**UNITED STATESSECURITIES 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  September 30, 2003.**                                                                                                                                                                     |
|                                                                                                                                                                                                                        |
| **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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**Allegiance Telecom, 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 check markwhether the registrant (1) has filed all reports required to be filed bySection 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 check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act). Yes oNo ý

 

As of November 19, 2003,the registrant has 124,742,246 shares of common stock, par value $0.01 pershare 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 September 30, 2003 and December 31, 2002                             |   |
|                              | Condensed  Consolidated Statements of Operations for the three and nine months ended  September 30, 2003 and 2002 |   |
|                              | Condensed  Consolidated Statements of Cash Flows for the nine months ended September 30,  2003 and 2002           |   |
|                              | 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**

**ALLEGIANCE TELECOM, INC. ANDSUBSIDIARIES**

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

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

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

 
|                                                                                                                                                                                                                   |   | **September  30,  2003** |      | **December  31,  2002** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|-----------|-------------------------|--------|
|                                                                                                                                                                                                                   |   | **(Unaudited)**          |      |                    |   |
|                                                                                                                                                                                                                   |   |                     |      |                    |   |
| **ASSETS**                                                                                                                                                                                                             |   |                     |      |                    |   |
| Current assets:                                                                                                                                                                                                        |   |                     |      |                    |   |
| Cash and cash  equivalents                                                                                                                                                                                             |   | $                        | 284,062   |                    | $      | 253,311 |   |
| Short-term  investments                                                                                                                                                                                                |   | 501                      |      | 30,955                  |   |
| Restricted  short-term investments                                                                                                                                                                                     |   | 1,822                    |      | —                  |   |
| Accounts  receivable, net                                                                                                                                                                                              |   | 117,730                  |      | 153,196                 |   |
| Prepaid expenses  and other current assets                                                                                                                                                                             |   | 25,139                   |      | 18,916                  |   |
| Total current  assets                                                                                                                                                                                                  |   | 429,254                  |      | 456,378                 |   |
| Property and  equipment, net                                                                                                                                                                                           |   | 745,822                  |      | 924,106                 |   |
| Deferred debt  issuance costs, net                                                                                                                                                                                     |   | 14,194                   |      | 15,879                  |   |
| Long-term  investments, restricted                                                                                                                                                                                     |   | 6,905                    |      | 881                     |   |
| Other assets, net                                                                                                                                                                                                      |   | 29,608                   |      | 43,974                  |   |
| Total assets                                                                                                                                                                                                           |   | $                        | 1,225,783 |                    | $      | 1,441,218 |   |
|                                                                                                                                                                                                                   |   |                     |      |                    |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY (DEFICIT)**                                                                                                                                                               |   |                     |      |                    |   |
| Current  liabilities not subject to compromise:                                                                                                                                                                        |   |                     |      |                    |   |
| Accounts payable                                                                                                                                                                                                       |   | $                        | 37,895    |                    | $      | 59,282 |   |
| Accrued  liabilities and other current liabilities                                                                                                                                                                     |   | 81,324                   |      | 124,444                 |   |
| Current portion  of long-term debt                                                                                                                                                                                     |   | —                   |      | 561,532                 |   |
| Total current  liabilities not subject to compromise                                                                                                                                                                   |   | 119,219                  |      | 745,258                 |   |
| Liabilities  subject to compromise (see Note 2)                                                                                                                                                                        |   | 1,336,142                |      | —                  |   |
| Long-term  liabilities not subject to compromise:                                                                                                                                                                      |   |                     |      |                    |   |
| Long-term debt                                                                                                                                                                                                         |   | —                   |      | 639,691                 |   |
| Other long-term  liabilities                                                                                                                                                                                           |   | 6                        |      | 12,545                  |   |
| Total long-term  liabilities not subject to compromise                                                                                                                                                                 |   | 6                        |      | 652,236                 |   |
| Commitments and  contingencies (see Note 11)                                                                                                                                                                           |   |                     |      |                    |   |
| Stockholders’  equity (deficit):                                                                                                                                                                                  |   |                     |      |                    |   |
| Preferred stock,  $.01 par value, 1,000,000 shares authorized, no shares issued or outstanding  at September 30, 2003 and December 31, 2002                                                                            |   | —                   |      | —                  |   |
| Common stock,  $.01 par value, 750,000,000 shares authorized, 125,264,444 and 125,157,605  shares issued and 124,742,246 and 124,830,110 shares outstanding at September  30, 2003 and December 31, 2002, respectively |   | 1,252                    |      | 1,251                   |   |
| Additional  paid-in capital                                                                                                                                                                                            |   | 1,808,382                |      | 1,808,690               |   |
| Common stock in  treasury, at cost, 522,198 and 327,495 shares at September 30, 2003 and  December 31, 2002, respectively                                                                                              |   | (45                      | )         | (45                     | )      |
| Common stock  warrants                                                                                                                                                                                                 |   | 1,857                    |      | 1,857                   |   |
| Deferred  compensation                                                                                                                                                                                                 |   | (2,569                   | )         | (5,149                  | )      |
| Accumulated  deficit                                                                                                                                                                                                   |   | (2,038,461               | )         | (1,762,880              | )      |
| Total  stockholders’ equity (deficit)                                                                                                                                                                             |   | (229,584                 | )         | 43,724                  |   |
| Total  liabilities and stockholders’ equity (deficit)                                                                                                                                                             |   | $                        | 1,225,783 |                    | $      | 1,441,218 |   |

 

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

 

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**ALLEGIANCETELECOM, INC. AND SUBSIDIARIES**

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

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

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

**(Unaudited)**

 
|                                                              |   | **Three  Months Ended  September 30,** |    | **Nine  Months Ended  September 30,** |   |
|-------------------------------------------------------------------|--------|----------------------------------------|---------|---------------------------------------|--------|
|                                                              |   | **2003**                               |    | **2002**                              |   | **2003** |   | **2002** |   |
|                                                              |   |                                   |    |                                  |   |   |   |   |   |
| Revenues                                                          |   | $                                      | 188,186 |                                  | $      | 219,539 |   | $ | 589,414 |   | $ | 566,071 |   |
| Operating  expenses:                                              |   |                                   |    |                                  |   |   |   |   |   |
| Network                                                           |   | 96,753                                 |    | 118,297                               |   | 313,195 |   | 295,698 |   |
| Selling, general  and administrative                              |   | 86,047                                 |    | 114,247                               |   | 301,184 |   | 326,280 |   |
| Depreciation and  amortization                                    |   | 65,504                                 |    | 72,139                                |   | 197,429 |   | 211,658 |   |
| Non-cash  deferred compensation                                   |   | 631                                    |    | 1,510                                 |   | 2,240 |   | 2,042 |   |
| Goodwill  impairment charge                                       |   | —                                 |    | —                                |   | 2,105 |   | 110,823 |   |
| Total operating  expenses                                         |   | 248,935                                |    | 306,193                               |   | 816,153 |   | 946,501 |   |
| Loss from  operations                                             |   | (60,749                                | )       | (86,654                               | )      | (226,739 | ) | (380,430 | ) |
| Other income  (expense):                                          |   |                                   |    |                                  |   |   |   |   |   |
| Interest income                                                   |   | 834                                    |    | 1,564                                 |   | 2,666 |   | 5,375 |   |
| Interest expense                                                  |   | (8,988                                 | )       | (28,020                               | )      | (58,642 | ) | (77,460 | ) |
| Other income  (expense) (see Note 12)                             |   | 2,610                                  |    | —                                |   | 5,887 |   | — |   |
| Total other  income (expense)                                     |   | (5,544                                 | )       | (26,456                               | )      | (50,089 | ) | (72,085 | ) |
| Loss from  operations before reorganization items                 |   | (66,293                                | )       | (113,110                              | )      | (276,828 | ) | (452,515 | ) |
| Reorganization  items (see Note 13)                               |   | 3,193                                  |    | —                                |   | 1,247 |   | — |   |
| Net loss                                                          |   | $                                      | (63,100 | )                                     | $      | (113,110 | ) | $ | (275,581 | ) | $ | (452,515 | ) |
| Net loss per  share, basic and diluted                            |   | $                                      | (0.52   | )                                     | $      | (0.97 | ) | $ | (2.28 | ) | $ | (3.89 | ) |
| Weighted average  number of shares outstanding, basic and diluted |   | 120,802,701                            |    | 117,197,411                           |   | 120,684,247 |   | 116,436,186 |   |

 

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 OFCASH FLOWS**

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

**(Unaudited)**

** **
|                                                                                        |   | **Nine  Months Ended September 30,** |     |
|---------------------------------------------------------------------------------------------|--------|-------------------------------------------|----------|
|                                                                                        |   | **2003**                                  |     | **2002** |   |
| Cash flows from  operating activities:                                                      |   |                                      |     |   |   |
| Net loss                                                                                    |   | $                                         | (275,581 | ) | $ | (452,515 | ) |
| Adjustments to  reconcile net loss to cash provided by (used in) operating activities— |   |                                      |     |   |   |
| Reorganization  expense, net                                                                |   | (1,247                                    | )        | — |   |
| Depreciation and  amortization                                                              |   | 197,429                                   |     | 211,658 |   |
| Provision for  uncollectible accounts receivable                                            |   | 27,731                                    |     | 48,535 |   |
| Gain on sale of  investment                                                                 |   | (3,277                                    | )        | — |   |
| Accretion of  investments                                                                   |   | (1                                        | )        | (219 | ) |
| Accretion of  Series B and 12 7¤8%  notes                                              |   | 6,659                                     |     | 35,902 |   |
| Amortization of  deferred debt issuance costs                                               |   | 1,685                                     |     | 2,395 |   |
| Amortization of  deferred compensation                                                      |   | 2,240                                     |     | 2,042 |   |
| Goodwill  impairment charge                                                                 |   | 2,105                                     |     | 110,823 |   |
| Changes in assets  and liabilities —                                                   |   |                                      |     |   |   |
| Decrease  (increase) in accounts receivable                                                 |   | 8,261                                     |     | (64,725 | ) |
| Decrease  (increase) in prepaid expenses and other current assets                           |   | (8,836                                    | )        | 10,863 |   |
| Decrease  (increase) in other assets                                                        |   | 5,804                                     |     | (4,940 | ) |
| Decrease in  accounts payable                                                               |   | (25,654                                   | )        | (17,177 | ) |
| Increase  (decrease) in accrued liabilities and other current liabilities                   |   | (60,573                                   | )        | 40,079 |   |
| Net cash used in  operating activities before reorganizations items                         |   | (123,255                                  | )        | (77,279 | ) |
| Reorganization  items:                                                                      |   |                                      |     |   |   |
| Reorganization expense,  net                                                                |   | 1,247                                     |     | — |   |
| Net  restructuring gain                                                                     |   | (10,795                                   | )        | — |   |
| Reclassification  of debt subject to compromise                                             |   | (1,199,261                                | )        |   |   |
| Increase in  post-petition restructuring accruals                                           |   | 4,930                                     |     | — |   |
| Increase in  liabilities subject to compromise                                              |   | 1,349,750                                 |     | — |   |
| Net cash  provided by (used in) operating activities                                        |   | 22,616                                    |     | (77,279 | ) |
| Cash flows from  investing activities:                                                      |   |                                      |     |   |   |
| Purchases of  property and equipment                                                        |   | (15,880                                   | )        | (110,427 | ) |
| Capitalized  interest                                                                       |   | (275                                      | )        | (5,810 | ) |
| Purchases of  subsidiaries, net of cash acquired                                            |   | —                                    |     | (28,479 | ) |
| Purchases of  investments                                                                   |   | (8,321                                    | )        | (57,634 | ) |
| Proceeds from  sale of investments                                                          |   | 34,233                                    |     | 77,148 |   |
| Net cash  provided by (used in) investing activities                                        |   | 9,757                                     |     | (125,202 | ) |
| Cash flows from  financing activities:                                                      |   |                                      |     |   |   |
| Proceeds from  issuance of common stock, net                                                |   | 32                                        |     | 3,147 |   |
| Proceeds from  borrowings under senior secured credit facilities                            |   | 7,414                                     |     | 135,300 |   |
| Payments on  senior secured credit facilities                                               |   | (5,000                                    | )        | — |   |
| Payments on  capital lease obligations                                                      |   | (4,068                                    | )        | (5,037 | ) |
| Other                                                                                       |   | —                                    |     | (1 | ) |
| Net cash  provided by (used in) financing activities                                        |   | (1,622                                    | )        | 133,409 |   |
| Increase  (decrease) in cash and cash equivalents                                           |   | 30,751                                    |     | (69,072 | ) |
| Cash and cash  equivalents, beginning of period                                             |   | 253,311                                   |     | 374,084 |   |
| Cash and cash  equivalents, end of period                                                   |   | $                                         | 284,062  |   | $ | 305,012 |   |
| Supplemental  disclosure of cash flow information:                                          |   |                                      |     |   |   |
| Cash paid for  interest                                                                     |   | $                                         | 26,895   |   | $ | 37,801 |   |
| Supplemental  disclosure of non-cash investing and financing activities:                    |   |                                      |     |   |   |
| Assets acquired  under capital lease obligations                                            |   | 1,488                                     |     | 31,907 |   |
| Fair value of  assets acquired in business acquisitions                                     |   | —                                    |     | 58,825 |   |
| Liabilities  assumed in business acquisitions                                               |   | —                                    |     | 28,825 |   |
| Common stock  issued for business acquisitions (242,968 shares at September 30, 2002)  |   | —                                    |     | 1,303 |   |

 

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

 

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## **ALLEGIANCE TELECOM, INC. AND SUBSIDIARIES**

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

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS**

**Three and Nine Months EndedSeptember 30, 2003 and 2002**

**(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 Company providesservice in major metropolitan areas in the United States of America as follows: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/Boca Raton and White Plains.

 

The Company has preparedthe accompanying unaudited condensed consolidated financial statements inaccordance with accounting principles generally accepted in the United Statesof America for interim financial information and are in the form prescribed bythe Securities and Exchange Commission in instructions to Form 10-Q andArticle 10 of Regulation S-X. Accordingly, they do not include all ofthe information and footnotes required by accounting principles generallyaccepted in the United States of America for complete financial statements. Theinterim unaudited condensed consolidated financial statements should be read inconjunction with the Company’s audited consolidated financial statements as ofand for the year ended December 31, 2002. In the opinion of management,all adjustments (consisting only of normal recurring adjustments) considerednecessary for a fair presentation have been included. Operating results for thethree and nine months ended September 30, 2003 are not necessarilyindicative of the results that may be expected for the year endingDecember 31, 2003.

 

Certain amounts in theprior 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 Company is currently operating as “debtors-in-possession”under the jurisdiction 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, the Companyis authorized 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.

 

Under Section 362 ofthe Bankruptcy Code, the filing of a bankruptcy petition automatically staysmost actions against the Company, including most actions to collectpre-petition indebtedness or to exercise control of the property of theCompany’s estate. Absent an order of the Bankruptcy Court, substantially allpre-petition liabilities will be addressed under a plan of reorganization. TheBankruptcy Court has established November 26, 2003 as the bar date for filingproofs of claims. The aggregate amount of pre-petition claims is not known atthis time since the bar date for claims has not yet passed nor have allcontract rejection claims been filed.

 

Under Section 365 ofthe Bankruptcy Code, the Company may assume or reject certain pre-petitionexecutory contracts and unexpired leases, including leases of real property,subject to the approval of the Bankruptcy Court and certain other conditions. Ingeneral, rejection of an unexpired lease or executory contract is treated as apre-petition breach of the lease or contract generally resulting in any breachdamages being treated as pre-petition liabilities. Counterparties to theserejected contracts or unexpired leases may file proofs of claim against theCompany’s estate for damages, if any, relating to

 

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such rejections.The Company cannot presently determine with certainty the ultimate aggregateliability which will result from the filing of claims relating to suchcontracts and unexpired leases that have been or may be rejected.

 

The United States Trusteefor the Southern District of New York has appointed an official committee ofunsecured creditors (the “Creditors’ Committee”). The Creditors’ Committee andits legal representatives have a right to be heard on all matters that comebefore the Bankruptcy Court. The rights and claims of various creditors andsecurity holders will be determined by a plan of reorganization that isconfirmed by the Bankruptcy Court. Under the priority rules established by theBankruptcy Code, certain post-petition liabilities and certain pre-petitionliabilities (e.g., senior secured debt) are given priority over unsecuredpre-petition indebtedness and need to be satisfied before unsecured creditorsor stockholders are entitled to any distribution. Any Chapter 11 plan filed bythe Company may provide that unsecured creditors of subsidiaries of AllegianceTelecom, Inc. will need to be satisfied before any distribution to theunsecured creditors or stockholders of Allegiance Telecom, Inc. As aresult, a plan of reorganization could result in holders of the Company’sSeries B 11 3/4% notes due 2008 and 12 7/8%senior notes due 2008 receiving little or no value as part of the plan ofreorganization. Based on the Company’s current discussions with certaincreditors regarding a plan of reorganization, the common stock of AllegianceTelecom, Inc. will probably receive no value as part of the reorganization.

 

In order to exit Chapter11 successfully, the Company will need to propose and obtain confirmation bythe Bankruptcy Court of a plan of reorganization that satisfies therequirements of the Bankruptcy Code. As provided by the Bankruptcy Code, theCompany initially had the exclusive right to file a plan of reorganization for120 days from the Commencement Date, which expired September 11,2003. Under a Bridge Order and various Stipulation and Orders, the initialexclusivity period has been extended to December 16, 2003.  There can be no assurance that theBankruptcy Court will extend the exclusivity period beyond that date or thatthe Company will file a plan of reorganization by that date. If the Companyfails to file a plan of reorganization during this period (or any extendedperiod approved by the Bankruptcy Court) or if such plan is not accepted by therequired number of creditors within the applicable time period, any party ininterest may subsequently file its own plan of reorganization. The Company hasbeen in discussions with various third parties who may be interested inpurchasing some or all of the Company through the bankruptcy process, eitherthrough a 363 sale (a sale pursuant to Section 363 of Chapter 11 of the BankruptcyCode) or in connection with a plan of reorganization. At this time, it is notpossible to predict accurately the effect of the Chapter 11 reorganizationprocess on the Company’s business, creditors or stockholders, when the Companymay emerge from Chapter 11 or what the disposition will be of any claimsagainst the Company. The Company’s future results depend on the timely andsuccessful confirmation and implementation of a plan of reorganization.

 

***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 following table setsforth the liabilities of the Company subject to compromise as ofSeptember 30, 2003:

 
|                                                                                                                            |   | **September 30,  2003** |      |
|---------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|-----------|
|                                                                                                                            |   |                         |      |
| Accounts payable  and other claims                                                                                              |   | $                            | 135,593   |   |
| Senior secured  credit facilities, variable interest rate                                                                       |   | 472,714                      |      |
| Series B 11 3¤4%  notes, face amount $445,000 due February 15, 2008; effective interest rate of  12.21%; at accreted value |   | 440,489                      |      |
| 12 7¤8%  senior notes, face amount $205,000 due May 15, 2008; effective interest rate  of 13.24%; at accreted value        |   | 202,354                      |      |
| Capital lease  obligations                                                                                                      |   | 84,992                       |      |
| Total  liabilities subject to compromise                                                                                        |   | $                            | 1,336,142 |   |

 

Pursuant to SOP 90-7, anobjective of financial statements issued by an entity in Chapter 11 is toreflect its financial evolution during the proceeding. For that purpose, thefinancial statements for periods including and subsequent to filing the Chapter11 petition should distinguish transactions and events that are directlyassociated with the reorganization from the ongoing operations of the business.Certain expenses, realized gains and losses and provisions for losses notdirectly related to ongoing operations are reflected separately in theconsolidated statement of operations as reorganization items (seeNote 13).

 

Additionally,pre-petition debt that is subject to compromise must be recorded at the allowedclaim amount, which

 

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generally resultsin the write-off of any deferred financing amounts associated with the debt.Only certain claims relating to pre-petition debt have been allowed by the BankruptcyCourt as of September 30, 2003. As a result, a majority  of pre-petition debt subject to compromiseis recorded at its pre-petition value.

 

Deferred debt issuancecosts include costs incurred by the Company in raising debt proceeds. Thesecosts were being amortized to interest expense over the life of the relateddebt pre-petition. In accordance with SOP 90-7, the Company stopped recordinginterest expense on the Company’s Series B 11  3/4%notes due 2008 and 12  7/8% senior notes due2008 as of the Commencement Date. Accordingly, the deferred debt issuance costsrelated to this debt is no longer being amortized. Under the Final CashCollateral Order, discussed below, the Company is required to continueincurring and paying interest under its senior secured credit agreement.Accordingly, the deferred debt issuance costs related to the senior securedcredit facilities continue to be amortized to interest expense over the life ofthe debt.

 

Certain pre-petition debtthat is classified as subject to compromise, specifically the senior securedcredit facilities, continues to accrue interest. Interest on the remainingpre-petition debt that is subject to compromise ceased to accrue when thebankruptcy was filed. On June 26, 2003, the Company received finalBankruptcy Court approval for the use of its cash collateral under an AmendedFinal Order Authorizing Use of Cash Collateral by Consent (the “Final CashCollateral Order”). The Final Cash Collateral Order among other things:(1) restricts the Company’s use of cash, (2) requires the Company toprepare and follow a budget and maintain a minimum weekly cash balance, and(3) requires the Company to provide certain financial, operational andother information to its senior lenders and the Creditors’ Committee. Underthis Final Cash Collateral Order, the Company is required to continue incurringand paying interest under its senior secured credit agreement.

 

The unaudited 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 11reorganization cases. Specifically, the unaudited condensed consolidatedfinancial statements do not present the amount which will ultimately be paid tosettle liabilities and contingencies which may be required in the Chapter 11reorganization. The Company has not filed a plan of reorganization as of thisdate, but currently intends to file one in the near term. The plan, when filedwill be subject to the acceptance by the required creditors and approval by theBankruptcy Court.

 

In accordance with theguidance provided by the Financial Accounting Standards Board in Statement ofFinancial Accounting Standards No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets,” the Company considered the bankruptcy filing onMay 14, 2003 a triggering event which required that the Company’s long-livedassets be evaluated for impairment. Based on management’s best estimate of thefuture cash flows of the Company, it has been determined that the undiscountedcash flows generated from the Company’s assets are sufficient to recover theircurrent carrying value. These cash flows are based on numerous assumptions,including, among other things, the Company continuing to operate as a goingconcern and the achievement of certain operating results and cost reductions.Management does not believe there have been any triggering events requiring anevaluation of the Company’s long-lived assets for impairment during the threemonths ended September 30, 2003.

 

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 ofJune 30, 2003 to evaluate impairment of long-lived assets; therefore, thefair values assigned to the assets upon emergence may be different than the carryingvalues recorded as of September 30, 2003. As a result, an adjustment tothe fair value of long-lived assets may be required.

 

Because of the ongoingnature of the reorganization cases, the outcome of which is not presentlydeterminable, the unaudited condensed consolidated financial statementscontained herein are subject to material uncertainties and may not beindicative of the results of the Company’s future operations or financialposition. No assurance can be given that the Company will be successful inreorganizing its affairs within the Chapter 11 bankruptcy proceedings.

 

As a result of the itemsdiscussed above, there is substantial doubt about the Company’s ability tocontinue as a going concern. The ability of the Company to continue as a goingconcern is dependent upon, but not limited to, formulation, approval, andconfirmation of a plan of reorganization and the ability to obtain positiveresults of operations. The unaudited condensed consolidated financialstatements do not include any adjustments to the recorded amounts or reflectany amounts that may be ultimately paid to settle liabilities and contingencieswhich may be required in the Chapter 11 reorganization or the

 

8

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effect of anychanges, which may be made in connection with the Company’s operationsresulting from a plan of reorganization.

 

9

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**3.  Stock-Based Compensation:**

 

At September 30,2003, 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 accountingfor the Company’s plans. Fixed stock option and restricted stock awards withpro-rata vesting are recognized as expense using the straight-line method overthe vesting period. Effective on the Commencement Date, vesting for theCompany’s restricted stock ceased as a result of the Company’s bankruptcyproceedings, although amortization of deferred compensation related torestricted stock continued and is included in the reported expense below (seeNote 2).

 

Had compensation cost forthe Company’s plans been determined based on the fair value of the stockoptions as of the grant dates for awards under the plans consistent with themethod prescribed by the Financial Accounting Standards Board in Statement ofFinancial Accounting Standards No. 123, “Accounting for Stock-BasedCompensation,” the Company’s net loss applicable to common stock and net lossper share would have increased to the pro forma amounts indicated below. TheCompany utilized the following assumptions in calculating the estimated fairvalue of each stock option on the date of grant using the Black-Scholesoption-pricing model with the following weighted-average assumptions forgrants:

 
|                     |   | **September 30,  2003** |   | **September 30,  2002** |   |
|--------------------------|--------|------------------------------|--------|------------------------------|--------|
|                     |   |                         |   |                         |   |
| Dividend yield           |   | —                       | %      | —                       | %      |
| Expected  volatility     |   | 123.0                        | %      | 123.0                        | %      |
| Expected life            |   | 3.0                          |   | 3.0                          |   |
| Risk-free  interest rate |   | 2.05                         | %      | 2.32                         | %      |

 
|                                                                                                  |   | **Three  Months Ended September 30,** |    | **Nine  Months Ended September 30,** |   |
|-------------------------------------------------------------------------------------------------------|--------|---------------------------------------|---------|--------------------------------------|--------|
|                                                                                                  |   | **2003**                              |    | **2002**                             |   | **2003** |   | **2002** |   |
|                                                                                                  |   |                                  |    |                                 |   |   |   |   |   |
| Reported net loss                                                                                     |   | $                                     | (63,100 | )                                    | $      | (113,110 | ) | $ | (275,581 | ) | $ | (452,515 | ) |
| Add: stock-based  employee compensation expense included in reported net income                       |   | 631                                   |    | 1,510                                |   | 2,240 |   | 2,042 |   |
| Deduct:  stock-based employee compensation expense determined under fair value method  for all awards |   | (4,571                                | )       | (15,878                              | )      | (30,927 | ) | (72,014 | ) |
| Pro forma net  loss                                                                                   |   | $                                     | (67,040 | )                                    | $      | (127,478 | ) | $ | (304,268 | ) | $ | (522,487 | ) |
|                                                                                                  |   |                                  |    |                                 |   |   |   |   |   |
| Net loss per  share, basic and diluted — as reported                                             |   | $                                     | (0.52   | )                                    | $      | (0.97 | ) | $ | (2.28 | ) | $ | (3.89 | ) |
| Net loss per  share, basic and diluted — pro forma                                               |   | $                                     | (0.55   | )                                    | $      | (1.09 | ) | $ | (2.52 | ) | $ | (4.49 | ) |

 

**4.  Business Acquisitions:**

 

On June 17, 2002,the Company purchased substantially all of the assets and assumed substantiallyall of the liabilities of WorldCom’s customer premise equipment sales andequipment maintenance businesses, known in the industry as “Shared TechnologiesFairchild” or “Shared Technologies.” The acquisition was accounted for usingthe purchase method, and accordingly, the net assets and results of operationsof Shared Technologies have been included in the Company’s consolidatedfinancial statements since the date of acquisition.

 

Revenues of SharedTechnologies included in the Company’s condensed consolidated financialstatements for the three months ended September 30, 2003 and 2002 were$27,770 and $40,269, respectively. Total revenues included for the nine monthsended September 30, 2003 and 2002 were $91,130 and $45,741, respectively.Total network expenses related to the Shared Technologies businesses for thethree months ended September 30, 2003 and 2002 were $16,763 and $23,655,and for the nine months ended September 30, 2003 and 2002 were $53,909 and$27,908, respectively.

 

The following presentsthe unaudited pro forma results of the Company for the three and nine monthsended September 30, 2002, as if the acquisition of the Shared Technologiesbusinesses had been consummated at the beginning of

 

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the periodpresented. The pro forma results are prepared for comparative purposes only anddo not necessarily reflect the results that would have occurred had theacquisitions occurred at the beginning of the periods presented or the resultswhich may occur in the future.

 
|                                   |   | **Three  Months Ended  September 30, 2002** |    | **Nine Months  Ended  September 30, 2002** |   |
|----------------------------------------|--------|--------------------------------------------------|---------|-------------------------------------------------|--------|
|                                   |   | **(Unaudited)**                                  |    | **(Unaudited)**                                 |   |
|                                   |   |                                             |    |                                            |   |
| Revenue                                |   | $                                                | 219,539 |                                            | $      | 644,170 |   |
| Net loss                               |   | (113,110                                         | )       | (451,119                                        | )      |
| Net loss per  share, basic and diluted |   | (0.97                                            | )       | (3.87                                           | )      |
|                                        |        |                                                  |         |                                                 |        |  |  |

 

The purchase price of theShared Technologies businesses was allocated to the assets acquired andliabilities assumed, based on their respective estimated fair values atacquisition. The Company’s purchase price allocation was finalized during thequarter ended June 30, 2003. In connection with these final adjustmentsrelated to pre-acquisition assets and liabilities, the Company recordedadditional goodwill of $2,105. At June 30, 2003, the Company’s marketcapitalization continued to remain at a level below its book value, indicatingthat an impairment of enterprise goodwill existed as of June 30, 2003.Accordingly, the Company recorded a charge of $2,105, reflecting the amount ofthe impairment as of June 30, 2003 to eliminate the enterprise goodwillintangible.

 

**5.  Property and Equipment:**

 

Property and equipmentincludes network equipment, land, leasehold improvements, software, officeequipment, furniture and fixtures and construction-in-progress. These assetsare stated at cost, which includes direct costs and capitalized interest andare depreciated over their respective useful lives using the straight-linemethod. During the three months ended September 30, 2003 and 2002, $0 and$1,258, respectively, of interest expense was capitalized related to networkconstruction-in-progress. During the nine months ended September 30, 2003and 2002, $275 and $5,810, respectively, of interest expense was capitalized.Repair and maintenance costs are expensed as incurred.

 

Property and equipment atSeptember 30, 2003 and December 31, 2002, consisted of the following:

 
|                                     |   | **September 30,  2003** |      | **December 31,  2002** |   | **Useful  Lives  (in years)** |   |
|------------------------------------------|--------|------------------------------|-----------|-----------------------------|--------|-------------------------------|--------|
|                                     |   |                         |      |                        |   |                          |   |
| Network  equipment                       |   | $                            | 1,168,598 |                        | $      | 1,148,583                     |   | 2-20 |   |
| Land                                     |   | 9,365                        |      | 9,365                       |   | —                        |   |
| Leasehold  improvements                  |   | 141,889                      |      | 145,713                     |   | 7-10                          |   |
| Software                                 |   | 127,527                      |      | 125,229                     |   | 3                             |   |
| Office equipment  and other              |   | 49,193                       |      | 46,991                      |   | 2-5                           |   |
| Furniture and  fixtures                  |   | 18,941                       |      | 21,334                      |   | 7                             |   |
| Property and  equipment, in service      |   | 1,515,513                    |      | 1,497,215                   |   |                          |   |
| Less:  Accumulated depreciation          |   | (777,143                     | )         | (592,069                    | )      |                          |   |
| Property  and equipment, in service, net |   | 738,370                      |      | 905,146                     |   |                          |   |
| Construction-in-progress                 |   | 7,452                        |      | 18,960                      |   |                          |   |
| Property and  equipment, net             |   | $                            | 745,822   |                        | $      | 924,106                       |   |   |   |

 

11

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**6.  Other Assets:**

 

Other assets atSeptember 30, 2003 and December 31, 2002, consisted of the following:

 
|                            |   | **September 30,  2003** |   | **December 31,  2002** |   |
|---------------------------------|--------|------------------------------|--------|-----------------------------|--------|
|                            |   |                         |   |                        |   |
| Acquired  customer lists        |   | $                            | 62,800 |                        | $      | 62,800 |   |
| Long-term  deposits             |   | 17,262                       |   | 17,030                      |   |
| Equipment  pending deployment   |   | 6,724                        |   | 8,688                       |   |
| Other                           |   | 1,503                        |   | 5,645                       |   |
| Total other  assets             |   | 88,289                       |   | 94,163                      |   |
| Less:  Accumulated amortization |   | (58,681                      | )      | (50,189                     | )      |
| Other assets,  net              |   | $                            | 29,608 |                        | $      | 43,974 |   |

 

The acquired intangiblesare being amortized over their estimated useful life of three years using thestraight-line method. Amortization expense related to intangible assets totaled$8,492 and $26,844 during the nine months ended September 30, 2003 and2002, respectively. The estimated aggregate future amortization expense forintangible assets remaining as of September 30, 2003 is as follows:

 
| Remainder of 2003 |   | $     | 1,808  |   |
|-------------------|--------|-------|--------|--------|
| 2004              |   | 2,311 |   |
| Total             |   | $     | 4,119  |   |

 

Long-term deposits include a $8,707 prepayment toAT&T for long-distance services. The Company has filed a motion to rejectits Master Carrier Agreement with AT&T under which this deposit was made.If approved, AT&T may have a rejection damage claim that may be equal tosome or all of this prepayment and the Bankruptcy Court may allow AT&T tooffset some or all of its rejection damages against this prepayment.  The parties are currently engaged in negotiations.

 

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.

 

**7.  Accrued Liabilities and Other CurrentLiabilities:**

 

Accrued liabilities andother current liabilities at September 30, 2003 and December 31,2002, consisted of the following:

 
|                                               |   | **September 30,  2003** |   | **December 31,  2002** |   |
|----------------------------------------------------|--------|------------------------------|--------|-----------------------------|--------|
|                                               |   |                         |   |                        |   |
| Accrued employee  compensation and benefits        |   | $                            | 20,115 |                        | $      | 11,824 |   |
| Accrued network  expenses                          |   | 11,571                       |   | 52,643                      |   |
| Business  acquisition costs                        |   | —                       |   | 10,502                      |   |
| Accrued taxes                                      |   | 14,247                       |   | 10,051                      |   |
| Accrued interest  expense                          |   | 754                          |   | 4,154                       |   |
| Deferred revenue                                   |   | 29,287                       |   | 29,009                      |   |
| Other                                              |   | 5,350                        |   | 6,261                       |   |
| Accrued  liabilities and other current liabilities |   | $                            | 81,324 |                        | $      | 124,444 |   |

 

12

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Included in businessacquisition costs at December 31, 2002 is $6,684 of reserves primarily fortermination of acquired redundant network elements and closure of acquiredduplicate facilities. At September 30, 2003, all business acquisitionscosts are included in liabilities subject to compromise in accordance with SOP90-7 (see Note 2).

 

**8.  Long-Term Debt:**

 

As a result of theCompany’s bankruptcy proceedings, all contractual debt payments are suspendedand subject to revised payment terms during the bankruptcy process on aspecific case basis. As discussed in Note 2, the only debt payments beingmade as of September 30, 2003 relate to interest on the senior securedcredit facilities and monthly payments under capital leases. Additionally, as aresult of the bankruptcy filing, there is an event of default under the seniorsecured credit facilities and both series of notes, which, by their terms,would ordinarily accelerate all amounts due upon the event of default.

 

The senior secured creditfacilities, notes and capital lease obligations are now classified asliabilities subject to compromise (see Note 2) and are not reflected inthe table below. No changes to the carrying amount of these debts have beenmade in the accompanying condensed consolidated balance sheet as a result ofthe filing.

 

Long-term debt atSeptember 30, 2003 and December 31, 2002, consisted of the following:

 
|                                                                                                                       |   | **September 30,  2003** |   | **December 31, 2002** |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|------------------------------|--------|---------------------------------|--------|
|                                                                                                                       |   |                         |   |                            |   |
| Series B 11 3/4%  notes, face amount $445,000 due February 15, 2008; effective interest rate of  12.21%; at accreted value |   | $                            | — |                            | $      | 433,974 |   |
| 12 7/8%  senior notes, face amount $205,000 due May 15, 2008; effective interest rate  of 13.24%; at accreted value        |   | —                       |   | 202,210                         |   |
| Senior secured  credit facilities, variable interest rate                                                                  |   | —                       |   | 470,300                         |   |
| Capital lease  obligations (see Note 9)                                                                                    |   | —                       |   | 94,739                          |   |
| Total debt                                                                                                                 |   | —                       |   | 1,201,223                       |   |
| Less: current  portion of long-term debt                                                                                   |   | —                       |   | 561,532                         |   |
| Long-term debt                                                                                                             |   | $                            | — |                            | $      | 639,691 |   |

 

***Senior Secured Credit Facilities.***  In February 2000, the Company closed on$500,000 of senior secured credit facilities (the “Credit Facilities”). TheCredit Facilities consist of a $350,000 seven-year revolving credit facilityand a $150,000 two-year delayed draw term loan facility. Interest is generallythe London Interbank Offered Rate (“LIBOR”) plus 4.50%. As ofSeptember 30, 2003, there were $326,925 and $145,789 of borrowingsoutstanding under the seven-year revolving credit facility and the two-yeardelayed draw term loan facility, respectively. The blended borrowing rate onoutstanding borrowings at September 30, 2003, is 5.63% and will remainfixed until December 24, 2003.

 

The Credit Facilities aresecured by (1) the capital stock of Allegiance Telecom Company Worldwide(which stock is owned by its parent holding company, AllegianceTelecom, Inc.) and (2) substantially all of the assets of AllegianceTelecom Company Worldwide and its subsidiaries, including the capital stockowned by that entity in each of its subsidiaries. The Final Cash CollateralOrder also provides the senior lenders with certain replacement liens asdescribed in such Order. Under this Order and various Stipulation and ConsentOrders the Creditors’ Committee has until December 1, 2003 to among otherthings, challenge the senior lenders’ prepetition liens, claims or securityinterests or the lenders’ pre-petition obligations.

 

On November 27,2002, the Company reached an agreement with its senior bank creditors regardingmodifications to the Credit Facilities. Under this agreement, the Companyobtained a waiver of all existing financial covenants through April 30,2003 and replaced those covenants during this period with a free cash flow fromoperations covenant and a total leverage covenant. Under this interimamendment, the Company could not permit its consolidated total debt to exceedat any time (i) $1,275,000 from November 27, 2002 throughApril 29, 2003 and (ii) $645,000 thereafter. Under the terms of theinterim amendment, the Company repaid $15,000 of the Credit Facilities, whichwas applied to the initial amortization of the facility scheduled to begin in2004.

 

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From November 27,2002 to April 29, 2003, the Company negotiated with its senior bankcreditors to develop a mutually acceptable plan of restructuring. OnApril 29, 2003, in anticipation of its breach of various covenants in theCredit Facilities, the Company and its senior bank creditors entered into aforbearance agreement. The Company received a forbearance from its senior bankcreditors until May 15, 2003 to allow the various parties to continuenegotiations. In exchange, the Company made a $5,000 principal payment andagreed to certain other covenants. On May 14, 2003, the Company filed forbankruptcy under Chapter 11 as discussed above.

 

In June 2002, theCompany requested a draw of the remaining $150,000 under the Credit Facilities,however, the Company initially received only $135,300 of the $150,000, with 3of the 26 banks in the bank syndicate refusing to fund the request.  On July 15, 2003, the Company enteredinto a settlement agreement with Bayerische Hypo-und Vereinsbank and BankAustria Creditanstalt Corporate Finance, Inc. (collectively, the “Banks”)regarding funding disputes.  OnJuly 29, 2003, the Bankruptcy Court approved the settlement agreement andon July 31, 2003, the Banks delivered the Net Funding Obligation to theCompany, required under the settlement agreement in the amount of $7,414.  On October 24, 2003, the Company enteredinto a settlement agreement with Dresdner Bank AG regarding these fundingdisputes.  On October 27, 2003, theCompany filed a motion with the Bankruptcy Court for approval of the settlementagreement.  The motion is scheduled tobe heard by the Court on November 19, 2003. Per the settlement agreement, the Net Funding Obligation of $5,113 willbe delivered to the Company by Dresdner Bank AG within two business daysfollowing Bankruptcy Court approval.  

 

**9.  Leases:**

 

The Company has enteredinto various capital lease agreements, with expirations through 2022, coveringdedicated optical fiber capacity and certain equipment. Assets and futureobligations related to capital leases are included in the accompanyingcondensed consolidated balance sheet in property and equipment and liabilitiessubject to compromise, respectively. Depreciation of assets held under capitalleases is included in depreciation and amortization expense.

 

The Company has entered intovarious operating lease agreements, with expirations through 2011, for networkfacilities, office space and equipment. Total rent expense on operating leasesfor the three months ended September 30, 2003 and 2002, was $6,726 and$9,843, and for the nine months ended September 30, 2003 and 2002 was$23,245 and $26,421, respectively.

 

Future minimum leaseobligations for all non-cancelable capital and operating lease agreements withinitial or remaining terms of one year or more at September 30, 2003, areas follows:

 
| **Years ending December 31,**                                                            |   | **Capital  Leases** |    | **Operating  Leases** |   |
|------------------------------------------------------------------------------------------|--------|---------------------|---------|-----------------------|--------|
|                                                                                     |   |                |    |                  |   |
| 2003                                                                                     |   | $                   | 3,791   |                  | $      | 5,733 |   |
| 2004                                                                                     |   | 11,634              |    | 22,573                |   |
| 2005                                                                                     |   | 11,623              |    | 21,916                |   |
| 2006                                                                                     |   | 11,641              |    | 19,981                |   |
| 2007                                                                                     |   | 9,295               |    | 17,909                |   |
| Thereafter                                                                               |   | 106,604             |    | 24,465                |   |
| Total minimum  future lease payments                                                     |   | $                   | 154,588 |                  | $      | 112,577 |   |
|                                                                                     |   |                |    |                  |   |
| Amount  representing interest                                                            |   | (69,596             | )       |                  |   |
| Present value of  minimum lease payments (included in liabilities subject to compromise) |   | 84,992              |    |                  |   |
| Current portion  (included in liabilities subject to compromise)                         |   | (4,719              | )       |                  |   |
| Long-term  capital lease obligations (included in liabilities subject to compromise)     |   | $                   | 80,273  |                  |   |   |

 

Certain operating andcapital lease agreements contain renewal and purchase options at the end of theinitial lease terms. The Company is analyzing its contracts and leases todetermine those executory contracts and unexpired leases relating to capitaland operating leases that may be burdensome to the Company and should berejected pursuant to Section 365 of the Bankruptcy Code.

 

14

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**10. Capitalization:**

 

During the nine monthsended September 30, 2003, 56,839 shares of common stock were issued underthe Company’s Employee Stock Discount Purchase Plan for proceeds of $32. Thereare no more shares available for issuance under this Employee Stock DiscountPurchase Plan.

 

**11. Commitments and Contingencies:**

 

In October 2002, the Companyexecuted a Master Carrier Agreement with AT&T Corp. Under this agreement,the Company committed to purchase from AT&T Corp. a minimum of $10,000 ofservices per year through February 2007.  The Company has filed a motion with the Bankruptcy Court to reject theAT&T Master Carrier Agreement.  Theparties are currently engaged in negotiations.

 

In March 2002, theCompany executed a Communications Transport Services Agreement with SouthernCalifornia Edison Company. Under this agreement, the Company committed topurchase from Southern California Edison Company an average of $260 of serviceseach month through March 2005.  TheCompany has not yet assumed or rejected this agreement pursuant to theBankruptcy Code.

 

In April 2003, theCompany executed an Agreement for Additional Services, Security, and Settlementof Certain Matters with WorldCom, Inc. (on behalf of itself and all of itsaffiliates and subsidiaries). Under this agreement, the Company committed topurchase from WorldCom an aggregate of $14,000 of services fromFebruary 28, 2003 to April 30, 2004 and an aggregate of at least$12,000 of services from May 1, 2004 to April 30, 2005. Furthermore,under this agreement, the Company agreed to (a) extend the term of itsDomestic and Metro Private Line Special Carrier Service Agreement (“MSA”)between WorldCom and the Company dated September 29, 2000, as amended,until April 30, 2005 and (b) increase the volume commitment under theMSA from $700 per month to $900 per month through April 30, 2005. TheCompany has not yet assumed or rejected this agreement pursuant to theBankruptcy Code.

 

In October 2002, the Companyexecuted an agreement for financial advisory and investment banking serviceswith Greenhill & Co., LLC (“Greenhill”). On September 18, 2003, the Bankruptcy Court approved this agreement.  Under the agreement, the Company has agreedto pay Greenhill a transaction fee in the amount of $6,500, contingent upon theconsummation of a plan of reorganization or the sale of substantially all ofthe Company’s assets.

 

In June 2003, the Companyexecuted an agreement for advisory services with Impala Partners, LLC(“Impala”).  In August 2003, the Companyexecuted an amendment to the original agreement.  Under this amendment, the Company agreed to pay Impala a successfee in the amount of $2,500 payable upon the effective date followingconfirmation of a plan of reorganization or the sale of the Company.

 

**12. Other Income and Expense:**

 

At December 31,2002, the Company held an investment in commercial paper, which was included incash and cash equivalents. The original purchase price of the commercial paperwas $9,025. During 2001, the investment was written down to its market valuedue to a decline in its value, which was deemed to be other than temporary. Animpairment of $3,069 was recorded to interest income during 2001. DuringJune 2003, the Company sold its investment in the commercial paper in theopen market for proceeds of $9,233, which resulted in the Company realizing again of $3,277. The proceeds of the sale were re-invested in the Company’smoney market investment accounts, which are classified as cash and cashequivalents.

 

On April 15, 2003, theCompany entered into a settlement agreement with WorldCom to settle variousdisputes that each party had against the other.  The settlement was approved by the Bankruptcy Court in theWorldCom Chapter 11 proceeding on May 28, 2003.  Under the settlement agreement, all pre-acquisition amountspayable to WorldCom that were related to the acquisition of Shared Technologieswere forgiven.  During the quarter endedSeptember 30, 2003, the Company determined that it was appropriate to recognizecertain benefits related to specific terms of the settlement agreement andrelieved those pre-petition liabilities covered by the settlement, resulting ina gain of $2,610.

 

15

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**13. Reorganization Items:**

 

Pursuant to SOP 90-7, theCompany is required to segregate certain expenses, realized gains and lossesand 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 and ninemonths ended September 30, 2003:

 
|                                |   | **Three  Months Ended  September 30, 2003** |   | **Nine  Months Ended  September 30, 2003** |   |
|-------------------------------------|--------|--------------------------------------------------|--------|-------------------------------------------------|--------|
|                                |   | **(Unaudited)**                                  |   | **(Unaudited)**                                 |   |
|                                |   |                                             |   |                                            |   |
| Professional  fees                  |   | $                                                | 7,142  |                                            | $      | 9,548 |   |
| Other  restructuring (gains)/losses |   | (10,335                                          | )      | (10,795                                         | )      |
| Total  reorganization items         |   | $                                                | (3,193 | )                                               | $      | (1,247 | ) |

 

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**ITEM2. Management’s****Discussion and Analysis of Financial Condition and Results of Operations**

 

The following discussionand analysis relates to our financial condition and results of operations andshould be read in conjunction with the accompanying condensed consolidatedfinancial statements and notes to those financial statements contained in thisreport, as well as the section captioned “Risk Factors” in this report.Additionally, the following discussion and analysis should be read inconjunction with our audited consolidated financial statements and notes to thosefinancial statements included in our Annual Report on Form 10-K, asamended for the year ended December 31, 2002. AllegianceTelecom, Inc. is generally referred to in the remainder of this report as“we,” “our company” or “Allegiance.”

 

OVERVIEW

 

We are a facilities-basednational local exchange carrier that provides telecommunications services tobusiness, government and other institutional users in major metropolitan areasacross the United States and we are focused primarily on small to medium-sizedbusinesses. We currently offer an integrated suite of telecommunicationsproducts and services including local, long distance, Internet, datacolocation, web hosting and customer premise equipment sales and maintenanceservices. Our principal competitors are the incumbent local exchange carriers(also known in the industry as the “ILECs”), as well as long distance carriers,customer premises sales and maintenance businesses, and other integratedcommunications providers.

 

We began operations inlate 1997 with an objective to grow rapidly and establish our company as anational local exchange carrier covering the major metropolitan areas acrossthe United States. By the end of 2001, we completed the network rollout in our36 targeted markets: Atlanta, Austin, Baltimore, Boston, Chicago, Cleveland,Dallas, Denver, Detroit, Fort Lauderdale, Fort Worth, Houston, Long Island, LosAngeles, Miami, Minneapolis/St. Paul, New York, Northern New Jersey, Oakland,Ontario/Riverside, CA, 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 WhitePlains, NY.

 

We use multipletechnologies in our network and a mixture of leased and owned facilities at theedge of our communications network in order to effectively and efficientlyserve our customer base where it is physically located. Our focus is onproviding facilities-based services, and we generally provide services viaresale on a limited basis. We utilize resale and what is known as the unbundlednetwork element platform (“UNE-P”) to deliver services in a small number ofsales where our facilities-based services would not be practicable or costeffective and as an interim measure until the resold services can be convertedto facilities-based services. UNE-P is a method where a carrier can lease allelements of a service from an incumbent local carrier, including switching. Asof September 30, 2003, approximately 95% of our retail lines in service wereprovided over our own network facilities. The services that we provide via ourown network generate higher margins than services provided by other carriersthat are resold by us. Consistent with our facilities-based approach, weinstall voice and data aggregation and switching equipment in our own premises.We also install voice and data aggregation equipment in the central offices or“hubs” of the existing local incumbent carrier’s networks, also known ascolocation. This voice and data aggregation equipment connects directly tocustomers through the “local loop,” which consists of the existing copper wireand fiber running from the local incumbent carrier’s central offices to eachcustomer location. The local loop is owned by the incumbent carriers but can beleased by competitive carriers under the terms of the Telecommunications Act of1996. As of September 30, 2003, we had transmissions equipment colocatedin 851 central offices. Our local presence in incumbent local exchange carriercentral offices along with our leasing of the local loops provides us with aflexible platform for delivering traditional voice and data access services toend-user customers. We connect our colocations to our main switching center ineach market by either leasing additional network elements from the incumbentcarriers and other providers on a short-term basis or by using dedicated fiberon a long-term basis. We have increasingly focused on dedicated fiber becauseof the growth of our customer base and traffic volume as well as itsreliability.

 

As we have developed ourlocal networks to service end-user customers, we have also attempted tocapitalize on our expertise and investment at the edge of our network and inour intercity Internet backbone. We have leveraged our network assets byproviding network solutions to other service providers, primarily the leadingnational and regional Internet providers. These national network providers haveend-user customers but do not generally have the facilities and expertise todirectly access these customers in all relevant geographic areas through thelocal loop. Many of these providers focus on the residential Internet accessmarket.

 

***BANKRUPTCYPROCEEDINGS***

 

On May 14, 2003 (the“Commencement Date”), Allegiance Telecom, Inc. and its direct and indirectsubsidiaries filed

 

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voluntarypetitions for relief under Chapter 11 of the United States Bankruptcy Code inthe United States Bankruptcy Court for the Southern District of New York (the“Bankruptcy Court”). The reorganization is being jointly administered under thecaption “In re Allegiance Telecom, Inc. et al. Case No. 03-13057(RDD)” (the “Chapter 11 cases”). We are currently operating our business as“debtors-in-possession” under the jurisdiction of the Bankruptcy Court and inaccordance with the applicable provisions of the Bankruptcy Code, the FederalRules of Bankruptcy Procedure and applicable court orders. In general, asdebtors-in-possession, we are authorized to continue to operate as an ongoingbusiness, but may not engage in transactions outside the ordinary course ofbusiness without the prior approval of the Bankruptcy Court. We plan tocontinue operating our business in the ordinary course. Consistent with theprovisions of the Bankruptcy Code, we plan to pay our vendors for all goods andservices provided or delivered after the Commencement Date.

 

In order to reorganizeand emerge from Chapter 11 successfully, we will need to propose, and obtainconfirmation by the Bankruptcy Court, a plan of reorganization that satisfiesthe requirements of the Bankruptcy Code. As provided by the Bankruptcy Code, weinitially had the exclusive right to file a plan of reorganization for120 days, which expired September 11, 2003. Under a Bridge Order andvarious Stipulation and Orders, the initial exclusivity period has beenextended until December 16, 2003.  Therecan be no assurances that the Bankruptcy Court will extend the exclusivityperiod beyond that date.  If we fail tofile a plan of reorganization during this period (or any extended periodapproved by the Bankruptcy Court) or if such plan is not accepted by therequired number of creditors within the applicable time period, any party ininterest may subsequently file its own plan of reorganization. We have beenengaged in discussions with various third parties who may be interested inpurchasing some or all of our company through the bankruptcy process, eitherthrough a 363 sale (a sale pursuant to Section 363 of Chapter 11 of theBankruptcy Code) or in connection with a plan of reorganization.  A plan of reorganization would address,among other things, the terms of any such sale, the treatment of ourpre-petition obligations, the revised capital structure of the newlyreorganized entity and provide for our corporate governance subsequent to exitfrom bankruptcy.****There can be no assurance at this time that a plan ofreorganization will be confirmed by the Bankruptcy Court or that any such planwill be implemented successfully.

 

Under Section 362 ofthe Bankruptcy Code, the filing of a bankruptcy petition automatically staysmost actions against a debtor, including most actions to collect pre-petitionindebtedness or to exercise control over the property of the debtor’s estate.Absent an order of the Bankruptcy Court, substantially all pre-petitionliabilities are subject to payment, if any, under the plan of reorganization.The Bankruptcy Court has established November 26, 2003 as the bar date forfiling proofs of claims. The aggregate amount of pre-petition claims is notknown at this time since the bar date for claims has not yet passed nor haveall contract rejection claims been filed.

 

Under Section 365 ofthe Bankruptcy Code, we may assume or reject certain executory contracts andunexpired leases, including leases of real property, subject to the approval ofthe Bankruptcy Court and certain other conditions. In general, rejection of anunexpired lease or executory contract is treated as a pre-petition breach ofthe lease or contract, generally resulting in any breach damages being treatedas pre-petition liabilities. Subject to certain exceptions, this rejectionrelieves us of performing our future obligations under that unexpired lease orcontract 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 an executory contract or unexpired lease requires a debtor to cure mostexisting defaults, including payment of any pre-petition amounts outstandingunder such executory contract or unexpired lease. Due to the uncertain natureof many of the potential rejection and abandonment related claims and to theuncertain amount needed for cure payments, we are unable to project themagnitude of these claims and cure amounts with any degree of certainty at thistime.

 

The United States Trusteefor the Southern District of New York has appointed an official committee ofunsecured creditors (the “Creditors’ Committee”). The Creditors’ Committee andits legal representatives have a right to be heard on all matters relating toour Chapter 11 cases that come before the Bankruptcy Court. There can beno assurance that the Creditors’ Committee will support our positions or ourultimate plan of reorganization, once proposed, and disagreements between theCreditors’ Committee and Allegiance could protract the Chapter 11 casesand could negatively impact Allegiance’s ability to operate during theChapter 11 cases.

 

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 andcertain pre-petition liabilities (e.g., our senior secured debt) need to besatisfied before unsecured creditors or stockholders are entitled to anydistribution. Any Chapter 11 plan filed by us may provide that unsecuredcreditors of subsidiaries of Allegiance Telecom, Inc. will need to besatisfied before any distribution to the unsecured creditors or stockholders ofAllegiance Telecom, Inc.  As a result,a plan of reorganization could result in holders of our bonds and othersecurities receiving little or no value as part of the plan ofreorganization.  Based on currentdiscussions with our creditors

 

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regarding a planof reorganization, Allegiance Telecom, Inc. common stock will probablyreceive no value as part of the reorganization.****In light of the foregoing,we consider our bonds and common stock to be highly speculative and we cautionthe holders of such securities that such securities may ultimately bedetermined to have no value. Accordingly, we urge that extreme caution be exercised with respect toexisting and future investments in any of such securities and claims.

 

At this time, it is notpossible to predict accurately the effect of the Chapter 11 reorganizationprocess on our business, our creditors or our stockholders or when we mayemerge from Chapter 11. Our future results depend on the timely and successfulconfirmation and implementation of a plan of reorganization. No assurance canbe given that we will be successful in reorganizing our affairs within theChapter 11 proceedings.

 

For copies of courtfilings made in our Chapter 11 cases, please go to the Bankruptcy Court’swebsite, at www.nysb.uscourts.gov. Please note that a PACER password isrequired to access documents on the Bankruptcy Court’s website.

 

***RECENT DEVELOPMENTS***

 

On November 13, 2003, Oscar Private Equity Investments filed a classaction securities lawsuit in the District Court of the Northern District ofTexas entitled *Oscar Private Equity Investments v. Allegiance Telecom, Inc., et al.*,(Index No. 2-03CV-2761H) (the “Complaint”). The action is brought against Royce J. Holland and Thomas M. Lord asofficers of the Company.  The Complaintspecifically states that the Company is not named a defendant although it isstyled as an action against the Company. The Complaint alleges that, the defendant officers breached theirfiduciary duty to the plaintiff class, violated Section 10(b) of the Securitiesand Exchange Act of 1934, and violated Rule 10b-5 of the Securities andExchange Commission (“SEC”) promulgated thereunder.  The action seeks compensatory damages of an unspecified amount,rescission, and the award of costs and disbursements of bringing suit.  The Company’s insurance carriers have beennotified of the lawsuit.  Although it istoo early for the Company to reach a conclusion as to the ultimate outcome ofthis action, management believes that there are substantial defenses to theclaims asserted in this action, and the defendant officers intend to defendagainst the action vigorously.

 

***RESULTS OF OPERATIONS—****Three andNine Months Ended September 30, 2003 Compared With Three and Nine MonthsEnded September 30, 2002*

 

**Revenues**

 

During the third quarterof 2003 and 2002, we generated revenues of approximately $188.2 millionand $219.5 million, respectively. For the nine months endedSeptember 30, 2003 and 2002, we generated revenues of approximately$589.4 million and $566.1 million, respectively. Revenues havedecreased $31.3 million or 14% compared to the three months endedSeptember 30, 2002. Most of this decrease was a result of a decrease of$11.9 million in intercarrier compensation and a decrease of $12.5 million incustomer equipment sales and maintenance revenues. Our revenue is lower thanour projected revenue and has been negatively impacted by, among other things:

 

•                                          thecommencement of our Chapter 11 cases

 

•                                          churn

 

•                                          thegoing concern qualification contained in our 2002 year-end independentaccountant’s report

 

•                                          thegeneral malaise in the telecommunications industry which has adversely affectedthe willingness of potential customers to purchase their telecommunicationsservices from competitive carriers, such as us

 

•                                          ourinability to receive bid and performance bonds for potential customer contracts

 

•                                          thepoor economy which has caused our customers to decrease or delay theirpurchases from us

 

•                                          decreasesin carrier access and interconnection revenues due to dispute settlements andFCC-mandated regulatory rate reductions

 

•                                          decreasesin our web hosting revenues as we continued to curtail that product line

 

•                                          decreasesand turnover in our sales force

 

On a year-to-date basis,revenues have increased 4% compared to the nine months ended September 30,2002. This increase in revenues is attributable to our acquisition of thecustomer premise equipment sales and equipment maintenance businesses, alsoknown as Shared Technologies Fairchild, in June 2002, which contributed$91.1 million to 2003 revenues for the nine months ended September 30,2003, and $45.7 million to 2002 revenues for the nine months endedSeptember 30, 2002, respectively.

 

Our focus has shiftedfrom high revenue growth to profitability and we do not anticipate the level ofrevenue growth that we have experienced in the past. Future revenue growth willdepend on our ability to add new customers, retain existing customers andmanage churn, increase customer usage and sell additional services to our existingcustomers. We believe that managing our churn is one of our biggest challenges.The amount of churn directly impacts our revenues. See the discussion of linechurn under the caption “Liquidity and Capital Resources” below.

 

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Local voice servicerevenues for the three months ended September 30, 2003 and 2002 were$80.9 million and $96.6 million, and for the nine months endedSeptember 30, 2003 and 2002, were $253.7 million and$282.7 million, respectively. The decrease in local voice service revenuesduring 2003 is primarily a result of lower rates for carrier access andinterconnection revenues as mandated by our negotiated agreements withcarriers, the FCC and certain states. Local voice service revenues as a percentof total revenues has decreased from approximately 44% for the quarter endedSeptember 30, 2002 to approximately 43% for the quarter endedSeptember 30, 2003. Local voice service revenues consisted of:

 

•                                          themonthly recurring charge for basic local voice service;

 

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

 

•                                          chargesfor additional 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.

 

We expect local voiceservice revenues to continue to decrease from period to period as a percent oftotal revenues, as a result of our increasing focus on integrated voice, dataand customer premise equipment sales and services, the resolution of certainregulatory disputes and uncertainties and lower rates for carrier access andinterconnection revenues as mandated by our negotiated agreements withcarriers, the FCC and certain states. We are currently examining certain ofthese negotiated access agreements to determine which of those executorycontracts may be burdensome to us and should be rejected pursuant toSection 365 of the Bankruptcy Code. There can be no assurance that we willbe able to reject these access agreements; if we are able to reject suchagreements, we believe these other carriers would need to pay us for access atour higher tariffed rates which could increase our access revenues from thesecarriers. See the discussion under “Risk Factors,” which contains a detaileddiscussion of the risks and uncertainties associated with our local voicerevenues.

 

Long distance service revenues for the three monthsended September 30, 2003 and 2002 were $9.8 million and$12.7 million, and for the nine months ended September 30, 2003 and2002 were $32.4 million and $35.5 million, respectively. Longdistance service revenues as a percent of total revenues has decreased fromapproximately 6% for the quarter ended September 30, 2002 to approximately5% for the quarter ended September 30, 2003. We have negotiated a new longdistance agreement with a new long-distance provider that should reduce ourcosts to provide long distance services to our customers and allow us to bemore competitive in the pricing of our long distance services. We have alsofiled a motion to reject our existing Master Carrier Agreement with AT&T.  If approved our variable cost per minute forlong distance services will decrease. We are currently in negotiations with AT&T.  We are currently in the process of balancingour long distance traffic between our new carrier and our existing carrier, andwe expect to realize cost savings as this process is completed.

 

Data revenues, includingrevenues generated from Internet access, web hosting and high-speed dataservices, for the three months ended September 30, 2003 and 2002 were$69.7 million and $70.0 million, and for the nine months endedSeptember 30, 2003 and 2002 were $212.2 million and$202.2 million, respectively. Data revenues as a percent of total revenueshas increased from approximately 32% for the quarter ended September 30,2002 to approximately 37% for the quarter ended September 30, 2003. Wealso believe that the continuing evolution of communications networks willpromote the integration of voice and data services over the same facilities,thereby further increasing the availability of cost-effective data offerings.

 

The rate of growth in ourdata revenues has been affected by negative trends. We believe that the demandfor high-end web hosting services has decreased in response to a generaleconomic slowdown. Moreover, an over capacity of data center space hasdecreased prices for these high-end services. High-end services includededicated hosting services where we provide the customer with a dedicatedcomputer server in our data centers and colocation services where we providedata center space and services for a customer who locates its own computerserver on our premises. We believe that the general economic slowdown hascaused a deterioration in our shared hosting business as well. We are currentlyexploring the potential sale of our shared web hosting business and any sale ofthis business would decrease our shared web hosting data revenues.

 

Similarly, the demand forservices we offer to network service providers who provide dial-up Internetaccess services is also experiencing the effects of over capacity and decreaseddemand. The resulting financial hardship has lessened the number of these typesof network service providers. During 2000, we signed a long-term contract toprovide an integrated

 

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network solutionand certain services to Genuity Solutions Inc., a network servicesprovider and operator of a nationwide Internet network. Our contract wasestablished specifically to support Genuity’s customer contracts, includingthat with America Online, and expires on December 31, 2006. Under thiscontract, Genuity committed to pay us an aggregate of $563.0 million overthe term of the contract, subject to our performance under and the other termsand conditions of the contract. Genuity assigned our Integrated NetworkSolution Purchase Agreement to a subsidiary of Level 3Communications, Inc. on February 4, 2003. We anticipate thatLevel 3 will continue to be our largest customer for the foreseeablefuture. For the three months ended September 30, 2003 and 2002, revenuesfrom this contract were $27.3 million and $26.2 million, and for thenine months ended September 30, 2003 and 2002, revenues from this contractwere $84.2 million and $60.5 million, respectively. The revenues fromthis contract accounted for 14% and 12% of our total revenues for the quartersended September 30, 2003 and 2002, respectively, and 39% and 37% of ourdata revenues for the same periods. In addition, approximately 85% of thereciprocal compensation earned by us from other carriers is as a result of theother carriers terminating Level 3 traffic on our networks. Reciprocalcompensation revenues for the three months ended September 30, 2003 and2002 were $4.0 million and $7.1 million and for the nine months endedSeptember 30, 2003 and 2002 were $19.8 million and$25.0 million, respectively.

 

The contract contains specific provisions that allow Level 3 to(a) decrease its purchase commitment in certain situations, including but notlimited to, if Level 3’s customer, AOL, reduces its services withLevel 3 under Level 3’s service relationship with AOL or (b) todecrease the purchase commitment or terminate the contract if Level 3 receivesa bona fide competitive offer for a certain amount of services from a thirdparty for services similar in type to the services provided by Company underthe contract and the Company does not agree to reduce its prices to match thecompetitive offer.  In the event,Level 3 is required to use commercially reasonable efforts to move some ofits existing business to Allegiance to minimize the effect of any downturn ofbusiness on Allegiance. In addition, Level 3 is obligated to allocate anysuch discontinuance of business proportionately across all of Level 3’ssuppliers serving the area in which AOL requests a discontinuance of service.Level 3 is obligated when practicable to give us ninety days writtennotice of any discontinuance of service as a result of a downturn in businessfrom AOL. Finally, Level 3 may not exercise its right to reduce its serviceas a result of a downturn in business from AOL under the contract until afterOctober 1, 2003. Level 3 has informally told us that it expects tosuffer a downturn in business from AOL, but Level 3 has not provided uswith any formal notice under the contract of the amount of downturn we willexperience.

 

Level 3 has indicated to the Company that in its contract with AOL,Level 3 has agreed to a scheduled reduction in services beginning in the thirdquarter of 2004 through the fourth quarter of 2004.  Level 3 has also told the Company that as a result of suchscheduled downturn, Level 3 expects to pass through a downturn of at least 39%of the managed modem ports provided by the Company to Level 3 starting in thethird quarter of 2004 through the fourth quarter of 2004 in addition to anydownturn related to a reduction in demand for services from AOL. The Companyplans to oppose any pass through of the scheduled downturn in services fromAOL. In the event that Level 3 is successful in passing through the scheduleddownturn to the Company, the Company is unable at this time to determine withany certainty the revenue impact, if any, of such a pass through.

 

In the event thatLevel 3 receives a competitive offer from a third party under the contract andAllegiance does not match the competitive offer, Level 3 may either reduce thepurchase commitment under the contract to the amount of services covered by thecompetitive offer or terminate the contract in its entirety.  If the Company matches a qualifying competitiveoffer, Allegiance will experience reduced revenues under the contract.  Level 3 has indicated that it believes thatthe prices for the services under the contract are above market and that it mayseek competitive offers from third parties in conformance with thecontract.  If Level 3 does receive acompetitive offer that complies with the contract’s requirements, the Companycould experience reduced revenues under the contract.

 

The contract alsoprovides that if we receive a going concern qualification or experience anevent of default as defined under our senior credit agreement, (a) Level 3may exercise an option to purchase all of the dedicated assets andinfrastructure used by us to provide the integrated network solution to Level 3and (b) Level 3 would still be required to continue to purchase certainservices from us for the remainder of the term of the agreement. If Level 3exercises its option, it would be required to pay (1) for the dedicatedassets, the remaining undepreciated value of the dedicated assets (as reflectedon our books at the time of exercise of the option) and (2) for thecertain services, the remaining overall value of the agreement less the amountspaid to purchase the dedicated assets and infrastructure. Any such purchase transactionwould require Bankruptcy Court approval. We have not received any notice fromLevel 3 that it intends to exercise its rights under this provision of theagreement.

 

We have receivedcommunications from Level 3 claiming, among other things, that we havefailed to meet the applicable performance warranties under the contract; andthat certain rights that Level 3 has under the contract, including, butnot limited to, Level 3’s ability to require us to secure anothersubcontractor for certain services and/or Level 3 can terminate our ability tosupply such services, may already be triggered. In addition, Level 3 hasclaimed that it is entitled to offsets against the August 2003 andNovember 2003 payments for Allegiance’s alleged failure to deliver certainservices.  Finally, Level 3 has allegedthat the Company's failure to deliver certain services may constitute a breachof the contract.  We do not believe thatwe have failed to meet the performance warranties alleged by Level 3; wedo not believe that we have failed to deliver the services alleged byLevel 3; we do not believe that we have breached the contract; nor do webelieve that, even if Allegiance has not delivered the services in accordancewith the contract, that the offset amounts claimed by Level 3 arecalculated in accordance with the contract. If we are found to have failed tomeet the performance warranties under the contract, Level 3 may offsetfuture payments to us and, if such failure continues for an extended period oftime, Level 3 could terminate the contract.

 

If the Companyexperiences a downturn in its services with Level 3, the Company may offersimilar services to other internet service providers, except AOL amongothers.  If Level 3 terminates thecontract the Company may offer services in competition with Level 3 to AOL andall other Internet service providers. If we were to lose some or all of the revenues under this contract, wedo not believe we could implement sufficient cost-cutting measures tooffset such decrease in revenues. The resulting reduction in revenue (includingreduction in reciprocal compensation revenues) and/or loss of this contractwould have a material adverse effect on our business. We are continuing ournegotiations with Level 3 to modify certain service level warranties,remedies and penalties under the contract, as well as other modifications tothe contract. We can provide no assurances that these negotiations will besuccessfully concluded.

 

On November 3, 2003,Level 3 paid Allegiance approximately $13.9 million of the$25 million quarterly payment due in November 2003. Level 3 offsetagainst the quarterly payment approximately $89 thousand for certainoffsets that Level 3 claims it is due for Allegiance’s alleged failure to delivercertain ports. In addition, Level 3 has withheld approximately$11.0 million of the November 2003 payment until Level 3 has an orderfrom the Bankruptcy Court confirming Level 3’s reservation of rights withrespect to Level 3’s claims for offsets. Allegiance vigorously denies thatLevel 3 is entitled to any of the offsets claimed by Level 3.

 

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Notwithstanding thesetrends and uncertainties, we expect continued demand by small and medium sizedbusiness customers for dedicated access to the Internet and integratedservices. Indeed, our Integrated Access Service which delivers high-speed,“always on” Internet access and allows multiple voice, data and Internetcombinations over a single access loop remains our fastest growing productoffering. During the quarter ended September 30, 2003, Integrated AccessService represented approximately 37% of our net lines sold for the quarter(and when including all services delivered via T1 circuits, 54% of our netlines sold for the quarter). We believe that line churn rates (the rate atwhich customers disconnect their lines) for Integrated Access Service whenvoice and data are bundled is lower than that of our local voice service. Oneof the challenges we face in this area is ongoing network efficiency andservice delivery improvements to retain the competitive advantages of thisservice offering.

 

In June 2002, weacquired substantially all of the assets and assumed certain liabilities of thecustomer premise equipment sales and customer premise equipment maintenancebusiness, also known as Shared Technologies Fairchild, from WorldCom. Customerpremise equipment sales and maintenance revenues for the three months endedSeptember 30, 2003 and 2002 were $27.8 million and $40.3 millionand for the nine months ended September 30, 2003 and 2002 were$91.1 million and $45.7 million, respectively. Customer premiseequipment sales and maintenance revenues as a percent of total revenues isapproximately 15% and 18% for the quarters ended September 30, 2003 and2002. As a result of our bankruptcy, until we received Bankruptcy Courtauthority to procure limited bid and performance bonds on October 8, 2003, wehad not been able to obtain certain bid and performance bonds or provide othertypes of financial security as required by many of our customers. As a result,we have lost current customers to our competitors and have a reduced ability togain new customers. Moreover, some customers will not purchase services fromcompanies in bankruptcy, so certain opportunities are not available to us. Theloss of current and potential customers has impacted our revenues and willcontinue to impact our revenues as long as these conditions exist.

 

**Network Expenses**

 

For the quarters endedSeptember 30, 2003 and 2002, network expenses were $96.8 million and$118.3 million, and for the nine months ended September 30, 2003 and2002, network expenses were $313.2 million and $295.7 million,respectively. Network expenses related to the Shared Technologies business,acquired in June 2002, included in the quarters ended September 30,2003 and 2002 were $16.8 million and $23.7 million, and for the ninemonths ended September 30, 2003 and 2002 were $53.9 million and$27.9 million, respectively. Network expenses as a percentage of totalrevenues decreased from 54% for the quarter ended September 30, 2002 to51% for the quarter ended September 30, 2003. While there can be noassurance that we will be successful in creating or continuing the existingoperating efficiencies, we expect to control costs and that network expenses asa percentage of total revenues will reduce over time. We are performing anextensive review of our network architecture and a rationalization of theoverall profitability of our business on a colocation, market, and productbasis. As such, we may decommission a colocation arrangement, rebuild orreplace infrastructure facilities and reduce or sell entire markets. Inaddition, we may eliminate some products and services currently offered. As aresult of such events, we may be able to reduce our future network costs. Withrespect to the implementation of this review and rationalization, we mayconvert a limited number of facilities-based customers to UNE-P, deployalternate unbundled network element applications, or, in some instances,eliminate a colocation, product or service completely. In addition, we areanalyzing our contracts and leases to determine those executory contracts andunexpired leases relating to our network that may be burdensome to us and shouldbe rejected pursuant to Section 365 of the Bankruptcy Code. If we receiveBankruptcy Court approval to reject any of these executory contracts orunexpired leases, we expect our future network costs to decrease as a result.

 

Gross margin hasincreased from 46% for the quarter ended September 30, 2002 to 49% for thequarter ended September 30, 2003. The increase in gross margin is related,among other things to reduced network expenses related to network optimizationactivities, as well as reductions in network expenses associated with thebankruptcy process.  Gross margin iscalculated as revenues less network expenses, divided by revenues. We expectour gross margins to improve as we reject burdensome network contracts and /orenter into amendments or new contracts with lower costs and as we realize costefficiencies in our network over time.

 

Network expensesinclude:

 

•                                          thecost of leasing local loop lines which connect our customers to our network;

 

•                                          thecost of leasing high-capacity digital lines that interconnect our network andwith the networks of the incumbent local exchange carriers;

 

•                                          thecost of leasing high-capacity digital lines that connect our switchingequipment to our transmission equipment located in the central offices of theincumbent local exchange carrier;

 

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•                                          thecost of enhancing our network;

 

•                                          thecost of completing local, toll and long distance calls originated by ourcustomers, including switched access and reciprocal compensation charges paidby us;

 

•                                          thecost of long distance services resold by us to our customers;

 

•                                          thecost of leasing space in incumbent local exchange carrier central offices andthe cost of electric power purchased from the incumbent for colocating our transmissionequipment;

 

•                                          operatingand maintenance expenses for dark fiber;

 

•                                          thecost of customer premise equipment which has been sold by us and the cost ofproviding maintenance services on such equipment;

 

•                                          thecost of Internet transit and transport;

 

•                                          thecost of leasing certain portions of our nationwide Internet network; and

 

•                                          forShared Technologies, the costs of equipment and labor for the installation andmaintenance of equipment.

 

Network expenses do notinclude an allocation of our depreciation or amortization expenses.

 

The costs to lease localloop lines, high-capacity digital T-1 loop lines, and high-capacity digitalinteroffice facilities from the incumbent local exchange carriers vary bycarrier 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 these high-capacitydigital interoffice facilities on dedicated fiber. Even in areas of highdensity and traffic in our markets, however, the incumbent local exchangecarriers are sometimes the only available source of high-capacity digitalinteroffice facilities.

 

We expect that ournetwork costs will continue to be a significant part of our ongoing cost ofservices.

 

In accounting for thecosts of constructing switching and transmission equipment for a new market, wecapitalized as a component of property and equipment only the initialnon-recurring charges associated with our network facilities.

 

We incur “reciprocalcompensation” costs in providing both voice and data services and expectreciprocal compensation costs to be a major portion of our cost of services. Wemust enter into an interconnection agreement with the incumbent local exchangecarrier in each market we provide service to make widespread calling availableto our customers and these agreements are approved by the state regulatoryagency. These agreements typically set the cost per minute to be charged byeach party for the calls that are exchanged between the two carriers’ networks.Generally, a carrier must compensate another carrier when a local call by thefirst carrier’s customer terminates on the other carrier’s network. Thesereciprocal compensation costs are a variable cost that will grow as ourcustomers’ outbound calling volume grows. Over time, the rates for reciprocalcompensation have decreased and in some of our markets, we exchange localtraffic 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 of securing longdistance service capacity is a variable cost that increases in direct relationshipto increases in our customer base and increases in long distance callingvolumes. We have entered into a new long distance agreement and have filed amotion with the Bankruptcy Court to reject our existing long distanceagreement. We are currently engaged in negotiations with AT&T.  Although there can be no assurances that theBankruptcy Court grants this motion, if we are successful, our variable costper minute for long distance services will decrease. If we are unsuccessful inrejecting this contract, we are required under that contract to spend a minimumdollar amount each month.

 

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We install voice and dataaggregation and switching equipment in space owned or leased by other parties,including locating our equipment in central offices of local incumbent exchangecarriers’ networks. We incur rent and utility charges in leasing this space. Weexpect these costs to generally remain constant in the near future as we do notplan to expand to additional colocation sites. We are in the process ofevaluating our colocation space needs as part of our bankruptcy and we mayreduce the number of colocations that we are currently occupying which couldreduce our colocation expenses.

 

We sell and install telecommunicationscustomer premise equipment and provide maintenance services on such equipment.Our costs to provide these products and services include both time and materialcosts. These costs will increase or decrease in relation to the demand for theseproducts and services.

 

We have developed anational 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 anumber of settlement-free peering arrangements with other Internet backboneproviders. Most of these arrangements are month-to-month and generally can beterminated by either party upon notice. If we lose any of these arrangements orif the other Internet backbone provider requires payment by us for the exchangeof traffic, our network costs may materially increase.

 

**Selling, General and AdministrativeExpenses**

 

For the quarters endedSeptember 30, 2003 and 2002, selling, general and administrative expenseswere $86.0 million and $114.2 million, and for the nine months endedSeptember 30, 2003 and 2002, selling, general and administrative expenseswere $301.2 million and $326.3 million, respectively. Selling, generaland administrative expenses related to the Shared Technologies business,acquired in June 2002, included in the quarters ended September 30,2003 and 2002 were $9.9 million and $13.4 million, and for the ninemonths ended September 30, 2003 and 2002 were $34.6 million and$14.5 million, respectively. Selling, general and administrative expensesas a percentage of total revenues decreased from 52% for the quarter endedSeptember 30, 2002 to 46% for the quarter ended September 30, 2003.

 

Selling, general andadministrative 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 achievement of certaineconomies of scale as we have grown the business. During the nine months endedSeptember 30, 2003, these decreases were partially offset by the inclusionof selling, general and administrative expenses related to the SharedTechnologies business and by $9.8 million of employee bonuses paid includingthose under a key employee retention program.

 

Selling, general andadministrative expenses include salaries, benefits and related personnel costs,administration and facilities costs, sales and marketing costs, customer careand billing costs, investor and media relations, insurance, professional feesand bad debt expense. As a result of our transition from rapid revenue growthto a plan geared towards reducing cash used in operations and achievingpositive cash flow, we reduced headcount, including the number of sales teamsduring the second half of 2002 and first three quarters of 2003. Our totalheadcount decreased from 4,198 at September 30, 2002 to 2,912 atSeptember 30, 2003. As of September 30, 2003, the sales force,including sales managers and sales administrators, had decreased to 793 from1,290 as of September 30, 2002. We expect selling, general andadministrative expenses to continue to decrease as a percentage of revenues aswe focus on reducing cash used, integrating our operations and achieving economiesof scale in our business. We are analyzing our contracts and leases todetermine

 

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those executorycontracts and unexpired leases relating to our selling, general andadministrative expenses that may be burdensome to us and should be rejectedpursuant to Section 365 of the Bankruptcy Code. If we receive BankruptcyCourt approval to reject any of these executory contracts or unexpired leases,we expect our future selling, general and administrative costs to decrease as aresult.

 

We have an invoice processing agreement (the “BillingAgreement”) with Daleen Solutions, Inc. (“Daleen”).  Daleen is one of our primary invoice processing vendors forbilling our customers.  On October 30,2003, Daleen notified Allegiance that it was electing to not renew the BillingAgreement.  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 it couldsend Allegiance notice of its intent to elect to not renew the BillingAgreement.  On November 19, 2003, theBankruptcy Court denied Daleen’s Motion, but Daleen may appeal the BankruptcyCourt’s ruling.  If the BankruptcyCourt’s decision is not appealed or upheld on appeal, the Billing Agreementwill renew on December 31, 2003 for an additional one year term on the sameterms and conditions as the existing Billing Agreement.  If we are unable to continue billing ourcustomers relating to these events, it may have a material adverse effect onour company and our business, as further discussed below in “Risk Factors.”

 

# **Depreciation**

 

During the quarters endedSeptember 30, 2003 and 2002, depreciation expense was $63.1 millionand $64.0 million, respectively. For the nine months endedSeptember 30, 2003 and 2002, depreciation expense was $188.9 millionand $184.7 million, respectively. The increase is primarily the result ofcapital expenditures and assets placed in service between September 30,2002 and September 30, 2003.

 

**Amortization of Purchased Intangibles**

 

In connection with theacquisitions completed since inception, we assigned an aggregate of$62.8 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 September 30, 2003 and 2002, we recorded$2.4 million and $8.1 million of amortization of customer lists, andfor the nine months ended September 30, 2003 and 2002, we recorded$8.6 million and $26.9 million of amortization of customer lists,respectively.

 

**Deferred Compensation Expenses**

 

For the quarters endedSeptember 30, 2003 and 2002, we recognized $0.6 million and$1.5 million, respectively, of amortization of deferred compensationexpense, and for the nine months ended September 30, 2003 and 2002, werecognized $2.2 million and $2.0 million, respectively, ofamortization of deferred compensation expense. Such deferred compensation wasrecorded in connection with membership units of Allegiance Telecom, LLC sold tocertain management employees and grants of stock options and restricted commonshares to certain employees under our 1997 stock option plan and 1998 stockincentive plan.

 

**Interest Expense and Interest Income**

 

For the three monthsended September 30, 2003 and 2002 and the nine months endedSeptember 30, 2003 and 2002, interest expense was $9.0 million,$28.0 million, $58.6 million and $77.5 million, respectively.Prior to the Commencement Date of our Chapter 11 cases, interest expenseincluded the accretion of the 11 3/4%notes and related amortization of the original issue discount, the amortizationof 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, the deferreddebt issuance costs related to this debt are no longer being amortized tointerest expense. Under a Bankruptcy Court order, we are required to continueincurring and paying interest under our senior secured credit facilities and wehave continued to amortize the deferred debt issuance costs related to thesenior secured credit facilities to interest expense.

 

Interest income for threeand nine months ended September 30, 2003 was $0.8 million and$2.7 million, respectively. Interest income for three and nine monthsended September 30, 2002 was $1.6 million and $5.4 million,respectively. Interest income results from short-term investments, cash andcash equivalents. Interest income during the periods ended September 30,2002 is greater than for the periods ended September 30, 2003 because wehad additional cash invested in interest-bearing instruments and becauseof higher average interest rates.

 

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During the nine monthsended September 30, 2003, at the direction of the US Trustee in ourChapter 11 cases, we sold an investment in commercial paper in the open marketin order to comply with our revised investment guidelines. The sale was atmarket value and resulted in the realization of a gain of $3.3 million.

 

**Operating Losses**

 

Our loss from operationsfor the three and nine months ended September 30, 2003 was$60.8 million and $226.7 million, respectively. Our loss fromoperations for the three and nine months ended September 30, 2002 was$86.7 million and $380.4 million, respectively.

 

**Reorganization Items**

 

Reorganization itemsconsist of costs associated with our bankruptcy proceedings that are notdirectly attributable to the ongoing operations of our business. During thethree and nine months ended September 30, 2003, we incurred$7.1 million and $9.5 million, respectively, in professional fees andrecognized a gain of $10.3 million and $10.8 million, respectively,related to other restructuring activities. We expect to continue to incursignificant costs associated with our reorganization.

 

***LIQUIDITY ANDCAPITAL RESOURCES***

 

As of September 30,2003, we had approximately $284.6 million of unrestricted cash andshort-term investments, compared with $284.3 million of unrestricted cashand short-term investments as of December 31, 2002. We do not have anyoff-balance sheet financing arrangements, special purpose entities or assetsecuritizations. On June 26, 2003, we received final Bankruptcy Courtapproval for the use of our cash collateral under an Amended Final OrderAuthorizing Use of Cash Collateral by Consent (the “Final Cash CollateralOrder”). The Final Cash Collateral Order among other things: (1) restrictsour use of cash, (2) requires us to prepare and follow a budget and maintaina minimum weekly cash balance, and (3) requires us to provide certainfinancial, operational and other information to our senior lenders. Under thisFinal Cash Collateral Order, we are required to continue incurring and payinginterest under our senior secured credit agreement (at the applicablenon-default rate of interest).

 

As of September 30,2003, we had $1,336.1 million of outstanding liabilities subject tocompromise, including $1,115.5 million of indebtedness (including debtunder our senior secured credit agreement and two series of bonds). We areparty to a senior secured credit agreement and two indentures. As ofSeptember 30, 2003, approximately $472.7 million of our indebtednesswas borrowed under our senior secured credit agreement, as described in moredetail below. As of that same date, approximately $642.8 million of ourindebtedness was borrowed under our two indentures.

 

Our existing cash andshort-term investment balances is expected to decline during fiscal 2003.Decreased demand for our services or high customer churn, as noted above, couldadversely impact our liquidity. Customer demand for our services depends inpart on our ability to efficiently and timely switch customers from their priorcarrier to our service, respond to customer service and billing issues andprovide quality service. We expect to reduce our debt in the bankruptcyreorganization process; however, at this time, we cannot predict the levels ofdebt that we will maintain after the reorganization process is complete. It ispossible that if the debt reduction is not enough, because of operatingperformance or other factors, we may not be able to fully fund our operations,planned capital investments and debt service. Please see the discussion belowunder the caption “Senior Secured Credit Agreement” and below under the caption“Risk Factors.”

 

Our financial projectionsare based on forecasts of, among other things, customer demand and line churn,i.e. the rate at which customers discontinue their lines. Customers leave ourservice for a variety of reasons, including but not limited to, the customer:(a) leaving our service area, (b) going out of business or downsizingits business, (c) being unhappy with our service, (d) general marketconditions, (e) leaving for better pricing, (f) needing a differenttelecom solution that we do not provide, (g) disruptions in servicerelating to our network optimization activities and (h) concern regardingour bankruptcy and financial condition. In the quarter ended September 30,2003, the average retail line churn was approximately 2.6% and includingwholesale, our average line churn was approximately 1.7%. Line churn is thenumber of voice grade equivalent lines (for example, a fully-utilized data T-1counts as 24 lines) that are disconnected each month divided by the totalnumber of voice grade equivalent lines that we have in service at the beginningof that month. The line churn is difficult to forecast and

 

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remains one of thespecific challenges on which we are focused. We expect that retail line churnas well as retail and wholesale line churn will range between 2% to 3% in 2003.We expect retail and wholesale line churn to improve in 2004 and beyond. Wehave responded to high line churn with many customer retention initiativesincluding, new service offerings, more attractive rate plans, back officeimprovements, roll out of Singl.eView billing system, proactive contact withcustomers, and root cause resolutions. The above churn metrics do not includechurn related to businesses such as Shared Technologies, Allegiance BusinessInternet access services, or web hosting. We are in the process ofdecommissioning 22 of our colocations and provisioning existing customersserved by those colocations by alternative methods.  This may impact customer service and increase customer churn. Wecan provide no assurances that we will be able to effectively manage or reduceour line churn. If we are unable to do so, this will materially affect ourbusiness, revenues and liquidity.

 

Decreased customer demandmay also stem from uncertainty of our bankruptcy filing, the industry in whichwe compete and the general economy. Many of our competitors have also declaredbankruptcy, de-listed from the public securities markets and/or identifiedfinancing problems. Some of our potential customers as well as currentcustomers have expressed concerns about our financial stability in light of ourbankruptcy filing, the general economy and the telecommunications industry in general.We believe customer perception will continue to have an impact on our abilityto attract and retain customers. Specifically, our financial condition haslimited our ability to secure bid and performance bonds which are required bysome customers of our customer premises equipment sales and maintenancebusiness. Moreover, our customers may not purchase additional services and maycancel existing services as a result of our bankruptcy filing, our specificfinancial condition, including the independent auditors’ report for 2002 thatcites conditions which raise substantial doubt about our ability to continue asa going concern, and general economic conditions.

 

For the quarters endedSeptember 30, 2003 and 2002, we made capital expenditures of$1.9 million and $28.2 million, respectively. For the nine monthsended September 30, 2003 and 2002, we made capital expenditures of$15.9 million and $110.4 million, respectively. As ofSeptember 30, 2003, we had transmission equipment colocated in 851 centraloffices. Pursuant to our current business plan, we expect to spendapproximately the same amount for capital expenditures for the last quarter of2003 as that spent for the first three quarters of 2003. We expect to fund ourcapital expenditures with available cash and future cash flow.

 

We have purchaseddedicated fiber rings in 24 of our markets. As of September 30, 2003, wehad dedicated fiber rings in operation in 24 markets including Austin,Baltimore, Boston, Chicago, Dallas, Denver, Detroit, Ft. Worth, Houston, LongIsland, Los Angeles, 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. 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 September 30, 2003, our totalcosts have been $194.6 million, and we are committed to spend anadditional $143.5 million for this fiber, which will be incurred over thelife of these existing fiber supply arrangements ending in 2023. We plan tofund this cost with our available cash and future cash flow. We are analyzingour fiber contracts in light of our bankruptcy and may need to reject certainof such contracts pursuant to Section 365 of the Bankruptcy Code.Alternatively, we may attempt to re-negotiate these contracts with the vendorsto obtain more reasonable terms in light of current market conditions.

 

**ContractualObligations**

 

The following summarizessome of our future financial commitments at September 30, 2003 and theeffect such obligations are expected to have on our liquidity and cash flow infuture 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                                |   | $                          | 1,123  |                        | $      | 54 |   | $ | 357 |   | $ | 712 |   | $ | — |   |
| Interest  payments                                 |   | 420                        |   | 104                         |   | 185 |   | 131 |   | — |   |
| Capital lease  obligations, including interest (3) |   | 161                        |   | 11                          |   | 23 |   | 25 |   | 102 |   |
| Operating leases                                   |   | 113                        |   | 23                          |   | 43 |   | 32 |   | 15 |   |
| Other material  long-term obligations (3)          |   | 59                         |   | 26                          |   | 29 |   | 4 |   | — |   |
| Total  contractual cash obligations                |   | $                          | 1,876  |                        | $      | 218 |   | $ | 637 |   | $ | 904 |   | $ | 117 |   |

 

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(1)                                  Weare analyzing our contracts and leases to determine those executory contractsand unexpired leases that may be burdensome to us and should be rejectedpursuant to Section 365 of the Bankruptcy Code. This table reflects anysuch executory contracts or unexpired leases that have already been rejected withBankruptcy Court approval but does not reflect any additional executorycontracts or unexpired leases that may be rejected in the future in our Chapter11 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. No adjustment that might result from the potentialimpact of these acceleration events or the bankruptcy is reflected in thistable.

 

(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**

 

In February 2000, weclosed on $500.0 million of new senior secured credit facilities, whichreplaced our prior $225 million revolving credit facility. These newsenior secured credit facilities consist of a $350.0 million revolvingcredit facility and a $150.0 million delayed draw term loan facility.Interest on amounts drawn is generally the 6-month London Interbank OfferedRate plus 4.50% per annum. Our senior credit agreement contains certainrepresentations, warranties and covenants, including many financial covenants.

 

During the third quarter of 2001, we drew$200.0 million under the revolving credit facility and $150.0 millionunder the delayed draw term loan. The interest rate applicable to this draw is5.68% per annum and will remain fixed until March 18, 2004, and then it will beadjusted based on the London Interbank Offered Rate in effect at that time. InJune 2002, we requested a draw of the remaining $150 million underthe revolving credit facility. The interest rate applicable to this draw is5.50% per annum and will remain fixed until December 26, 2003, and then itwill be adjusted based on the London Interbank Offered Rate in effect at thattime.

 

As of June 30, 2003,we had received $135.3 million of the $150.0 million requested inJune 2002, with 3 of the 26 banks in the bank syndicate refusing to fund ourrequest. On July 15, 2003, we entered into a settlement agreement withBayerische Hypo-und Vereinsbank and Bank Austria Creditanstalt Corporate Finance, Inc.(collectively, the “Banks”) regarding these funding disputes. On July 29,2003, the Bankruptcy Court approved this settlement agreement. On July 31,2003, the Banks delivered the Net Funding Obligation to us required under thissettlement agreement in the amount of $7.4 million. On October 24, 2003,we entered into a settlement agreement with Dresdner Bank AG regarding thesefunding disputes.  On October 27, 2003,we filed a motion with the Bankruptcy Court for approval of this settlementagreement. If approved, Dresdner Bank AG would be obligated to deliver to usits Net Funding Obligation of $5.1 million.

 

The obligations under thesenior credit agreement are secured by (1) the capital stock of AllegianceTelecom Company Worldwide (which stock is owned by its parent holding company,Allegiance Telecom, Inc.) and (2) substantially all of the assets ofAllegiance Telecom Company Worldwide and its subsidiaries, including thecapital stock owned by Allegiance Telecom Company Worldwide in each of its subsidiaries.The Final Cash Collateral Order also provides the senior lenders with certainreplacement liens as described in such Order. Under this Order and variousStipulation and Consent Orders, the Creditors’ Committee has until December 1,2003 to among other things, challenge the senior lenders’ prepetition liens,claims or security interests or the lenders’ pre-petition obligations.

 

***CRITICAL ACCOUNTINGPOLICIES***

 

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,

 

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differ from thoseestimates.

 

Our critical accountingpolicies are discussed below. Each of these areas involves complex situationsand a high degree of judgment either in the application and interpretation ofexisting literature or in the development of estimates that impact ourfinancial 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. 101, “RevenueRecognition in Financial Statements” (“SAB 101”), which provides additionalguidance on revenue recognition as well as criteria for when revenue isrealized and earned and related costs are incurred. The application of SAB 101requires management’s judgment on the amount and timing of revenue recognition.Should changes in conditions cause management to determine the revenuerecognition criteria are not met for certain future transactions, revenuerecognized for any reporting period could 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 isrequired in assessing the ultimate realization of our accounts receivable. Weevaluate the collectibility of our accounts receivable based on a combinationof factors. We recognize allowances for doubtful accounts based on the lengthof time the receivables are past due, the current business environment and ourhistorical experience. In circumstances where we are aware of a specificcustomer’s or carrier’s inability to meet its financial obligations to us, werecord a specific allowance against amounts due, to reduce the net recognizedreceivable to the amount we reasonably believe 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 whichindicate that the carrying amount of an asset may not be recoverable. Ifimpairment indicators are present, we analyze the projected undiscounted cashflows associated with our property and equipment and intangible assets todetermine the fair value of these assets. Considerable management judgment isnecessary in establishing the assumptions used as a basis for this analysis.

 

The commencement of ourbankruptcy proceedings is a potential indicator that the carrying value ofcertain of our assets may not represent their fair value. We performed ananalysis comparing estimated future cash flows to the carrying value of ourproperty and equipment and intangible assets at May 14, 2003. Thisanalysis did not indicate that an impairment exists as of May 14, 2003.Although we believe our estimates and assumptions used in this calculation arereasonable, actual results could vary significantly from these estimates.Should changes in conditions or facts cause us to revise our estimates, wecould be required to record impairment charges in future periods, which mayhave a significant impact on our results of operations.

 

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**Other Matters.**  We do not have any of the following:

 

•              Off-balance sheet financialarrangements

 

•              Trading activities that includenon-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 ACCOUNTINGPRONOUNCEMENTS***

 

We continually monitorand revise our accounting policies as developments occur. The followingrecently issued accounting pronouncements may impact the future presentation ofour financial condition and results of operations.

 

In June 2001, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 143, “Accounting for Asset Retirement Obligations.” Thisstatement addresses financial accounting and reporting for obligationsassociated with the retirement of tangible long-lived assets and the associatedasset retirement costs. Our adoption of this statement did not have a materialeffect on our financial position or results of operations.

 

In June 2002, theFinancial Accounting Standards Board issued Statement of Financial AccountingStandards No. 146, “Accounting for Costs Associated with Exit or DisposalActivities.” This statement addresses financial accounting and reporting forcosts associated with exit or disposal activities. Adoption of this statementis required for exit or disposal activities initiated after December 31,2002, with early application encouraged. Our adoption of this statement did nothave a material effect on our financial position or results of operations.

 

In November 2002,the FASB’s Emerging Issues Task Force (“EITF”) reached a consensus on IssueNo. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF IssueNo. 00-21 provides guidance on how to account for arrangements thatinvolve the delivery or performance of multiple products, services and/orrights to use assets. The provisions of EITF Issue No. 00-21 will apply torevenue arrangements entered into in fiscal periods beginning afterJune 15, 2003. Our adoption of this statement did not have a materialeffect on our financial position or results of operations.

 

In May 2003, the FinancialAccounting Standards Board issued Statement of Financial Accounting StandardsNo. 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.

 

***CERTAIN RELATEDPARTY TRANSACTIONS***

 

On April 4, 2001,Anthony Parella, President of Shared Technologies, borrowed $3.0 millionfrom us. Mr. Parella issued a promissory note payable to us, which notewas payable on April 4, 2004. In September 2001, Mr. Parellaborrowed an additional $1.2 million from us. Mr. Parella issued afull recourse promissory note (the “Full Recourse Note”) payable to us for atotal amount of $4.2 million plus previously accrued interest of $81,564on the April 4, 2001 note. The Full Recourse Note is payable on April 4,2004. This note accrues interest at 2.73% per annum, which was theNovember 2001 applicable federal rate, and interest is payable when thisnote is due. In the event Mr. Parella resigns or is terminated by us forcause (as defined in the Full Recourse Note), then this note will becomeimmediately due and payable. Under the Full Recourse Note, we have the right toenforce the repayment obligation of Mr. Parella by looking to his personalassets. The Full Recourse Note is also secured by a pledge of Mr. Parella’sAllegiance stock options, as well as 350,000 shares of Allegiance common stock.The $4.2 million was used by Mr. Parella to repay certain debt thathe incurred in connection with the purchase of land. That debt was secured byMr. Parella’s Allegiance stock and he would have been forced to sell suchstock to satisfy the debt if he did not obtain another means of repaying thedebt. We determined that making the loan to Mr. Parella was in the bestinterests of our stockholders because it allowed him to avoid a forced sale ofhis shares and instead be able to take the time necessary to sell his land.

 

The loan toMr. Parella is reflected in “other current assets” in our financialstatements. If Mr. Parella does not

 

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repay his loanunder the terms of his note, we will have recourse to his Allegiance stockoptions, shares of Allegiance common stock and personal recourse.

 

During the three and ninemonths ended September 30, 2003, Swidler Berlin Shereff Friedman, LLP performedlegal services for us. Andrew Lipman, a member of our board of directors, is asenior partner at this law firm. We recorded approximately $0 and $97,000 inlegal fees by this firm in the three and nine months ended September 30,2003, respectively. We intend to continue using this law firm in fiscal 2003for advice on legal matters.

 

***FORWARD-LOOKINGSTATEMENTS***

 

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 and strategies,our anticipation of revenues from designated markets, and statements regardingthe development of our businesses, possible impact of our bankruptcy filing onour business, possible actions by the Bankruptcy Court, the Creditors’Committee, our senior lenders or other creditors, the markets for our servicesand products, our anticipated capital expenditures, operations support systemsor changes in regulatory requirements and other statements contained in thisreport 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:

 

•                                          ourability to obtain court approval with respect to motions in our Chapter 11cases prosecuted by us from time to time;

 

•                                       ourability to develop, prosecute, confirm and consummate one or more plans ofreorganization with respect to the Chapter 11 cases;

 

•                                          risksassociated with third parties seeking and obtaining court approval to terminateor shorten the exclusivity period for Allegiance to propose and confirm one ormore plans of reorganization, for the appointment of a Chapter 11 trustee or toconvert the Chapter 11 cases to Chapter 7 cases;

 

•                                          ourability to obtain and maintain normal and reasonable terms with vendors andservice providers and to maintain contracts that are critical to ouroperations;

 

•                                          ourability to perform under and maintain our Level 3 customer contract;

 

•                                          DaleenSolutions, Inc.'s ability to perform under its billing services contract;

 

•                                          thepotential adverse direct and indirect impact of the Chapter 11 cases on ourbusiness;

 

•                                          thecosts and availability of financing;

 

•                                          ourability to execute our business plan, including our ability to provide qualitycustomer service and develop efficient operations support systems and otherback office systems,

 

•                                          ourability to attract, motivate and/or retain key employees;

 

•                                          regulatory,judicial and legislative developments;

 

•                                          generaleconomic conditions; and

 

•                                          theeffects of the war in Iraq and any other hostilities or act of war or anyterrorist attack.

 

You should consider allof our subsequent written and oral forward-looking statements only in light ofsuch cautionary

 

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statements. Youshould not place undue reliance on these forward-looking statements and youshould understand that they represent management’s view only as of the dates wemake them.

 

***RISK FACTORS***

 

Our businesses aresubject to a number of risks including: (i) bankruptcy related riskfactors; and (ii) general business and financial risk factors. Any or allof such factors, which are enumerated below, could have a material adverseeffect on the business, financial condition or results of operations of ourcompany.

 

***Bankruptcy RelatedRisk Factors***

 

**Our operations may be disrupted dueto the filing of the Chapter 11 proceeding.**  On May 14, 2003, we filed voluntarypetitions for relief under Chapter 11 of the Bankruptcy Code. The impact thatthe Chapter 11 cases may have on our operations cannot be accurately predictedor quantified. Since the announcement of the amendment to our senior creditagreement in November 2002, the challenges 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 in March 2003,customers have in some cases declined to conduct business with our company andcertain vendors have either declined to conduct business with us or have askedfor deposits, letters of credit and other forms of security prior to providingservices to us. In addition, we have had difficulty in obtaining bid andperformance bonds which are required by some customers of our customer premiseequipment sales and maintenance business. We have also experienced the loss oftalented key employees and could experience more losses of key talent in thefuture attributable to our reorganization efforts. The continuation of theChapter 11 cases could further adversely affect our operations and our currentand potential relationships with our customers, employees, suppliers, and otherrepresentatives.

 

**Any plan of reorganization that wepropose may not be acceptable to our creditors and other stakeholders and/ormay not be confirmed by the Bankruptcy Court.**If our plan isnot confirmed and/or an alternative reorganization cannot be agreed upon, it ispossible that the company may be sold under Section 363 of Chapter 11 ofthe Bankruptcy Code.

 

**We may lose exclusivity by failing tosubmit a plan of reorganization by the end of the exclusivity period.**  Allegiance currently is the only party ableto submit a plan of reorganization in its bankruptcy proceeding.  However, if we do not submit a plan ofreorganization by December 16, 2003, or any extension, any party in interestmay submit a plan of reorganization that may include the sale of the companypursuant to Section 363 of Chapter 11 Bankruptcy Code.

 

**Any sale of the company may notinclude all of the assets of the company.**  There can be no assurances that if we enterinto a sale of the company under Section 363 of Chapter 11 Bankruptcy Code thatany assets not sold will be operated as a going concern.

 

**Our common stock and high-yield bondsare unsecured and located at our holding company and as a result, arestructuring of our debt may substantially reduce the value of our bonds andcommon stock, potentially to zero.** We operate our businessthrough subsidiaries and have no material assets at our holding company,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.  We have proposed materialreductions in our level of senior secured debt and believe that this isrequired to have a feasible reorganization plan.  Any Chapter 11 plan filed by us may provide that unsecuredcreditors of subsidiaries of Allegiance Telecom, Inc. will need to besatisfied before any distribution to the unsecured creditors or stockholders ofAllegiance Telecom, Inc.  As aresult, a plan of reorganization could result in holders of our bonds receivinglittle or no value as part of the plan of reorganization.  Based on current discussions with ourcreditors regarding a plan of reorganization, our common stock will probablyreceive no value as part of the reorganization.** **In light of the foregoing, we consider our bonds and commonstock to be highly speculative and we caution the holders of such securitiesthat such securities may ultimately be determined to have no value.  Accordingly, we urge that extreme caution beexercised with respect to existing and future investments in any of suchsecurities and claims.

 

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***General Business,Financial and Other Risk Factors***

 

**We anticipate having future operatingand net losses.**  Wehave incurred operating and net losses every year since we began operations. Wehave invested significant amounts of capital and other expenditures indeveloping our business and deploying our networks, systems and services and wewill continue to invest capital for the operation of our business. We willcontinue to have significant operating and net losses in our business until weestablish a sufficient revenue-generating customer base to cover our costs. Forthe quarter ended September 30, 2003, we had net operating losses of$60.7 million and net losses including reorganization items of$63.1 million. Even if we emerge from bankruptcy, we can make noassurances that we will achieve or sustain profitability or generate sufficientoperating income to meet our working capital, capital expenditure and debt servicerequirements.

 

**Our customer contract withLevel 3 Communications represented 14% of our total revenues for thequarter ended September 30, 2003 and the loss of this customer wouldmaterially and adversely impact our business.**  Our largest customer is Level 3 Communications, Inc.,who is the assignee of Genuity Solutions Inc.’s interest in theGenuity/Allegiance Integrated Network Solution Purchase Agreement. Revenuesfrom this contract were $27.3 million and $26.2 million for the threemonths ended September 30, 2003 and 2002, and $84.2 million and$60.5 million for the nine months ended September 30, 2003 and 2002,respectively. This represented 14% and 12% of our total revenues for thequarters ended September 30, 2003 and 2002, respectively, and 39% and 37% ofour data revenues for the same periods. In addition, approximately 85% of thereciprocal compensation earned by us from other carriers is as a result of theother carriers terminating the Level 3 traffic on our networks. Reciprocalcompensation revenues for the three months ended September 30, 2003 and2002, were $4.0 million and $7.1 million and for the nine monthsended September 30, 2003 and 2002 were $19.8 million and$25.0 million, respectively. We anticipate that Level 3 will continueto be our largest customer for the foreseeable future. If we fail to meet theperformance warranties under this contract or fulfill certain other obligationsunder this contract, Level 3 may be allowed to offset future payments tous and, if such failure continues for an extended period of time, Level 3could terminate this contract. The contract contains specific provisions thatallow Level 3 (a) to decrease its purchase commitment in certainsituations, including but not limited to, if Level 3’s customer, AOL,reduces its services with Level 3 under Level 3’s contract with AOL,or (b) to decrease the purchase commitment or terminate the contract if Level 3receives a bona fide competitive offer for a certain amount of services from athird party for services similar in type to the services provided by Companyunder the contract and the Company does not agree to reduce its prices to matchthe competitive offer. In addition, if the Company matches any qualifyingcompetitive offer from a third party, the Company could experience reducedrevenues.  If we were to lose some orall of the revenues under the contract, we do not believe we could implementsufficient cost-cutting measures to offset such decrease in revenues or be ableto replace the revenues in a short period of time. The resulting reduction inrevenue (including reduction in reciprocal compensation revenues) and/or lossof this contract would have a material adverse effect on us. Please see thediscussion of this customer contract under “Management’s Discussion andAnalysis of Financial Condition and Results of Operations.”

 

**Oneof our primary invoice processing vendors has a "going concern"qualification and any financial difficulties experienced by it could have anadverse impact to our business.**  We have an invoice processing agreement (the“Billing Agreement”) with Daleen Solutions, Inc. (“Daleen”).  Daleen is one of our primary invoiceprocessing vendors for billing our customers and we believe that the amountspaid by us under the Billing Agreement represent a substantial portion ofDaleen’s revenues.  The original term ofthe Billing Agreement expires on December 31, 2003 and automatically renews foradditional one year terms, unless either party gives the other party notice ofits intent to not renew this agreement at least sixty days prior to theexpiration of then existing term.  OnOctober 30, 2003, Daleen notified us that it was electing to not renew theBilling Agreement, but that it would like to discuss the terms of a newcontract.  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 us notice of its intent to elect to not renew the Billing Agreement.  On November 19, 2003, the Bankruptcy Courtdenied Daleen’s Motion, but Daleen may appeal the Bankruptcy Court’sruling.  If the Bankruptcy Court’sdecision is not appealed or upheld on appeal, the Billing Agreement will renewon December 31, 2003 for an additional one year term on the same terms andconditions as the existing Billing Agreement.

 

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On January 30, 2003, Daleen Technologies, Inc.’sauditors, KPMG LLP, issued an Independent Auditors’ Report on Daleen Technologies,Inc. that contained a “going concern” qualification.  Daleen is a wholly owned subsidiary of Daleen Technologies, Inc.(“Daleen Technologies”).  On May 21,2003, Daleen Technologies filed a Form 8-K with the Securities and ExchangeCommission warning that if we fail to continue business with DaleenTechnologies and Daleen Technologies fails to obtain additional financing orfails to engage in one or more strategic alternatives, it may have a materialadverse effect on Daleen Technologies’ ability to operate as a goingconcern.  In addition, on October 31,2003, Daleen Technologies filed a Form 8-K with the Securities and Exchange Commission warning that if we ceaseto do business 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.  

 

There can be no assurance that Daleen will remain inbusiness through the migration of our customers off the Daleen service orprovide the services required under the Billing Agreement.  If Daleen ceases to remain in business orfails to provide the services under the Billing Agreement, it may have amaterial adverse effect on our company and our business.

 

**The regulation of interconnectionwith incumbent local carriers involves uncertainties, and the resolution ofthese uncertainties could adversely affect our business.**Although the incumbent local carriers are required under the TelecommunicationsAct of 1996 to unbundle and make available elements of their network and permitus to purchase only the origination and termination services that we need,thereby decreasing our capital and operating expenses, such unbundling may notbe done as quickly as we require, may be priced higher than we expect, and/orthe incumbent local exchange carriers may erect barriers to use of suchelements. This is important because we rely on the facilities of these othercarriers to provide services to our customers. Our ability to obtain theseinterconnection agreements on favorable terms, and the time and expenseinvolved in negotiating them, can be adversely affected by legal and regulatorydevelopments.

 

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 unbundled network elements, including local loops anddedicated transport, the principal elements used by us. We use unbundled localloops and unbundled high capacity digital loops to connect our customerlocations to our voice and data transmission equipment colocated in theincumbent local carriers’ central offices, and dedicated transport to connectour transmission equipment to our switches and data equipment which aregenerally located at our central offices. The FCC also stated its intention toreview every three years the unbundling obligations of incumbent local exchangecarriers. The U.S. Court of Appeals for the District of Columbia Circuitremanded, but did not vacate, the FCC’s Order on May 24, 2002. The FCC’srequest for rehearing of that decision was denied, but the Court agreed todelay until February 20, 2003 the issuance of the mandate. OnFebruary 20, 2003, the FCC announced its decision in the triennial reviewas briefly discussed below. While these court and FCC proceedings were pending,we entered into interconnection agreements with a number of incumbent localcarriers through negotiations or, in some cases, adoption of anothercompetitive local carrier’s approved agreement. These agreements remain ineffect, although in some cases one or both parties may be entitled to demandrenegotiation of particular provisions or of the entire agreement based onintervening changes in the law. However, it is uncertain whether any of theseagreements will be so renegotiated or whether we will be able to obtain renewalof these agreements on as favorable terms when they expire. The incumbent localexchange carriers have in each instance requested renegotiation of ourinterconnection agreements.

 

Our facilities-basedstrategy 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 Allegiance 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, unbundled networkelement platforms, high capacity loops

 

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such as those weuse for many of our data and integrated voice and data services, subloops,network interface devices, the high-frequency portion of the loop, switching,and interoffice transmission facilities. The FCC announced its decision onFebruary 20, 2003 in the triennial review proceeding and released thewritten order on August 21, 2003.  Inaddition, the FCC has subsequently issued clarifications to the order througherrata.  General highlights of the orderare as follows:

 

•                                          Ingeneral, the FCC’s triennial review order revised its standard of review fordetermining when unbundled network elements are made available to competitors.Specifically, the FCC’s revised standard recognized the benefits offacilities-based competition and confirmed that continued provision of UNEs isessential to the growth of facilities-based networks such as those operated byus.

 

•                                          Withrespect to unbundled switching, the FCC adopted a process whereby the statepublic utilities commission will consider whether competitors are impaired ifthey do not have access to Bell companies’ switch services on a UNEbasis under the regulatory construct known as unbundled network elementplatform (“UNE-P”). We expect that this state review will result in a review ofthe hot cut process (transferring a customer from the Bell’s systems to oursystems) and could potentially enhance our ability to transition new customersto our networks.

 

•                                          Thedecision also confirms that facilities-based competitive carriers like us cancontinue to obtain access to loops in almost all markets. The FCC alsoclarified the conditions under which the Bell companies must make availableunbundled loops for competitors. This should reduce the time it takes us toinstall a customer’s services, especially in certain ILEC areas.

 

•                                          Ontransport issues, the FCC adopted a standard proposed by us whereby transportwill be taken off the UNE list on a route-specific basis when there are twocompetitive wholesale providers of transport or three self-provisionedtransport links by non-ILEC sources. This approach is consistent with oursmart-build strategy for local transport of using ILEC facilities only as atransition to dark fiber or the facilities of other providers.

 

•                                          TheFCC decision 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 reviewgives us an opportunity to efficiently expand our facilities-based network toadditional areas not directly accessed by our current colocation footprint andto potentially reduce the number of colocations we have, thereby reducing ournetwork costs.

 

•                                          TheFCC exempted hybrid fiber/copper loops that provide packetized datatransmission from the UNE rules. The FCC preserved access to high-capacityloops, such as DS1’s, DS3’s, dark fiber and copper subloops that transmitservices using existing TDM (time division multiplexing) technology. Sincevirtually all of our current business customers are served using unbundledcopper loops or DS1’s that use TDM technology, the FCC’s exemption of hybridfiber/copper loops that provide packet-based technology should not impact ourcurrent operations.  In the future, asnew packet-based technologies are deployed in the local loop infrastructure,this ruling by the FCC could cause an adverse impact on our ability to competewith the ILECs for small to medium-sized business customers. We and othercompetitive carriers have appealed the broadband sections of the triennialreview order in the D.C. Circuit Court of Appeals based on our view that theFCC’s exemption of hybrid/fiber loops is unlawful and in violation of theTelecommunications Act of 1996.  We areunable to predict at this time the timing or outcome of the decision by theD.C. Circuit Court on this matter.

 

•                                          TheFCC also exempted from unbundling any end-to-end fiber loop that is defined asfiber-to-the-home (“FTTH”) for new greenfielddevelopments.  After the release of thetriennial review order, the FCC issued an errata that expanded the FTTHdefinition beyond residential dwellings to include end-to-end fiber loops thatalso extend all the way to a premise that would include small businesses thatwe might serve.  We and othercompetitive carriers have sought a stay of this aspect of the triennial revieworder which is also pending before the D.C. Circuit Court of Appeals.  The D.C. Circuit has subsequentlyconsolidated all stay motions and appeals of the triennial review order and hasindicated its intent to consider all challenges to the triennial review orderon an expedited basis.  The Court hasannounced a schedule for hearing all of these appeals with oral arguementsscheduled for January 28, 2004.  Weanticipate a decision from the D.C. Circuit Court could be issued as early asthe second quarter of 2004.  If the FTTHsection of the triennial review order is not ultimately overturned, it wouldprevent us from being able to provide services to small businesses in newgreenfield developments.

 

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In addition to the potential impact on our businessfrom the hybrid/fiber loop and the FTTH sections of the triennial review, theILECs have recently filed petitions for reconsideration at the FCC seekinggreater relief from certain additional aspects of the FCC’s decision.  These petitions seek to expand the FTTH new-build greenfield exemption toapply also to fiber-to-the-curb deployments as well.  We and other competitive carriers are opposing these petitions atthe FCC, and a decision could be forthcoming in the next few months.  If the FCC should grant one or more of theseILEC requests, it would materially reduce the number of small businesses thatwe can serve and would have a material adverse effect on our business.

 

Any action by the FCC,state regulators or the courts limiting the availability of unbundled networkelements, especially unbundled local loops, network interface devices orinteroffice transmission facilities, could increase our costs and otherwisehave a material adverse impact on our business.

 

On February 15,2002, the FCC released a Notice of Proposed Rulemaking requesting comment onthe future regulatory treatment of wireline broadband Internet access services.The FCC has tentatively concluded that when an entity provides wireline broadbandInternet access over its own transmission facilities, the service should beclassified as an information service, rather than a telecommunications service.If the FCC adopts this conclusion, wireline broadband Internet access servicesprovided by local exchange carriers would be subject to substantially lessregulation, and this could result in the incumbent carriers not having toprovide unbundled loops or unbundled high capacity digital loops over the linesused by us to provide broadband Internet access. We purchase unbundled highcapacity digital loops from incumbent carriers to provide our own broadbandInternet access service and integrated access service. While we cannot predictthe outcome of this proceeding, any curtailment of the incumbent carriers’ unbundlingobligations for the loop component used by them to provide broadband Internetaccess services or changes in the cost basis therefore could materiallyincrease our costs and adversely affect our ability to compete effectively withthe incumbent carriers’ broadband Internet access products. Our currentunderstanding is that the FCC will issue this rulemaking in the near future.

 

In early May 2003,the Illinois legislature passed and the governor signed legislation that couldsignificantly increase rates for unbundled local loops that SBC charges tocompetitors including us in Illinois. We are currently evaluating the impact ofthe legislation on our business, but we expect that our network expenses forunbundled loops in certain local calling zones of the Chicago metropolitan areamay be increased to a level that will make our products and services lesscompetitive with SBC’s retail offerings. The legislation grandfathers up to35,000 existing lines under the old rates for two years but applies to all newinstallations immediately. In addition, any lines that churn off of service maynot be replaced by new lines at the grandfathered rate, but rather will be atthe new rates. A lawsuit was filed seeking to overturn the Illinois law infederal district court and seeking a stay of the effectiveness of the law. Thedistrict court overturned the law and stayed the effectiveness of the rateincrease. The seventh circuit court of appeals upheld the lower district courtdecision. It is not clear whether SBC may appeal this ruling to the UnitedStates Supreme Court. If the district court’s decision is not ultimatelyupheld, we may have to significantly reduce or abandon our efforts to add newlines or customers in certain calling areas of Illinois and evaluate theviability of continuing to operate in the Chicago market when the two yeargrandfathering period has expired. If the district court’s decision isultimately overturned or other states in which we operate were to enact similarlegislation, it could have a material adverse impact on our business.

 

The FCC has issued aNotice of Proposed Rulemaking to examine and potentially revise the procedureand rules for calculating the prices that ILECs charge competitors forunbundled network elements (UNEs). The process could result in an increase(possibly material) in the prices that we pay the ILECs for UNEs. A materialincrease in UNE prices, especially for local loops and local transport, wouldhave a material adverse impact on our business.

 

**The regulation of access chargesinvolves uncertainties, and the resolution of these uncertainties couldadversely affect our business.** We earn “access charge”revenue by connecting our voice service customers to their selected toll andlong distance carriers for outbound calls or by delivering inbound toll andlong distance traffic to our voice service customers. Our interstate accesscharges were filed largely mirroring those used by the National ExchangeCarrier Association (“NECA”), an association of independent local exchangecarriers, and our state access charges were generally set at rates comparableto those set by state associations similar to NECA or of individual incumbentcarriers operating in other areas within the same state. These charges aregenerally higher than those charged by the larger incumbent local exchangecarriers operating in the same areas because these large incumbent localexchange carriers have many more customers and therefore have lower per unitcosts. Access charges are intended to compensate the local exchange carrier forthe costs incurred in originating and terminating toll and long distance callson its network and we believe our access charges are appropriately set atlevels approximately the same as those of the smaller carriers, but we anticipatethat these rates will decline over time. Our switched access rates will have tobe adjusted to comply with future decisions of the FCC or state commissions andthese adjustments could have a material adverse effect on us. We have enteredinto a limited number of agreements with other carriers regarding access rateswhich settled certain access charge disputes. We are in the process of

 

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evaluating theseagreements to determine whether to reject or assume these agreements in ourChapter 11 bankruptcy cases. There can be no assurance that we will be able toreject those access agreements; if we are able to reject such agreements, webelieve the other carriers would need to pay us for access at our highertariffed rates which could increase our access revenues.

 

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 us if we are unable to offsetthem 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. We have not yet assumed this agreement in our BankruptcyCase and we are evaluating whether to assume or reject this agreement.

 

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. We anticipate that implementation of the FCC’s decision willlead to an industry-wide reduction in interstate access rates, even by thosecarriers that are not bound by the decision, including smaller carriers.Reduction in interstate access rates will have a material adverse effect on usunless we are able to offset the access revenues with other revenues.

 

Several states in whichwe offer intrastate access services, including Colorado, Maryland,Massachusetts, Missouri, New Jersey, New York, Texas, Virginia and Washington,have proposed or required that access charges of competitive local carriers becapped at the rates charged by incumbent local carriers operating in the samearea as the competitive local carriers with respect to calls originating orterminating in such area, except where the competitive carrier can establishthat its costs justify a higher access rate through a formal cost proceeding.We believe that it is possible that other states will enact similarrequirements. We also believe, however, that it is more likely that many stateswill use 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 revenues.

 

**We could lose revenues if calls toInternet service providers are treated as long distance interstate calls.**We earn “reciprocal compensation” revenue by terminating on our network, localcalls that originate on another carrier’s network. We believe that under theTelecommunications Act of 1996, other local exchange carriers should have tocompensate us when their customers place calls to our customers who areInternet service providers. Most incumbent local carriers disagree. A majorityof our reciprocal compensation revenues are a result from calls to ourcustomers that are Internet service providers, such as Level 3. Regulatorydecisions providing that other carriers do not have to compensate us for thesecalls could limit our ability to service this group of customers profitably andcould have a material adverse effect on us. Given the uncertainty as to whetherreciprocal compensation should be payable in connection with calls to Internetservice providers, we recognize 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. Although no order has yet been issued, it has beenreported that on August 7, 2003, the Minnesota Public Utilities Commissionestablished a rate of zero cents for the end-office switching component ofterminating local calls subject to reciprocal compensation. We believe, basedon the recommendation of the Commission staff, that this reduction will nottake place until we negotiate and execute an amendment to our interconnectionagreement with Qwest in Minnesota to reflect this regulatory change. Thesereductions in compensation will have a material adverse effect on us if we areunable 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 thatInternet service provider traffic is interstate for jurisdictional

 

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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 that Order, the FCCcategorized 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 us if we areunable to offset them with other revenues. Additional disputes over theappropriate treatment of Internet service provider traffic are expected.

 

**Our success depends on our keypersonnel and we may not be able to replace key employees who leave, especiallyduring our reorganization under Chapter 11 of the Bankruptcy Code.**We are managed by a number of key employees, most notably Royce J. Holland, ourChairman and Chief Executive Officer, who is widely recognized as one of thepioneers in managing providers of competitive local exchange services. The lossof services of one or more of these key individuals, particularlyMr. Holland, could materially and adversely affect our business and ourprospects. Most of our key employees do not have employment agreements, and wedo not maintain key person life insurance for any of our employees. However,many of these key employees are covered by a key employee retention program,which has been approved by the Bankruptcy Court.

 

**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 ourgrowth and our ability to control and monitor costs, bill and servicecustomers, initiate, implement and track customer orders and achieve operatingefficiencies. We have introduced a new billing platform across our geographicmarkets and have begun to migrate all existing customers to this new billing platform.Although we are taking steps to manage the implementation of the new billingsystem and we believe that the new billing system will enhance our ability toaccurately and efficiently bill for our services, we cannot assure you that thetransition to the new billing system will not have any adverse impact on ourbusiness. We believe this new billing system will be more effective andaccurate in delivering the quality billing functions that we need. Since ourinception, we have also been engaged in developing and integrating ouressential information systems consisting of our billing system, our sales orderentry system, our customer implementation system, our electronic bondingsystems and our switch information systems. In addition, we continue to integrateour acquired businesses. These are challenging projects because all of thesesystems were developed by different vendors and must be coordinated throughcustom software and integration processes. Our sales, line count and other coreoperating and financial data are generated by these systems and the accuracy ofthis data depends on the quality and progress of the system integrationproject. Although we have made significant progress in our system integrationefforts, we have not completed it and we may experience additional negativeadjustments to our financial and operating data as we complete this effort.These adjustments have not had a material adverse effect on our financial oroperating data to date but until we complete the entire project we cannotassure you that any such adjustments arising out of our systems integrationefforts will not have a material adverse effect in the future. If we are unableto develop, acquire and integrate our operations and financial systems, ourcustomers could experience delays in connection of service, billing issuesand/or lower levels of client service. We also cannot assure you that any ofour systems will be successfully implemented on a timely basis or at all, thatmigrating will be transparent to our users or that our systems will perform asexpected because among other things,:

 

•                                          wehave and will likely continue to have difficulties in getting products andservices from our vendors delivered in a timely and effective manner, atacceptable costs and at the service and performance level required;

 

•                                          wemay fail to adequately identify all of our information and processing needs;

 

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•                                          ourprocessing or information systems may fail or be inadequate;

 

•                                          wemay not be able to effectively integrate such products or services;

 

•                                          wemay not be able to effectively migrate existing customers due to a dispute withour existing billing services provider;

 

•                                          wemay fail to upgrade systems as necessary; and

 

•                                          thirdparty vendors may cancel or fail to maintain, renew or upgrade our licenseagreements that relate to these systems.

 

Our failure tosuccessfully implement these systems would have a material adverse effect onour business and prospects.

 

**We are dependent on many vendors andsuppliers and their financial difficulties may adversely affect our business.**We depend on many vendors and suppliers to conduct our business. For example,we purchase our network assets and customer premise equipment from equipmentmanufacturers and other suppliers and we lease fiber and other circuits fromother carriers as well as from companies who construct these network elementsfor resale. Many of these third parties have experienced substantial financialdifficulties in recent months, in some cases leading to bankruptcies andliquidations. In particular, the providers of fiber for our metropolitan fiberrings as well as our long-haul fiber routes have experienced financialdifficulties, including difficulty in raising the necessary capital to completefiber construction projects and in some cases filing for bankruptcy. Thefinancial difficulties of these companies could have a material adverse effecton our business and prospects.

 

On February 14,2003, Broadwing Communications Services, Inc., a supplier of long distanceservices to us, alleged that we were in material default of our Master ServiceAgreement with Broadwing. Broadwing is demanding $6.6 million in disputedcharges and is threatening to terminate service to our customers. Broadwing hasalso demanded an additional security deposit from us. In response, we soughtand received a temporary restraining order. An agreed preliminary injunctionwas signed on April 17, 2003, preventing Broadwing from terminating ourservice and referring the dispute to arbitration. This dispute has been stayedwhile we are in bankruptcy. We have not included this dispute in network costsas of September 30, 2003, as we believe it is not probable that we will berequired to pay this disputed amount.

 

**Our financial results could beadversely affected by churn and the financial difficulties of our customers.**We expect retail as well as retail and wholesale line churn to continue toaverage approximately 2% to 3% per month, which means that approximately 2% to 3%of our total number of retail/retail and wholesale lines in service woulddiscontinue our service each month. However, our ability to retain ourcustomers and control our churn rate (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 timelymeet the needs 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, (g) our ability to limit service disruptions as we optimize ournetwork and migrate our existing customers to our new billing platform and(h) an ability to overcome our customers’ concerns regarding our bankruptcy.We can make no assurances that our churn rates (including line churn) will notincrease. If our churn rates (including line churn) increase or are higher thanexpected, this could have a material adverse effect on our business andprospects.

 

We provide services tosmall and medium-sized businesses as well as network service providers. Many ofthese businesses 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 such customers reject the customer’s contract with us in its bankruptcy. Inaddition, among other things, we believe companies in financial difficulty areless likely to expand their operations and related demand for communicationsservices and to migrate from dial-up Internet connections to more advanceddedicated connections such as those that we offer.

 

**The financial difficulties of othercompetitive communications providers could adversely affect our business.**Many competitive local exchange carriers, long distance carriers, and otheremerging communications providers have experienced substantial financial difficultiesover the past year, in some cases leading to bankruptcies and liquidations.

 

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The financialdifficulties of these companies could reflect poorly on our own financialstability, may diminish our ability to obtain further capital, may adverselyaffect the willingness of potential customers to move their communicationsservices to an emerging carrier like Allegiance and may result in losses orwrite-offs of reciprocal compensation and access revenues from these carriers.Moreover, we have experienced efforts by established carriers to promote thisproblem by suggesting to their customers that they should not risk placingtheir communications services in the hands of an emerging carrier including onethat has filed for bankruptcy. Some of our competitors have emerged frombankruptcy and others currently in bankruptcy may do so as well. Many of thesecompanies have been able to reduce their debt and otherwise recapitalize theirbusiness and as a result, may be able to gain greater market share by reducingthe prices for their products and services. These companies may be able toreduce their prices to a point lower than our prices and yet still be able tomake a profit because of their reduced debt. We may lose business as a resultof this price competition, and such loss of business may have a materialadverse effect on us.

 

**If we do not interconnect with andmaintain efficient working relationships with our primary competitors, theincumbent local carriers, our business will be adversely affected.**Many new carriers, including us, have experienced difficulties in working withthe incumbent local carriers with respect to initiating, interconnecting, andimplementing the systems used by these new carriers to order and receiveunbundled network elements and wholesale services and locating the newcarriers’ equipment in the offices of the incumbent local carriers. As acompetitive carrier, we must coordinate with incumbent local carriers so thatwe can provide local service to customers on a timely and competitive basis.The Telecommunications Act of 1996 created incentives for regional Belloperating companies to cooperate with competitive carriers and permit access totheir facilities by denying such companies the ability to provide in-regionlong distance services until they have satisfied statutory conditions designedto open their local markets to competition. The FCC has granted approval toBellSouth, Verizon and SBC to provide in-region long distance service in everystate where they operate.  At this time,the FCC has also granted approval for Qwest to provide in-region long distanceservice in every state where they operate with the exception of Arizona.  Once authorized to provide long distanceservice, the RBOCs may have less incentive to be accommodating to us. Inaddition, these companies may limit the development of their systems that theywere doing prior to being permitted to offer long distance services.

 

The regional Belloperating companies have been fined numerous times by both federal and stateauthorities for their failure to comply with applicable telecommunications lawsand regulations. We do not believe these fines have had any meaningful impacton the anticompetitive practices of many of these companies and in fact believethat these practices are increasing in most of our markets. We attempt toenforce our rights against these incumbent monopolies but often times theremedies are inadequate to change their anticompetitive practices and in anyevent provide us with little or no recovery of the damages we have suffered asa result of these practices. Moreover, efforts by us to enforce our rightsagainst these companies may further diminish the level of cooperation wereceive from them. If we cannot obtain the cooperation of a regional Belloperating company in a region, whether or not it has been authorized to offerlong distance service or a regional Bell operating company otherwise fails tomeet our requirements, for example, because of (1) labor shortages,(2) work stoppages or (3) disruption caused by mergers or otherorganizational changes or terrorist attacks, our ability to offer localservices in such region on a timely and cost-effective basis will be materiallyadversely affected. Specifically, Verizon and the unions, CommunicationsWorkers of America and the International Brotherhood of Electrical Workers,have been working with a Federal mediator since July 29, 2003, attemptingto renegotiate the applicable union contracts. Although the union contractsexpired at midnight August 2, 2003, Verizon employees in 13 states and theDistrict of Columbia have reported to work as normal. We purchase services fromVerizon to enable us to provide services to our existing and new customers andany strike by these unions could have a material adverse affect on ourbusiness.

 

We have experienceddifficulties also with receiving payment from the incumbent local exchangecarriers on reciprocal compensation, access charges, and other servicesprovided by us to them. These balances in some instances may be significant andmaterial. We have generally been able to reach mutually acceptable settlementsof these amounts in the past, but there can be no assurance that we will beable to do so in the future. If we do not receive payments from the incumbentlocal exchange carriers with respect to these services provided by us to themand/or if we are unable to reach settlement agreements for the incumbent localexchange companies to pay amounts owed to us, it could have a material adverseeffect on us. In addition, some of our interconnection agreements allow theincumbent local exchange carriers to increase the security amount held by them.In addition, some utilities may seek additional assurances in the form of depositsor other security in accordance with our bankruptcy filings and the bankruptcyrules. If we are forced to increase any security provided to these carriers,this would reduce the amount of cash available for expenses of our businesswhich could have a material adverse effect on our business.

 

**Our principal competitors for localservices, the incumbent local carriers, and potential additional**

 

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**competitors, have advantages that maymaterially adversely affect our ability to compete with them.**The telecommunications industry is highly competitive. In each of the marketstargeted by us, we will compete principally with the incumbent local carrierserving that area. Many of our current and potential competitors in the localmarket have financial, technical, marketing, personnel and other resources,including brand name recognition, substantially greater than ours, as well asother competitive advantages over us. Incumbent local carriers also enjoy otheradvantages that may adversely affect our ability to compete with them, such asour need to purchase critical elements of our network from them. Incumbentlocal carriers are established providers of local telephone services to all orvirtually all telephone subscribers within their respective service areas.Incumbent local carriers also have long-standing relationships with federal andstate regulatory authorities. FCC and state administrative decisions andinitiatives provide the incumbent local carriers with pricing flexibility fortheir:

 

•                                          privatelines, which are private, dedicated telecommunications connections betweencustomers;

 

•                                          specialaccess services, which are dedicated lines from a customer to a long distancecompany provided by the local phone company; and

 

•                                          switchedaccess services, which refers to the call connection provided by the localphone company’s switch between a customer’s phone and the long distancecompany’s switch.

 

In addition, with respectto competitive access services, such as special access services as opposed toswitched access services, the FCC has granted incumbent local carriersincreased pricing flexibility and deregulation for such access services aftercertain competitive levels are reached. If the incumbent local carriers areallowed by regulators to offer discounts to large customers through contracttariffs, engage in aggressive volume and term discount pricing practices fortheir customers, and/or seek to charge competitors excessive fees forinterconnection to their networks or access to unbundled network elements,competitors such as us could be materially adversely affected. If futureregulatory decisions afford the incumbent local carriers increased pricingflexibility or other regulatory relief, such decisions could also have amaterial adverse effect on competitors such as us.

 

We also face, and expectto continue to face, competition in the local market from other current andpotential market entrants, including long distance carriers seeking to enter,reenter or expand entry into the local exchange marketplace such as AT&T,WorldCom and Sprint, and from other competitive local carriers, wirelesscarriers, resellers, competitive access providers, cable television companies,electric utilities, microwave carriers and private networks built by large endusers. In addition, the development of new technologies could give rise tosignificant new competitors in the local market.

 

**Significant competition in providinglong distance and Internet services could reduce the demand for andprofitability of our services.** We also face significantcompetition in providing long distance and Internet services. Many of thesecompetitors have greater financial, technological, marketing, personnel andother 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 promotional incentives.Prices in the long distance market have declined significantly in recent yearsand are expected to continue to decline. We face competition from largecarriers such as AT&T, WorldCom and Sprint, wireless carriers and manysmaller long distance carriers. Other competitors include regional Belloperating companies providing long distance services outside of their localservice area and, with the removal of regulatory barriers, long distanceservices within such local service areas, other competitive local carriers,microwave and satellite carriers and private networks owned by large end users.The FCC has granted approval to provide in-region long distance service toBellSouth and Verizon in all of their states; to SBC Communications inCalifornia, Texas, Oklahoma, Missouri, Arkansas, Kansas and Nevada; and toQwest in Montana, Utah, Washington, Wyoming, Colorado, Idaho, Iowa, Nebraska,North Dakota, South Dakota, New Mexico and Oregon. We may also increasinglyface competition from companies offering local and long distance data and voiceservices over the Internet. Such companies could enjoy a significant costadvantage because they do not currently pay many of the charges or fees that wehave to pay.

 

The Internet servicesmarket is highly competitive and there are limited barriers to entry. We expectthat competition will continue to intensify. Our competitors in this marketinclude Internet service providers, incumbent local carriers, othertelecommunications companies, online service providers, cable companies, andInternet software providers.

 

**Our need to comply with extensivegovernment regulation can increase our costs and slow our growth.**Our networks and the provision of telecommunications services are subject tosignificant regulation at the federal, state and local levels. Delays inreceiving required regulatory approvals or the enactment of new adverseregulation or regulatory

 

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requirements mayslow our growth and have a material adverse effect upon us.

 

The FCC exercisesjurisdiction over us with respect to interstate and international services. Wemust obtain, and have obtained through our subsidiary, Allegiance TelecomInternational, Inc., prior FCC authorization for installation and operationof international facilities and the provision, including by resale, ofinternational long distance services.

 

State regulatorycommissions exercise jurisdiction over us because we provide intrastateservices. We are required to obtain regulatory authorization and/or filetariffs at state agencies in most of the states in which we operate. If andwhen we seek to build our own network segments, local authorities regulate ouraccess to municipal rights-of-way. Constructing a network and selling and maintainingtelephone equipment is also subject to numerous local regulations such asbuilding codes and licensing. Such regulations vary on a city by city andcounty by county basis. In some states, we are required to obtain statecontractor licenses. If we do not obtain such required licenses, we may besubject to fines, revocation of our certificates and licenses and otherpenalties.

 

Regulators at both thefederal and state level require us to pay various fees and assessments, fileperiodic reports, and comply with various rules regarding the contents of ourbills, protection of subscriber privacy, service quality and similar matters onan ongoing basis.

 

We cannot assure you thatthe FCC or state commissions will grant required authority or refrain from takingaction against us if we are found to have provided services without obtainingthe necessary authorizations, or to have violated other requirements of theirrules and orders. Regulators or others could challenge our compliance withapplicable rules and orders. Such challenges could cause us to incursubstantial legal and administrative expenses and cause material adverseeffects.

 

In addition, federal andstate regulators regulate our ability to discontinue services and/or changeprices to our customers. We can give no assurance that we will be able todiscontinue unprofitable services to our customers in a timely fashion. Nor canwe provide any assurance that we can raise prices or change our rate plans forsuch unprofitable services in a timely fashion. Accordingly, we may be forcedto continue to charge reduced prices for unprofitable services for theforeseeable future.

 

**Deregulation of thetelecommunications industry involves uncertainties, and the resolution of theseuncertainties could materially adversely affect our business.**The Telecommunications Act of 1996 remains subject to judicial review andadditional FCC rulemaking, and thus it is difficult to predict what effect thelegislation will have on us and our operations. There are currently manyregulatory actions underway and being contemplated by federal and stateauthorities regarding interconnection pricing, access to and pricing forunbundled network elements and other issues that could result in significantchanges to the business conditions in the telecommunications industry. Wecannot assure you that these changes will not have a material adverse effectupon us. On February 20, 2003, the FCC announced its decision in itstriennial review of the obligations of incumbent carriers to provide competitorsaccess to unbundled network elements. A brief summary of that decision isprovided under “The regulation of interconnection with incumbent local carriersinvolves uncertainties, and the resolution of these uncertainties couldadversely affect our business.”

 

**We continue to monitor our networkfrom a performance and cost perspective and as a result, our networkoptimization routines may have an adverse effect on our customers.**Our engineering and operations organizations continually monitor and analyzethe utilization of our network. As a result, they may develop projects tomodify or eliminate network circuits or colocation facilities that areunderutilized or unprofitable. This ongoing process may result in limitednetwork outages for a subset of our customers, adversely affecting ourrelationship with them and may increase our customer disputes and/or customerchurn.

 

**Our common stock is an extremelyrisky investment for a variety of reasons, including those listed in the“Bankruptcy Related Risk Factors” above.** Allegiance Telecom,Inc.’s common stock is currently traded on the Over the Counter Bulletin Boardunder the symbol “ALGXQ.OB.” The NASDAQ National Market delisted the commonstock on May 27, 2003. We believe there is now decreased liquidity of ourcommon stock. Extreme caution should be exercised with respect to investmentsin any of such securities.

 

**Our past acquisitions may bedifficult to integrate, disrupt our business, dilute our stockholders anddivert management attention.** We have acquired a number ofcompanies as part of our business plan, especially companies that provideInternet and web hosting services. Acquisitions involve risks and presentissues, including, among others:

 

•                                          thedifficulty of integrating the acquired operations, including provisioning,billing and customer service systems;

 

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•                                          thediversion of personnel from other business concerns and potential disruption ofour ongoing business;

 

•                                          expectationsof financial results not being met;

 

•                                          unanticipatedcosts associated with acquisitions;

 

•                                          thedifficulty in combining the service offerings of the acquired company with ourexisting service offerings;

 

•                                          theinability of management to maintain uniform standards, controls, procedures andpolicies;

 

•                                          therisks of entering businesses and markets in which we have little or no directprior experience;

 

•                                          theimpairment of relationships with employees or customers of the acquired companyas a result of changes in management or otherwise arising out of suchtransactions;

 

•                                          useof some of our available cash to purchase these businesses; and

 

•                                          dilutionof current stockholders due to issuances of additional securities asconsideration for acquisitions.

 

We can make no assurancesthat we will be able to successfully integrate acquired businesses oroperations that we have acquired. In addition, we may not achieve theanticipated benefits from our acquisitions. If we fail to achieve theanticipated benefits from such acquisitions, we may incur increased expensesand experience a shortfall in our anticipated revenues and we may not obtain asatisfactory return on our investment.

 

**ITEM3. Quantitative and****Qualitative Disclosures About Market Risk**

 

Our investment policy islimited by our existing bond indentures and senior credit agreement. We arerestricted to investing in financial instruments with a maturity of one year orless. The indentures require investments in high quality instruments, such asobligations of the U.S. government or any agency thereof guaranteed by theUnited States of America, money market deposits and commercial paper with arating of A1/P1.

 

We are thus exposed tomarket risk related to changes in short-term U.S. interest rates. We managethese risks by closely monitoring market rates and the duration of ourinvestments. We do not enter into financial or commodity investments forspeculation or trading purposes and are not a party to any financial orcommodity derivatives.

 

Interest income earned on our investment portfolio isaffected by changes in short-term interest rates. We believe that we are notexposed to significant changes in fair value because of our conservativeinvestment strategy. However, the estimated interest income for 2003, based onthe estimated average 2002 earned rate on investments, is $4.0 million.Assuming a 100-basis-point drop in the estimated average rate, we would beexposed to a $2.8 million reduction in interest income for the year. Thefollowing table illustrates this impact on a quarterly basis:

 
|                                                                                                  |   | **Quarter  Ending**        |   |
|-------------------------------------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                                                  |   | **March 2003**             |   | **June 2003** |   | **September  2003** |   | **December  2003** |   | **Total** |   |
|                                                                                                  |   | **(dollars  in millions)** |   |
|                                                                                                  |   |                       |   |   |   |   |   |   |   |   |   |
| Estimated  average investments                                                                        |   | $                          | 274.0  |   | $ | 266.4 |   | $ | 276.9 |   | $ | 270.8 |   |   |   |
| Estimated  average interest earned at the average rate of 1.44% for the year ended  December 31, 2002 |   | 1.0                        |   | 1.0 |   | 1.0 |   | 1.0 |   | $ | 4.0 |   |
| Estimated impact  of interest rate drop                                                               |   | 0.7                        |   | 0.7 |   | 0.7 |   | 0.7 |   | 2.8 |   |
|                                                                                                       |        |                            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

Our outstanding long-termdebt consists both of long-term, fixed rate notes, not subject to interest ratefluctuations, and our senior secured credit facilities. Borrowings under oursenior secured credit facilities incur interest at a variable rate, based onleverage ratios, and is currently the London Interbank Offered Rate plus 4.50%.Our blended borrowing rate, taking new borrowings into account, is now 5.63%per annum and this interest rate will remain fixed until December 24, 2003.

 

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Therefore, we willnot be exposed to market risk related to rate fluctuations until the end of thefourth quarter of 2003.

 

Beginning inDecember 2003, we will be exposed to market risk related to market changesin the 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 2003 of lessthan $0.1 million.

 

**ITEM 4. *Controls and Procedure******s***

 

Our principal executiveofficer and our principal financial officer, after management’s evaluation,with the participation of such officers, have evaluated the effectiveness ofour disclosure controls and procedures (as defined in Exchange ActRules 13a-15(e) and 15d-15(e)) as of the end of the period covered by thisreport, and have concluded that, based on such evaluation, that our disclosurecontrols and procedures were effective. There was no change in our internalcontrol over financial reporting that occurred during the fiscal quartercovered by this report that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

The company’s management,including the CEO and CFO, does 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 the 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 or proceduresmay deteriorate. Because of the inherent limitations in a cost-effectivecontrol system, misstatements due to error or fraud may occur and not bedetected. Based upon the controls evaluation, our CEO and CFO have concludedthat, subject to the limitations noted above, as of the date of the controlsevaluation, our disclosure controls and procedures were effective to providereasonable assurance that material information relating to us is made known tomanagement, including the CEO and CFO, particularly during the period when ourperiodic reports are being prepared.

 

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

 

**ITEM 1****. *LegalProceedings***

 

On May 14, 2003,Allegiance Telecom, Inc. and all of its direct and indirect wholly ownedsubsidiaries 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 reorganization is being jointly administeredunder the caption “In re Allegiance Telecom, Inc. et al. Case No. 03-13057(RDD).” We are authorized under Chapter 11 to continue to operate as an ongoingbusiness as “debtors in possession,” but may not engage in transactions outsidethe ordinary course of business without the prior approval of the BankruptcyCourt. As of the date of the bankruptcy filing, most pending litigation isstayed. The rights and claims of various creditors and security holders will bedetermined by a plan of reorganization and under the priority rules establishedby the Bankruptcy Code, certain post-petition liabilities and certainpre-petition liabilities (e.g., our senior secured debt) need to be satisfiedbefore unsecured creditors or stockholders are entitled to any distribution.Any Chapter 11 plan filed by us may provide that unsecured creditors ofsubsidiaries of Allegiance Telecom, Inc. will need to be satisfied beforeany distribution to the unsecured creditors or stockholders of AllegianceTelecom, Inc.  As a result, a planof reorganization could result in holders of our bonds receiving little or novalue as part of the plan of reorganization. Based on current discussions with our creditors regarding a plan ofreorganization, Allegiance Telecom, Inc. common stock will probably receive novalue as part of the reorganization.** **Inlight of the foregoing, we urge that extreme caution be exercised with respectto existing and future investments in any of such securities and claims.  A plan of reorganization must be confirmedby the Bankruptcy Court. At this time, it is not possible to predict accuratelythe effect of the Chapter 11 reorganization process on our business, ourcreditors or our stockholders or when we may emerge from Chapter 11. Our futureresults depend on the timely and successful confirmation and implementation ofa plan of reorganization.

 

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

 

Not applicable.

 

**ITEM 3****. *DefaultsUpon Senior 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 in the first quarter of 2003, (3) comply with the leverage, interestcoverage and debt service ratios, (4) deliver an unqualified audit opinionfor the period ended December 31, 2002 and (5) enter into a permanentamendment to our senior credit agreement. On April 29, 2003, we received aforbearance from our lenders until May 15, 2003. On May 1, 2003, wefiled a Form 8-K describing and attaching this press release andforbearance agreement. As a result of our bankruptcy filing, there is an eventof default under our senior credit agreement as well as our two indentures.

 

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

 

We did not submit anymatter to a vote of our stockholders during the quarter endedSeptember 30, 2003.

 

**ITEM 5****. *OtherInformation***

 

None.

 

**ITEM 6****. *Exhibits andReports on Form 8-K***

 

(a)           The following exhibits are filed withthis report and made a part hereof.

 
| **Exhibit  Number** |   | **Description**                                                                                             |
|---------------------|--------|-------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                        |
| 11.1                |   | Statement regarding computation of per share loss  for the three months ended September 30, 2003            |
| 11.2                |   | Statement regarding computation of per share loss  for the nine months ended September 30, 2003             |
| 11.3                |   | Statement regarding computation of per share loss  for the three months ended September 30, 2002            |
| 11.4                |   | Statement regarding computation of per share loss  for the nine months ended September 30, 2002             |
| 31.1                |   | Certification of the Principal Executive Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2                |   | Certification of the Principal Financial Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1                |   | Certification of the Chief Executive Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002     |
| 32.2                |   | Certification of the Chief Financial Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002     |

 

(b)           Reports on Form 8-K.

 

AllegianceTelecom, Inc. filed a current report on Form 8-K on July 28, 2003reporting that it was postponing its annual stockholders’ meeting originallyscheduled for July 29, 2003.

 

Allegiance Telecom, Inc. filed a current report onForm 8-K on July 31, 2003 announcing that Allegiance Telecom, Inc. and allof its subsidiaries filed their monthly operating statement for the months ofMay and June 2003 with the U.S. Bankruptcy Court for the Southern District ofNew York.

 

Allegiance Telecom, Inc. filed a current report onForm 8-K on August 22, 2003 discussing its results of operations andfinancial condition for the fiscal quarter ended June 30, 2003.

 

Allegiance Telecom, Inc. filed a current report onForm 8-K on September 4, 2003 announcing that Allegiance Telecom, Inc. andall of its subsidiaries filed their monthly operating statement for the monthof July 2003 with the U.S. Bankruptcy Court for the Southern District of NewYork.

 

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Allegiance Telecom, Inc. filed a current report onForm 8-K on September 29, 2003 announcing that Allegiance Telecom, Inc.and all of its subsidiaries filed their monthly operating statement for themonth of August 2003 with the U.S. Bankruptcy Court for the Southern Districtof New York.

 

Allegiance Telecom, Inc. filed a current report onForm 8-K on October 31, 2003 announcing that Allegiance Telecom, Inc. andall of its subsidiaries filed their monthly operating statement for the monthof September 2003 with the U.S. Bankruptcy Court for the Southern District ofNew York.

 

Allegiance Telecom, Inc. filed a current report onForm 8-K on November 10, 2003 discussing its results of operations andfinancial condition for the fiscal quarter ended September 30, 2003.

 

 

**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: November 19, 2003

 

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**INDEX TO EXHIBITS**

 
| **Exhibit  Number** |   | **Description**                                                                                             |
|---------------------|--------|-------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                        |
| 11.1                |   | Statement regarding computation of per share loss  for the three months ended September 30, 2003            |
| 11.2                |   | Statement regarding computation of per share loss  for the nine months ended September 30, 2003             |
| 11.3                |   | Statement regarding computation of per share loss  for the three months ended September 30, 2002            |
| 11.4                |   | Statement regarding computation of per share loss  for the nine months ended September 30, 2002             |
| 31.1                |   | Certification of the Principal Executive Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 31.2                |   | Certification of the Principal Financial Officer  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1                |   | Certification of the Chief Executive Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002     |
| 32.2                |   | Certification of the Chief Financial Officer  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002     |

 

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