<PAGE>   1






                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549

                                    FORM 10-Q

           [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
                         SECURITIES EXCHANGE ACT OF 1934

                              FOR THE QUARTER ENDED
                               SEPTEMBER 30, 1998

          [ ] 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 0-21894

                               SOURCE MEDIA, INC.
             (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

              DELAWARE                                13-3700438
    (STATE OF INCORPORATION)                      (I.R.S. EMPLOYER
                                                IDENTIFICATION NUMBER)

                           5400 LBJ FREEWAY, SUITE 680
                               DALLAS, TEXAS 75240
                    (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)

                                 (972) 701-5400
              (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)

INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED
TO BE FILED BY SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING
THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS
REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING
REQUIREMENTS FOR THE PAST 90 DAYS.
                   YES   [X]                    NO   [ ]


  NUMBER OF SHARES OF COMMON STOCK OUTSTANDING AT NOVEMBER 8, 1998: 12,631,623


<PAGE>   2



                               SOURCE MEDIA, INC.

                                    FORM 10-Q

                    FOR THE QUARTER ENDED SEPTEMBER 30, 1998
<TABLE>
<CAPTION>


PART I.  FINANCIAL INFORMATION
                                                                                                   Page Number
                                                                                                   -----------

<S>               <C>                                                                              <C> 
     Item 1.      Consolidated Financial Statements

                  Consolidated Balance Sheets (Unaudited)
                           September 30, 1998 and December 31, 1997                                    3-4

                  Consolidated Statements of Operations (Unaudited)
                           Three and nine months ended                                                   5
                           September 30, 1998 and 1997

                  Consolidated Statements of Cash Flows (Unaudited)
                           Nine months ended September 30, 1998 and 1997                                 6

                  Notes to Consolidated Financial Statements                                          7-13
 

     Item 2.      Management's Discussion and Analysis of Financial                                  14-21
                  Condition and Results of Operations

PART II.  OTHER INFORMATION

     Item 1.      Legal Proceedings                                                                  21-22


     Item 2.      Changes in Securities                                                               N/A

     Item 3.      Defaults Upon Senior Securities                                                     N/A

     Item 4.      Submission of Matters to a Vote of Securities Holders                               N/A

     Item 5.      Other Information                                                                   N/A

     Item 6.      Exhibits and Reports on Form 8-K                                                   22-23
</TABLE>



                                       2

<PAGE>   3







PART I - FINANCIAL INFORMATION

                               SOURCE MEDIA, INC.
                           CONSOLIDATED BALANCE SHEETS
                                   (UNAUDITED)
<TABLE>
<CAPTION>

                                                                            DEC. 31,         SEPT. 30,
                                                                             1997               1998                  
                                                                        ------------       ------------

<S>                                                                     <C>                <C>         
ASSETS
Current assets:
        Cash and cash equivalents                                       $  8,430,941       $  9,860,357
        Short-term investments                                            15,615,419          3,750,000
        Restricted investments                                            11,709,921         17,552,084
        Trade accounts receivable, less allowance                               --                 --
           for doubtful accounts of $153,694 and $404,431
           in 1997 and 1998, respectively                                  2,796,241          4,331,090
        Deferred expenses                                                    990,687            506,821
        Prepaid expenses and other current assets                            843,005            885,942
                                                                        ------------       ------------
Total current assets                                                      40,386,214         36,886,294

Property and equipment:
        Production equipment                                               5,693,939          5,894,144
        Computer equipment                                                 2,652,103          3,253,630
        Other equipment                                                      753,883          1,041,607
        Furniture and fixtures                                               523,516            659,281
                                                                        ------------       ------------
                                                                           9,623,441         10,848,662

Accumulated depreciation                                                   4,193,484          6,077,366
                                                                        ------------       ------------

Net property and equipment                                                 5,429,957          4,771,296

Intangible assets:
        Patents                                                           14,942,465         14,944,243
        Goodwill                                                          22,372,837          6,698,137
        Contract rights                                                   24,487,000         11,933,377
                                                                        ------------       ------------
                                                                          61,802,302         33,575,757

Accumulated amortization                                                  10,528,869         13,320,170
                                                                        ------------       ------------

Net intangible assets                                                     51,273,433         20,255,587

Restricted investments                                                    11,090,574                  0
Other non-current assets                                                   5,321,848          4,858,971
                                                                        ------------       ------------

Total assets                                                            $113,502,026       $ 66,772,148
                                                                        ============       ============

</TABLE>

                                        3


                               
<PAGE>   4
                               SOURCE MEDIA, INC.
                     CONSOLIDATED BALANCE SHEETS (CONTINUED)
                                   (UNAUDITED)
<TABLE>
<CAPTION>

                                                                                      DEC. 31,           SEPT. 30,
                                                                                        1997                1998          
                                                                                  -------------        -------------

<S>                                                                               <C>                  <C>          
LIABILITIES AND STOCKHOLDERS' EQUITY (CAPITAL DEFICIENCY)
Current liabilities:
        Trade accounts payable                                                    $   1,654,404        $     772,424
        Accrued interest                                                              2,066,667            5,000,000
        Accrued payroll                                                                 150,062              451,239
        Other accrued liabilities                                                     1,226,425            1,352,755
        Unearned income                                                               4,024,164            3,235,945
                                                                                  -------------        -------------
Total current liabilities                                                             9,121,722           10,812,363

Long-term debt                                                                      100,000,000          100,000,000

Minority interests in consolidated subsidiaries                                       3,839,552            3,839,552
Note receivable and accrued interest from minority
        stockholder, net of discount of $95,437 and
        $64,152 in 1997 and 1998, respectively                                         (723,645)            (766,149)
                                                                                  -------------        -------------
                                                                                      3,115,907            3,073,403

Senior redeemable payment-in-kind (PIK) preferred stock,
           $25 liquidation preference, $.001 par value, net of
           discount
           Authorized shares - 1,712,000, Issued and outstanding
           shares 800,000 and 883,765 in 1997 and 1998, respectively                 13,696,799           15,982,903

Stockholders' equity (capital deficiency):
           Common stock, $.001 par value:
           Authorized shares - 50,000,000
           Issued shares - 11,969,039 and 13,003,210 in 1997
              and 1998, respectively                                                     11,969               13,003
        Less treasury stock, at cost - 410,963 and 374,980 in 1997
              and 1998, respectively                                                 (4,075,127)          (3,705,676)
        Capital in excess of par value                                               81,482,951           83,586,386
        Accumulated deficit                                                         (89,729,242)        (142,929,402)
        Foreign currency translation                                                    (23,760)              15,434
        Notes receivable and accrued interest
              from stockholders                                                         (99,193)             (76,266)
                                                                                  -------------        -------------
Total stockholders' equity (capital deficiency)                                     (12,432,402)         (63,096,521)
                                                                                  -------------        -------------

Total liabilities and stockholders' equity (capital deficiency)                   $ 113,502,026        $  66,772,148
                                                                                  =============        =============
</TABLE>



See accompanying notes.

                                        4


<PAGE>   5
                               SOURCE MEDIA, INC.
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                                   (UNAUDITED)

<TABLE>
<CAPTION>

                                                  THREE MONTHS ENDED SEPT. 30,             NINE MONTHS ENDED SEPT. 30,
                                                     1997               1998                1997               1998
                                               -------------------------------         --------------------------------

<S>                                               <C>                 <C>              <C>                 <C>         
Monetary revenues                               $ 2,652,251         $ 6,343,418        $  7,988,259        $ 17,334,860
Nonmonetary revenues                              1,517,204             377,036           4,927,961           1,490,037
                                               ------------        ------------        ------------        ------------
      Total revenues                              4,169,455           6,720,454          12,916,220          18,824,897

Monetary cost of sales                            2,043,173           3,479,732           4,944,983           8,783,693
Nonmonetary cost of sales                         1,517,204             377,036           4,927,961           1,490,037
                                               ------------        ------------        ------------        ------------
      Total cost of sales                         3,560,377           3,856,768           9,872,944          10,273,730
                                               ------------        ------------        ------------        ------------

Gross profit                                        609,078           2,863,686           3,043,276           8,551,167

Selling, general and administrative expenses      4,728,858           6,493,310          13,803,350          17,827,039
Impairment of intangible assets                        --                  --                  --            25,935,715
Amortization of intangible assets                   925,461           1,236,467           2,769,073           5,083,908
Research and development expenses                   837,120             916,809           2,681,587           2,614,806
                                               ------------        ------------        ------------        ------------
                                                  6,491,439           8,646,586          19,254,010          51,461,468
                                               ------------        ------------        ------------        ------------
Operating loss                                   (5,882,361)         (5,782,900)        (16,210,734)        (42,910,301)

Interest expense                                  1,681,272           3,191,445           2,661,647           9,600,800
Interest income                                     (83,329)           (456,450)           (238,578)         (1,597,710)
Other (income) expense                               (1,475)             12,665             (60,089)            (27,255)
                                               ------------        ------------        ------------        ------------
Net loss                                       ($ 7,478,829)       ($ 8,530,560)       ($18,573,714)        (50,886,135)
                                               ============        ============        ============        ============
Preferred stock dividends                              --               733,999                --             2,314,024

Net loss attributable to common stockholders     (7,478,829)         (9,264,559)        (18,573,714)        (53,200,160)
                                               ============        ============        ============        ============

Basic and diluted net  loss per common share   ($      0.65)       ($      0.76)       ($      1.64)       ($      4.51)
                                               ============        ============        ============        ============

Weighted average common shares outstanding       11,434,443          12,194,706          11,292,655          11,792,427
                                               ============        ============        ============        ============
</TABLE>


See accompanying notes.


                                       5

<PAGE>   6



                               SOURCE MEDIA, INC.
                      CONSOLIDATED STATEMENTS OF CASH FLOWS
                                   (UNAUDITED)
<TABLE>
<CAPTION>

                                                                         NINE MONTHS ENDED SEPTEMBER 30,
                                                                             1997                1998
                                                                        ------------         ------------

<S>                                                                     <C>                  <C>         
OPERATING ACTIVITIES
Net loss                                                                ($18,573,714)       ($50,886,136)
Adjustments to reconcile net loss to net cash used in
       operating activities:
       Impairment of intangible assets                                          --            25,935,715
       Depreciation                                                        1,561,339           1,883,882
       Amortization of intangible assets                                   2,769,073           5,083,909
       Deferred compensation                                                    --             1,752,089
       Non-cash interest expense                                           2,630,392             602,477
       Non-cash interest income                                                 --              (818,256)
       Provision for losses on accounts receivable                            32,712             250,737
       Write-off of debt issue costs                                         315,068                --
       Warrants issued for services provided                                 279,571                --
       Issuance of common stock in litigtion settlement                      299,063
       Other, net                                                            (43,216)            (46,244)
Changes in operating assets and liabilities:
       Trade accounts receivable                                            (233,405)         (1,785,587)
       Prepaid expenses and other assets                                     274,638             (42,937)
       Deferred expenses                                                    (309,645)            483,866
       Trade accounts payable and accrued liabilities                         39,291           2,495,913
       Unearned income                                                      (389,916)           (788,219)
                                                                        ------------        ------------
Net cash used in operating activities                                    (11,348,749)        (15,878,792)
                                                                                                       0
INVESTING ACTIVITIES
       Capital expenditures                                               (1,675,544)         (1,225,221)
       Acquisition of equipment and contract rights                       (1,350,000)               --
       Redemption of short-term investments                                     --            17,932,086
                                                                        ------------        ------------
Net cash provided by (used in)  investing activities                      (3,025,544)         16,706,865

FINANCING ACTIVITIES
       Proceeds from issuance of long-term debt                           13,922,625                --
       Proceeds from issuance of common stock upon exercise
            of stock options                                                 551,308             721,832
       Other                                                                (200,219)           (159,683)
                                                                        ------------        ------------
Net cash provided by financing activities                                 14,273,714             562,149

Effect of exchange rate changes on cash and cash equivalents                 (43,985)             39,194
                                                                        ------------        ------------

Net increase (decrease) in cash and cash equivalents                        (144,564)          1,429,416
Cash and cash equivalents at beginning of period                           4,302,943           8,430,941
                                                                        ------------        ------------

Cash and cash equivalents at end of period                              $  4,158,379        $  9,860,357
                                                                        ============        ============
</TABLE>


See accompanying notes.

                                        6


<PAGE>   7







                               SOURCE MEDIA, INC.

             NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

Unless the context otherwise requires, (a) all references to the "Company" or
"Source" include Source Media, Inc. and its wholly-owned subsidiaries, SMI
Holdings, Inc. ("Holdings"), IT Network, Inc. ("IT Network"), Interactive
Channel, Inc. ("Interactive Channel"), and Interactive Channel Technologies,
Inc., marketed under the name of VirtualModem ("ICT" which was formerly known as
Cableshare, Inc.), and (b) all references to the Company's activities, results
of operations or financial condition prior to June 23, 1995 relate to Holdings.

1.  Basis of Presentation

         The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and the instructions for Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management these financial statements
include all adjustments, consisting of normal recurring accruals, necessary to
present fairly the financial position, results of operations and cash flows of
Source Media, Inc. and its consolidated subsidiaries for the periods indicated.
The balance sheet at December 31, 1997, has been derived from the audited
financial statements at that date. For further information, refer to the
consolidated financial statements and notes thereto included in the Company's
Annual Report on Form 10-K for the year ended December 31, 1997.

2.  Net Loss Per Common Share

         For the three and nine months ended September 30, 1998, in accordance
with the requirements of Statement of Financial Accounting Standards ("SFAS")
No. 128, "Earnings Per Share", net loss per common share amounts ("basic EPS")
were computed by dividing net loss attributable to common stockholders by the
weighted average number of common shares outstanding. A diluted earnings per
share has not been presented because the options and warrants are anti-dilutive.
Net loss per share amounts for the same prior-year period do not differ from the
amounts previously disclosed due to the anti-dilutive nature of the stock
options and warrants.

3.  Contingencies

         In October 1998, the Company settled all litigation in Ontario,
Canada with Marvin Lerch, the former Chief Executive Officer and former
shareholder of ICT and certain of his relatives, also former ICT shareholders.
The settlement resolved both litigation commenced in December 1993 against the
Company and certain executive officers and a former director of ICT for actions
allegedly intended to depress the value of ICT and the litigation filed in June
1994 by Marvin Lerch against ICT and certain persons claiming wrongful
termination of his employment with ICT. Under the terms of the settlement, all
parties agreed to dismiss both cases, and the Company agreed to transfer a total
of 87,500 shares of the Company's common stock to the plaintiffs. The Company
expects to record an additional expense of $400,000 in the fourth quarter 1998
when the settlement is expected to be completed.





                                       7
<PAGE>   8

         On May 11, 1998, ICT and Holdings, both wholly-owned subsidiaries of
Source, filed an action in U.S. District Court for the District of Delaware
against WorldGate Communications, Inc. ("WorldGate") alleging that WorldGate has
infringed four of the Company's patents. Each party has filed a Motion to
Dismiss certain claims and no date has been set for a hearing by the district
court. The Company intends to aggressively defend its patents.

         In July 1998, the Company instituted a copyright infringement action in
Michigan federal court against certain companies competing with IT Network's
telephone business, alleging that these competitors infringed certain IT Network
copyrighted information. On October 14, 1998, the federal judge issued a
preliminary injunction in favor of the Company enjoining the competitors from,
among other things, selling, licensing, distributing or reproducing works
derived from the Company's information. The Company is also involved in certain
litigation in federal and state courts in Kansas related to tortious
interference and violations of non-compete agreements by former employees of IT
Network. The Company intends to aggressively pursue all of these cases.

         On August 21, 1998, the first of 13 class action cases was filed
against the Company and certain officers and directors in federal court in the
Northern District of Texas. The litigation is all conducted under the provisions
of the Private Securities Litigation Reform Act of 1995. The federal court will
appoint the lead plaintiff and counsel, which is expected within the next 30
days. The Company believes that all the cases are without merit and will
vigorously defend itself, its officers and directors.

         In addition, the Company is aware of certain claims against the Company
and ICT that have not developed into litigation, or if they have, are dormant.
Further, the Company and ICT are parties to ordinary routine litigation, none of
which is expected to have a material adverse effect on the Company's results of
operations or its financial condition.

4.  Acquisitions

         In January 1997, the Company acquired all of the outstanding shares of
ICT held by minority interest shareholders in exchange for approximately
1,390,000 shares of the Company's common stock, making ICT a wholly-owned
subsidiary of the Company. The Company also issued options to purchase 177,000
shares of the Company's common stock at exercise prices ranging from $1.43 to
$4.96 per share to certain employees and directors of ICT in exchange for their
outstanding options to purchase ICT common shares, and incurred cash expenses
related to the acquisition of approximately $675,000. The aggregate purchase
price for the acquisition of the ICT minority interest was approximately $11.2
million, and the acquisition was accounted for by the purchase method of
accounting. The purchase price was allocated primarily to patents, which are
being amortized over a five year period.

         On October 30, 1997, the Company acquired certain of the electronic
publishing assets of Brite Voice Systems, Inc. ("Brite") for a purchase price of
approximately $35.6 million. The Brite acquisition has been accounted for by the
purchase method of accounting and the purchase price was allocated to equipment,
contract rights and goodwill based on the estimated fair values of the assets at
the date of acquisition. See Note 5 related to subsequent impairment of the
assets acquired.


                                       8

<PAGE>   9



         Also on October 30, 1997, the Company acquired certain of the assets of
Voice News Network, Inc. ("VNN"), a subsidiary of Tribune Media Services a unit
of Tribune Company, for a purchase price of $9.0 million. The VNN acquisition
has been accounted for by the purchase method of accounting and the purchase
price was allocated to equipment, contract rights and goodwill based on the
estimated fair values of the assets at the date of acquisition.

         The following represents the unaudited pro forma results of operations
as if the above acquisitions had occurred on January 1, 1997, after giving
effect to certain adjustments, including interest expense, preferred stock
dividends, and amortization of intangibles resulting from the allocation of the
purchase price.

                                                      Nine Months Ended
                                                      September 30, 1997
                                                    ---------------------
                                                    (In thousands, except
                                                      Per share amount)
Total revenues                                                 $   24,643
Gross margin                                                        8,821
Operating loss                                                    (16,428)
Net loss attributable to common stockholders                   $  (27,019)
Net loss per common share                                      $    (2.38)

         The pro forma results given above are not necessarily indicative of
what actually would have occurred if the acquisition had been in effect during
the period presented, and is not intended to be a projection of future results
or trends.

5.    Impairment

         The carrying value of intangible assets is reviewed for impairment
whenever events or changes in circumstances indicate that there may be
impairment. If the review indicates that any of the intangibles will not be
recoverable, as determined by an analysis of undiscounted cash flows, the
intangible asset will be reduced to its estimated fair value. Subsequent to the
Brite acquisition, the Company learned that former Brite and IT Network
employees had formed a third company to service many of these former Brite
clients. As a result, several former Brite customers did not renew their
contracts with IT Network. The Company reviewed the valuation of the
acquired assets recorded at the time of the acquisition, and found these assets
were impaired. As a result of the financial analysis of the expected discounted
future cash flows of the remaining customer base, the Company recorded a $25.9
million ($2.24 per share) non-cash write-down of the Brite contract rights,
non-compete agreement and goodwill in the second quarter 1998.

6.    Long-Term Debt and Notes Payable

         On April 3, 1996, the Company issued a senior note (the "First Tranche
Note") in the principal amount of $5.0 million and a warrant (the "First Tranche
Warrant") which entitled the holder thereof to purchase 500,000 shares of the
Company's common stock at a purchase price of $10.21 per share. On September 30,
1996 and March 31, 1997, the Company issued additional senior notes in the
amounts of $326,806 and $350,090, respectively, for the payment of interest on
the First Tranche Note. The First Tranche Note and the additional senior notes
(collectively, the "Aggregate First Tranche Notes") were due on March 31, 2001,
and bore interest at the rate





                                       9
<PAGE>   10



of 13% per annum through March 31, 1998, and 12% thereafter. The estimated fair
market value at the date of issuance of the First Tranche Warrant of $745,830
was credited to capital in excess of par value and the First Tranche Note was
recorded at a corresponding discount. The discount on the First Tranche Note was
being amortized to interest expense using the effective interest rate method
over the stated term of the First Tranche Note, resulting in an effective
interest rate of 16.2%.

         On April 9, 1997, the Company received cash proceeds of $15.0 million
upon the issuance of additional senior notes (the "Second Tranche Notes") in the
principal amount of $15.0 million and warrants (the "Second Tranche Warrants")
which entitled the holders thereof to purchase in the aggregate 2,000,000 shares
of the Company's common stock at a purchase price of $6.00 per share at any time
until their expiration on March 31, 2004. The estimated fair market value of the
Second Tranche Warrants of $1.7 million at the date of issuance was credited to
capital in excess of par value and the Second Tranche Notes were recorded at a
corresponding discount. The discount on the Second Tranche Notes was being
amortized to interest expense using the effective interest rate method over the
stated terms of the Second Tranche Notes resulting in an effective interest rate
of 15.4%. Additionally, in connection with the issuance of the Second Tranche
Notes and the Second Tranche Warrants, the Aggregate First Tranche Notes and the
First Tranche Warrant were amended and restated to terms identical to those of
the Second Tranche Notes and the Second Tranche Warrants, respectively. The
amended Aggregate First Tranche Notes and the Second Tranche Notes were due on
March 31, 2002, and bore interest at the rate of either: (i) 12% per annum
through March 31, 1999, if paid in cash, or (ii) 13% per annum through March 31,
1999, if paid through the issuance of additional notes, and 12% thereafter. On
September 30, 1997, the interest due on the Aggregate First Tranche Notes and
the Second Tranche Notes was paid through the issuance of additional notes, with
terms identical to those of the Second Tranche Notes, in the amount of
approximately $1.3 million and warrants to purchase approximately 165,000 shares
of common stock. The estimated fair market values of the notes and warrants
issued in lieu of a cash interest payment on September 30, 1997, were
approximately $1.1 million and $1.1 million, respectively, which were recorded
as interest expense during 1997.

         The amendment of the Aggregate First Tranche Notes and First Tranche
Warrant was accounted for as the extinguishment and replacement of the existing
senior notes and the cancellation of the existing warrants and issuance of new
warrants due to the significance of the modification to the terms of the senior
notes and warrants. The extinguishment resulted in a loss of approximately
$315,000, which was included in other (income) expense during the second quarter
of 1997.

         On October 30, 1997, the Company issued senior secured notes (the
"Senior Secured Notes" or the "Notes") in the principal amount of $100 million,
which bear interest at the rate of 12% per annum through November 1, 2004.
Interest on the Notes is payable semi-annually on May 1 and November 1 of each
year commencing on May 1, 1998, to holders of record at the close of business on
April 15th or October 15th immediately preceding the interest payment date. The
Company placed approximately $22.6 million of the net proceeds from the
offering, representing funds sufficient, together with interest thereon, to pay
the first four interest payments on the Notes, into an escrow account.




                                       10

<PAGE>   11



         In connection with the issuance of the Senior Secured Notes, the
Company used $22.2 million of the proceeds received to pay off the amended
Aggregate First Tranche Notes and the Second Tranche Notes, including accrued
interest thereon, and the notes issued on September 30, 1997, in lieu of a cash
interest payment. The early extinguishment of these notes resulted in a charge
to earnings of approximately $3.5 million related to the unamortized discount on
the Second Tranche Notes and the related unamortized issuance costs and was
recorded as an extraordinary item in the fourth quarter of 1997. The proceeds
were also used to complete the Company's acquisitions of certain assets more
fully described in Note 4 - Acquisitions.

         The Senior Secured Notes are fully and unconditionally guaranteed,
jointly and severally, by each of the Company's subsidiaries (the "Subsidiary
Guarantors"). The guarantees are senior obligations of the Subsidiary Guarantors
and are secured by substantially all of the assets of the Subsidiary Guarantors.
The guarantees rank pari passu in right of payment with all existing and future
senior indebtedness of the Subsidiary Guarantors and rank senior in right of
payment to all existing and future subordinated obligations of the Subsidiary
Guarantors. The guarantees may be released upon the occurrence of certain
events. The guarantee executed by IT Network contains a covenant that restricts
payments of dividends on its capital stock to an amount sufficient to cover debt
service on the Notes, redemptions or repurchases of the Notes or the Preferred
Stock, dividends on the Preferred Stock, and corporate overhead. The assets of
the Subsidiary Guarantors are not restricted as to the redemption of the Notes
or Preferred Stock or payment of the interest or dividends thereon. The assets
of the parent, Source, consist solely of investments in its subsidiaries and
invested proceeds from the Senior Secured Notes and the Preferred Stock and
related warrants. Financial statements for the Subsidiary Guarantors and Source
are not presented because management has determined that they would not be
material to investors.

         Except as described below, the Company may not redeem the Notes prior
to November 1, 2001. On or after such date, the Company may redeem the Notes, in
whole or in part, at any time, at various redemption prices set forth in the
indenture governing the sale of the Notes, together with accrued and unpaid
interest, if any, to the date of redemption. In addition, at any time and from
time to time on or prior to November 1, 2000, the Company may, subject to
certain requirements, redeem up to 35% of the aggregate principal amount of the
Notes with the cash proceeds of one or more equity offerings at a redemption
price equal to 112% of the principal amount to be redeemed, together with
accrued and unpaid interest, if any, to the date of redemption, provided, that,
at least $65 million of the aggregate principal amount of the Notes remain
outstanding immediately after each such redemption. The Notes are not subject to
any sinking fund requirement. Upon the occurrence of a change in control, the
Company will be required to make an offer to repurchase the Notes at a price
equal to 101% of the principal amount thereof, together with accrued and unpaid
interest, if any, to the date of the repurchase. The indenture contains certain
covenants including, but not limited to, limitations on indebtedness, restricted
payments, liens, restrictions on distributions from restricted subsidiaries,
sales of assets and subsidiary stock, affiliate transactions, issuances of
capital stock of restricted subsidiaries and sale/leaseback transactions.

7.   Senior PIK Preferred Stock

         On October 30, 1997, the Company received cash proceeds of $20.0
million upon the issuance of 800 units (the "Units"). Each Unit consisting of
1,000 shares of non-voting Senior PIK Preferred Stock (the "Preferred Stock")
with a liquidation preference of $25.00 per share




                                       11
<PAGE>   12


and 558.75 warrants (the "October 1997 Warrants") to purchase one share of the
Company's common stock at a purchase price of $0.01 per share. In the aggregate,
the October 1997 Warrants represent the right to purchase 447,000 shares of
common stock. The Units were sold in connection with the Company's acquisitions
of certain of the assets more fully described in Note 4 - Acquisitions.

         Dividends on the Preferred Stock are payable quarterly on each February
1, May 1, August 1 and November 1 at an annual rate of 13 1/2% of the
liquidation preference per share. Dividends may be paid, at the Company's
option, on any dividend payment date occurring on or prior to November 1, 2002,
either in cash or by the issuance of additional shares of PreferredStock with a
liquidation preference equal to the amount of such dividends; thereafter,
dividends will be paid in cash. The indenture governing the sale of the Senior
Secured Notes limits the amount of cash dividends that may be paid on the
Preferred Stock. At any time and from time to time on or prior to November 1,
2000, the Company may, subject to certain requirements, redeem up to 35% of the
aggregate liquidation value of the Preferred Stock with the cash proceeds of one
or more equity offerings at a redemption price equal to the liquidation
preference thereof, plus accumulated dividends, on the date of redemption. After
November 1, 2000, and prior to November 1, 2002, the Preferred Stock is not
redeemable. On or after November 1, 2002, the Company may redeem the Preferred
Stock, in whole or in part, at any time, at various redemption prices, plus
accumulated and unpaid dividends, to the date of redemption. Upon the occurrence
of a change in control, the Company will be required to make an offer to
purchase the outstanding shares of the Preferred Stock at a price equal to 101%
of the liquidation preference thereof, plus accumulated and unpaid dividends, to
the date of purchase. The Preferred Stock will be subject to mandatory
redemption in whole on November 1, 2007, at a price equal to 100% of the then
effective liquidation preference thereof, plus, without duplication, all accrued
and unpaid dividends to the date of redemption. The certificate of designation
contains certain covenants including, but not limited to, limitations on
indebtedness, restricted payments, affiliate transactions, issuances of capital
stock of restricted subsidiaries and sale/leaseback transactions.

         The Preferred Stock ranks senior to all classes of common stock and to
each other class of capital stock or series of preferred stock with respect to
dividend rights and rights on liquidation, winding-up and dissolution of the
Company. The Preferred Stock is non-voting except in certain circumstances. The
Company may not authorize any new class of preferred stock that ranks senior or
pari passu to the Preferred Stock without the approval of the holders of at
least a majority of the shares of Preferred Stock then outstanding, voting or
consenting, as the case may be, as one class, provided, however, that the
Company can issue additional shares of Preferred Stock to satisfy dividend
payments on outstanding shares of Preferred Stock; and provided further,
however, that the Company can issue shares of preferred stock ranking pari passu
with the Preferred Stock if after giving effect thereto, the Consolidated
Coverage Ratio, as defined in the certificate of designations, is greater than
1.7 to 1.0.

         The estimated fair market value of the October 1997 Warrants, which was
estimated to be approximately $5.5 million, was credited to capital in excess of
par value and the Preferred Stock was recorded at a corresponding discount. The
Preferred Stock was recorded net of $1.2 million of issuance costs and the
discount on the Preferred Stock which are being accreted as additional Preferred
Stock dividends using the effective interest rate method over a 10 year period,
resulting in an effective dividend rate of 19.3%.




                                       12

<PAGE>   13




         On February 1, May 1, and August 1, 1998, the quarterly dividends due
on the Preferred Stock were paid through the issuance of additional Preferred
Stock having a liquidation preference of $675,000; $698,000; and $721,000
respectively, with terms identical to those of the Preferred Stock. The
estimated fair market value of the stock issued in lieu of a cash interest
payment on February 1, May 1, and August 1, 1998, was approximately $488,000;
$698,000; and $664,000 which were recorded as preferred stock dividends.

8.    Stock Compensation

         On January 2, 1998, the Company granted stock options to employees. The
options fully vest on January 2, 2004. If certain target stock prices are met,
the vesting accelerates. As a portion of the underlying shares for these options
had not been authorized by the shareholders at the date of grant, the portion of
unauthorized options were treated as a variable compensation plan through July
28, 1998, when the shareholders authorized the shares. As a result of this
accounting treatment, the Company has recognized non-cash expense in selling,
general, and administrative expenses of $1.1 million and $1.8 million for the
three and nine months ended September 30, 1998, respectively.





                                       13

<PAGE>   14




ITEM 2.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

Unless the context otherwise requires, all references to the "Company" or
"Source" include Source Media, Inc. and its wholly-owned subsidiaries, SMI
Holdings, Inc. ("Holdings"), IT Network, Inc. ("IT Network"), Interactive
Channel, Inc. ("Interactive Channel"), and Interactive Channel Technologies,
Inc., marketed under the name of VirtualModem ("ICT" which was formerly known as
Cableshare, Inc.).

FORWARD LOOKING INFORMATION AND RISK FACTORS

         The Company or its representatives may make forward looking statements,
oral or written, including statements in this report's Management's Discussion
and Analysis of Financial Condition and Results of Operations, press releases
and filings with the Securities and Exchange Commission about confidence and
strategies and plans and expectations about demand, demand and acceptance of new
and existing products, potential acquisitions, potential for profits and returns
on investments in products and markets that are forward looking statements
involving risks and uncertainties that could significantly impact the Company.
Although the Company believes that the expectations reflected in these forward
looking statements are reasonable, there can be no assurance that the actual
results or developments anticipated by the Company will be realized or, even if
substantially realized, that they will have the expected effects on its business
or operations. Among the factors that could cause actual results to differ
materially from the Company's expectations are its ability to secure
distribution for the Interactive Channel; delays in the deployment of digital
set-top boxes; failure to make available advanced analog or digital set-top
boxes incorporating the Company's technology; inability of the Company to
protect its technology; obsolescence of the Company's technology; ability to
successfully integrate, retain and grow the acquired customer base into existing
operations; general economic and business conditions; industry trends;
competition; equipment costs and availability; ability to successfully identify
and solve the Company's Year 2000 issues in a timely manner; terms and
deployment of capital; availability of qualified personnel; changes in, or the
failure to comply with, government regulation; and other factors discussed from
time to time in the Company's Annual Report on Form 10-K and other Securities
and Exchange Commission filings.

GENERAL

         Source provides on-demand information, services and programming through
the telephone and has developed technology and a programming service to provide
such information services and programming through cable television over the
Company's proprietary digital platforms through its subsidiaries, IT Network,
ICT and Interactive Channel. IT Network's products and services are available
through Yellow Pages to over 100 million households, offices and hotel rooms in
North America and the Caribbean and through inserts in daily newspapers with an
aggregate circulation of over 20 million. Interactive Channel is an interactive
cable television programming network designed to provide on-demand information
and services, and Internet access, to the cable television industry over
existing two-way cable infrastructure, with the use of an advanced analog or a
digital set-top box, or utilizing telephone line return in one-way systems.




                                       14
<PAGE>   15




         IT Network is the nation's leading provider of voice information
content and advertising sales services through telephone directories and
newspapers and also provides related support services to certain Yellow Pages
directory and newspaper publishers participating with the Company in offering
voice information services ("Publisher Partners"). The Company sells
advertising, both print and audiotex, primarily to local advertisers in the
markets it serves. Additionally, it provides a variety of support services
related to advertising clients including inbound and outbound customer service,
plus producing and delivering audio content and system management of audiotex
systems. Advertising clients pay to sponsor and deliver a promotional message
before and after the delivery of the voice information. The Company provides
voice information services to 8 of the 10 largest Yellow Pages directory
publishers in the country.

         The Interactive Channel has been created to supply programming and
services allowing a subscriber to access on-demand local and national news,
weather, sports and school information and interactive programming guides, and
to purchase goods, and can allow a subscriber to browse the Internet, send and
receive e-mail and access a variety of other offerings over existing cable
infrastructure and telephone lines, using an advanced analog or digital set-top
box. The Interactive Channel can allow the Company or cable system operators to
sell interactive multimedia advertising space on cable television using text,
voice and images. The Interactive Channel can be broadcast by cable operators
utilizing the Company's proprietary two-way technology called VirtualModem 2.0.
The VirtualModem 2.0 technology can enable any two-way cable television system
equipped with a compatible advanced analog or digital set-top box or utilizing
telephone line return in one-way systems to deliver two-way, on-demand
programming with the touch of a remote control. In less than one second, the
Interactive Channel can allow subscribers to access interactive programming
delivered over the cable system to their television.

         IT Network earns monetary revenues through advertising sponsorships and
services provided to certain Regional Bell Operating Companies or their
affiliates or other Yellow Pages publishers (collectively, Directory
Publishers). Monetary revenues and associated costs relating to print ads
appearing in Yellow Pages are recognized at the time of distribution by the
Directory Publishers. For certain contracts, where an obligation exists to
service the customer for the contract period, a portion of the revenue is
deferred and amortized on a straight-line basis over the term of the respective
contracts, beginning at the time of the annual distribution of the applicable
local Yellow Pages directory, or at the applicable contract start date, if
later, and continuing to the end of the term of the respective contracts, which
is typically from 3 to 12 months. The Company also earns monetary revenues from
sales of voice information services to certain Publisher Partners. The Company
is earning a significant percentage of its monetary revenues by acting as a
sales agent for advertising in directories published by Publisher Partners and
providing voice information services in those directories. Monetary revenues
relating to non-Yellow Pages products are recognized as the services are
performed.

         The Company has entered into nonmonetary barter agreements with local
television and radio stations. These media sponsors provide the Company with
advertising time on their stations and update local news, weather and sports
voice information messages in exchange for promotional messages and print
advertisements in the Network Guide. Revenues and cost of sales associated with
these nonmonetary barter transactions are included in the Company's consolidated
statements of operations at the estimated fair value of the on-air
advertisements and information content provided to the Company by media
sponsors. The Company expects that




                                       15

<PAGE>   16




nonmonetary revenues as a percentage of total revenues will continue to decline
in the future as the Company earns a higher percentage of its revenues as a
service provider or sales agent rather than from sales of advertising in the
Network Guide.

         On October 30, 1997, the Company purchased certain of the electronic
publishing assets of Brite for $35.6 million and certain of the assets of VNN, a
unit of Tribune Company, for $9.0 million. Throughout the second quarter of
1998, a significant portion of the customer contracts purchased in the Brite
acquisition were cancelled or not renewed. As a result, the Company reviewed the
value assigned to the contract rights and certain related intangible assets
acquired in the Brite purchase and found them, along with the goodwill
associated with the Brite acquisition, to be impaired, resulting in a write-off
of $25.9 million in the second quarter of 1998.

HIGHLIGHTS OF THIRD QUARTER RESULTS

         During the third quarter of 1998, the Company generated record revenues
for the Company for the fourth consecutive quarter and announced the cable
television industry's first digital carriage agreement, allowing delivery of 
high speed interactivity and web access over today's standard digital cable
television set-top boxes.

         The Company continues to invest in the expansion of its sales force.
From the first of the year, the Company has increased its sales force from 15 to
42 sales people. The Company has experienced record bookings and intends to
continue its sales force growth.

NINE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997

         Monetary revenues increased 117% from $8.0 million to $17.3 million due
to the acquisitions of Brite and VNN. Advertising sales grew 87% to $7.3
million. This growth of advertising sales can be attributed primarily to
internal growth in the Company's client base, as well as to the acquisition of 
Brite in the fourth quarter of 1997. In addition, the Company has entered into
certain new advertiser agreements which earned approximately $1.7 million in
revenue for the period. Under the new advertiser agreements, revenue from print
advertising is earned at the time of the directory distribution, while revenue
for services agreements and prior advertising agreements is earned and
recognized over the term of the contract. Unearned income will become less
significant in future periods as less revenue is deferred under the new
contracts.

         Monetary costs of sales increased 78% from $4.9 million to $8.7
million. IT Network's cost of sales increased from $2.8 million to $7.3 million.
This increase was due to increased costs associated with increased revenue,
transition costs associated with the acquisitions as well as the direct and
indirect expenses associated with the total failure of the Galaxy IV satellite.
Cost of sales for the Interactive Channel are down 55% from $1.7 million to $0.8
million due to cost reduction efforts and the discontinuing of Colorado Springs
operations.

         Nonmonetary revenue and costs of sales decreased by 70% from $4.9
million to $1.5 million as the Company continues to reduce its volume of barter
contracts. Nonmonetary revenue now represents only 8% of total revenue compared
with approximately 38% of total revenue in the prior period.





                                       16


<PAGE>   17





         The net result of this activity is that the Company's total revenue
increased 46% (from $12.9 million to $18.8 million) while total gross margin
increased 181% (from $3.0 million to $8.6 million).

         Selling, general and administrative expenses increased from $13.8
million to $17.8 million. This net increase resulted from (i) an increase of
$4.6 million primarily to sell and support new services and advertising
contracts acquired from Brite and VNN, (ii) a decrease of $2.4 million in
television related expenses, primarily due to the discontinuation of Colorado
Springs operations, (iii) and an increase of $1.8 million in stock option plan
expense. As a portion of the underlying shares for these options had not been
authorized by the shareholders at the date of grant, the portion of unauthorized
options were treated as a variable compensation plan through July 28, 1998, when
the shareholders authorized the shares. As a result of this accounting
treatment, the Company has recognized non-cash expense in selling, general and
administrative expenses of $1.8 million for the nine months ended September 30,
1998. The Company expects to recognize additional non-cash expense of $0.5
million in the fourth quarter.

         Impairment of Intangible Assets. An adjustment of $25.9 million was
made in the second quarter to reflect the impairment of certain contract rights,
non-compete agreements and goodwill associated with the Brite purchase. See Note
5 to the Consolidated Financial Statements.

         Research and development expenses remain virtually unchanged at
approximately $2.6 million as the Company discontinued the development of analog
products and increased investment on the design and development of its digital
interactive television technologies.

         Interest expense, interest income. Interest expense increased $6.9
million from $2.7 million to $9.6 million. This expense is associated with a
$100 million debt financing completed by the Company in October 1997 and
described in detail in the Notes to the Consolidated Financial Statements.
Interest income increased $1.4 million from $0.2 million to $1.6 million due to
an increased cash balance from the financing.

         Preferred stock dividends. PIK preferred stock dividends of $2.3
million for the nine months ended September 30, 1998, was related to a $20
million PIK preferred stock financing completed by the Company in October 1997
and described in detail in the Notes to the Financial Statements.

THREE MONTHS ENDED SEPTEMBER 30, 1998 AND 1997

         Monetary revenues increased 139% from $2.7 million to $6.3 million due
to the acquisitions of Brite and VNN. Advertising sales grew 119% to $3.2
million, primarily due to growth of the Company's client base.

         Monetary costs of sales increased from $2.0 million to $3.5 million
with the doubling of revenue. IT Network's cost of sales increased from $1.0
million to $3.2 million, while the Company's television initiatives cost of
sales decreased from $1.0 million to $0.3 million. With the cable industry
accelerating its deployment plans for digital set-top boxes, the Company has
focused its resources on digital products and has scaled back its analog
projects including 





                                       17
<PAGE>   18



discontinuing of Colorado Springs operations which has helped to improve
monetary gross margins from 23% to 45%.

         Nonmonetary revenue and costs of sales was reduced by 75% from $1.5
million to $0.4 million as the Company continues to reduce its volume of barter
contracts. Nonmonetary revenue now reflects only 6% of total revenue compared
with approximately 36% of total revenue in the prior period.

         The net result of this activity is that the Company's total revenue
increased 61% (from $4.2 million to $6.7 million) while total gross margin
increased 370% (from $0.6 million to $2.9 million).

         Selling, general and administrative expenses increased from $4.7
million to $6.5 million. This net increase resulted from (i) an increase of $1.6
million primarily through increased sales, marketing and administrative expenses
incurred by IT Network to support increased sales, new services and advertising
contracts acquired from Brite and VNN as well as new markets, (ii) a $0.2
million decrease in general corporate expenses, (iii) a $1.1 million non-cash
expense associated with the variable plan accounting for a stock option grant,
(iv) and a $0.7 million decrease of certain personnel salaries, subscriber
acquisition, travel and other Interactive Channel expenses. As a portion of the
underlying shares for these options had not been authorized by the shareholders
at the date of grant, the portion of unauthorized options were treated as a
variable compensation plan through July 28, 1998, when the shareholders
authorized the shares. As a result of this accounting treatment, the Company has
recognized non-cash expense in selling, general and administrative expenses of
$1.1 million for the three months ended September 30, 1998.

         Research and development expenses have increased from $0.8 million to
$0.9 million as the Company expands its efforts on the digital design and
development of its interactive television technologies and the expected fourth
quarter introduction of VirtualModem 2.0 software.

         Interest expense, interest income. Interest expense increased from $1.7
million to $3.2 million. This increase is due to a higher debt balance
associated with a $100 million debt financing completed by the Company in
October 1997. Interest income increased $0.4 million due to interest earned on
the proceeds from the debt and preferred stock offerings.

         Preferred stock dividends. PIK preferred stock dividends of $0.7
million for the quarter ended September 30, 1998, was related to a $20 million
PIK preferred stock financing completed by the Company in October 1997.

LIQUIDITY AND CAPITAL RESOURCES

         Since its inception, the Company has experienced substantial operating
losses and net losses as a result of its efforts to (i) develop, deploy and
support IT Network, (ii) acquire a controlling interest in ICT, and (iii)
develop, conduct trials and commercially launch the Interactive Channel. As of
September 30, 1998, the Company had an accumulated deficit of approximately
$142.9 million and had used cumulative net cash in operations of $68.5 million.
The difference at September 30, 1998, between the accumulated deficit and
cumulative net cash used in operations since inception was attributable
primarily to nonmonetary charges related to 




                                       18
<PAGE>   19



financing incentives and extinguishment of debt, write-down of analog set-top
boxes and intangible assets, depreciation and amortization and other non-cash
expenses. As a result of the October 1997 Brite and VNN acquisitions, the
Company has experienced growth in its revenues, gross margins, and operating
expenses. However, the effect of the lost customers associated with the Brite
acquisition will continue to have a negative impact on the Company's revenues
and profitability. The Company will continue to incur operating losses at least
through 1998, although it expects that cash used in IT Network operations
excluding related interest expense will decrease going forward as a result of
other growth initiatives. The launch of the Company's television products and
services may require additional expenditures, which may require the Company to
raise additional capital.

         Since its inception, the Company has financed its operations primarily
through an aggregate $156.6 million raised from various financing activities,
including the incurrence of debt and issuance of the Company's common stock and
preferred stock. In October 1997, the Company issued $100.0 million of its
Senior Secured Notes and $20.0 million of its Senior PIK Preferred Stock. The
interest escrow account created pursuant to the Indenture will be used to fund
the first four interest payments on the Senior Secured Notes. The first interest
payment from the interest escrow account was made on May 1, 1998. The Company's
primary source of liquidity is its cash, cash equivalents and short-term
investments, which totaled $31.2 million at September 30, 1998. This cash
position consists of $17.6 million held in escrow for debt payments, and $13.6
million of operating cash. The Company's first debt payment not currently held
in escrow is due May 1, 2000.

         The Company currently believes its resources will be sufficient to meet
the Company's anticipated cash needs for working capital and other capital
expenditures related to the further development of the Interactive Channel, ICT
and IT Network through the fourth quarter of 1999.

         The Company's future capital requirements will depend on many factors,
including, but not limited to the following factors, some of which are outside
the Company's control: (i) the operating results of IT Network, including the
Company's ability to successfully integrate its acquired businesses into its
existing business, and to retain and grow its customer base, (ii) the success
and timing of the development, introduction and deployment of the Interactive
Channel, (iii) the extent to which the Company is able to generate revenues from
licensing its proprietary technology, (iv) the number of file servers and other
equipment which the Company purchases in support of the Interactive Channel, (v)
the levels of advertising expenditures necessary to increase awareness of the
Interactive Channel, (vi) the extent of market acceptance of such products,
(vii) potential acquisitions or asset purchases, (viii) the deployment of
digital set-top boxes incorporating the Company's technology, and (ix)
competitive factors.

YEAR 2000 DISCLOSURE

         The Year 2000 issue is the result of computer programs being written
using two digits rather than four to define the applicable year. Any of the
Company's computer programs or hardware that have date-sensitive software or
embedded chips may recognize a date using "00" as the year 1900 rather than the
year 2000. This could result in a system failure or miscalculations causing
disruptions of operations, including, among other things, a temporary inability
to process transactions, send invoices, or engage in similar normal business
activities.




                                       19

<PAGE>   20



         Based on recent assessments, the Company determined that it will be
required to modify or replace portions of its software and certain hardware so
that those systems will properly utilize dates beyond December 31, 1999. The
Company presently believes that with modifications or replacements of existing
software and certain hardware, the Year 2000 issue can be mitigated. However, if
such modifications and replacements are not made, or are not completed timely,
the Year 2000 issue could have a material impact on the operations of the
Company.

         The Company's plan to resolve the Year 2000 issue involves the
following four phases: assessment, remediation, testing and implementation. To
date, the Company has completed its initial assessment of all systems that could
be significantly affected by the Year 2000. The Company's three operating
divisions: ICT, Interactive Channel and IT Network as well as the Corporate unit
were included in the assessment. The assessment indicated that most of the
Company's significant information technology systems could be affected. That
assessment also indicated that software and hardware (embedded chips) used in
the IT Network's interactive voice response systems also are at risk
(hereinafter referred to as operating systems). In addition, the Company is
gathering information about the Year 2000 compliance status of its significant
suppliers and subcontractors and is continuing to monitor their compliance.

         For its information technology exposures, to date the Company is 40%
complete on the remediation phase and expects to complete software reprogramming
and replacement for all systems no later than August 1, 1999. Once software is
reprogrammed or replaced for a system, the Company begins testing and
implementation. These phases run concurrently for different systems. To date,
the Company has completed 25% of its testing and has implemented 15% of its
remediated systems. Completion of the testing phase for all significant systems
is expected by March 31, 1999, with all remediated systems fully tested and
implemented by May 31, 1999.

         The remediation of operating equipment is significantly more difficult
than the remediation of the information technology systems because some of the
software operating systems are no longer supported by the manufacturers of that
equipment. As such, the Company is initiating the remediation phase of its
operating equipment. Testing of this equipment is also more difficult than the
testing of the information technology systems; as a result, the Company is only
10% complete with the testing of its remediated operating equipment. Once
testing is complete, the operating equipment will be ready for immediate use.
The Company expects to complete its remediation efforts by June 30, 1999.
Testing and implementation of affected equipment is expected to be 100% complete
by October 31, 1999.

         The Company is in the process of working with third party vendors to
ensure that the Company's systems that interface directly with third parties are
Year 2000 compliant by December 31, 1999. The Company has completed 75% of its
remediation efforts on these systems and is 30% complete with the testing phase.
Testing of all significant systems is expected no later than February 28, 1999.
Implementation is 50% complete and is expected to be completed by May 31, 1999.

         The Company is querying its significant suppliers and subcontractors
that do not share information systems with the Company (external agents). To
date, the Company is not aware of any external agent with a Year 2000 issue that
would materially impact the Company's results of operations, liquidity, or
capital resources. However, the Company has no means of ensuring that external
agents will be Year 2000 ready. The inability of external agents to complete
their Year 




                                       20

<PAGE>   21



2000 resolution process in a timely manner could materially impact the Company.
The effect of non-compliance by external agents is not determinable.

         The Company will utilize both internal and external resources to
reprogram, or replace, test, and implement the software and operating equipment
for Year 2000 modifications. The total cost of the Year 2000 project is
estimated at $1.4 million and is being funded through operating cash flows. To
date, the Company has incurred approximately $0.2 million, related to all phases
of the Year 2000 project. Of the total remaining project costs, approximately
$1.0 million is attributable to the purchase of new software and operating
equipment, which will be capitalized. The remaining $0.2 million relates to
repair of hardware and software and will be expensed as incurred.

         Management of the Company believes it has an effective program in place
to resolve the Year 2000 issue in a timely manner. As noted above, the Company
has not yet completed all necessary phases of the Year 2000 program. There can
be no assurance that the Company's efforts to solve its potential Year 2000
problems will be successful, or even partially successful. In the event that the
Company does not complete any additional phases, the Company would be unable to
take customer orders, provide services and products, invoice customers or
collect payments. In addition, disruptions in the economy generally resulting
from Year 2000 issues could also materially adversely affect the Company. The
Company could be subject to litigation for computer systems product failure, for
example, equipment shutdown or failure to properly date business records. The
amount of potential liability and lost revenue cannot be reasonably estimated at
this time.

         The Company has contingency plans for certain critical applications and
is working on such plans for others. These contingency plans involve, among
other actions, manual workarounds, telecommunication alternatives, and adjusting
staffing strategies.

NET OPERATING LOSS CARRYFORWARDS

         At December 31, 1997, Holdings had net operating loss carryforwards of
approximately $60.9 million for U.S. Federal income tax purposes, which begin to
expire in 2003. The Internal Revenue Code of 1986, as amended, imposes
limitations on the use of net operating loss carryforwards if certain stock
ownership changes occur. Consequently, the Company's

utilization of pre-1996 net operating losses is limited to approximately $9.0
million in a given year.

PART II - OTHER INFORMATION

Item 1 - Legal Proceedings

         In October 1998, the Company settled all litigation in Ontario, Canada
with Marvin Lerch, the former Chief Executive Officer and former shareholder of
ICT and certain of his relatives, also former ICT shareholders. The settlement
resolved both litigation commenced in December 1993 against the Company and
certain executive officers and a former director of ICT for actions allegedly
intended to depress the value of ICT and the litigation filed in June 1994 by
Marvin Lerch against ICT and certain persons claiming wrongful termination of
his employment with ICT. Under the terms of the settlement, all parties agreed
to dismiss both cases, and the 





                                       21


<PAGE>   22


Company agreed to transfer a total of 87,500 shares of the Company's common
stock to the plaintiffs. The Company expects to record an additional expense of
$400,000 in the fourth quarter 1998 when the settlement is expected to be
completed.

         On May 11, 1998, ICT and Holdings, both wholly-owned subsidiaries of
Source, filed an action in U.S. District Court for the District of Delaware
against WorldGate Communications, Inc. ("WorldGate") alleging that WorldGate has
infringed four of the Company's patents. Each party has filed a Motion to
Dismiss certain claims and no date has been set for a hearing by the district
court. The Company intends to aggressively defend its patents.

         In July 1998, the Company instituted a copyright infringement action in
Michigan federal court against certain companies competing with IT Network's
telephone business, alleging that these competitors infringed certain IT Network
copyrighted information. On October 14, 1998, the federal judge issued a
preliminary injunction in favor of the Company enjoining the competitors from,
among other things, selling, licensing, distributing or reproducing works
derived from the Company's information. The Company is also involved in certain
litigation in federal and state courts in Kansas related to tortious
interference and violations of non-compete agreements by former employees of IT
Network. The Company intends to aggressively pursue all of these cases.

         On August 21, 1998, the first of 13 class action cases was filed
against the Company and certain officers and directors in federal court in the
Northern District of Texas. The litigation is all conducted under the provisions
of the Private Securities Litigation Reform Act of 1995. The federal court will
appoint the lead plaintiff and counsel, which is expected within the next 30
days. The Company believes that all the cases are without merit and will
vigorously defend itself, its officers and directors.

         In addition, the Company is aware of certain claims against the Company
and ICT that have not developed into litigation, or if they have, are dormant.
Further, the Company and ICT are parties to ordinary routine litigation, none of
which is expected to have a material adverse effect on the Company's results of
operations or its financial condition.

Item 2 - Changes in Securities - not applicable

Item 3 - Defaults Upon Senior Securities - not applicable

Item 4 - Submission of Matters to a Vote of Security Holders - not applicable

Item 5 - Other information - not applicable

Item 6 - Exhibits and Reports on Form 8-K

(a)      Exhibits

         Exhibit 27 - Financial Data Schedule

(b)      Reports on Form 8-K during the three months ended September 30, 1998

         Form 8-K (Date of Event August 25, 1998) filed on August 26, 1998,
         attaching the Company's press release announcing that Source Media,
         Inc. was served with a class action.





                                       22



<PAGE>   23



                                   SIGNATURES

         Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.


                                         SOURCE MEDIA, INC.
                                         (Registrant)

Date:   November 13, 1998                By: /s/ Paul Tigh
                                         -------------------------------------
                                             Paul Tigh
                                             Chief Financial Officer and
                                             Treasurer
                                             (Principal Financial Officer and
                                             Duly Authorized Officer)





                                       23


<PAGE>   24




                               Index to Exhibits


Exhibit
  No.               Description

  27                Financial Data Schedule