##### Table of Contents



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-QSB (Mark One) þ
    
    QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   o
    
    TRANSITION REPORT UNDER SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period from  to Commission file number 0-27751 WQN, INC.  Delaware
    
    75-2838415(State or other jurisdiction of
    
    (I.R.S. EmployerIncorporation or organization)
    
    Identification No.)
 14911 Quorum Drive, Suite 140, Dallas, Texas
    
    75254(Address of principal executive offices)

    
    (Zip Code)Issuers telephone number, including area code:
    
    (972) 361-1980
 Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the
Exchange Act during the past 12 months (or for such shorter period that the issuer was required to
file such reports), and (2) has been subject to such filing requirements for the past 90 days.YES þ NOo At April 30, 2005, the registrant had outstanding 6,878,062 shares of par value $.01 common stock. Transitional Small Business Disclosure Format (check one): Yes o No þ




---



TABLE OF CONTENTS  PART IFINANCIAL INFORMATIONITEM 1. FINANCIAL STATEMENTSITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONITEM 3. CONTROLS AND PROCEDURESPART II-OTHER INFORMATIONITEM 1. LEGAL PROCEEDINGSITEM 2. CHANGES IN SECURITIESITEM 3. DEFAULTS UPON SENIOR SECURITIESITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERSITEM 5. OTHER INFORMATIONITEM 6. EXHIBITS AND REPORTS ON FORM 8-KSIGNATURESCertification of CEO Pursuant to Section 302Certification of CFO Pursuant to Section 302Certification of CEO Pursuant to Section 906Certification of CFO Pursuant to Section 906    Table of Contents  WQN, INC. 
 PART IFINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS. WQN, INC.
CONSOLIDATED BALANCE SHEETS March 31,
    
    
    December 31,2005
    
    
    2004(unaudited)Current assets:Cash and cash equivalents
    
    $
    10,404,548
    
    
    $
    9,942,280Investment in partnership
    
    
    2,574,985
    
    
    
    2,944,243Accounts receivable, net
    
    
    880,701
    
    
    
    874,219Current portion of notes receivable and accrued interest
    
    
    775,980
    
    
    
    2,408,679Prepaid expenses and other current assets
    
    
    1,122,578
    
    
    
    806,068Total current assets
    
    
    15,758,792
    
    
    
    16,975,489Property and equipment, net
    
    
    706,227
    
    
    
    597,522Note receivable
    
    
    116,667
    
    
    
    204,167Other assets, net
    
    
    846,525
    
    
    
    972,794Total assets
    
    $
    17,428,211
    
    
    $
    18,749,972Current liabilities:Accounts payable
    
    $
    1,568,360
    
    
    $
    1,481,188Accrued expenses
    
    
    245,885
    
    
    
    457,459Deferred revenue
    
    
    474,898
    
    
    
    444,988Promissory note
    
    
    300,000
    
    
    
    300,000Total current liabilities
    
    
    2,589,143
    
    
    
    2,683,635Commitments and contingenciesStockholders equity:Preferred stock, par value $0.01 per share;
Authorized shares10,000,000; none issued and
outstanding at March 31, 2005 and December 31, 2004
    
    
    
    
    
    
    Common stock, par value $0.01 per share;
Authorized shares50,000,000; issued and
outstanding shares 6,878,062 at March 31, 2005
and 6,830,062 at December 31, 2004
    
    
    68,781
    
    
    
    68,301Additional capital
    
    
    43,202,359
    
    
    
    43,180,859Accumulated deficit
    
    
    (28,432,072
    )
    
    
    (27,182,823
    )Total stockholders equity
    
    
    14,839,068
    
    
    
    16,066,337Total liabilities and stockholders equity
    
    $
    17,428,211
    
    
    $
    18,749,972
 The accompanying notes are an integral part of these condensed consolidated financial statements. -2-




---



##### Table of Contents



WQN, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED) Three months ended March 31,2005
    
    
    2004Retail telephony revenue
    
    $
    2,528,418
    
    
    $
    1,996,835Wholesale telephony and other revenue
    
    
    5,079,320
    
    
    
    16,311Total revenue
    
    
    7,607,738
    
    
    
    2,013,146Cost of revenue
    
    
    7,325,411
    
    
    
    1,542,303Gross profit
    
    
    282,327
    
    
    
    470,843Operating expenses:Selling, general and administrative
    
    
    1,058,460
    
    
    
    1,102,103Merger expenses
    
    
    
    
    
    
    1,167,240Depreciation and amortization
    
    
    167,941
    
    
    
    167,393Total operating expenses
    
    
    1,226,401
    
    
    
    2,436,736Operating loss
    
    
    (944,074
    )
    
    
    (1,965,893
    )Interest income, net
    
    
    64,083
    
    
    
    41,809Loss from partnership investment
    
    
    (369,258
    )
    
    
    Loss from continuing operations
    
    
    (1,249,249
    )
    
    
    (1,924,084
    )Loss from discontinued operations
    
    
    
    
    
    
    (87,564
    )Net loss
    
    $
    (1,249,249
    )
    
    $
    (2,011,648
    )Net loss per share  basic and diluted:Continuing operations
    
    $
    (0.18
    )
    
    $
    (0.30
    )Discontinued operations
    
    
    
    
    
    
    (0.01
    )Net loss per share
    
    $
    (0.18
    )
    
    $
    (0.31
    )Weighted average common shares outstanding  basic and diluted
    
    
    6,861,529
    
    
    
    6,417,431
 The accompanying notes are an integral part of these condensed consolidated financial statements. -3-




---



##### Table of Contents



WQN, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS EQUITY
(UNAUDITED) Common
    
    
    Stock
    
    
    Additional
    
    
    AccumulatedShares
    
    
    Amount
    
    
    Capital
    
    
    Deficit
    
    
    TotalBalance at December 31, 2004
    
    
    6,830,062
    
    
    $
    68,301
    
    
    $
    43,180,859
    
    
    $
    (27,182,823
    )
    
    $
    16,066,337Exercise of employee stock
options
    
    
    48,000
    
    
    
    480
    
    
    
    21,500
    
    
    
    
    
    
    
    21,980Net loss
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (1,249,249
    )
    
    
    (1,249,249
    )Balance at March 31, 2005
    
    
    6,878,062
    
    
    $
    68,781
    
    
    $
    43,202,359
    
    
    $
    (28,432,072
    )
    
    $
    14,839,068
 The accompanying notes are an integral part of these condensed consolidated financial statements. -4-




---



##### Table of Contents



WQN, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED) Three months ended March 31,2005
    
    
    2004Operating ActivitiesNet loss from continuing operations
    
    $
    (1,249,249
    )
    
    $
    (1,924,084
    )Adjustments to reconcile net loss to net cash used in operating activities:Loss from discontinued operations
    
    
    
    
    
    
    (87,564
    )Depreciation and amortization
    
    
    167,941
    
    
    
    213,144Loss on disposition of property and equipment and asset write-downs
    
    
    
    
    
    
    76,522Loss from investment in partnership
    
    
    369,258
    
    
    
    Changes in operating assets and liabilities:Accounts receivable
    
    
    (23,783
    )
    
    
    (14,729
    )Accounts payable and accrued expenses
    
    
    (199,402
    )
    
    
    371,243Deferred revenue
    
    
    29,910
    
    
    
    24,879Other assets
    
    
    (192,498
    )
    
    
    44,078Net cash used in operating activities
    
    
    (1,097,823
    )
    
    
    (1,296,511
    )Investing ActivitiesAdditions to property and equipment
    
    
    (199,389
    )
    
    
    (47,422
    )Payments received on note from the sale of subsidiary
    
    
    87,500
    
    
    
    Payments from (loan to) Ntera Holdings, Inc.
    
    
    1,650,000
    
    
    
    (2,000,000
    )Net proceeds from (cash used in) investing activities
    
    
    1,538,111
    
    
    
    (2,047,442
    )Financing ActivitiesProceeds from exercise of stock options
    
    
    21,980
    
    
    
    619,766Increase (decrease) in cash and cash equivalents
    
    
    462,268
    
    
    
    (2,724,187
    )Cash and cash equivalents at beginning of period
    
    
    9,942,280
    
    
    
    17,931,820Cash and cash equivalents at end of period
    
    $
    10,404,548
    
    
    $
    15,207,633Supplemental Disclosure of Cash Flow InformationInterest paid
    
    $
    2,387
    
    
    $
    1,094
 The accompanying notes are an integral part of these condensed consolidated financial statements. -5-




---



##### Table of Contents



WQN, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED) 1. Basis of Presentation The accompanying unaudited condensed consolidated financial statements of WQN, Inc. and
subsidiaries (collectively, the Company) have been prepared in accordance with generally accepted
accounting principles for interim financial information and with the instructions to Form 10-QSB
and Item 310(b) of Regulation S-B. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for annual financial statements. In
the opinion of management, all adjustments (consisting only of normal recurring accruals)
considered necessary for a fair presentation have been included. The results for the interim
periods presented are not necessarily indicative of the results that may be expected for any future
period. The balance sheet at December 31, 2004 has been derived from the audited financial
statements at that date but does not include all of the information and footnotes required by
generally accepted accounting principles for complete financial statements. The financial
statements in this Form 10-QSB should be read in conjunction with the financial statements and
notes thereto included in the Companys Annual Report on Form 10-KSB for the year ended December
31, 2004. 2. Discontinued Operations In July 2004, the Company sold all of the outstanding capital stock of its wholly-owned
subsidiary buyindiaonline.com, Inc. (Cash2India) to a private company for approximately
$1,552,000. The Cash2India business comprised the Companys previously reported financial services
segment and is accounted for as a discontinued operation in the accompanying condensed consolidated
financial statements. Under the terms of the transaction, the Company received $852,000 in cash, a
promissory note for $700,000, and a warrant to purchase common stock in the acquiring company. The
cash payment included consideration for $352,000 in working capital associated with Cash2India at
the time of the sale. The promissory note bears interest at 5% per annum, is secured by the capital
stock of Cash2India, and is to be repaid in twenty-four consecutive monthly payments of $29,167
plus accrued interest. The balance of the promissory note and accrued interest was $466,667 as of
March 31, 2005. As a result of the transaction the Company recorded gain on the disposition of
Cash2India of approximately $777,000 in the third quarter of 2004. The net loss from discontinued
operations is comprised as follows: Three months endedMarch 31, 2004Revenue
    
    $
    154,942Cost of revenue
    
    
    (59,301
    )Gross profit
    
    
    95,641Operating expenses
    
    
    (183,205
    )Net loss
    
    
    (87,564
    )Gain on disposal
    
    
    Net loss on discontinued operations
    
    $
    (87,564
    )
 -6-




---



##### Table of Contents



WQN, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)
(UNAUDITED) 3. Earnings (Loss) Per Share Stock options and warrants convertible into 879,259 and 1,649,856 shares of the Companys
common stock at March 31, 2005 and 2004, respectively, are excluded from the calculation of diluted
loss per share because the Company reported losses from continuing operations in those periods and
their effect would be antidilutive. 4. Related Party Transactions The Companys founder, Chief Executive Officer and President holds a controlling interest in
Eagle Venture Capital, which owns approximately 2.5 million outstanding shares of the common stock
of the Company as of March 31, 2005. A consulting company managed by one of the Companys
directors holds warrants outstanding to acquire 100,000 shares of the Companys common stock. The
warrants have an exercise price of $6.00 per share and expire in 2005. In November 2004, the
Company invested $3 million in a partnership managed by an affiliate of a director of the Company
(see Note 9). Certain other Company directors and officers have invested separately in the
partnership. 5. Merger Agreement with Ntera Holdings On March 16, 2004, the Company entered into an Agreement and Plan of Merger (the Agreement)
with Ntera Holdings, Inc., a Delaware corporation (Ntera), providing for a transaction that would
have resulted in a change of control of WQN. In connection with the Agreement, WQN extended to
Ntera a bridge loan in the principal amount of $2 million bearing interest of 7% per annum. On
September 2, 2004, the Company terminated the Agreement with Ntera. The balance of the note and
accrued interest at March 31, 2005 was $425,980. On April 1, 2005 the company received a payment
of $403,689 from Ntera bringing the total proceeds received from Ntera to $2,109,788 and the
Company expects to receive the remaining balance of $22,291 during the second quarter of 2005. The
loan is secured by the assets of Ntera. 6. Promissory Note The Company has borrowed $300,000 from a financial institution under a term promissory note
agreement (the Note). The Note bears interest at the financial institutions prime rate as
adjusted from time to time (5.75% at March 31, 2005) less 2.25% per annum. The Note is due in
October 2005 and is collateralized by a $300,000 certificate of deposit bearing interest of 1.48%
per annum. 7. Value Communications Transaction In April 2004, the Company purchased from Value Communications Corporation (ValuCom), a
wholly owned subsidiary of Rediff.com India Limited, certain assets consisting primarily of
ValuComs customer list, brand, trademarks, web sites, internally built software, and certain
hardware for $500,000. The Company paid $200,000 of the total consideration at closing with the
remaining $300,000 to be paid in twelve monthly installments of $25,000 commencing May 2004. In
addition, the Company entered into an advertising agreement with Rediff.com, Inc. (Rediff)
entitling WQN to marketing services including exclusive rights to prominent online advertising
space on the Rediff.com U.S. website, the premier online destination for Indians in North America.
Under the terms of the advertising agreement, the Company will pay Rediff $50,000 for twelve
consecutive months commencing in May 2004 for the advertising services. The Company provided both
ValuCom and Rediff irrevocable letters of credit for the Companys remaining obligation under the
agreements. The letters of credit are secured by deposits in money market funds and the amount of
the letters of credit and the security deposits are reduced as the monthly installments are paid.
At March 31, 2005, the Companys obligation under both the agreements totaled $75,000.
Substantially all of the ValuCom purchase consideration was allocated to customer lists, which is
included in other assets and is being amortized over four years. -7-




---



##### Table of Contents



WQN, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(Continued)
(UNAUDITED) 8. Distribution and Marketing Agreement In September 2004, we entered into a distribution and marketing agreement with a privately
held company. As a result of the agreement, the Companys products are sold from more than 5,000
retail outlets in the Southern California market. We sell telephony and other products to a
network of distributors who then re-sell the product to the retail outlets. The revenues generated
through this agreement are included in wholesale telephony revenues. In connection with the
agreement, we paid the private company $50,000 and issued a warrant to purchase 40,000 shares of
our common stock for a total consideration of approximately $126,000, as valued by the
Black-Scholes pricing model, which is included in other assets and is being amortized over the
three year term of the agreement. The warrants exercise price is $0.01. 9. Investment in Partnership In November 2004, the Company invested $3 million in a partnership managed by an affiliate of
a director of the Company. The majority of the partnership assets are to be invested in private
investments in public entities. The partnership investments will take the form of common equity,
preferred equity, convertible debt and/or equity or debt securities. Although the partnership will
endeavor to engage in hedging transactions in order to mitigate downside risk, there can be no
assurance that the partnerships investments will be successful and, as a result, the Company may
lose all or some of its investment. The partnership agreement contains certain restrictions,
including limits on the Companys ability to withdraw capital from the partnership and limits on
the transferability of the Companys interests in the partnership. The Company can receive a
distribution on its capital account by giving the partnership 60 days written notice. The Company
records its proportionate share of earnings and losses from the partnership. For the quarter ended
March 31, 2005, the Company recorded a loss from its partnership investment of $369,258. 10. Stock-Based Compensation The Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees, in the primary financial statements and has provided supplemental
disclosures required by Statement of Financial Accounting Standards No. 123, Accounting for
Stock-Based Compensation and by Statement of Financial Accounting Standards No. 148, Accounting
for Stock-Based Compensation  Transition and Disclosure an amendment of FASB Statement No. 123.
Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation,
(SFAS 123) requires the disclosure of pro forma net loss and loss per share computed as if the
Company had accounted for its employee stock options under the fair value method set forth in SFAS
123. The following table illustrates the effect on net loss and loss per share as if the Company
had applied the fair value recognition provisions of SFAS 123. Three months ended March 31,2005
    
    
    2004Net loss as reported
    
    $
    (1,249,249
    )
    
    $
    (2,011,648
    )Less stock-based employee
compensation expense
    
    
    (48,060
    )
    
    
    (107,800
    )Pro forma net loss
    
    $
    (1,297,309
    )
    
    $
    (2,119,448
    )Loss per share:As reported  basic and diluted
    
    $
    (0.18
    )
    
    $
    (0.31
    )Pro forma  basic and diluted
    
    $
    (0.19
    )
    
    $
    (0.33
    )
 -8-




---



##### Table of Contents



11. Legal Matters In September 2004, the Company settled a dispute with a vendor from which it had purchased
telecommunication services. Under the terms of the settlement, the Company agreed to purchase from
the vendor a total of $960,000 in telecommunication services at rates less than the Company is
paying for similar services over a fourteen month period. The Company must purchase a minimum of
$80,000 per month in services beginning in the month that is four months after the settlement date. The Company is a defendant from time to time in lawsuits and disputes arising in the ordinary
course of business. The Company believes that resolution of all known contingencies is uncertain,
and there can be no assurance that future costs related to such litigation would not be material to
the Companys financial position or results of operations. -9-




---



##### Table of Contents



ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF OPERATION The following discussion of the financial condition and results of operations of WQN, Inc.
should be read in conjunction with the Managements Discussion and Analysis or Plan of Operation
(including Risk Factors That May Affect Results of Operations and Financial Condition) and the
Consolidated Financial Statements and the Notes thereto included in the Companys Annual Report on
Form 10-KSB for the year ended December 31, 2004. Forward-Looking Statements Certain statements in this report, including statements of WQNs and managements
expectations, intentions, plans and beliefs, including those contained in or implied by
Managements Discussion and Analysis or Plan of Operation and the Notes to Condensed Consolidated
Financial Statements, are forward-looking statements, within the meaning of Section 21E of the
Securities Exchange Act of 1934, as amended (the Exchange Act), that are subject to certain
events, risks and uncertainties that may be outside WQNs control. These forward-looking statements
include statements of managements plans and objectives for WQNs future operations and statements
of future economic performance, information regarding our expansion and possible results from
expansion, our expected growth, our capital budget and future capital requirements, the
availability of funds and our ability to meet future capital needs, the realization of our deferred
tax assets, and the assumptions described in this report underlying such forward-looking
statements. Actual results and developments could differ materially from those expressed in or
implied by such statements due to a number of factors, including, without limitation, those
described in the context of such forward-looking statements, our expansion and acquisition
strategy, our ability to achieve operating efficiencies, our dependence on network infrastructure,
capacity, telecommunications carriers and other suppliers, industry pricing and technology trends,
evolving industry standards, domestic and international regulatory matters, general economic and
business conditions, the strength and financial resources of our competitors, our ability to find
and retain skilled personnel, the political and economic climate in which we conduct operations and
the risk factors described from time to time in our other documents and reports filed with the
Securities and Exchange Commission. Overview We are a Voice Over Internet Protocol (VoIP) telephony company providing international long
distance services. VoIP enables voice communications over the Internet by compressing voice into
data packets that can be efficiently transmitted over data networks and then converted back into
voice at the receiving end. Our customers utilize our enhanced VoIP services platform to make and
receive calls using their home phone, business phone, personal computer and mobile phone. Our business includes the provision of enhanced Internet-based and other telephony services
under various brand names to individual consumers primarily seeking to make international calls as
well as the provision of enhanced Internet-based and other telephony services to resellers,
corporations and service providers under their brand names and carrier transmission services
whereby we sell our excess capacity to other long-distance carriers. We also distribute telephony
services, including prepaid long distance and prepaid wireless, through a network of over 90
private distributors. Through this network we estimate that our products are sold through over
10,000 retail outlets of which more than 5,000 retail outlets are located in Southern California.
We expect to begin selling our proprietary VoIP products through this distribution channel
beginning in 2005. As of March 31, 2005, Eagle Venture Capital, LLC (Eagle Venture) owned approximately 2.5
million, or 37%, of our outstanding shares of common stock. Eagle Venture is primarily owned by B.
Michael Adler, our founder and Chief Executive Officer. We were incorporated in October 1996 as a Texas corporation. We reincorporated in Delaware in
October 1999. In November 2004, we changed our name to WQN, Inc. from WorldQuest Networks, Inc. Our primary source of revenue is the fees that we receive from our telephony customers for
completing calls over our network and from the sale of telephony products to our network of
distributors in the Southern California market. Our Internet telephony revenue is dependent on the
volume of voice traffic carried over the network, which is measured in terms of minutes of voice
traffic and the fees per minute of traffic we charge our customers. We recognize this revenue in
the period in which the call is completed. We bill our retail customers on a prepaid basis through
credit cards. Our revenue from the sale of telephony products to our distributors is included as
wholesale telephony revenue. We provide some of our credit worthy wholesale customers with terms
that generally allow them to pay for our products within two weeks. All other wholesale customers
pay for our products in advance. -10-




---



##### Table of Contents



Cost of telephony revenue consists primarily of data communication and telecommunication
expenses to terminate long distance traffic over our networks, which vary proportionately with the
volume of traffic carried over our network. These costs include Internet related expenses to send
voice traffic over the Internet, fees we pay to terminate calls, fees we pay to utilize the
traditional telephone network to terminate our calls, expenses incurred to connect our customers to
our network, and fees we pay to other service providers for the purchase of telecom and other
products which we distribute. Selling, general and administrative expenses consist of advertising and promotional
expenditures, payroll and related expenses for executive and administrative personnel, facilities
expenses, professional services expenses, travel and other general corporate expenses. Discontinued Operations In July 2004, the Company sold all of the outstanding capital stock in its wholly-owned
subsidiary buyindiaonline.com, Inc. (Cash2India) to a private company for approximately
$1,552,000. Under the terms of the transaction, the Company received $852,000 in cash, a
promissory note for $700,000, and a warrant to purchase common stock in the acquiring company.
The cash payment included consideration for $352,000 in working capital associated with Cash2India
at the time of the sale. The promissory note bears interest at 5% per annum, is secured by the
capital stock of Cash2India, and is to be repaid in twenty-four consecutive monthly payments of
$29,167 plus accrued interest. The balance of the promissory note and accrued interest was $466,667
as of March 31, 2005. Cash2India is accounted for as a discontinued operation in the accompanying
consolidated financial statements. Merger Agreement with Ntera Holdings On March 16, 2004, the Company entered into an Agreement and Plan of Merger (the Agreement)
with Ntera Holdings, Inc., a Delaware corporation (Ntera), providing for a transaction that would
have resulted in a change of control of WQN. In connection with the Agreement, WQN extended to
Ntera a bridge loan in the principal amount of $2 million bearing interest of 7% per annum, which
is secured by the assets of Ntera. On September 2, 2004, the Company terminated the Agreement with
Ntera. The balance of the note and accrued interest at March 31, 2005 was $425,980. On April 1,
2005 the company received a payment of $403,689 from Ntera bringing the total proceeds received
from Ntera to $2,109,788 and the Company expects to receive the remaining balance of $22,291 during
the second quarter of 2005. The loan is secured by the assets of Ntera. Distribution and Marketing Agreement In September 2004, we entered into a distribution and marketing agreement with a privately
held company. As a result of the agreement, the Companys products will be sold in more than 5,000
retail outlets in the Southern California market. We sell telephony and other products to a
network of distributors who then re-sell the product to the retail outlets. The revenues generated
through this agreement are included in wholesale telephony revenues. -11-




---



##### Table of Contents



Critical Accounting Policies The Companys significant accounting policies are summarized in Note 2 of its consolidated
financial statements included in the Companys Annual Report on Form 10-KSB for the year ended
December 31, 2004. While all these significant accounting policies impact its financial condition
and results of operations, the Company views certain of these policies as critical. Policies
determined to be critical are those policies that have the most significant impact on the Companys
financial statements and require management to use a greater degree of judgment and/or estimates.
Actual results may differ from those estimates. The Company believes that given current facts and
circumstances, it is unlikely that applying any other reasonable judgments or estimate
methodologies would cause a material effect on the Companys consolidated results of operations,
financial position or liquidity for the periods presented in this report. The accounting policies
identified as critical are as follows: Revenue Recognition The Company recognizes revenues in accordance with generally accepted accounting principles as
outlined in SAB No. 101 as revised by 104 which requires that four basic criteria be met before
revenue can be recognized: (1) persuasive evidence of an arrangement exists, (2) product delivery,
including customer acceptance, has occurred or services have been rendered, (3) the price is fixed
or determinable and (4) collectibility is reasonably assured. Retail telephony revenue is recorded
net of estimated returns and allowances and is recognized as calling services are used. Wholesale
traffic revenue is recognized as calls are processed. Revenue on the distribution of telephony
products is included in wholesale telephony revenue, is recorded net of estimated returns and
allowances and is recognized when the products are shipped to the customer. Distribution products
are processed by other carriers therefore no future service is provided by the Company. Property and Equipment Property and equipment are depreciated over their useful lives. Useful lives are based on
managements estimates of the period that the assets will generate revenue. Any change in
conditions that would cause management to change its estimate as to the useful lives of a group or
class of assets may significantly impact the Companys depreciation expense on a prospective basis. Web Site Development Costs Our products and services are sold predominantly through our web sites. We incur costs to
maintain and add new functionality to our existing web sites and to develop new web sites. Costs
related to the planning and post implementation phases of our web site development efforts are
expensed. Direct costs incurred in the development phase are capitalized and amortized over the
products estimated useful life of one to three years, which is included in depreciation expense.
Costs associated with minor enhancements and maintenance for web sites are expensed. Investment in Partnership The Companys investment in partnership is accounted for on the equity basis of accounting.
Gains and losses are included in income (loss) from partnership investment. The Company can receive
a distribution on its partner capital account by giving the partnership 60 days written notice. Income Taxes As of March 31, 2005, we had approximately $25,104,000 of net operating loss carry forwards
for federal income tax purposes, which expire beginning in 2011. We have not recognized an income
tax benefit for our losses because of uncertainty regarding future realizability and we have
provided a full valuation allowance on our deferred tax assets. -12-




---



##### Table of Contents



Results of Operations Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004 Revenue Revenue increased approximately 278% to $7,608,000 for the three months ended March 31, 2005
from $2,013,000 for the three months ended March 31, 2004. The $5,595,000 increase in revenue is
attributable to a $5,063,000 increase in wholesale telephony revenue and a $532,000 increase in
retail telephony revenue. The increase in wholesale telephony revenue is primarily attributable to
a distribution and marketing agreement we entered into in September 2004 giving the Company access
to a distribution network consisting of more than 5,000 retail locations in Southern California.
During the first quarter of 2005, the majority of the wholesale telephony revenue was from the sale
of telephony product we purchased from other providers. Retail telephony increased approximately
27% over the prior year quarter and approximately 23% from the sequential quarter ended December
31, 2004. The increase in retail telephony is primarily attributable to the addition of an Indian
based call center in the fourth quarter of 2004 from which we sell our telephony products. Overall,
our minutes of use have increased 75% to 21.5 million minutes for the three months ended March 31,
2005, up from 12.3 million minutes for the three months ended March 31, 2004. A substantial portion of our retail telephony customers are calling from the United States to
India. The Indian international telephony market continues to experience downward pricing
pressures and it is unlikely that this trend will reverse in the near future. Cost of Revenue Cost of revenue increased approximately 375% to $7,325,000 for the three months ended March
31, 2005 from $1,542,000 for the three months ended March 31, 2004. This $5,783,000 increase is due
primarily to a shift in revenue mix. Lower margin wholesale revenue comprised 67% of our total
revenues in the first quarter of 2005 compared to 1% in the comparable 2004 period. Our gross
profit percentage was approximately 4% during the first quarter of this year, a decrease from
approximately 23% in the year ago quarter. The decrease in gross profit percentage during the
quarter was primarily due to the addition of lower margin wholesale telephony revenue. Excluding
the wholesale operations, our gross profit margin for the first quarter of 2005 was approximately
7% compared to approximately 23% in the year ago quarter. The decrease in our retail gross profit
margin was primarily attributable to an increase in the average termination price per minute
without a corresponding increase in the average selling price per minute. The increase in the
average termination price per minute is due primarily to the loss of certain carriers serving the
Indian international telephony market, which continues to experience pricing pressures. We expect
our retail telephony gross profit margin will improve in the second quarter of 2005 as we have
secured improved termination rates and as we have increased our average selling price. Selling, General and Administrative Selling, general and administrative expenses decreased approximately 4% to $1,058,000 for the
three months ended March 31, 2005 from $1,102,000 for the three months ended March 31, 2004. This
$44,000 decrease is due primarily to lower personnel costs partially offset by increased selling,
general and administrative expenses in connection with the introduction of RocketVoIP, the
Companys proprietary next generation VoIP technology service and to higher selling expenses
associated with the addition of the Indian based call center. Merger Expenses During the first quarter of 2004 we incurred merger related expenses of approximately
$1,167,000 primarily for legal fees and professional services associated with the previously
announced Ntera Holdings, Inc. merger agreement (see Part I, Item 2  Merger Agreement with Ntera
Holdings), which was terminated in September 2004. Depreciation and Amortization Depreciation and amortization was $168,000 for the three months ended March 31, 2005, which is
substantially unchanged from $167,000 for the three months ended March 31, 2004. -13-




---



##### Table of Contents



Interest Income, Net Interest income, net consists of interest earned on cash and cash equivalents and notes
receivable less interest expense on borrowings. Interest earned on cash and cash equivalents and
notes receivable increased to $66,000 for the three months ended March 31, 2005 from $43,000 for
the three months ended March 31, 2004. The increase is due primarily to interest income earned on
the bridge loan made to Ntera Holdings, Inc. in March 2004 and interest income earned on the
Companys note receivable from the sale of Cash2India, the financial services subsidiary. Interest
expense for the 2005 first quarter totaled approximately $2,000 compared to $1,000 in the
comparable 2004 quarter. Loss From Investment In Partnership The Company accounts for its partnership interest under the equity method of accounting and
for the quarter ended March 31, 2005 recorded a loss from its equity investment of $369,000. Loss From Continuing Operations We incurred a loss from continuing operations of $1,249,000 for the three months ended March
31, 2005 compared to a loss of $1,924,000 for the three months ended March 31, 2004. This $675,000,
or 35%, decrease in loss from continuing operations is primarily attributable to a $1,167,000
decrease in merger expenses, a $44,000 decrease in selling, general and administrative expenses and
to $22,000 increase in interest income, net partially offset by a $189,000 reduction in the
Companys gross profit and a $369,000 loss from partnership investment. Income/(Loss) From Discontinued Operations The income/(loss) from discontinued operations is due to the sale of the Companys financial
services subsidiary, which comprised the financial services segment (see Note 2, Discontinued
Operations in notes to the financial statements). For the periods presented, the loss from
discontinued operations were attributable to the loss from operations of the entity. The Company
had a loss from discontinued operations during the first quarter of 2004 of approximately $88,000. Liquidity and Capital Resources As of March 31, 2005, we had approximately $10,405,000 of cash and cash equivalents and
working capital of approximately $13,169,000. We generated negative cash flow from operating
activities of approximately $1,098,000 during the three months ended March 31, 2005, compared with
negative cash flow from operating activities of approximately $1,297,000 during the three months
ended March 31, 2004. Net cash used in operating activities for the 2005 and 2004 periods
primarily resulted from operating losses as well as changes in working capital. The $199,000
decrease in cash used in operating activities in the 2005 period from the 2004 period is due
primarily to expenses incurred in connection with the Ntera Holdings, Inc. merger agreement in the
2004 period partially offset by changes in operating assets and liabilities during 2005. Net cash proceeds from investing activities was $1,538,000 for the three months ended March
31, 2005 compared to cash used in investing activities of $2,047,000 for the three months ended
March 31, 2004. Net cash proceeds for the 2005 first quarter are comprised of debt repayments of
$1,737,000 partially offset by capital expenditures of $199,000. Cash used in investing activities
for the quarter ended March 31, 2004 is attributable to a $2,000,000 loan made to Ntera Holdings,
Inc. in connection with the merger agreement, which was terminated in September 2004. The balance
of the Ntera note and accrued interest at March 31, 2005 was $425,980. On April 1, 2005 the
company received a payment of $403,689 from Ntera bringing the total proceeds received from Ntera
to $2,109,788 and the Company expects to receive the remaining balance of $22,291 during the second
quarter of 2005. The loan is secured by the assets of Ntera. The Company has borrowed $300,000 from a financial institution under a term promissory note
agreement (the Note). The Note bears interest at the financial institutions prime rate as
adjusted from time to time (5.75% at March 31, 2005) less 2.25% per annum. The Note is due in
October 2005 and is collateralized by a $300,000 certificate of deposit bearing interest of 1.48%
per annum. The Company provided ValuCom and Rediff irrevocable letters of credit in connection with the
Companys purchase of certain assets from ValuCom and the Companys advertising agreement with
Rediff. The letters of credit are secured by deposits in a money market fund and the amount of the
letters of credit and security deposits are reduced as the monthly installments are paid. At March
31, 2005, the Companys obligation under both agreements was $75,000. -14-




---



##### Table of Contents



The Company received a $700,000 note in connection with the sale of the outstanding capital
stock of its wholly-owned subsidiary Cash2India. The note bears interest at 5% per annum, is
secured by the capital stock of Cash2India, and is to be repaid in twenty-four consecutive monthly
payments of $29,167 plus accrued interest. The balance of the promissory note and accrued interest
was $466,667 as of March 31, 2005. In November 2004, the Company invested $3 million in a partnership managed by an affiliate of
a director of the Company. The majority of the partnership assets are to be invested in private
investments in public entities. The partnership investments will take the form of common equity,
preferred equity, convertible debt and/or equity or debt securities. Although the partnership will
endeavor to engage in hedging transactions in order to mitigate downside risk, there can be no
assurance that the partnerships investments will be successful and, as a result, the Company may
lose all or some of its investment. The partnership agreement contains certain restrictions,
including limits on the Companys ability to withdraw capital from the partnership and limits on
the transferability of the Companys interests in the partnership. The Company can receive a
distribution on its partner capital account by giving the partnership 60 days written notice. The
Company records its proportionate share of earnings and losses from the partnership based on its
share of the partnership and for the quarter ended March 31, 2005 recorded a loss from its
partnership investment of $369,000. The Company generated cash from financing activities of $22,000 for the three months ended
March 31, 2005 and $620,000 for the three months ended March 31, 2004 related to the exercise of
stock options. We currently anticipate that our existing cash resources will be sufficient to meet our
anticipated needs for working capital and capital expenditure requirements through at least the
next 24 months. We may need to raise additional funds prior to the expiration of such period if,
for example, we pursue business or technology acquisitions or experience operating losses that
exceed our current expectations. If we raise additional funds through the issuance of equity,
equity-related or debt securities, such securities may have rights, preferences or privileges
senior to those of the rights of our common stock and our stockholders may experience additional
dilution. We cannot be certain that additional financing will be available to us on favorable terms
when required, or at all. Income Taxes As of March 31, 2005, we had approximately $25,104,000 of net operating loss carry forwards
for federal income tax purposes, which expire beginning in 2011. We have not recognized an income
tax benefit for our losses as we have provided a full valuation allowance on our deferred tax
assets, which consists primarily of net operating loss carry forwards, because of uncertainty
regarding future realizability. Limitations on the utilization of these carry forwards may result
if we experience a change of control, as defined in the Internal Revenue Code of 1986, as amended,
as a result of changes in the ownership of our common stock. 
 ITEM 3. CONTROLS AND PROCEDURES In accordance with Exchange Act Rules 13a-15 and 15d-15, we carried out an evaluation, under
the supervision and with the participation of management, including our Chief Executive Officer and
Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the
end of the period covered by this Report on Form 10-QSB. Based on that evaluation, our Chief
Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures
were effective as of March 31, 2005 to provide reasonable assurance that information required to be
disclosed in our reports filed or submitted under the Exchange Act is recorded, processed,
summarized and reported within the time periods specified in the Securities and Exchange
Commissions rules and forms. There has been no change in our internal controls over financial reporting that occurred
during the three months ended March 31, 2005 that has materially affected, or is reasonably likely
to materially affect, our internal controls over financial reporting. -15-




---



##### Table of Contents



PART II-OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS In September 2004, the Company settled a dispute with a vendor from which it had purchased
telecommunication services. Under the terms of the settlement, the Company agreed to purchase from
the vendor a total of $960,000 in telecommunication services at rates less than the Company is
paying for similar services over a fourteen month period. The Company must purchase a minimum of
$80,000 per month in services beginning in the month that is four months after the settlement date. The Company is a defendant from time to time in lawsuits and disputes arising in the ordinary
course of business. The Company believes that resolution of all known contingencies is uncertain,
and there can be no assurance that future costs related to such litigation would not be material to
the Companys financial position or results of operations. 
 ITEM 2. CHANGES IN SECURITIES The effective date of our first registration statement, filed on Form SB-2 under the
Securities Act of 1933 (no. 333-93019) relating to our initial public offering of our Common Stock,
was February 4, 2000. A total of 3,162,500 shares of our Common Stock were sold at a price of
$13.00 per share. Net proceeds to WQN were approximately $36.3 million. From the time of receipt
through March 31, 2005, the net proceeds were applied toward:  
    repayment of indebtedness, $4,498,000;
    equipment purchases including additional back-up systems, $4,670,000;
    software development, $1,117,000
    investments, $3,000,000
    merger and acquisition related, $1,587,000; and
    General corporate purposes, including operating losses, payment of
outstanding payables, payoffs of capital leases, liability insurance
premiums, development of strategic relationships and research and
development of new products, $11,023,000. The remaining proceeds are being used as working capital or are being held in high quality,
short-term investment instruments such as short-term corporate investment grade or United States
Government interest-bearing securities. Of the $4,498,000 paid for repayment of indebtedness, $1,440,000 was paid to Eagle Venture
Capital, LLC, which owns approximately 37% of our Common Stock and is controlled by B. Michael
Adler, our Chief Executive Officer and President. The $3,000,000 investment was made in an
investment partnership affiliated with E. Denton Jones, one of the Companys directors. -16-




---



##### Table of Contents



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) The following exhibits are filed as a part of this Report on Form 10-QSB
pursuant to Item 601 of regulation S-B: ExhibitNumber
    
    Description of Exhibits2.1
    
    Agreement and Plan of Merger, dated as of March 16, 2004, among WorldQuest, Ntera Holdings, Inc.
and Engin Yesil, filed as exhibit 2.1 to WorldQuests Current Report on Form 8-K/A dated March 19,
2004, as amended, and incorporated herein by this reference.2.2
    
    Stock Purchase Agreement dated as of July 26, 2004, by and among Xoom Corporation, Inc., WorldQuest
Networks, Inc., and WQN Mercury Inc., filed as exhibit 2.2 to WorldQuests Quarterly Report as
Form 10-QSB
for the quarter ended June 30, 2004.2.3
    
    Promissory Note dated as of July 26, 2004, by and between Xoom Corporations, Inc. and WorldQuest
Networks,
Inc. filed as exhibit 2.3 to WorldQuests Quarterly Report as Form 10-QSB for the quarter ended
June 30, 2004.2.4
    
    Stock Pledge Agreement dated as of July 26, 2004 by and between Xoom Corporation, Inc. and
WorldQuest Networks, Inc., filed as exhibit 2.4 to WorldQuests Quarterly Report as Form 10-QSB
for the quarter ended June 30, 2004.2.5
    
    Stock Purchase Warrant dated as of July 26, 2004 by and between Xoom Corporation, Inc. and
WorldQuest Networks, Inc., filed as exhibit 2.5 to WorldQuests Quarterly Report as Form 10-QSB
for the quarter ended June 30, 2004.3.1
    
    Certificate of Incorporation of WorldQuest, filed as Exhibit 3.1 to WorldQuests Form SB-2
Registration Statement, File No. 333-82721 (the Prior Registration Statement), and incorporated
herein by reference.3.2
    
    Bylaws of WorldQuest, filed as Exhibit 3.2 to the Prior Registration Statement, and incorporated
herein by this reference.4.1
    
    Specimen common stock certificate, filed as Exhibit 4.1 to the Prior Registration Statement, and
incorporated herein by this reference.4.2.1
    
    Representatives Warrant dated February 4, 2000 granted to John G. Kinnard and Company
Incorporated for 68,750 shares of common stock, filed as Exhibit 4.3.1 to WorldQuests Annual
Report on Form 10-KSB for the fiscal year ended December 31, 1999, and incorporated herein by
reference.4.2.2
    
    Representatives Warrant dated February 4, 2000 granted to Kaufman Bros., L.P. for 178,750 shares
of common stock, filed as Exhibit 4.3.2 to WorldQuests Annual Report on Form 10-KSB for the
fiscal year ended December 31, 1999, and incorporated herein by reference.4.2.3
    
    Representatives Warrant dated February 4, 2000 granted to WestPark Capital, Inc. for 27,500
shares of common stock, filed as Exhibit 4.3.3 to WorldQuests Annual Report on Form 10-KSB for
the fiscal year ended December 31, 1999, and incorporated herein by reference.4.3
    
    Form of Unsecured Subordinated Convertible Promissory Note issued in the private placement closed
in December 1999 (the Private Placement), filed as Exhibit 4.5 to WorldQuests Form SB-2
Registration Statement, file no. 333-93019 (the Second Registration Statement), and incorporated
herein by this reference.4.4
    
    Form of Warrant issued in the Private Placement, filed as Exhibit 4.4 to the Second Registration
Statement, and incorporated herein by this reference.4.5
    
    Warrant to purchase 50,000 shares of common stock granted to Advanced Multimedia Group, Inc. on
March 16, 2000, filed as Exhibit 4.7 to WorldQuests Annual Report on Form 10-KSB for the fiscal
year ended December 31, 2000, and incorporated herein by this reference.
 -17-




---



##### Table of Contents



ExhibitNumber
    
    Description of Exhibits4.6
    
    Warrant to purchase 50,000 shares of common stock granted to Advanced Multimedia Group, Inc. on
April 26, 2000, filed as Exhibit 4.8 to WorldQuests Annual Report on Form 10-KSB for the fiscal
year ended December 31, 2000, and incorporated herein by this reference.10.1
    
    Amended 1997 Stock Option Plan, filed as Exhibit 10.2 to the Prior Registration Statement, and
incorporated herein by this reference.10.2
    
    Stock Option Agreement dated December 7, 1998 granted to Michael R. Lanham by WorldQuest, filed as
Exhibit 10.3 to the Prior Registration Statement, and incorporated herein by this reference.10.3
    
    Form of Registration Rights Agreement executed in connection with the Private Placement, filed as
Exhibit 10.6 to the Second Registration Statement, and incorporated herein by this reference.10.4
    
    2001 Stock Option Plan, filed as Exhibit 4.8 to WorldQuests Form S-8 Registration Statement, File
No. 333-54498, and incorporated herein by this reference.10.5
    
    Employment agreement by and between WorldQuest Networks, Inc. and B. Michael Adler effective as of
April 14, 2003 filed as exhibit 10.10 to WorldQuests Quarterly Report as Form 10-QSB for the
quarter ended June 30, 2003.10.6
    
    Employment agreement by and between WorldQuest Networks, Inc. and Victor E. Grijalva effective as
of April 14, 2003 filed as exhibit 10.12 to WorldQuests Quarterly Report as Form 10-QSB for the
quarter ended June 30, 2003.10.7
    
    2002 Stock Option Plan.*31.1
    
    Certification of the Companys Chief Executive Officer, pursuant to Rule 13a-14(a) and 15d-14(a),
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*31.2
    
    Certification of the Companys Chief Financial Officer, pursuant to Rule 13a-14(a) and 15d-14(a),
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.*32.1
    
    Certification of the Companys Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.*32.2
    
    Certification of the Companys Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
   *
    
    Filed herewith. 
 SIGNATURES In accordance with the requirements of the Exchange Act, the registrant has duly caused this report
to be signed on its behalf by the undersigned, there-unto duly authorized. WQN, INC.May 12, 2005
    By:
    /s/ Victor E. GrijalvaVictor E. GrijalvaVice President, Chief Financial
Officer,
Secretary and Treasurer
(Principal Financial and Accounting Officer) -18-