SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

OR

[  ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM           TO

COMMISSION FILE NUMBER: 000-28467

Z-TEL TECHNOLOGIES, INC.

601 SOUTH HARBOUR ISLAND BOULEVARD, SUITE 220
TAMPA, FLORIDA 33602
(813) 273-6261
(Address, including zip code, and
telephone number including area code, of
Registrant’s principal executive offices)

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE

     SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK, PAR VALUE $.01 PER SHARE, PREFERRED STOCK PURCHASE RIGHTS

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes [X] No [  ]

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12B-2 of the Exchange Act)

Yes [  ] No [X]

The number of shares of the Registrant’s Common Stock outstanding as of November 11, 2004 was approximately 41,711,821.

TABLE OF CONTENTS

2

Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES

The accompanying notes are an integral part of these consolidated financial statements.

3

Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES

The accompanying notes are an integral part of these consolidated financial statements.

4

Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES

The accompanying notes are an integral part of these consolidated financial statements

5

Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES

     The accompanying notes are an integral part of these consolidated financial statements

6

Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES

NOTE 1. NATURE OF BUSINESS

(a) Description of Business

Z-Tel Technologies, Inc. and subsidiaries (“Z-Tel,” “we” or “us”) is a provider of advanced, integrated telecommunications services targeted to consumer (residential) and business subscribers. We offer local and long distance telephone services in combination with enhanced communications features accessible through the telephone, the Internet and certain personal digital assistants. We offer our Z-LineHOME® and Z-LineBUSINESS® services in forty-nine states. Our customers are primarily concentrated in ten states. We also provide long-distance telecommunications services to customers nationally.

We introduced our wholesale services during the first quarter of 2002. This service provides other companies with the opportunity to provide local, long-distance and enhanced telephone service to their own residential and business end user customers on a private label basis by utilizing our telephone exchange services, enhanced services platform, infrastructure and back-office operations.

Historically we have utilized the unbundled network elements platform (“UNE-P”) as the primary basis of delivering our services to our retail end users and end users of our wholesale customers. Under UNE-P we utilize various unbundled elements of the incumbent local exchange carriers to facilitate the delivery of our services to end users.

(b) Liquidity and capital resources

We have a limited operating history and our operations are subject to certain risks and uncertainties, particularly related to the evolution of the regulatory environment, which impacts our access to and cost of the network elements that we utilize to provide services to our customers, access to adequate financing, and competition within the industry.

We have incurred significant losses since our inception, resulting in an accumulated deficit at September 30, 2004 of approximately $350.7 million. We also had total liabilities recorded at September 30, 2004 of approximately $84.2 million. We experienced positive cash flows from operations for the three months ended March 31, 2004, but experienced negative cash flows from operations for the past two quarters.

The company’s reported cash position declined on a net basis for the three months and nine months ended September 30, 2004 by approximately $3.4 and $7.3 million respectively.

At September 30, 2004, we had cash on hand of approximately $4.7 million. In addition, we have an asset based loan facility with Textron Financial Corporation (“Textron”), which provides us with up to $25 million to fund operations. We were utilizing $12.5 million as of September 30, 2004, which was approximately the maximum then available to us under the loan availability calculation. We did not meet the fixed charge coverage ratio for the quarter ended June 30, 2004 or September 30, 2004. All other financial covenants have been met per our agreement with Textron. Per the agreement, Textron can cancel the loan arrangement with us; however, we believe that it is unlikely that Textron would take such measures. We are working to resolve this issue without triggering a cancellation of the agreement. At current collection rates, we will collect the total amount outstanding under this facility in just over a month. We believe that Textron is adequately secured under this facility. In addition, we have already disclosed to Textron the cost saving measures recently implemented that would allow us to meet the fixed charge coverage ratio required in future quarters. Textron has advised us that additional interest at a rate of 300 basis points per annum will be effective as of October 4, 2004.

On August 24, 2004, we entered into a $15 million Standby Credit Facility Agreement with The 1818 Fund III, L.P., which is one of a family of funds managed by Brown Brothers Harriman. On August 25, 2004, we were advanced $5 million pursuant to the credit facility. Loans under the credit facility are represented by a Senior Unsecured Promissory Note bearing interest at 9.95% annually. The note matures March 31, 2006, but under certain circumstances may be extended by the company until August, 2006. As of the quarter ended September 2004, we did not meet a “cross-default” covenant due to the non-compliance with the Textron asset based loan facility. Per the standby credit facility agreement, this could trigger an immediate demand of payment upon notice by The 1818 Fund. Upon discussions with The 1818 Fund a waiver was signed that indicates they will not require immediate payment within the next 90 days. This loan has been reclassified to short term on the balance sheet.

A Nasdaq Listing Qualifications Hearing Panel has granted us a temporary exception from shareholders' equity/$35 million market value of listed securities/net income and minimum bid price requirements for continued listing on The Nasdaq SmallCap Market, subject to certain conditions, including submission of documentation indicating compliance with all the requirements for continued listing on the SmallCap Market before expiration of the exception. The exception expires December 1, 2004. If Z-Tel meets the terms of the exception, our shares will continue to be listed on the SmallCap Market. We have plans in place, including a tender offer to our preferred shareholders and a reverse stock split, to meet the terms of the exception, but we cannot assure the success of those plans. Commencing Monday November 8, 2004 and for the duration of the exception, the trading symbol for Z-Tel’s shares will be “ZTELC.”

As a result of these current negative impacts there may be a significant doubt about our ability to continue as a going concern.

(c) Change of Management

On August 25, 2004, then president and chief executive officer and Board member D. Gregory Smith and then chief technology officer and Board member Charles W. McDonough resigned from their positions to found a new company. Messrs. Smith and McDonough intend to pursue certain product and business initiatives that were under development in our Atlanta technology center at

7

the time of their resignation. Z-Tel’s Board of Directors authorized us to negotiate an agreement with Messrs. Smith and McDonough defining the specific activities, assets and personnel to be transferred to the new company and other terms of the transaction. The Board has appointed Trey Davis as Acting Chief Executive Officer and Executive Vice President. Mr. Davis will retain his present duties as Chief Financial Officer. The Board also appointed Frank Grillo as Acting Chief Operating Officer and Executive Vice President.

Subsequent to the change of management, several actions have been initiated to improve the overall operating cash flow of the company. The most significant was a change in our direction that reduced the focus on enhanced services development and increased the focus on building our customer base, revenue streams and continuing VoIP deployment plans. This involved a reduction in force that occurred in September 2004 to help align our cost structure with our new direction.

NOTE 2. BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been prepared by us in accordance with accounting principles generally accepted in the United States of America for interim financial information and are in the form prescribed by the Securities and Exchange Commission’s (“SEC”) instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes for complete financial statements as required by accounting principles generally accepted in the United States of America. The interim unaudited financial statements should be read in conjunction with our audited financial statements as of and for the year ended December 31, 2003, included in our Annual Report on Form 10-K filed with the SEC on March 30, 2004. In the opinion of management, all adjustments considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for the year ending December 31, 2004.

(a) Reclassification

Certain amounts in the consolidated statements of operations for the three and nine months ended September 30, 2003 have been reclassified to conform to the presentation for the three and nine months ended September 30, 2004.

NOTE 3. SIGNIFICANT ACCOUNTING POLICIES AND RECENT ACCOUNTING PRONOUNCEMENTS

(a) Significant Accounting Policies

Our significant accounting policies are included in the Notes to Consolidated Financial Statements in our Annual Report on Form 10-K for the year ended December 31, 2003.

(b) Stock-based compensation

We account for our stock option plans in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations and comply with the disclosure provisions of Statements of Financial Accounting Standards (“SFAS”) No. 123, “Accounting for Stock-Based Compensation” and SFAS No. 148 “Accounting for Stock-Based Compensation – Transition and Disclosure, an Amendment of SFAS 123, Accounting for Stock-Based Compensation.” As such, we record compensation expense on the date of grant only if the current market price of the underlying stock exceeds the exercise price. Additionally, if a modification is made to an existing grant, any related compensation expense is calculated on the date both parties accept the modification and recorded on the date the modification becomes effective.

The following table illustrates, in accordance with the provisions of SFAS No. 148, the effect on net loss and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation (encompassing the impacts of both stock option and restricted stock grants).

8

We calculated the fair value of each grant on the date of grant using the Black-Scholes option pricing model. In addition to there being no payments of dividends on our common stock, the following assumptions were used for each respective period:

There were no stock option grants in the third quarter of 2004 so the discount rate and volatility percentage are shown as “Not Applicable” (N.A). Incremental shares of common stock equivalents are not included in the calculation of net loss per share as the inclusion of such equivalents would be anti-dilutive.

(c) Recent Accounting Pronouncements

In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 03-6, “Participating Securities and the Two-Class Method under Financial Accounting Standards Board (“FASB”) Statement No. 128, Earnings per Share.” EITF 03-6 clarifies what constitutes a participating security and provides further guidance in applying the two-class method of calculating earnings per share (“EPS”). The consensus reached by the EITF in this Issue is effective for reporting periods beginning after March 31, 2004. We adopted EITF Issue No. 03-06 during the quarter ended June 30, 2004. There was no impact of the adoption on the computation of EPS, as the effect is anti-dilutive. In periods of net income, we will utilize the two-class method of computing EPS.

NOTE 4. WHOLESALE SERVICES

In February 2003, we executed an agreement providing for the resale of our local wire line telecommunications services and for the provisioning of ancillary services with Sprint. Under this agreement, we provide Sprint access to our Web-integrated, enhanced communications platform and operational support systems. We are the primary obligor for certain underlying expenses that are incorporated into our pricing in connection with the agreement and therefore, are recording revenues using a gross presentation. This accounting method results in revenue being recorded for certain per-line, per-minute, and direct costs and the corresponding expenses being recorded in the appropriate operating expense line. As a result of this accounting treatment, increases or decreases in pricing or volume that impact certain direct costs that are incurred in connection with this agreement would have little or no impact on net income, as the amount is recorded in an equivalent amount in both revenue and expense. Our wholesale services agreement with Sprint is non-exclusive in nature.

As of September 30, 2004, under our contract with Sprint, we had approximately $1.9 million of deferred revenue recorded, of which $0.1 million is recorded as long-term deferred revenue.

Sprint revenues were 30.9% of total revenues for the three months ended September 30, 2004, as compared to 27.5% for the prior year period. Sprint revenues were 32.3% of total revenues for the nine months ended September 30, 2004, as compared to 16.3% for the prior year period.

NOTE 5. ACCOUNTS RECEIVABLE AGREEMENT

In April 2004, we signed a three-year asset based loan facility with Textron Financial Corporation (“Textron”). This agreement provides us with an availability to borrow up to $25 million at a 6% interest rate. Our overall availability is based on the eligibility of our accounts receivable, subject to certain limitations and advance rates. The new asset based loan facility is expected to provide us with additional liquidity because it includes residential, business and wholesale accounts receivable while our prior arrangement with RFC Capital Corporation (“RFC”) only included certain portions of our accounts receivable. We believe that this new agreement may provide us with additional working capital financing flexibility to help facilitate the growth of our business, to the extent growth materializes in our business.

This agreement has three primary quarterly financial covenants: a fixed charge coverage ratio, accounts receivable turnover requirement and an unfunded capital expenditures cap. The ratio requirements begin low and increase each quarter through December 31, 2004 and then remain constant. We did not meet the fixed charge coverage ratio for the quarters ended June 30, 2004 and September 30, 2004. All other financial covenants have been met per our agreement with Textron. Per the agreement, Textron can cancel the loan arrangement with us; however, we believe that it is unlikely that Textron would take such measures. At current collection rates, we will collect the total amount outstanding under this facility in just over a month. We believe that Textron is adequately secured under this facility. Textron notified us on October 1, 2004 that they would be charging an additional interest rate of 300 basis points starting on October 4, 2004 due to the fixed charge coverage ratio not being met.

There are also disposition of asset limitations, limits on change of control, certain notification requirements, change in management limitations and certain other restrictions. There are also certain limitations on our ability to access subordinated debt within the

9

confines of the agreement; however, we believe the agreement will provide us with flexibility for future debt financing alternatives. Under the amended asset based loan structure with Textron, we had an outstanding loan balance to Textron of approximately $12.5 million at September 30, 2004.

NOTE 6. STANDBY CREDIT FACILITY

On August 24, 2004, we entered into a $15 million Standby Credit Facility Agreement with The 1818 Fund III, L.P. (“The 1818 Fund”), which is one of a family of funds managed by Brown Brothers Harriman. On August 25, 2004, we were advanced $5 million pursuant to the credit facility. Loans under the credit facility are represented by a Senior Unsecured Promissory Note bearing interest at 9.95% annually. The note matures March 31, 2006, but under certain circumstances may be extended by the company until August, 2006.

As of September 2004, we did not meet a “cross-default” covenant due to the non-compliance with the Textron asset based loan facility. Per the standby credit facility agreement, this could trigger an immediate demand of payment upon notice by The 1818 Fund. Upon discussions with The 1818 Fund, a waiver was signed that indicates they will not require immediate payment within the next 90 days. This loan has been reclassified to short term on the balance sheet.

NOTE 7. INTANGIBLE ASSETS

In accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” we reassessed the expected useful lives of existing intangible assets. This reassessment resulted in no changes to the expected useful lives of our intangible assets. We only have one intangible asset as of September 30, 2004.

Summarized below is our only recorded intangible asset that will continue to be amortized under SFAS No. 142. It is a customer list that was acquired in April of 2000 in connection with our acquisition of Touch 1 Communications, Inc. (“Touch1”).

The following table presents current and expected amortization expense of the existing intangible asset as of September 30, 2004 for each of the following periods:

NOTE 8. RESTRUCTURING CHARGES

On May 17, 2004, a termination agreement was signed for our New York office lease on which we had previously recorded a lease abandonment charge. The settlement included a $90,000 payment in lieu of the remaining balance of $299,545 previously recorded as a lease abandonment charge. The settlement payment consisted of a one-time payment of $30,000, paid at the time of agreement, and three promissory notes of $20,000 payable on November 1, 2004, May 1, 2005 and August 30, 2005, respectively. All other expenses associated with this restructuring have been paid in full.

In June 2004, we approved and implemented a restructuring to improve our future cash flows and operating earnings. The restructuring included a reduction in work force. In accordance with SFAS No. 146 “Accounting for Costs Associated with Exit or Disposal Activities” the restructuring costs were considered a “One-Time Termination Benefit” and as such we recognized the restructuring costs as a liability at the communication date of June 8, 2004. The restructuring charge included termination benefits in connection with the reduction in force of 102 employees. The total charge taken in the second quarter of 2004 was $0.8 million of which approximately $40,000 was paid in the second quarter. The majority of the remainder of termination benefits were paid in full at the end of August 2004.

In September 2004, we approved and implemented a restructuring based on the change in management that occurred on August 25, 2004 and the subsequent change in business focus. The restructuring included a reduction in force of 152 employees and a write-off of certain assets. This restructuring is expected to reduce payroll expense by 25 percent. In accordance with SFAS No. 146

10

“Accounting for Costs Associated with Exit or Disposal Activities” the restructuring costs were considered a “One-Time Termination Benefit” and as such we recognized the restructuring costs as a liability at the communication date of September 1, 2004. The total charge taken in the third quarter of 2004 was approximately $3.2 million.

SFAS No. 146 replaces the EITF 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity,” used with the 2002 restructuring plan.

The following table shows the restructuring charges and related accruals recognized under the plans and the effect on our consolidated financial position:

NOTE 9. STOCK BASED COMPENSATION

(a) Stock Options

For employee stock options, the FASB issued SFAS No. 123, “Accounting for Stock-Based Compensation,” requiring entities to recognize as an expense, over the vesting period, the fair value of the options or utilize the accounting for employee stock options used under APB Opinion No. 25. We apply the provisions of APB Opinion No. 25 and consequently recognize compensation expense over the vesting period for grants made to employees and directors only if, on the measurement date, the market price of the underlying stock exceeds the exercise price. We do provide the pro forma net loss and earnings per share disclosures as required under SFAS No. 123 for grants made as if the fair value method defined in SFAS No. 123 had been applied. We recognize expense over the vesting period of the grants made to non-employees based on utilizing the Black-Scholes stock valuation model to calculate the value of the option on the measurement date.

(b) Restricted Stock

In March and April 2004, our compensation committee approved the granting of 403,000 shares of restricted stock with a then approximate value of $1.1 million to certain executive officers and key employees. Consideration paid for this stock is par value of $0.01 and continued employment. We apply the provisions of APB Opinion No. 25 and consequently recognize compensation expense over the vesting period for grants made to employees.

NOTE 10. COMMITMENTS AND CONTINGENCIES

We have disputed billings and access charges from certain inter-exchange carriers (“IXCs”) and incumbent local exchange carriers (“ILECs”). We contend that these billings are not in accordance with the interconnection, service level, or tariff agreements between us and certain IXCs and ILECs. We have not paid these disputed amounts and, while we can make no guarantee, management believes that we will prevail or mostly prevail in these disputes. At September 30, 2004, the total disputed amounts were approximately $19.0 million.

11

NOTE 11. RELATED PARTY TRANSACTIONS

On September 29, 2004 we signed an agreement with SipStorm, Inc., a company formed by our former Chief Executive officer, D. Gregory Smith, and former Chief Technology Officer, Charles McDonough. Under this agreement we have transferred selected computer hardware, software and intellectual property rights to SipStorm. These non-core assets are mainly related to our second generation enhanced service products. SipStorm will continue development of these applications and will provide us with access to the developed product over the course of the next 15 months. Relative to the purchase, SipStorm has assumed responsibility for certain accounts payable, future maintenance payments and provided a promissory note in the amount of $2.8 million. The promissory note is secured by shares of our preferred stock held by Messrs. Smith and McDonough. In the third quarter, we wrote-off approximately $1.9 million in outstanding accounts payable, $2.7 million in capitalized software and $0.4 million in computer hardware as a result of this transaction and the discontinued operations that resulted from management's change in business focus.

The agreement reached with SipStorm is a related party transaction as Mr. D. Gregory Smith, former Z-Tel Chief Executive Officer and company founder of SipStorm, still has a substantial investment in Z-Tel with approximately 17% of common shares outstanding, 11% of Series D preferred stock and 16% of Series G preferred stock. All the Series D and G preferred stock is pledged as collateral for the promissory note mentioned in Note 10 for the SipStorm sale.

NOTE 12. COMPUTATION OF NET LOSS PER SHARE

Basic net loss per share is computed by dividing net loss attributable to common stockholders by the weighted average number of common shares outstanding during the period. Incremental shares of common stock equivalents are not included in the calculation of net loss per share as the inclusion of such equivalents would be anti-dilutive.

Net loss per share is calculated as follows:

Basic and diluted net loss per share are the same for each of the periods presented. The following table includes potentially dilutive items that were not included in the computation of diluted net loss per share for all periods presented because to do so would be anti-dilutive in each case:

NOTE 13. LEGAL AND REGULATORY PROCEEDINGS

During June and July 2001, three separate class action lawsuits were filed against us, certain of our current and former directors and officers (the “D&Os”) and firms engaged in the underwriting (the “Underwriters”) of our initial public offering of stock (the “IPO”). The lawsuits, along with approximately 310 other similar lawsuits filed against other issuers arising out of initial public offering allocations, have been assigned to a Judge in the United States District Court for the Southern District of New York for pretrial coordination. The lawsuits against us have been consolidated into a single action. A consolidated amended complaint was filed on April 20, 2002. A Second Corrected Amended Complaint (the “Amended Complaint”), which is the operative complaint, was filed on July 12, 2002.

The Amended Complaint is based on the allegations that our registration statement on Form S-1, filed with the Securities and Exchange Commission (“SEC”) in connection with the IPO, contained untrue statements of material fact and omitted to state facts necessary to make the statements made not misleading by failing to disclose that the underwriters allegedly had received additional, excessive and undisclosed commissions from, and allegedly had entered into unlawful tie-in and other arrangements with, certain customers to whom they allocated shares in the IPO. The plaintiffs in the Amended Complaint assert claims against us and the D&Os pursuant to Section 11 of the Securities Act of 1933 and Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated by the SEC there under. The plaintiffs in the Amended Complaint assert claims against the D&Os pursuant to Sections 11 and 15 of the Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated by the SEC there under. The plaintiffs seek an undisclosed amount of damages, as well as pre-judgment and post-judgment interest, costs and expenses, including attorneys’ fees, experts’ fees and other costs and disbursements. Initial discovery has

12

begun. We believe we are entitled to indemnification from our Underwriters.

A settlement has been reached by the respective lawyers for the plaintiffs, the issuers and insurers of the issuers. The principal terms of the proposed settlement are (i) a release of all claims against the issuers and their officers and directors, (ii) the assignment by the issuers to the plaintiffs of certain claims the issuers may have against the Underwriters and (iii) an undertaking by the insurers to ensure the plaintiffs receive not less than $1 billion in connection with claims against the Underwriters. Hence, under the terms of the settlement our financial obligations will likely be covered by insurance. Our board of directors has approved the settlement. To be binding, the settlement must be executed by the parties and thereafter submitted to and approved by the court. The settlement will not be binding upon any plaintiffs electing to opt-out of the settlement.

The Metropolitan Government of Nashville and Davidson County, Tennessee, on behalf of the Metropolitan Nashville Employee Benefit Board (collectively “Metro Nashville”), filed the foregoing lawsuit against us on September 20, 2002. The lawsuit asserted claims under Delaware Law, the Uniform Commercial Code, and state law and sought actual damages of $18 million, punitive damages of $18 million, interest, and court costs. Metro Nashville alleged that we wrongfully and improperly delayed delivery of a stock certificate, preventing Metro Nashville from selling or taking other steps to protect the value of their shares while the market price of our stock declined significantly. On May 18, 2004, we entered into a settlement agreement whereby we paid Metro Nashville $800,000 in cash and delivered to Metro Nashville 585,723 shares of our common stock. We also agreed to file on Metro Nashville’s behalf a registration statement on Form S-3 allowing resale of those shares. That registration statement became effective July 15, 2004.

On October 9, 2003, Z-Tel Communications, Inc., our wholly-owned subsidiary corporation, filed a lawsuit against SBC Communications, Inc. and several of its subsidiaries (collectively, “SBC”) in federal court in Texas, where both SBC and Z-Tel do business. The lawsuit alleges SBC’s violation of the federal antitrust laws, the Racketeering Influenced Corrupt Organizations Act (RICO), the Lanham Act, and other federal and state laws. The complaint seeks damages and an injunction against SBC. On November 20, 2003, SBC filed a motion to dismiss the complaint. On August 6, 2004, the court denied in part, and granted in part, SBC’s motion to dismiss the complaint, allowing certain antitrust, RICO, and Lanham Act claims to proceed. Although we intend to pursue our claims against SBC vigorously, we cannot predict the outcome of this litigation with any certainty.

Susan Schad, on behalf of herself and all others similarly situated, filed a class action lawsuit against Z-Tel Communications, Inc., our wholly-owned subsidiary corporation, on May 13, 2004. The lawsuit alleges that our subsidiary has engaged in a pattern and practice of deceiving consumers into paying amounts in excess of their monthly rates by deceptively labeling certain line-item charges as government-mandated taxes or fees when in fact they were not. The complaint seeks to certify a class of plaintiffs consisting of all persons or entities who contracted with Z-Tel for telecommunications services and were billed for particular taxes or regulatory fees. The complaint asserts a claim under the Illinois Consumer Fraud and Deceptive Businesses Practices Act and seeks unspecified damages, attorneys’ fees and court costs. On June 22, 2004, our subsidiary filed a notice of removal in the state circuit court action, removing the case to the federal district court for the Northern District of Illinois, Eastern Division, C.A. No. 4 C 4187. On July 26, 2004, Plaintiff filed a motion to remand the case to the state circuit court. Plaintiff’s motion is still pending. Although we believe the plaintiff’s allegations are without merit and intend to defend the lawsuit vigorously, we cannot predict the outcome of this litigation with any certainty.

The availability to Z-Tel of unbundled network elements pursuant to section 251 of the Telecommunications Act of 1996 is currently subject to considerable legal uncertainty and litigation. In particular, our access to unbundled analog switching – a key component of the Unbundled Network Element Platform combination of elements, or UNE-P – is the subject of litigation by our Bell company competitors and other incumbent local exchange carriers. In 2003, in the Triennial Review Order, the Federal Communications Commission (“FCC”) ruled that entrants like Z-Tel would be able to purchase analog switching and dedicated transport on an unbundled basis, subject to state-by-state review of whether such unbundling was needed in their states. Carriers were involved in those state-by-state proceedings when, on March 2, 2004, the D.C. Circuit Court of Appeals overturned the FCC’s decision as an improper delegation of authority to state public utility commissions. See Report and Order and Order on Remand and Further Notice of Proposed Rulemaking, Review of Section 251 Unbundling Obligations of Incumbent Local Exchange Carriers, 18 FCC Rcd 16978 (2003) (“Triennial Review Order”), rev’d in part and remanded, United States Telecom Ass’n v. FCC, Nos. 00-1012, 00-1015, 03-1310 et al. (D.C. Cir. March 2, 2004) (“USTA II”).

The D.C. Circuit ordered that the unbundled transport and switching rules be vacated as of June 15, 2004. Both the U.S. Solicitor General and the FCC declined to appeal the case, and U.S. Supreme Court Justice William Rehnquist denied the request of Z-Tel and other CLECs for a stay of the decision. Z-Tel and a number of other competitive local exchange carriers filed a Petition for Writ of Certiorari before the United States Supreme Court, as did the State of California and the California Public Utilities Commission. Those appeals of the USTA II litigation were denied by when the Supreme Court denied certiorari on October 12, 2004.

On June 16, 2004, the D.C. Circuit decision in USTA II became effective and the FCC’s unbundling rules that were the subject of the appeal were vacated. Shortly thereafter, the largest four Bell operating companies (Verizon, BellSouth, SBC and Qwest) made several statements about their intent as to whether to continue to provide CLECs like Z-Tel access to unbundled switching (a critical component of the Unbundled Network Element Platform, or UNE-P) in certain circumstances, high-capacity loops, dedicated transport, and EELs. To varying degrees, we depend upon access to UNE-P, high capacity loops, transport and EELs to provide our services, including our new VoIP services.

On August 20, 2004, the Commission issued an Order and Notice of Proposed Rulemaking (“NPRM”) implementing interim rules in response to the D.C. Circuit’s vacatur in United States Telecom Ass’n v. FCC and seeking comment on permanent unbundling rules to

13

implement obligations under section 251(c)(3) of the Act. The Commission Order set forth a two-phase plan to govern the provision of unbundled network elements (“UNEs”) while the Commission considers permanent rules. Under the first phase of the interim plan, ILECs must continue to make available dedicated transport, mass market switching and enterprise loops in accordance with the rates, terms and conditions set forth in their interconnection agreements as of June 15, 2004. Under the second phase of the plan, ILECs would be required for an additional six months to continue to provide such UNEs to requesting carriers for the embedded customer base subject to the rate increases specified in the Commission’s Order. In its NPRM, the Commission sought comment on how to establish sustainable new unbundling rules in response to the D.C. Circuit’s decision. Specifically, the Commission sought comment on how various ILEC offerings and obligations fit into the unbundling framework, how best to define the relevant markets to develop unbundling rules and how to make determinations on access to individual network elements. In conjunction with CompTel and Pace Industry Associations, Z-Tel has participated in responding to the FCC’s request for comments in this proceeding. Z-Tel plans to remain active in these FCC proceedings, as it was during the Triennial Review proceeding in 2002 and 2003. Several state commissions are also considering options as to whether to impose unbundling obligations under state law, in the absence of federal requirements. Z-Tel intends to participate in those state proceedings to the extent that such state policies could have a material impact on Z-Tel’s operations.

On August 23, 2004, USTA, Qwest and Verizon filed a petition for mandamus at the D.C. Circuit. Among other things, they asked that the court retain jurisdiction of any TRO related cases, and that the Court order that the interim rules be vacated if the FCC does not produce impairment findings by December 31^st. The FCC responded and indicated that it plans to finish the Triennial rules by year-end. The D.C. Circuit has now issued an order to hold consideration of the mandamus petition pending further order of the court. Parties must file motions to govern further proceedings by January 4^th. In effect, this gives the FCC the opportunity to finish the rules by year-end without action by the court, but leaves the door open for the court to act if the FCC does not complete the job. By holding this motion in abeyance rather than rejecting it, the court has made it easier for itself to retain jurisdiction of the case. While it is to be expected that appeals of the final rules will be filed in various appeals circuits, this open mandamus petition makes it likely that they will be heard at the D.C. Circuit. That is significant, because it means that the final rules will be judged under the D.C. Circuit’s interpretation of the Telecom Act. Given the D.C. Circuit’s ruling on the TRO and statements made by various commissioners at the time the interim rules were issued and since then, it is our expectation that the FCC will produce final rules on at least some of the Triennial issues by year end.

If the FCC does not write adequate final UNE rules or if state commissions do not take action under state law, there could be an immediate, significant, adverse and material impact upon our business. ILECs might utilize the reversal of the unbundling rules to deny us access to their local networks or sharply increase the price of that access. We believe that in the event the vacated unbundling rules are not replaced by either the FCC or the state commissions, we have interconnection agreements with our principal ILEC suppliers (including Verizon, SBC, BellSouth and Qwest) that will permit us to obtain access to local network elements during the intervening time period. However, several of these Bell companies have provided us notice that they wish to renegotiate those agreements to take into account the vacating of the unbundling rules. Negotiation and arbitration of those terms is likely to take some time and could result in uncertainty as to our legal rights in the interim. It is also possible that while those negotiations are pending, any or all of those incumbent local telephone company suppliers will refuse to abide by the terms of the existing agreements or terminate those agreements outright. Z-Tel is currently evaluating all of its legal options to ensure that we can continue to meet the needs of our existing and future customers. We believe we have legal rights to purchase these elements pursuant to state law and under section 271 of the telecommunications Act of 1996, which the FCC has ruled to be a separate, alternative legal requirement for Bell companies to provide wholesale network access. However, enforcing those rights could be costly and require simultaneous litigation throughout our multi-state service area, and the final result of such litigation may or may not assure us of these alternative means of access.

Therefore, there is considerable uncertainty about the rates, terms and conditions by which we will be able to access the local networks of the ILECs at this time. This legal uncertainty can harm our business and could affect our ability to secure financing for our ongoing operations and our investment in new facilities and equipment. The uncertainty also harms our business by making it more difficult to sell our services. If ILECs attempt to impose wholesale price increases and regulators or courts do not act to stop such action, it may become uneconomic for Z-Tel to offer service in many, if not all, of the territories where we currently offer services. Z-Tel is actively considering all of its options in response to this uncertainty, which may include retail price increases, limitation or scaling back of our current business plan, reductions in overhead or staffing, as well as litigation or regulatory actions. We have and will continue to communicate these challenges to regulators and policymakers throughout the United States Government and the states.

With regard to pricing of network elements, states and the FCC are currently re-evaluating the pricing of network elements. As a result, it is possible that some states could increase or lower rates from existing levels. Currently, the incumbent local exchange carriers Verizon, BellSouth, SBC and Qwest have rate cases pending before state regulatory commissions in at least one state in each of their respective territories. Our intent is to be an active participant in many of these rate cases and any others that might be critical to our operations. The FCC is also currently reevaluating its prescribed methodology for calculating unbundled network element rates. In the 2002 Verizon v. FCC decision, the U.S. Supreme Court affirmed the FCC’s current pricing methodology, called “Total Element Long Run Incremental Cost,” or “TELRIC.” The current FCC rulemaking proposes to modify the TELRIC methodology by mandating that states set prices based upon the forward-looking costs of operating the existing network architecture of incumbent local telephone company networks. In many instances, modifying the TELRIC methodology in this way could increase the rates we pay for certain elements and result in lower rates for other elements. We believe that the FCC’s proposals to modify TELRIC are inconsistent with the Supreme Court’s decision in the Verizon case, meaning that new FCC TELRIC rules may be subject to considerable litigation

14

if they are adopted. Finally, all four Bell companies also have pending before the FCC petitions asking that the FCC forbear from application of the “TELRIC” pricing rules for UNE-P access. Z-Tel has opposed those petitions, but by operation of law, the FCC is required to address those petitions by the end of this year.

During the pendency of the Triennial Review proceeding described above, Verizon filed a petition requesting that the FCC forbear from applying items four through six and ten of the Telecommunication Act’s section 271 checklist once the corresponding elements no longer need to be unbundled under section 251(d)(2). Immediately prior to the Commission’s statutory deadline to rule on its petition, Verizon submitted a letter requesting that the Commission limit the pending forbearance petition to the broadband elements that the Commission found on a national basis in the Triennial Review proceeding do not have to be unbundled under section 251. The FCC denied that petition, and Verizon sought judicial review of the Commission’s order. In an opinion released in July 2004, the Court of Appeals for the D.C. Circuit found that the Commission had failed adequately to explain its decision not to grant Verizon’s original petition, and remanded the matter to the Commission. BellSouth, SBC and Qwest then filed petitions seeking similar relief to that sought by Verizon. On October 27, 2004, the FCC released an Order in which the Commission forbear from enforcing the requirements of section 271, for all four petitioners (the Bell Operating Companies (BOCs)), with regard to the broadband elements that the Commission, on a national basis, relieved from unbundling in the TRO. The elements identified by the FCC which no longer require availability under Section 271’s checklist are fiber-to-the-home loops (FTTH loops), fiber-to-the-curb loops (FTTC loops), the packetized functionality of hybrid loops, and packet switching. At this time, the impact of the FCC’s October 27th Order in this proceeding upon Z-Tel’s future service offerings has yet to be determined.

In the ordinary course of business, we are involved in legal and regulatory proceedings, disputes and tax audits at the federal, state and local level that are generally incidental to our ongoing operations. In addition, from time to time, we are the subject of customer and vendor complaints filed with the state utility commissions of the states in which they operate or the Federal Communications Commission. Most complaints are handled informally and at this time there are no formal proceedings pending. While there can be no assurance of the ultimate disposition of incidental legal proceedings or customer complaints, we do not believe their disposition will have a material adverse effect on our consolidated results of operations or financial position.

NOTE 14. SEGMENT REPORTING

We have two reportable operating segments: Retail Services and Wholesale Services.

The retail services segment includes our Z-LineHOME® and Z-LineBUSINESS® services that offer bundled local and long-distance telephone services in combination with enhanced communications features accessible, through the telephone, the Internet and certain personal digital assistants. We offer Z-LineHOME and Z-LineBUSINESS in forty-nine states. Our customers are primarily concentrated within metropolitan areas in ten states for both our Z-LineHOME and Z-LineBUSINESS services. The top five states with approximate customer concentrations are: New York 34%, Michigan 9%, Illinois 9%, Georgia 7% and Texas 6%. This segment also includes our Touch 1 residential long-distance 1+ offering that is available nationwide as well as our VoIP offering that was launched for beta customers in May 2004. The SipStorm sale was part of our retail services segment.

The wholesale services segment allows companies to offer telephone exchange and enhanced services to residential and small business customers. This service is currently available in forty-nine states and Sprint is our primary customer within this line of business.

Management evaluates the performance of each business unit based on segment results. It is also important to note that we only record directly assignable expenses against the wholesale services business segment and therefore, all employee benefits, occupancy, insurance, and other indirect or corporate related expenses are reflected in the retail services business segment.

The following summarizes the financial information concerning our reportable segments for the three months ended September 30, 2004 and 2003:

The following summarizes the financial information concerning our reportable segments for the nine months ended September 30, 2004 and 2003:

15

The following table reconciles our segment information to the consolidated financial information for the three and nine months ended September 30, 2004 and 2003:

NOTE 15. SUBSEQUENT EVENTS

In October 2004, we reached an agreement with Qwest Corporation that would allow us to continue to provide our enhanced wire line and broadband telecommunications services in the Qwest service territory regardless of the outcome of pending regulatory proceedings. Under the agreement, Qwest has committed to provide Z-Tel with access to its Qwest Platform Plus Service (QPP) as a replacement to today’s Unbundled Network Element Platform (UNE-P) throughout its 14-state service area until July 2008. QPP offers Z-Tel access to the same network elements, features and functions as Z-Tel purchases today from Qwest.

In October 2004, we issued a tender offer to exchange our three outstanding series of convertible preferred stock as follows:

A vote on this offer, along with certain related matters, is scheduled at the shareholders meeting planned for November 19, 2004. The offer and related conversions is expected to be completed by the end of November 2004. If all of the holders of the outstanding preferred stock elect to exchange their shares, on a fully diluted basis, the holders of the Series D Preferred Stock will own approximately 34.0% of Z-Tel’s outstanding common stock, the holders of the Series E Preferred Stock approximately 35.0%, the holders of the Series G Preferred Stock approximately 9.2%, the existing holders of the common stock approximately 13.8% and approximately 8.0% will be available for issuance under a new management equity incentive plan.

A Nasdaq Listing Qualifications Hearing Panel has granted us a temporary exception from shareholders' equity/$35 million market value of listed securities/net income and minimum bid price requirements for continued listing on The Nasdaq SmallCap Market, subject to certain conditions, including submission of documentation indicating compliance with all the requirements for continued listing on the SmallCap Market before expiration of the exception. The exception expires December 1, 2004. If Z-Tel meets the terms of the exception, our shares will continue to be listed on the SmallCap Market. We have plans in place, including a tender offer to our preferred shareholders and a reverse stock split, to meet the terms of the exception, but we cannot assure the success of those plans. Commencing Monday November 8, 2004 and for the duration of the exception, the trading symbol for Z-Tel’s shares will be “ZTELC.”

16

Effective October 29, 2004, Chuck Hyman resigned from our Board of Directors.

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

You should read the following discussion together with the “Selected Consolidated Financial Data,” financial statements and related notes included in this document. This discussion contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those projected in the forward-looking statements as a result of certain factors, including, but not limited to, those discussed in “Item 1. Business,” “Cautionary Statements Regarding Forward-Looking Statements,” and “Risks Related to our Financial Condition and our Business” included in our Form 10-K filed with the Securities and Exchange Commission on March 30, 2004. Factors that may affect our results of operations include, but are not limited to, our limited operating history and cumulative losses, uncertainty of customer demand, potential software failures and errors, potential network and interconnection failure, dependence on local exchange carriers, dependence on third party vendors, success and profitability of our wholesale services, dependence on key personnel, uncertainty of government regulation, legal and regulatory uncertainties, and competition. We disclaim any obligation to update information contained in any forward-looking statement.

OVERVIEW

We are an emerging provider of advanced, integrated telecommunications services targeted to residential and business customers. For management purposes, we are organized into two reportable operating segments: retail services and wholesale services. In addition to providing our services on a retail basis, we are also providing these services on a wholesale basis. Our wholesale service offering allows other companies to have the ability to utilize our telephone exchange services, enhanced services platform, and even our infrastructure and back-office operations to provide services on a retail basis to their own end users under their own private label brand. Under such an arrangement our wholesale services customer owns the resulting base of end users and we simply earn a cost plus fee from our wholesale services customer typically structured on a per month per line in service basis. The nature of our business is rapidly evolving.

Historically we have utilized the unbundled network elements platform (“UNE-P”) as the basis of delivering our primary services to our retail end users and end users of our wholesale customers. Under UNE-P we utilize various elements of the incumbent local exchange carriers’ to facilitate the delivery of our services to our own end users and the end users of our wholesale services customers.

Our current business strategy is to maintain our existing retail UNE-P base while deploying our own facility-based network for voice-over Internet protocol (“VoIP”) services. We launched our VoIP service to business customers in May 2004 in Florida and Georgia. We expect to have a residential offering available in Florida and New York during the fourth quarter of 2004. To support the residential offering, the network deployments will consist of collocating equipment in the ILEC’s end offices. We also intend to increasingly convert our residential customer base from the UNE-P platform to the VoIP platform as we turn up more markets. This should reduce our dependence on the ILECs and provide additional cost savings to increase our operating profitability with greater product flexibility. We may or may not be successful in this endeavor.

As our facility-based networks are deployed, we are ramping up on sales and marketing efforts in order to drive customer growth. We concentrated our efforts during the second quarter on preparing for our full scale VoIP launch in the Tampa and Atlanta markets. We have a full in-house sales force operating in Tampa and Atlanta. During the fourth quarter, this sales force will be expanded to New York and will continue to expand based on our network deployment schedules. Our fourth quarter 2004 financial and operating results will include our investments to expand our business services unit and to prepare for our VoIP initiatives we expect to increasingly expand through 2005.

We focused the balance of our resources during the third quarter of 2004 on growing our residential and business UNE-P base. Although some of the cost will be seen in the third quarter financial results, the line count impact will mainly be seen in the fourth quarter. Importantly, we are obtaining clients within this part of our business services unit that we can potentially convert to our VoIP platform as we turn up various markets.

On September 29, 2004 we signed an agreement with SipStorm, Inc., a company formed by our former Chief Executive Officer, D. Gregory Smith and former Chief Technology Officer, Charles McDonough. Under this agreement, we have transferred selected computer hardware, software and intellectual property rights to SipStorm. These non-core assets are mainly related to our second generation enhanced service products. SipStorm will continue development of these applications and will provide us with access to the developed product over the course of the next 15 months. Relative to the purchase, SipStorm has assumed responsibility for certain accounts payable, future maintenance payments and provided a promissory note in the amount of $2.8 million. The promissory note is secured by shares of our preferred stock held by Messrs. Smith and McDonough. In the third quarter, we wrote-off approximately $1.9 million in outstanding accounts payable, $2.7 million in capitalized software and $0.4 million in computer hardware as a result of this transaction and the discontinued operations that resulted from management’s change in business focus.

In evaluating our financial condition and operating performance the most important matters on which we focus are lines in service, revenue per unit, cost per unit, bad debt expense, expenses as a percentage of revenues and results by operating segment. These measures and other analysis are discussed in detail throughout the following paragraphs and provide insight into how we analyze and review our business. Because of significant uncertainty in the regulatory environment in which we operate (created by a recent court case, See Part II, Item I, Legal Proceedings), we must monitor and respond to any negative regulatory developments.

CONSOLIDATED RESULTS OF OPERATIONS

The three and nine months ended September 30, 2004 compared to the same period in the prior year.

17

The following consolidated Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with results by segment. Key selected financial and operating data for the three and nine months ended September 30, 2004 and 2003 are as follows:

(*) Not meaningful

18

Revenues. The decrease in revenue for the third quarter 2004 from the third quarter 2003 was primarily a result of the decline in residential UNE-P lines, access fee revenue declines and the loss of MCI as a wholesale services customer. Revenues decreased by $21.8 million to $60.9 million for the three months ended September 30, 2004, compared to $82.7 million the prior year. Revenues decreased by $21.4 million to $193.2 million for the nine months ended September 30, 2004, compared to $214.6 million the prior year.

The following table provides a break-down of our revenues and changes for the three and nine months ended September 30, 2004 compared to the same period in 2003:

Two significant drivers impact our revenues: lines in service and average monthly revenue per unit (“ARPU.”) The more significant driver impacting our changes in revenue is the amount of lines in service. The following table provides a break-down of our lines in service:

19

ARPU provides a business measure of the average monthly revenue generation attributable to each line in service. ARPU is calculated by taking total revenues divided by the number of months in the period and is divided by the average lines in service during the period. We use this measure when analyzing our retail services revenue, but not when assessing our wholesale services revenue. This is due to the gross accounting method used to record our wholesale services revenue which makes the ARPU calculation for wholesale services a largely meaningless business measure. The following table provides a summary of our ARPU: