**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

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**FORM 10-Q**

 
| ý                                                                                                                                                                    |   | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------|
|                                                                                                                                                                      |   |                                                                                               |
| **For the Quarterly Period Ended  March 31, 2004.**                                                                                                                  |
|                                                                                                                                                                      |   |                                                                                               |
| **or**                                                                                                                                                                    |
|                                                                                                                                                                      |   |                                                                                               |
| **o**                                                                                                                                                                     |   | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                      |   |                                                                                               |
| **For the transition period  from                      to** |
|                                                                                                                                                                      |   |                                                                                               |
| **Commission file number 0-24509**                                                                                                                                        |

 

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**AllegianceTelecom, Inc.**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                                                     |   | **75-2721491**                     |
|------------------------------------------------------------------|--------|------------------------------------|
| (State or other  jurisdiction  of incorporation or organization) |   | (IRS Employer  Identification No.) |

 

# **9201 North Central Expressway**

**Dallas, Texas 75231**

(Address ofprincipal executive offices) (Zip Code)

 

**(214) 261-7100**

(Registrant’stelephone number, including area code)

 

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Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days. Yes ýNo o

 

Indicate by checkmark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act). Yes oNo ý

 

As of May 14,2004, the registrant has 120,350,803 shares of common stock, par value $0.01per share outstanding.

 

 

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**ALLEGIANCE TELECOM, INC. ANDSUBSIDIARIES**

 

**FORM 10-Q INDEX**

** **
| **PART I.  FINANCIAL INFORMATION** |                                                                                                 |
|------------------------------------|------------------------------------------------------------------------------------------------------|
| Item 1.                            | Financial  Statements                                                                                |   |
|                               | Condensed  Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003                    |   |
|                               | Condensed  Consolidated Statements of Operations for the three months ended March 31,  2004 and 2003 |   |
|                               | Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  2004 and 2003 |   |
|                               | Notes  to Condensed Consolidated Financial Statements                                                |   |
| Item  2.                           | Management’s  Discussion and Analysis of Financial Condition and Results of Operations          |   |
| Item 3.                            | Quantitative and Qualitative Disclosures about  Market Risk                                          |   |
| Item 4.                            | Controls and Procedures                                                                              |   |
|                               |                                                                                                 |   |
| **PART II.  OTHER INFORMATION**    |                                                                                                 |
| Item 1.                            | Legal  Proceedings                                                                                   |   |
| Item  2.                           | Changes  in Securities and Use of Proceeds                                                           |   |
| Item 3.                            | Defaults  Upon Senior Securities                                                                     |   |
| Item 4.                            | Submission of Matters  to a Vote of Security Holders                                                 |   |
| Item 5.                            | Other  Information                                                                                   |   |
| Item 6.                            | Exhibits and Reports on  Form 8-K                                                                    |   |
|                               | Signatures                                                                                           |   |
|                               | Index to  Exhibits                                                                                   |   |

 

2

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**PARTI.****FINANCIAL INFORMATION**

 

**ITEM 1. *Financial Statements***

 

**ALLEGIANCE TELECOM, INC. ANDSUBSIDIARIES**

**(Debtors and Debtors-in-Possession)**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

**(in thousands, except share and pershare data)**

** **
|                                                                                                                                                                     |   | **March 31,  2004** |      | **December  31,  2003** |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|-----------|-------------------------|--------|
|                                                                                                                                                                     |   | **(unaudited)**     |      |                    |   |
| **ASSETS**                                                                                                                                                               |   |                |      |                    |   |
|                                                                                                                                                                     |   |                |      |                    |   |
| Current assets:                                                                                                                                                          |   |                |      |                    |   |
| Cash and cash  equivalents                                                                                                                                               |   | $                   | 247,020   |                    | $      | 282,220 |   |
| Short-term  investments                                                                                                                                                  |   | 2,516               |      | 1,958                   |   |
| Restricted  short-term investments                                                                                                                                       |   | —              |      | 365                     |   |
| Accounts  receivable, net                                                                                                                                                |   | 116,161             |      | 106,055                 |   |
| Prepaid expenses  and other current assets                                                                                                                               |   | 21,517              |      | 19,985                  |   |
| Total current  assets                                                                                                                                                    |   | 387,214             |      | 410,583                 |   |
| Property and  equipment, net                                                                                                                                             |   | 629,393             |      | 682,618                 |   |
| Deferred debt  issuance costs, net                                                                                                                                       |   | 13,500              |      | 13,847                  |   |
| Long-term  investments, restricted                                                                                                                                       |   | 7,565               |      | 7,758                   |   |
| Other assets,  net                                                                                                                                                       |   | 18,842              |      | 20,715                  |   |
| Total assets                                                                                                                                                             |   | $                   | 1,056,514 |                    | $      | 1,135,521 |   |
|                                                                                                                                                                     |   |                |      |                    |   |
| **LIABILITIES AND STOCKHOLDERS’  DEFICIT**                                                                                                                          |   |                |      |                    |   |
|                                                                                                                                                                     |   |                |      |                    |   |
| Current  liabilities not subject to compromise:                                                                                                                          |   |                |      |                    |   |
| Accounts payable                                                                                                                                                         |   | $                   | 26,257    |                    | $      | 26,031 |   |
| Accrued  liabilities and other current liabilities                                                                                                                       |   | 67,833              |      | 85,972                  |   |
| Total current  liabilities not subject to compromise                                                                                                                     |   | 94,090              |      | 112,003                 |   |
| Liabilities  subject to compromise (see Note 2)                                                                                                                          |   | 1,335,249           |      | 1,336,989               |   |
| Commitments and  contingencies (see Note 10)                                                                                                                        |   |                |      |                    |   |
|                                                                                                                                                                     |   |                |      |                    |   |
| Stockholders’  deficit:                                                                                                                                             |   |                |      |                    |   |
| Preferred stock,  $.01 par value, 1,000,000 shares authorized, no shares issued or outstanding  at March 31, 2004 and December 31, 2003                             |   | —              |      | —                  |   |
| Common stock,  $.01 par value, 750,000,000 shares authorized, 125,264,444 shares issued and  120,350,803 shares outstanding at March 31, 2004 and December 31, 2003 |   | 1,252               |      | 1,252                   |   |
| Additional  paid-in capital                                                                                                                                              |   | 1,808,335           |      | 1,808,335               |   |
| Common stock in  treasury, at cost, 4,913,641 shares at March 31, 2004 and December 31,  2003                                                                       |   | (45                 | )         | (45                     | )      |
| Common stock  warrants                                                                                                                                                   |   | 1,857               |      | 1,857                   |   |
| Deferred  compensation                                                                                                                                                   |   | (1,463              | )         | (2,001                  | )      |
| Accumulated  deficit                                                                                                                                                     |   | (2,182,761          | )         | (2,122,869              | )      |
| Total  stockholders’ deficit                                                                                                                                        |   | (372,825            | )         | (313,471                | )      |
| Total  liabilities and stockholders’ deficit                                                                                                                        |   | $                   | 1,056,514 |                    | $      | 1,135,521 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

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**ALLEGIANCE TELECOM, INC. ANDSUBSIDIARIES**

**(Debtors and Debtors-in-Possession)**

**CONDENSED CONSOLIDATED STATEMENTS OF OPE****RATIONS**

**(in thousands, except share and pershare data)**

**(unaudited)**

** **
|                                                              |   | **Three  Months Ended  March 31,** |    |
|-------------------------------------------------------------------|--------|-----------------------------------------|---------|
|                                                              |   | **2004**                                |    | **2003** |   |
|                                                              |   |                                    |    |   |   |
| Revenues                                                          |   | $                                       | 179,993 |   | $ | 204,577 |   |
|                                                              |   |                                    |    |   |   |
| Operating  Expenses:                                              |   |                                    |    |   |   |
| Network                                                           |   | 77,081                                  |    | 111,453 |   |
| Selling, general  and administrative                              |   | 78,171                                  |    | 116,574 |   |
| Depreciation and  amortization                                    |   | 56,165                                  |    | 66,633 |   |
| Non-cash  deferred compensation                                   |   | 538                                     |    | 953 |   |
| Total operating  expenses                                         |   | 211,955                                 |    | 295,613 |   |
| Loss from  operations                                             |   | (31,962                                 | )       | (91,036 | ) |
|                                                              |   |                                    |    |   |   |
| Other Income  (Expense):                                          |   |                                    |    |   |   |
| Interest income                                                   |   | 564                                     |    | 1,005 |   |
| Interest expense                                                  |   | (9,026                                  | )       | (30,053 | ) |
| Total other  income (expense)                                     |   | (8,462                                  | )       | (29,048 | ) |
| Net loss before  reorganization items                             |   | (40,424                                 | )       | (120,084 | ) |
|                                                              |   |                                    |    |   |   |
| Reorganization  items                                             |   | (19,467                                 | )       | — |   |
|                                                              |   |                                    |    |   |   |
| Net Loss                                                          |   | $                                       | (59,891 | ) | $ | (120,084 | ) |
|                                                              |   |                                    |    |   |   |
| Net loss per  share, basic and diluted                            |   | $                                       | (0.50   | ) | $ | (1.00 | ) |
|                                                              |   |                                    |    |   |   |
| Weighted average  number of shares outstanding, basic and diluted |   | 120,556,655                             |    | 120,443,391 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

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**ALLEGIANCE TELECOM, INC. ANDSUBSIDIARIES**

**(Debtors and Debtors-in-Possession)**

**CONDENSED CONSOLIDATED STATEMENTS OF CAS****H FLOWS**

**(in thousands, except share and pershare data)**

**(unaudited)**

** **
|                                                                          |   | **Three  Months Ended  March 31,** |    |
|-------------------------------------------------------------------------------|--------|-----------------------------------------|---------|
|                                                                          |   | **2004**                                |    | **2003** |   |
| Cash flows from  operating activities:                                        |   |                                    |    |   |   |
| Net loss                                                                      |   | $                                       | (59,891 | ) | $ | (120,084 | ) |
| Adjustments to  reconcile net loss to cash used in operating activities— |   |                                    |    |   |   |
| Reorganization  expenses, net                                                 |   | 19,467                                  |    | — |   |
| Depreciation and  amortization                                                |   | 56,165                                  |    | 66,633 |   |
| Provision for  uncollectible accounts receivable                              |   | 3,085                                   |    | 14,033 |   |
| Accretion of  investments                                                     |   | —                                  |    | (1 | ) |
| Accretion of  Series B and 12 7/8% notes                                      |   | —                                  |    | 6,500 |   |
| Amortization of  deferred debt issuance costs                                 |   | 347                                     |    | 779 |   |
| Amortization of  deferred compensation                                        |   | 538                                     |    | 953 |   |
| Changes in  assets and liabilities, net of effects of acquisitions—      |   |                                    |    |   |   |
| Decrease  (increase) in accounts receivable                                   |   | (13,010                                 | )       | 3,961 |   |
| Increase in  prepaid expenses and other current assets                        |   | (1,532                                  | )       | (4,488 | ) |
| Decrease in  other assets                                                     |   | 444                                     |    | 1,103 |   |
| Increase  (decrease) in accounts payable                                      |   | (263                                    | )       | 9,140 |   |
| Increase  (decrease) in accrued liabilities and other current liabilities     |   | (18,201                                 | )       | 14,611 |   |
| Net cash used in  operating activities before reorganization items            |   | (12,851                                 | )       | (6,860 | ) |
| Reorganization  items—                                                   |   |                                    |    |   |   |
| Reorganization  expenses, net                                                 |   | (19,467                                 | )       | — |   |
| Net  restructuring losses                                                     |   | 338                                     |    | — |   |
| Increase in post-petition  restructuring accruals                             |   | 490                                     |    | — |   |
| Increase in  liabilities subject to compromise                                |   | 134                                     |    | — |   |
| Net cash used in  operating activities                                        |   | (31,356                                 | )       | (6,860 | ) |
| Cash flows from  investing activities:                                        |   |                                    |    |   |   |
| Purchases of  property and equipment                                          |   | (2,595                                  | )       | (9,190 | ) |
| Capitalized  interest                                                         |   | —                                  |    | (225 | ) |
| Purchases of  investments                                                     |   | —                                  |    | (3,000 | ) |
| Proceeds from  sale of investments                                            |   | —                                  |    | 25,000 |   |
| Net cash  provided by (used in) investing activities                          |   | (2,595                                  | )       | 12,585 |   |
| Cash flows from  financing activities:                                        |   |                                    |    |   |   |
| Proceeds from  issuance of common stock, net                                  |   | —                                  |    | 32 |   |
| Payments on  capital lease obligations                                        |   | (1,249                                  | )       | (1,427 | ) |
| Net cash used in  financing activities                                        |   | (1,249                                  | )       | (1,395 | ) |
|                                                                          |   |                                    |    |   |   |
| Increase  (decrease) in cash and cash equivalents                             |   | (35,200                                 | )       | 4,330 |   |
| Cash and cash  equivalents, beginning of period                               |   | 282,220                                 |    | 253,311 |   |
| Cash and cash  equivalents, end of period                                     |   | $                                       | 247,020 |   | $ | 257,641 |   |
| Supplemental  disclosure of cash flow information:                            |   |                                    |    |   |   |
| Cash paid for  interest                                                       |   | $                                       | 8,737   |   | $ | 9,335 |   |
| Supplemental  disclosure of non-cash investing and financing activities:      |   |                                    |    |   |   |
| Assets acquired  under capital lease obligations                              |   | —                                  |    | $ | 7 |   |

 

The accompanyingnotes are an integral part of these consolidated financial statements.

 

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**ALLEGIANCE TELECOM, INC. ANDSUBSIDIARIES**

**(Debtors and Debtors-in-Possession)**

**NOTES TO CONDENSED CONSOLIDATED FINANCIA****L STATEMENTS**

**Three Months Ended March 31,2004 and 2003**

**(dollars in thousands, except shareand per share data)**

**(unaudited)**

 

**1. General:**

 

AllegianceTelecom, Inc. is a facilities-based national local exchange carrier thatprovides integrated telecommunications services to business, government andother institutional users in major metropolitan areas across the United Statesof America and it is focused primarily on small to medium-sized businesses.Allegiance Telecom, Inc. was incorporated on April 22, 1997, as aDelaware corporation, and it and its subsidiaries are generally referred toherein as the “Company.”

 

The Companyprovides service in major metropolitan areas in the United States of America asfollows: Atlanta, Austin, Baltimore, Boston, Chicago, Cleveland, Dallas,Denver, Detroit, Fort Lauderdale, Fort Worth, Houston, Long Island, LosAngeles, Miami, Minneapolis/St. Paul, New York City, Northern New Jersey,Oakland, Ontario/Riverside, Orange County, Philadelphia, Phoenix, Pittsburgh,Portland, Sacramento, St. Louis, San Antonio, San Diego, San Francisco, SanJose, Seattle, Tampa, Washington, D.C., West Palm Beach/Boca Raton and White Plains,New York.

 

The Company hasprepared the accompanying unaudited condensed consolidated financial statementsin accordance with accounting principles generally accepted in the UnitedStates of America for interim financial information and are in the formprescribed by the Securities and Exchange Commission in instructions toForm 10-Q and Article 10 of Regulation S-X. Accordingly, they donot include all of the information and footnotes required by accountingprinciples generally accepted in the United States of America for completefinancial statements. The interim unaudited condensed consolidated financialstatements should be read in conjunction with the Company’s auditedconsolidated financial statements as of and for the year ended December 31,2003. In the opinion of management, all adjustments (consisting only of normalrecurring adjustments) considered necessary for a fair presentation have beenincluded. Operating results for the three months ended March 31, 2004 arenot necessarily indicative of the results that may be expected for the yearending December 31, 2004.

 

Certain amounts inthe prior period’s condensed consolidated financial statements have beenreclassified to conform to current period presentation.

 

**2. Reorganization and Going Concern:**

 

***Voluntary Bankruptcy Filing.***  On May 14, 2003 (the “CommencementDate”), Allegiance Telecom, Inc. and all of its direct and indirect whollyowned subsidiaries filed voluntary petitions for relief under Chapter 11 of theUnited States Bankruptcy Code in the United States Bankruptcy Court for theSouthern District of New York (the “Bankruptcy Court”) in order to facilitatethe restructuring of the Company’s debt, trade liabilities and otherobligations. The reorganization is being jointly administered under the caption“In re Allegiance Telecom, Inc., et al. Case No. 03-13057 (RDD)” (the “Chapter11 cases”). The Company is currently operating as “debtors-in-possession” underthe jurisdiction of the Bankruptcy Court and in accordance with the applicable provisionsof the Bankruptcy Code, the Federal Rules of Bankruptcy Procedure andapplicable court orders. In general, as debtors-in-possession, the Company isauthorized under Chapter 11 to continue to operate as an ongoing business,but may not engage in transactions outside the ordinary course of businesswithout the prior approval of the Bankruptcy Court.

 

UnderSection 362 of the Bankruptcy Code, the filing of a bankruptcy petitionautomatically stays most actions against the Company, including most actions tocollect pre-petition indebtedness or to exercise control of the property of theCompany’s estate. Absent an order of the Bankruptcy Court, in Chapter 11substantially all pre-petition liabilities will be addressed under a plan ofreorganization. The Bankruptcy Court established November 26, 2003 as thebar date for filing proofs of claims. The aggregate amount of pre-petitionclaims is not known at this time since the claims are still being reviewed andnot all of the contract rejection claims have yet been filed.

 

UnderSection 365 of the Bankruptcy Code, the Company may assume or rejectcertain pre-petition executory contracts and unexpired leases, including leasesof real property, subject to the approval of the Bankruptcy Court and certain

 

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other conditions. In general, subject to certain conditions, rejectionof a pre-petition unexpired lease or executory contract relieves the Company ofperforming future obligations under an unexpired lease or executory contractand is treated as a pre-petition breach of such lease or contract, generallyresulting in any breach damages being treated as pre-petition liabilities.Counterparties to these rejected contracts or unexpired leases may file proofsof claim against the Company’s estate for such damages, if any. Generally, theassumption of a pre-petition executory contract or unexpired lease requires adebtor to cure most existing financial defaults, if any, including payment ofany pre-petition amounts owed, but not previously paid, under such executorycontract or unexpired lease. Due to the uncertain nature of many of thepotential rejection and abandonment related claims and to the uncertain amountneeded for cure payments, the Company cannot presently determine with certaintythe ultimate aggregate liability that will result from cures or the filing ofclaims relating to such pre-petition contracts and unexpired leases that havebeen or may be assumed or rejected.

 

The United States Trustee forthe Southern District of New York appointed an official committee of unsecuredcreditors (the “Creditors’ Committee”). The Creditors’ Committee and its legalrepresentatives have a right to be heard on all matters related to theCompany’s Chapter 11 cases that come before the Bankruptcy Court. The rightsand claims of various creditors and security holders will be determined by aplan of reorganization that is confirmed by the Bankruptcy Court. Under thepriority rules established by the Bankruptcy Code, certain post-petitionliabilities and certain pre-petition liabilities (e.g., senior secured debt)are given priority over unsecured pre-petition indebtedness and need to besatisfied before unsecured creditors or stockholders are entitled to anydistribution.

 

Beginning after itfiled the Chapter 11 cases, the Company had discussions with various thirdparties who were interested in purchasing some or all of the Company throughthe bankruptcy process, either through a 363 sale (a sale pursuant toSection 363 of Chapter 11 of the Bankruptcy Code) or in connection with aplan of reorganization. On December 18, 2003, the Company signed an AssetPurchase Agreement with Qwest Communications International Inc. (“Qwest”)to purchase substantially all of the assets of the Company, except for theCompany’s customer premises equipment sales and maintenance business, dedicateddial-up access services business operated under an agreement with Level 3Communications, LLC (“Level 3”), shared hosting business, and certain other assets.

 

OnDecember 18, 2003 the Company filed with the Bankruptcy Court a Motion ForOrders Pursuant To Sections 105(a), 363, 365 And 1146(c) Of The BankruptcyCode: (A)(i) Fixing The Time, Date And Place For The Bidding ProceduresHearing And (ii) Approving The No-Shop Provisions Set Forth In The AssetPurchase Agreement With Qwest Communications International Inc.;(B)(i) Establishing Bidding Procedures And Bid Protections In ConnectionWith The Sale Of Substantially All Of The Assets Of The Debtors, (ii) ApprovingThe Form And Manner Of Notices, (iii) Approving The Asset PurchaseAgreement Subject To Higher And Better Offers And (iv) Setting A SaleApproval Hearing Date; And (C)(i) Approving The Sale To QwestCommunications International Inc. Free And Clear Of All Liens, Claims AndEncumbrances, (ii) Authorizing The Assumption And Assignment Of CertainExecutory Contracts And Unexpired Leases And (iii) Granting Related Relief(the “Bidding Procedures Motion”). On January 9, 2004, the BankruptcyCourt approved the motion establishing certain bidding procedures and approvedthe Qwest Asset Purchase Agreement subject to higher and better offers.

 

OnFebruary 12 and 13, 2004, the Company conducted an auction for the Companyin which on February 13, 2004, XO Communications, Inc. (“XO”) wasselected as the winning bidder based on its offer of approximately $311,000 incash and approximately 45.38 million shares of XO common stock. OnFebruary 18, 2004 the Company entered into an Asset Purchase Agreementwith XO. On February 20, 2004, the Bankruptcy Court entered its Order(I) Approving the Sale Free and Clear of All Liens, Claims andEncumbrances to the Successful Bidder, (II) Authorizing the Assumption andAssignment of Certain Executory Contracts and Unexpired Leases, and(III) Granted Related Relief. Under the XO Asset Purchase Agreement, XOwill purchase the stock of the operating subsidiaries of the Company as well assubstantially all of the other assets of the Company, except its customerpremises equipment sales and maintenance business, the dedicated dial-up accessservices business operated under an agreement with Level 3, the shared hostingbusiness, and certain other assets. The transaction is structured so that oncecertain governmental approvals are received and certain other conditions aremet, XO is obligated to place into escrow the consideration for the purchaseand XO will be able to operate the assets it is acquiring subject to theCompany’s consent and in accordance with applicable law, regulations, andtariffs. The government approvals were obtained on April 5, 2004, and theescrow funding occurred on April 14, 2004. Since XO has now funded thepurchase price into escrow under the XO Asset Purchase Agreement, XO has nowassumed the risk of loss of the assets it is acquiring and XO’s conditions toclose this transaction are limited. Closing is conditioned upon the satisfaction (or waiver) of theconditions to the “Effective Date” set forth in our plan of reorganization(e.g., the confirmation order becoming a final order). The XO Asset PurchaseAgreement provides that either company may terminate the XO Asset PurchaseAgreement after funding into escrow has occurred but before final closing, if,among other things, the other party breaches the XO Asset Purchase Agreement.Final closing under the XO Asset Purchase Agreement is scheduled to occur aspart of the confirmation and effectiveness of the

 

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Company’s plan of reorganization unless either party elects to proceedwithout a plan of reorganization.  Ifthe Company’s plan of reorganization is not confirmed by the Bankruptcy Courtby June 7, 2004, or made effective by June 30, 2004, XO may elect to purchasethe assets of the Company outside a plan of reorganization. The Company may atany time elect to close without a plan of reorganization.

 

XO is currentlyoperating the acquired assets of the Company pursuant to an operating agreementsubject to the Company’s consent and in accordance with applicable law,existing service agreements, regulations, and tariffs. For the servicesprovided by XO, the Company will pay XO the costs of operating the acquiredassets (including reimbursing the costs of the Company associated with thoseacquired assets) plus thirty percent; provided, however, that XO shall be paidsolely out of the revenues generated by the acquired assets and all such costsare collectible solely from the cash receipts relating to the acquired assets.In the event that the cash receipts do not cover the costs to operate theacquired assets, the Company has no obligation to reimburse XO for any costs inexcess of the cash receipts; provided, however, that any shortfall may berecovered from any months where the cash receipts from the acquired assets arein excess of XO’s fees for operating the acquired assets. The operatingagreement expires once all consents have been obtained to transfer the acquiredassets to XO and the assets have been transferred to XO.

 

Under the XO AssetPurchase Agreement, XO will determine the leases and executory contracts thatit is assuming and those that the Company may reject on closing. Leases andexecutory contracts that XO has requested that the Company reject may createadditional liabilities for the Company and reduce the recovery by individualcreditors in the Chapter 11 cases.

 

At this time, itis not possible to predict when and whether final closing will occur under theXO Asset Purchase Agreement. In addition, if the XO transaction does not closethere can be no assurance that the Company will be able to sell the assetssubject to this transaction to Qwest or other interested parties. Finally,there can be no assurance that if the Company is not sold that it will be ableto successfully reorganize and emerge from bankruptcy as the Company hasterminated the employment of a significant number of employees who would benecessary if the Company were to try to emerge as a stand-alone business.  The Company cannot accurately predict theeffect of the Chapter 11 reorganization process on its business or itsstakeholders. The Company’s future results depend on the timely and successfulconfirmation and implementation of a plan of reorganization. No assurance canbe given that the Company will be successful in reorganizing its affairs withinthe Chapter 11 proceedings.

 

In order toreorganize under Chapter 11 successfully, the Company will need to propose andobtain confirmation by the Bankruptcy Court of a plan of reorganization thatsatisfies the requirements of the Bankruptcy Code. As provided by theBankruptcy Code, the Company initially had the exclusive right to file aplan of reorganization for 120 days from the Commencement Date, whichexpired September 11, 2003. Under various orders, the initial exclusivityperiod has been extended until July 14, 2004.

 

On April 22, 2004,the Company filed its Second Amended Disclosure Statement and Second AmendedJoint Plan of Reorganization with the Bankruptcy Court (the “Plan”). On April22, 2004, the Bankruptcy Court entered an order (a) approving Allegiance’sSecond Amended Disclosure Statement pursuant to Section 1125 of the BankruptcyCode; (b)

 

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approving (i) procedures for solicitation of votes to accept or rejectthe Plan and the tabulation of such votes on the Plan, and (ii) certain relatedmaterials in connection therewith; and (c) scheduling the date and time onwhich the Court will hold a hearing to consider confirmation of the Plan.  Ballots have been distributed to thoseclasses entitled to vote on the Plan. The Confirmation Hearing is scheduled for June 7, 2004 at 10:00 a.m. atthe Bankruptcy Court, but may be continued from time to time without furthernotice; except that notice of any such adjournment(s) will be set forth on thewebsite of the Company’s voting agent at www.bmccorp.net/allegiance.

 

The proposed Planaddresses, among other things, the treatment of pre-petition obligations. Thisproposed Plan will result in holders of the Company’s Series B 11 3/4%notes due 2008 and 12 7/8% senior notes due 2008receiving less than the face value of such notes as part of this Plan.Additionally, based on this proposed Plan filed by the Company, holders of theCompany’s common stock will receive no value as part of the reorganization (andall shares of Allegiance Telecom, Inc. common stock will be extinguished andcancelled).

 

Unless an electionis made to close the transactions in accordance with the XO Asset PurchaseAgreement under Section 363 of the Bankruptcy Code, the closing under theXO Asset Purchase Agreement is scheduled to occur prior to or simultaneouslywith the effectiveness of the plan of reorganization. If the plan ofreorganization is not confirmed, or, if the plan is not confirmed andexclusivity has expired, the Company, or any other party in interest, couldattempt to formulate a different plan of reorganization. Such a plan mightinvolve either a reorganization or continuation of the Company’s business or anorderly liquidation of the Company’s assets. In addition, if the plan is notconfirmed by June 7, 2004 or has not become effective by June 30, 2004 and XOhas not consented to such delay, XO may elect to proceed to close under the XOAsset Purchase Agreement without the plan of reorganization.

 

Pursuant to SOP90-7, the Company is required to segregate certain expenses, realized gains andlosses and provisions for losses not directly related to ongoing operations asreorganization items in the condensed consolidated statements of operations.The following reorganization items were incurred during the three months endedMarch 31, 2004:

 
|                                |   | **March 31,  2004** |   |
|-------------------------------------|--------|---------------------|--------|
|                                |   |                |   |
| Professional  fees                  |   | $                   | 6,129  |   |
| Other  restructuring (gains)/losses |   | 13,338              |   |
| Total  reorganization items         |   | $                   | 19,467 |   |

 

Otherrestructuring losses at March 31, 2004 include a $13,000 fee paid to Qwest forterminating the Qwest Asset Purchase Agreement, as required by the agreement.

 

***Accounting Impact.***  These condensed consolidated financialstatements have been prepared in accordance with the provisions of the AmericanInstitute of Certified Public Accountants Statement of Position 90-7 “FinancialReporting by Entities in Reorganization Under the Bankruptcy Code” (“SOP90-7”). Pursuant to SOP 90-7, the Company’s pre-petition liabilities that aresubject to compromise are reported separately on the balance sheet as anestimate of the amount that will ultimately be allowed by the Bankruptcy Court.

 

The followingtable sets forth the liabilities of the Company subject to compromise as ofMarch 31, 2004:

 
| Accounts payable and other claims                                                                                                                                                           |   | $       | 106,306   |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|---------|-----------|--------|
| Senior secured  credit facilities, variable interest rate                                                                                                                                   |   | 477,827 |      |
| Series B 11  3/4 % notes, face amount $445,000 due February 15,  2008; effective interest rate of 12.21%; at accreted value, including interest  accrued through the Commencement Date |   | 453,270 |      |
| 12 7/8  % senior notes, face amount $205,000 due May 15, 2008; effective  interest rate of 13.24%; at accreted value, including interest accrued  through the Commencement Date        |   | 215,405 |      |
| Capital lease  obligations (see Note 8)                                                                                                                                                |   | 82,441  |      |
| Total  liabilities subject to compromise                                                                                                                                                    |   | $       | 1,335,249 |   |

 

Pursuant to SOP90-7, an objective of financial statements issued by an entity inChapter 11 is to reflect its financial evolution during the proceeding.For that purpose, the financial statements for periods including and subsequentto filing the Chapter 11 petition should distinguish transactions and eventsthat are directly associated with the reorganization from the

 

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ongoing operations of the business. Certain expenses, realized gainsand losses and provisions for losses not directly related to ongoing operationsare reflected separately in the condensed consolidated statement of operationsas reorganization items.

 

Additionally,pre-petition debt that is subject to compromise must be recorded at the allowedclaim amount, which generally results in the write-off of any deferredfinancing amounts associated with the debt. Only certain claims relating topre-petition debt have been allowed by the Bankruptcy Court as ofMarch 31, 2004. As a result, a majority of pre-petition debt subject tocompromise is recorded at its pre-petition value.

 

Deferred debtissuance costs include costs incurred by the Company in raising debt proceeds.These costs were being amortized to interest expense over the life of therelated debt pre-petition. In accordance with SOP 90-7, the Company stoppedrecording interest expense on the Company’s Series B 11 3/4%notes due 2008 and 12 7/8% senior notes due 2008 as ofthe Commencement Date. Accordingly, the deferred debt issuance costs related tothis debt is no longer being amortized. Under the Second Amended CashCollateral Order, discussed below, the Company is required to continueincurring and paying interest under its senior secured credit agreement at theapplicable non-default rate of interest. Accordingly, the deferred debtissuance costs related to the senior secured credit facilities continue to beamortized to interest expense over the life of the debt.

 

Certainpre-petition debt that is classified as subject to compromise, specifically thesenior secured credit facilities, continues to accrue interest. Interest on theremaining pre-petition debt that is subject to compromise ceased to accrue whenthe bankruptcy was filed. On March 31, 2004, the Company receivedBankruptcy Court approval for the continued use of its cash collateral under aSecond Stipulation and Consent Order Extending the Expiration Date of theSecond Amended Final Order Authorizing Use of Cash Collateral by Consent (the“Second Amended Cash Collateral Order”). The Second Amended Cash CollateralOrder among other things: (1) restricts the Company’s use of cash,(2) requires the Company to prepare and follow a budget and maintain aminimum weekly cash balance, and (3) requires the Company to providecertain financial, operational and other information to its senior lenders andthe Creditors’ Committee. Under this Second Amended Cash Collateral Order, theCompany is required to continue incurring and paying interest under its seniorsecured credit agreement (at the applicable non default rate of interest).  The Second Amended Cash Collateral Orderexpires by its own terms on July 14, 2004.

 

The condensedconsolidated financial statements contained herein have been prepared inaccordance with accounting principles generally accepted in the United Statesof America applicable to a going concern, and do not purport to reflect or toprovide all of the possible consequences of the ongoing Chapter 11 cases.Specifically, the condensed consolidated financial statements do not presentthe amount that will ultimately be paid to settle liabilities and contingenciesthat may be required in the Chapter 11 cases.

 

In accordance withthe guidance provided by the Financial Accounting Standards Board in Statementof Financial Accounting Standards No. 144, “Accounting for the Impairmentor Disposal of Long-Lived Assets,” the Company considered the bankruptcy filingon May 14, 2003 and the pending sale of the business as ofDecember 31, 2003 triggering events which required that the Company’slong-lived assets be evaluated for impairment. Based on the expectedconsideration from the sale of the majority of the Company’s assets to XOapproved by the Bankruptcy Court on February 20, 2004, it was determinedthat the proceeds generated from the sale are sufficient to recover the currentcarrying value of the Company’s long-lived assets.

 

Under accountingguidelines commonly referred to as “fresh start,” the fair value of all assetsof the Company will be estimated as it emerges from bankruptcy in conformitywith accounting principles generally accepted in the United States of America,specifically by Financial Accounting Standards Board in Statement of FinancialAccounting Standards No. 141 “Business Combinations.” Under fresh startaccounting, an enterprise value will be determined based on a plan ofreorganization for the Company and will be used to determine the fair value ofall the Company’s assets and liabilities at that time. The assumptions in theplan of reorganization may vary from the assumptions used by the Company as ofDecember 31, 2003 to evaluate impairment of long-lived assets; therefore,the fair values assigned to the assets upon emergence may be different than thecarrying values recorded as of March 31, 2004. As a result, an adjustment tothe fair value of long-lived assets may be required.

 

Because of theongoing nature of the Chapter 11 cases, the outcome of which is not presentlydeterminable, the condensed consolidated financial statements contained hereinare subject to material uncertainties and may not be indicative of the resultsof the Company’s future operations or financial position. No assurance can begiven that the Company will be successful in completing the sale of XO or inreorganizing its affairs within the Chapter 11 cases.

 

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As a result of theitems discussed above, the Company’s independent auditors have issued theirIndependent Auditors’ Report on the Company’s consolidated financial statementsfor the fiscal year ended December 31, 2003 with an explanatory paragraphregarding the Company’s ability to continue as a going concern. The condensedconsolidated financial statements have been prepared on a going concern basis,which contemplates continuity of operations, realization of assets andsatisfaction of liabilities in the ordinary course of business. The ability ofthe Company to continue as a going concern is dependent upon, but not limitedto, formulation, approval, and confirmation of a plan of reorganization and theability to obtain positive results of operations. The condensed consolidatedfinancial statements do not include any adjustments to the recorded amounts orreflect any amounts that may be ultimately paid to settle liabilities andcontingencies which may be required in the Chapter 11 cases or the effect ofany changes, which may be made in connection with the Company’s operationsresulting from a plan of reorganization.

 

**3. Stock Based Compensation:**

 

At March 31,2004, the Company had three stock-based compensation plans, the 1997Nonqualified Stock Option Plan, the 1998 Stock Incentive Plan and the EmployeeStock Discount Purchase Plan. The Company applies the provisions of AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued toEmployees” (APB No. 25) and the related interpretations in accounting forthe Company’s plans. Fixed stock option awards with pro-rata vesting arerecognized as expense using the straight-line method over the vesting period.

 

Had compensationcost for the Company’s plans been determined based on the fair value of thestock options as of the grant dates for awards under the plans consistent withthe method prescribed in Statement of Financial Accounting StandardsNo. 123, “Accounting for Stock-Based Compensation,” the Company’s net lossapplicable to common stock and net loss per share would have increased to thepro forma amounts indicated below. The Company utilized the followingassumptions in calculating the estimated fair value of each stock option on thedate of grant using the Black-Scholes option-pricing model with the followingweighted-average assumptions for grants:

 
|                     |   | **March 31,  2004** |   | **March 31,  2003** |   |
|--------------------------|--------|--------------------------|--------|--------------------------|--------|
| Dividend yield           |   | —                   | %      | —                   | %      |
| Expected  volatility     |   | 123.0                    | %      | 123.0                    | %      |
| Expected life            |   | 3.0                      |   | 3.0                      |   |
| Risk-free  interest rate |   | 2.05                     | %      | 2.03                     | %      |

 
|                                                                                                  |   | **March 31,  2004** |    | **March 31,  2003** |   |
|-------------------------------------------------------------------------------------------------------|--------|--------------------------|---------|--------------------------|--------|
| Reported net  loss                                                                                    |   | $                        | (59,891 | )                        | $      | (120,084 | ) |
| Add: stock-based  employee compensation expense included in reported net income                       |   | 538                      |    | 953                      |   |
| Deduct:  stock-based employee compensation expense determined under fair value method  for all awards |   | (2,809                   | )       | (15,367                  | )      |
| Pro forma net  loss                                                                                   |   | $                        | (62,162 | )                        | $      | (134,498 | ) |
|                                                                                                  |   |                     |    |                     |   |
| Net loss per  share, basic and diluted—as reported                                               |   | $                        | (0.50   | )                        | $      | (1.00 | ) |
| Net loss per  share, basic and diluted—pro forma                                                 |   | $                        | (0.52   | )                        | $      | (1.12 | ) |

 

**4. Property and Equipment:**

 

Property andequipment includes network equipment, land, leasehold improvements, software,office equipment, furniture and fixtures and construction-in-progress. Theseassets are stated at cost, which includes direct costs and capitalized interestand are depreciated over their respective useful lives using the straight-linemethod. Repair and maintenance costs are expensed as incurred.

 

Property andequipment at March 31, 2004 and December 31, 2003, consisted of thefollowing:

 

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|                                     |   | **March 31,  2004** |      | **December  31,  2003** |   | **Useful  Lives  (in years)** |   |
|------------------------------------------|--------|--------------------------|-----------|-------------------------|--------|-------------------------------|--------|
| Network  equipment                       |   | $                        | 1,171,198 |                    | $      | 1,170,909                     |   | 2-20 |   |
| Land                                     |   | 6,000                    |      | 6,000                   |   | —                        |   |
| Leasehold  improvements                  |   | 140,885                  |      | 140,875                 |   | 7-10                          |   |
| Software                                 |   | 125,194                  |      | 125,121                 |   | 3                             |   |
| Office equipment  and other              |   | 42,952                   |      | 49,643                  |   | 2-5                           |   |
| Furniture and  fixtures                  |   | 14,446                   |      | 14,432                  |   | 7                             |   |
| Property and equipment,  in service      |   | 1,500,675                |      | 1,506,980               |   |                          |   |
| Less:  Accumulated depreciation          |   | (872,561                 | )         | (826,405                | )      |                          |   |
| Property and  equipment, in service, net |   | 628,114                  |      | 680,575                 |   |                          |   |
| Construction-in-progress                 |   | 1,279                    |      | 2,043                   |   |                          |   |
| Property and  equipment, net             |   | $                        | 629,393   |                    | $      | 682,618                       |   |   |   |

 

**5. Other Assets:**

 

Other assets atMarch 31, 2004 and December 31, 2003, consisted of the following:

 
|                            |   | **March 31,  2004** |   | **December 31,  2003** |   |
|---------------------------------|--------|--------------------------|--------|-----------------------------|--------|
| Acquired  customer lists        |   | $                        | 63,001 |                        | $      | 62,800 |   |
| Long-term  deposits             |   | 10,484                   |   | 10,924                      |   |
| Equipment pending  deployment   |   | 5,958                    |   | 5,906                       |   |
| Other                           |   | 1,316                    |   | 1,574                       |   |
| Total other  assets             |   | 80,759                   |   | 81,204                      |   |
| Less:  Accumulated amortization |   | (61,917                  | )      | (60,489                     | )      |
| Other assets,  net              |   | $                        | 18,842 |                        | $      | 20,715 |   |

 

The acquiredintangibles are being amortized over their estimated useful life of one tothree years using the straight-line method. Amortization expense related tointangible assets totaled $1,429 and $3,108 during the quarters endedMarch 31, 2004 and 2003, respectively. The aggregate future amortizationexpense for intangible assets remaining as of March 31, 2004 is $1,084 and willbe fully amortized during 2004.

 

Equipment pendingdeployment consists of equipment purchased and being staged for deployment inthe Company’s network. This equipment will be classified as property andequipment when it is deployed.

 

**6. Accrued Liabilities and Other Current Liabilities:**

 

Accruedliabilities and other current liabilities at March 31, 2004 andDecember 31, 2003, consisted of the following:

 
|                                               |   | **March 31,  2004** |   | **December 31,  2003** |   |
|----------------------------------------------------|--------|--------------------------|--------|-----------------------------|--------|
| Accrued employee  compensation and benefits        |   | $                        | 19,543 |                        | $      | 25,483 |   |
| Accrued network  expenses                          |   | 17,833                   |   | 13,359                      |   |
| Accrued taxes                                      |   | 16,627                   |   | 17,332                      |   |
| Deferred revenue                                   |   | 10,484                   |   | 26,156                      |   |
| Other                                              |   | 3,346                    |   | 3,642                       |   |
| Accrued  liabilities and other current liabilities |   | $                        | 67,833 |                        | $      | 85,972 |   |

 

**7. Long-Term Debt:**

 

As a result of the Company’sbankruptcy proceedings, all contractual debt payments are suspended and subjectto revised payment terms during the bankruptcy process on a specific casebasis. As discussed in Note 2, the only debt payments being made as ofMarch 31, 2004 relate to interest (at the non-default rate) on the seniorsecured credit facilities

 

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and monthly payments under capital leases. Additionally, as a result ofthe bankruptcy filing, there is an event of default under the senior securedcredit facilities and both series of notes, which, by their terms, wouldordinarily accelerate all amounts due upon the event of default.

 

The senior securedcredit facilities, notes and capital lease obligations are classified asliabilities subject to compromise as of March 31, 2004 and December 31, 2003.No changes to the carrying amount of these debts have been made in theaccompanying condensed consolidated balance sheet as a result of the filing.

 

**8. Leases:**

 

The Company hasentered into various capital lease agreements, with expirations through 2023,covering dedicated optical fiber capacity and certain equipment. Assets andfuture obligations related to capital leases are included in the accompanyingconsolidated balance sheet in property and equipment and long-term debt,respectively. Depreciation of assets held under capital leases is included indepreciation and amortization expense.

 

The Company has enteredinto various operating lease agreements, with expirations through 2015, fornetwork facilities, office space and equipment. Rent expense on operatingleases for the quarters ended March 31, 2004 and 2003, was $6,516 and$8,346, respectively.

 

Future minimumlease obligations for all non-cancelable capital and operating lease agreementswith initial or remaining terms of one year or more at March 31, 2004, areas follows:

 
| **Years ending December 31,**                                                       |   | **Capital  Leases** |   | **Operating  Leases** |    |
|------------------------------------------------------------------------------------------|--------|---------------------|--------|-----------------------|---------|
| 2004                                                                                     |   | $                   | 8,864  |                  | $       | 16,915 |   |
| 2005                                                                                     |   | 11,671              |   | 21,792                |    |
| 2006                                                                                     |   | 11,689              |   | 19,851                |    |
| 2007                                                                                     |   | 9,343               |   | 17,847                |    |
| 2008                                                                                     |   | 9,320               |   | 12,079                |    |
| Thereafter                                                                               |   | 97,790              |   | 12,485                |    |
| Total minimum  future lease payments                                                     |   | 148,677             |   | $                     | 100,969 |   |
|                                                                                     |   |                |   |                  |    |
| Amount  representing interest                                                            |   | (66,236             | )      |                  |    |
|                                                                                     |   |                |   |                  |    |
| Present value of  minimum lease payments (included in liabilities subject to compromise) |   | $                   | 82,441 |                  |    |   |

 

Certain operating and capitallease agreements contain renewal and purchase options at the end of the initiallease terms. In conjunction with XO, the Company is analyzing its contracts andleases to determine those executory contracts and unexpired leases that XO willhave the Company reject pursuant to Section 365 of the Bankruptcy Code.

 

**9.  Related Parties:**

 

During 2001, theCompany loaned $4,200 to a director and executive vice president of the Companyunder a full recourse promissory note. The note was payable in full onApril 4, 2004, and the Company has entered into a forbearance agreementwith the executive under which it has agreed not to exercise remedies under thenote at this time. The outstanding balance accrues interest at 2.73% per annum,which was the November 2001 applicable federal rate, and interest ispayable when the note is due. In the event the executive resigns or is terminatedby Allegiance for cause, this note will become immediately due and payable. Thenote is included in other current assets in the accompanying consolidatedbalance sheet. A reserve for the full amount of the value of the loan wasestablished during 2003 due to the uncertainty of the collectibility of thisloan.

 

**10. Commitments and Contingencies:**

 

InMarch 2002, the Company executed a Communications Transport ServicesAgreement with Southern California Edison Company. Under this agreement, theCompany committed to purchase from Southern California Edison Company an

 

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average of $260 of services each month through March 2005. TheCompany has not yet assumed or rejected this agreement pursuant to the BankruptcyCode.

 

InApril 2003, the Company executed an Agreement for Additional Services,Security, and Settlement of Certain Matters with WorldCom, Inc. (on behalfof itself and all of its affiliates and subsidiaries). Under this agreement,the Company committed to purchase from WorldCom an aggregate of $14,000 ofservices from February 28, 2003 to April 30, 2004 and an aggregate ofat least $12,000 of services from May 1, 2004 to April 30, 2005.Furthermore, under this agreement, the Company agreed to (a) extend theterm of its Domestic and Metro Private Line Special Carrier Service Agreement(“MSA”) between WorldCom and the Company dated September 29, 2000, asamended, until April 30, 2005, (b) increase the volume commitmentunder the MSA from $700 per month to $900 per month through April 30, 2005and (c)  provide a letter of credit. TheCompany has not yet assumed or rejected this agreement pursuant to theBankruptcy Code in the Company’s Chapter 11 cases.

 

InOctober 2002 (and amended on May 8, 2003), the Company executed anagreement for financial advisory and investment banking services withGreenhill & Co., LLC (“Greenhill”). On September 18, 2003, theBankruptcy Court approved this agreement. Under the agreement, the Company hasagreed to pay Greenhill a transaction fee in the amount of $6,500, payable uponthe effective date of the plan of reorganization.  Certain amounts of the monthly fees that the Company has alreadypaid Greenhill from the Commencement Date through the effective date of theplan of reorganization will be credited against the transaction fee.  As of March 31, 2004, the Company had paidGreenhill a total of $1,138.2 in fees since the Commencement Date.

 

In June 2003,the Company executed an agreement for advisory services with Impala Partners,LLC (“Impala”). In August 2003, the Company executed an amendment to theoriginal agreement. Under this amendment, the Company agreed to pay Impala asuccess fee in the amount of $2,500 payable upon the effective date of the planof reorganization.

 

**11.  Long-Term SalesContract:**

 

Effective in 2000,and amended in 2000, 2001 and 2002, the Company executed a long-term contractto provide an integrated network solution and certain services to GenuitySolutions Inc., a network service provider and operator of a nationwideInternet network. The contract was established specifically to supportGenuity’s customer contracts, including that with America Online and expires onDecember 31, 2006. Under this agreement, Genuity committed to pay anaggregate of $563,010 over the term of the contract, subject to the Company’sperformance under the contract and the other terms and conditions of thecontract.  Genuity assigned thiscontract to a subsidiary of Level 3 on February 4, 2003.

 

The Company andLevel 3 had a number of disputes regarding this contract.  On February 27, 2004, Level 3 andAllegiance agreed to settle their disputes regarding the agreement subject to,among other things, Bankruptcy Court approval. Under the settlement agreementupon execution, among other things, Level 3 shall reimburse the Company foramounts paid to KMC and additional amounts intended to reimburse the Companyfor expenses in operating the dial-up access business for Level 3 sinceFebruary 1, 2004, Level 3’s obligation to pay the February 2004payment shall be suspended, and the Company shall immediately begin paying toLevel 3 an amount equal to all reciprocal compensation related to traffic underthe agreement, subject to Bankruptcy Court approval. Upon Bankruptcy Court approvaland the occurrence of the escrow closing under the XO Purchase Agreement andconsummation of the agreement, among other things:

 

•                                          Level3 shall pay the Company $54 million;

 

•                                          theintegrated network agreement would be terminated and Level 3 would have no obligationto pay the February 2004 payment;

 

•                                            theCompany would transfer to Level 3 all of the dedicated assets andinfrastructure used by the Company to provide the integrated network solutionto Level 3; and

 

•                                          Level 3 andthe Company would grant mutual releases.

 

Inaddition, the Company is obligated to continue to provide certain terminationassistance services commencing upon payment by Level 3 of the $54 million andending six-months after closing of the XO Asset Purchase Agreement and theCompany will be paid an amount designed to cover expenses to provide thetransition services. On April 6, 2004, the

 

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Bankruptcy Court entered an amended order approving the settlementagreement.  On April 19, 2004, theCompany and Level 3 closed the initial transactions contemplated by thesettlement agreement including the payment of $54 million by Level 3 to theCompany.

 

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**ITEM 2.*****Management’s Discussion and Analysis of******Financial Condition and Results ofOperations***

 

Thefollowing discussion and analysis relates to our financial condition andresults of operations and should be read in conjunction with the accompanyingconsolidated financial statements and notes to those financial statementscontained in this report, as well as the section captioned “Risk Factors” inthis report. Additionally, the following discussion and analysis should be readin conjunction with our audited consolidated financial statements and notes tothose financial statements included in our Annual Report on Form 10-K forthe year ended December 31, 2003. Allegiance Telecom, Inc. isgenerally referred to in this Management’s Discussion and Analysis of FinancialCondition and Results of Operations as “we,” “us,” “our,” “our company,”“company” or “Allegiance”.

 

### ***OVERVIEW***

 

Weare a facilities-based national local exchange carrier that provides integratedtelecommunications services to business, government and other institutionalusers in major metropolitan areas across the United States and we are focusedprimarily on small to medium-sized businesses. We currently offer an integratedsuite of telecommunications products and services including local, longdistance, Internet, data colocation, web hosting and customer premisesequipment sales and maintenance services. Our principal competitors are theincumbent local exchange carriers (also known in the industry as the “ILECs”),as well as long distance carriers, customer premises equipment sales and maintenancebusinesses, and other integrated communications providers.

 

Webegan operations in late 1997 with an objective to grow rapidly and establishour company as a national local exchange carrier covering major metropolitanareas across the United States. By the end of 2001, we completed the networkrollout in our 36 targeted markets: Atlanta, Austin, Baltimore, Boston,Chicago, Cleveland, Dallas, Denver, Detroit, Fort Lauderdale, Fort Worth,Houston, Long Island, Los Angeles, Miami, Minneapolis/St. Paul, New York City,Northern New Jersey, Oakland, Ontario/Riverside, Orange County, Philadelphia,Phoenix, Pittsburgh, Portland, Sacramento, St. Louis, San Antonio, San Diego,San Francisco, San Jose, Seattle, Tampa, Washington, D.C., West Palm Beach/BocaRaton and White Plains, NY.

 

Weuse multiple technologies in our network and a mixture of leased and ownedfacilities at the edge of our communications network in order to effectivelyand efficiently serve our customer base where it is physically located. Ourfocus is on providing facilities-based services, and we generally provideservices via resale on a limited basis. We utilize resale and what is known asthe unbundled network element platform (“UNE-P”) to deliver services in a smallnumber of sales where our facilities-based services would not be practicable orcost effective and as an interim measure until the resold services can beconverted to facilities-based services. UNE-P is a method where a carrier canlease all elements of a service from an incumbent local carrier, includingswitching. As of March 31, 2004, approximately 95% of our retail lines inservice were provided over our own network facilities. The services that weprovide via our own network generate higher margins than services provided byother carriers that are resold by us. Consistent with our facilities-basedapproach, we install voice and data aggregation and switching equipment in ourown premises. We also install voice and data aggregation equipment in thecentral offices or “hubs” of the existing local incumbent carrier’s networks,also known as colocation. This voice and data aggregation equipment connectsdirectly to customers through the “local loop,” which consists of the existingcopper wire and fiber running from the local incumbent carrier’s centraloffices to each customer location. The local loop is owned by the incumbentcarriers but can be leased by competitive carriers under the terms of theTelecommunications Act of 1996. Our local presence in incumbent local exchangecarrier central offices along with our leasing of the local loops provides uswith a flexible platform for delivering traditional voice and data accessservices to end-user customers. We connect our colocations to our mainswitching center in each market by either leasing additional network elementsfrom the incumbent carriers and other providers on a short-term basis or byusing dedicated fiber on a long-term basis. We have increasingly focused ondedicated fiber because of the growth of our customer base and traffic volumeas well as its reliability.

 

Aswe have developed our local networks to service end-user customers, we havealso attempted to capitalize on our expertise and investment at the edge of ournetwork and in our intercity Internet backbone. We have leveraged our networkassets by providing network solutions to other service providers, primarily theleading national and regional Internet providers. These national networkproviders have end-user customers but do not generally have the facilities andexpertise to directly access these customers in all relevant geographic areasthrough the local loop. Many of these providers focus on the residentialInternet access market.

 

***BANKRUPTCY PROCEEDINGS***

 

OnMay 14, 2003 (the “Commencement Date”), Allegiance Telecom, Inc. andits direct and indirect subsidiaries filed

 

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voluntary petitions for relief under Chapter 11 of the UnitedStates Bankruptcy Code in the United States Bankruptcy Court for the SouthernDistrict of New York (the “Bankruptcy Court”). The reorganization is beingjointly administered under the caption “In re Allegiance Telecom, Inc. etal. Case No. 03-13057 (RDD)” (the “Chapter 11 cases”). We arecurrently operating our business as “debtors-in-possession” under thejurisdiction of the Bankruptcy Court and in accordance with the applicableprovisions of the Bankruptcy Code, the Federal Rules of Bankruptcy Procedureand applicable court orders. In general, as debtors-in-possession, we are authorizedto continue to operate as an ongoing business, but may not engage intransactions outside the ordinary course of business without the prior approvalof the Bankruptcy Court.

 

UnderSection 362 of the Bankruptcy Code, the filing of a bankruptcy petitionautomatically stays most actions against a debtor, including most actions tocollect pre-petition indebtedness or to exercise control over the property ofthe debtor’s estate. Absent an order of the Bankruptcy Court, substantially allpre-petition liabilities will be addressed under a plan of reorganization. TheBankruptcy Court in our Chapter 11 cases established November 26,2003 as the bar date for filing proofs of claims. The aggregate amount ofpre-petition claims is not known with specificity at this time since the claimsare still being reviewed and not all of the contract rejection claims have yetbeen filed.

 

UnderSection 365 of the Bankruptcy Code, we may assume or reject certainpre-petition executory contracts and unexpired leases, including leases of realproperty, subject to the approval of the Bankruptcy Court and certain otherconditions. In general, rejection of a pre-petition unexpired lease orexecutory contract is treated as a pre-petition breach of such lease orcontract, generally resulting in any breach damages being treated aspre-petition liabilities. Subject to certain exceptions, a rejection relievesus of performing our future obligations under an unexpired lease or executorycontract but entitles the counterparty to a pre-petition general unsecuredclaim, if any, for damages against our estate caused by the rejection.Counterparties to these rejected contracts or unexpired leases may file proofsof claim against our estate for such damages, if any. Generally, the assumptionof a pre-petition executory contract or unexpired lease requires a debtor tocure most existing financial defaults, including payment of any pre-petitionamounts owed and outstanding, under such executory contract or unexpired lease.Due to the uncertain nature of many of the potential rejection and abandonmentrelated claims and to the uncertain amount needed, among other things, for curepayments, we are unable to project the magnitude of these claims and cureamounts with any degree of certainty at this time.

 

TheUnited States Trustee for the Southern District of New York has appointed anofficial committee of unsecured creditors (the “Creditors’ Committee”). TheCreditors’ Committee and its legal representatives have a right to be heard onall matters relating to our Chapter 11 cases that come before theBankruptcy Court. There can be no assurance that the Creditors’ Committee willsupport our positions and disagreements between the Creditors’ Committee andAllegiance could protract the Chapter 11 cases and could negatively impactAllegiance’s ability to operate during the Chapter 11 cases and to sellits assets to XO Communications, Inc. (“XO”) under the XO Asset PurchaseAgreement, which is discussed below.

 

Therights and claims of various creditors and security holders will be determinedby our plan of reorganization as confirmed by the Bankruptcy Court under thepriority rules established by the Bankruptcy Code— certain post-petitionliabilities and certain pre-petition liabilities (e.g., our senior secureddebt) need to be satisfied before our unsecured creditors or commonstockholders are entitled to any distribution.

 

OnDecember 18, 2003, we signed an Asset Purchase Agreement with QwestCommunications International Inc. (“Qwest”) to purchase substantially allof the assets of our company, except for our company’s customer premisesequipment sales and maintenance business, dedicated dial-up access servicesbusiness operated under an agreement with Level 3 Communications, LLC(“Level 3”), shared hosting business, and certain other assets.  On December 18, 2003 we filed with theBankruptcy Court a Motion For Orders Pursuant To Sections 105(a), 363, 365And 1146(c) Of The Bankruptcy Code: (A)(i) Fixing The Time, Date And PlaceFor The Bidding Procedures Hearing And (ii) Approving The No-ShopProvisions Set Forth In The Asset Purchase Agreement With Qwest CommunicationsInternational Inc.; (B)(i) Establishing Bidding Procedures And BidProtections In Connection With The Sale Of Substantially All Of The Assets OfThe Debtors, (ii) Approving The Form And Manner Of Notices,(iii) Approving The Asset Purchase Agreement Subject To Higher And BetterOffers And (iv) Setting A Sale Approval Hearing Date; And(C)(i) Approving The Sale To Qwest Communications International Inc.Free And Clear Of All Liens, Claims And Encumbrances, (ii) Authorizing TheAssumption And Assignment Of Certain Executory Contracts And Unexpired LeasesAnd (iii) Granting Related Relief (the “Bidding Procedures Motion”). OnJanuary 9, 2004, the Bankruptcy Court approved the motion establishingcertain bidding procedures and approved the Qwest Asset Purchase Agreementsubject to higher and better offers.

 

OnFebruary 12 and 13, 2004, the company conducted an auction for the companyand on February 13, 2004, XO was selected as the winning bidder based onits offer of approximately $311 million in cash and approximately45.38 million

 

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shares of XO common stock. On February 18, 2004, the company enteredinto an Asset Purchase Agreement with XO. On February 20, 2004, theBankruptcy Court entered its Order (I) Approving the Sale Free and Clearof All Liens, Claims and Encumbrances to the Successful Bidder,(II) Authorizing the Assumption and Assignment of Certain ExecutoryContracts and Unexpired Leases, and (III) Granted Related Relief. Underthe XO Asset Purchase Agreement, XO will purchase the stock of the operatingsubsidiaries of the company as well as substantially all of the other assets ofour company, except our customer premises equipment sales and maintenancebusiness, our dedicated dial-up access services business operated under anagreement with Level 3, the shared hosting business, and certain otherassets. On April 14, 2004, we and XO closed the sale transaction into escrowwith XO delivering the cash and stock consideration to an independent escrowagent.  Under the XO Asset PurchaseAgreement, XO assumes the risk of loss of the assets it is acquiring and XO’sconditions to close this transaction are limited.  Closing is conditioned upon the satisfaction (or waiver) of theconditions to the “Effective Date” set forth in our plan of reorganization(e.g., the confirmation order becoming a final order).  The XO Asset Purchase Agreement providesthat either party may terminate the XO Asset Purchase Agreement after closinginto escrow but before final closing, if, among other things, the other partybreaches the XO Asset Purchase Agreement. Final closing under the XO AssetPurchase Agreement is scheduled to occur as part of the confirmation andeffectiveness of our plan of reorganization unless either party elects toproceed without a plan of reorganization. If the company’s plan of reorganization is not confirmed by June 7, 2004or made effective by June 30, 2004, XO may elect to purchase the assets of thecompany outside a plan of reorganization. If this occurs it could have a material effect on the recovery by ourstakeholders.

 

Webelieve that there is little likelihood that the sale transaction will notclose. However, events may occur in our bankruptcy, in XO’s financial conditionor otherwise that may interfere with or prevent a closing and therefore we canmake no assurance that the sale to XO will ultimately close. Accordingly, atthis time, it is not possible to predict when and whether final closing willoccur under the XO Asset Purchase Agreement. In addition, there can be noassurance that we will be able to sell the assets subject to this transactionto Qwest or other interested parties if the XO transaction does not close.Finally, there can be no assurance that if our company is not sold that it willbe able to successfully reorganize and emerge from bankruptcy as the companyhas terminated the employment of a significant number of employees who would benecessary if we were to emerge as a stand alone business. We cannot accuratelypredict the effect of the Chapter 11 reorganization process on ourbusiness or our stakeholders.  Ourfuture results depend on the timely and successful confirmation andimplementation of a plan of reorganization. No assurance can be given that wewill be successful in reorganizing our affairs within the Chapter 11proceedings.

 

XOis currently operating the acquired assets of our company pursuant to an operatingagreement subject to Allegiance’s reasonable consent and in accordance withapplicable law, existing service contracts, regulations, and tariffs. For theservices provided by XO, we will pay XO the costs of operating the acquiredassets (including reimbursing our costs associated with those acquired assets)plus thirty percent; provided, however, that XO shall be paid solely out of therevenues generated by the acquired assets and are collectible solely from thecash receipts relating to the acquired assets. In the event that the cashreceipts do not cover the costs to operate the acquired assets, we have noobligation to reimburse XO for any costs in excess of the cash receipts;provided, however, that any shortfall may be recovered from any months wherethe cash receipts from the acquired assets are in excess of XO’s fees foroperating the acquired assets. The operating agreement expires once allconsents have been obtained to transfer the acquired assets to XO and theassets have been transferred to XO.

 

Underthe XO Asset Purchase Agreement, XO will determine the contracts that it isassuming and those that we may reject on closing. Rejected contracts may createadditional liabilities for our company and reduce the recovery by individualcreditors in our Chapter 11 proceedings.

 

Inorder to reorganize and emerge from Chapter 11 successfully, we will needto propose, and obtain confirmation by the Bankruptcy Court, a plan ofreorganization that satisfies the requirements of the Bankruptcy Code. On April22, 2004, we filed our Second Amended Disclosure Statement and Second AmendedJoint Plan of Reorganization (“Plan”) in our Chapter 11 cases. On April22, 2004, the Bankruptcy Court entered an order (a) approving Allegiance’sSecond Amended Disclosure Statement pursuant to Section 1125 of the BankruptcyCode; (b) approving (i) procedures for solicitation of votes to accept orreject the Plan and the tabulation of such votes on the Plan, and (ii) certainrelated materials in connection therewith; and (c) scheduling the date and timeon which the Court will hold a hearing to consider confirmation of thePlan.  Ballots have been distributed tothose classes entitled to vote on the Plan. The Confirmation Hearing is scheduled for June 7, 2004 at 10:00 a.m. atthe Bankruptcy Court, but may be continued from time to time without furthernotice; except that notice of any such adjournment(s) will be set forth on thewebsite of our voting agent at www.bmccorp.net/allegiance.

 

Thefollowing summary of the Plan should be read in conjunction with the Plan filedwith the Bankruptcy Court. In

 

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general, the proposed Plan is premised on a closing of the XO AssetPurchase Agreement. The Plan provides among other things for:

 

•                                          The creationof the Allegiance Telecom Liquidating Trust (“ATLT”) with three directorsselected by the Creditors Committee and the appointment of a Plan Administratorwho is retained as of the effective date of the Plan and selected by theCreditors Committee;

 

•                                          All of thesubsidiaries of Allegiance Telecom Company Worldwide being deemed consolidatedfor the purposes of voting and distributions under the Plan;

 

•                                          All of thesubsidiaries of Allegiance Telecom Company Worldwide being reorganized and,upon the effective date of the Plan with respect to each such subsidiary, thestock of such reorganized subsidiaries (other than the Shared Technologiessubsidiary) being transferred to XO;

 

•                                          Thedissolution of our company upon the completion of transfer to XO of all assetsbeing acquired by XO;

 

•                                          On theeffective date of the Plan, all notes, instruments, certificates, and otherdocuments evidencing the senior secured debt, unsecured debt securities, commonstock of Allegiance, equity interests, and any stock options, warrants or otherrights to purchase common stock being cancelled and the obligations of ourcompany or any reorganized subsidiary discharged;

 

•                                          Thereorganization of our company’s Shared Technologies subsidiary and the stock ofsuch reorganized Shared Technologies being delivered to ATLT (which means thatthe shares of the reorganized Shared Technologies will not be immediatelydistributed to the applicable creditors and instead will be held by the trust);

 

•                                          The filing byall of the reorganized subsidiaries of new certificates of incorporation andby-laws;

 

•                                          Theresignation of all existing directors and officers of our subsidiaries as ofthe effective date of the Plan, and the election of directors and officers ofour subsidiaries (except for the reorganized Shared Technologies) selected byXO and the election of new directors of Shared Technologies by the Creditor’sCommittee;

 

•                                          On theeffective date of the Plan, we shall provide cash to the reorganized SharedTechnologies in an amount intended to be sufficient to operate the business ona going forward basis and any cash necessary to fund continuing benefitliability that the reorganized Shared Technologies may have with respect tocontinuation of group benefits to employees; and

 

•                                          The assumptionof certain of our contracts by the reorganized subsidiaries of the company, theassignment of certain contracts to XO, and the rejection of certain othercontracts, all of which shall be disclosed shortly before the date of theconfirmation hearing on the Plan by the Bankruptcy Court.

 

Insummary, the Plan provides for the following distributions to the holders ofclaims in our company:

 

•                                          Theadministrative claimants and priority claims holders with claims against thecompany and any of its subsidiaries along with the senior secured debt holdersshall receive cash equal to the entire amount of their allowed claim;

 

•                                          The unsecuredcreditors of Allegiance Telecom, Inc. and all of its subsidiaries shall begiven an option to receive: (1) either a cash recovery or trust interestsreflecting an ownership in the XO common stock delivered as part of the saletransaction, and (2) either a cash recovery or trust interests reflecting anownership in the stock of the Shared Technologies business.  Those unsecured creditors that elect toreceive cash in lieu of either or both of these trust interests will receivecash in an amount equal to 50% of the aggregate value of the applicable trustinterests.   Additionally, all unsecuredcreditors of Allegiance Telecom, Inc. and all of its subsidiaries will receivetrust interests reflecting an ownership in the other assets of the company thatare not being acquired by XO. It is important to note that under the proposedPlan, those unsecured creditors that elect to receive trust interestsreflecting an ownership in either the XO Common Stock or the SharedTechnologies common stock will not immediately receive shares of XO commonstock or shares of Shared Technologies. The trust administrator will determinewhether to (1) liquidate the XO common stock and Shared Technologies commonstock in an orderly manner and distribute proceeds to the holders of theapplicable trust interests or (2) distribute shares of XO common stock orShared Technologies common stock to the holders of the applicable trustinterests on some future date. The timing and manner of distributing of theassets of the liquidating trust, including the XO common stock and the commonstock of the reorganized Shared Technologies, have not been

 

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determined but itis possible that the liquidating trust will retain these assets for some timeand perhaps sell the XO or Shared Technologies common stock in one or moretransactions, distributing the proceeds under the terms of the Plan. The natureand transferability of the ownership interests our creditors will receive insuch liquidating trust have also not yet been defined. In general, if theamount of claims of unsecured creditors making the cash election exceeds the amountof cash available, the unsecured creditors of Allegiance Telecom CompanyWorldwide will receive cash in full before the unsecured creditors ofAllegiance Telecom, Inc. receive any cash, and, if there is insufficientcash to satisfy all of the unsecured creditors of Allegiance Telecom CompanyWorldwide making a cash election, such creditors making the election willreceive a pro-rata share of the cash. If there is insufficient cash to pay allunsecured creditors of Allegiance Telecom, Inc. making a cash electionafter satisfying in full all unsecured creditors of Allegiance Telecom CompanyWorldwide making the cash election, the Allegiance Telecom, Inc. unsecuredcreditors making the cash election will receive a pro-rata share of theremaining cash. In general, cash elections in each class of creditors will besatisfied first to those electing cash in lieu of trust interests in thereorganized Shared Technologies Inc. and then to those electing cash in lieu ofthe trust interests in XO common stock; and

 

•                                          The commonstock and equity holders of the company shall receive no distributions underthe Plan (and all shares of Allegiance Telecom, Inc. common stock will beextinguished and cancelled).

 

Asdiscussed, the Plan provides that the XO common stock and common stock of thereorganized Shared Technologies business will be deposited into the trust. Theinitial issuance and the resale of these trust interests raise certainsecurities law issues under the Bankruptcy Code and federal and statesecurities laws. The company has not obtained, and does not intend to obtain, a“no-action” letter from the Securities and Exchange Commission to the effectthat the Securities and Exchange Commission will not take enforcement action ifthe trust interests are issued in accordance with the provisions of the Planwithout registration under the Securities Act. The shares of XO common stockunder the terms of the XO Asset Purchase Agreement are to be either exempt fromregistration under the Securities Act of 1933 or registered thereunder by XO.XO has taken the position that it is not required to provide such registrationif the use of the liquidating trust makes an exemption from registrationunavailable. We and our unsecured creditors disagree with this position. Therecan be no assurance that we will prevail in obtaining an exemption fromregistration or in obtaining registration by XO of the XO common stock.

 

Thebond (i.e., our 11 3/4 % and 12 7/8% notes) indenturetrustees allege that we may have granted certain liens and guaranties to thesenior secured lenders under the Credit Agreement in violation of theaffirmative negative pledge covenants contained in the bond indentures and, asa result, the holders of bond claims may be entitled to secured claims againstall of our assets based on the guaranties and equal and ratable liens againstall of the assets of our company. The senior secured creditors and we disputethese allegations. If the Bankruptcy Court determines that these allegationsare legally valid then the holders of bond claims will be treated *pari passu*with the senior secured creditor claims. In such event, the holders of suchclaims would receive significant distributions on account of such claims andthe holders of unsecured claims, based on the absolute priority rule, wouldreceive no distribution. However, if the Bankruptcy Court determined that theallegations are not legally cognizable, then the bond claims would bestructurally subordinated to the senior secured creditors claims and theunsecured claims of Allegiance Telecom Company Worldwide. In such event, theholders of the bond claims, based on the absolute priority rule, would beentitled to distributions only after all claims against Allegiance TelecomCompany Worldwide and its subsidiaries were paid in full. The proposed Planwould settle and resolve all of these claims. See also the discussion under“Bankruptcy Related Risk Factors.”

 

Inaddition, in accordance with the terms of the Court’s Amended Final OrderAuthorizing Use of Cash Collateral by Consent, dated June 26, 2003 (assubsequently further amended), the Creditors Committee and its advisorsconducted an investigation of the validity, amount, perfection, priority, andenforceability of the senior secured creditors’ liens, claims and securityinterests, and our company’s obligations arising under the Credit Agreement. Asa result of this investigation, the Creditors Committee believes that(a) approximately $26 million, held in a separate bank account of ourcompany is unencumbered (*i.e.*, not subject to any liens or securityinterests of the senior secured creditors) and (b) we have claims thatcould equitably subordinate the senior secured creditor claims pursuant tosection 510(c) of the Bankruptcy Code. We believe that such cash is unencumbered,but do not take a position with respect to the Creditors Committee’s submissionthat the senior secured creditors’ claims may be equitably subordinated. Thesenior secured creditors dispute the Creditors Committee’s allegations. Theproposed Plan would settle and resolve all of these claims.

 

Certainholders of claims against and interests in the company are permitted to vote toaccept or reject the Plan. The Plan provides that the holders of allowedunsecured claims against the company are permitted to vote on the Plan. Thesenior

 

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secured debt holders are deemed to have accepted the Plan since theywill be receiving full value and are thus not entitled to vote under the Planand the common stock and equity holders in the company are not entitled to voteunder the Plan as they are deemed to have rejected the Plan since they willreceive no distributions under the Plan. The Bankruptcy Code defines“acceptance” of a plan by a class of claims as acceptance by creditors in thatclass that hold at least two-thirds in dollar amount and more than one-half innumber of the claims that actually timely cast ballots for acceptance orrejection of such plan. The holders of allowed unsecured claims against AllegianceTelecom Company Worldwide and its subsidiaries are in one class under the Planand the holders of allowed unsecured claims against AllegianceTelecom, Inc. are in another class under the Plan. Thus, acceptance of thePlan will occur only if at least two-thirds in dollar amount and a majority innumber of the holders of such claims of each of these two unsecured claimclasses that actually timely cast their ballots vote in favor of acceptance ofthe Plan. A vote may be disregarded if the Bankruptcy Court determines, afternotice and a hearing, that such acceptance or rejection was not solicited orprocured in good faith or in accordance with the provisions of the BankruptcyCode. If a class of claims entitled to vote on the Plan rejects the Plan, the companymay, with the consent of the Creditors Committee, amend the Plan or requestconfirmation of the Plan pursuant to Section 1129(b) of the BankruptcyCode or the “cramdown” provision or both. Section 1129(b) permits theconfirmation of a plan notwithstanding the non-acceptance of a plan by one ormore impaired classes if it does not “discriminate unfairly” and is “fair andequitable” with respect to each non-accepting class. In the event that a classof claims entitled to vote on the Plan votes to reject the Plan, the company’sdetermination whether to request confirmation of the Plan pursuant tosection 1129(b) of the Bankruptcy Code will be announced prior to or atthe confirmation hearing on the Plan.

 

Ingeneral, in order for the Plan to become effective, among other things, thefollowing must either have occurred or be waived:

 

•                                          TheBankruptcy Court shall have entered a Confirmation Order, in form and substancereasonably acceptable to the company, the senior secured creditors, theCreditors Committee and, if applicable, XO, and shall have become final;

 

•                                          All actions,documents, instruments, and agreements, including the Certificates ofIncorporation and By-laws, each of the other documents necessary to implementand effectuate the Plan and the XO Asset Purchase Agreement shall have beentaken or executed and delivered, as the case may be;

 

•                                          The companyshall have received all authorizations, consents, regulatory approvals, rulingsor documents that are necessary to implement and effectuate the Plan and the XOAsset Purchase Agreement; and

 

•                                          Ifapplicable, each of the conditions to Closing under the XO Asset PurchaseAgreement shall have been satisfied or waived in accordance with the provisionsthereof.

 

Unlessan election is made to close the transactions in accordance with the XO AssetPurchase Agreement under Section 363 of the Bankruptcy Code, the Closingunder the XO Asset Purchase Agreement is scheduled to occur prior to orsimultaneously with the effectiveness of the Plan.

 

Ifthe Plan is not confirmed and consummated, the company’s alternatives include(i) election under the XO Asset Purchase Agreement to close underSection 363, (ii) liquidation of the company under Chapter 7 ofthe Bankruptcy Code and (iii) the preparation and presentation of analternative plan or plans of reorganization. If no Chapter 11 plan can beconfirmed, the Chapter 11 cases may be converted to cases underChapter 7 of the Bankruptcy Code in which a trustee would be elected orappointed to liquidate the assets of the company. The company believes thatliquidation under Chapter 7 would result in, among other things,(i) smaller distributions being made to stakeholders than those providedfor in the Plan because of additional administrative expenses attendant to theappointment of a trustee and the trustee’s employment of attorneys and otherprofessionals, (ii) additional expenses and claims, some of which would beentitled to priority, which would be generated during the liquidation and fromthe rejection of leases and other executory contracts in connection with acessation of the company’s operations and (iii) the failure to realize thegreater, going concern value of the company’s assets.

 

Ifthe proposed Plan is not confirmed, or, if the proposed Plan is not confirmedand exclusivity has expired, the company, or any other party in interest, couldattempt to formulate a different plan of reorganization. Such a plan mightinvolve either a reorganization or continuation of the company’s business or anorderly liquidation of the company’s assets. The company has concluded that theproposed Plan represents the best alternative to protect the interests ofcreditors, equity interest holders and other parties in interest.

 

Webelieve that the proposed Plan enables the company to successfully andexpeditiously emerge from Chapter 11,

 

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preserves its business and allows creditors to realize the highestrecoveries under the circumstances. In a liquidation under Chapter 11 ofthe Bankruptcy Code, the assets of the company would be sold in an orderlyfashion which could occur over a more extended period of time than in aliquidation under chapter 7 and a trustee need not be appointed. Accordingly,creditors would receive greater recoveries than in Chapter 7 liquidation.Although Chapter 11 liquidation is preferable to Chapter 7liquidation, we believe that liquidation under Chapter 11 is a much lessattractive alternative to stakeholders because a greater return to stakeholdersis provided for in the proposed Plan.

 

Forcopies of court filings made in our Chapter 11 cases, please go to theBankruptcy Court’s website, at www.nysb.uscourts.gov. Please note that a PACERpassword is required to access documents on the Bankruptcy Court’s website.  In addition, certain documents relating toour Chapter 11 cases are available at www.bmccorp.net.

 

### ***RESULTSOF OPERATIONS***

 

**Revenues**

 

*Three Months Ended March 31,2004 Compared With Three Months Ended March 31, 2003*

 

Duringthe first quarter of 2004 and 2003, we generated revenues of approximately$180.0 million and $204.6 million, respectively. Revenues havedecreased $24.6 million or 12% compared to the three months ended March 31,2003. Our revenue has been negatively impacted by, among other things:

 

•                                          thecommencement of our Chapter 11 cases;

 

•                                          churn;

 

•                                          sales forceturnover;

 

•                                          the goingconcern qualification contained in our 2003 and 2002 year-end independentaccountants’ reports;

 

•                                          the generalmalaise in the telecommunications industry that has adversely affected thewillingness of potential customers to purchase their telecommunicationsservices from competitive carriers, such as us;

 

•                                          the pooreconomy which has caused our customers to decrease or delay their purchasesfrom us;

 

•                                          decreases incarrier access and interconnection revenues primarily due to disputesettlements and FCC-mandated regulatory rate reductions which account for $10.7million of the decrease in revenue from the first quarter of 2003 to the firstquarter of 2004;

 

•                                          decreases inour web hosting revenues as we continued to curtail that product line; and

 

•                                          uncertaintiesrelating to the sale process.

 

Ourfocus has shifted from high revenue growth to profitability and we do notanticipate the level of revenue growth that we have experienced in the past.Future revenue growth will depend on our ability to add new customers, retainexisting customers and manage churn, increase customer usage and selladditional services to our existing customers. We believe that managing our churnis one of our biggest challenges. The amount of churn directly impacts ourrevenues. See the discussion of line churn under the caption “Liquidity andCapital Resources” below.

 

Localvoice service revenues for the quarters ended March 31, 2004 and 2003 were$72.1 million and $85.2 million, respectively. The decrease in localvoice service revenues during 2003 and 2004 is primarily a result of lowerrates for carrier access and interconnection revenues as mandated by ournegotiated agreements with carriers, the FCC and certain states. Local voiceservice revenues as a percent of total revenues has decreased fromapproximately 42% for the quarter ended March 31, 2003 to approximately40% for the quarter ended March 31, 2004. Local voice service revenues consistedof:

 

•                                          the monthlyrecurring charge for basic local voice service;

 

•                                          usage-basedcharges to end-users for local and toll calls in certain markets;

 

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•                                          charges foradditional services and features such as call waiting and call forwarding;

 

•                                          certainnon-recurring charges, such as set-up and installation charges; and

 

•                                          carrieraccess and interconnection revenues from switched access charges to longdistance carriers and reciprocal compensation charges to other local carriers.

 

Weexpect local voice service revenues to continue to decrease from period toperiod as a percent of total revenues, as a result of our increasing focus onintegrated voice, data and customer premises equipment sales and maintenanceservices, the resolution of certain regulatory disputes and uncertainties andlower rates for carrier access and interconnection revenues as mandated by ournegotiated agreements with carriers, the FCC and certain states. The companyhas entered into a limited number of agreements with other carriers regardingaccess rates that settled certain access charge disputes. We have alreadyrejected one of these negotiated access agreements and have successfullynegotiated another. XO, under the XO Asset Purchase Agreement, has the right todetermine whether remaining agreements are rejected or assumed. XO has notcompleted the process of evaluating the remaining agreements to determinewhether to reject or assume these agreements in our Chapter 11 cases. Therecan be no assurance that we will be able to reject those remaining accessagreements; if we are able to reject such agreements, we believe the othercarriers may be obligated to pay us for access at our higher tariffed rates forthose calls originating and terminating on the assets being acquired by XOwhich could increase XO’s access revenues. See the discussion under “RiskFactors,” which contains a detailed discussion of the risks and uncertaintiesassociated with our local voice revenues.

 

Longdistance service revenues for the quarters ended March 31, 2004 and 2003were $13.1 million and $11.5 million, respectively. Long distanceservice revenues as a percent of total revenues has increased fromapproximately 6% for the quarter ended March 31, 2003 to approximately 7% forthe quarter ended March 31, 2004. We have negotiated new long distanceagreements with our long-distance providers that should reduce our costs toprovide long distance services to our customers and allow us to be more competitivein the pricing of our long distance services.

 

Datarevenues, including revenues generated from Internet access, web hosting andhigh-speed data services, for the quarters ended March 31, 2004 and 2003were $66.9 million and $72.7 million, respectively. Data revenues asa percent of total revenues has increased from approximately 35% for thequarter ended March 31, 2003 to approximately 37% for the quarter endedMarch 31, 2004. We believe that the continuing evolution of communicationsnetworks will promote the integration of voice and data services over the samefacilities, thereby further increasing the availability of cost-effective dataofferings, but we caution that our historic level of data revenue is notindicative of future levels because, as discussed below, our long-termintegrated network services contract with Level 3 Communications has beenterminated pursuant to a settlement agreement with Level 3 as described below.

 

Therate of growth in our data revenues has been affected by negative trends. Webelieve that the demand for high-end web hosting services has decreased inresponse to a general economic slowdown. Moreover, an over capacity of datacenter space has decreased prices for these high-end services. High-endservices include dedicated hosting services where we provide the customer witha dedicated computer server in our data centers and colocation services wherewe provide data center space and services for a customer who locates its owncomputer server on our premises. We believe that the general economic slowdownhas caused deterioration in our shared hosting business as well.

 

Similarly,the demand for services we offer to network service providers who providedial-up Internet access services is also experiencing the effects of over capacityand decreased demand. The resulting financial hardship has lessened the numberof these types of network service providers. During 2000, we signed a long-termcontract to provide an integrated network solution and certain services toGenuity Solutions Inc., a network services provider and operator of anationwide Internet network. Our contract was established specifically tosupport Genuity’s customer contracts, including that with America Online, andexpires on December 31, 2006. Under this contract, Genuity committed topay us an aggregate of $563.0 million over the term of the contract,subject to our performance under and the other terms and conditions of thecontract. Genuity assigned this contract to a subsidiary of Level 3 onFebruary 4, 2003.  For the quartersended March 31, 2004 and 2003, revenues from this contract were $27.7million and $30.0 million, respectively. The revenues from this contractaccounted for 15% of our total revenues for the quarters ended March 31,2004 and 2003, and 41% and 41% of our data revenues for the same periods. Inaddition, a significant portion of the reciprocal compensation earned by usfrom other carriers is as a result of the other carriers terminatingLevel 3 traffic on our networks. Reciprocal compensation revenues for thequarters ended March 31, 2004 and 2003 were $0.8 million and$8.5 million, respectively.   Asdiscussed below, we have terminated this long-term contract with Level 3 and weand XO will no longer receive any revenue thereunder or the reciprocalcompensation revenue derived therefrom.

 

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Weand Level 3 had a number of disputes regarding this contract.  On February 27, 2004, Level 3 andAllegiance agreed to settle their disputes regarding the agreement subject to,among other things, Bankruptcy Court approval. In summary, under the settlementagreement, among other things, Level 3 shall reimburse us for amounts paidto KMC Telecom XI since February 1, 2004 and upon consummation, an additional amountintended to reimburse the company for expenses of operating the dial-up accessbusiness for Level 3 since February 1, 2004, Level 3’sobligation to pay the February 2004 payment shall be suspended, and weshall immediately begin paying to Level 3 an amount equal to allreciprocal compensation related to traffic under the agreement, all subject toBankruptcy Court approval. Upon Bankruptcy Court approval, the occurrence ofthe escrow closing under the XO Purchase Agreement, and the consummation of thesettlement agreement, among other things:

 

•                                          Level 3shall pay us $54 million;

 

•                                          theintegrated network agreement would be terminated and Level 3 would have noobligation to pay the February 2004 payment;

 

•                                          we wouldtransfer to Level 3 all of the dedicated assets and infrastructure used byus to provide the integrated network solution to Level 3; and

 

•                                          we andLevel 3 would grant mutual releases.

 

In addition, weare obligated to continue to provide certain termination assistance servicescommencing on Level 3 paying us $54 million and ending six months followingclosing of the XO Asset Purchase Agreement and we will be paid an amountdesigned to cover our expenses to provide the transition services. OnApril 6, 2004, the Bankruptcy Court entered an amended order approving thesettlement agreement.  On April 19,2004, we and Level 3 closed the initial transactions contemplated by theSettlement Agreement including the payment of $54 million by Level 3 to us.  As such, neither we nor XO will have thebenefit of this line of business in the future and this will materially reduceour data revenues and reciprocal compensation revenues.

 

In June 2002,we acquired substantially all of the assets and assumed certain liabilities ofthe customer premises equipment sales and maintenance business, also known asShared Technologies Fairchild, from WorldCom. Customer premises equipment salesand maintenance revenues for the quarters ended March 31, 2004 and 2003were $27.9 million and $35.2 million, respectively. Customer premisesequipment sales and maintenance revenues as a percent of total revenues wereapproximately 15% and 17% for the quarters ended March 31, 2004 and 2003,respectively. As a result of our bankruptcy, until we received Bankruptcy Courtauthority to procure limited bid and performance bonds on October 8, 2003,we had not been able to obtain certain bid and performance bonds or provideother types of financial security as required by many of our customers. As aresult, we have lost current customers to our competitors and have a reducedability to gain new customers. Moreover, some customers will not purchaseservices from companies in bankruptcy, so certain opportunities are notavailable to us. The loss of current and potential customers has impacted ourrevenues and will continue to impact our revenues as long as these conditionsexist.   XO will not be acquiring theShared Technologies business.

 

**Network Expenses**

 

*Three Months Ended March 31, 2004 Compared With ThreeMonths Ended March 31, 2003*

 

For the quartersended March 31, 2004 and 2003, network expenses were $77.1 million and$111.5 million, respectively; network expenses related to the SharedTechnologies business, acquired in June 2002, included in the quartersended March 31, 2004 and 2003 were $15.5 million and $20.2 million,respectively. Network expenses as a percentage of total revenues decreased from54% for the quarter ended March 31, 2003 to 43% for the quarter endedMarch 31, 2004.  Network expensesfor the quarter ended March 31, 2004 was positively affected by the sale of ourlong-term contract with Level 3 to them effective February 1, 2004 because inthat sale we assigned our subcontract with KMC Telecom XI under which we wereincurring approximately $3.0 million in network expense per month.  Network expense reduction is also the resultof our ongoing elimination of excess cost through our restructuring.   While there can be no assurance that wewill be successful in creating or continuing the existing operatingefficiencies, we expect to control costs and that network expenses as apercentage of total revenues will reduce over time. With respect to theimplementation of this review and rationalization, we have converted a limitednumber of facilities-based customers to UNE-P, deployed alternate unbundlednetwork element

 

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applications, or, in some instances, eliminated colocations. Inaddition, prior to entering into the XO Asset Purchase Agreement we wereanalyzing our contracts and leases to determine those executory contracts andunexpired leases relating to our network that may be burdensome to us andshould be rejected pursuant to Section 365 of the Bankruptcy Code. Sincewe have entered into the XO Asset Purchase Agreement, we are now working withXO to determine what contracts XO will ask us to assume and those that are notassumed by XO may be rejected by us.

 

Gross margin hasincreased from 46% for the quarter ended March 31, 2003 to 57% for thequarter ended March 31, 2004. Gross margin is calculated as revenues lessnetwork expenses, divided by revenues.

 

Network expensesinclude:

 

•                                          the cost ofleasing local loop lines which connect our customers to our network;

 

•                                          the cost ofleasing high-capacity digital lines that interconnect our network and with thenetworks of the incumbent local exchange carriers;

 

•                                          the cost ofleasing high-capacity digital lines that connect our switching equipment to ourtransmission equipment located in the central offices of the incumbent localexchange carrier;

 

•                                          the cost ofenhancing our network;

 

•                                          the cost ofcompleting local, toll and long distance calls originated by our customers,including switched access and reciprocal compensation charges paid by us;

 

•                                          the cost oflong distance services resold by us to our customers;

 

•                                          the cost ofleasing space in incumbent local exchange carrier central offices and the costof electric power purchased from the incumbent for colocating our transmissionequipment;

 

•                                          operating andmaintenance expenses for dark fiber;

 

•                                          the cost ofcustomer premises equipment that has been sold by us and the cost of providingmaintenance services on such equipment;

 

•                                          the cost ofInternet transit and transport;

 

•                                          the cost ofleasing certain portions of our nationwide Internet network; and

 

•                                          for ourShared Technologies business, the costs of equipment and labor for theinstallation and maintenance of equipment.

 

Network expensesdo not include an allocation of our depreciation or amortization expenses.

 

The costs to leaselocal loop lines, high-capacity digital T-1 loop lines, and high-capacitydigital interoffice facilities from the incumbent local exchange carriers varyby carrier and by state and are regulated under the Telecommunications Act of1996. In virtually all areas, we lease local loop lines and high-capacitydigital T-1 loop lines from the incumbent local exchange carriers to connectour customers’ premises to our transmission equipment colocated in the centraloffices of the incumbent carriers. In the areas of low density and traffic inthe metropolitan areas that we serve, we also depend on the incumbent localexchange carriers to provide us high-capacity digital interoffice facilities toconnect our switch to our transmission equipment colocated in the incumbents’central offices. In the areas of high density and traffic in our markets, inaddition to the incumbent carriers, there are other carriers from whom we leasehigh-capacity digital interoffice facilities; we can generally lease thoseinteroffice facilities at lower or comparable prices and with higher networkreliability than those interoffice facilities provided by the incumbent localexchange carriers. We have increasingly focused on obtaining thesehigh-capacity digital interoffice facilities on dedicated fiber. Even in areasof high density and traffic in our markets, however, the incumbent localexchange carriers are sometimes the only available source of high-capacitydigital interoffice facilities. These cost and availabilities may be impactedby actions taken by federal and state regulatory agencies in reviewing thecosts to provide these facilities, see discussion under “Risk Factors Relatingto Regulations.”

 

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In accounting forthe costs of constructing switching and transmission equipment for a newmarket, we capitalized as a component of property and equipment only theinitial non-recurring charges associated with our network facilities.

 

We incur“reciprocal compensation” costs in providing both voice and data services andexpect reciprocal compensation costs to be a major portion of our cost ofservices. We must enter into an interconnection agreement with the incumbentlocal exchange carrier in each market we provide service to make widespreadcalling available to our customers and these agreements are approved by thestate regulatory agency. These agreements typically set the cost per minute tobe charged by each party for the calls that are exchanged between the twocarriers’ networks. Generally, a carrier must compensate another carrier when alocal call by the first carrier’s customer terminates on the other carrier’snetwork. These reciprocal compensation costs are a variable cost that will growas our customers’ outbound calling volume grows. Over time, the rates forreciprocal compensation have decreased and in some of our markets, we exchangelocal traffic with the incumbent local carrier on a bill-and-keep basis (whichgenerally means that neither carrier pays for the traffic that terminates onthe other carrier’s network). We also incur switched access charges forintrastate toll traffic we exchange with other carriers. The rates forintrastate access traffic are regulated by state authorities and are usuallycontained in carriers’ access tariffs.

 

The cost ofsecuring long distance service capacity is a variable cost that increases indirect relationship to increases in our customer base and increases in longdistance calling volumes. We have entered into new long distance agreements andas a result, our variable cost per minute for long distance services hasdecreased.

 

We install voiceand data aggregation and switching equipment in space owned or leased by otherparties, including locating our equipment in central offices of local incumbentexchange carriers’ networks. We incur rent and utility charges in leasing thisspace. We expect these costs to generally remain constant in the near future aswe do not plan to expand to additional colocation sites. XO and we are in theprocess of evaluating our colocation space needs as part of our bankruptcy andwe may reduce the number of colocations that we are currently occupying whichcould reduce our colocation expenses.

 

We sell andinstall telecommunications customer premises equipment and provide maintenanceservices on such equipment. Our costs to provide these products and servicesinclude both time and material costs. These costs will increase or decrease inrelation to the demand for these products and services.

 

We have developeda national Internet data network by connecting our markets with leasedhigh-capacity digital lines. The costs of these lines will increase if we needto increase capacity to address increased customer demand.

 

We currently have a number ofsettlement-free peering arrangements with other Internet backbone providers.Most of these arrangements are month-to-month and generally can be terminatedby either party upon notice. If we lose any of these arrangements or if theother Internet backbone provider requires payment by us for the exchange oftraffic, our network costs may materially increase.

 

**Selling, General and Administrative Expenses**

 

*Three Months Ended March 31, 2004 Compared With ThreeMonths Ended March 31, 2003*

 

Selling, generaland administrative expenses were $78.2 million and $116.6 million for thequarters ended March 31, 2004 and 2003, respectively. Selling, general andadministrative expenses related to our Shared Technologies business, acquiredin June 2002, included in the quarters ended March 31, 2004 and 2003were $9.9 million and $12.8 million, respectively. Selling, generaland administrative expenses as a percentage of total revenues decreased from57% for the quarter ended March 31, 2003 to 43% for the quarter endedMarch 31, 2004.

 

Selling, generaland administrative expenses have decreased due to our cost containment efforts(including a decrease in our headcount), increased collection efforts, whichhave resulted in a decrease in bad debt expense, and the rejection of certainexecutory contracts pursuant to Section 363 of the Bankruptcy Code.

 

Selling, generaland administrative expenses include salaries, benefits and related personnelcosts, administration and facilities costs, sales and marketing costs, customercare and billing costs, investor and media relations, insurance, professionalfees and bad debt expense. As a result of our transition from rapid revenuegrowth to a plan geared towards reducing cash used in operations and achievingpositive cash flow, we reduced headcount, including the number of sales teamsstarting in the second half of 2002 and continuing through 2003. Our totalheadcount decreased from 3,622 at March 31, 2003 to 2,837 atMarch 31, 2004. As of March 31, 2004, the sales force, includingsales managers and sales

 

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administrators, had decreased to 817 from 1,027 as of March 31,2003. Prior to entering into the XO Asset Purchase Agreement, we were analyzingour contracts and leases to determine those executory contracts and unexpiredleases relating to our selling, general and administrative expenses that may beburdensome to us and should be rejected pursuant to Section 365 of theBankruptcy Code. Since we have entered into the XO Asset Purchase Agreement, weare now working with XO to determine which executory contracts and leases XOwill ask us to assume and those that are not assumed may be rejected by us.

 

We have an invoiceprocessing agreement (the “Billing Agreement”) with Daleen Solutions, Inc.(“Daleen”). Daleen is one of our primary invoice processing vendors for billingour customers. On October 30, 2003, Daleen notified Allegiance that it waselecting to not renew the Billing Agreement. On October 31, 2003, Daleenfiled a Motion For Relief From the Automatic Stay Under Section 362 of theBankruptcy Code (“Motion”) seeking relief from the automatic stay so that itcould send Allegiance notice of its intent to elect to not renew the BillingAgreement. On November 19, 2003, the Bankruptcy Court denied Daleen’s Motion.As a result, the Billing Agreement renewed on December 31, 2003 for anadditional one year term on the same terms and conditions as the existingBilling Agreement. We are in the process of migrating our customers off of theDaleen Billing Agreement. If we are unable to continue billing our customersduring this migration period, it may have a material adverse effect on ourcompany and our business, as further discussed in “Risk Factors Relating toOperations.”

 

**Depreciation**

 

*Three Months Ended March 31, 2004 Compared With ThreeMonths Ended March 31, 2003*

 

During thequarters ended March 31, 2004 and 2003, depreciation expense was $54.7million and $63.5 million, respectively. Depreciation expense for thequarter ended March 31, 2004, decreased comparable to depreciation expensefor the quarter ended March 31, 2003, as we had completed the deploymentof our networks and initiation of services in new markets prior to 2002 and didnot incur significant additional capital expenditures during 2003.

 

**Amortization of Purchased Intangibles**

 

*Three Months Ended March 31, 2004 Compared With ThreeMonths Ended March 31, 2003*

 

In connection withthe acquisitions completed since inception, we assigned an aggregate of$63.0 million of the purchase price to customer lists. These intangibleassets are being amortized over their estimated useful lives of one to threeyears. For the quarters ended March 31, 2004 and 2003, we recorded$1.4 million and $3.1 million of amortization of customer lists,respectively.

 

**Deferred Compensation Expenses**

 

*Three Months Ended March 31, 2004 Compared With ThreeMonths Ended March 31, 2003*

 

For the quartersended March 31, 2004 and 2003, we recognized $0.5 and $1.0 million,respectively, of amortization of deferred compensation expense. Such deferredcompensation was recorded in connection with grants of stock options andrestricted common shares to certain employees under our 1997 stock option planand 1998 stock incentive plan.

 

**Interest Expense and Interest Income**

 

*Three Months Ended March 31, 2004 Compared With ThreeMonths Ended March 31, 2003*

 

Interest incomefor quarters ended March 31, 2004 and 2003 was $0.6 million and$1.0 million, respectively. Interest income results from short-terminvestments, cash and cash equivalents. Interest income during the three monthsended March 31, 2003 is greater than for the three months endedMarch 31, 2004 because we had additional cash invested in interest-bearinginstruments and because of higher average interest rates.

 

For the quartersended March 31, 2004 and 2003, interest expense was $9.0 million and$30.1 million, respectively. Prior to the Commencement Date of our Chapter11 cases, interest expense included the accretion of the 11 3/4% notes and related amortization of the original issue discount, theamortization of the original issue discount on the 12 7/8% notes, and the interest charges and amortization of deferred debt issuancecosts related to our $500 million senior secured credit facilities. As ofthe Commencement Date of our Chapter 11 cases, we stopped recording interestexpense on the 11 3/4 % notes and the 12 7/8% notes in accordance with Statement of Position 90-7. Additionally, thedeferred debt issuance costs related to this debt

 

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are no longer being amortized to interest expense. Under a BankruptcyCourt order, we are required to continue incurring and paying interest at theapplicable non-default rate of interest under our senior secured creditfacilities and we have continued to amortize the deferred debt issuance costsrelated to the senior secured credit facilities to interest expense.

 

**Operating Losses**

 

*Three Months Ended March 31, 2004 Compared With ThreeMonths Ended March 31, 2003*

 

Our loss fromoperations for the quarters ended March 31, 2004 and 2003 was $32.0million and $91.0 million, respectively.

 

**Reorganization Items**

 

#### *Three Months Ended March 31, 2004 compared with ThreeMonths Ended March 31, 2003*

 

Reorganizationitems consist of costs associated with our bankruptcy proceedings that are notdirectly attributable to the ongoing operations of our business. During thequarter ended March 31, 2004, we incurred $6.1 million in professionalfees and recognized a loss of $13.3 million related to other restructuringactivities. We expect to continue to incur significant costs associated withour reorganization.

 

***LIQUIDITY AND CAPITAL RESOURCES***

 

As ofMarch 31, 2004, we had approximately $249.5 million of unrestrictedcash and short-term investments, compared with $284.2 million ofunrestricted cash and short-term investments as of December 31, 2003. Wedo not have any off-balance sheet financing arrangements, special purposeentities or asset securitizations. On March 31, 2004, we received finalBankruptcy Court approval for the continued use of our cash collateral under aSecond Stipulation and Consent Order Extending the Expiration Date of theSecond Amended Final Order Authorizing Use of Cash Collateral by Consent (the“Second Amended Cash Collateral Order”). The Second Amended Cash CollateralOrder among other things: (1) restricts our use of cash, (2) requiresus to prepare and follow a budget and maintain a minimum weekly cash balance,and (3) requires us to provide certain financial, operational and otherinformation to our senior lenders. Under this Second Amended Cash CollateralOrder, we are also required to continue incurring and paying interest under oursenior secured credit agreement (at the applicable non-default rate ofinterest).

 

As ofMarch 31, 2004, we had $1,335.2 million of outstanding liabilitiessubject to compromise, including $1,120.6 million of indebtedness(including debt under our senior secured credit agreement and two series ofbonds). We are party to a senior secured credit agreement and two indentures.As of March 31, 2004, approximately $477.8 million of ourindebtedness was borrowed under our senior secured credit agreement, asdescribed in more detail below. As of that same date, approximately$642.8 million of our indebtedness was borrowed under our two indentures.

 

Our existing cashand short-term investment balances relating to operations are expected todecline during 2004.  Our accountsreceivable increased by approximately $13.0 million during the quarter endedMarch 31, 2004.  This use of cash is dueprimarily to the increase in the receivable related to the Level 3agreement.  We also saw a decrease inour accrued liabilities and other current liabilities during the first quarterof 2004 of approximately $18.2 million. This use of cash was caused by a decrease in deferred revenue primarilydue to the Level 3 agreement and due to payment of other items such as taxesand bonuses.

 

Decreased demandfor our services or high customer churn, as noted above, could adversely impactour liquidity. Customer demand for our services depends in part on our abilityto efficiently and timely switch customers from their prior carrier to ourservice, respond to customer service and billing issues and provide qualityservice. Please see the discussion below under the caption “Senior SecuredCredit Agreement” below and under the caption “Risk Factors.”

 

The future successof our business being sold to XO depends, among other things, on customerdemand and line churn, i.e. the rate at which customers discontinue theirlines. Customers leave our service for a variety of reasons, including but notlimited to, the customer: (a) leaving our service area, (b) going outof business or downsizing its business, (c) being unhappy with ourservice, (d) general market conditions, (e) leaving for betterpricing, (f) needing a different telecom solution that we do not provide,(g) disruptions in service relating to our network optimization activitiesand (h) concern regarding our bankruptcy and financial condition. In thequarter ended March 31, 2004, the average retail line churn wasapproximately 2.9% and including wholesale, our average line churn wasapproximately 1.8%. Line churn is the number of voice grade equivalent

 

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lines (for example, a fully-utilized data T-1 counts as 24 lines) thatare disconnected each month divided by the total number of voice gradeequivalent lines that we have in service at the beginning of that month. Theabove churn metrics do not include churn related to businesses such as SharedTechnologies, Allegiance Business Internet access services, or web hosting. Weare in the process of decommissioning 22 of our colocations and provisioningexisting customers served by those colocations by alternative methods wherepracticable. This may impact customer service and increase customer churn. Wecan provide no assurances that we or XO will be able to effectively manage orreduce our line churn. If we or they are unable to do so, this will materiallyaffect our business, revenues and liquidity.

 

Decreased customerdemand may also stem from uncertainty of our bankruptcy filing, the sale to XO,the industry in which we compete and the general economy. Many of ourcompetitors have also declared bankruptcy, de-listed from the public securitiesmarkets and/or identified financing problems. Some of our potential customersas well as current customers have expressed concerns about our financialstability in light of our bankruptcy filing, the general economy and thetelecommunications industry in general. We believe customer perception willcontinue to have an impact on our ability to attract and retain customers.Specifically, our financial condition has limited our ability to secure bid andperformance bonds that are required by some customers of our customer premisesequipment sales and maintenance business. Moreover, our customers may notpurchase additional services and may cancel existing services as a result ofour bankruptcy filing, our specific financial condition, including theindependent auditors’ reports for 2003 and 2002 that cite conditions whichraise substantial doubt about our ability to continue as a going concern, andgeneral economic conditions.

 

For the quartersended March 31, 2004 and 2003, we made capital expenditures of$2.6 million and $9.2 million, respectively. As of March 31,2004, we had transmission equipment colocated in 838 central offices. Pursuantto our current business plan, we expect to spend approximately $32 millionfor capital expenditures during 2004.  This expectation, however, is based on our plan to focus sales ingeographic locations where we have excess capacity.  If XO does not follow this strategy, capital expenditures for thebusiness in 2004 could be materially different.

 

We have purchaseddedicated fiber rings in 24 of our markets. As of March 31, 2004, we haddedicated fiber rings in operation in 24 markets including Austin, Baltimore,Boston, Chicago, Dallas, Denver, Detroit, Ft. Worth, Houston, Long Island, LosAngeles, New York City, Northern New Jersey, Philadelphia, Phoenix, Pittsburgh,Portland, San Antonio, San Diego, San Francisco, St. Louis, Seattle,Washington, D.C., and White Plains, New York. We have also acquired long-haulpoint-to-point fiber connectivity between several markets in the northeastcorridor. Our cost of fiber includes both the amounts we pay to the fiberprovider as well as the cost of the electronic equipment that we purchase andinstall to make the fiber operational. As of March 31, 2004, our totalcosts have been $198.6 million, and we are committed to spend anadditional $139.3 million for this fiber, which will be incurred over thelife of these existing fiber supply arrangements ending in 2023. Since weentered into the XO Asset Purchase Agreement, we are now working with XO todetermine which fiber contracts XO will ask us to assume and those that are notassumed may be rejected by us.  Sincethese fiber contracts represent multi-year commitments, rejections maymaterially increase the amount of pre-petition claims against our company.

 

**Contractual Obligations**

 

The followingsummarizes some of our future financial commitments at March 31, 2004 andthe effect such obligations are expected to have on our liquidity and cash flowin future periods:

 
|                                              |   |                       |   | **Payments  due by Period** |   |
|---------------------------------------------------|--------|----------------------------|--------|-----------------------------|--------|
| **Contractual Obligations(1)**                    |   | **Total**                  |   | **Less than  1 year**       |   | **1 to 3  years** |   | **3 to 5  years** |   | **After  5 years** |   |
|                                              |   | **(dollars  in millions)** |   |
|                                              |   |                       |   |                        |   |   |   |   |   |   |   |
| Long-term  debt(2):                               |   |                       |   |                        |   |   |   |   |   |   |   |
| Principal  payments                               |   | $                          | 1,128  |                        | $      | 1,128 |   | $ | — |   | $ | — |   | $ | — |   |
| Interest  payments                                |   | 20                         |   | 20                          |   | — |   | — |   | — |   |
| Capital lease  obligations, including interest(3) |   | 148                        |   | 12                          |   | 23 |   | 18 |   | 95 |   |
| Operating leases                                  |   | 101                        |   | 22                          |   | 41 |   | 28 |   | 10 |   |
| Other material  long-term obligations(3)          |   | 17                         |   | 15                          |   | 2 |   | — |   | — |   |
| Total  contractual cash obligations               |   | $                          | 1,414  |                        | $      | 1,197 |   | $ | 66 |   | $ | 46 |   | $ | 105 |   |

 

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(1)                                  Weare working with XO to analyze our contracts and leases to determine thoseexecutory contracts and unexpired

 

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leases that XO plans toassume and those that are burdensome to XO and may be rejected pursuant toSection 365 of the Bankruptcy Code. This table excludes any such executorycontracts or unexpired leases that have already been rejected with BankruptcyCourt approval but does not reflect any additional executory contracts orunexpired leases that may be rejected in the future in our Chapter 11 cases.

 

(2)                                  Asdiscussed in more detail herein, as a result of the bankruptcy filing onMay 14, 2003, there is an event of default under our senior creditagreement and our indentures; as a result of such events of default, under theterms of such agreement and indentures, the financing arrangements areimmediately due and payable. Interest payments reflect payments due during 2004under the Senior Secured Credit Agreement.

 

(3)                                  Doesnot include future obligations that may arise under purchase orders, sincedelivery of services under those purchase orders has not been made.

 

**Senior Secured Credit Agreement**

 

InFebruary 2000, we closed on $500.0 million of new senior securedcredit facilities, which replaced our prior $225 million revolving creditfacility. These new senior secured credit facilities consist of a$350.0 million revolving credit facility and a $150.0 million delayeddraw term loan facility. Interest on amounts drawn is generally the 6-monthLondon Interbank Offered Rate plus 4.50% per annum. Our senior credit agreementcontains certain representations, warranties and covenants, including manyfinancial covenants. Our credit agreement (including our financial covenantschedules), as amended and indentures are publicly available in our filingswith the Securities and Exchange Commission and should be reviewed in theirentirety to gain a full understanding of the covenants and other requirementsapplicable to us under those documents.

 

During the thirdquarter of 2001, we drew $200.0 million under the revolving creditfacility and $150.0 million under the delayed draw term loan. The interestrate applicable to this draw was 5.68% per annum in 2003 and as ofMarch 19, 2004 the interest rate applicable to this draw was adjusted to5.61%, based on the London Interbank Offered Rate in effect at that time. InJune 2002, we requested a draw of the remaining $150 million under therevolving credit facility. The interest rate applicable to this draw was 5.50%per annum through December 24, 2003. As of December 24, 2003, theinterest rate applicable to this draw was adjusted to 5.72%, based on theLondon Interbank Offered Rate in effect at that time.

 

As ofJune 30, 2003, we had received $135.3 million of the$150.0 million requested in June 2002, with 3 of the 26 banks in thebank syndicate refusing to fund our request. On July 15, 2003, we enteredinto a settlement agreement with Bayerische Hypo-und Vereinsbank and BankAustria Creditanstalt Corporate Finance, Inc. (collectively, the “Banks”)regarding these funding disputes. On July 29, 2003, the Bankruptcy Courtapproved this settlement agreement. On July 31, 2003, the Banks deliveredthe net funding obligation to us required under this settlement agreement inthe amount of $7.4 million. On October 24, 2003, we entered into asettlement agreement with Dresdner Bank AG regarding these funding disputes. OnNovember 19, 2003, the Bankruptcy Court approved the settlement agreementand on November 20, 2003, Dresdner Bank AG delivered the net fundingobligation to the company, required under the settlement agreement in theamount of $5.1 million.

 

The obligationsunder the senior credit agreement are secured by (1) the capital stock ofAllegiance Telecom Company Worldwide (which stock is owned by its parentholding company, Allegiance Telecom, Inc.) and (2) substantially allof the assets of Allegiance Telecom Company Worldwide and its subsidiaries,including the capital stock owned by Allegiance Telecom Company Worldwide ineach of its subsidiaries. The Second Amended Cash Collateral Order alsoprovides the senior lenders with certain replacement liens as described in suchOrder. Under this Order, we are required to continue incurring and payinginterest under our senior secured credit facilities (at the applicablenon-default rate of interest) and we have continued to amortize the deferreddebt issuance costs related to the senior secured credit facilities to interestexpense.

 

***CRITICAL ACCOUNTING POLICIES***

 

Our discussion andanalysis of our financial condition and results of operations is based upon ourconsolidated financial statements, which have been prepared in accordance withaccounting principles generally accepted in the United States of America. Thepreparation of these consolidated financial statements requires us to makeestimates and assumptions about the effect of matters that are inherentlyuncertain. These estimates and assumptions affect the reported amounts ofassets, liabilities, revenues and expenses and disclosure of contingent assetsand liabilities that exist at the date of our consolidated financialstatements. While we believe our estimates are appropriate, actual results can,and often do, differ from those estimates.

 

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Our criticalaccounting policies are discussed below. Each of these areas involves complexsituations and a high degree of judgment either in the application andinterpretation of existing literature or in the development of estimates thatimpact our financial statements.

 

**Revenue Recognition.**  We recognize revenues as we provide servicesto our customers. Our revenue recognition policies are designed to comply withall applicable accounting principles generally accepted in the United States ofAmerica, including SEC Staff Accounting Bulletin No. 104, “RevenueRecognition” (“SAB 104”), which provides additional guidance on revenuerecognition as well as criteria for when revenue is realized and earned andrelated costs are incurred. The application of SAB 104 requires management’sjudgment on the amount and timing of revenue recognition. Should changes inconditions cause management to determine the revenue recognition criteria arenot met for certain future transactions, revenue recognized for any reporting periodcould be adversely affected.

 

The assessment ofcollectibility is particularly critical in determining whether or not revenueshould be recognized. A portion of our revenues is for reciprocal compensationgenerated by calls placed to Internet service providers who are our customers.In addition, a portion of our revenues is switched access charge revenue forconnecting our voice customers to their selected toll or long distance carriersfor outbound calls or for delivering inbound toll and long distance traffic toour voice customers. Our ability to earn reciprocal compensation revenues andswitched access revenues as well as the rates is the subject of numerousregulatory and legal challenges and various interconnection agreements. Untilthese issues are ultimately resolved, our policy is to recognize these revenuesonly when realization is probable.

 

**Accounts Receivable.**A considerable amount of judgment is required in assessing the ultimaterealization of our accounts receivable. We evaluate the collectibility of ouraccounts receivable based on a combination of factors. We recognize allowancesfor doubtful accounts based on the length of time the receivables are past due,the current business environment and our historical experience. In circumstanceswhere we are aware of a specific customer’s or carrier’s inability to meet itsfinancial obligations to us, we record a specific allowance against amountsdue, to reduce the net recognized receivable to the amount we reasonablybelieve will be collected.

 

Some of our customers andinterconnection carriers have sought bankruptcy protection, which has resultedin an increase in our allowance for doubtful accounts. For customers who havefiled for bankruptcy, our policy is to fully reserve outstanding receivablesfor services provided in periods prior to their bankruptcy filing. If thefinancial condition of our customers and /or interconnecting carriers were todeteriorate further or if economic conditions worsened, additional allowancesmay be required in the future.

 

**Network Expenses.**  We recognize network expenses as theproducts and services are provided and delivered to us by our vendors. Therecognition of network expense and the related liabilities for network expenserequires certain estimates and assumptions to be made by management. Ouraccruals for unbilled leased network facilities, network access charges, andequipment colocation charges are based on line counts, estimated usage, andactive colocation sites. Additionally, our accrual includes charges invoiced bynetwork providers, which are probable network expenses but have not yet beenpaid due to disputes with these carriers. Should changes in conditions or factscause us to revise our estimates, our financial condition and results ofoperations could be significantly impacted.

 

**Impairment of Long-Lived Assets.**  We review the carrying values of propertyand equipment and intangible assets for impairment in accordance with Statementof Financial Accounting Standards No. 144, “Accounting for the Impairmentor Disposal of Long-Lived Assets” (“SFAS 144”). Under SFAS 144, weare required to identify current events or changes in circumstances thatindicate that the carrying amount of an asset may not be recoverable. Ifimpairment indicators are present, we analyze the projected cash flowsassociated with our property and equipment and intangible assets to determinethe fair value of these assets. Considerable management judgment is necessaryin establishing the assumptions used as a basis for this analysis.

 

We considered thebankruptcy filing on May 14, 2003 and the pending sale of the business asof December 31, 2003 triggering events that required that our long-livedassets be evaluated for impairment. Based on the expected sale of the majority ofthe company’s assets to XO Communications approved by the Bankruptcy Court onFebruary 20, 2004, we determined that the proceeds generated from the saleare sufficient to recover the current carrying value of the company’slong-lived assets. Although we believe our estimates and assumptions used inthis calculation are reasonable, actual results could vary significantly fromthese estimates. Should changes in conditions or facts cause us to revise ourestimates, we could be required to record impairment charges in future periods,which may have a significant impact on our results of operations.

 

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**Liabilities Subject to Compromise.**  As a result of the commencement of theChapter 11 cases, our consolidated financial statements reflect the provisionsof Statement of Position 90-7 and are prepared on a going-concern basis, whichcontemplates continuity of operations, realization of assets and liquidation ofliabilities in the ordinary course of business. However, because of the Chapter11 cases, such realization of assets and liquidation of liabilities, withoutsubstantial adjustments and/or changes of ownership, are subject touncertainty.

 

One of the key provisionsof Statement of Position 90-7 requires the reporting of our liabilitiesincurred prior to the commencement of the Chapter 11 cases as liabilitiessubject to compromise. The various liabilities that are subject to compromiseinclude pre-petition debt, accounts payable, accrued expenses and other long-termliabilities. The amounts for these items represent our estimate of known orpotential pre-petition claims to be resolved in connection with the Chapter 11cases. Such claims remain subject to future adjustments. Adjustments may resultfrom (i) negotiations, (ii) actions of the Bankruptcy Court,(iii) further developments with respect to disputed claims,(iv) rejection of executory contracts and unexpired leases, or(v) other events.

 

**Off-Balance Sheet FinancingArrangements.**  We donot have any off-balance sheet financing arrangements.

 

**Other Matters.**  We do not have any trading activities thatinclude non-exchange traded contracts accounted for at fair value.

 

Management has discussedthe development and selection of these critical accounting estimates with theaudit committee of our board of directors, and the audit committee has reviewedour disclosure relating to them.

 

***NEW ACCOUNTING PRONOUNCEMENTS***

 

We continually monitorand revise our accounting policies as developments occur. The following recentlyissued accounting pronouncements may impact the future presentation of ourfinancial condition and results of operations.

 

In November 2002,the Financial Accounting Standards Board’s Emerging Issues Task Force (“EITF”)reached a consensus on Issue No. 00-21, “Revenue Arrangements withMultiple Deliverables.” EITF Issue No. 00-21 provides guidance on how toaccount for arrangements that involve the delivery or performance of multipleproducts, services and/or rights to use assets. The provisions of EITF IssueNo. 00-21 apply to revenue arrangements entered into in fiscal periodsbeginning after June 15, 2003. Our adoption of this statement did not havea material effect on our financial position or results of operations.

 

In May 2003, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 150, “Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity.” This Statement establishesstandards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity. This Statementis effective for financial instruments entered into or modified afterMay 31, 2003, and otherwise is effective at the beginning of the firstinterim period beginning after June 15, 2003. Our adoption of thisstatement, certain provisions of which have been delayed, did not have amaterial effect on our financial position or results of operations.

 

In May 2003, theEITF reached a consensus on Issue 01-8, *Determining Whether an Arrangement Contains a Lease*.Under the provisions of EITF 01-8, arrangements conveying the right to controlthe use of specific property, plant or equipment must be evaluated to determinewhether they contain a lease. We enter into contracts for the long-term supplyand sale of IT services and systems that, depending on the facts andcircumstances, could be subject to EITF 01-8. The new rules are being appliedprospectively to such contracts entered into or modified after July 1,2003. Accordingly, the impact of EITF 01-8 on our future results of operationsand financial position will depend on the terms contained in contracts signedafter such date. The impact of EITF 01-8 on our results of operations andfinancial position was not material.

 

In January 2003, theFASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation ofVariable Interest Entities, an Interpretation of ARB No. 51,” whichaddresses consolidation by business enterprises of variable interest entities(“VIEs”) either: (1) that do not have sufficient equity investment at riskto permit the entity to finance its activities without additional subordinatedfinancial support, or (2) in which the equity investors lack an essentialcharacteristic of a controlling financial interest. In December 2003, theFASB completed deliberations of proposed modifications to FIN 46 (“RevisedInterpretations”) resulting in multiple effective dates based on the nature aswell as the creation date of the VIE. VIEs created after January 31, 2003,but prior to January 1, 2004, may be accounted for either based on theoriginal interpretation or the Revised Interpretations.

 

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However, the RevisedInterpretations must be applied no later than our first quarter of 2004. VIEscreated after January 1, 2004 must be accounted for under the RevisedInterpretations. Special Purpose Entities (SPEs”) created prior toFebruary 1, 2003 may be accounted for under the original or RevisedInterpretation’s provision no later than our fourth quarter of 2003. Non-SPEscreated prior to February 1, 2003, should be accounted for under theRevised Interpretation’s provisions no later than our first quarter of 2004.The adoption of FIN 46 did not have a material effect on our financial positionor results of operations.

 

***CERTAIN RELATED PARTY TRANSACTIONS***

 

On April 4, 2001,Anthony J. Parella, President of our Shared Technologies business, borrowed$3.0 million from us. Mr. Parella issued a promissory note payable tous, which note was payable on April 4, 2004. In September 2001,Mr. Parella borrowed an additional $1.2 million from us.Mr. Parella issued a full recourse promissory note (the “Full RecourseNote”) payable to us for a total amount of $4.2 million plus previouslyaccrued interest of $81,564 on the April 4, 2001 note. This note accruesinterest at 2.73% per annum, which was the November 2001 applicablefederal rate, and interest is payable when this note is due. The Full RecourseNote was payable on April 4, 2004 and, as discussed below, we have enteredinto a forbearance agreement with Mr. Parella under which we have agreednot to exercise our remedies under the Full Recourse Note at this time. Underthe Full Recourse Note, we have the right to enforce the repayment obligationof Mr. Parella by looking to his personal assets. The Full Recourse Noteis also secured by a pledge of Mr. Parella’s Allegiance stock options, aswell as 350,000 shares of Allegiance common stock, none of which has any value underour proposed Plan of Reorganization. The $4.2 million was used byMr. Parella to repay certain debt that he incurred in connection with thepurchase of land. That debt was secured by Mr. Parella’s Allegiance stockand he would have been forced to sell such stock to satisfy the debt if he didnot obtain another means of repaying the debt. We determined that making theloan to Mr. Parella at that time was in the best interests of ourstockholders because it allowed him to avoid a forced sale of his shares andinstead be able to take the time necessary to sell his land.

 

The loan toMr. Parella is reflected in “other current assets” in our financialstatements. A reserve for the full amount of the value of the loan wasestablished in the fourth quarter of 2003 due to the uncertainty of thecollectibility of this loan primarily as a result of uncertainty regarding thevalue of Mr. Parella’s personal assets and the existence of claimsasserted by Mr. Parella against us as set forth in a proof of claim filed withthe Bankruptcy Court in November 2003. We, Mr. Parella and theCreditors Committee are in the process of working out a resolution ofMr. Parella’s obligations under the Full Recourse Note and his relatedclaims against us and, as of April 2, 2004, with the advice and consent ofthe Creditors Committee we agreed to forebear from exercising any remediesunder the Full Recourse Note while this process is ongoing and Mr. Parellahas foregone all rights under his Key Employee Retention Plan pendingresolution of the disputes relating to the Full Recourse Note.

 

During the quarter endedMarch 31, 2004, Swidler Berlin Shereff Friedman, LLP performed legalservices for us. Andrew Lipman, a member of our board of directors, is a seniorpartner at this law firm. We recorded approximately $0.3 million in legalfees by this firm in the quarter ended March 31, 2004.  We intend to continue using this law firm inthe future for advice on legal matters.

 

***FORWARD-LOOKING STATEMENTS***

 

Certain statements inthis report constitute “forward-looking statements” within the meaning of thePrivate Securities Litigation Reform Act of 1995, and we intend that suchforward-looking statements be subject to the safe harbors created by this law.You generally can identify these statements by our use of forward-looking wordssuch as “plans,” “estimates,” “believes,” “expects,” “may,” “will,” “should” or“anticipates” or the negative or other variations of such terms or comparableterminology, or by discussion of strategy that involve risks and uncertainties.We often use these types of statements when discussing our plans andstrategies, our anticipation of revenues from designated markets, andstatements regarding the development of our businesses, the markets for ourservices and products, our anticipated capital expenditures, operations supportsystems or changes in regulatory requirements and other statements contained inthis report regarding matters that are not historical facts.

 

We caution you that theseforward-looking statements are only predictions and estimates regarding futureevents and circumstances. We cannot assure you that we will achieve the futureresults reflected in these statements. The risks we face that could cause usnot to achieve these results are many and include, but are not limited to, therisks discussed in this report as well as our ability to do the following in atimely manner, at reasonable costs and on satisfactory terms and conditions:

 

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•                                          successfullyclose the sale of substantially all of our assets to XOCommunications, Inc.;

 

•                                          successfullysell or reorganize our Shared Technologies business in connection with ourreorganization under chapter 11 of the United States Bankruptcy Code;

 

•                                          successfullysell the assets not being sold to XO Communications, Inc. or reorganizedas part of Shared Technologies business in connection with our reorganizationunder chapter 11 of the United States Bankruptcy Code; and

 

•                                          successfullyresolve all claims on a favorable basis in our reorganization under chapter 11of the United States Bankruptcy Code.

 

In addition to thoserisks, our ability to achieve future results relating to the operation ofbusinesses not being sold to XO Communications, Inc., including our SharedTechnologies customer premises equipment sales and maintenance business and ourshared hosting business, are many and include, but are not limited to, therisks discussed in this report as well as our ability to do the following in atimely manner, at reasonable costs and on satisfactory terms and conditions:

 

•                                          successfullycontinue to market our services to current and new customers;

 

•                                          attract andmaintain a quality employee work force;

 

•                                          maintain goodrelations with our employees;

 

•                                          retain ourcustomers; and

 

•                                          providequality customer service.

 

Regulatory, legislativeand judicial developments could also cause actual results to differ materiallyfrom the future results reflected in such forward-looking statements. Youshould consider all of our subsequent written and oral forward-lookingstatements only in light of such cautionary statements. You should not placeundue reliance on these forward-looking statements and you should understandthat they represent management’s view only as of the dates we make them.

 

***RISK FACTORS***

 

Our businesses aresubject to a number of risks including: (i) bankruptcy related riskfactors; (ii) risk factors associated with the sale to XO Communications,Inc. not closing; (iii) risk factors relating to XO Communications, Inc.;(iv) risk factors relating to operations; (v) risk factors related toregulation; (vi) risk factors related to the acquisition of substantiallyall of the company’s assets by XO; (vii) risk factors related to XO’scommon stock; and (viii) general business, financial and other riskfactors associated with our Shared Technologies business. Any or all of suchfactors, which are enumerated below, could have a material adverse effect onthe business, financial condition or results of operations of our company.

 

***Bankruptcy Related Risk Factors***

 

**Our operations have been affected andmay continue to be disrupted due to the filing of the Chapter 11proceeding**. On May 14, 2003, we filed voluntarypetitions for relief under Chapter 11 of the Bankruptcy Code. The impactthat the Chapter 11 cases have had on our operations cannot be accuratelypredicted or quantified. Since the announcement of the amendment to our seniorcredit agreement in November 2002, the challenge of selling ourtelecommunications products and services to new and existing customers hasincreased. In particular, since the announcement of our receipt of a goingconcern qualification from our independent public accountants inMarch 2003, customers have in some cases declined to conduct business withour company and certain vendors have either declined to conduct business withus or have asked for deposits, letters of credit and other forms of securityprior to providing services to us. Since we have filed petitions for reliefunder Chapter 11 of the Bankruptcy Code, these challenges of selling ourtelecommunications products and services to new and existing customers havecontinued and increased. In addition, we have had difficulty in obtaining bidand performance bonds that are required by some customers of our SharedTechnologies business. We have also experienced the loss of talented keyemployees and could experience more losses of key talent in the futureattributable to our reorganization efforts. The continuation of theChapter 11 cases could further adversely affect our operations and ourcurrent and potential

 

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relationships with our customers, employees, suppliers, and otherrepresentatives.

 

**The proposed Plan of Reorganizationwe have filed may not be acceptable to our creditors and other stakeholdersand/or may not be confirmed by the Bankruptcy Court.** On March18, 2004, we filed our initial plan of reorganization and disclosure statementwith the Bankruptcy Court.  Certain creditors filedobjections.  For example, on April 13, 2004, subsidiaries of VerizonCommunications Inc. filed an objection to our motion for an orderapproving our disclosure statement and for authority to begin solicitingacceptances of our proposed plan of reorganization.  As discussed above,on April 22, 2004, the Bankruptcy Court entered an order (a) approvingAllegiance’s Second Amended Disclosure Statement pursuant to Section 1125 ofthe Bankruptcy Code; (b) approving (i) procedures for solicitation of votes toaccept or reject the Plan and the tabulation of such votes on the Plan, and(ii) certain related materials in connection therewith; and (c) scheduling thedate and time on which the Court will hold a hearing to consider confirmationof the Plan.  Ballots have beendistributed to those classes entitled to vote on the Plan.  Althoughwe believe that the proposed Plan will satisfy all requirements necessary forconfirmation by the Bankruptcy Court, there can be no assurance that theBankruptcy Court will reach the same conclusion and that the creditors willvote to approve it.  Verizon has recently filed a “TradeCreditors’ First Set of Interrogatories and Requests for Production ofDocuments to the Official Committee of Unsecured Creditors.” Verizon is seeking information on, among other things, (1) certainclaims of our bondholders that they are entitled to equal andratable liens against all of our assets and (2) the proposed compromise andsettlement with the bond indenture trustee relating to these claimsand other claims described in the Plan.  There can be no assurancethat modifications to the Plan will not be required for confirmation or thatsuch modifications would not necessitate the resolicitation of votes. Inthe event any impaired class of claims does not accept our proposed Plan, theBankruptcy Court may nevertheless confirm the Plan at our request if at leastone impaired class has accepted the Plan (such acceptance being determinedwithout including the vote of any “insider” in such class), and, as to eachimpaired class that has not accepted our Plan, if the Bankruptcy Courtdetermines that the Plan “does not discriminate unfairly” and is “fair andequitable” with respect to the dissenting Impaired classes. We believe that ourproposed Plan of Reorganization satisfies these requirements. However, if ourproposed Plan is not confirmed and/or an alternative reorganization cannot beagreed upon, it is possible that the company or XO may elect to have the saleof assets proceed under Section 363 of Chapter 11 of the Bankruptcy Code.If the proposed Plan of Reorganization we have filed with the Bankruptcy Courtis not ultimately approved and we do not elect to undertake an alternativereorganization, the amount of consideration available to our creditors may besubstantially reduced and we do not in any event expect any consideration to beavailable to our equity and common stock holders.

 

**The proposed Plan of Reorganizationsubstantially reduces the value of our bonds**. We operate ourbusiness through subsidiaries and have no material assets at our holdingcompany, Allegiance Telecom, Inc., other than the common stock of our mainoperating company, Allegiance Telecom Company Worldwide. Our holding company isthe issuer of our common stock and our high-yield bonds. These securities arenot guaranteed by any of our operating subsidiaries and therefore have noclaims against the assets of those operating subsidiaries. As such, all of theassets of those operating subsidiaries are subject to the claims of our seniorsecured creditors and our unsecured creditors at our subsidiary operatingcompanies. Moreover, the only material asset of our holding company, the commonstock of our main operating company, Allegiance Telecom Company Worldwide, ispledged as collateral to our senior secured creditors. The rights and claims ofvarious creditors and security holders will be determined by a plan ofreorganization that is confirmed by the Bankruptcy Court. Under the priorityrules established by the Bankruptcy Code, certain post-petition liabilities andpre-petition liabilities (i.e., our senior secured debt) of a debtor need to besatisfied before unsecured creditors or stockholders are entitled to anydistribution.

 

Under our proposed Plan,the administrative claimants and priority claims holders with claims againstthe company and any of its subsidiaries along with the senior secured debtholders will receive cash equal to the entire amount of their allowedclaim.  The unsecured creditors of Allegiance Telecom, Inc. and all of itssubsidiaries shall be given an option to receive: (1) either a cash recovery ortrust interests reflecting an ownership in the XO common stock delivered aspart of the sale transaction, and (2) either a cash recovery or trust interestsreflecting an ownership in the stock of the Shared Technologies business.  Those unsecured creditors that elect toreceive cash in lieu of either or both of these trust interests will receivecash in an amount equal to 50% of the aggregate value of the applicable trustinterests.   Additionally, all unsecuredcreditors of Allegiance Telecom, Inc. and all of its subsidiaries will receivetrust interests reflecting an ownership in the other assets of the company thatare not being acquired by XO. It is important to note that under the proposed Plan, those unsecuredcreditors that elect to receive trust interests reflecting an ownership ineither the XO Common Stock or the Shared Technologies common stock will notimmediately receive shares of XO common stock or shares of Shared Technologies.The timing and manner of distributing of the assets of the liquidating trust,including the XO common stock and the common stock of the reorganized SharedTechnologies, have not been determined but it is possible that the liquidatingtrust will retain these assets for some time and perhaps sell the XO or SharedTechnologies common stock in one or more transactions and distribute theproceeds under the terms of the Plan. The nature and transferability of theownership interests our creditors will receive in such liquidating trust havealso not yet been defined. If the amount of claims of unsecured creditorsmaking the cash election exceeds the amount of cash available, the unsecuredcreditors of Allegiance Telecom Company Worldwide will receive cash in fullbefore the unsecured creditors of Allegiance Telecom, Inc. receive anycash, and, if there is insufficient cash to satisfy all of the unsecuredcreditors of Allegiance Telecom Company Worldwide making a cash election, suchcreditors making the election will receive a pro-rata share of the cash. Ifthere is insufficient cash to pay all unsecured creditors of AllegianceTelecom, Inc. making a cash election after satisfying in full allunsecured creditors of Allegiance Telecom Company Worldwide making the cashelection, the Allegiance Telecom, Inc. unsecured creditors making the cashelection will receive a pro-rata share of the remaining cash. In general, cashelections in each class of creditors will be satisfied first to those electingcash in lieu of trust interests in the reorganized Shared Technologies and thento those electing cash in lieu of the trust interests in XO common stock.

 

**Underthe XO Asset Purchase Agreement, we have undertaken the responsibility forpaying certain cures associated with contracts with incumbent local exchangecarriers that are being assumed by our reorganized operating subsidiaries**.In addition, we have some additional liability for paying for cures underagreements being assumed by our reorganized Shared Technologies business andfor those other contracts being assumed and assigned to XO. We believe that theamounts that we will be obligated to pay to cure financial defaults underassumed agreements will not exceed the amount of cash remaining after wesatisfy amounts owed under the senior secured loans. However, there can be noassurance that the cure amounts

 

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will not exceed our projections and could leave us with insufficientcash to pay the senior secured lenders in full. In such event, any shortfall indistributions would reduce any amounts distributed to our bondholders and othercreditors.

 

In light of theforegoing, we consider the value of our bonds to be highly speculative.Accordingly, we urge that extreme caution be exercised with respect to existingand future investments in any of such securities and claims.

 

**Our proposed Plan of Reorganizationprovides that the common stock holders receive no distributions under the Planand as a result our common stock will have no value**. Underour proposed Plan of Reorganization, our common stock holders will receive novalue as part of the reorganization. In light of the foregoing, we consider ourcommon stock to be worthless.

 

**Theoutcome of certain disputes with XO under the XO Asset Purchase Agreement couldresult in a decrease in amounts distributed to our creditors.**  XO and we are currently in dispute on anumber of provisions contained in the XO Asset Purchase Agreement.  Wedisagree on, among other things, (1) the extent of liabilities to be assumed byXO and (2) XO’s obligations to pay certain amounts of severance.  Wecurrently estimate the amount in dispute to be at least $20 million. The outcome of these disputes could result in a decrease in amounts distributedto our creditors.

 

**The success of the liquidating trustand the ultimate distribution of the proceeds of the sale of our assets and thestock of a reorganized Shared Technologies depend on key personnel that thetrust may not be able to retain**. The success of theliquidating trust, the wind-down of our company and the distributions, if any,under our proposed Plan of Reorganization depends on a large part on ourability to retain key existing Allegiance employees to the liquidating trust.There can be no assurance that we will be able to retain the services of theexisting key Allegiance employees to the liquidity trust or replace theirservices if they leave. The loss of the services of one or more key individualsto the liquidity trust could materially and adversely affect the timeliness andultimate distributions, if any, under our proposed Plan of Reorganization.

 

***Risks Factors Associated With the Sale toXO Communications, Inc. Not Closing***

 

**If the sale to XO Communications doesnot close, we may not be able to continue to operate**. OnFebruary 18, 2004, the company entered into an Asset Purchase Agreementwith XO, and the Bankruptcy Court approved the XO Asset Purchase Agreement onFebruary 20, 2004. Under the XO Asset Purchase Agreement, XO will purchasethe stock of the operating subsidiaries of the company as well as substantiallyall of the other assets of our company, except our Shared Technologies customerpremises equipment sales and maintenance business, our shared hosting business,our dedicated dial-up access services business operated under an agreement withLevel 3, and certain other assets. The transaction is structured so that oncecertain governmental approvals are received, XO is obligated to place intoescrow the consideration for the purchase and XO will be able to operate theassets it is acquiring under an operating agreement subject to Allegiance’sconsent and in accordance with applicable law, regulations, and tariffs. Thesegovernmental approvals were obtained by April 5, 2004. XO has placed intoescrow the consideration for the purchase of our company and began operatingthe acquired assets of our company pursuant to the operating agreement. As aresult, XO has now assumed the risk of loss of the assets it is acquiring andXO’s conditions to close the sale are limited. Closing is conditioned upon thesatisfaction (or waiver) of the conditions to the “Effective Date” set forth inour plan of reorganization (e.g., the confirmation order becoming a finalorder). The XO Asset Purchase Agreement provides that either party mayterminate the XO Asset Purchase Agreement after closing into escrow but beforefinal closing, if, among other things, the other party breaches the XO AssetPurchase Agreement. Final closing will occur under the XO Asset PurchaseAgreement when our plan of reorganization is confirmed and becomes effective,unless either party elects to proceed without a plan of reorganization. OnApril 22, 2004, we filed our Second Amended Disclosure Statement and SecondAmended Joint Plan of Reorganization with the Bankruptcy Court. We believe thatthere is little likelihood that the sale transaction will not close. However,events may occur in our bankruptcy, in XO’s financial condition or otherwisethat may interfere with or prevent a closing and therefore there is a risk thatthe sale to XO will not close and we can make no assurance that the sale to XOwill ultimately close.

 

We have incurredoperating and net losses every year since we began operations. We have investedsignificant amounts of capital and other expenditures in developing ourbusiness and deploying our networks, systems and services and we will continueto invest capital for the operation of our business. We will continue to havesignificant operating and net losses in our business until we establish asufficient revenue-generating customer base to cover our costs. For the quarterended March 31, 2004, we had an operating loss of $32.0 million andnet losses including reorganization items of $59.9 million.

 

We have experiencedsignificant churn in our sales force over the year and we may not be able toreplace departing sales persons if the XO sale does not close. We relysignificantly on our retail sales force for revenue growth and churn reduction.We have experienced significant churn in our sales force as a result of thebankruptcy process and the announced sale to Qwest and then XO.  In addition, as part of the operatingagreement, we have lost a significant number of sales and other employees sinceclosing in the escrow.  If the XO saledoes not close and we are unable to attract and retain satisfactory sales andother personnel, we may not be able to continue to maintain current revenueamounts and that could have a material adverse effect on the business.

 

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Our largest customer in2003 was Level 3, who is the assignee of Genuity Solutions Inc.’s interestin the Genuity/Allegiance Integrated Network Solution Purchase Agreement.Revenues from this contract were $27.7 million and $30.0 million forthe quarters ended March 31, 2004 and 2003, respectively. This represented15% of our total revenues for those quarters, and 41% and 41% of our datarevenues for the quarters ended March 31, 2004 and 2003, respectively. In addition,a majority of the reciprocal compensation earned by us from other carriers is aresult of the other carriers terminating the Level 3 traffic on our networks.Reciprocal compensation revenues for the quarters ended March 31, 2004 and2003 were $0.8 million and $8.5 million, respectively. The companyand Level 3 have entered into a Settlement Agreement under which Level 3 willcease to be our largest customer and we will have substantially reduced servicerevenues. In addition, the company will have reduced reciprocal compensationrevenue. The resulting reduction in revenue (including reduction in reciprocalcompensation revenues) will have a material adverse effect on us.

 

If the sale to XOCommunications were not to close, we do not believe we could implementsufficient cost-cutting measures to offset such decrease in revenues resultingfrom the loss of the revenues under the Level 3 contract and we may not be ableto replace the revenues in a short period of time. As a result, the company maynot be able to continue to operate and may be forced into liquidation. In aliquidation, the common stock would remain worthless and holders of our bondsmay receive considerably less than they would receive under the proposed Planof Reorganization which is less than the face amount of such bonds. Potentiallythe holders of our bonds could receive little or no value. Even if we are ableto emerge from bankruptcy, if XO does not complete the acquisition, we can makeno assurances that we will achieve or sustain profitability or generatesufficient operating income to meet our working capital, capital expenditureand debt service requirements. Accordingly, we urge that extreme caution beexercised with respect to existing and future investments in any of our securitiesor claims.

 

***Risk Factors Relating to XOCommunications, Inc. (“XO”)***

 

**An investment in our securitiesinvolves all of the risks associated with an investment in XO common stockbecause such stock will be issued to us as part of the consideration under theXO Asset Purchase Agreement and after a final closing under such agreement,ultimately will be distributed to our creditors in accordance with our proposedPlan of Reorganization. We are generally not in a position to know all of thoserisks associated with an investment in XO or to know any of them accurately.Investors in our securities are urged to review the SEC filings made by XO, andin particular the risk factors set forth in the XO Annual Report onForm 10-K filed with respect to the year ended December 31, 2003, andthe XO Quarterly Report on Form 10-Q filed with respect to the quarter endingMarch 31, 2004. We make no representation as to the accuracy or completeness,however, as to any such filings or such risk factors.**

 

***Risk Factors Relating to Operations***

 

**One of our primary invoice processingvendors has a “going concern” qualification and any financial difficultiesexperienced by it could have an adverse impact on the revenues we are sellingto XO**. We have an invoice processing agreement (the “BillingAgreement”) with Daleen Solutions, Inc. (“Daleen”). Daleen is one of ourprimary invoice processing vendors for billing of customers and we believe thatthe amounts paid by us under the Billing Agreement represent a substantialportion of Daleen’s revenues. The original term of the Billing Agreementexpired on December 31, 2003 and automatically renews for additionalone-year terms, unless either party gives the other party notice of its intentto not renew this agreement at least sixty days prior to the expiration of thenexisting term. On October 30, 2003, Daleen notified us that it waselecting to not renew the Billing Agreement, but that it would like to discussthe terms of a new contract. On October 31, 2003, Daleen filed a Motion ForRelief From the Automatic Stay Under Section 362 of the Bankruptcy Code(“Motion”) seeking relief from the automatic stay so that it could send usnotice of its intent to elect to not renew the Billing Agreement. OnNovember 19, 2003, the Bankruptcy Court denied Daleen’s Motion. As aresult of the Court’s decision, the Billing Agreement renewed onDecember 31, 2003 for an additional one-year term on the same terms andconditions as the existing Billing Agreement.

 

On January 30, 2003and again on February 2, 2004, Daleen Technologies, Inc.’s auditors,KPMG LLP, issued an Independent Auditors’ Report on DaleenTechnologies, Inc. that contained a “going concern” qualification. Daleenis a wholly owned subsidiary of Daleen Technologies, Inc. (“DaleenTechnologies”). On May 21, 2003, Daleen Technologies filed a Form 8-Kwith the Securities and Exchange Commission warning that if we fail to continuebusiness with Daleen Technologies and Daleen Technologies fails to obtainadditional financing or fails to engage in one or more strategic alternatives,it may have a material adverse effect on Daleen Technologies’ ability tooperate as a going concern. In addition, on October 31, 2003, DaleenTechnologies filed a Form 8-K with the Securities and Exchange Commission warningthat if we

 

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cease to do business with Daleen Technologies and Daleen Technologiesfails to obtain additional financing or fails to engage in one or morestrategic alternatives, it may have a material adverse effect on DaleenTechnologies’ ability to operate as a going concern.

 

While we are currentlymigrating our customers off of the Daleen service, there can be no assurancethat Daleen will remain in business through the migration of our customers offthe Daleen service or provide the services required under the BillingAgreement. If Daleen Technologies ceases to remain in business or fails toprovide the services under the Billing Agreement through the migration period,it may have a material adverse effect on our company and the business we areselling to XO.

 

**The financial results generated bythe business we are selling XO could be adversely affected by churn and thefinancial difficulties of our customers**. Our ability toretain customers and control churn (including line churn) is dependent on anumber of factors, including, but not limited to, (a) our ability toprovide quality service, customer care and accurate and timely billing,(b) our ability to offer competitive pricing and overcome so called “win-back”programs offered by our competitors, (c) our ability to timely meet theneeds and demands of our customers, (d) our ability to properlyincentivize our sales force to build strong customer relationships,(e) the economic viability of our customers (see the discussion in thefollowing paragraph), (f) the strength and recovery of the United Stateseconomy, and (g) our ability to limit service disruptions as XO integratesour assets and operations with the XO assets and operations and optimizesnetworks and new billing platforms. We can make no assurances that our churnrates (including line churn) will not increase. If our churn rates (includingline churn) increase or are higher than expected, this could have a materialadverse effect on XO’s business and prospects as XO will inherit these riskswhen they acquire substantially all of our assets and operations.

 

The business beingacquired by XO from us provides services to small and medium-sized businesses.Many of these businesses have experienced substantial financial difficulties inrecent months, in some cases leading to bankruptcies and liquidations. Thefinancial difficulties of these companies could have a material adverse effecton XO’s financial results if it is unable to collect revenues from thesecustomers or if such customers reject the customer’s contract with XO in itsbankruptcy or fail to renew their contracts with XO. In addition, among otherthings, companies in financial difficulty may be less likely to expand theiroperations and related demand for communications services and to migrate fromdial-up Internet connections to more advanced dedicated connections such asthose that XO offers.

 

**Significant competition in providinglong distance and Internet services could reduce the demand for andprofitability of the business we are selling XO.** Significantcompetition exists in the market for long distance and Internet services. Manyof the competitors in these markets have greater financial, technological,marketing, personnel and other resources than those available to us.

 

The long distancetelecommunications market has numerous entities competing for the samecustomers and a high average turnover rate, as customers frequently change longdistance providers in response to the offering of lower rates or promotionalincentives. Prices in the long distance market have declined significantly inrecent years and are expected to continue to decline. We have traditionallyfaced competition from large carriers such as AT&T, MCI (formerly WorldCom)and Sprint, wireless carriers and many smaller long distance carriers. Othercompetitors include regional Bell operating companies providing long distanceservices outside of their local service area and, with the removal ofregulatory barriers, long distance services within such local service areas,other competitive local carriers, microwave and satellite carriers and privatenetworks owned by large end users. The FCC has granted approval to BellSouth,Verizon, SBC, and Qwest to provide in-region long distance service in everystate and the District of Columbia where they provide local exchange services.The business we are selling XO may also increasingly face competition fromcompanies offering local and long distance data and voice services over the Internet.Such companies could enjoy a significant cost advantage because they do notcurrently pay many of the charges or fees that we have to pay.

 

The Internet servicesmarket is highly competitive and there are limited barriers to entry. We expectthat competition will continue to intensify. Significant competitors in thismarket include but are not limited to, Internet service providers, incumbentlocal carriers, other telecommunications companies, electric utilities, onlineservice providers, cable companies, and Internet software providers.

 

**Labor difficulties at our majorsuppliers, including the ILECs, could have an adverse effect on our operations**.Many of our suppliers, including the ILECs, have employees covered bycollective bargaining agreements. For example, news reports indicate that SBCCommunications Inc. and Communications Workers of America (CWA), whorepresents a significant number of SBC Communications, have not reachedagreement on a new contract. The CWA recently announced that 90 percent of theunionized employees at SBC have voted to authorize a strike. If SBC, or any ofour suppliers, experience a work slowdown, stoppage, or strike, it may impactour ability to install new customers and service

 

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existing customers. If we are unable to install new customers orservice existing customers, it could have an adverse effect on our operationsand our financial results.

 

***Risk Factors Relating to Regulation***

 

**Attempts to limit the basic competitiveframework of the Telecommunications Act of 1996 could interfere with thesuccessful implementation of XO’s business plan**. Successfulimplementation of our and XO’s business plan is predicated on the assumptionthat the basic framework for competition in the local exchange services marketestablished by the Telecom Act will remain in place. We expect that there willbe attempts to limit or eliminate this basic framework through a combination offederal legislation, new rulemakings by the FCC and challenges to existing andproposed regulations by the Regional Bell Operating Companies. It is notpossible to predict the nature of any such action or its impact on our or XO’sbusiness and operations.

 

**We may not be able to continue toconnect our network to the incumbent local exchange carrier’s network ormaintain Internet peering arrangements on favorable terms, which would impairthe growth and performance**. We are required to be a party tointerconnection agreements with the incumbent local exchange carrier andcertain independent local exchange carriers or ILECs in order to connect ourcustomers to the public telephone network. If we are unable to renegotiate ormaintain interconnection agreements in all of our markets on favorable terms,it could adversely affect our ability to provide services in the affectedmarkets.

 

Peering agreements withInternet service providers allow us to access the Internet and exchange transitwith these providers. Depending on the relative size of the carriers involved,these exchanges may be made without settlement charge. Recently, many Internetservice providers that had previously offered peering have reduced oreliminated peering relationships or are establishing new, more restrictivecriteria for peering and an increasing number of these service providers areseeking to impose charges for transit. Increases in costs associated withInternet and exchange transit could have a material adverse effect on ourmargins for our products that require Internet access. We may not be able torenegotiate or maintain peering arrangements on favorable terms, which couldimpair our growth and performance.

 

The company hasexperienced difficulties also with receiving payment from the incumbent localexchange carriers on reciprocal compensation, access charges, and otherservices provided by the company to them. These balances in some instances maybe significant and material. The company has generally been able to reachmutually acceptable settlements of these amounts in the past, but there can beno assurance that we will be able to do so in the future. If we do not receivepayments from the incumbent local exchange carriers with respect to theseservices provided by us to them and/or if we are unable to reach settlementagreements for the incumbent local exchange companies to pay amounts owed tous, it could have a material adverse effect on us.

 

**The regulation of facilities that weand XO can purchase from the incumbent local carriers involves uncertainties,and the resolution of these uncertainties could adversely affect XO’s business**.Although the incumbent local carriers are required under the TelecommunicationsAct of 1996 to unbundle and make available certain elements of their networkand permit XO and us to purchase only the origination and termination servicesthat we need, thereby decreasing XO’s and our capital and operating expenses,such unbundling may not be done as quickly as we require, may be priced higherthan we expect, and/or the incumbent local exchange carriers may erect barriersto use such elements. This is important because our business being acquired byXO relies on the facilities of these other carriers to provide services to ourcustomers. Our ability to obtain these agreements on favorable terms, and thetime and expense involved in negotiating them, can be adversely affected bylegal and regulatory developments.

 

The United States SupremeCourt vacated a FCC rule determining which network elements the incumbent localcarriers must provide to competitors on an unbundled basis. On November 5,1999, the FCC released an order revising its unbundled network element rules toconform to the Supreme Court’s interpretation of the law, and reaffirmed theavailability of the UNEs, including local loops and dedicated transport, theprincipal elements used by us. We use unbundled local loops and unbundled highcapacity digital loops to connect customer locations to voice and datatransmission equipment colocated in the incumbent local carriers’ centraloffices, and dedicated transport to connect transmission equipment to itsswitches and data equipment which are generally located at its central offices.The FCC also stated its intention to review every three years the unbundlingobligations of incumbent local exchange carriers. The U.S. Court of Appeals forthe District of Columbia Circuit remanded (except for line-sharing), but didnot vacate, the FCC’s Order on May 24, 2002. The FCC’s request forrehearing of that decision was denied, but the Court agreed to delay untilFebruary 20, 2003 the issuance of the mandate. On February 20, 2003,the FCC announced its decision in the triennial review as briefly discussedbelow. While these court and FCC proceedings were pending, the company enteredinto interconnection agreements with a number of incumbent local carriers

 

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through negotiations or, in some cases, adoption of another competitivelocal carrier’s approved agreement. These agreements remain in effect, althoughin some cases one or both parties may be entitled to demand renegotiation ofparticular provisions or of the entire agreement based on intervening changesin the law. However, it is uncertain whether any of these agreements will be sorenegotiated or whether we or XO will be able to obtain renewal of theseagreements on as favorable terms when they expire. The incumbent local exchangecarriers have in each instance requested renegotiation of the company’sinterconnection agreements, and in certain instances petitioned the stateregulatory commission for arbitration of provisions relating to the triennialreview.

 

Our facilities-basednetwork allows us to control much of our network but we are still dependent oncertain essential network elements that we lease from incumbent carriers. OnDecember 20, 2001, the FCC released a Notice of Proposed Rulemaking aspart of its comprehensive “triennial review” of the unbundling rules itimplemented on November 5, 1999. In this review, the FCC examined thecircumstances under which incumbent local exchange carriers will be required tomake parts of their networks available to carriers like our company on anunbundled basis under Section 251 of the Telecommunications Act of 1996.In particular, the FCC reviewed whether incumbents should be required to offeron an unbundled basis, among other things, local voice grade loops, unbundlednetwork element platforms, high capacity loops such as those we use for many ofour data and integrated voice and data services, subloops, network interface devices,the high-frequency portion of the loop, switching, and interoffice transmissionfacilities. The FCC announced its decision on February 20, 2003 in thetriennial review proceeding and released the written order on August 21,2003. In addition, the FCC has subsequently issued clarifications to the orderthrough errata. General highlights of the triennial review order are asfollows:

 

•                                          In general,the FCC’s triennial review order revised its standard of review for determiningwhen UNEs are made available to competitors. Specifically, the FCC’s revisedstandard recognized the benefits of facilities-based competition and confirmedthat continued provision of UNEs is essential to the growth of facilities-basednetworks such as those operated by competitive carriers.

 

•                                          With respectto unbundled switching, the FCC adopted a process whereby the state publicutilities commission would consider whether competitors are impaired if they donot have access to the incumbent’s switch services on a UNE basis under the regulatoryconstruct known as unbundled network element platform (“UNE-P”). If upheld onappeal, we expect that this state review will result in a review of the hot cutprocess (transferring a customer from the incumbent’s systems to competitivecarrier’s systems) and could potentially enhance their ability to transitionnew customers to their networks.

 

•                                          The decisionalso confirmed that facilities-based competitive carriers like us can continueto obtain access to loops in almost all markets. The FCC also clarified theconditions under which the Bell companies must make available unbundled loopsfor competitors. On transport issues, the FCC adopted a standard proposed by uswhereby transport will be taken off the UNE list on a route-specific basis whenthere are two competitive wholesale providers of transport or threeself-provisioned transport links by non-ILEC sources.

 

•                                          The FCCdecision also makes it easier for competitive carriers like us to obtainEnhanced Extended Links (“EELs”). These are combinations of loops and transportthat connect back to the competitive carrier’s switch. Although we do notcurrently use EELs on an extensive basis, this aspect of the triennial revieworder may give us an opportunity to efficiently expand our facilities-based networkto additional areas not directly accessed by our current colocation footprintand to potentially reduce the number of colocations we have, thereby reducingnetwork costs.

 

•                                          The FCCexempted hybrid fiber/copper loops that provide packetized data transmissionfrom the UNE rules. The FCC preserved access to high-capacity loops, such asDS1’s, DS3’s, dark fiber and copper subloops that transmit services usingexisting TDM (time division multiplexing) technology. Since virtually all ofthe company’s current business customers are served using unbundled copperloops or DS1’s that use TDM technology, the FCC’s exemption of hybridfiber/copper loops that provide packet-based technology should not impact ourcompany’s operations being acquired by XO. In the future, as new packet-basedtechnologies are deployed in the local loop infrastructure, this ruling by theFCC, if upheld on appeal, could cause an adverse impact on XO’s ability tocompete with the ILECs for small to medium-sized business customers.

 

•                                          The FCC alsoexempted from unbundling any end-to-end fiber loop that is defined asfiber-to-the-home (“FTTH”) for new greenfield developments. After the releaseof the triennial review order, the FCC issued an errata that expanded the FTTHdefinition beyond residential dwellings to include end-to-end fiber loops that

 

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also extend allthe way to a premise that would include small businesses that we might serve.

 

•                                          The FCCclarified two aspects of the pricing for UNEs: the cost of capital anddepreciation. With respect to the cost of capital, the FCC found that theappropriate cost of capital was the risk associated with participating in acompetitive market with facilities-based competition. The FCC also clarifiedthat the cost of capital used by the states in setting UNE rates should includeany unique risks associated with new services and that the cost of capital mayvary by UNE. With respect to depreciation, the FCC clarified that it would beappropriate for states to employ accelerated depreciation to reflectanticipated declines in asset values in a competitive market. These changescould result in material increases in the price we pay for certain UNEs.

 

In addition to thepotential impact on our business from the hybrid/fiber loop and the FTTHsections of the triennial review, the ILECs have recently filed petitions forreconsideration at the FCC seeking greater relief from certain additionalaspects of the FCC’s decision. These petitions seek to expand the FTTHnew-build greenfield exemption to apply also to fiber-to-the-curb deploymentsas well. We and other competitive carriers are opposing these petitions at theFCC, and a decision could be forthcoming in the next few months. If the FCCshould grant one or more of these ILEC requests, it could materially reduce thenumber of small businesses that we can serve and would have a material adverseeffect on our business.

 

The incumbent localexchange carriers appealed in the D.C. Circuit Court of Appeals the sections ofthe triennial review order relating to the whether competitive carriers wereimpaired without access to mass market switching, high capacity loops, andinteroffice transport and the FCC’s decision to delegate to the stateregulatory commissions the authority to establish the market definition for theimpairment analysis and whether competitive carriers were impaired withoutaccess to these elements. In addition, the incumbent local exchange carriersappealed the methodology for finding no impairment for these elements. We andother competitive carriers appealed the broadband sections of the triennialreview order based on our view that the FCC’s exemption of hybrid/fiber loopsis unlawful and in violation of the Telecommunications Act of 1996. We andother competitive carriers sought a stay of this aspect of the triennial revieworder. The D.C. Circuit subsequently consolidated all stay motions and appealsof the triennial review order and issued its decision on March 3, 2004.Under this decision, the Court found that the FCC’s nationwide determinationthat competitive carriers were impaired without access to mass marketswitching, high capacity loops, and interoffice transport was improper. Inaddition, the Court found that the FCC had improperly delegated authority tothe state regulatory commissions to make the determination of market definitionand impairment. Further, the Court upheld the broadband section of thetriennial review order implementing unbundling limitations for hybrid fiber/copperloops and FTTH section of the triennial review order. If these determinationsregarding access to high capacity loops interoffice transport, EEL and the FTTHsection are not ultimately overturned, it could prevent us and XO from beingable to provide services to small businesses in new greenfield developments.

 

In addition, the D.C.Circuit Court of Appeals set a deadline for its rules becoming effective of thelater of 60 days following the March 3, 2004 release of order or thedate that the D.C. Circuit Court of Appeals refuses a request for rehearing ofthe decision. A majority of the FCC Commissioners has expressed an intent toappeal the decision to the U.S. Supreme Court and seek a stay of the D.C.Circuit Court of Appeals’ order. It is unclear whether the U.S. Department ofJustice will support the majority of the FCC Commissioners’ efforts to appealthe order or if the U.S. Supreme Court will grant a stay or agree to hear anappeal if one is sought. On March 31, 2004, all five of the FCC Commissionerssigned a letter urging the telecommunications industry to engage in a seriouseffort to reach mutually acceptable terms for offering unbundled networkelements. The FCC has also petitioned the D.C. Circuit for a 45-day extensionof the Court’s mandate to allow the parties to negotiate a mutually acceptablesolution and an extension of deadline for filing an appeal of the D.C.Circuit’s decision to the U.S. Supreme Court. We have responded to the FCCCommissioner’s letter with a letter committing to participate in thenegotiations and to support the FCC’s request for the 45-day extension. OnApril 13, 2004, the DC Circuit extended the stay of the mandate through June15, 2004. The failure of the D.C. Circuit Court of Appeals’ order to be furtherstayed or a failure to reach an agreement with the ILECs could createsignificant uncertainty in the FCC’s unbundling rules for a significant periodof time and could have a material adverse impact on XO’s and our ability toserve existing customers and add new customers.

 

**Any action by the FCC, stateregulators or the courts limiting the availability of UNEs, especiallyunbundled local loops, network interface devices or interoffice transmissionfacilities, could increase our costs and otherwise have a material adverseimpact on the business we are selling to XO.** OnFebruary 15, 2002, the FCC released a Notice of Proposed Rulemakingrequesting comment on the future regulatory treatment of wireline broadbandInternet access services. The FCC has tentatively concluded that when an entityprovides wireline broadband Internet access over its own transmissionfacilities, the service should be classified as an information service, ratherthan a telecommunications service. If the FCC adopts this conclusion, wirelinebroadband Internet access services provided by local exchange carriers would besubject to substantially less regulation, and this could result in theincumbent carriers not having to provide unbundled loops or

 

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unbundled high capacity digital loops over the lines used by us toprovide broadband Internet access. The business being acquired by XO from ourcompany purchases unbundled high capacity digital loops from incumbent carriersto provide its own broadband Internet access service and integrated accessservice. Any curtailment of the incumbent carriers’ unbundling obligations forthe loop component used by them to provide broadband Internet access servicesor changes in the cost basis therefore could materially increase the costsassociated with our services and adversely affect ours and XO’s ability tocompete effectively with the incumbent carriers’ broadband Internet accessproducts. Our current understanding is that the FCC will issue this rulemakingin the near future.

 

In early May 2003, theIllinois legislature passed and the governor signed legislation that sought tosignificantly increase rates for unbundled local loops that SBC charges tocompetitors including us and XO in Illinois. A lawsuit was filed seeking tooverturn the Illinois law in federal district court and seeking a stay of theeffectiveness of the law. The district court overturned the law and stayed theeffectiveness of the rate increase. The seventh circuit court of appeals upheldthe lower district court decision but admonished the Illinois CommerceCommission to conclude its TELRIC proceeding addressing the costs of UNEsquickly. If SBC is able to convince the Commission to increase UNE loop ratesto the level that SBC sought through this legislation, we and XO may have tosignificantly reduce or abandon our efforts to add new lines or customers incertain calling areas of Illinois and evaluate the viability of continuing tooperate in the Chicago market. A decision by the Illinois Commerce Commissionis expected in 2Q of 2004. 

 

There are alsoTELRIC proceedings in other states in which we and XO operate that have thepotential to increase the price of UNE facilities purchased by our company andmay have retroactive effect. For example, the Public Utilities Commission ofOhio recently adopted interim wholesale rates increasing the price of two wireUNE analog loops to up to $3 dollars depending on location.  On May 3, 2004, a proposed order was issued by a California PublicUtilities Commission (“Commission”) Administrative Law Judge (“ALJ Decision”)in a proceeding reexamining SBC’s California wholesale UNE rates.Contemporaneously with the issuance of the ALJ Decision, an alternativedecision was issued by Commissioner Wood (“Alternative Decision”). WholesaleUNE rates promulgated in this proceeding are intended to replace,retroactively, interim wholesale UNE rates. Under the ALJ Decision somewholesale UNE rates will decrease while others will increase. If the Commissionadopts the ALJ Decision as proposed, the average monthly rates for DS0s couldincrease approximately $3 per DS0 loops depending on location and this couldsignificantly increase our costs to serve our California customers because ofAllegiance’s significant use of UNE DS0 loops. In addition, if the Commissionadopts the ALJ Decision as proposed, we believe that it might also result in asignificant one-time charge for the true-up of costs for DS0-loops providedunder the interim rates. If the Commission were to adopt the AlternativeDecision as proposed, we believe that the financial impact could be even moresubstantial.  The full Commission mustapprove permanent wholesale UNE rates before they are effective.  The Commission may adopt the ALJ Decision,the Alternative Decision, or issue an entirely different decision. A decisionby the full Commission is expected sometime 3Q 2004. Action in these andother states to raise wholesale rates could have a material adverse impact onour business being sold to XO.

 

The FCC has also issued aNotice of Proposed Rulemaking to undertake a comprehensive review of pricesthat the ILEC’s charge competitors, such as us, for UNEs we use to serve ourcustomers and to potentially revise the procedures and rules for calculatingsuch prices. The FCC concluded that it would continue to base UNE prices on theforward-looking costs of providing such services. The FCC, however, tentativelyconcluded that its UNE pricing rules should more closely account for the realworld attributes of routing and topography of the ILEC networks in developmentof forward-looking costs. This process could result in an increase (possiblymaterial) in the prices that we pay the ILECs for UNEs.

 

**The regulation of voice over Internetprotocol (VoIP) may have an adverse effect on the business we are selling to XO**.Several carriers have filed petitions with the FCC regarding whether serviceproviders using voice over Internet protocol (VoIP) are obligated to pay accesscharges for traffic they originate and/or terminate. The FCC recently issued aDeclaratory Ruling that certain VoIP services were information services andthus exempt from access charges and another decision that certain VoIP servicesare subject to switched access charges. In addition, the FCC issued a Notice ofProposed Rulemaking to examine the proper regulatory classification for VoIPservices and whether access charges are appropriate for these services. Ifservice providers using VolP are able to avoid access charges and stateregulation, it may have a material adverse impact on the revenues of thebusiness we are selling to XO.   Inaddition, if any of the company’s customers are using the company’s services toprovide VoIP services, we may be subject to switched access charges which couldbe material.

 

**The regulation of access chargesinvolves uncertainties, and the resolution of these uncertainties couldadversely affect our business.** The business we are selling toXO earns “access charge” revenue by connecting voice service customers to theirselected toll and long distance carriers for outbound calls or by deliveringinbound toll and long distance traffic to our voice service customers. Thecompany’s interstate access charges were filed largely mirroring those used bythe National Exchange Carrier Association (“NECA”), an association ofindependent local exchange carriers, and the company’s state access chargeswere generally set at rates comparable to those set by state associationssimilar to NECA or of individual incumbent carriers operating in other areaswithin the same state. These charges are generally higher than those charged bythe larger incumbent local exchange carriers operating in the same areasbecause these large incumbent local exchange carriers have many more customersand therefore have lower per unit costs. Access charges are intended tocompensate the local exchange carrier for the costs incurred in originating andterminating toll and long distance calls on its network and we believe ourcompany’s access charges are appropriately set at levels approximately the sameas those of the smaller carriers, but we anticipate that these rates willdecline over time. XO may have to adjust our switched access rates to complywith future decisions of the FCC or state commissions and these adjustmentscould have a material adverse effect on

 

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the business we are selling to XO. We have entered into a limitednumber of agreements with other carriers regarding access rates that settledcertain access charge disputes. We have already rejected one of these accessagreements and re-negotiated another. XO under the XO Asset Purchase Agreementhas the right to determine whether the remaining agreements will be rejected orassumed. XO has not completed the process of evaluating the remainingagreements to determine whether to reject or assume these agreements in ourChapter 11 cases. There can be no assurance that we will be able to rejectthose remaining access agreements; if we are able to reject such agreements, webelieve the other carriers may be obligated to pay XO for access at our highertariffed rates for those calls originating and terminating on the assets beingacquired by XO.

 

On April 27, 2001,the FCC issued a Report and Order in the Access Charge Reform docket addressingcompetitive local exchange carrier interstate access charge rates. The FCCestablished safe harbor benchmark interstate rates that decrease over threeyears to the rates charged by incumbent local exchange carriers. The FCC statedthat interexchange carriers must pay the benchmark rates for the interstateaccess services they receive or face suit in federal court. AT&T hasappealed the FCC’s Report and Order to the U.S. Court of Appeals for theDistrict of Columbia Circuit. On April 27, 2001, the FCC also released aNotice of Proposed Rulemaking pursuant to which it is examining all forms ofintercarrier compensation including access charges, and seeks comment on thefeasibility of adopting a bill-and-keep approach for all such compensation.Federally mandated reductions in access charges or adoption of a bill-and-keepapproach could have a material adverse effect on our business if we are unableto offset them with other revenues.

 

On May 31, 2002,WorldCom Network Services, Inc. filed an informal complaint against us atthe FCC claiming that it is entitled to a refund of a portion of the interstateswitched access charges paid by WorldCom to us prior to the effective date ofthe safe harbor benchmark rates that it alleges were unjust and unreasonable.We have since settled this matter, along with other disputes that each partyhad against the other. The settlement was effective April 15, 2003 and wasapproved by the Bankruptcy Court in the WorldCom Chapter 11 proceeding onMay 28, 2003. XO is evaluating whether to assume or reject this agreementin our Chapter 11 cases.

 

On May 31, 2000, theFCC approved a proposal made by a coalition of the largest incumbent localcarriers, AT&T and Sprint, to restructure interstate access charges.Pursuant to the proposal, certain incumbent carriers, designated as “price cap”incumbent local carriers, are required to reduce their interstate access ratesto targeted levels approved by the FCC or submit cost studies to justifydifferent rates. The implementation of the FCC’s decision may lead to anindustry-wide reduction in interstate access rates, even by those carriers thatare not bound by the decision, including smaller carriers. Reduction ininterstate access rates may have a material adverse effect on our businessunless we are able to offset the access revenues with other revenues.

 

Several states in whichwe are offering intrastate access services through the assets being acquiredfrom the company, including Colorado, Maryland, Massachusetts, Missouri, NewJersey, New York, Texas, Virginia and Washington, have proposed or requiredthat access charges of competitive local carriers be capped at the ratescharged by incumbent local carriers operating in the same area as thecompetitive local carriers with respect to calls originating or terminating insuch area, except where the competitive carrier can establish that its costsjustify a higher access rate through a formal cost proceeding. Other states mayenact similar requirements. It may also be more likely that many states willuse the same approach for intrastate long distance as the FCC ultimatelydecides to use for interstate long distance. If these proposals are adopted,they could have a material adverse effect on our business and XO’s revenues.

 

**We could lose revenues if calls toInternet service providers are treated as long distance interstate calls**.We have traditionally earned “reciprocal compensation” revenue by terminatingon our network, local calls that originate on another carrier’s network. Webelieve that under the Telecommunications Act of 1996, other local exchangecarriers should have to compensate local carriers when their customers placecalls to their customers who are Internet service providers. Most incumbentlocal carriers disagree. A majority of our reciprocal compensation revenuesresult from calls to our customers that are Internet service providers, such asLevel 3. Regulatory decisions providing that other carriers do not have tocompensate us for these calls could limit our and XO’s ability to service thisgroup of customers profitably and could have a material adverse effect on thebusiness we are selling to XO. Given the uncertainty as to whether reciprocalcompensation should be payable in connection with calls to Internet serviceproviders, we have recognized such revenue only when realization of it isprobable. In addition, the per minute compensation rates the FCC establishedfor calls to Internet service providers under new interconnection agreementsare significantly lower than the reciprocal compensation rates under ourprevious agreements. On December 24, 2003, the Minnesota Public UtilitiesCommission affirmed its approval of a rate of zero cents for the end-officeswitching component of terminating local calls subject to reciprocalcompensation, except for calls to Internet service providers.

 

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While this ruling does not apply to Internet bound calls, thesereductions in compensation will, nonetheless, have a material adverse effect onus if we are unable to offset them with other revenues.

 

The obligation to payreciprocal compensation does not extend to long distance interstate calls. TheFCC in its Declaratory Ruling of February 26, 1999, determined that Internetservice provider traffic is interstate for jurisdictional purposes, but alsodetermined that its current rules neither required nor prohibited the paymentof reciprocal compensation for such calls. In the absence of a federal rule,the FCC determined that state commissions had authority to interpret andenforce the reciprocal compensation provisions of existing interconnectionagreements and to determine the appropriate treatment of Internet serviceprovider traffic in arbitrating new agreements. The Court of Appeals for theDistrict of Columbia Circuit issued a decision on March 24, 2000, vacatingthe Declaratory Ruling. The court held that the FCC had not adequatelyexplained its conclusion that calls to Internet service providers should not betreated as “local” traffic. On April 27, 2001, the FCC issued its Order onremand from the Court of Appeals and concluded that it had erred in itsanalysis of Internet traffic in the Declaratory Ruling. In its new Order, theFCC categorized such traffic as “information access” and held that it is notsubject to reciprocal compensation obligations. Nonetheless, it established aninterim, transitional recovery mechanism pursuant to which Internet serviceprovider traffic will continue to be compensated, but at rates declining over aperiod of three years. In a decision issued May 3, 2002, the U.S. Court ofAppeals for the District of Columbia Circuit remanded for further proceedings,but did not vacate, the FCC’s Order on remand, holding that the section of theAct on which the FCC relied did not support its conclusion that Internetservice provider traffic is not subject to reciprocal compensation. In a Noticeof Proposed Rulemaking released April 27, 2001, the FCC initiated arulemaking to examine all forms of intercarrier compensation, includingreciprocal compensation, and sought comment on the feasibility of adopting abill-and-keep approach for such compensation. Federally mandated reductions inreciprocal compensation will have a material adverse effect on the business weare selling XO if we or XO are unable to offset them with other revenues.Additional disputes over the appropriate treatment of Internet service providertraffic are expected.

 

***Risk Factors Related to the Acquisition ofSubstantially All of the company’s Assets by XO***

 

**XO may not successfully consummatethe acquisition of substantially all of our company’s assets**.XO’s acquisition of substantially all of the assets of our company has beenapproved by the U.S. Bankruptcy Court and certain governmental agencies. XO’sobligation to close is mainly conditioned upon the satisfaction (or waiver) ofthe conditions to the “Effective Date” set forth in our plan of reorganization(e.g., the confirmation order becoming a final order) and we believe that thereis little likelihood that the sale transaction will not close. However, eventsmay occur in our bankruptcy, in XO’s financial condition or otherwise that mayinterfere with or prevent a closing and therefore there is a risk that the saleto XO will not close and we can make no assurance that the sale to XO willultimately close. In such event, XO will not be able to realize theimprovements in XO’s network infrastructure and resulting competitiveadvantages associated with XO’s ownership of our company’s assets.

 

**The acquisition of the company by XOmay be difficult to integrate, disrupt XO’s business, dilute XO’s stockholdersand divert management attention**. Acquisitions involve risksand present issues, including, among others:

 

•                                          keyAllegiance employees may not be retained by or may not join XO;

 

•                                          thedifficulty of integrating the acquired operations of our company, includingprovisioning, billing and customer service systems;

 

•                                          the diversionof personnel from other business concerns and potential disruption of XO’songoing business;

 

•                                          expectationsof financial results not being met;

 

•                                          unanticipatedcosts associated with the acquisition of the assets of our company;

 

•                                          thedifficulty in combining the service offerings of the assets of our company withXO’s existing service offerings;

 

•                                          the inabilityof XO management to maintain uniform standards, controls, procedures andpolicies;

 

•                                          theimpairment of relationships with employees or customers of our company as aresult of changes in management or otherwise arising out of such transactions;

 

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•                                          use ofsignificant amount of XO’s available cash to purchase the assets of ourcompany; and

 

•                                          dilution ofcurrent XO stockholders due to issuances of additional securities asconsideration for acquisitions.

 

We can make no assurancethat XO will be able to successfully integrate acquired businesses oroperations of our company that it is acquiring. In addition, XO may not achievethe anticipated benefits from the acquisition of our company. If XO fails toachieve the anticipated benefits from the acquisition of our company, it mayincur increased expenses and experience a shortfall in its anticipated revenuesand XO may not obtain a satisfactory return on its investment.

 

**XO may not realize the network andselling, operating, and administrative synergies that XO estimates inconnection with the acquisition of substantially all of our company’s assets**.While our company has been told that XO is confident that XO has correctlyestimated the potential network and selling, operating, and administrativesynergies that XO can realize in connection with the acquisition of ourcompany’s assets, it is possible that XO’s estimates could prove to beincorrect. For example, XO may discover during the process of integrating ourassets into XO’s network and business infrastructures that some of the acquiredassets require greater maintenance or earlier replacement than originallyanticipated, or that it may take longer to integrate the assets. In addition,unanticipated growth in XO’s business as a result of the acquisition of ourcompany’s assets may require that some facilities or support functions that XOcurrently anticipates will be combined or reduced may be necessary to retainfor XO to maintain XO’s operations. The synergies that XO anticipates it willrealize are also dependent on XO’s ability to combine our company’s assets withXO’s own network infrastructure in a manner that permits XO to realize thosesynergies. If XO has not estimated the potential synergies correctly, or if XOis not able to integrate our company’s assets into XO’s network infrastructureeffectively, XO may not realize the amounts of synergies in connection with theacquisition of our company’s assets that they anticipated, or such synergiesmay take longer to realize.

 

**We believe that many of our keyAllegiance employees will not be joining XO at the final closing, and the lossof these key employees may adversely affect XO’s ability to successfullyintegrate our business**. Our success has depended in largepart on our ability to attract, develop, motivate and retain a number of keyemployees, most notably Royce J. Holland, our Chairman and Chief ExecutiveOfficer, who is widely recognized as one of the pioneers in managing providersof competitive local exchange services. We believe many of these key employees,including, but not limited to, Mr. Holland, and our Chief OperatingOfficer, Chief Financial Officer, General Counsel of Allegiance Telecom, Inc.,Chief Technology Officer, Chief Information Officer, General Counsel ofAllegiance Telecom Company Worldwide, Senior Vice President of Finance andAccounting, Senior Vice President, Sales, Senior Vice President NetworkPlanning, Engineering and Operations, Senior Vice President, Wholesale Salesand Alternate Channels and other key senior executives, will not be joining XOat the final closing. The loss of services of these key employees maymaterially and adversely affect XO’s ability to successfully integrate andoperate our business.

 

***Risk Factors Related to XO’s Common Stock***

 

**An entity owned and controlled byMr. Carl C. Icahn is XO’s majority stockholder**. Anentity owned and controlled by Mr. Carl C. Icahn, Chairman of XO’s boardof directors, has filed a Schedule 13D with the Securities and ExchangeCommission indicating that it owns over 60% of XO’s outstanding common stock asof January 31, 2004. As a result of this majority ownership position,Mr. Icahn can elect all of XO’s directors, appoint the members of thecommittees of XO’s Board of Directors, appoint key members of XO’s executivemanagement team, and appoint XO’s auditors. Currently, Mr. Icahn isChairman of the Board of Directors of XO and three employees of IcahnAssociates sit on XO’s Board of Directors as well as various Committees of XO’sBoard of Directors. Under applicable law and XO’s certificate of incorporationand by-laws, certain actions cannot be taken without the approval of holders ofa majority of XO’s voting stock including, without limitation, mergers and thesale of substantially all of XO’s assets and amendments to XO’s certificate ofincorporation and by-laws. XO anticipates that Mr. Icahn will continue tocontrol a majority of XO’s outstanding capital stock following the issuance ofXO Communications, Inc. shares in connection with XO’s acquisition ofAllegiance assets and consequently will continue to have these governancerights.

 

**Future sales of XO’s common stockcould adversely affect its price and/or XO’s ability to raise capital.**Futuresales of substantial amounts of XO common stock, or the perception that suchsales could occur, could adversely affect the prevailing market price of suchcommon stock and XO’s ability to raise capital. As of May 3, 2004, there were 136,553,035 shares of XO common stockoutstanding. The shares of XO common stock owned by an entity owned andcontrolled by Mr. Icahn, are restricted shares that may be sold only undera registration statement or an exemption from federal securities registrationrequirements. Mr. Icahn, through various entities that he owns orcontrols, has the right to require XO to register, under the Securities Act of1933, shares of XO common stock held by such entities and to include shares ofXO common stock held by them in certain registration statements filed by XO,pursuant to a Registration Rights Agreement approved by 

 

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the Bankruptcy Court in connection with XO’s Chapter 11proceedings.

 

Pursuant to XO’s plan ofreorganization, XO issued three series of warrants to purchase up to anaggregate of approximately 9.5 million, 7.1 million and7.1 million additional shares of common stock, at exercise prices of$6.25, $7.50 and $10.00 per share, respectively. The warrants will expire onJanuary 16, 2010.

 

XO has optionsoutstanding to purchase approximately 9.5 million shares of common stockoutstanding under XO’s 2002 Stock Incentive Plan as of February 20, 2004.Unless surrendered or cancelled earlier under the terms of the stock incentiveplan, those options will expire beginning in 2013. In addition, XO’s stockincentive plan authorizes future grants of options to purchase common stock, orawards of restricted common stock, with respect to an additional 6.3 millionshares of common stock in the aggregate.

 

**The common stock of XO will besubject to substantial overhang as a result of the common stock being paid toour company in consideration of the sale of substantially all of the assets ofour company to XO**. XO has placed into our escrowapproximately 45.38 million common shares of XO common stock in partialconsideration for substantially all of the assets of our company. Our company’sproposed Plan of Reorganization will create a liquidating trust, which willissue trust interests evidencing beneficial ownership of such XO common stock.After the final closing, at some point in the future, the liquidating trustwill either sell shares of the XO common stock it holds or distribute suchcommon stock to the holders of the trust interests. The sale or distribution ofthe approximately 45.38 million shares of XO common stock may not occurfor some period. During such time that the XO common stock has not been sold ordistributed, the price for the common stock of XO may be depressed and or maybe subject to fluctuations due to the overhang of these shares. The shares ofXO common stock under the terms of the XO Asset Purchase Agreement are to beeither exempt from registration under the Securities Act of 1933 or registeredthereunder by XO. XO has taken the position that it is not required to providesuch registration if the use of the liquidating trust makes an exemption fromregistration unavailable. We and our unsecured creditors disagree with thisposition. There can be no assurance that we will prevail in obtaining anexemption from registration or in obtaining registration by XO of the XO commonstock. In light of the foregoing, we consider the value of our bonds and anyclaims in our company to be highly speculative. Accordingly, we urge thatextreme caution be exercised with respect to existing and future investments inany such securities.

 

**The float and liquidity of XO commonstock may have an adverse effect on the XO common stock**. XOcommon stock is quoted on the over the counter bulletin board system and hasaverage daily trading volume of 492,772 shares over the three-month periodended on April 5, 2004. Under our proposed Plan of Reorganization, the XOcommon stock paid in consideration by XO for our company’s assets will be heldin a liquidating trust to be distributed to our creditors pursuant to our Planof Reorganization. The timing and manner of distributing such XO common stockhave not been determined but it is possible that the liquidating trust will retainthis common stock for some time and perhaps sell it in one or moretransactions, distributing the proceeds under the terms of our plan ofreorganization. The nature and transferability of the ownership interests ourcreditors will receive in such liquidating trust have also not yet beendefined. Until our plan of reorganization has been finalized and approved, wecan provide no assurance regarding the timing or nature of the ultimatedistribution, if any, of the XO common stock or other assets held by theliquidating trust or the proceeds therefrom.

 

In addition, while suchXO common stock is held by the liquidating trust, the value of such XO commonstock may fluctuate without the ultimate beneficiaries of such XO common stockunder the proposed Plan being able to sell their the XO common stock that maybe distributed to them. In addition, the relatively low daily trading volumesof XO common stock may adversely affect the value that may be received for anysuch XO common stock distributed by the liquidating trust under the proposedPlan.

 

**An entity owned or controlled byMr. Carl C. Icahn is the majority holder of XO’s secured debt**.As of December 31, 2003, Mr. Icahn holds over 90% of the debt in XO’ssecured credit facility of $339.2 million. Under the secured creditfacility, XO has no current debt service requirements since cash interestpayments as well as automatic and permanent quarterly reductions of theprincipal amount outstanding under XO’s Credit Facility do not commence until2009. However, in the event that consolidated excess Cash Flow (as defined inXO’s Credit Facility) for any fiscal quarter during the term of the agreementis greater than $25 million, at the request of the lender, XO will pay anamount equal to 50% of such excess cash flow greater than $25 milliontoward the reduction of outstanding indebtedness. In addition, if the ratio ofXO’s consolidated earnings before interest, taxes depreciation and amortizationfor the four consecutive quarters exceeds 4:1, XO would also be required to paycash interest, unless waived by the lenders. Mr. Icahn’s control over thesecured debt may cause XO to take certain actions that may not be in the bestinterest of XO’s common stock holders and that would have an adverse effect on

 

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the consideration being paid to our company as a result of the sale toXO.

 

***General Business, Financial and Other RiskFactors Associated with our Shared Technologies Business***

 

**The stockof Shared Technologies will initially be held by ATLT**. Under the proposed Plan of Reorganization, the stock of SharedTechnologies (a) will be held by one shareholder, the Allegiance TelecomLiquidating Trust and (b) is an illiquid security because it will not be tradedin the public markets.  As such, weconsider the value of any securities based on the Shared Technologies stock tobe highly speculative.

 

**Technological changes and new productofferings may adversely affect Shared Technologies sales**. Themarket for communications products and services are characterized bytechnological change and frequent new product introductions. Accordingly, webelieve that the future success of our Shared Technologies business will dependon our ability to identify and incorporate in a timely manner new products andenhancements to existing products and services that gain market acceptance.There can be no assurance that the products and services that we offer will notbecome technologically obsolete, or that it will be able to identify, market orsupport new products successfully, that such new products will gain marketacceptance or that it will be able to respond effectively to technologicalchange. Our ability to keep pace with technological changes or offer productswith market acceptance may adversely affect Shared Technologies’ sales revenuesand profitability.

 

**The success of our SharedTechnologies business depends on key personnel and it may not be able to retainand/or replace key employees**. Our success depends in largepart on our ability to attract, develop, motivate and retain highly skilled andeducated professionals possessing technical expertise and business generationskills. Qualified consultants, telecommunications systems installers and othertechnical resources are in great demand and are likely to remain a limitedresource for the foreseeable future. There can be no assurance that we will beable to attract and retain sufficient numbers of qualified personnel in thefuture. The loss of services of one or more of key individuals could materiallyand adversely affect our business and prospects. Most of our key employees donot have employment agreements. The loss of a significant number ofconsultants, selling professionals and systems installers could have a materialadverse effect on the Shared Technologies business.

 

**The success of Shared Technologiesdepends on retaining good relations with its employees**. OurShared Technologies business has collective bargaining agreements coveringcertain of its employees. We believe that our relationship with these employeesis good. However, any disruption in the relations with the employees covered bythese collective bargaining agreements could have an adverse effect on ourShared Technologies business.

 

**We are dependent on effectivebilling, customer service and information systems and we may have difficultiesin developing, maintaining and enhancing these systems**.Sophisticated back office information and processing systems are vital to ourShared Technologies business’ growth and its ability to control and monitorcosts, bill and service customers, initiate, implement and track customerorders and achieve operating efficiencies. Over the next year, we will need toupgrade and integrate our billing and information systems. We believe that a newbilling system will enhance our ability to accurately and efficiently bill forour products and services. Although we cannot ensure that the transition to anew billing system will not have any adverse impact on our business, we believea new billing system will be more effective and accurate in delivering thequality billing functions that Shared Technologies needs. If we are unable todevelop, acquire and integrate our operations and financial systems, SharedTechnologies customers could experience billing issues and/or lower levels ofclient service. We also cannot ensure that any of Shared Technologies’ systemswill be successfully implemented on a timely basis or at all, that migratingwill be transparent to its users or that its systems will perform as expected.The failure to successfully implement these systems would have a materialadverse effect on the Shared Technologies business and prospects.

 

**Shared Technologies is dependent onmany vendors and suppliers and their financial difficulties may adverselyaffect our business**. Shared Technologies depends on manyvendors and suppliers to conduct its business. For example, Shared Technologiespurchases its customer premises equipment and repair parts from equipmentmanufacturers and other suppliers. Many of these third parties have experiencedsubstantial financial difficulties in recent months, in some cases leading tobankruptcies and liquidations. The financial difficulties of these companiescould have a material adverse effect on Shared Technologies’ business andprospects.

 

**Shared Technologies’ financialresults could be adversely affected by the termination of its maintenanceservice contracts and the financial difficulties of its customers**.Shared Technologies’ ability to retain its customers is dependent on a numberof factors, including, but not limited to, (a) its ability to providequality service, customer care and

 

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accurate and timely billing, (b) its ability to offer competitivepricing, (c) its ability to timely meet the needs and demands of itscustomers, (d) its ability to properly incentivize its sales force tobuild strong customer relationships, (e) the economic viability of itscustomers, (f) the strength and recovery of the United States economy,(g) its ability to limit service disruptions as Shared Technologiesoptimizes its organization and migrate its existing customers to a new billingplatform and (h) its ability to overcome its customers’ concerns regardingits bankruptcy and emergence as a stand-alone company. A large portion of ourShared Technologies business’ profit is dependant on long-term contracts forthe provision of maintenance services. While many of Shared Technologies’customers have long-term contracts, many of Shared Technologies customers haveprovisions in their agreements that allow them to terminate their existingservices agreements prior to the end of the term. We can make no assurancesthat our Shared Technologies’ customers will not terminate their maintenanceservice contracts. If our customers leave in significant numbers, this couldhave a material adverse effect on the Shared Technologies’ business andprospects.

 

Shared Technologiesprovides services to small, medium and large-sized businesses. Many of thesebusinesses have experienced substantial financial difficulties in recentmonths, in some cases leading to bankruptcies and liquidations. The financialdifficulties of these companies could have a material adverse effect on ourfinancial results if we are unable to collect revenues from these customers orif our customers reject their contract with Shared Technologies in theirbankruptcies. In addition, among other things, we believe companies infinancial difficulty are less likely to expand their operations and relateddemand for customer premises equipment.

 

**Shared Technologies’ may acquire newbusinesses in order to grow which in turn creates certain business risks.**SharedTechnologies may acquire other businesses in order to gain economies of scaleand scope and to contribute to the depth and versatility of its product andservice offerings and the locations from which it can offer them. However,there can be no assurance that Shared Technologies will be able to identifysuitable acquisition candidates or that, if identified, it will be able toacquire such businesses on acceptable terms, or that Shared Technologies willhave the cash or securities to pay for such acquisitions. Moreover, othercompanies are competing for acquisition candidates, which could increase theprice of acquisition targets and decrease the number of attractive businessesavailable for acquisition.

 

Furthermore, there can beno assurance that the anticipated economic, operation and other benefits of anyfuture acquisitions will be achieved or that Shared Technologies will be ableto successfully integrate acquired businesses in a timely manner withoutsubstantial costs, delays or other operational or financial problems. Thedifficulties of such integration may initially be increased by the necessity ofintegrating personnel with disparate business backgrounds and cultures. Inaddition, acquisitions may involve the expenditure of significant funds.Failure to effectively integrate the acquired companies may adversely affectour ability to secure new business or retain its existing customers. Inaddition, there can be no assurance that the acquired companies will operateprofitably. Acquisitions also involve a number of additional risks, includingdiversion of management attention, potential loss of key customers orpersonnel, risks associated with unanticipated problems, liabilities orcontingencies, and risks of entering markets in which Shared Technologies haslimited or no direct expertise. The occurrence of some or all of the eventsdescribed in these risks could have a material adverse effect on our SharedTechnologies business, operating results and financial condition.

 

**Shared Technologies’ success will bedependant on strategic alliances that may not continue.**Shared Technologies has a series of agreements authorizing it to act as adistributor of communications equipment from a variety of manufacturers.Periodically, these distribution agreements expire and new agreements must benegotiated. There can be no assurance that any manufacturer with whom we dobusiness today will elect to continue its relationship in the future withShared Technologies on substantially the same terms and conditions as containedin the parties’ prior agreements. We believe that an interruption, or substantialmodification, of Shared Technologies’ distribution relationship with any of itsmanufacturers could have a material adverse effect on the Shared Technologies’business, operating results and financial condition. In addition, much ofShared Technologies’ success will be derived from market acceptance of eachmanufacturer’s products. These products compete with those offered by severalother communications equipment manufacturers and from new technologies, such asvoice over Internet protocol (VoIP). Reduced market acceptance for the productsour Shared Technologies’ business distributes, as a result of competition orother factors, could adversely affect its business, operating results andfinancial condition.

 

**The Shared Technologies’ business inabilityto successfully compete in its market place may cause sales and profits todecline**. The communications industry is intensely competitiveand rapidly changing. The primary competitors to our Shared Technologies’business today include Nextira One, Norstan, and the Regional Bell OperatingCompanies. Many of these competitors have longer operating histories, greaterfinancial and human resources, and greater name recognition than we do.

 

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**Operating results of SharedTechnologies may be difficult to predict and may vary greatly from quarter toquarter**. Variations in Shared Technologies revenues andoperating results occur from quarter to quarter as a result of a number offactors, including equipment sales and installations commenced and completedduring a quarter, the number of business days in a quarter, the size and scopeof assignments and general economic conditions. Because a significant portionof Shared Technologies’ expenses will be relatively fixed, a variation in thenumber of product sales or the timing of the initiation or completion of systeminstallations or consulting projects can cause significant fluctuations inoperating results from quarter to quarter. In light of the foregoing, we considerthe value of our bonds to be highly speculative. Accordingly, we urge thatextreme caution be exercised with respect to existing and future investments inany such securities.

 

**Under certain circumstances, ourShared Technologies business may need additional capital and such capital maynot be available**. Our Shared Technologies business may needadditional capital to fund capital expenditures, working capital, debt serviceand cash flow deficits to operate its business, acquire new business, developnew products and services, expand its service area and services, and to deployits services and systems. Our proposed Plan of Reorganization provides thatShared Technologies may be provided $5 million in working capital prior tobeing made independent. In the event such amount is insufficient, SharedTechnologies may have to borrow or secure alternative resources for suchamounts and in the event that it has to repay amounts borrowed under itsfinancing agreements earlier than expected or if its estimates of capitalrequirements and revenues are inaccurate, it may need to access alternativesources of capital, reduce or delay capital expenditures, sell assets,refinance or restructure its debt and/or modify its business plan, which mayhave a material adverse effect on it. If Shared Technologies cannot obtainalternative financing when needed, this would have a material adverse impact onits business.

 

**Shared Technologies may be subject tocompetition from new products and services that Shared Technologies may not beable to offer**. Shared Technologies may face competition fromentirely new products and services delivered by non-traditional competitors,such as voice over Internet protocol (VoIP) providers. At least one incumbentlocal exchange carrier has indicated that it plans to begin deploying suchservices. These services may compete with the Shared Technologies business byallowing customers to purchase bundled services, which include some of thefeatures offered, by the customer premises equipment sold and maintained byShared Technologies. Our Shared Technologies business may not be able toeffectively develop competing products and services and such failure could havea material adverse affect on our Shared Technologies business.

 

**ITEM 3****.*****Quantitative and QualitativeDisclosures About Market Risk***

 

Our investment policy isrestricted to the guidelines established under Section 345(a) of theBankruptcy Code, which authorizes a debtor-in-possession to deposit or investan estate’s money (including cash) so as to yield the maximum reasonable netreturn on such money, taking into account the safety of such deposit orinvestment. Our excess cash is invested in a mutual fund that invests in highquality investments such as obligations of the United States government or anyagency thereof guaranteed by the United States of America, bankers’acceptances, certificates of deposit and time deposits from banks, repurchaseagreements, commercial instruments, municipal securities and master notes.

 

We are thus exposed to market risk related to changes in short-termU.S. interest rates. We manage these risks by closely monitoring market ratesand the duration of our investments. We do not enter into financial orcommodity investments for speculation or trading purposes and are not a partyto any financial or commodity derivatives.

 

Interest income earned onour investment portfolio is affected by changes in short-term interest rates.We believe that we are not exposed to significant changes in fair value becauseof our conservative investment strategy. However, the estimated interest incomefor 2004, based on the estimated average 2003 earned rate on investments, is$2.2 million. Assuming a 50-basis-point drop in the estimated averagerate, we would be exposed to a $1.2 million reduction in interest incomefor the year. The following table illustrates this impact on a quarterly basis:

 
|                                                                                                       |   | **Quarter  Ending**        |   |
|------------------------------------------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                                                       |   | **March 2004**             |   | **June 2004** |   | **September  2004** |   | **December  2004** |   | **Total** |   |
|                                                                                                       |   | **(dollars  in millions)** |   |
|                                                                                                       |   |                       |   |   |   |   |   |   |   |   |   |
| Estimated average  investments                                                                             |   | $                          | 266.8  |   | $ | 238.3 |   | $ | 229.4 |   | $ | 225.6 |   |   |   |
| Estimated  average interest earned at the average rate of 0.94% for the year ended  December 31, 2003 |   | 0.6                        |   | 0.6 |   | 0.5 |   | 0.5 |   | 2.2 |   |
| Estimated impact  of interest rate drop                                                                    |   | 0.3                        |   | 0.3 |   | 0.3 |   | 0.3 |   | 1.2 |   |
|                                                                                                            |        |                            |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Our outstanding long-term debt consists both of long-term, fixed ratenotes, not subject to interest rate fluctuations, and our senior secured creditfacilities. Borrowings under our senior secured credit facilities incurinterest at a variable rate, based on leverage ratios, and is currently the6-month London Interbank Offered Rate plus 4.50%. Our blended borrowing rate,taking new borrowings into account, is now 5.64% per annum and this interestrate will remain fixed until June 24, 2004. Therefore, we will not beexposed to market risk related to rate fluctuations until the end of the secondquarter of 2004.

 

Beginning inJune 2004, we will be exposed to market risk related to market changes in the6-month London Interbank Offered Rate and other market indexes. Based on ourcurrent level of debt, the impact of a 100-basis-point increase in our averageinterest rate would cause an increase in interest expense during 2004 ofapproximately $1.7 million.

 

**ITEM 4****.*****Controls and Procedures***

 

Our principal executive officer and our principalfinancial officer, after management’s evaluation, with the participation ofsuch officers, have evaluated the effectiveness of our disclosure controls andprocedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) asof the end of the period covered by this report, and have concluded that, basedon such evaluation, that our disclosure controls and procedures were effective.There was no change in our internal control over financial reporting thatoccurred during the fiscal quarter covered by this report that has materiallyaffected, or is reasonably likely to materially affect, our internal controlover financial reporting.

 

Our company’s management,including the CEO and CFO, do not expect that our disclosure controls or ourinternal controls will prevent all error and all fraud. A control system, nomatter how well conceived and operated, can provide only reasonable, notabsolute, assurance that the objectives of the control system are met. Further,the design of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts. Because of the inherent limitations in all control systems, noevaluation of controls can provide absolute assurance that all control issuesand instances of fraud, if any, within our company have been detected. Theseinherent limitations include the realities that judgments in decision-makingcan be faulty, and that breakdowns can occur because of simple error ormistake. Additionally, controls can be circumvented by the individual acts ofsome persons, by collusion of two or more people, or by management override ofthe control. The design of any system of controls also is based in part uponcertain assumptions about the likelihood of future events, and there can be noassurance that any design will succeed in achieving its stated goals under allpotential future conditions; over time, control may become inadequate becauseof changes in conditions, or the degree of compliance with the policies orprocedures may deteriorate. Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected. Based upon the controls evaluation, our CEO and CFO haveconcluded that, subject to the limitations noted above, as of the date of thecontrols evaluation, our disclosure controls and procedures were effective toprovide reasonable assurance that material information relating to us is madeknown to management, including the CEO and CFO, particularly during the periodwhen our periodic reports are being prepared.

 

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**PARTII****. OTHER INFORMATION**

 

**ITEM 1. *LegalProceedings***

 

On May 14, 2003 (the“Commencement Date”), Allegiance Telecom, Inc. and its direct and indirectsubsidiaries filed voluntary petitions for relief under Chapter 11 of theUnited States Bankruptcy Code in the United States Bankruptcy Court for theSouthern District of New York (the “Bankruptcy Court”). The reorganization isbeing jointly administered under the caption “In re AllegianceTelecom, Inc. et al. Case No. 03-13057 (RDD)” (the “Chapter 11cases”). We are currently operating our business as “debtors-in-possession”under the jurisdiction of the Bankruptcy Court and in accordance with theapplicable provisions of the Bankruptcy Code, the Federal Rules of BankruptcyProcedure and applicable court orders. On April 22, 2004, we filed our SecondAmended Disclosure Statement and Second Amended Joint Plan of Reorganization(“Plan”) in our Chapter 11 cases. We expect that the Plan will beconfirmed by the Bankruptcy Court in the second quarter of 2004. However, therecan be no assurance that the plan will be confirmed or that it will not beamended or changed. Please see discussions in “Management’s Discussion andAnalysis of Financial Condition and Results of Operations—BankruptcyProceedings.”

 

On November 13,2003, Oscar Private Equity Investments filed a class action securities lawsuitin the District Court of the Northern District of Texas entitled *OscarPrivate Equity Investments v. Allegiance Telecom, Inc., et al.*,(Index No. 2-03CV-2761H) (the “Complaint”). The original action wasbrought against Royce J. Holland and Thomas M. Lord as officers ofthe company. The Complaint specifically states that the company is not named adefendant although it is styled as an action against the company. The Complaintalleges that, the defendant officers breached their fiduciary duty to theplaintiff class, violated Section 10(b) of the Securities and Exchange Actof 1934, and violated Rule 10b-5 of the Securities and Exchange Commission(“SEC”) promulgated thereunder. The action seeks compensatory damages of anunspecified amount, rescission, and the award of costs and disbursements ofbringing suit. The company’s insurance carriers have been notified of thelawsuit. On February 5, 2004, the defendant officers filed a motion todismiss the complaint. On February 25, 2004, the Plaintiffs filed theirresponse, which sought the Court’s permission to amend their complaint. OnMarch 17, 2004, the Court denied the defendant officers motion as mootbecause the Court found that the plaintiffs could amend their lawsuit once as amatter of right and the Court directed the plaintiffs to file the amendedcomplaint by March 26, 2004. On March 26, 2004, the plaintiffs filedan amended complaint and added two additional officer defendants,C. Daniel Yost and Anthony J. Parella in their capacity as officersof the company. The amended complaint realleges essentially the same causes ofaction previously alleged, seeks the same remedies, but adds additional factualallegations. On April 9, 2004, the defendant officers filed a motion todismiss the amended complaint. Although it is too early for the company toreach a conclusion as to the ultimate outcome of this action, the defendantofficers believe that there are substantial defenses to the claims asserted inthis action, and the defendant officers intend to defend against the actionvigorously.

 

On February 8, 2004,Level 3 commenced an adversary proceeding against the company, whichsought a declaratory judgment that the company was in a continuing materialbreach of the INSPA and as a result Level 3 was entitled to terminate theINSPA agreement. In another motion filed February 4, 2004, Level 3claims that it is entitled to recoup $25 million in credits againstpayments it would otherwise owe the company under the agreement related tocertain alleged performance warranty breaches. On February 27, 2004,Level 3 and the company entered into a settlement agreement that resolvedthis action. On April 6, 2004, the Bankruptcy Court entered into anamended order approving the settlement agreement. On April 19, 2004, thecompany and Level 3 closed the initial transactions contemplated by thesettlement agreement including the payment of $54 million by Level 3 to us.

 

Except with respect tothe above-described proceedings, we are not party to any legal proceeding thatwe believe would, individually or in the aggregate, have a material adverseeffect on our financial condition or results of operations.

 

**ITEM 2.*Changes inSecurities and Use of Proceeds***

 

Not applicable.

 

**ITEM 3.*Defaults UponSenior Securities***

 

On April 30, 2003,we publicly announced that we were in default under the terms of our seniorcredit agreement. We were in default under the senior credit agreement becausewe failed to, among other things (1) comply with the total leveragecovenant, which prohibited us from having more than $645 million in debtas of April 30, 2003, (2) comply with the free cash flow covenant,which required us to have no more than negative $19 million of free cashflow, (3) comply with the leverage,

 

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interest coverage and debt service ratios, (4) deliver anunqualified audit opinion for the period ended December 31, 2002 and(5) enter into a permanent amendment to our senior credit agreement. On April 29,2003, we received a forbearance from our lenders until May 15, 2003. OnMay 1, 2003, we filed a Form 8-K describing and attaching this pressrelease and forbearance agreement. As a result of our bankruptcy filing, thereis an event of default under our senior credit agreement as well as our twoindentures.

 

**ITEM 4.*Submissionof Matters to a Vote of Security Holders***

 

We did not submit anymatter to a vote of our stockholders during the quarter ended March 31,2004.

 

**ITEM 5. *OtherInformatio**n***

 

None.

 

**ITEM 6.*Exhibitsand Reports on Form 8-K***

 

(a)                                  Thefollowing exhibits are filed with this report and made a part hereof.

 
| **Exhibit   Number** |   | **Description**                                                                                           |
|----------------------|--------|-----------------------------------------------------------------------------------------------------------|
| 11.1                 |   | Statement Regarding  Computation of Per Share Earnings (Loss) for the three months ended March 31,  2004. |
| 11.2                 |   | Statement Regarding  Computation of Per Share Earnings (Loss) for the three months ended March 31,  2003. |
| 31.1                 |   | Section 302  Certification                                                                                |
| 31.2                 |   | Section 302  Certification                                                                                |
| 32.1                 |   | Section 906  Certification                                                                                |
| 32.2                 |   | Section 906  Certification                                                                                |

 

(b)                                 Reportson Form 8-K.

 

Allegiance Telecom, Inc. filed a current report on Form 8-Kon February 2, 2004 announcing that Allegiance Telecom, Inc. and allof its subsidiaries filed their monthly operating statement for the month ofDecember 2003 with the U.S. Bankruptcy Court for the Southern District ofNew York.

 

AllegianceTelecom, Inc. filed a current report on Form 8-K on March 1,2004 announcing that Allegiance Telecom, Inc. and all of its subsidiariesfiled their monthly operating statement for the month of January 2004 withthe U.S. Bankruptcy Court for the Southern District of New York.

 

AllegianceTelecom, Inc. filed a current report on Form 8-K on March 31,2004 announcing that Allegiance Telecom, Inc. and all of its subsidiariesfiled their monthly operating statement for the month of February 2004with the U.S. Bankruptcy Court for the Southern District of New York.

 

AllegianceTelecom, Inc. filed a current report on Form 8-K on April 20, 2004discussing its results of operations and financial condition for the fiscalyear and fourth quarter ended December 31, 2003.

 

AllegianceTelecom, Inc. filed a current report on Form 8-K on April 21, 2004announcing the sale of certain assets to XO Communications, Inc. and aSettlement Agreement and sale of certain assets to Level 3 Communications, LLC.

 

AllegianceTelecom, Inc. filed a current report on Form 8-K on May 3, 2004announcing that Allegiance Telecom, Inc. and all of its subsidiaries filedtheir monthly operating statement for the month of March 2004 with theU.S. Bankruptcy Court for the Southern District of New York.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 

 
|                      | ALLEGIANCE TELECOM,  INC. |
|---------------------------|---------------------------|
|                      |                      |
|                      | BY:                       | /s/ ROYCE J.  HOLLAND |
|                      |                      | Royce J.  Holland, |
|                      |                      | *Chairman of the Board and* |
|                      |                      | *Chief Executive Officer* |
|                      |                      |   |
|                      | BY:                       | /s/ THOMAS M.  LORD |
|                      |                      | Thomas M. Lord, |
|                      |                      | *Executive Vice President of  Corporate* |
|                      |                      | *Development and Chief Financial  Officer* |
| Dated: May 17,  2004 |                      |   |

 

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**INDEX TO EXHIBIT****S**

** **
| **Exhibit   Number** |   | **Description**                                                                                           |
|----------------------|--------|-----------------------------------------------------------------------------------------------------------|
| 11.1                 |   | Statement Regarding  Computation of Per Share Earnings (Loss) for the three months ended March 31,  2004. |
| 11.2                 |   | Statement Regarding  Computation of Per Share Earnings (Loss) for the three months ended March 31,  2003. |
| 31.1                 |   | Section 302  Certification                                                                                |
| 31.2                 |   | Section 302  Certification                                                                                |
| 32.1                 |   | Section 906 Certification                                                                                 |
| 32.2                 |   | Section 906  Certification                                                                                |

 

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