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

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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES

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

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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES

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

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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES

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

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Z-TEL TECHNOLOGIES, INC. AND SUBSIDIARIES

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

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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

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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).

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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

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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

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“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