the experience of
others, in this sector is limited. As a result we could encounter numerous
unforeseen difficulties and challenges. Uncertainties Relating to Wholesale Initiative. Our wholesale initiative is
still developing. We believe we are the first competitive local exchange
carrier to offer wholesale local exchange services. We undoubtedly will
encounter unforeseen delays, capital expenditures and upfront costs, regulatory
and legal issues (which may include legal challenges to our wholesale strategy
by incumbent local exchange carriers), technical difficulties and other
challenges. There can be no assurance that we will overcome these challenges
successfully or without expenditure of substantial resources. Moreover, since
we must pay the incumbent local exchange carrier fees relating to local
telephone usage by both our retail and wholesale customers, we will be highly
dependent upon our wholesale customers. Their failure to pay fees to us may
make it difficult or impossible for us to pay fees to the incumbent local
exchange carriers upon which we rely. Rapid Expansion. We are attempting to grow our business rapidly in terms of the
number of services we offer, the number of customers we serve and the regions
we serve. We are expending substantial sums in anticipation of increased sales
resulting from a new marketing partner relationship. There can be no assurance
this marketing initiative will be launched as expected or that it will be
successful, particularly in light of the legal and regulatory uncertainties
described elsewhere in this report. Furthermore, there is no assurance that we
will successfully manage our efforts to:  
    
    expand, train, manage and retain our employee base; 49




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
    
    expand and improve our customer service and support systems and improve the performance of billing systems;
    
    introduce and market new products and services and new pricing
plans in addition to Z-LineHOME and our other service offerings;
    
    enhance and upgrade the features of our software;
    
    capitalize on new opportunities in the competitive marketplace; or
    
    control our expenses. The strains posed by these demands are magnified by the emerging nature of our
operations. If we cannot manage our growth effectively, our results of
operations could be adversely affected. Difficulties in Expanding Network Infrastructure. We must continue to develop,
expand and adapt our network infrastructure as the number of our users and the
amount of information they wish to access and transfer increases and as our
customers demands change. We cannot be sure that we will be able to develop,
expand or adapt the network infrastructure to meet additional demand or our
customers changing requirements on a timely basis, at a commercially
reasonable cost, or at all. If we fail to expand our network infrastructure on
a timely basis or adapt it to either changing customer requirements or evolving
industry standards, these failures could cause our business to perform poorly. Ability to Resell Long Distance Services. We offer long distance telephone
services as part of our service packages. We currently have agreements with
various long distance carriers to provide transmission and termination services
for all of our long distance traffic. Recently, several long distance carriers
have encountered financial difficulties, including both carriers
utilized by us. Financial difficulties encountered by any of our carriers could
cause disruption of service to our customers and could diminish the value of
any receivables or credits that may be due to us from such carriers. Our
agreements with long distance carriers generally provide for the resale of long
distance services on a per-minute basis and contain minimum volume commitments.
In cases in which we have agreed to minimum volume commitments and fail to meet
them, we will be obligated to pay underutilization charges. In some instances,
if we incur underutilization charges, our basic rate will increase, which could
further adversely affect our operating results. We recently settled a dispute by
agreeing to a higher rate. Risk of Software Failures and Errors. The software that we use and the software
that we have developed internally and are continuing to develop may contain
undetected errors. Although we have extensively tested our software, errors may
be discovered in the software during the course of its use. Any errors may
result in partial or total failure of our network, loss or diminution in
service delivery performance, additional and unexpected expenses to fund
further product development or to add programming personnel to complete or
correct development, and loss of revenue because of the inability of customers
to use our products or services, which could adversely affect our business
condition. Protection of Proprietary Technology. We currently rely on a combination of
copyright, trademark and trade secret laws and contractual confidentiality
provisions to protect the proprietary information that we have developed. Our
ability to protect our proprietary technology is limited, and we cannot assure
you that our means of protecting our proprietary rights will be adequate or
that our competitors will not independently develop similar technology. Also,
we cannot be certain that the intellectual property that incumbent local
exchange carriers or others claim to hold and that may be necessary for us to
provide our services will be available on commercially reasonable terms. If we
were found to be infringing upon the intellectual property rights of others, we
might be required to enter into royalty or licensing agreements, which may be
costly or not available on commercially reasonable terms. If successful, a
claim of infringement against us and our inability to license the infringed or
similar technology on terms acceptable to us could adversely affect our
business. Dependence on Information Systems. Our billing, customer service and management
information systems are newly developed and we may face unexpected system
difficulties, which would adversely affect our service levels and,
consequently, our business. Sophisticated information and processing systems
are vital to our ability to monitor costs, render monthly invoices for
services, process customer orders and achieve operating efficiencies. We rely
on internal systems and third party vendors, some of which have a limited
operating history, to provide our information and processing systems. If our
systems fail to perform in a timely and effective manner and at acceptable
costs, or if we fail to adequately identify all of our information and
processing needs or if our related processing or information systems fail,
these failures could have a material adverse effect on our business. In addition, our right to use third party systems is dependent upon license
agreements. Some of these agreements are cancelable by the vendor, and the
cancellation or nonrenewal of these agreements could seriously impair our
ability to process orders or bill our customers. As we continue to provide
local telephone service, the need for sophisticated billing and information
systems will also increase significantly and we will have significant
additional requirements for data interface with incumbent local exchange
carriers and others. We cannot be certain that we will be able to meet these
additional requirements. 50




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Network Failure. The successful operation of our network will depend on a
continuous supply of electricity at multiple points. Although the system that
carries signals has been designed to operate under extreme weather conditions
(including heavy rain, wind and snow), like all other telecommunications
systems, our network could be adversely affected by such conditions. Our
network, however, is equipped with a back-up power supply and our existing
network operations center is equipped with both a battery backup and an on-site
emergency generator. If a power failure causes an interruption in our service,
the interruption could negatively impact our operations. Our network also may be subject to physical damage, sabotage, tampering or
other breaches of security (by computer virus, break-ins or otherwise) that
could impair its functionality. In addition, our network is subject to unknown
capacity limitations that may cause interruptions in service or reduced
capacity for our customers. Any interruptions in service resulting from
physical damage or capacity limitations could cause our systems to fail. Dependence on Local Exchange Carriers. We rely on incumbent local exchange
carriers to supply key unbundled components of their network infrastructure to
us on a timely and accurate basis, and in the quantities and quality demanded
by us. We may from time to time experience delays or other problems in
receiving unbundled services or facilities which we request, and there can be
no assurance that we will able to obtain such unbundled elements on the scale
and within the time frames required by us. Any failure to obtain these
components, services or additional capacity on a timely and accurate basis
could adversely affect us. Anticipated Capital Needs. If we expand more rapidly than currently anticipated
or if our working capital needs exceed our current expectations, we may need to
raise additional capital from debt or equity sources. If we cannot obtain
financing on acceptable terms or at all, we may be required to modify, delay or
abandon our current business plan, which is likely to materially and adversely
affect our business and, as a result, the value of our common stock. We have an
accounts receivable facility with RFC Corporation that provides for the sale of
up to $25 million of our receivables to RFC. This facility expires in July
2004. We are currently in negotiations to replace this facility. Dependence on Third Party Vendors. We currently purchase the majority of our
telecommunications equipment as needed from third party vendors, including
Lucent Technologies, Inc., Sonus Networks, Inc., Dialogic Communications
Corporation, Hewlett-Packard Company, Compaq Computer Corporation, Sun
Microsystems, Inc. and EMC Corporation. In addition, we currently license our
software from third party vendors, including Oracle Corporation, INPRISE
Corporation, Mercator Software, Inc., Microsoft Corporation, Nuance
Communications, Inc., SpeechWorks International, Inc., Telution, Inc., AMS,
Inc., Netscape Communications, Inc. and Accenture. We typically do not enter
into any long-term agreements with our telecommunications equipment or software
suppliers. Any reduction or interruption in supply from our equipment suppliers
or failure to obtain suitable software licensing terms could have a disruptive
effect on our business and could adversely affect our results of operations. Dependence on Management and Key Personnel. We depend on a limited number of
key personnel who would be difficult to replace. If we lose the services of
some of our key personnel, our business could suffer. We currently maintain a
$5,000,000 key man life insurance policy on the life of Mr. D. Gregory Smith,
our president, chief executive officer and chairman of the board. We also
depend on a limited number of key management, sales, marketing and product
development personnel to manage and operate our business. In particular, we
believe that our success depends to a significant degree upon our ability to
attract and retain highly skilled personnel, including our engineering and
technical staff. If we are unable to attract and retain our key employees, the
value of our common stock could suffer. Government Regulation and Legal Uncertainties. We are subject to varying
degrees of federal, state, and local regulation. We must also comply with
various state and federal obligations that are subject to change, such as the
duty to contribute to universal service subsidies, the impact of which we
cannot assess on a going-forward basis as the rates change periodically. Our
failure to comply with regulatory requirements may result in fines or other
penalties being imposed on us, including loss of certification to provide
services. Decisions of the FCC and state regulatory commissions providing incumbent local
exchange carriers with increased flexibility in how they price their services
and with other regulatory relief, could have a material adverse effect on our
business and that of other competitive local exchange carriers. Future
regulatory provisions may be less favorable to competitive local exchange
carriers and more favorable to their competitors. If incumbent local exchange
carriers are allowed by regulators to engage in substantial volume and term
discount pricing practices for their end-user customers, or charge competitive
local exchange carriers higher fees for interconnection to the incumbent local
exchange carriers networks, our business, operating results and financial
condition could be materially, adversely affected. Incumbent local exchange
carriers may also seek to delay competitors through legal or regulatory
challenges, or by recalcitrant responses to requirements that they open their
markets through interconnection and unbundling of network elements. Our legal
and administrative expenses may be increased because of our having to actively
participate in rate cases filed by incumbent local exchange carriers, in which
they seek to increase the rates they can charge for the unbundled network
element platform components. Our profitability may be adversely affected if
those carriers prevail in those 51




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cases. Pending court cases, in which certain provisions of the
Telecommunications Act of 1996 will be conclusively interpreted, may result in
an increase in our cost of obtaining unbundled network elements. We are also subject to federal and state laws and regulations prohibiting
slamming, which occurs when specific procedures are not followed when a
customer changes telecommunications services. Although we attempt to diligently
comply with all such laws and regulations and have procedures in place to
prevent slamming, if violations of such laws and regulations occur, we could
become subject to significant fines and penalties, legal fees and costs, and
our business reputation could be harmed. Competition. The telecommunications and information services markets are
intensely competitive and rapidly evolving. We expect competition to increase
in the future. Many of our potential competitors have longer operating
histories, greater name recognition, larger customer bases and substantially
greater financial, personnel, marketing, engineering, technical and other
resources than us. We believe the principal competitive factors affecting our
business operations will be price, the desirability of our service offering,
quality and reliability of our services, innovation and customer service. Our
ability to compete effectively will depend upon our ability to maintain high
quality, market-driven services at prices generally equal to or below those
charged by our competitors. Competitor actions and responses to our actions
could, therefore, materially and adversely affect our business, financial
condition and results of operations. We face competition from a variety of participants in the telecommunications
market. The largest competitor for local service in each market in which we
compete is the incumbent local exchange carrier serving that market. Incumbent
local exchange carriers have established networks, long-standing relationships
with their customers, strong political and regulatory influence, and the
benefit of state and federal regulations that favor incumbent local exchange
carriers. In the local exchange market, the incumbent local exchange carriers
continue to hold near-monopoly positions. The long distance telecommunications
market in which we compete has numerous entities competing for the same
customers and a high average churn rate as customers frequently change long
distance providers in response to the offering of lower rates or promotional
incentives. Prices in the long distance market have declined significantly in recent years
and are expected to continue to decline. We will face competition from large
interexchange carriers. Other competitors are likely to include incumbent local
exchange carriers providing out-of-region (and, with the removal of regulatory
barriers, in-region) long distance services, other incumbent local exchange
carriers, other competitive local exchange carriers, cable television
companies, electric utilities, wireless telephone system operators, microwave
and satellite carriers and private networks owned by large end users. The Telecommunications Act of 1996 facilitates such entry by requiring
incumbent local exchange carriers to allow competing providers to acquire local
services at wholesale prices for resale and to purchase unbundled network
elements at cost-based prices. A continuing trend toward combinations and
strategic alliances in the telecommunications industry, including potential
consolidation among incumbent local exchange carriers or competitive local
exchange carriers, or transactions between telephone companies and cable
companies outside of the telephone companys service area, or between
interexchange carriers and competitive local exchange carriers, could give rise
to significant new competitors. The enhanced and information services markets are also highly competitive and
we expect that competition will continue to intensify. Our competitors in these
markets will include information service providers, telecommunications
companies, on-line service providers and Internet service providers. Unauthorized Transactions; Theft of Services. We may be the victim of fraud or
theft of service. From time to time, callers have obtained our services without
rendering payment by unlawfully using our access numbers and personal
identification numbers. We attempt to manage these theft and fraud risks
through our internal controls and our monitoring and blocking systems. If these
efforts are not successful, the theft of our services may cause our revenue to
decline significantly. To date, we have not encountered material fraud or theft
of our service. 
 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We do not enter into financial instruments for trading or speculative purposes
and do not currently utilize derivative financial instruments. Our operations
are conducted primarily in the United States and as such are not subject to
material foreign currency exchange rate risk. The fair value of our investment portfolio or related income would not be
significantly impacted by either a 100 basis point increase or decrease in
interest rates due mainly to the short-term nature of the major portion of our
investment portfolio. We have no material future earnings or cash flow exposures from changes in
interest rates on our long-term debt obligations, as substantially all of our
long-term debt obligations are fixed rate obligations. 52




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ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA PAGEReport of Independent Certified Public Accountants
    
    
    F-2Consolidated Financial Statements:Consolidated Balance Sheets
    
    
    F-3Consolidated Statements of Operations
    
    
    F-4Consolidated Statements of Changes in
Stockholders Equity (Deficit) and
Comprehensive Income
    
    
    F-5Consolidated Statements of Cash Flows
    
    
    F-6Notes to Consolidated Financial Statements
    
    
    F-8
 F-1




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REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To
 the Board of Directors and Stockholders of Z-Tel Technologies, Inc. and
Subsidiaries In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, of changes in stockholders equity
(deficit) and comprehensive income and of cash flows present fairly, in all
material respects, the financial position of Z-Tel Technologies, Inc. and its
subsidiaries at December 31, 2003 and 2002, and the results of their operations
and their cash flows for each of the three years in the period ended December
31, 2003 in conformity with accounting principles generally accepted in the
United States of America. These financial statements are the responsibility of
the Companys management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of these
statements in accordance with auditing standards generally accepted in the
United States of America, which require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audits provide a reasonable basis for our opinion. /s/ PricewaterhouseCoopers LLPTampa, FloridaMarch 29, 2004
 F-2




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA) December 31,
    
    December 31,2003
    
    2002AssetsCurrent assets:Cash and cash equivalents
    
    $
    12,013
    
    
    $
    16,037Accounts receivable, net of allowance for doubtful
accounts of $13,804 and $17,401
    
    
    24,600
    
    
    
    26,749Prepaid expenses and other current assets
    
    
    7,664
    
    
    
    5,741Total current assets
    
    
    44,277
    
    
    
    48,527Property and equipment, net
    
    
    39,069
    
    
    
    48,320Intangible assets, net
    
    
    2,287
    
    
    
    4,116Other assets
    
    
    3,820
    
    
    
    5,748Total assets
    
    $
    89,453
    
    
    $
    106,711Liabilities, Mandatorily Redeemable Convertible Preferred
Stock and Stockholders DeficitCurrent liabilities:Accounts payable and accrued liabilities
    
    $
    59,230
    
    
    $
    51,771Deferred revenue
    
    
    11,068
    
    
    
    10,172Current portion of long-term debt
and capital lease obligations
    
    
    5,017
    
    
    
    5,964Total current liabilities
    
    
    75,315
    
    
    
    67,907Long-term deferred revenue
    
    
    361
    
    
    
    6,277Long-term debt and capital lease obligations
    
    
    514
    
    
    
    4,180Total liabilities
    
    
    76,190
    
    
    
    78,364Mandatorily redeemable convertible preferred stock, $.01 par value;
50,000,000 shares authorized; 8,855,089 issued; 8,738,422 and 8,855,089
outstanding (aggregate liquidation value of $158,779 and $145,503)
    
    
    144,282
    
    
    
    127,631Commitments
and contingencies (Notes
11, 16 and 21)Stockholders deficit:Common stock, $.01 par value; 150,000,000
shares authorized; 36,186,686 and 35,609,803 shares issued;
35,845,136 and 35,268,253 outstanding
    
    
    362
    
    
    
    356Notes receivable from stockholders
    
    
    (1,121
    )
    
    
    (1,589
    )Additional paid-in capital
    
    
    189,008
    
    
    
    205,090Accumulated deficit
    
    
    (318,880
    )
    
    
    (302,753
    )Treasury stock, 341,550 shares at cost
    
    
    (388
    )
    
    
    (388
    )Total stockholders deficit
    
    
    (131,019
    )
    
    
    (99,284
    )Total liabilities, mandatorily redeemable convertible preferred
stock and stockholders deficit
    
    $
    89,453
    
    
    $
    106,711
 The accompanying notes are an integral part of these consolidated financial statements. F-3




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) Years EndedDecember 31,2003
    
    2002
    
    2001Revenues
    
    $
    289,180
    
    
    $
    238,397
    
    
    $
    280,350Operating expenses:Network operations, exclusive of depreciation and
amortization shown below
    
    
    135,097
    
    
    
    94,474
    
    
    
    159,617Sales and marketing
    
    
    18,753
    
    
    
    12,327
    
    
    
    31,243General and administrative
    
    
    127,018
    
    
    
    122,579
    
    
    
    156,107Depreciation and amortization
    
    
    23,449
    
    
    
    23,936
    
    
    
    23,277Asset impairment charge
    
    
    
    
    
    
    1,129
    
    
    
    59,247Wholesale development costs
    
    
    
    
    
    
    1,018
    
    
    
    Restructuring charge
    
    
    
    
    
    
    1,861
    
    
    
    Total operating expenses
    
    
    304,317
    
    
    
    257,324
    
    
    
    429,491Operating loss
    
    
    (15,137
    )
    
    
    (18,927
    )
    
    
    (149,141
    )Nonoperating income (expense):Interest and other income
    
    
    2,086
    
    
    
    3,509
    
    
    
    6,862Interest and other expense
    
    
    (3,076
    )
    
    
    (4,137
    )
    
    
    (3,789
    )Total nonoperating income (expense)
    
    
    (990
    )
    
    
    (628
    )
    
    
    3,073Net loss
    
    
    (16,127
    )
    
    
    (19,555
    )
    
    
    (146,068
    )Less mandatorily redeemable convertible
preferred stock dividends and accretion
    
    
    (17,480
    )
    
    
    (15,589
    )
    
    
    (15,059
    )Less deemed dividend related to beneficial
conversion feature
    
    
    (186
    )
    
    
    (186
    )
    
    
    (9,356
    )Net loss attributable to common stockholders
    
    $
    (33,793
    )
    
    $
    (35,330
    )
    
    $
    (170,483
    )Weighted average common shares outstanding
    
    
    35,396,922
    
    
    
    34,951,720
    
    
    
    33,908,374Basic and diluted net loss per share
    
    $
    (0.95
    )
    
    $
    (1.01
    )
    
    $
    (5.03
    )
 The accompanying notes are an integral part of these consolidated financial statements. F-4




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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY (DEFICIT)
AND COMPREHENSIVE INCOME
(In thousands, except share data)The accompanying notes are an integral part of these consolidated financial statements Common Stock
    
    Notes Receivablefrom
    
    UnearnedStock
    
    AdditionalPaid-InShares
    
    Par Value
    
    Stockholders
    
    Compensation
    
    CapitalBalance, December 31, 2000
    
    
    33,754,235
    
    
    $
    340
    
    
    $
    (839
    )
    
    $
    (255
    )
    
    $
    227,304Issuance of common stock for exercise
of stock options
    
    
    254,731
    
    
    
    3
    
    
    
    (820
    )
    
    
    
    
    
    
    1,000Issuance of common stock for exercie
of warrants
    
    
    25,714
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Issuance of common stock for the
purchase of software
    
    
    27,500
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    155Vesting of stock options granted below
intrinsic value
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    133Accelerated vesting of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    49Mandatorily convertible redeemable
dividends and preferred stock accretion
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (15,059
    )Warrants issued with preferred stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,333Treasury stock received upon cancellation
of notes receivable from stockholder
    
    
    (61,875
    )
    
    
    
    
    
    
    70Net lossForeign currency translation adjustmentComprehensive lossBalance, December 31, 2001
    
    
    34,000,305
    
    
    
    343
    
    
    
    (1,589
    )
    
    
    (122
    )
    
    
    217,782Issuance of common stock
    
    
    1,000,000
    
    
    
    10
    
    
    
    
    
    
    
    
    
    
    
    2,320Issuance of common stock for exercise of warrants
    
    
    171,429
    
    
    
    2Issuance of common stock for exercise of options
    
    
    361
    
    
    
    Conversion of mandatorily convertible redeemable
preferred stock
    
    
    76,158
    
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    679Vesting of stock options granted below
intrinsic value
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    122Accelerated vesting of stock options and issuance of shares
    
    
    20,000
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    84Mandatorily redeemable convertible preferred
stock dividends and accretion
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (15,775
    )Net lossBalance, December 31, 2002
    
    
    35,268,253
    
    
    
    356
    
    
    
    (1,589
    )
    
    
    
    
    
    
    205,090Exercise of stock options
    
    
    394,144
    
    
    
    4
    
    
    
    
    
    
    
    
    
    
    
    518Exercise of warrants
    
    
    73,714
    
    
    
    1Accelerated vesting of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    123Conversion of mandatorily redeemable
convertible preferred stock to common
    
    
    109,025
    
    
    
    1
    
    
    
    
    
    
    
    
    
    
    
    943Repayment of notes receivable
    
    
    
    
    
    
    
    
    
    
    468Mandatorily redeemable convertible preferred
stock dividends and accretion
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (17,666
    )Net lossBalance, December 31, 2003
    
    
    35,845,136
    
    
    $
    362
    
    
    $
    (1,121
    )
    
    $
    
    
    
    $
    189,008
   [Continued from above table, first column(s) repeated] AccumulatedOther
    
    
    
    
    
    TotalAccumulated
    
    Comprehensive
    
    Treasury
    
    Stockholders'Deficit
    
    Loss
    
    Stock
    
    DeficitBalance, December 31, 2000
    
    $
    (137,130
    )
    
    $
    (2
    )
    
    $
    (318
    )
    
    $
    89,100Issuance of common stock for exercise
of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    183Issuance of common stock for exercie
of warrants
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Issuance of common stock for the
purchase of software
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    155Vesting of stock options granted below
intrinsic value
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    133Accelerated vesting of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    49Mandatorily convertible redeemable
dividends and preferred stock accretion
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (15,059
    )Warrants issued with preferred stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,333Treasury stock received upon cancellation
of notes receivable from stockholder
    
    
    
    
    
    
    
    
    
    
    (70
    )
    
    
    Net loss
    
    
    (146,068
    )
    
    
    
    
    
    
    
    
    
    
    (146,068
    )Foreign currency translation adjustment
    
    
    
    
    
    
    2
    
    
    
    
    
    
    
    2Comprehensive loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (146,066
    )Balance, December 31, 2001
    
    
    (283,198
    )
    
    
    
    
    
    
    (388
    )
    
    
    (67,172
    )Issuance of common stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,330Issuance of common stock for exercise of warrants
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2Issuance of common stock for exercise of options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Conversion of mandatorily convertible redeemable
preferred stock
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    680Vesting of stock options granted below
intrinsic value
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    122Accelerated vesting of stock options and issuance of shares
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    84Mandatorily redeemable convertible preferred
stock dividends and accretion
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (15,775
    )Net loss
    
    
    (19,555
    )
    
    
    
    
    
    
    
    
    
    
    (19,555
    )Balance, December 31, 2002
    
    
    (302,753
    )
    
    
    
    
    
    
    (388
    )
    
    
    (99,284
    )Exercise of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    522Exercise of warrants
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1Accelerated vesting of stock options
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    123Conversion of mandatorily redeemable
convertible preferred stock to common
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    944Repayment of notes receivable
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    468Mandatorily redeemable convertible preferred
stock dividends and accretion
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (17,666
    )Net loss
    
    
    (16,127
    )
    
    
    
    
    
    
    
    
    
    
    (16,127
    )Balance, December 31, 2003
    
    $
    (318,880
    )
    



    $
    
    
    
    $
    (388
    )
    
    $
    (131,019
    )
 F-5




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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands) Year EndedDecember 31,2003
    
    2002
    
    2001Cash flows from operating activities:Net loss
    
    $
    (16,127
    )
    
    $
    (19,555
    )
    
    $
    (146,068
    )Adjustments to reconcile net loss to net cash used in
operating activities:Depreciation and amortization
    
    
    23,449
    
    
    
    23,936
    
    
    
    23,277Provision for bad debts
    
    
    14,022
    
    
    
    23,964
    
    
    
    55,530Asset impairment charge
    
    
    
    
    
    
    1,129
    
    
    
    59,247(Gain) loss on disposal of equipment
    
    
    (43
    )
    
    
    (132
    )
    
    
    (329
    )Expense charged for granting of stock options
    
    
    123
    
    
    
    206
    
    
    
    182Change in operating assets and liabilities:Increase in accounts receivable
    
    
    (11,873
    )
    
    
    (23,671
    )
    
    
    (17,140
    )(Increase) decrease in prepaid expenses
    
    
    (1,923
    )
    
    
    (1,780
    )
    
    
    1,106Decrease (increase) in other assets
    
    
    1,888
    
    
    
    1,655
    
    
    
    (1,070
    )Increase in accounts payable and accrued liabilities
    
    
    7,460
    
    
    
    2,149
    
    
    
    5,138Increase (decrease) in deferred revenue
    
    
    (5,020
    )
    
    
    10,498
    
    
    
    (1,715
    )Total adjustments
    
    
    28,083
    
    
    
    37,954
    
    
    
    124,226Net cash provided by (used in) operating activities
    
    
    11,956
    
    
    
    18,399
    
    
    
    (21,842
    )Cash flows from investing activities:Purchases of property and equipment
    
    
    (11,036
    )
    
    
    (15,193
    )
    
    
    (15,426
    )Principal repayments received on notes receivable
    
    
    40
    
    
    
    590
    
    
    
    7Issuance of note receivable
    
    
    
    
    
    
    (997
    )
    
    
    (196
    )Net cash used in investing activities
    
    
    (10,996
    )
    
    
    (15,600
    )
    
    
    (15,615
    )Cash flows from financing activities:Payments on long-term debt and capital lease obligations
    
    
    (5,903
    )
    
    
    (5,622
    )
    
    
    (7,532
    )Proceeds from issuance of mandatorily redeemable
convertible preferred stock
    
    
    
    
    
    
     
    
    
    
    17,500Payments of issuance cost for mandatorily redeemable
convertible preferred stock
    
    
    
    
    
    
    
    
    
    
    (450
    )Payment of preferred stock dividends
    
    
    (72
    )
    
    
    (34
    )
    
    
    Principal repayments received on notes receivable issued for stock
    
    
    468
    
    
    
    
    
    
    
    Proceeds from exercise of stock options and warrants
    
    
    523
    
    
    
    2
    
    
    
    183Net cash provided by (used in) financing activities
    
    
    (4,984
    )
    
    
    (5,654
    )
    
    
    9,701Adjustment for foreign currency translation
    
    
    
    
    
    
    
    
    
    
    (2
    )Net decrease in cash and cash equivalents
    
    
    (4,024
    )
    
    
    (2,855
    )
    
    
    (27,758
    )Cash and cash equivalents, beginning of period
    
    
    16,037
    
    
    
    18,892
    
    
    
    46,650Cash and cash equivalents, end of period
    
    $
    12,013
    
    
    $
    16,037
    
    
    $
    18,892
 F-6




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##### Table of Contents



Year EndedDecember 31,2003
    
    2002
    
    2001Supplemental disclosure of cash flow information:Cash paid for interest
    
    $
    3,070
    
    
    $
    2,788
    
    
    $
    2,648Non-cash investing and financing activities:Property and equipment acquired under capital
lease obligations
    
    $
    1,290
    
    
    $
    222
    
    
    $
    2,395Increase in additional paid-in capital for stock
options granted
    
    $
    518
    
    
    $
    84
    
    
    $
    1,051Common stock granted for wholesale services contract
    
    $
    
    
    
    $
    2,330
    
    
    $
    Net increase in unearned stock
compensation for stock options granted
    
    $
    
    
    
    $
    122
    
    
    $
    133Accrued dividends and accretion on preferred stock
    
    $
    17,480
    
    
    $
    15,589
    
    
    $
    15,059Notes receivable issued for common stock
    
    $
    
    
    
    $
    
    
    
    $
    820Forgiveness of note receivable issued for common stock
    
    $
    
    
    
    $
    
    
    
    $
    (70
    )Common stock issued for purchase of assets
    
    $
    
    
    
    $
    
    
    
    $
    155Treasury stock received upon cancellation of
note receivable for common stock
    
    $
    
    
    
    $
    
    
    
    $
    (70
    )Conversion of preferred stock to common stock
    
    $
    943
    
    
    $
    680
    
    
    $
    Beneficial conversion associated with preferred
stock issuance
    
    $
    186
    
    
    $
    186
    
    
    $
    9,356
 The accompanying notes are an integral part of these consolidated financial statements. F-7




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##### Table of Contents



Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(ALL TABLES ARE IN THOUSANDS, EXCEPT FOR SHARE AND PER SHARE DATA) 1. NATURE OF BUSINESS DESCRIPTION OF BUSINESS Z-Tel Technologies, Inc. and subsidiaries (we or us) incorporated in
Delaware on January 15, 1998 as Olympus Telecommunications Group, Inc. In March
1998, Olympus Telecommunications Group, Inc. changed its name to Z-Tel
Technologies, Inc. We are an emerging provider of advanced, integrated telecommunications services
targeted to residential and small business subscribers. We offer local and long
distance telephone services in combination with enhanced communication features
accessible through the telephone, the Internet and certain personal digital
assistants. We offer our Z-LineHOME and Z-LineBUSINESS services in
forty-nine
states. Our customers are primarily in ten states. We also provide
long-distance telecommunications services to customers nationally. We
 introduced our wholesale services during the first quarter of 2002. This
service provides other companies with the opportunity to provide local,
long-distance and enhanced telephone service to residential and small business
customers by utilizing our telephone exchange services, enhanced services
platform, infrastructure and back-office operations. LIQUIDITY AND CAPITAL RESOURCES We have a limited operating history and our operations are subject to certain
risks and uncertainties, particularly related to the evolution of the
regulatory environment, which impacts our access to and cost of the network
elements used to provide services to our customers; access to adequate
financing; and competition within the industry. We
 have incurred significant losses since our inception, resulting in an
accumulated deficit at December 31, 2003 of approximately $318.9 million. We
also had debt outstanding of approximately $5.5 million. We experienced
positive cash flows from operations for the first time during 2002 and also had positive cash flows from operations for the year ended December 31,
 2003. Prior to 2002, we had historically been dependent on financing from
investors to sustain our operating activities. At December 31, 2003, we had cash on hand of approximately $12.0 million. In
addition, we had an accounts receivable factoring agreement which provides us
with up to $25 million dollars to fund operations, of which we were utilizing
$13.9 million as of December 31, 2003. This factoring agreement expires on July
27, 2004. Currently, we anticipate obtaining an asset-based loan to replace our
current accounts receivable factoring agreement. We expect that this agreement
will provide us with $3.0 to $5.0 million of additional
liquidity immediately, up to a
maximum of $25 million of total liquidity as it is currently contemplated. The additional
liquidity is a result of additional accounts receivable being eligible under
this arrangement. We anticipate generating, through normal operations, the
remaining cash flows necessary to meet our operating, investing and financing
requirements. We also are exploring potential subordinated debt arrangements and
financing of certain capital expenditures.
If actual results differ materially from our current plan or if
expected financing is not available, we have the
ability and intent to curtail growth initiatives and spending, including the
reduction of certain discretionary capital and marketing costs or the
implementation of a workforce reduction, in order to continue as a
going-concern. There can be no assurance, however, that we will be able to
implement our strategies or obtain additional financing under favorable terms,
if at all. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES PRINCIPLES OF CONSOLIDATION The consolidated financial statements include all our accounts and our wholly-
owned subsidiaries. All intercompany accounts and transactions have been
eliminated. CASH AND CASH EQUIVALENTS We consider all highly liquid investments with original maturity dates of three
months or less to be cash equivalents. F-8




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##### Table of Contents



PREPAID EXPENSES AND OTHER CURRENT ASSETS Prepaid expenses and other current assets consist primarily of prepaid
maintenance and support, insurance contracts advances to suppliers and certain
disputes with vendors that require payment and filing of a dispute claim. PROPERTY AND EQUIPMENT, NET Property and equipment are recorded at historical cost. Depreciation and
amortization are calculated on a straight-line basis over the assets useful
life. Maintenance and repairs are expensed as incurred, while renewals and
betterments are capitalized. Upon the sale or other disposition of property,
the cost and related accumulated depreciation are removed from the accounts and
any gain or loss is recognized in operations. Under the Statement of Position
(SOP) 98-1, Accounting for the Cost of Computer Software Developed or
Obtained for Internal Use, we expense computer software costs related to
internal software that is incurred in the preliminary project stage. When the
capitalization criteria of SOP 98-1 have been met, costs of developing or
obtaining internal-use computer software are capitalized. We capitalized
approximately $3.1, $3.7 and $3.9 million of employee salary costs for
internally developed software for the years ended December 31, 2003, 2002 and
2001, respectively. Internal use software is included as a component of
property and equipment on the consolidated balance sheet. We also incur
research and development costs, such as employee salaries and outside
consultants, that are expensed in our general and administrative expense. We
expensed approximately $6.0, $7.4 and $8.9 million of research and development
costs for the years ended December 31, 2003, 2002 and 2001, respectively. LONG-LIVED ASSETS We review long-lived assets for impairment whenever events or changes in
circumstances indicate that the carrying amount of an asset may not be
recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future net expected
undiscounted cash flows to be generated by the asset. If such assets are
considered to be impaired, the impairment to be recognized is measured by the
amount by which the carrying amount of the assets exceeds the discounted cash
flows. We recognized an impairment of $59.2 million related to goodwill
acquired from the acquisition of Touch 1 Communications, Inc. (Touch 1) as a
result of the sale of our telemarketing centers in 2001. We adopted Statement of Financial Accounting Standards (SFAS) No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets on a
prospective basis on January 1, 2002. This statement supercedes SFAS No. 121,
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to Be Disposed Of. However, SFAS 144 retains the fundamental provisions of
SFAS No. 121 for the recognition and measurement of the impairment of
long-lived assets to be held and used and the measurement of long-lived assets
to be disposed of by sale. Impairment of goodwill is not included in the scope
of SFAS No. 144 and will be treated in accordance with the accounting standards
established in SFAS No. 142, Goodwill and Other Intangible Assets. According
to SFAS No. 144, long-lived assets are to be measured at the lower of carrying
amount or fair value less cost to sell, whether reported in continuing or
discontinued operations. The statement applies to all long-lived assets,
including discontinued operations, and replaces the provisions of APB Opinion
No. 30, Reporting the Results of Operations  Reporting the Effects of
Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions, for the disposal of segments
of a business. INTANGIBLE ASSETS, NET We adopted SFAS No. 141 Business Combinations and SFAS No. 142, Goodwill and
Other Intangible Assets, as of January 1, 2002. SFAS 141 addresses the initial
recognition and measurement of goodwill and other intangible assets acquired in
a business combination. SFAS No. 142 addresses the initial recognition and
measurement of intangible assets acquired outside of a business combination,
whether acquired individually or with a group of other assets, and the
accounting and reporting for goodwill and other intangible assets subsequent to
their acquisition. These standards require all future business combinations to
be accounted for using the purchase method of accounting. Certain intangible
assets will no longer be amortized ratably but instead will be subject to
impairment tests at least annually. Intangible assets on the consolidated balance sheet consist of customer lists
resulting from our acquisition of Touch 1 in 2000. The customer lists are
amortized over five years using the straight-line method and reviewed for
impairment as outlined in our long-lived assets policy above. All goodwill was
written-down to a zero value in 2001. See footnote 8 Intangible assets for
further discussion. REVENUE RECOGNITION Revenues are recognized when
earned. Revenues related to long distance, carrier access
service and certain other usage driven charges are billed monthly in arrears and the associated
revenues are recognized during the month of service. We record an
estimate for this amount. Subscription services are billed monthly
in advance and we recognize revenues for this service ratably over
the service period. We defer certain installation charges and
recognize this revenue ratably over the estimated life of our customer. Our wholesale services revenues are derived from contractual
arrangements. We perform a review of each contract and determine the
appropriate timing of revenue recognition depending on the facts
and circumstances of each individual item within the contract. We are currently deferring certain revenues over the life of our
arrangements, rather than recognizing these revenues up-front. In instances where we are the primary obligor for costs incurred we
use the gross method to record our revenues for wholesale
services. We operate in a heavily regulated industry; therefore, our pricing is subject to both state and federal
regulatory commission oversight. Such oversight could result in changes to the
amount we bill our customers in current and future periods. The gross accounting
presentation for our wholesale services business segment requires the
understanding that certain recorded revenues are actually direct cost
pass-through. For instance, under our Sprint contract we charge to Sprint, with
a zero mark-up, certain charges that we receive from the incumbent local
exchange carriers (ILECs) that are attributable to lines that are
owned by Sprint under the aforementioned agreement. However, late in the
third quarter of 2003 Sprint established its own billing codes with the ILECs
and has been adding all new customers to these codes. This had the effect of
reducing our gross monthly billings to Sprint, yet has no impact on the
profitability of the contract. Indeed, Sprints lines under the wholesale
services agreement were actually increasing significantly during the period in
reference. This action also has the impact of increasing total margins, even
though the profitability of the contract on a per line basis was unchanged. This
is why we chose to focus on the net income per wholesale services line in
service, as opposed to stated revenues or margins per se. F-9




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STOCK-BASED COMPENSATION For employee stock options, the FASB issued SFAS No. 123, Accounting for
Stock-Based Compensation requiring entities to recognize as an expense, over
the vesting period, the fair value of the options or utilize the accounting for
employee stock options used under Accounting
Principles Board (APB) Opinion No. 25. We apply the provisions of APB Opinion No. 25 and consequently recognize compensation
expense over the vesting period for grants made to employees and directors only
if, on the measurement date, the market price of the underlying stock exceeds
the exercise price. We provide the pro forma net income and earnings per share
disclosures as required under SFAS No. 123 for grants made as if the fair value
method defined in SFAS No. 123 had been applied. We recognize expense over the
vesting period of the grants made to non-employees based on utilizing the
Black-Scholes stock valuation model to calculate the value of the option on the
measurement date. The following table illustrates, in accordance with the provisions of SFAS No.
148, Accounting for Stock-Based Compensation  Transition and Disclosure, an
Amendment of SFAS 123, Accounting for Stock-Based Compensation, the effect on
net loss and earnings per share if we had applied the fair value recognition
provisions of SFAS No. 123, to stock-based employee compensation. For the years endedDecember 31,2003
    
    2002
    
    2001Net loss attributable to common stockholders, as reported
    
    $
    (33,793
    )
    
    $
    (35,330
    )
    
    $
    (170,483
    )Add: Stock based compensation included in net loss
    
    
    123
    
    
    
    206
    
    
    
    182Deduct: Total stock based employee compensation determined
under the fair value based method for all awards
    
    
    (5,821
    )
    
    
    (13,182
    )
    
    
    (13,043
    )Net loss attributable to common stockholders, pro forma
    
    $
    (39,491
    )
    
    $
    (48,306
    )
    
    $
    (183,344
    )Basic and Diluted Net Loss
Per Common ShareAs reported
    
    $
    (0.95
    )
    
    $
    (1.01
    )
    
    $
    (5.03
    )Pro forma
    
    $
    (1.12
    )
    
    $
    (1.38
    )
    
    $
    (5.41
    )
 We calculated the fair value of each grant on the date of grant using the
Black-Scholes option pricing model. In addition to there being no payments of
dividends on our common stock, the following assumptions were used for each
respective period: For the years endedDecember 31,2003
    
    2002
    
    2001Discount Rate
    
    
    3.1
    %
    
    
    3.1
    %
    
    
    4.7
    %Volatility
    
    
    96.6
    %
    
    
    93.0
    %
    
    
    87.0
    %Average Option Expected Life
    
    5 years
    
    
    5 years
    
    
    5 years
 Incremental shares of common stock equivalents are not included in the
calculation of net loss per share as the inclusion of such equivalents would be
anti-dilutive. ADVERTISING Advertising costs are expensed as incurred. Included in sales and marketing
expenses are advertising costs of approximately $5.3, $5.2 and $8.8 million
for the years ended December 31, 2003, 2002 and 2001, respectively. F-10




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INCOME TAXES We utilize the asset and liability method of accounting for income taxes. Under
this method, deferred income taxes are recorded to reflect the tax consequences
on future years of differences between the tax basis of assets and liabilities
and their financially reported amounts at each year-end based on enacted laws
and statutory rates applicable to the periods in which differences are expected
to affect taxable income. A valuation allowance is provided against the future
benefits of deferred tax assets if it is determined that it is more likely than
not that the future tax benefits associated with the deferred tax asset will
not be realized. FOREIGN CURRENCY TRANSLATION We sold our only foreign subsidiary during 2001. The assets and liabilities of our foreign subsidiary, whose functional currency
is other than the U.S. Dollar, are translated at the exchange rates in effect
on the reporting date, and income and expenses are translated at the weighted
average exchange rate during the period. The net effect of translation gains
and losses is not included in determining net income but is included in
accumulated other comprehensive income, which is reflected as a separate
component of shareholders equity. Foreign currency transaction gains and
losses are included in determining net income. Such gains and losses are not
material for any period presented. CONCENTRATIONS Financial instruments that potentially subject us to concentrations of credit
risk consist principally of cash and cash equivalents and accounts receivable.
We place our cash and cash equivalents in financial institutions considered by
management to be high quality. We maintain cash balances at financial
institutions in excess of the $100,000 insured by the Federal Deposit Insurance
Corporation (FDIC). We had approximately $2.4, $2.7 and $8.1 million invested
in interest bearing money market and short-term fixed income investments that
are not insured by the FDIC at December 31, 2003, 2002 and 2001, respectively.
We have not experienced any losses in these accounts and believe we are not
exposed to any significant credit risk on cash balances. During the normal course of business, we extend credit to residential and
business customers residing in the United States. Our customer base is
broken-down as follows: Percentage of Total BundledService Revenues2003
    
    2002New York
    
    
    33
    %
    
    
    46
    %Illinois
    
    
    10
    %
    
    
    13
    %Michigan
    
    
    9
    %
    
    
    13
    %Georgia
    
    
    6
    %
    
    
    4
    %Texas
    
    
    6
    %
    
    
    8
    %Kentucky
    
    
    6
    %
    
    
    0
    %Pennsylvania
    
    
    4
    %
    
    
    6
    %Maryland
    
    
    3
    %
    
    
    2
    %Florida
    
    
    3
    %
    
    
    0
    %California
    
    
    2
    %
    
    
    1
    %Indiana
    
    
    2
    %
    
    
    0
    %Tennessee
    
    
    2
    %
    
    
    0
    %Alabama
    
    
    2
    %
    
    
    0
    %Virginia
    
    
    2
    %
    
    
    2
    %All Others
    
    
    10
    %
    
    
    5
    %100
    %
    
    
    100
    %
 This results in a concentration of credit to residential and business customers
in these states. We believe our credit policies, collection procedures and
allowance for doubtful accounts minimize the exposure to significant credit
risk of accounts receivable balances. Additionally, as of December 31, 2003,
our wholesale services receivables are concentrated with Sprint Communications
Company L.P. (Sprint) as they are the primary wholesale customer. F-11




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We rely upon the Regional Bell Operating Companies (RBOCs) for
provisioning of customers and the RBOCs are the primary suppliers of local
central office switching and local telephone lines. Global Crossing Ltd and
Williams Communications Group Inc. (now WilTel Communications Group, Inc.)
are the primary suppliers for our long-distance calling. We have not incurred
any material impact to our operations or financial statements as a result of
the Chapter 11 bankruptcy filings made by these companies. We rely upon two separate service providers for provisioning and billing
services essential to support our operations. SEGMENT REPORTING SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information, requires that we report financial and descriptive information
about reportable segments, and how these segments were determined. We determine
the allocation and performance of resources based on total operations. Based on
these factors, management has determined that we operate as two segments as
defined by SFAS No. 131 during 2003 and 2002, retail services
and wholesale services. We did not earn wholesale services revenue in
2001. FINANCIAL INSTRUMENTS The recorded amounts of cash and cash equivalents approximate fair value due to
the short-term nature of these instruments. We have determined that due to the
interest rates and short-term nature of the capital lease obligation, the fair
value approximates the value recorded. We have determined that the long-term
debt assumed through acquisition is recorded at fair value. The interest rates
were adjusted to the current market rate for purchase accounting treatment and
we believe the debt is properly recorded at fair value. MANAGEMENTS USE OF ESTIMATES The preparation of 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. Estimates also affect the reported
amounts of revenues and expenses during the reporting period. Actual results
could differ from those estimates. NEW ACCOUNTING PRONOUNCEMENTS In November 2002, the Emerging Issues Task Force (EITF) of the Financial
Accounting Standards Board (FASB) reached a consensus on EITF No. 00-21,
Accounting for Revenue Arrangements with Multiple Deliverables. EITF
No. 00-21 addresses how to account for arrangements that may involve the
delivery or performance of multiple products, services and/or rights to use
assets. Revenue arrangements with multiple deliverables should be divided into
separate units of accounting if the deliverables in the arrangement meet
certain criteria. Arrangement consideration should be allocated among the
separate units of accounting based on their relative fair values. EITF No.
00-21 also supersedes certain guidance set forth in Staff Accounting Bulletin
No. 101 (SAB 101), Revenue Recognition in Financial Statements. The final
consensus is applicable to agreements entered into in quarters beginning after
June 15, 2003, with early adoption permitted. Additionally, companies are
permitted to apply the consensus guidance to all existing arrangements as a
cumulative effect of a change in accounting principle. We adopted this new
pronouncement effective July 1, 2003, on a prospective basis. This adoption did
not have a material impact on our consolidated financial statements. In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity. This
statement establishes standards for how an issuer classifies and measures
certain financial instruments with characteristics of both liabilities and
equity. This statement is effective for financial instruments entered into or
modified after May 31, 2003, and otherwise is effective for our quarter
beginning July 1, 2003. We reviewed this new pronouncement and concluded that
none of the mandatorily redeemable convertible preferred stock recorded in the
mezzanine section of our balance sheet is within the scope of SFAS No. 150.
This conclusion is based on the facts that no unconditional obligation
requiring the redemption of the securities exists because they are convertible
into common at the option of the holder and the conversion option is
substantial. We recognize that the FASB is in the process of possibly
promulgating additional rules in the future related to
securities similar to the ones that we have in the mezzanine section, but are
unable to determine what any future rules impact might have on our
consolidated financial statements. In June 2003, the FASB issued SFAS 149, An Amendment of Statement 133 on
Derivative Instruments and Hedging Activities. This statement amends and
clarifies financial accounting and reporting for hedging activities and
derivative instruments, including certain derivative instruments embedded in
other contracts. This Statement is effective for contracts entered into or
modified after June 30, 2003. We adopted SFAS 149 in the third quarter of 2003.
This adoption did not have any impact on our consolidated financial statements. F-12




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In December 2003, the Securities and Exchange Commission released Staff
Accounting Bulletin no. 104 (SAB 104), Revenue Recognition. SAB 104
clarifies existing guidance regarding revenues for contracts which contain
multiple deliverables to make it consistent with EITF No. 00-21. The adoption
of the provisions of EITF 00-21 and SAB 104 had no effect on our results of
operations. In January 2003, the FASB issued Interpretation No. 46, Consolidation of
Variable Interest Entities (FIN 46 ). FIN 46 requires an investor with a
majority of the variable interests in a variable interest entity to consolidate
the entity and also requires majority and significant variable interest
investors to provide certain disclosures. A variable interest entity is an
entity that has (1) equity investment at risk that is insufficient to finance
the entitys activities without receiving additional subordinated financial
support from the other parties, (2) a group of equity owners that are unable to
make substantive decisions about the entitys activities, or (3) equity that
does not absorb the entitys losses or receive the benefits of the entity. FIN
46 is effective for all new variable interest entities created or acquired
after January 31, 2003. We have evaluated our investments and
other relationships and have concluded that none qualify as a
variable interest entity as defined in FIN 46. RECLASSIFICATION To be consistent with emerging industry practices, the revenues for all periods
presented have been changed to reflect the billing to our customers of the
Universal Service Fund (USF) and other regulatory fees and the related
payments into the associated regulatory funds as network operations expense.
Operating income and net income for all periods presented were unaffected. The
additional revenues and expenses recorded were $4.2, $3.1 and $4.5 million for the
years ended December 31, 2003, 2002, and 2001, respectively. We also have certain
other amounts in the December 31, 2002 and 2001 financial statements that have
been reclassified to conform to the December 31, 2003 presentation.  3.
    
    WHOLESALE SERVICES In February 2003, we executed an agreement providing for the resale of our
local wireline telecommunications services and provision of ancillary services
with Sprint. Under this agreement, we provide Sprint access to our
Web-integrated, enhanced communications platform and operational support
systems. This contract includes various per-minute, per-line, and other charges
that are being recorded as revenue as earned. We are the primary
obligor for certain
underlying expenses that are incorporated into our pricing in connection with
the agreement and therefore, are recording revenues using a gross presentation,
consistent with the method used for our wholesale services agreement with MCI
WORLDCOM Communications, Inc. (MCI). This method results
in certain per-line,
per-minute and direct costs being recorded as revenues and the
corresponding expenses being recorded in the appropriate operating expense
line. As a result of this accounting treatment, increases or decreases in
pricing or volume that impact direct costs that are incurred in connection with
this agreement would have no impact on net income, as the amount is recorded in
an equivalent amount in both revenue and expense. Our wholesale services
agreement with Sprint is non-exclusive in nature. We are deferring $1.0 million of revenues for pre-contract payments by
recognizing this amount ratably over the life of the agreement. As of December 31, 2003, under our contract with Sprint, we had approximately
$4.7 million of deferred revenue, of which $0.3 million is recorded as
long-term deferred revenue. As of December 31, 2002, under our
contract with MCI we had approximately $3.6
and $6.3 million of long-term and short-term deferred revenue, respectively. On March 20, 2002, we entered into a 48-month agreement with MCI for wholesale
telephone exchange services, ancillary services and a limited-term technology
license. The agreement was cancelable by either party after eighteen months.
This agreement was significantly amended on November 1, 2002. Under the original terms of the agreement, MCI was to pay us a maximum of $50
million related to the use of our network in the form of a technology license
fee, should the agreement not be terminated early. Cash flows related to the
license were to be paid based on the number of MCI customers on our network, as
defined in the contract, and were subject to monthly minimum amounts. In
addition, MCI was to pay for services provided through usage-based fees
according to certain per line and per minute
calculations defined in the agreement and MCI was to also pay fees to us for
providing telephone exchange services, payroll costs and certain vendor fees.
We are the primary obligor for all costs incurred under this agreement. We recognized the $50 million license fee, and amounts received in advance
of the contract, on a straight-line basis over the four-year contract period
beginning in April 2002. In connection with the agreement, we issued MCI one
million shares of our common stock at a price of $2.33, the market price of our
stock at the date of the agreement. As a result of this transaction an asset
totaling $2.3 million was being amortized on a straight-line basis as a
reduction to revenues over the 48-month term of the agreement with the
remaining balance recorded in other non-current assets. Monthly usage-based
charges and cost reimbursements were recognized when earned. F-13




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On November 1, 2002 we significantly amended the terms or our agreement with
MCI. This amendment was made as a result of MCIs bankruptcy filing on July 21,
2002. The significant financial changes in this amendment were the elimination
of the $50 million limited-term technology license fee, increases to various
fees calculated on a per minute and per line basis, certain additional fees for
services provided, elimination of exclusivity clauses, a reduction to the
monthly minimum payments and forgiveness of certain amounts to be repaid to
MCI. Amounts received in advance of revenues being
 earned were being amortized
through December 31, 2004, the amended termination date of the agreement. The
amended agreement is cancelable by MCI without cause on or after April 1,
2002, given at least 90 days written notice to us. On August 7, 2003, we amended our contract with MCI to terminate the contract
on December 31, 2003. On August 15, 2003, MCI provided us with notice that they
were terminating the contract effective October 15, 2003, therefore, we recognized
$4.8 million of previously deferred revenue.  4.
    
    ACCOUNTS RECEIVABLE AGREEMENT In July 2000, we entered into an accounts receivable agreement with RFC Capital
Corporation, a division of Textron, Inc. (RFC), providing for the sale of
certain of our accounts receivable to RFC. The RFC agreement provides for
the purchase of up to $25.0 million of certain of our accounts receivable,
subject to selection criteria as defined in the contract. In July 2002, we
extended our agreement with RFC under substantially similar terms for an
additional two years. The purchase of the receivables is at the option of RFC
and they utilize selection criteria to determine which receivables will be
purchased. We had been selling our receivables to RFC at a 23% discount; Prior
to March 2002 we sold our receivables at a 32% discount. Our collection
percentage for receivables sold to RFC was 98.5% and 92.9% for the years ended
December 31, 2003 and 2002, respectively. We received an additional payment
from RFC for servicing the assets in an amount equal to every dollar collected
over the advance rate, less certain fees. The accounts receivable agreement did
not have a minimum receivable sales requirement. We sold approximately $138.2 and $135.2 million of receivables to RFC, for net
proceeds of approximately $111.9 and $107.3 million, during the years ended
December 31, 2003 and 2002, respectively. A net receivable servicing asset of
approximately $13.2 and $8.5 million is included in the accounts receivable
balance at December 31, 2003 and 2002, respectively. We recorded costs related
to the agreement of approximately $1.0, $1.3 and $1.1 million for the years
ended December 31, 2003, 2002 and 2001, respectively. Included in accounts
payable and accrued liabilities are advances for unbilled receivables in the
amount of $4.2 and $3.4 million at December 31, 2003 and 2002, respectively. We
were responsible for the continued servicing of the receivables sold.  5.
    
    ACCOUNTS RECEIVABLE WRITE-OFF During the second quarter of 2001, management performed a detailed analysis of
accounts receivable and also reviewed its credit policies relating specifically
to acceptance and provisioning of service to new customers. As a result of the
analysis and subsequent change in credit policy, we switched our focus from
collection efforts on overdue and delinquent account balances to a stringent
credit policy surrounding customer acceptance and a collection effort focused
on fewer delinquent accounts. The detailed analysis and change in credit policy
lead to a write-off of delinquent receivables of approximately $29.9 million
and revisions to the estimates used to develop the allowance for doubtful
accounts in the current and future periods. We had write-offs of accounts
receivable totaling approximately $17.6, $31.6 and $43.9 million for the years
ended December 31, 2003, 2002 and 2001, respectively. F-14




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6.
    
    PROPERTY AND EQUIPMENT At the respective dates, property and equipment consist of the following: DepreciableLives in
    
    December 31,Years
    
    2003
    
    2002Switching equipment
    
    
    5-10
    
    
    $
    14,489
    
    
    $
    14,170Computer equipment
    
    
    5-10
    
    
    
    35,965
    
    
    
    32,092Software
    
    
    3
    
    
    
    53,813
    
    
    
    46,753Furniture and office equipment
    
    
    5-10
    
    
    
    8,990
    
    
    
    9,034Leasehold improvements
    
    
    3-15
    
    
    
    6,247
    
    
    
    6,244Land and building
    
    
    20-30
    
    
    
    4,439
    
    
    
    4,439Construction-in-progress
    
    
    
    
    
    
    1,047124,990
    
    
    
    112,732Less accumulated depreciation and amortization
    
    
    
    
    
    
    85,921
    
    
    
    64,412Property and equipment, net
    
    
    
    
    
    $
    39,069
    
    
    $
    48,320
 Depreciation expense related to property and equipment amounted to
approximately $9.4, $10.5 and $11.5 million for the years ended December 31,
2003, 2002 and 2001, respectively. Amortization expense related to software
amounted to approximately $11.2, $11.3 and $8.5 million for the years ended
December 31, 2003, 2002 and 2001, respectively. At the respective dates, assets acquired under capital leases, included in
property and equipment, consist of the following: December 31,2003
    
    2002Computer equipment
    
    $
    2,443
    
    
    $
    1,288Software
    
    
    912
    
    
    
    8243,355
    
    
    
    2,112Less accumulated depreciation and amortization
    
    
    1,357
    
    
    
    788Capital leases, net
    
    $
    1,998
    
    
    $
    1,324
  7.
    
    ASSET IMPAIRMENT In the second quarter of 2001, management decided to reduce telemarketing
efforts, resulting in a majority of the operations and assets of telemarketing
centers acquired in 2000 from Touch 1 being voluntarily closed or sold. On June
30, 2001, the telemarketing centers sold accounted for approximately $1.0
million in property, plant and equipment. For these assets, we received 270,000
shares of preferred stock of the privately held acquiring company and a note
receivable of approximately $0.5 million. The loss recorded from this
transaction was approximately $1.0 million. As a result of the decision to reduce telemarketing efforts noted above and the
subsequent transactions, management performed an assessment of the value of the
intangible assets recorded in the Touch 1 acquisition. In the second quarter of
2001, it was determined that undiscounted future cash flows over the remaining
amortization period of certain intangible assets indicated that the value
assigned to the intangible assets might not be recoverable. Therefore, we
undertook an effort to determine the amount of expense to be recorded relating
to the impairment. The carrying value of the goodwill and identifiable intangibles recorded on the
books approximated $61.7 million prior to the impairment analysis. We
calculated the fair value of the intangibles by performing a discounted cash
flow analysis related to the remaining assets acquired in the Touch 1 purchase.
When we determined we would effectively cease any telemarketing efforts in the
future, the sole remaining assets from the Touch 1 purchase were certain
amounts of property, plant and equipment and intangibles (consisting of
customer lists and goodwill) acquired in the Touch 1 transaction. Assuming a
monthly attrition rate of 4.5% and a discount rate of 17.5% over an 18 month
period, it was determined that the remaining operations acquired from Touch 1
had a liquidation value which approximated the carrying value of the customer
lists acquired from Touch
1. At June 30, 2001, the carrying value of the identifiable intangibles
associated with the customer lists was approximately $6.8 million. Therefore,
during the second quarter of 2001, we recorded a loss of $54.9 million, the
difference between the carrying value of all intangibles and the carrying value
of the customer lists. F-15




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##### Table of Contents



For the year ended December 31, 2001, we recorded an additional $4.3 million of
impaired asset charges, composed of $3.0 million relating to unrealizable
software and development projects, $0.9 million of telemarketing property and
equipment and $0.4 million of securities deemed to be worthless. As of December
31, 2003 and 2002, we had approximately $2.3 and $4.1 million, respectively, of
net intangible assets related to customer lists. In April of 2002, we announced a restructuring plan that included a reduction
in force and the closure of the North Dakota call centers, acquired from Touch
1, resulting in the settlement of the leases in these locations and an asset
impairment charge totaling approximately $1.1 million being recorded in the
second quarter of 2002.  8. INTANGIBLE ASSETS In accordance with SFAS No. 142, we reassessed the expected useful lives of
existing intangible assets. This reassessment resulted in no changes to the
expected useful lives of our customer lists. We only have one intangible asset
as of December 31, 2003 as a result of all of our goodwill being written-off
during 2001. Summarized below are the major classes of intangible assets as a result of our
acquisition of Touch 1 in April of 2000 that will continue to be amortized
under SFAS No. 142. We do not have any intangible assets that will not be
amortized: DECEMBER 31, 2003
    
    DECEMBER 31, 2002CARRYING
    
    ACCUMULATED
    
    NET INTANGIBLE
    
    CARRYING
    
    ACCUMULATED
    
    NET INTANGIBLEAMOUNT
    
    AMORTIZATION
    
    ASSETS
    
    AMOUNT
    
    AMORTIZATION
    
    ASSETSINTANGIBLE ASSETS SUBJECT TO AMORTIZATION:Customer related intangible assets
    
    $
    9,145
    
    
    $
    6,858
    
    
    $
    2,287
    
    
    $
    9,145
    
    
    $
    5,029
    
    
    $
    4,116
 The following table presents current and expected amortization expense of the
existing intangible assets as of December 31, 2003 for each of the following
periods: AGGREGATE AMORTIZATION EXPENSE: For the year ended December 31, 2003
    
    $
    1,829Expected amortization expense for the years ending December 31,2004
    
    
    1,8292005
    
    
    458
  9.
    
    OTHER ASSETS At the respective dates, other assets consist of the following: 2003
    
    2002Deposits
    
    $
    3,062
    
    
    $
    3,166Contract signing bonus
    
    
    
    
    
    
    1,885Certificates of deposit, restricted
    
    
    673
    
    
    
    573Interest receivable
    
    
    54
    
    
    
    57Other
    
    
    31
    
    
    
    67$
    3,820
    
    
    $
    5,748
 The certificates of deposit are pledged as collateral on outstanding letters of
credit in the amount of approximately $0.7 and $0.6 million at December 31,
2003 and 2002, respectively, related to lease obligations on two of the our
office spaces and $0.1 million for certain surety bonds required for regulatory
purposes in 2003. F-16




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##### Table of Contents



10.
    
    ACCOUNTS PAYABLE AND ACCRUED LIABILITIES At the respective dates, accounts payable and accrued liabilities consist of
the following: 2003
    
    2002Trade accounts payable
    
    $
    39,176
    
    
    $
    24,541Accrued sales and use tax payable
    
    
    6,908
    
    
    
    13,936Advances on accounts receivable
    
    
    4,181
    
    
    
    3,425Accrued payroll
    
    
    2,560
    
    
    
    2,038Accrued rent
    
    
    1,263
    
    
    
    1,423Accrued transmission
    
    
    845
    
    
    
    1,256Other accrued liabilities
    
    
    4,297
    
    
    
    5,152$
    59,230
    
    
    $
    51,771
  11.
    
    LONG-TERM DEBT Long-term debt consists of the following: 2003
    
    2002RELATED PARTIES:Note payable to Corman Elegre, customer base pledged
as collateral payable in monthly installments, due
September, 2004, interest rate at 6%
    
    $
    2,364
    
    
    $
    5,070Note payable to First Revocable Trust of W. F.
Corman, unsecured payable in monthly installments,
due September 2004, interest rate at 6%
    
    
    132
    
    
    
    315Note payable to James F. Corman, unsecured, payable
in monthly installments, due September 2004, interest
rate at 6%
    
    
    45
    
    
    
    106UNRELATED PARTIES:Note payable to Franklin Investment Funds, unsecured,
payable in monthly installments, due September 2004,
interest rate of 6%
    
    
    919
    
    
    
    2,183Note payable to First National Bank of Atmore,
unsecured, personally guaranteed by James F. Corman,
payable in monthly installments, due September 2004,
interest rate at 6%
    
    
    123
    
    
    
    293Notes payable to Touch 1 pre-petition creditors (trade
vendors), unsecured, payable in monthly installments,
due September 2004, interest rate at 6%
    
    
    409
    
    
    
    732Notes payable to Touch 1 pre-petition creditors (trade
vendors), priority unsecured, payable in monthly
Installments, due September 2005, interest rate at 6%
    
    
    58
    
    
    
    2454,050
    
    
    
    8,944Less: Current portion
    
    
    (3,992
    )
    
    
    (5,193
    )Total long-term debt
    
    $
    58
    
    
    $
    3,751
 F-17




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##### Table of Contents



OPERATING LEASES We have entered into various non-cancelable operating leases for equipment and
office space with monthly payments through the year 2009. Included in general
and administrative expense is rental expense relating to operating leases of
approximately $2.9, $2.9 and $2.8 million for the years ended December 31,
2003, 2002, and 2001, respectively. Sales and marketing expense includes $0.0,
$0.3 and $0.6 million of rental expense relating to operating leases for the
year ended December 31, 2003, 2002 and 2001, respectively. CAPITAL LEASES We have entered into various capital lease obligations that have effective
interest rates ranging from 3.8% to 19.9%, with three capital leases remaining
with payments through 2006. Future minimum lease payments under non-cancelable operating and capital leases
and long-term debt as of December 31, 2003 are as follows: CAPITALOPERATING
    
    LEASE
    
    LONG-TERMYear ending december 31,
    
    LEASES
    
    OBLIGATIONS
    
    DEBT2004
    
    $
    2,939
    
    
    $
    1,245
    
    
    $
    3,9922005
    
    
    2,035
    
    
    
    489
    
    
    
    582006
    
    
    1,411
    
    
    
    41
    
    
    
    2007
    
    
    1,461
    
    
    
    
    
    
    
    2008
    
    
    1,518
    
    
    
    
    
    
    
    Thereafter
    
    
    907
    
    
    
    
    
    
    
    Less amount representing
estimated executory costs
(taxes, etc.), including
profit thereon, included
in minimum lease payments
    
    
    
    
    
    
    115
    
    
    
    Net minimum payment
    
    $
    10,271
    
    
    
    1,660
    
    
    $
    4,050Less amount representingInterest on obligations under
capital lease
    
    
    
    
    
    
    179Present value of minimum
lease payments (including
approximately $1,025 due
within one year)
    
    
    
    
    
    
    1,481
  12.
    
    MANDATORILY REDEEMABLE CONVERTIBLE PREFERRED STOCK In 2003, four holders of our Series D Convertible
 Preferred Stock (Series D Preferred)
converted their shares to common stock. There was a total of 66,667 shares of
Series D converted into 109,025 shares of common stock. We also paid $0.1
million in cash for certain dividends. In 2002, we had one conversion of 50,000
shares of Series D converted into 76,158 common shares. In July 2000, we filed a Certificate of Designation authorizing the
 issuance of 5.0 million shares of $.01 par value Series D Preferred. We received aggregate proceeds
 of approximately $56.3 million in connection with the sale of 4,688,247 shares of Series D Preferred
 at a price of $12.00 per share. The costs associated with the transaction were approximately
 $0.4 million. The Series D Preferred is convertible at an original conversion price of $12.00,
 which price is subject to adjustment for such items as; (i) a dividend or distribution to common
 shareholders (whether such dividend or distribution is in stock, securities or other property),
 (ii) a stock split, (iii) a stock combination, (iv) a reclassification of the common stock, (v)
 the issuance of stock or, securities convertible into or exercisable for our common stock at a
 price that is less than the   adjusted conversion price and other events that would cause
 dilution of ownership to the Series D Preferred stock. As a result of certain of these events the
 conversion price at December 31, 2003 is $8.63. The Series D Preferred is convertible into common stock
 at the option of the holder (i.e., initially convertible on a one-for-one basis); however,
 there are certain circumstances that provide for us to force a conversion of the stock. Series
 D Preferred is mandatorily redeemable in 2008, has an 8% cumulative dividend payable at times in cash and at
 times in-kind with additional Series D Preferred and has certain, liquidation preferences and
 voting rights. Each purchaser of Series D Preferred received a warrant to purchase a number of our shares
 of common stock equal to one-half of the amount of Series D Preferred purchased by such investor. Each
 warrant is exercisable at a price of $13.80 per share subject to certain adjustments that have
 lowered the exercise price to $9.88 per share, at December 31, 2003. In November 2000, we filed a Certificate of Designation authorizing the issuance of approximately
 6.3 million shares of $.01 par value Series E Convertible Preferred
Stock (Series E Preferred).
 We received proceeds of approximately $50.0 million in connection with the sale of 4,166,667
 shares of Series E Preferred at a price of $12.00 per share. The purchaser of Series E
 Preferred received a  warrant to purchase a number of our shares of common stock equal to
 one-half of the amount of Series E Preferred purchased by such investor. These warrants are
exercisable at a price of $13.80 per share subject to certain adjustments that have lowered the
 exercise price to $7.62  per share, at December 31, 2003. Series E Preferred is convertible at an
 original conversion price of $12.00, which price is subject to adjustment for such items as (i)
 a dividend or distribution to common shareholders (whether such dividend or distribution is in
 stock, securities or other property), (ii) a stock split, (iii) a stock combination, (iv) a
reclassification of the common stock, (v) the issuance of stock or securities convertible into
 or exercisable for our common shares at a price that is less than the adjusted conversion price,
 and (vi) other events that would cause dilution in the ownership of the holders of the
        Series E Preferred stock. As a result of these events the conversion
price at December 31, 2003
is $8.25. The Series E Preferred is convertible into common stock at the option of the holder
 (i.e.,  initially convertible on a one-for-one basis); however, there are certain circumstances
 that provide us the ability to force a conversion of the stock. Series E Preferred is mandatorily
redeemable 8 years from the original issue date, has an 8% cumulative dividend payable in-kind and has certain
liquidation preferences and voting rights. In July 2001, we filed a Certificate of Designation authorizing the issuance of
175 shares of Series G junior convertible preferred stock (Series G
Preferred). On July 2 and August 3, 2001, we issued an aggregate of 175 shares
of Series G Preferred for aggregate proceeds of $17.5 million, initially
convertible into 11,739,970 shares of common stock, at a conversion price of
$1.49, subject to adjustment for such items as; (i) a dividend or distribution
to common shareholders (whether such dividend or distribution is in stock,
securities or other property), (ii) a stock split, (iii) a stock combination,
(iv) a reclassification of the common stock, (v) the issuance of stock or
securities convertible into or exercisable for our common stock at a price that
is less than the adjusted conversion price and upon the occurrence of certain
other events that would cause dilution in the ownership of the holders of the
Series G Preferred. To date there has been no change in the conversion price.
In conjunction with the issuance of the Series G Preferred, we issued warrants
to purchase 3,000,000 shares of common stock at an exercise price of $0.01 per
share. Series G Preferred, becomes mandatorily redeemable September 18, 2006.
The Series G Preferred has a 12% cumulative dividend, is convertible at the
option of the holder and has certain liquidation rights; however, there are
certain circumstances that provide for an automatic conversion of the Series G
Preferred. F-18




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##### Table of Contents



In accordance with generally accepted accounting principles, we recorded a
deemed dividend of approximately $2.3 million, which results from the value
assigned to the warrants and a beneficial conversion feature associated with
the Series G Preferred transaction. These deemed dividends were originally
accreted over an expected life through December 31, 2001 (the earliest
redemption date). Once shareholder approval was obtained on October 30, 2001,
the remaining balance of $1.2 million was to be accreted over the
remaining 5-year redemption period. We recorded approximately $0.2, $0.2 and
$1.6 million of a deemed dividend related to this beneficial conversion feature
in 2003, 2002 and 2001, respectively. As a result of certain anti-dilution clauses in the Series D Preferred stock
agreement, the issuance of Series G Preferred triggered an additional
beneficial conversion feature related to the Series D Preferred agreement. The
deemed dividend of approximately $7.8 million was accreted immediately, in the
third quarter of 2001. In accordance with EITF 98-5, Accounting for Convertible Securities with
Beneficial Conversion Features or Contingently Adjustable Conversion Ratios,
APB Opinion No. 14, Accounting for Convertible Debt and Debt Issued with Stock
Purchase Warrants, EITF 00-27, Application of Issue No. 98-5 to Certain
Convertible Instruments and SFAS No. 128 Earnings Per Share we recorded
non-cash charges relating to a beneficial conversion, cumulative dividends and
preferred stock accretion. We recorded preferred stock dividends and accretion
of $17.5, $15.6 and $15.1 million for the years ended December 31, 2003, 2002
and 2001, respectively. We also recorded a deemed dividend related to a
beneficial conversion feature in the amounts of approximately $0.2, $0.2 and
$9.4 million for the years ended December 31, 2003, 2002 and 2001,
respectively. The recording of the beneficial conversion feature and the resulting preferred
stock accretion is the result of calculating the accounting conversion price
through a fair value allocation of the net proceeds received in the preferred
stock offerings between the preferred stock and the warrants issued. This
required the use of the Black-Scholes valuation model to calculate the fair
value on a per share or warrant basis for the Series D, E and G Preferred. The
beneficial conversion and resulting preferred stock accretion and the
cumulative dividend are included in the calculations of the net loss
attributable to common stockholders and the net loss per share calculation. 13. COMMON STOCK The board of directors has never declared dividends on our common stock since
January 15, 1998 (Inception). In March 2003, our Board of
Directors authorized the repurchase of up to one million shares of
our common stock for a twelve-month period. We did not repurchase any
shares. On February 19, 2001, our Board of Directors adopted a Stockholders Rights
Agreement (the Plan) designed to deter coercive takeover tactics and prevent
an acquirer from gaining control of us without engaging in negotiation with our
Board of Directors. Under the terms of the plan, preferred stock purchase rights were distributed
as a dividend at the rate of one right for each share of our common stock, par
value $0.01 per share and a corresponding number of rights for each outstanding
share of our Series D and E Preferred Stock outstanding at the close of
business on March 7, 2001. Until the rights become exercisable, additional
common stock or Series D and E Preferred will also have one right attached. The rights will become exercisable only upon certain triggering events whereby
certain persons or groups of persons have expressed the intent to acquire at
least 15% or more of the voting power of the outstanding common shares. Upon the occurrence of a triggering event, each right will entitle holders to
buy one one-thousandth of a share of our Series F Junior Participating
Preferred Stock, par value $0.001 per share, at an exercise price of $45 per
one-thousandth of a share, subject to adjustment. Each holder of a right will
thereafter have the right to receive, in lieu of Series F Junior Participating
Preferred Stock and upon payment of the exercise price, common stock (or in
certain circumstances, cash, property or other of our securities) having a
value equal to two times the exercise price of the right. Except as otherwise
provided in the plan, we will generally be able to redeem the rights at $0.001
per right at any time on or prior to a triggering event. The rights will expire
on February 19, 2011, unless earlier redeemed by the Board of Directors. 14. RESTRUCTURING CHARGES In April of 2002, we approved and implemented a restructuring to enhance our
future cash flows and operating earnings. The restructuring included a
reduction of force coupled with the closure of our North Dakota call centers
and our New York sales office. In accordance with EITF 94-3, Liability
Recognition for Certain Employee Termination Benefits and Other Costs to Exit
an Activity, the restructuring costs were recognized as liabilities at the
time management committed to the plan. Management determined that these costs
provided no future economic benefit to us. The restructuring charge includes termination benefits in connection with the
termination of 167 employees and lease abandonment costs. In addition, we
agreed to a settlement to exit the two leases for our call centers in North
Dakota as of July 1, F-19




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##### Table of Contents



2002. All termination benefits and settlements to exit our
leases in North Dakota are paid as of December 31, 2002. We have recorded a
lease abandonment charge representing the future lease payments for our New
York office as a liability and payments exist through August 2005. The following table shows the restructuring charges and related accruals
recognized under the plan and the effect on our consolidated financial
position: Employee
    
    Lease
    
    LeaseTermination
    
    Settlement
    
    AbandonmentBenefits
    
    Costs
    
    Costs
    
    TotalBalance at January 1, 2002
    
    $
    
    
    
    $
    
    
    
    $
    
    
    
    $
    Plan Charges
    
    
    913
    
    
    
    325
    
    
    
    623
    
    
    
    1,861Cash paid
    
    
    (913
    )
    
    
    (325
    )
    
    
    (72
    )
    
    
    (1,310
    )Balance at December 31, 2002
    
    
    
    
    
    
    
    
    
    
    551
    
    
    
    551Cash paid
    
    
    
    
    
    
    
    
    
    
    (200
    )
    
    
    (200
    )Balance at December 31, 2003
    
    $
    
    
    
    $
    
    
    
    $
    351
    
    
    $
    351
 15. INCOME TAXES We account for income taxes under SFAS No. 109, Accounting for Income Taxes.
Deferred income tax assets and liabilities are determined based upon
differences between financial reporting and tax basis of assets and liabilities
and are measured using the enacted tax rates and laws that will be in effect
when the differences are expected to reverse. A reconciliation of the difference between the effective income tax rate and
the statutory federal tax rate follows: 2003
    
    2002
    
    2001Tax at U.S. statutory rate
    
    $
    (5,644
    )
    
    $
    (6,844
    )
    
    $
    (51,145
    )State taxes, net of federal benefit
    
    
    (413
    )
    
    
    (  573
    )
    
    
    ( 2,698
    )Change in valuation allowance
    
    
    5,807
    
    
    
    7,255
    
    
    
    36,779Goodwill amortization
    
    
    
    
    
    
    
    
    
    
    19,725Other
    
    
    250
    
    
    
    162
    
    
    
    (2,661
    )$
    
    
    
    $
    
    
    
    $
    
 Significant components of our deferred tax assets and liabilities are as
follows: 2003
    
    2002Current deferred tax assets:Accounts receivable
    
    $
    5,246
    
    
    $
    6,612Other
    
    
    1,968
    
    
    
    95Noncurrent deferred tax assets:Net operating loss carryforward
    
    
    106,691
    
    
    
    99,869Deferred revenue
    
    
    271
    
    
    
    2,385Deferred compensation
    
    
    181
    
    
    
    616Excess capital losses
    
    
    133
    
    
    
    133Accrued expenses
    
    
    145
    
    
    
    696Other
    
    
    480
    
    
    
    541Gross deferred tax assets
    
    
    115,115
    
    
    
    110,947Less: Valuation allowance
    
    
    (111,900
    )
    
    
    (106,093
    )3,215
    
    
    
    4,854Noncurrent deferred tax liabilities:Property and equipment
    
    
    (2,346
    )
    
    
    (3,290
    )Intangible assets
    
    
    (869
    )
    
    
    (1,564
    )Net deferred tax asset
    
    $
    
    
    
    $
    
 F-20




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##### Table of Contents



Generally accepted accounting principles require a valuation allowance to
reduce the deferred tax assets reported if, based on the weight of the
evidence, it is more likely than not that some portion or all of the deferred
tax assets will not be realized. After consideration of all of the evidence,
management has determined that a valuation allowance of approximately $111.9
and $106.1 million is necessary at December 31, 2003 and 2002, respectively. At December 31, 2003 and 2002, our net operating loss carryforward for federal
income tax purposes is approximately $280.8 and $262.8 million, respectively,
expiring in various amounts from 2018 through 2023. Utilization of our net
operating loss carryforwards may be subject to annual limitations due to
ownership change rules as provided by the Internal Revenue Code and similar
state provisions. 16. COMMITMENTS AND CONTINGENCIES We have disputed billings and access charges from certain inter-exchange
carriers (IXCs) and incumbent local exchange carriers (ILECs). We contend
that the invoicing and billings of access charges to us are not in accordance with
the interconnection, service level, or tariff agreements between us and certain
IXCs and ILECs. We have not paid these disputed amounts and management believes
that we will prevail in these disputes. At December 31, 2003, the total
disputed amounts were approximately $18.2 million. In August 2000, we entered into an agreement with a service firm to outsource
customer provisioning and other ordering through electronic bonding with the
incumbent local exchange carriers. In September 2002, we renegotiated this
agreement, resulting in a lowering of our monthly minimum payments and an
increase to the fees we pay on a per transaction basis. Our annual commitment,
subject to certain adjustments, is approximately $9.6 million for the year
ending December 31, 2004. We made payments under the agreement totaling $11.8,
$9.7 and $6.3 million for the years ended December 31, 2003, 2002 and 2001,
respectively. The minimum payments are required by us, regardless of our use of
the services provided for in the contract. This contract provides, under
certain circumstances, for early termination and severance fees for such
action. We currently have agreements with two long-distance carriers to provide
transmission and termination services for all of our long distance traffic.
These agreements generally provide for the resale of long distance services on
a per-minute basis and contain minimum volume commitments. As a result of a settlement of a billing dispute associated with
minimum volume commitments required in one of these contracts
we have agreed to pay an increased per minute charge for minutes until the
achievement of certain minimum minute requirements which we expect to meet in
the first half of 2004. Once we meet the new agreed upon minimum minutes we
will revert to the terms of our original agreement. All other terms of the
original agreement continue in full force. We believe that we will be fully in
compliance with all minimum volume commitments during 2004. We accrued amounts
representing the incremental fees in 2003, so that the expense recorded per
minute is consistent throughout the agreement. In connection with certain of our wholesale services
 agreements, all or a portion of customer lines are provisioned using our company code. Therefore, we are
the customer of record for the regional bell operating companies wholesale
billing. It is very likely that the state commissions would require us to
continue providing services to the end user customer for at least a 90-day
period, regardless of whether our wholesale relationships continue. We have agreed to certain service level agreements (SLAs) for providing
service under our wholesale agreements. If we were to not fulfill the SLAs
after the phase-in period there are certain remedies including but not limited
to financial compensation. We have not had any financial compensation paid as a
result of any SLAs since our inception. 17. RELATED PARTY TRANSACTIONS In January 2001, we accelerated the vesting of 50,000 stock options granted to
an executive as part of his severance agreement. This acceleration resulted in
the employee being fully vested in stock options with a strike price of $3.64
when the stock was trading at $4.50. We recorded approximately $0.1 million in
general and administrative expense as a result of this transaction. In January 2002, we accelerated the vesting of 96,471 stock options granted to
an executive as part of his severance agreement. This acceleration resulted in
the employee being fully vested in stock options with a strike price of $1.30
when the stock was trading at $1.80. The employee forfeited 76,471 of his
vested options in return for the exercise of 20,000 shares of stock. We
recorded approximately $0.1 million in general and administrative expense as a
result of this transaction. In February 2003 we received a payment of $0.5 million from an executive
officer who is also on our Board of Directors in fulfillment of an outstanding
note receivable to us. In August 2003, we accelerated the vesting of 122,223 stock options granted to
an executive as part of his severance agreement. F-21




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##### Table of Contents



This acceleration resulted in
the employee being fully vested in stock options with a strike price of $1.30
per share and were in-the-money trading at $2.02 per share as the time of
acceleration. As a result of this transaction we recorded approximately $0.1
million in general and administrative expense. As of December 31, 2003 we have approximately $1.7 million of notes receivable
from employees and former employees for various reasons We have recorded
approximately $1.1 million of these loans as a contra to our equity as the
loans were for the purchase of stock. The remaining $0.6 million loans were
more of a personal nature and we have made an accrual for $0.5 million as some
of these loans are to former employees and the likelihood
of collection and lack of collateral make it likely that these amounts will not
be collectable. These notes are primarily due by December 2004 with
approximately $0.8 million due by that date. Only two notes are due beyond
this date, one is a note in the amount of approximately $0.8 million, due in
June 2005, and the other is approximately $0.1 million and is a demand note
that currently has no specific due date. We paid interest on our related party term debt in the amounts of
 $0.3, $0.4 and $0.6 million for the years ended December 31, 2003, 2002 and 2001,
respectively. 18. EMPLOYEE BENEFIT PLAN In 1999, we established a 401(k) plan covering defined employees who meet
established eligibility requirements. Under the original plan provisions, we
did not make matching contributions. Effective September 15, 2000, we merged
the plans of Touch 1 and ours and established a matching contribution for the
401(k) plan to 50% of participating contributions to a maximum matching amount
of 5% of a participants compensation. Our contribution was approximately $0.5
million for each of the years ended December 31, 2003, 2002 and 2001. 19. STOCK-BASED COMPENSATION Effective October 30, 1998, we adopted the 1998 Equity Participation Plan
(1998 Plan), for the grant to eligible employees and eligible participants of
options to purchase up to 1,261,000 shares of our common stock. During
September and November 1999, the Board of Directors (the Board) increased the
shares available for grant under the 1998 Plan to 6.0 and 7.5 million shares,
respectively. Effective April 20, 2000, we adopted the 2000 Equity Participation Plan (2000
Plan). This plan allows for the grant to eligible employees and eligible
participants of options to purchase up to 2.0 million shares of our common
stock. The 2000 Plan automatically increases the number of shares available for
grant on the first day of our fiscal year beginning in 2001 equal to the lesser
of (i) 3.0 million shares, (ii) 6% of the outstanding shares on such date, or
(iii) a lesser amount determined by the Board. Our plans are administered by a committee appointed by the Board, or by the
Board. The Board or the appointed committee shall administer the 2000 Plan,
select the eligible employees and eligible participants to whom options will be
granted, the price to be paid, the exercise period and the number of shares
subject to any such options and interpret, construe and implement the
provisions of the 2000 Plan. Stock option grants approximate the fair market value at the date of grant. The
vesting periods on these options range from immediately to four years and have
a maximum contractual life of ten years. Prior to the adoption of the 1998 Plan, the Board awarded options (the Initial
Plan) for the right to purchase 3,868,800 shares of common stock at a weighted
average option price per share of $2.83. The vesting periods on these options
range from immediately to four years, and have a maximum contractual life of
ten years. F-22




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##### Table of Contents



A summary of the stock option activity for the years ended December 31, 2003,
2002 and 2001 is presented below: 1998 Equity
    
    2000 EquityInitial Plan
    
    Participation Plan
    
    Participation Plan
    
    TotalWeighted
    
    
    
    
    
    Weighted
    
    
    
    
    
    Weighted
    
    
    
    
    
    WeightedAverage
    
    
    
    
    
    Average
    
    
    
    
    
    Average
    
    
    
    
    
    AverageNumber of
    
    Exercise
    
    Number of
    
    Exercise
    
    Number of
    
    Exercise
    
    Number of
    
    ExerciseShares
    
    Price
    
    Shares
    
    Price
    
    Shares
    
    Price
    
    Shares
    
    PriceOutstanding, December 31, 2000
    
    
    2,888,252
    
    
    $
    2.98
    
    
    
    3,627,188
    
    
    $
    13.07
    
    
    
    1,751,640
    
    
    $
    11.45
    
    
    
    8,267,080
    
    
    $
    9.20Granted
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4,257,450
    
    
    
    1.69
    
    
    
    4,257,450
    
    
    
    1.69Exercised
    
    
    (47,486
    )
    
    
    2.32
    
    
    
    (130,253
    )
    
    
    3.64
    
    
    
    
    
    
    
    
    
    
    
    (177,739
    )
    
    
    3.29Forfeited
    
    
    (97,144
    )
    
    
    2.49
    
    
    
    (638,227
    )
    
    
    12.70
    
    
    
    (727,376
    )
    
    
    9.84
    
    
    
    (1,462,747
    )
    
    
    10.60Outstanding, December 31, 2001
    
    
    2,743,622
    
    
    
    3.01
    
    
    
    2,858,708
    
    
    
    13.58
    
    
    
    5,281,714
    
    
    
    3.80
    
    
    
    10,884,044
    
    
    
    6.17Granted
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    3,370,475
    
    
    
    1.29
    
    
    
    3,370,475
    
    
    
    1.29Exercised
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (20,361
    )
    
    
    1.30
    
    
    
    (20,361
    )
    
    
    1.30Forfeited
    
    
    (17,593
    )
    
    
    3.31
    
    
    
    (480,845
    )
    
    
    19.97
    
    
    
    (1,242,132
    )
    
    
    3.58
    
    
    
    (1,740,570
    )
    
    
    8.10Outstanding, December 31, 2002
    
    
    2,726,029
    
    
    
    3.01
    
    
    
    2,377,863
    
    
    
    12.29
    
    
    
    7,389,696
    
    
    
    2.70
    
    
    
    12,493,588
    
    
    
    4.59Granted
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,712,600
    
    
    
    1.94
    
    
    
    1,712,600
    
    
    
    1.94Exercised
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (394,144
    )
    
    
    1.32
    
    
    
    (394,144
    )
    
    
    1.32Forfeited
    
    
    
    
    
    
    
    
    
    
    (292,237
    )
    
    
    3.21
    
    
    
    (437,183
    )
    
    
    12.31
    
    
    
    (696,420
    )
    
    
    8.67Expired
    
    
    (550,000
    )
    
    
    3.64
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (550,000
    )
    
    
    3.64Outstanding, December 31, 2003
    
    
    2,176,029
    
    
    $
    2.85
    
    
    
    2,085,626
    
    
    $
    13.56
    
    
    
    8,270,969
    
    
    $
    2.10
    
    
    
    12,565,624
    
    
    $
    4.14
 We did not grant any options to non-employees during 2003, 2002 and 2001. The following table summarizes information about stock options outstanding at
December 31, 2003: WeightedAverageExercise
    
    Number
    
    Number
    
    ExercisablePrice Range
    
    Outstanding
    
    Exercisable
    
    Price$0.00 - $1.00
    
    
    159,050
    
    
    
    73,189
    
    
    $
    0.85$1.01 - $2.00
    
    
    7,613,075
    
    
    
    4,176,775
    
    
    $
    1.28$2.01 - $3.00
    
    
    658,548
    
    
    
    184,609
    
    
    $
    2.26$3.01 - $4.00
    
    
    1,731,388
    
    
    
    1,729,691
    
    
    $
    3.65$5.01 - $6.00
    
    
    366,620
    
    
    
    366,620
    
    
    $
    5.45$6.01 - $7.01
    
    
    303,900
    
    
    
    302,700
    
    
    $
    7.00$7.00 -$8.00
    
    
    173,453
    
    
    
    170,953
    
    
    $
    7.39$8.01 - $9.00
    
    
    8,450
    
    
    
    7,900
    
    
    $
    8.96$9.01 - $10.00
    
    
    76,250
    
    
    
    76,250
    
    
    $
    10.00$11.01 - $12.00
    
    
    58,900
    
    
    
    58,900
    
    
    $
    12.00$12.01 - $13.00
    
    
    942,190
    
    
    
    940,190
    
    
    $
    13.00$13.01 - $47.00
    
    
    473,800
    
    
    
    1,000
    
    
    $
    30.5912,565,624
    
    
    
    8,088,777
 20. COMPUTATION OF NET LOSS PER SHARE Basic net loss per share is computed by dividing net loss attributable to
common stockholders by the weighted average number of common shares
outstanding during the period. Incremental shares of common stock equivalents
are not included in the calculation of net loss per share as the inclusion of
such equivalents would be anti-dilutive. F-23




---



##### Table of Contents



Net loss per share is calculated as follows: Year EndedDecember 31,2003
    
    2002
    
    2003Basic and diluted net loss per share:Net loss
    
    $
    (16,127
    )
    
    $
    (19,555
    )
    
    $
    (146,068
    )Less mandatorily redeemable convertible preferred
stock dividends and accretion
    
    
    (17,480
    )
    
    
    (15,589
    )
    
    
    (15,059
    )Less deemed dividend related to beneficial conversion feature
    
    
    (186
    )
    
    
    (186
    )
    
    
    (9,356
    )Net loss attributable to common stockholders
    
    $
    (33,793
    )
    
    $
    (35,330
    )
    
    $
    (170,483
    )Weighted average common shares outstanding
    
    
    35,396,922
    
    
    
    34,951,720
    
    
    
    33,908,374Basic and diluted net loss per share
    
    $
    (0.95
    )
    
    $
    (1.01
    )
    
    $
    (5.03
    )
 For each of the periods presented, basic and diluted net loss per share are the
same. The following table includes potentially dilutive items that were not
included in the computation of diluted net loss per share for all periods
presented because to do so would be anti-dilutive in each case: Year EndedDecember 31,2003
    
    2002
    
    2001Unexercised stock options
    
    
    12,565,624
    
    
    
    12,493,588
    
    
    
    10,884,044Unexercised warrants
    
    
    10,652,769
    
    
    
    10,443,330
    
    
    
    10,425,982Mandatorily redeemable preferred stock
convertible into common shares
    
    
    31,678,795
    
    
    
    27,901,655
    
    
    
    25,941,982Total potentially dilutive shares of common
stock equivalents
    
    
    54,897,188
    
    
    
    50,838,573
    
    
    
    47,252,008
 21. LEGAL AND REGULATORY PROCEEDINGS During June and July 2001, three separate class action lawsuits were filed
against us, certain of our current and former directors and officers (the
D&Os) and firms engaged in the underwriting (the Underwriters) of our
initial public offering of stock (the IPO). The lawsuits, along with
approximately 310 other similar lawsuits filed against other issuers arising
out of initial public offering allocations, have been assigned to a Judge in
the United States District Court for the Southern District of New York for
pretrial coordination. The lawsuits against us have been consolidated into a
single action. A consolidated amended complaint was filed on April 20, 2002. A
Second Corrected Amended Complaint (the Amended Complaint), which is the
operative complaint, was filed on July 12, 2002. The Amended Complaint is based on the allegations that our registration
statement on Form S-1, filed with the Securities and Exchange Commission
(SEC) in connection with the IPO, contained untrue statements of material
fact and omitted to state facts necessary to make the statements made not
misleading by failing to disclose that the underwriters allegedly had received
additional, excessive and undisclosed commissions from, and allegedly
had entered into unlawful tie-in and other arrangements with, certain customers
to whom they allocated shares in the IPO. The plaintiffs in the Amended
Complaint assert claims against us and the D&Os pursuant to Section 11 of the
Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934
and Rule 10b-5 promulgated by the SEC thereunder. The plaintiffs in the Amended
Complaint assert claims against the D&Os pursuant to Sections 11 and 15 of the
Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange
Act of 1934 and Rule 10b-5 promulgated by the SEC thereunder. The plaintiffs
seek an undisclosed amount of damages, as well as pre-judgment and
post-judgment interest, costs and expenses, including attorneys fees, experts
fees and other costs and disbursements. Initial discovery has begun. We believe
we are entitled to indemnification from our Underwriters. F-24




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##### Table of Contents



A memorandum of understanding has been reached by lawyers for the plaintiffs,
the issuers and insurers of the issuers. The memorandum sets forth the terms of
a proposed settlement, the principal components of which are (i) a release of
all claims against the issuers and their officers and directors, (ii) the
assignment by the issuers to the plaintiffs of certain claims the issuers may
have against the Underwriters and (iii) an undertaking by the insurers to
ensure the plaintiffs receive not less than $1 billion in connection with
claims against the Underwriters. Our board of directors has approved the
memorandum of understanding. To be binding, the settlement must be approved by
substantially all the issuers and thereafter submitted to and approved by the
court. The settlement will not be binding upon any plaintiffs electing to
opt-out of the settlement. The Metropolitan Government of Nashville and Davidson County, Tennessee, on
behalf of the Metropolitan Nashville Employee Benefit Board (collectively
Metro Nashville), filed a lawsuit against us on September 20,
2002. The lawsuit asserts claims under Delaware Law, the Uniform Commercial
Code, and state law and seeks actual damages of $18 million, punitive damages
of $18 million, interest, and court costs. Metropolitan Nashville Employee
Benefit Board is our common shareholder. Metro Nashville alleges that we
wrongfully and improperly delayed delivery of a stock certificate, preventing
Metro Nashville from selling or taking other steps to protect the value of
their shares while the price of our stock declined significantly. The court
denied our motion to dismiss on January 20, 2003 and denied our motion for
summary judgment on January 21, 2004. We filed a motion for reconsideration of
the Order Denying Summary Judgment on February 6, 2004. This motion is still
pending before the court. The court has scheduled trial to begin on May 17,
2004. We believe the lawsuit is without merit and intend to oppose the
allegations vigorously; however, we cannot predict the outcome of this
litigation with any certainty. On August 6, 2002, we filed a complaint against Southwestern Bell Telephone
Company (SWBT) before the Public Utility Commission of
Texas (PUCT),
requesting that the PUCT enjoin SWBT from disconnecting our access to customers
in Texas on the basis of a billing dispute between the parties. The billing
dispute centered on whether we owed SWBT certain amounts for collect calls from
SWBT retail customers to our retail customers. On August 23, 2002, the PUCT
issued in part the injunctive relief requested by us, making clear that
service not be interrupted. Since that injunction, we and SWBT have been
involved in a dispute resolution process over these and other billing disputes
between SWBT and SBC affiliates of SWBT. On October 9, 2003, Z-Tel Communications, Inc., our wholly-owned subsidiary
corporation, filed a lawsuit against SBC Communications, Inc. and several of
its subsidiaries (collectively, SBC) in federal court in Texas, where both
SBC and us do business. The lawsuit alleges SBCs violation of the federal
antitrust laws, the Racketeering Influenced Corrupt Organizations Act (RICO),
the Lanham Act, and other federal and state laws. The complaint seeks damages
and an injunction against SBC. On November 20, 2003, SBC filed a motion to
dismiss the complaint. This motion is pending before the court. We cannot
predict the outcome of this litigation with any certainty. In September 2003, the FCC released its final decision in the Triennial Review
proceeding. In the Triennial Review Order,the FCC also ruled that entrants
would no longer be able to access network elements utilized by incumbent local
telephone companies to provide broadband services, such as
fiber-to-the-premises loops, high-capacity transport, packet switching,
line-sharing for DSL services, and fiber-fed next-generation digital loop
carrier loops. These limitations on unbundled access could have a
significant impact upon our business; if incumbent carriers deploy
next-generation architectures as a replacement for their existing local plant,
there is the significant possibility that our ability to provide services to
our customers will be eliminated or severely restricted in such situations.
The FCC did reaffirm incumbent local telephone company obligations to provide
unbundled access to Enhanced Extended Links (EELs, a combination of loop and
transport) and the UNE-P combination in
particular circumstances, subject to review by state public utility
commissions. In particular, the FCC ruled that entrants like us would be
able to purchase dedicated transport (utilized in EELs) and analog switching
(utilized in UNE-P) on an unbundled basis, subject to state-by-state review of
whether such unbundling was needed in their states. Carriers were involved in those state-by-state proceedings when, on March 2,
2004, the D.C. Circuit Court of Appeals overturned the FCCs decision as an
improper delegation of authority to state public utility commissions. See
Report and Order on Remand and Further Notice of Proposed Rulemaking,
Review of Section 251 Unbundling Obligations of Incumbent Local Exchange
Carriers, 18 FCC Rcd 16978 (2003) (Triennial Review Order), revd in part and
remanded, United States Telecom Assn v. FCC, Nos. 00-1012, 00-1015, 03-1310 et
al.(D.C. Cir. March 2, 2004) (USTA II). The D.C. Circuit ordered that the
unbundled transport and switching rules be vacated after sixty days or upon
denial of a petition for rehearing, whichever occurs later. A majority of the
FCC has indicated that it will support an appeal of this decision. We
are
weighing our legal options with regard to this opinion, as are other
competitive carriers. If the USTA IIdecision is not stayed or reversed, it
could have immediate, significant, adverse and material impact upon our
business. For example, ILECs might utilize the reversal of the unbundling
rules to deny us access to their local networks. We depend upon such access to
provide our services to our customers. With regard to pricing, states and the FCC are currently re-evaluating the
pricing of network elements. As a result, it is possible that prices in some
states could increase or lower rates from existing levels. Currently, the
incumbent local exchange carriers Verizon, BellSouth, SBC and Qwest have rate
cases pending before state regulatory commissions in at least one state in each
of their respective territories. In particular, ongoing rate cases in Illinois,
Ohio, Indiana and Michigan could significantly raise the existing rates for
some network elements and network element combinations. Our intent is to be an
active participant in many of these rate cases and any others that might be
critical to our operations. We anticipate joining other competitive service
providers in arguing that existing rates and rates proposed by the incumbents
are overstated and do not reflect the true total element long run incremental
costing principles required by the FCC and the Telecommunications Act. The FCC,
in Docket No. 03- is currently reevaluating its prescribed methodology for
calculating unbundled network element rates. In the 2002 Verizon v. FCC
decision, the U.S. Supreme Court affirmed the FCCs current pricing
methodology, called Total Element Long Run Incremental
Cost, or

TELRIC. The current FCC rulemaking proposes to modify the TELRIC methodology
by mandating that states set prices based upon the forward-looking costs of
operating the existing network architecture of incumbent local telephone
company networks. In many instances, modifying the TELRIC methodology in this
way could increase the rates we pay for certain elements and result in lower
rates for other elements. We believe that the FCCs proposals to modify TELRIC
are inconsistent with the Supreme Courts decision in the Verizoncase, meaning
that new FCC TELRIC rules may be subject to considerable litigation if they are
adopted. While the prevailing productivity trends within the industry would predict the
adoption of lower rates in association with the provision of unbundled network
elements and network element combinations, we cannot predict the outcome of any
pending or potential rate case or judicial proceeding. Increases or decreases
in rate levels charged by incumbent local exchange carriers as a result of
regulatory and/or judicial review through rate case, court case or arbitration
proceedings could significantly impact our business plans. We believe that in the event the rules are vacated without any replacement by
either the FCC or the state utility commissions, we have interconnection
agreements with our principal ILEC vendors that will permit us to continue to
obtain access to local network elements during any intervening time period.
However, it is possible that any or all of those ILECs will refuse to abide by
the F-25




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##### Table of Contents



terms of those agreements or seek to terminate those agreements. We are
evaluating our legal options to ensure that we continue to meet the needs of
our existing and future customers. In the ordinary course of business, we are involved in legal and
regulatory proceedings, disputes and tax audits at the federal, state and local
level that are generally incidental to our ongoing operations. In addition,
from time to time, we are the subject of customer and vendor complaints filed
with the state utility commissions of the states in which they operate or the
Federal Communications Commission. Most complaints, are handled informally, and
at this time, there are no formal proceedings pending. While there can be no
assurance of the ultimate disposition of incidental legal proceedings or
customer complaints, we do not believe their disposition will have a material
adverse effect on our consolidated results of operations or financial position. 22. SEGMENT REPORTING We have two reportable operating segments: Retail Services and Wholesale
Services. Prior to 2002 we had only one
reportable segment: retail services. The retail services segment includes our Z-LineHOME and Z-LineBUSINESS services
that offer bundled local and long-distance telephone services in combination
with enhanced communication features accessible, through the telephone, the
Internet and certain personal digital assistants. We offer Z-LineHOME and
Z-LineBUSINESS in 49 states. Our customers are concentrated primarily in
metropolitan areas in 10 states for both our Z-LineHOME and Z-LineBUSINESS
services. This segment also includes our Touch 1 residential long-distance
offering that is available nation-wide. The wholesale services segment allows companies to offer telephone exchange and
enhanced services to residential and small business customers. This service is
currently available in 49 states and Sprint is our primary customer for this
offering. Management evaluates the performance of each business unit based on segment
results, exclusive of adjustments for unusual items. Special items are
transactions or events that are included in our reported consolidated results
but are excluded from segment results due to their nonrecurring or
non-operational nature. It is also important to understand when viewing our
segment results that we only record direct expenses in our wholesale services
and therefore, all employee benefits, occupancy, insurance, and other indirect
or overhead related expenses are reflected in the retail services segment. The following summarizes the financial information concerning our reportable
segments for the years ended December 31, 2003, 2002 and 2001: December 31,2003
    
    2002
    
    2001Retail ServicesRevenues
    
    $
    205,059
    
    
    $
    208,280
    
    
    $
    280,350Depreciation and amortization
    
    $
    20,956
    
    
    $
    22,428
    
    
    $
    23,277Segment results
    
    $
    (18,905
    )
    
    $
    (9,975
    )
    
    $
    (36,721
    )Capital expenditures
    
    $
    10,239
    
    
    $
    6,657
    
    
    $
    15,426Identifiable assets
    
    $
    77,108
    
    
    $
    97,914
    
    
    $
    116,737
 December 31,2003
    
    2002
    
    2001Wholesale ServicesRevenues
    
    $
    84,121
    
    
    $
    30,774
    
    
    $
    Depreciation and amortization
    
    $
    2,493
    
    
    $
    1,508
    
    
    $
    Segment results
    
    $
    24,717
    
    
    $
    11,315
    
    
    $
    Capital expenditures
    
    $
    797
    
    
    $
    8,536
    
    
    $
    Identifiable Assets
    
    $
    12,345
    
    
    $
    8,797
    
    
    $
    
 F-26




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The following table reconciles our segment information to the consolidated
financial information for 2003, 2002 and 2001: December 31,2003
    
    2002
    
    2001RevenuesTotal segment revenues
    
    $
    289,180
    
    
    $
    239,054
    
    
    $
    280,350MCI bankruptcy revenue reversal
    
    
    
    
    
    
    (657
    )
    
    
    Total consolidated
    
    $
    289,180
    
    
    $
    238,397
    
    
    $
    280,350
 December 31,2003
    
    2002
    
    2001Segment results:Total segment results
    
    $
    5,812
    
    
    $
    1,340
    
    
    $
    (36,668
    )Retroactive reduction to network access rate
    
    
    2,500
    
    
    
    8,981
    
    
    
    MCI bankruptcy
    
    
    
    
    
    
    (1,304
    )
    
    
    Write-off of accounts receivable
    
    
    
    
    
    
    
    
    
    
    (29,949
    )Asset impairment charge
    
    
    
    
    
    
    (1,129
    )
    
    
    (59,247
    )Wholesale development costs
    
    
    
    
    
    
    (1,018
    )
    
    
    Restructuring charge
    
    
    
    
    
    
    (1,861
    )
    
    
    Depreciation and amortization
    
    
    (23,449
    )
    
    
    (23,936
    )
    
    
    (23,277
    )Total consolidated operating loss
    
    $
    (15,137
    )
    
    $
    (18,927
    )
    
    $
    (149,141
    )
 23. SUBSEQUENT EVENTS In February 2004, we received from two employees an aggregate payment of $0.5
million for repayment of notes receivable. In March 2004, we signed an agreement with a large
 communication company with a
large embedded customer base. This agreement is a marketing arrangement in
which we would pay a monthly recurring commission and certain other
fees based on retail customers added during the agreement. We will own the end user and will consequently
be responsible for providing all
services and expenses associated with these customers, similar to our existing
retail UNE-P business. This agreement has no minimum requirements but we were
provided with formal notice for a projected launch of May 6, 2004. In March 2004, we granted 285,000 shares of
 restricted stock with an approximate value  of $0.8 million to certain
executive officers and key employees. The cost of the stock is $0.01, par
value, per share and vests one-third after one year and one thirty-sixth each
month thereafter. SUPPLEMENTAL QUARTERLY FINANCIAL INFORMATION (UNAUDITED) In the following summary of quarterly financial information, all adjustments
necessary for a fair presentation of each period were included. QUARTER ENDEDMARCH 31,
    
    JUNE 30,
    
    SEPTEMBER 30,
    
    DECEMBER 31,2003
    
    2003
    
    2003
    
    2003Revenues
    
    $
    60,929
    
    
    $
    71,046
    
    
    $
    82,716
    
    
    $
    74,489Operating loss
    
    
    (3,280
    )
    
    
    (5,587
    )
    
    
    (2,069
    )
    
    
    (4,201
    )Net loss
    
    
    (3,105
    )
    
    
    (6,008
    )
    
    
    (2,553
    )
    
    
    (4,461
    )Loss per share(1)
    
    $
    (0.21
    )
    
    $
    (0.30
    )
    
    $
    (0.18
    )
    
    $
    (0.26
    )Weighted average
shares outstanding
    
    
    35,268,253
    
    
    
    35,305,448
    
    
    
    35,368,759
    
    
    
    35,641,435
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QUARTER ENDEDMARCH 31,
    
    JUNE 30,
    
    SEPTEMBER 30,
    
    DECEMBER 31,2002
    
    2002
    
    2002
    
    2002Revenues
    
    $
    58,156
    
    
    $
    63,039
    
    
    $
    59,478
    
    
    $
    57,724Operating income (loss)
    
    
    (11,172
    )
    
    
    1,355
    
    
    
    (5,127
    )
    
    
    (3,983
    )Net income (loss)
    
    
    (10,607
    )
    
    
    259
    
    
    
    (4,962
    )
    
    
    (4,245
    )Loss per share (1-4)
    
    $
    (0.42
    )
    
    $
    (0.11
    )
    
    $
    (0.26
    )
    
    $
    (0.22
    )Weighted average
shares outstanding
    
    
    34,307,194
    
    
    
    35,074,936
    
    
    
    35,191,836
    
    
    
    35,220,240
  (1)
    
    Earnings per share were calculated for each three-month period on a
stand-alone basis.  (2)
    
    We recorded start-up costs of approximately $1.0 million for the
development our new wholesale services offering during the first quarter of
2002.  (3)
    
    We recorded approximately $1.9 million for termination benefits, lease
abandonment and lease settlement costs in connection with the closure of two
call centers in North Dakota and our New York sales office in the second
quarter of 2002.  (4)
    
    We recorded approximately $1.2, $1.3 and $9.0 million as a result of
retroactive rate reduction for the unbundled network elements in the
first quarter 2003, second quarter 2003 and second quarter 2002,
respectively. F-28




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ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. 
 ITEM 9a. CONTROLS AND PROCEDURES We maintain disclosure controls and procedures designed to ensure that material
information related to us, including our consolidated subsidiaries, is
recorded, processed, summarized and reported in accordance with SEC rules and
forms. Our management, with the participation of Chief Executive Officer, D.
Gregory Smith, and Chief Financial Officer, Horace J. Davis, III, has evaluated
the effectiveness of our disclosure controls and procedures as of the end of
the period covered by this report. Based upon that evaluation, Mr. Smith and
Mr. Davis have concluded that our disclosure controls and procedures are
effective in causing material information to be recorded, processed,
summarized, and reported so as to ensure the quality and timeliness of our
public disclosures in compliance with SEC rules and forms. There was no change in our internal control over financial reporting that
occurred during our most recent fiscal quarter that has materially affected, or
is reasonably likely to materially affect our internal control over financial
reporting. 53




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PART III 
 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT DIRECTORS AND EXECUTIVE OFFICERS Information regarding directors, nominees for director and executive officers
is in our 2004 Annual Meeting proxy statement and is incorporated herein by
reference. 
 ITEM 11. EXECUTIVE COMPENSATION Information regarding executive compensation is included in our 2004 Annual
Meeting proxy statement and is incorporated herein by reference. 
 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this item is included in our 2004 Annual Meeting proxy
statement and is incorporated herein by reference. 
 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this item is included in our 2004 Annual Meeting proxy
statement and is incorporated herein by reference. 
 ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES Information required by this item is included in our 2004 Annual Meeting proxy
statement and is incorporated herein by reference. 
 PART IV 
 ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. The following financial statements of Z-Tel Technologies, Inc. and the
report thereon of PricewaterhouseCoopers LLP dated March 29, 2004 are filed as
part of this report: Report of Independent Certified Public Accountants. Consolidated Balance Sheets at December 31, 2003 and 2002 Consolidated Statements of Operations for the years ended December 31, 2003,
2002, 2001. Consolidated Statements of Changes in Stockholders Equity (Deficit) for the
years ended December 31, 2003, 2002 and 2001. Consolidated Statements of Cash Flows for the years ended December 31, 2003,
2002 and 2001. Notes to Financial Statements.  (a)
    
    3. The following exhibits are filed as part of this report (exhibits
marked with an asterisk have been previously filed with the Commission
as indicated, and are incorporated herein by this reference): 54




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3(a) The following exhibits are filed as part of this report: EXHIBITNUMBER
    
    DESCRIPTION3.1
    
    Amended and Restated Certificate of Incorporation of Z-Tel, as
amended. Incorporated by reference to the correspondingly numbered
exhibit to our Quarterly Report on Form 10-Q for the quarter ended
June 30, 2001, filed on August 13, 2001.3.2
    
    Amended and Restated Bylaws of Z-Tel. Incorporated by reference to
the correspondingly numbered exhibit to our Registration Statement
on Form S-1 (File No. 333-89063), originally filed October 14,
1999, as amended and as effective December 14, 1999.4.1
    
    Form of Common Stock Certificate. Incorporated by reference to the
correspondingly numbered exhibit to our Registration Statement on
Form S-1 (File No. 333-89063), originally filed October 14, 1999,
as amended and as effective December 14, 1999.4.2
    
    See Exhibits 3.1 and 3.2 of this Form for provisions of the
Amended and Restated Certificate of Incorporation, as amended, and
our Bylaws defining rights of security holders.4.3
    
    Stock Purchase Agreement, dated July 6, 2000, by and between us
and the various purchasers of our Series D Convertible Preferred
Stock. Incorporated by reference to the correspondingly numbered
exhibit to our Quarterly Report on Form 10-Q for the quarter ended
June 30, 2000, filed on August 14, 2000.4.4
    
    Certificate of Designations, Preferences and Relative Rights,
Qualifications, Limitations and Restrictions relating to our
Series D Convertible Preferred Stock, as amended March 13, 2003.
Incorporated by reference to Exhibit 4.4 to our Quarterly Report
on Form 10-Q for the quarterly period ended June 30, 2000, filed
on August 14, 2000, and (the amendment) to Exhibit 4.20 of our
Quarterly Report on Form 10-Q for the quarter ended March 31,
2003, filed on May 15, 2003.4.5
    
    From of Registration Rights Agreement by and between us and each
of the purchasers of our Series D Convertible Preferred Stock.
Incorporated by reference to the correspondingly numbered exhibits
to our Quarterly Report on Form 10-Q for the quarter ended June
30, 2000, filed on August 14, 2000.4.6
    
    Form of Warrant for the purchase of shares of our common stock by
each of the purchasers of our Series D Convertible Preferred
Stock. Incorporated by




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EXHIBITNUMBER
    
    DESCRIPTIONreference to the correspondingly numbered exhibit to our Quarterly
Report on Form 10-Q for the quarter ended June 30, 2000, filed on
August 14, 2000.4.7
    
    Stock and Warrant Purchase Agreement, dated October 19, 2000, by
and among us and The 1818 Fund III, L.P. Incorporated by reference
to the correspondingly numbered exhibit to our Quarterly Report on
Form 10-Q for the quarter ended September 30, 2000, filed on
November 14, 2000.4.8
    
    Amended and Restated Certificate of Designation of 8% Convertible
Preferred Stock, Series E, Setting Forth the Powers, Preferences,
Rights, Qualifications, Limitations and Restrictions of Such
Series of Preferred Stock, as amended March 13, 2003. Incorporated
by reference to Exhibit 4.8 to our Quarterly Report on Form 10-Q
for the quarter ended June 30, 2001, filed on August 13, 2001, and
(the amendment) to Exhibit 4.21 of our Quarterly Report on Form
10-Q for the quarter ended March 31, 2003, filed on May 15, 2003.4.9
    
    Registration Rights Agreement between and among us and The 1818
Fund III, L.P. Incorporated by reference to the correspondingly
numbered exhibit to our Quarterly Report on Form 10-Q for the
quarter ended September 30, 2000, filed on November 14, 2000.4.10
    
    Warrant issued to The 1818 Fund III, L.P. for the purchase of
shares of our common stock. Incorporated by reference to the
correspondingly numbered exhibit to our Quarterly Report on Form
10-Q for the quarter ended September 30, 2000, filed on November
14, 2000.4.11
    
    Certificate of Designation of Series F Junior Participating
Preferred Stock. Incorporated by reference to the correspondingly
numbered exhibit to our Annual Report on Form 10-K for the year
ended December 31, 2000, filed on March 30, 2001.4.12
    
    Rights Agreement dated as of February 19, 2001 between us and
American Stock Transfer Trust Company, as Rights Agent.
Incorporated by reference to the correspondingly numbered exhibit
to our Annual Report on Form 10-K for the year ended December 31,
2000, filed on March 30, 2001. The agreement was amended July 2,
2001 to reflect the issuance of the Series G Preferred Stock.4.13
    
    Stock and Warrant Purchase Agreement, dated as of July 2, 2001, by
and between us, D. Gregory Smith, and others. Incorporated by
reference to Exhibit 1 to Amendment No. 1 of the Schedule 13D
filed July 12, 2001 with respect to our common stock by, among
other persons, The 1818 Fund III, L.P.4.14
    
    Warrant for the Purchase of Shares of Common Stock of Z-Tel, dated
as of July 2, 2001. Incorporated by reference to Exhibit 2 to
Amendment No. 1 of the Schedule 13D filed July 12, 2001 with
respect to our common stock by, among other persons, The 1818 Fund
III, L.P.




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EXHIBITNUMBER
    
    DESCRIPTION4.15
    
    Certificate of Designation for the Series G Preferred Stock.
Incorporated by reference to Exhibit 3 to Amendment No. 1 of the
Schedule 13D filed July 12, 2001 with respect to our common stock
by, among other persons, The 1818 Fund III, L.P.4.16
    
    Backup Purchase Agreement, dated as of July 2, 2001, by and among
Z-Tel Communications, Inc., a Delaware corporation and our wholly
owned subsidiary, Touch 1 Communications, Inc., an Alabama
corporation and our wholly owned subsidiary, D. Gregory Smith and
others. Incorporated by reference to Exhibit 4 to Amendment No. 1
of the Schedule 13D filed July 12, 2001 with respect to our common
stock by, among other persons, The 1818 Fund III, L.P.4.17
    
    Additional Investor Registration Rights Agreement, dated as of
July 2, 2001, between Z-Tel, D. Gregory Smith and others.
Incorporated by reference to Exhibit 5 to the Schedule 13D filed
July 24, 2001 with respect to our common stock by, among other
persons, D. Gregory Smith.4.18
    
    Voting Agreement, dated as of June 29, 2001, between us and
certain of our stockholders. Incorporated by reference to Exhibit
5 to Amendment No. 1 of the Schedule 13D filed July 12, 2001 with
respect to our common stock by, among other persons, The 1818 Fund
III, L.P.4.19
    
    Employee Stock Restriction Agreement, dated September 1, 1998, by
and between us and D. Gregory Smith. Incorporated by reference to
Exhibit 7 to the Schedule 13D filed July 24, 2001 with respect to
our common stock by, among other persons, D. Gregory Smith.10.2.1
    
    1998 Equity Participation Plan. Incorporated by reference to the
correspondingly numbered exhibit to our Registration Statement on
Form S-1 (File No. 333-89063), originally filed October 14, 1999,
as amended and as effective December 14, 1999.10.2.2
    
    2000 Equity Participation Plan. Incorporated by reference to
Appendix B to our Preliminary Proxy Statement filed on April 14,
2000, with the following amendment effective May 31, 2001:Section 2.1(a) of the Plan is hereby amended
in its entirety to read as follows:The shares of stock
subject to Options,
awards of Restricted
Stock, Performance
Awards, Dividend
Equivalents, awards of
Deferred Stock, Stock
Payments or Stock
Appreciation Rights
shall be Common Stock,
initially shares of the
Companys Common Stock,
par value $0.01 per
share. The aggregate
number of such shares
which may be issued upon
exercise of such options
or rights or upon any
such awards under the
Plan shall be Four




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EXHIBITNUMBER
    
    DESCRIPTIONMillion Five Hundred Thousand (4,500,000) plus an annual increase
to be added on the first day of the Companys fiscal year
beginning in 2001 equal to the lesser of (i) Three Million
(3,000,000) shares of the Companys Common Stock, (ii) 6% of the
outstanding shares on such date, or (iii) a lesser amount
determined by the Board. The shares of Common Stock issuable upon
exercise of such options or rights or upon any such awards may be
either previously authorized but unissued shares or treasury
shares.10.3
    
    Employment Agreement of D. Gregory Smith, dated July 30, 2002.
Incorporated by reference to the correspondingly numbered exhibit
to our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2002, filed on November 14, 2002.10.4
    
    Receivables Sales Agreement dated as of July 27, 2000 by and
between Z-Tel Communications, Inc., as seller and subservicer,
Touch 1 Communications, Inc., as seller and subservicer, and RFC
Capital Corporation, as purchaser. Incorporated by reference to
the correspondingly numbered exhibit to our Quarterly Report on
Form 10-Q for the quarter ended June 30, 2000, filed on August 14,
2000, with an amendment extending the agreement until July 27,
2004.10.5
    
    Form of Indemnification Agreement for our executive officers and
directors. Incorporated by reference to the correspondingly
numbered exhibit to our Annual Report on Form 10-K for the year
ended December 31, 2000, filed on March 30, 2001.10.6
    
    Employment Agreement of Ned Dumas Garrett, dated August 14, 2002.
Incorporated by reference to the correspondingly numbered exhibit
to our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2002, filed on November 14, 2002.10.7
    
    Employment Agreement of J. Bryan Bunting, dated August 14, 2002.
Incorporated by reference to the correspondingly numbered exhibit
to our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2002, filed on November 14, 2002.10.8
    
    Employment Agreement of Charles W. McDonough, dated August 14,
2002. Incorporated by reference to the correspondingly numbered
exhibit to our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2002, filed on November 14, 2002.10.9
    
    Employment Agreement of Robert A. Curtis, dated July 30, 2002.
Incorporated by reference to the correspondingly numbered exhibit
to our Quarterly Report on Form 10-Q for the quarter ended
September 30, 2002, filed on November 14, 2002.10.11
    
    Promissory Note, dated September 10, 1999, from Touch 1
Communications, Inc. and William F. Corman (First Revocable
Trust). Incorporated by reference to the correspondingly numbered
exhibits to our Annual Report on Form 10-K for the year ended
December 31, 2000, filed on March 30, 2001.




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EXHIBITNUMBER
    
    DESCRIPTION10.12
    
    Promissory Note, dated September 10, 1999, from Touch 1
Communications, Inc. and James F. Corman. Incorporated by
reference to the correspondingly numbered exhibits to our Annual
Report on Form 10-K for the year ended December 31, 2000, filed on
March 30, 2001.10.13
    
    Agreement for Wholesale Telephone Exchange Services, Z-Node
Services, Ancillary Services and Technology License, dated March
20, 2002, between Z-Tel Communications, Inc. and MCI WORLDCOM
Communications, Inc. Incorporated by reference to the
correspondingly numbered exhibit to our Quarterly Report on Form
10-Q for the quarter ended March 31, filed on May 15, 2002. The
agreement was amended August 7, 2003 to terminate the agreement
December 31, 2003.10.14
    
    Agreement for Resale of Local Wireline Telecommunications Services
and Provision of Ancillary Services, dated February 4, 2003,
between Z-Tel Communications, Inc. and Sprint Communications L.P.
Portions of this exhibit have been omitted pursuant to a request
for confidential treatment.21.
    
    List of Subsidiaries23.
    
    Consent of PricewaterhouseCoopers LLP31.1
    
    Certification of the Chief Executive Officer31.2
    
    Certification of the Chief Financial Officer32.1
    
    Written Statement of the Chief Executive Officer Pursuant to 18
U.S.C.ss.135032.2
    
    Written Statement of the Chief Financial Officer Pursuant to 18
U.S.C.ss.1350
 (b) Reports on Form 8-K On October 10, 2003 we filed a Form 8-K in connection with our lawsuit
against SBC. Information regarding this lawsuit is set forth in the section
entitled legal proceedings. On November 12, 2003, we furnished a Form 8-K in
connection with our earnings release and the subsequent earnings conference
call.




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this Report to be signed on its
behalf by the undersigned, thereunto duly authorized, as of the 29th day of
March, 2004. Z-TEL TECHNOLOGIES, INC. BY: /s/ D. GREGORY SMITH
   
 Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant in the capacities and on the dates indicated. SIGNATURE
    
    TITLE
    
    DATE/s/ D. Gregory Smith

D. Gregory Smith
    
    President, CEO, Chairman
of the Board and Director
(Principal Executive Officer)
    
    March 29, 2004/s/ Horace J. Davis III

Horace J. Davis III
    
    Senior Vice President Chief
Financial Officer
(Principal Financial and
Accounting Officer)
    
    March 30, 2004/s/Charles W. McDonough

Charles W. McDonough
    
    Senior Vice President
Chief Technology Officer, and
Director
    
    March 30, 2004/s/ Jeffrey A. Bowden

Jeffrey A. Bowden
    
    Director
    
    March 30, 2004/s/ Charles D. Hyman

Charles D. Hyman
    
    Director
    
    March 29, 2004/s/ Andrew C. Cowen

Andrew C. Cowen
    
    Director
    
    March 30, 2004/s/ John K. Aurell

John K. Aurell
    
    Director
    
    March 29, 2004/s/ Richard F. LaRoche, Jr.

Richard F. LaRoche, Jr
    
    Director
    
    March 29, 2004/s/ Lawrence C. Tucker

Lawrence C. Tucker
    
    Director
    
    March 30, 2004/s/ W. Andrew Krusen, Jr.

W. Andrew Krusen, Jr.
    
    Director
    
    March 30, 2004
 55